Understanding taxation law 2018 [(2018 Edition)] 9780409346923, 0409346926

Table of contents :
Full Title
Copyright
Preface
How to Use Understanding Taxation Law 2018
Table of Cases
Table of Statutes
Table of Contents
Chapter 1 Introduction
Nature of taxation
Historical development of income tax
The constitutional basis of taxation
Federal income taxation
Sources of taxation law
Statutory interpretation
Structure of the book
Chapter 2 Structure of the Acts and the Income Concept
Introduction
The income concept examined
Income under the ITAA97
Jurisdictional matters: An overview
Chapter 3 Income According to Ordinary Concepts
Introduction
Proposition 1: Amounts not convertible into money are not ordinary income
Proposition 2: Capital amounts do not have the character of income
Proposition 3: Gifts unrelated to employment, services or business do not have the character of income
Proposition 4: The proceeds of gambling and windfall gains are not income
Proposition 5: Mutual receipts are not income
Proposition 6: To be income, an amount must be beneficially derived
Proposition 7: Income is to be judged from the character it has in the hands of the recipient
Proposition 8: Income generally exhibits recurrence, regularity and periodicity
Proposition 9: Amounts derived from employment or the provision of services are income
Proposition 10: Amounts derived from carrying on a business are income
Proposition 11: Amounts derived from property are income
Proposition 12: Amounts received as substitutes for or compensation for lost income are themselves income
Conclusion
Chapter 4 The Derivation and Measurement of Income
Introduction
Refinements of the accrual basis
Profit as assessable income
Limits of specific profit
Deemed derivation
Conclusion
Chapter 5 Statutory Income
Introduction
Division 15: Some items of assessable income
Division 20: Amounts included to reverse the effect of past deductions
Retirement and termination payments
The remaining ITAA36 and ITAA97 framework
Chapter 6 Capital Gains Tax
Introduction
Fundamentals of CGT
CGT events
Entity making the gain or loss
Case study on CGT event A1
Chapter 7 Fringe Benefits Tax
Introduction
Historical background, tax policy and alternative mechanisms for taxing fringe benefits
Application of the fringe benefits tax: An overview
FBTAA definition of ‘fringe benefit’
Quantifying an employer’s fringe benefits tax liability
General principles applicable in valuing benefits
Rules for specific types of fringe benefit
Exempt fringe benefits
Reconciliation with income tax
Rebate for tax-exempt employers
Principles of salary packaging
Chapter 8 General Deductions
Introduction
The general deduction provision
The provision analysed
Conclusion
Chapter 9 Specific Deductions
Introduction
ITAA97 Div 25: Specific allowing and qualifying provisions
ITAA97 Div 26: Specific denying provisions
Deductions of particular amounts
The remaining ITAA36 framework
ITAA97 Pt 2-42 Divs 84–87: Personal services income
Limited recourse debt: ITAA97 Div 243
Forgiveness of commercial debt: ITAA97 Div 245
Chapter 10 Capital Allowances
Introduction
Key features of the ITAA97 Div 40 regime
The meaning of ‘depreciating asset’
The meaning of ‘hold a depreciating asset’
How decline in value is calculated
Key concepts used in calculating decline in value
The meaning of ‘taxable purpose’
Balancing adjustments
Roll-over relief
Relief for involuntary disposals
Low-value and software development pools
Project pools: Capital allowances for ‘black hole’ expenditure
Business-related costs
Depreciation under the simplified tax system
Capital works in ITAA97 Div 43
The basic conditions for ITAA97 Div 43 deductibility
Key elements in ITAA97 Div 43
How to calculate ITAA97 Div 43 deductions
Consequences of disposal of ITAA97 Div 43 capital works
Uniform capital allowances: Proposed technical changes
Chapter 11 Trading Stock
Introduction
Scheme of ITAA97 Div 70
Trading stock defined
Valuation of trading stock
Non-business disposals
Non-arm’s length transactions
Chapter 12 Taxation of Companies
Introduction
Types of corporate tax systems
The company as a tax entity
Classification of interests in companies under the debt and equity rules
What is a company for tax purposes?
The distinction between private and public companies
The Australian dividend imputation system: The company’s perspective
The franking account
Franking a distribution
Anti-dividend streaming rules
Anti-franking credit trading rules
Tainting and untainting the share capital account
Anti-capital benefit streaming rules
Changes in corporate ownership: Tax effects other than CGT
Consolidated groups
CGT from a company’s perspective
CGT roll-overs and companies
Chapter 13 Taxation of Shareholders
Introduction
Dividends as income under ordinary concepts
The Australian dividend imputation system: The shareholder’s perspective
The ITAA36 definition of ‘dividend’
Deemed dividends
Non-share dividends
Tax effects for shareholders of a receipt of dividends
Alternative forms of corporate distribution: ITAA rules
Gross-up and tax offset denied where imputation system manipulated
CGT from a shareholder’s perspective
Value shifting provisions
CGT roll-overs and shareholders
Demerger relief
2016 Tax incentives for investment in early stage innovation companies
Chapter 14 Taxation of Partnerships
What is a partnership for tax purposes?
The basic tax treatment of partnership income
Derivation of partnership income and incurring a partnership loss
The tax treatment of partners’ salaries and other internal transactions
The consequences of a change in the composition of a partnership
Payments for work in progress on a change in composition
Statutory provisions applicable on a change in composition
The assignment of partnership interests
Anti-avoidance provisions relevant to partnerships
Partnerships and dividend imputation
CGT and partnerships
Taxation of limited partnerships
Foreign hybrids
Chapter 15 Taxation of Trusts
Introduction
Scope of the tax provisions dealing with trusts
Fundamentals of the taxation of trusts
The meaning of the terms used in ITAA36 Pt III Div 6
Problems where trust income and tax income differ
Trusts and dividend imputation: Receipt of franked dividends
CGT and trusts
Trusts of deceased estates
Unit trusts which are taxed as companies
Trust loss provisions
Measures to curtail avoidance through chains of trusts
Trusts and consolidated groups
Trusts and demerger relief
Chapter 16 Tax Administration
Introduction
Legislative overview and the Commissioner’s powers of administration
The self-assessment system
Income tax returns
Assessments
Taxpayer advice
Record-keeping obligations of taxpayers
Commissioner’s information-gathering powers
Disputes with the Taxation Office
Objections, reviews and appeals
Methods to improve compliance: Penalties
Collection of taxes
Mechanisms for enforced collection
Settlement arrangements and compromise of debt
Chapter 17 Anti-Tax Avoidance Measures
Introduction
General anti-avoidance measures
Specific anti-tax avoidance measures
Chapter 18 International Aspects
Introduction
Taxation of residents
Taxation of foreign residents
Thin capitalisation
Transfer pricing
Australia’s responses to the OECD BEPS actions on transfer pricing
Double taxation agreements
The Multilateral Instrument
Amendments to Pt IVA in response to BEPS
Other aspects of Australia’s response to the BEPS Reports and recent developments
Chapter 19 Goods and Services Tax
Background
The basics of GST
Special treatment of ‘exempt supplies’
Central provisions of GST
Taxable supplies
Security deposits
Enterprise
Registration
Taxable importations
Liability for GST
GST-free supplies
Input taxed supplies
Non-taxable importations
Anti-avoidance
Conclusion
Index

Citation preview

Understanding Taxation Law 2018

Understanding

Taxation Law 2018 JOHN TAYLOR BA, LLB, LLM (Hons), PhD (Syd), Cert H Ed (UNSW) PROFESSOR School of Taxation and Business Law Business School UNSW Australia MICHAEL WALPOLE BA, LLB, Grad Dip Tax (Natal), PhD (UNSW) PROFESSOR School of Taxation and Business Law Business School UNSW Australia MARK BURTON LLB (Hons) (UTas), PhD (ANU) ASSOCIATE PROFESSOR Melbourne Law School University of Melbourne TONY CIRO BEc (Hons), LLB (Hons) (Monash), BCL (Oxon), PhD (Monash) PROFESSOR Faculty of Law and Business Australian Catholic University IAN MURRAY BSc (Hons), LLB (Hons) (UWA), LLM (UNSW) SENIOR LECTURER Faculty of Law University of Western Australia

LexisNexis Butterworths Australia 2018

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© 2018 Reed International Books Australia Pty Limited trading as LexisNexis. First edition 2002; Second edition 2004; Third edition 2009; Fourth edition 2010; Fifth edition 2011; Sixth edition 2012; Seventh edition 2014; Eighth edition 2016. Ninth edition 2017. Reprinted 2005, 2006 and 2008. This book is copyright. Except as permitted under the Copyright Act 1968 (Cth), no part of this publication may be reproduced by any process, electronic or otherwise, without the specific written permission of the copyright owner. Neither may information be stored electronically in any form whatsoever without such permission. Inquiries should be addressed to the publishers. Typeset in ITC StoneSans and Sabon. Printed in China. Visit LexisNexis Butterworths at www.lexisnexis.com.au

Preface There is value in drawing an analogy between the Australian taxation system and the distinction, known to the earliest astronomers and navigators, between fixed stars and planets. The fixed stars were, of course, real stars — suns of other solar systems — which appeared fixed because the technology of the time was unable to detect their movement. By contrast, the planets of our solar system were revolving around the sun and, hence, moving in patterns that could be discerned even with a trained naked eye. By tracking the movement of the moon and planets relative to the fixed stars, and armed with an accurate clock and a mass of charts and tables, early navigators could determine their position at sea. Likewise, the Australian taxation system can be seen as an almost constantly changing foreground — the detailed legislation and rulings that seek to give effect to underlying policy choices — and a more fixed background of principle and policy issues that never really go away. All analogies, of course, break down at some point. Although almost as large as the universe, the Australian taxation system differs from it in that the constantly changing foreground is far larger and more technically complex than the fixed background of principle and policy behind it. The result is a tendency in text and commentary writing to focus on the complex details of the foreground at the expense of the background. Our view is that, while detailed legislative provisions are important, they should be grappled with against the background of the issues that caused them to exist in the first place. We believe it is useful for the student of taxation to navigate by viewing the vast, detailed and complex foreground that is the Australian taxation system against the

more stable, and in some respects simpler, background of principle and policy issues that the system seeks to address. For this reason, in the chapters that follow we have generally tried to include a discussion of the historical and/or policy background and, in some cases, design choices that stand behind the existing legislation. Frequently, we have tried to tease out policy and design considerations by the use of questions and activities. We believe that the current tax environment amplifies the need for such an approach. Greater disruption and division arising from globalisation, demographic and technological change and a more uncertain world, from economic and geopolitical perspectives are leading to widespread demands for a more responsive tax regulator, greater tax transparency and ‘fairer’ taxation. While there has been much noise about reform of the Australian domestic tax system, the reform process is largely piecemeal. It is in relation to businesses and individuals operating overseas that fast moving and widespread changes are being made. For instance, the Base Erosion and Profits Shifting actions at the international level and domestic anti-avoidance laws such as the Multinational Anti-Avoidance Law and the Diverted Profits Tax. Australia’s federal tax regulator, the Australian Taxation Office is currently also ‘reinventing’ itself. In considering and responding to these demands and reforms it is vitally important not to lose sight of the tax system’s background of principle and policy. Navigation also involves limiting your knowledge by concentrating on the more important aspects of what is to be known. By an awareness of the positions of key fixed stars and of the patterns of movements of the moon and planets, you can determine where you are. Endeavouring to have a detailed knowledge of the precise terms of the entirety of the Australian tax legislation would be both pointless and impossible. But by understanding the operation of certain key structural provisions in the legislation, the student will gain a sense not only of how the system as a whole fits together but also of where the inevitable new developments fit into the system. Hence, we have limited the detailed discussion in the chapters that follow to those features of the Australian taxation system that we believe are foundational to an understanding of

the system as a whole. Provisions that are less important structurally or which have more limited general significance or are of undue complexity are discussed on the web page that accompanies the book. Navigation is about skill as much as it is about knowledge and vision. Skill in navigation is all about doing it; about getting used to using instruments; about finding your way. In studying taxation law, certain key skills should be developed. These include: an ability to appreciate the overall effect of legislative provisions and what impact they have on existing principles; an ability to ascertain the meaning of legislative provisions; a familiarity with reading and understanding the significance of cases; and an ability to apply legislative provisions and principles from cases in a commercial context. Skills are developed incrementally. You must practise using navigational instruments before you venture into the open sea. Throughout the chapters that follow, we have tried incrementally to develop skills in reading and applying legislation and cases. We have included digestible extracts from cases with fact summaries and key passages from the judgments. We have extracted key provisions from the legislation and key passages from Australian Taxation Office (ATO) rulings. Our hope is that students reading these extracts in the context of a chapter will gradually become less intimidated by legislation and cases and will develop the necessary skills in understanding and applying them. To assist in this process, we have included activities, discussion questions, problems and case studies. Charts are, of course, one of the oldest navigational aids of all. We have been conscious that learning styles differ among learners and that some respond to visual cues rather than verbal ones. For this reason, we have included diagrams, charts, tables and examples. We have also included a set of learning objectives at the beginning of each chapter and have tried to express these in terms of outcomes that may be assessed by either a student or a teacher. The book concentrates on the Income Tax Assessment Act 1997

(Cth) (ITAA97) and the Income Tax Assessment Act 1936 (Cth) (ITAA36), and on the jurisprudence interpreting those Acts and associated Acts. Chapters on fringe benefits tax (FBT) and goods and services tax (GST) have also been included. Note that references to legislation are to Commonwealth Acts unless specified otherwise. In general, the law has been stated as at the end of August 2017 but, where possible, significant subsequent developments as late as 1 October 2017 have been noted. Some significant changes since the last edition include: Updating references to the ATO website and ATO Rulings in Chapters 1 and 2. Including in Chapter 3 a discussion of the High Court decision in Blank v FCT [2016] HCA 42; 2016 ATC 20-586. Including in Chapter 6 a note of TD2017/1 on whether intangible capital improvements can be separate assets from land via the operation of s 108-70(2) or (3). A discussion in Chapter 12 of changes to the corporate tax rate for companies with an aggregated turnover of less than $10 million for the income years from 2016–17 up to 2023–24 and how these changes affect the operation of the dividend imputation system. Chapter 12 also includes a discussion of the changes proposed to the corporate loss carry forward rules by the Treasury Laws Amendment (2017 Enterprise Incentives) Bill 2017 which had not passed through Parliament at the time the chapter was updated. Chapter 13 takes into account the effect of the changes in the corporate rate on the dividend imputation system as it affects shareholders. Chapter 13 also includes a discussion of s 207-157 dealing with ‘dividend washing’. References to ATO websites and ATO Rulings have been updated in Chapter 16. Chapter 18 takes into account the effects of changes in the Australian corporate tax rate for foreign resident shareholders receiving dividends. Chapter 18 notes the increase in both the

withholding rate and the withholding threshold that apply to purchasers of certain taxable Australian property from foreign residents. Changes to Australian transfer pricing rules to take into account the BEPS final recommendations have been discussed. Chapter 18 also includes a discussion of Australia’s adoption of the Multilateral Instrument and a discussion of Australia’s Diverted Profits Tax. Chapter 19 has been significantly updated for changes to cross border supplies of both intangibles and of low value goods. Readers can look forward to further updates in the next edition as the low value goods legislation and offshore vendor registration becomes operative from July 2018. At LexisNexis Butterworths, we would like to thank Pamela O’Neill, Georgina Gordon, Geraldine Maclurcan, Gem Erika Lee and our editor Annabel Adair. John Taylor would like to thank Amy Koit for updating Study help pages relating to the chapters that he was responsible for. Once again, each of us would like to thank his family for their patience and support. 26 October 2017

How to use Understanding Taxation Law 2018 This book contains features that support learning a nd help you identify the important principles of taxation law. This prepares you for tutorials, assignments and exams.

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References are to paragraph numbers Bold numbers indicate main case references Italic numbers indicate footnote references

Table of Cases A ABB Australia Pty Ltd v FCT (2007) …. 4.41 Abbott v Philbin [1961] …. 3.5, 5.46, 5.47 Aberdeen Construction Group Ltd v IRC [1977] …. 6.110 Academy Cleaning & Security Pty Ltd v DCT [2017] …. 8.40, 8.52 AGC (Advances) Ltd v FCT (1975) …. 3.13, 8.21, 8.22, 8.23, 8.26, 8.56, 8.65, 9.1, 9.24 AGC (Investments) Ltd v FCT (1992) …. 3.13, 3.54 Airservices Australia v Canadian Airlines International Ltd (1999) …. 6.93 Aktiebolaget Volvo v FCT (1978) …. 3.66, 5.12 All States Frozen Food Ltd v FCT (1990) …. 11.2, 11.16 Allen (Inspector of Taxes) v Farquharson Bros & Co (1932) …. 8.26 Alliance Insurance Co Ltd v FCT (1921) …. 8.4 Allied Mills Industries Pty Ltd v FCT (1989) …. 3.18 Allina v FCT (1991) …. 13.109 Allison v Murray [1975] …. 6.112 Allman v FCT (1998) …. 3.19, 3.68 Allsop v FCT (1965) …. 3.20 Altnot Pty Ltd and FCT, Re [2013] …. 6.150 Amalgamated Society of Engineers v Adelaide Steamship Co Ltd (1920)

…. 1.9 Amalgamated Zinc (de Bavay’s) Ltd v FCT (1935) …. 8.4, 8.7, 8.10, 8.11, 8.12, 8.21, 8.22, 8.23, 8.26, 8.54, 8.56, 8.59, 8.71 Amway of Australia v FCT …. 7.43 Anderson v CT (Vic) (1937) …. 1.27 ANZ Banking Group Ltd v FCT (1994) …. 8.45, 8.46 Archer Brothers Pty Ltd v FCT (1953) …. 13.68–13.70 Armco (Australia) Pty Ltd v FCT (1948) …. 2.11 Armirthalingam and Commissioner of Taxation [2012] …. 16.11 Arthur Murray (NSW) Pty Ltd v FCT (1965) …. 2.6, 4.15, 4.16–4.20, 4.36, 4.38, 4.40, 11.17 Ash v FCT (1938) …. 8.26, 8.54 Ashgrove Pty Ltd v FCT (1994) …. 6.34 Associated Minerals Consolidated Ltd v FCT (1994) …. 8.59 Associated Newsagents Co-operative Ltd v FCT (1970) …. 2.23 Atlas Tiles Ltd v Briers (1978) …. 5.32 Atwood Oceanics Australia Pty Ltd v FCT (1989) …. 7.40 Ausnet Transmission Group Pty Ltd v FCT (2015) …. 3.15 Australasian Catholic Assurance Co Ltd v FCT (1959) …. 3.53, 3.56, 4.21, 4.23, 11.3 Australasian Jam Co Pty Ltd v FCT (1953) …. 11.21, 11.24 Australian Dental Association (NSW) v FCT (1934) …. 2.21 Australian Insurance Association v FCT (1979) …. 2.23 Australian Machinery & Investment Co Ltd v DFCT (1946) …. 2.44, 2.48, 11.5, 11.11 Australian Mercantile Land and Finance Co Ltd v FCT (1929) …. 3.64 Australian National Hotels Ltd v FCT (1988) …. 8.13, 8.56, 8.69 AVCO Financial Services Ltd v FCT (1982) …. 3.21, 11.11 Avondale Motors (Parts) Pty Ltd v FCT (1971) …. 12.99

B

Babka v FCT (1989) …. 3.26, 3.47, 3.49, 3.51, 8.27 Ballarat Brewing Co Ltd v FCT (1951) …. 4.36, 8.44, 8.46, 8.48 Barclay’s Bank plc v IRC (UK) [1994] …. 13.107 Barclays Mercantile Business Finance Ltd v Mawson (Inspector of Taxes) [2005] …. 10.20 Barina Corp Ltd v FCT (1985) …. 11.20, 11.24, 11.25 Barratt v FCT (1992) …. 4.6, 4.11, 4.12, 4.13 Batchelor v FCT [(2014] FCAFC 41) …. 5.23 Beak v Robson [1943] …. 3.17 Bell & Moir Corp Pty Ltd v FCT (1999) …. 8.63 Best v FCT (2005) …. 7.40 BHP Billiton Petroleum (Bass Strait) Pty Ltd v FCT (2002) …. 4.13, 4.16, 4.16 BHP Billiton Direct Reduced Iron Pty Ltd v Duffus, DCT (2007) …. 9.65 Bivens v Six Unknown Named Agents of Federal Bureau of Narcotics (1971) …. 6.72 Blank v FCT [2016] …. 3.14, 5.4 Block v FCT 2007 …. 10.94 Blockey v FCT (1923) …. 3.56, 5.8, 8.57 Boating Industries Association of NSW v FCT (1985) …. 2.23 Bohemians Club v Acting FCT (1918) …. 3.30 BP Australia Ltd v FCT (1965) …. 3.13, 8.65–8.67 BP Oil Refinery (Bulwer Island) Ltd v FCT (1992) …. 9.8 BP Refinery (Kwinana) Ltd (1960) …. 10.36 Brajkovich v FCT (1989) …. 3.26, 3.28, 3.47, 8.27 Bray v FCT (1978) …. 9.46 Brent v FCT (1971) …. 3.15, 4.32, 4.42, 6.104 British Insulated & Helsby Cables v Atherton (1926) …. 8.61, 8.63 British Steel Corp v Granada Television Ltd [1981] …. 6.72 BRK (Bris) Pty Ltd v FCT (2001) …. 15.77, 17.4

Broken Hill Theatres Pty Ltd v FCT (1952) …. 6.111, 8.63, 8.67 Brooks v FCT (2000) …. 6.38, 6.46, 6.47 Brookton Co-operative Society Ltd v FCT (1981) …. 4.41, 13.34 Brown v FCT [2002] …. 3.23 Burnside and Marrakai Ltd v FCT (1957) …. 1.32

C Cachia v FCT (No 2) (2005) …. 9.62 Caelli Constructions (Vic) Pty Ltd v FCT [2005] …. 7.12 Cajkusic v FCT (2006) …. 15.80 California Copper Products Ltd (in liq) v FCT (1934) …. 3.18, 3.68 California Copper Syndicate Ltd v Harris (Surveyor of Taxes) (1904) …. 3.8, 3.9, 3.11, 3.12, 3.13, 3.44, 3.53, 3.56–3.58, 4.22, 5.45 Caltex Ltd v FCT (1960) …. 2.11 Calvert (Inspector of Taxes) v Wainwright [1947] …. 3.22, 3.39 Cameron v FCT (1923) …. 1.11 Cannop Coal Co Ltd v IRC (1918) …. 3.51, 8.58 Canny Gabriel Jackson Advertising Pty Ltd v Volume Sales (Finance) Pty Ltd (1974) …. 14.8, 14.81 Cappid Pty Ltd v FCT (1971) …. 2.21 Carapark Holdings Ltd v FCT (1967) …. 2.16, 8.13 Carlisle & Silloth Golf Club v Smith (1912) …. 3.30 Carpentaria Transport Pty Ltd v FCT (1990) …. 10.12, 10.13 Case 7/2010 (AAT) (2010) …. 6.130 Case 15/2004 (AAT) (2004) …. 9.26 Case 46/94 (AAT) (1994) …. 2.21 Case 11 (CTBR) (1952) …. 14.29 Case 19 (CTBR) (1946) …. 11.21 Case 24 (CTBR) (1961) …. 9.12 Case 31 (CTBR) (1972) …. 4.42

Case 45 (CTBR) (1978) …. 3.49 Case 56 (CTBR) (1962) …. 9.12 Case 59 (CTBR) (1968) …. 14.29 Case 75 (CTBR) (1954) …. 4.43 Case 81 (CTBR) (1985) …. 14.27, 14.29 Case 89 (CTBR) (1951) …. 15.70 Case 109 (CTBR) (1970) …. 4.18 Case 110 (CTBR) (1966) …. 14.29 Case 113 (CTBR) (1970) …. 4.18 Case 136 (CTBR) (1983) …. 8.75 Case 5877 (AAT) (1990) …. 10.52 Case 6086 (AAT) (1990) …. 9.47 Case 9451 (AAT) (1928) …. 15.105 Case 9465 (AAT) (1994) …. 10.52 Case 9723 (AAT) (1994) …. 2.21 Case 11431 (AAT) (1996) …. 6.106 Case B47 (1970) …. 4.18 Case B51 (1970) …. 4.18 Case C22 (1966) …. 14.29 Case C103 (1953) …. 5.32 Case D62 (1972) …. 4.42 Case K25 (1978) …. 3.49 Case L54 …. 5.4 Case M96 (1980) …. 3.64 Case R13 (1984) …. 8.37 Case S75 (1985) …. 14.27, 14.28, 14.29 Case T57 (1986) …. 9.46 Case T69 (1968) …. 14.27 Case T91 (1986) …. 9.23 Case U75 (1987) …. 5.32 Case U163 (1987) …. 5.32

Case V76 (1988) …. 5.4 Case V133 (1988) …. 8.37 Case W40 (1989) …. 3.20 Case X64 (1990) …. 9.47 Case X78 (1990) …. 2.43 Case Z9 (1992) …. 5.4 Casimaty v FCT (1997) …. 3.11 Cawthen (JR), Estate of and FCT, Re (2008) …. 6.86 Cecil Bros Pty Ltd v FCT (1964) …. 8.31, 8.32, 11.31 Charles Moore & Co (WA) Pty Ltd v FCT (1956) …. 8.6, 8.12–8.14, 8.26, 8.71, 9.26, 11.27 Checker Taxicab Co Ltd v Stone [1930] …. 14.10 Chow Yoong Hong v Choong Fah Rubber Manufactory [1962] …. 18.44 Church of the New Faith v Commr of Pay-roll Tax (Vic) (1983) …. 2.21 Cliffs International Inc v FCT (1979) …. 8.68 CMI Services Pty Ltd v FCT (1990) …. 3.54 Coal Developments (German Creek) Pty Ltd v FCT (2008) …. 12.102 Coleambally Irrigation Mutual Co-Operative Ltd v FCT (2004) …. 3.32 Coles Myer Finance Ltd v FCT (1993) …. 4.1, 8.42, 8.44, 8.47, 8.49, 8.50 Colonial Mutual Life Assurance Society Ltd v FCT (1946) …. 3.53, 3.56, 4.5, 4.22, 4.23, 8.27, 11.3 —v— (1953) …. 3.1, 3.35 Commercial and General Acceptance Ltd v FCT (1977) …. 2.11, 3.21, 3.56, 3.57, 4.24, 4.28, 11.11 Commercial Union Assurance Co of Australia Ltd v FCT (1977) …. 8.43, 8.45, 8.47 Commercial Union Australia Mortgage Co Ltd v FCT (1996) …. 4.18, 4.19 Commissioner for ACT Revenue Collections v Council of Dominican

Sisters of Australia (1991) …. 2.21 —v Eccentric Club Ltd [1924] …. 3.30 Commissioner of Inland Revenue (Cook Islands) v A B Donald Ltd (1965) …. 9.10 Commissioner of Inland Revenue (NZ) v Edge (1956) …. 11.27 —v Mitsubishi Motors New Zealand Ltd [1996] …. 8.46 —v National Bank of New Zealand (1977) …. 4.43 —v Philips Gloeilampenfabrieken (1954) …. 2.45 —v Wattie [1999] …. 3.61 —v Webber (1956) …. 8.26 Commissioner of Inland Revenue (UK) see IRC Commissioner of Pay-roll Tax (Vic) v Cairnmillar Institute (1992) …. 9.47 Commissioner of Stamp Duties (NSW) v Bryan (1989) …. 6.73 Commissioner of Stamp Duties (Qld) v Livingston [1965] …. 15.126, 15.127 Commissioner of Succession Duties (SA) v Executor Trustee & Agency Co of South Australia Ltd (1947) …. 6.93 Commissioner of Taxation (Cth) v All States Frozen Food Pty Ltd (1989) …. 11.14 —v Ampol Exploration Ltd (1986) …. 8.58 —v Anstis (2010) …. 8.15, 8.80 —v Applegate (1979) …. 2.38, 2.39 —v Australian Gas Light Co (1983) …. 4.13, 4.20 —v Australian Guarantee Corp (1984) …. 8.47, 8.50 —v Australian Music Traders Association (1990) …. 3.31 —v AXA Asia Pacific Holdings Ltd (2010) …. 6.94 —v Ballesty (1977) …. 8.79 —v Bamford (2010) …. 15.72, 15.80, 15.82 —v Beville (1953) …. 14.29 —v BHP Billiton Ltd (2011) …. 9.90

—v Bivona (1989) …. 3.45 —v Black (1990) …. 13.8, 13.10 —v Blake (1984) …. 3.24, 3.37, 3.39 —v Blakely (1951) …. 13.7 —v Brand (1995) …. 8.21, 8.23, 8.50 —v Brewing Investments Ltd (2000) …. 13.76 —v Brixius (1987) …. 16.47 —v Broken Hill Proprietary Co Ltd (1969) …. 10.36 —v Brown (1999) …. 8.22, 8.54, 8.59 —v Byrne Hotels Qld Pty Ltd [2011] …. 6.150 —v Chapman (1989) …. 8.59 —v Citibank Ltd (1993) …. 2.11, 4.26, 4.28, 4.39, 8.47 —v Citilink Melbourne Ltd (2006) …. 8.42 —v Collings (1976) …. 8.37, 8.79 —v Consolidated Press Holdings Ltd; CPH Property Pty Ltd v FCT (2001) …. 13.97, 17.8, 17.14 —v Cooke & Sherden (1980) …. 2.10, 3.4–3.6, 7.2 —v Cooling (1990) …. 2.15, 2.17, 2.18, 3.1, 3.55, 3.60, 3.61 —v Cooper (1991) …. 8.15, 8.20, 8.74 —v Copplestone (1981) …. 9.46 —v Creer (1986) …. 8.50 —v Cripps & Jones Holdings Pty Ltd (1987) …. 1.28 —v CSR Ltd (2000) …. 3.20 —v Cyclone Scaffolding Pty Ltd (1987) …. 4.25, 11.18 —v Dalco (1990) …. 16.38 —v David Jones Finance & Investments Pty Ltd (1991) …. 16.49 —v Day (2008) …. 8.7, 8.13 —v De Luxe Red and Yellow Cabs Cooperative (Trading) Society Ltd (1998) …. 7.58 —v Devuba Pty Ltd [2015] …. 6.150 —v Dixon (1952) …. 3.24, 3.37, 3.38, 3.39, 3.43

—v Donoghue [2015] …. 16.13 —v Dulux Holdings Pty Ltd (2001) …. 6.29 —v Dunn (1989) …. 4.12, 4.16, 4.36 —v Edwards (1994) …. 8.14, 8.75 —v Email Ltd (1999) …. 8.63 —v Energy Resources Australia Ltd (1996) …. 3.21, 8.50 —v Everett (1980) …. 14.24, 14.50, 14.51, 14.52, 14.75 —v Finn (1961) …. 8.56, 8.79, 8.80, 9.37 —v Firstenberg (1976) …. 4.11, 4.12, 4.13, 4.16, 4.36 —v Forsyth (1981) …. 8.14, 8.29, 8.70, 8.78 —v Foxwood (Tolga) Pty Ltd (1981) …. 8.41 —v French (1957) …. 2.43 —v Futuris Corp Ltd [2008] …. 16.13 —v Galland (1987) …. 14.24, 14.25, 14.29, 14.52 —v Genys (1987) …. 8.79 —v GKN Kwikform Services Pty Ltd (1991) …. 3.44, 3.52, 3.55, 3.68, 11.18 —v Grant (1991) …. 11.15, 14.39, 14.41 —v Green (1950) …. 8.55 —v Groser (1982) …. 3.39, 3.64 —v Guy (1996) …. 6.46, 6.92 —v Gwynvill Properties Pty Ltd (1986) …. 8.50 —v H [2010] …. 13.28 —v Happ (1952) …. 14.24, 14.32, 14.33 —v Harmer (1991) …. 15.73, 15.75 —v Harris (1980) …. 3.24, 3.39 —v Hart (2004) …. 17.3, 17.8, 17.11, 17.14 —v Hatchett (1971) …. 8.15, 8.20, 8.70, 8.72, 8.80 —v Hunter Douglas Ltd (1983) …. 3.21 —v Hyteco Hiring Pty Ltd (1992) …. 11.18 —v Ilbery (1981) …. 8.35, 8.50

—v Indooroopilly Services (Qld) Pty Ltd (2007) …. 7.11 —v Inkster (1989) …. 3.19, 3.37, 3.68 —v Isherwood & Dreyfus Pty Ltd (1979) …. 8.31 —v James Flood Pty Ltd (1953) …. 2.6, 4.15, 8.39, 8.40, 8.41, 8.42, 8.44, 8.46–8.49, 9.34, 9.36 —v Jenkins (1982) …. 2.38, 2.39 —v Jones [2002] …. 8.22 —v Klan (1985) …. 8.13, 8.15, 8.55 —v Kropp (1976) …. 8.15, 8.79 —v La Rosa (2003) …. 3.5, 3.29, 9.26, 9.42 —v Lascelles-Smith (1978) …. 8.15 —v Lau (1984) …. 8.50 —v Lawford (1937) …. 14.31, 15.130 —v Lean [2009] …. 9.26 —v Lenzo (2008) …. 17.14 —v McArdle (1988) …. 5.47 —v McDonald (1987) …. 14.2, 14.9, 14.22 —v McPhail (1968) …. 9.46 —v Macquarie Bank Ltd [2013] …. 12.112 —v McNeil (2005) …. 6.53, 13.5 —v— (2007) …. 3.35, 6.41–6.44, 6.53, 6.113, 13.2, 13.33, 13.115 —v Maddalena (1971) …. 8.24, 8.55, 9.29 —v Man (1985) …. 8.79 —v Marbray Nominees Pty Ltd (1985) …. 15.77 —v Markey (1989) …. 8.29 —v Marr (E A) & Sons (Sales) Pty Ltd (1984) …. 8.27, 8.59 —v Marshall & Brougham Pty Ltd (1987) …. 9.24 —v Melrose (1923) …. 14.24 —v Mercantile Mutual Insurance (Workers Compensation) Ltd (1999) …. 2.6, 8.45 —v Merv Brown Pty Ltd (1985) …. 3.44, 3.52

—v Mitchum (1965) …. 2.43 —v Montgomery (1998) …. 3.61 —v Munro (1926) …. 9.18 —v Murphy (1961) …. 6.133, 11.18 —v Murry (1998) …. 6.49, 6.74, 6.111 —v Myer Emporium Ltd (1987) …. 2.17, 3.8, 3.11, 3.13, 3.45, 3.56, 3.57, 3.58–3.61, 3.68, 5.8, 5.22, 6.2 —v News Australia Holdings Pty Ltd [2010] …. 17.14 —v Northumberland Development Co Ltd (1995) …. 3.63 —v Orica Ltd (1998) …. 6.29, 6.69 —v Osborne (1990) …. 3.51, 8.58 —v Patcorp Investments Ltd (1976) …. 2.40, 11.11, 17.4 —v Payne (2001) …. 8.7, 8.12, 8.13, 8.79, 9.32 —v Peabody (1994) …. 13.100, 17.3, 17.8, 17.11, 17.14 —v Phillips (1978) …. 8.32, 8.33, 8.35, 8.36 —v Qantas Airways Ltd (2012) …. 19.12, 19.17 — v— [2014] …. 7.45 —v Radilo Enterprises Pty Ltd (1997) …. 13.99 —v Radnor Pty Ltd (1991) …. 3.48, 3.51 —v Ramsden [2005] …. 15.74 —v Ranson (1989) …. 2.28 —v Raymor (NSW) Pty Ltd (1990) …. 8.50, 11.2 —v Reynolds (1981) …. 5.24 —v Riverside Road Lodge Pty Ltd (1990) …. 8.24 —v Roberts (1992) …. 8.22 —v Rowe (1997) …. 2.15, 2.16, 2.18, 2.19, 3.1, 3.2, 3.61, 3.69, 5.22, 8.27 —v Rozman (2010) …. 13.27 —v Ryan (2000) …. 1.27, 1.29 —v Sahhar (1984) …. 16.47 —v St Helens Farm (ACT) Pty Ltd (1981) …. 13.107

—v St Hubert’s Island Pty Ltd (1978) …. 3.45, 3.53, 8.57, 11.8, 11.9, 11.20, 11.27 —v Sarah Lee Household and Body Care (Australia) Pty Ltd (2000) …. 6.87 —v Sealy (1987) …. 5.32 —v Scully (1942) …. 7.14 —v Sherritt Gordon Mines Ltd (1977) …. 3.66, 5.12, 5.13 —v Slater Holdings Ltd (1984) …. 13.5, 13.35 —v— (No 2) (1984) …. 2.6, 2.15, 2.18 —v Slaven (1984) …. 3.19, 3.68 —v Sleight [2004] …. 17.11, 17.14 —v Smith (1978) …. 8.15 —v Smith (D P) (1981) …. 3.19, 3.68, 8.6, 8.7, 8.13, 8.14, 8.29, 8.56 —v SNF (Australia) Pty Ltd [2010] …. 18.68, 18.72 —v— [2011] …. 18.66, 18.72, 18.72 —v Snowden & Willson Pty Ltd (1958) …. 8.6, 8.8, 8.13, 8.28, 8.52, 8.63 —v South Australian Battery Makers Pty Ltd (1978) …. 8.31–8.33, 8.37 —v Spotless Services Ltd (1996) …. 17.8, 17.13 —v Star City Pty Ltd [2009] …. 8.42 —v Stone (2005) …. 3.25, 3.37, 3.40, 3.47 —v Sutton Motors (Chullora) Wholesalers Pty Ltd (1985) …. 11.3, 11.16 —v Sydney Refractive Surgery Centre Pty Ltd (2008) …. 3.18 —v Thorogood (1927) …. 4.4 —v Toms (1989) …. 7.40 —v Total Holdings (Australia) Pty Ltd (1979) …. 3.51, 8.7, 8.24, 8.27 —v Totledge Pty Ltd (1982) …. 15.71, 15.72 —v United Aircraft Corp (1943) …. 2.44, 2.49 —v Uther (1965) …. 13.5

—v Vogt (1975) …. 8.79 —v Wade (1951) …. 1.26, 3.68, 11.3, 11.27 —v Walker (1985) …. 3.49, 3.50 —v Walter Thompson (J) (Australia) Pty Ltd (1944) …. 7.57 —v WE Fuller Pty Ltd (1959) …. 2.20 —v Western Suburbs Cinemas Ltd (1952) …. 3.8, 9.8, 9.10, 9.13, 9.14 —v Westfield Ltd (1991) …. 16.49 —v Westraders Pty Ltd (1980) …. 1.30 —v Whiting (1943) …. 15.69, 15.70, 15.71, 15.75, 15.78, 15.127 —v Whitfords Beach Pty Ltd (1982) …. 1.6, 2.11, 2.12, 3.8, 3.11, 3.48, 3.56, 3.57, 3.58, 4.1, 4.22, 4.24, 4.28 —v Wiener (1978) …. 8.79 —v Wilcox (1982) …. 9.29 —v Williams (1972) …. 3.11 —v Woite (1982) …. 3.17, 3.41 —v Word Investments Ltd [2008] …. 2.21 Commissioner of Taxation (NSW) v Ash (1937) …. 8.12 —v Cam & Sons Ltd (1936) …. 2.43 —v Commercial Banking Co of Sydney (1927) …. 8.27 —v Kirk [1900] …. 2.47, 4.4 —v Malouf (2009) …. 8.38 —v Manufacturers Mutual Insurance Ltd …. 8.48 —v Meeks (1915) …. 2.44, 2.47 —v Stevenson (1937) …. 13.6, 13.7, 13.62 Commissioner of Taxation (NZ) v Webber (1956) …. 8.26 Commissioner of Taxation (SA) v Executor Trustee and Agency Co of South Australia Ltd (Carden’s case) (1938) …. 4.4, 4.5, 4.5, 4.6, 4.8–4.12, 4.15–4.17, 4.21, 4.36, 4.43, 9.83 Commissioner of Taxation (Vic) v Nicholas (1938) …. 13.6, 13.9, 13.11, 13.34 —v Phillips (1936) …. 3.68

Commissioner of Taxation (WA) v Newman (1921) …. 11.2, 11.27 Commissioner of Taxes (NZ) v The Kauri Co [1913] …. 5.10 Commissioners for Special Purposes of Income Tax v Pemsel [1891] …. 15.9 Commonwealth Aluminium Corp Ltd v FCT (1977) …. 8.46, 8.47 Compania de Tabacos v Philipinas (1927) …. 1.1 Compass Group (Vic) Pty Ltd v FCT (2008) …. 7.40 Consolidated Press Holdings v FCT (2001) …. 17.14 Constable v FCT (1952) …. 3.34 Cooke v FCT (2004) …. 17.14 Cooney v Kuring-gai Municipal Council (1963) …. 3.45 Cooper Brooks (Wollongong) Pty Ltd v FCT (1981) …. 1.28 Coughlan v FCT (1991) …. 11.15, 14.41, 14.42, 14.43 Countess of Bective, The v FCT (1932) …. 15.29 Country Magazine Pty Ltd v FCT (1968) …. 4.8, 4.17, 4.18 CPT Custodian Pty Ltd v Commissioner of State Revenue (2005) …. 15.68 Crane v FCT (2005) …. 7.40 Crane (G E) Sales Pty Ltd v FCT (1971) …. 9.21 Crommelin v FCT (1998) …. 14.40, 14.41 Cronulla-Sutherland Leagues Club Ltd v FCT (1989) …. 2.21 Cunliffle v FCT (1983) …. 8.14, 8.74

D Dalton v DCT (1998) …. 3.51 DCT v W R Moran Pty Ltd (1939) …. 1.11 Dean v FCT; McLean v FCT (1997) …. 3.38, 7.57 Denlay v FCT [2011] …. 16.13 Denmark Community Windfarm Ltd v FCT [2017] …. 5.23 Dibb v FCT (2003) …. 5.32

Dickenson v FCT (1958) …. 3.10, 3.17 Dingwall v FCT (1995) …. 6.89, 6.91, 6.105, 13.108 Donaldson v FCT [1974] …. 5.46, 7.2 Dormer v FCT (2002) …. 4.9 Doutch v FCT [2016] …. 6.150 DPP (Cth) v Buckett [2004] …. 16.8 Drewery v Ware-Lane [1960] …. 6.46 Duggan and Ryall v FCT (1972) …. 15.51 Dwight v FCT (1992) …. 15.73, 15.75, 15.76 Dymond, Re (1959) …. 1.10

E Eastern Nitrogen Ltd v FCT (2001) …. 17.14 Edelsten v Wilcox and FCT (1988) …. 16.70 Edgerton-Warburton v FCT (1934) …. 3.65 Edwards v Bairstow [1956] …. 3.51 Eisner v Macomber (1920) …. 1.7, 3.10 Electricity Supply Industry Superannuation (Qld) Ltd v FCT (2003) …. 12.71 Ell v FCT (2006) …. 3.47 Ellis v Joseph Ellis & Co [1905] …. 14.29 Elmsie v FCT (1993) …. 13.107 Emmerson v Computer Time International Ltd (in liq) [1977] …. 6.111 Employee v FCT (2010) …. 6.130 Employers’ Mutual Indemnity Association Ltd v FCT (1991) …. 3.53, 3.54 Emu Bay Railway Co Ltd v FCT (1944) …. 8.28, 8.41 Equitable Life and General Insurance Co Ltd v FCT (1990) …. 3.55 Equuscorp Pty Ltd v Glengallan Investments Pty Ltd (2004) …. 17.4 Esquire Nominees Ltd v FCT (1973) …. 2.40, 2.46

Esso Australia Resources Ltd v FCT (1998) …. 8.58 Europa Oil (NZ) Ltd (No 2) v CIR (NZ) [1976] …. 8.31–8.33 Evans v FCT (1989) …. 3.26, 3.49, 8.27, 8.57 Evans Medical Supplies v Moriarty [1957] …. 3.15

F Fairfax v FCT (1965) …. 1.9 Falk and FCT [2015] …. 5.23 Farmer v Juridical Society of Edinburgh (1914) …. 2.21 Farnsworth v FCT (1949) …. 11.16 Favaro v FCT (1997) …. 16.11 FCT see Commissioner of Taxation (Cth) Federal Coke Co Pty Ltd v FCT (1977) …. 2.16, 2.17, 3.12, 3.22, 3.35, 3.36 Federal Wharf Co Ltd v DFCT (1930) …. 3.63 Ferguson v FCT (1979) …. 3.46, 3.47–3.49, 3.51, 8.18, 8.57, 8.58 Fletcher v FCT (1991) …. 8.13, 8.36, 8.37, 9.12, 17.4 —v IRC [1972] …. 3.31 Forbes v NSW Trotting Club Ltd (1979) …. 6.72 Forrest v FCT (2010) …. 5.32 Fouche v Superannuation Fund Board (1952) …. 15.75 Fraunschiel v FCT (1989) …. 5.47 Freeman v FCT (1983) …. 5.32, 8.59 Fullerton v FCT (1991) …. 8.79 Furniss v Dawson (1984) …. 17.4 Futuris Corporation Ltd v FCT [2009] …. 17.11

G Gaillie & Davidson Motors Pty Ltd v FCT (1985) …. 3.50

Gair v FCT (1944) …. 3.36 Garrett v FCT (1982) …. 8.79 Gartside v IRC [1968] …. 15.67 General Motors Acceptance Corp (UK) Ltd v IRC [1985] …. 11.16 Geraghty v Minter (1979) …. 6.74 Gerard Cassegrain & Co Pty Ltd and FCT, Re [2010] …. 6.95 Gerard Cassegrain & Co Pty Ltd v FCT [2011] …. 6.95 Gibb v FCT (1966) …. 13.74–13.76 Giris Pty Ltd v FCT (1969) …. 15.51 Glantre Engineering Ltd v Goodhand [1983] …. 3.41 Glenboig Union Fireclay & Co Ltd v IRC (1922) …. 3.18, 3.68 Glennan v FCT (1999) …. 3.59 Glenville Pastoral Co Pty Ltd v FCT (1963) …. 13.68, 13.70, 13.71–13.73, 13.75 Goldsbrough Mort & Co Ltd v FCT (1976) …. 6.130 Goodman Fielder Wattie Ltd v FCT (1991) …. 8.58 GP International Pipecoaters Pty Ltd v FCT (1990) …. 2.16, 3.12, 3.35, 3.39, 3.52, 4.23, 4.29, 4.31 Gray v FCT (1989) …. 1.27, 1.28 GRE Insurance Ltd v FCT (1992) …. 3.13, 3.54 Grealy v FCT (1989) …. 5.31, 5.32 Great Western Railway Co v Helps [1918] …. 3.22, 3.39 Gregory v FCT (1937) …. 2.38 Griffin v FCT (1986) …. 8.79 Griffin Coal Mining Co v FCT (1990) …. 8.55, 8.58 Grollo Nominees Pty Ltd v FCT (1997) …. 17.7 Grove v Young Men’s Christian Association (1903) …. 3.30, 3.45 Guinea Airways Ltd v FCT (1949) …. 8.26, 8.69, 11.12

H

Ha v New South Wales; Walter Hammond & Associates Pty Ltd v New South Wales (1997) …. 19.2 Haggarty v FCT (1989) …. 5.32 Hallstroms Pty Ltd v FCT (1946) …. 8.28, 8.61, 8.63, 8.67 Handley v FCT (1981) …. 8.14, 8.29, 8.70, 8.78 Hanlon v FCT (1982) …. 8.58 Hannavy v FCT (2001) …. 4.42 Harding v FCT (1917) …. 4.4 Haritos v FCT [2015] …. 16.47 Harmer v FCT (1991) …. 15.65, 15.66, 15.76 Harrowell v FCT (1967) …. 13.63, 13.75, 13.76 Hart v FCT [2003] …. 3.47 Harris v FCT (1980) …. 3.24, 3.39 Hayes v FCT (1956) …. 2.17, 3.12, 3.22, 3.23, 3.24, 3.35, 4.28, 5.4 Healey v FCT [2012] …. 6.81,, 15.92 Heather v PE Consulting Group Ltd [1972] …. 8.60, 18.66 Heavy Minerals Pty Ltd v FCT (1966) …. 3.8, 3.18, 3.68, 5.22 Henderson v FCT (1969) …. 11.7, 11.14, 11.15 —v— (1970) …. 4.1, 4.4, 4.9, 4.10, 4.11, 4.13, 4.21, 4.25, 4.36, 4.37, 9.31, 9.83, 11.7, 14.41 Henry Jones (IXL) Ltd v FCT (1991) …. 3.58 Hepples v FCT (1990) …. 6.63, 6.68, 6.70, 6.72, 6.73 —v— (1992) …. 6.34, 6.48, 6.49, 6.53 —v— (No 2) (1992) …. 3.17 Herald & Weekly Times v FCT (1932) …. 8.4, 8.6, 8.7, 8.10, 8.13 Higgs v Olivier [1951] …. 3.17 Hilton v FCT (1992) …. 5.32 Hoare & Co Ltd, Re [1904] …. 13.70 Hochstrasser v Mayes [1960] …. 3.39, 3.42 Holroyd v Marshall (1862) …. 14.51 Hooker Rex Pty Ltd v FCT (1988) …. 8.47, 8.50

Hospital Products Ltd v United States Surgical Corporation (1984) …. 14.4, 14.11 Howland-Rose v FCT (2002) …. 17.4 Hughes v Fripp (1922) …. 14.25, 14.26, 14.31, 14.33 Hyde v Sullivan (1955) …. 3.49 Hyteco Hiring Pty Ltd v FCT (1992) …. 3.44, 3.52

I Imperial Chemical Industries of Australia and New Zealand Ltd v FCT (1970) …. 10.11, 10.13 Income Tax Acts (No 2), Re [1930] …. 2.8 Inglis v FCT (1980) …. 3.467, 8.57, 8.58, 8.59 Innes or Grant v G & G Kynoch [1919] …. 6.130 International Nickel Australia Ltd v FCT (1977) …. 2.11, 3.21 Intoll Management Pty Ltd v FCT [2012] …. 12.113 Investment and Merchant Finance Corp Ltd v FCT (1971) …. 2.47, 3.53, 4.21, 4.23, 11.5, 11.11 Ipec Insurance Ltd v FCT (1975) …. 3.53 IRC v British Salmson Aero Engines Ltd (1938) …. 8.61 —v Burmah Oil Co Ltd (1981) …. 17.4 —v Duke of Westminster [1936] …. 1.1, 1.27 —v Incorporated Council of Law Reporting (1889) …. 14.13 —v Korean Syndicate Ltd (1921) …. 3.51 —v Lebus’s Exors (1946) …. 14.10 —v Morrison [1932] …. 4.8 IRC (NZ) see Commissioner of Inland Revenue (NZ) Ivanhoe South Goldmining Co v C of T (SA) [1896] …. 4.4

J Jacob v FCT (1971) …. 16.39

James v Commonwealth (1928) …. 1.11 —v FCT (1924) …. 13.11 Jarrold v Boustead (1964) …. 3.41 Jayatilake v FCT (1991) …. 8.81 Jazareed Pty Ltd v FCT (1989) …. 9.4 Jennings Industries Ltd v FCT (1984) …. 3.55, 3.59 John v FCT (1989) …. 6.46, 8.57, 8.69, 11.2, 11.3, 11.5, 11.11, 13.11, 17.4 John Fairfax & Sons Pty Ltd v FCT (1959) …. 3.8, 8.6, 8.19, 8.54, 8.56, 8.63, 8.69, 11.2 John Holland Group Pty Ltd v FCT [2015] …. 7.25 Jolly v FCT (1933) …. 5.8 Jones v FCT (1932) …. 3.49 —v Leeming [1930] …. 1.14 Just v FCT (1949) …. 3.1, 3.16, 3.35, 3.37

K Kafataris v FCT [2008] …. 15.97 Keighery (WP) Pty Ltd v FCT (1957) …. 17.12 Keily v FCT (1983) …. 2.15, 3.37 Kelly v FCT (1985) …. 3.22, 3.24, 3.25, 3.42, 3.43 —v IRC (NZ) (1969) …. 14.51 Kenny & Good Pty Ltd v MGICA (1992) Ltd (1999) …. 6.93 Kensall Parsons & Co v IRC (1938) …. 3.18, 3.68 Keycorp Ltd and Telstra Payment Solutions Ltd v FCT (2007) …. 9.64, 9.65 Kidston Goldmines v FCT (1991) …. 8.29, 8.37 Kimche v FCT [2004] …. 16.11 King v CIR (1974) …. 8.41 Klopper v DFCT (1997) …. 9.46, 9.49

Knowles (J&G) v FCT (2000) …. 7.14 Koitaki Para Rubber Estates Ltd v FCT (1941) …. 2.40 Kosciusko Thredbo Pty Ltd v FCT (1984) …. 3.55 Kratzmann v FCT (1970) …. 8.59 Kratzmann’s Hardware Pty Ltd v FCT (1985) …. 11.3, 11.18 Kwikspan Purlin Systems Pty Ltd v FCT (1984) …. 3.16, 5.13

L Laidler v Perry [1966] …. 3.22 Lancey (HR) Shipping Co Pty Ltd v FCT (1951) …. 16.34 Lang v James Morrison & Co Ltd (1911) …. 14.10 Law Shipping Co Ltd v IRC [1924] …. 9.10, 9.11 Le Grande v FCT (2002) …. 5.32 Leary v FCT (1980) …. 3.22, 9.46 Lees & Leech Pty Ltd v FCT (1997) …. 3.39, 3.60 Lend Lease Custodian Pty Ltd v FCT [2006] …. 6.89 Leonard v FCT (1919) …. 14.29 Levene v IRC [1928] …. 2.38 Lewis Emanuel & Son Ltd v White (HM Inspector of Taxes) (1965) …. 3.51 Liftronic Pty Ltd v FCT (1996) …. 3.18, 3.68 Lilyvale Hotel Pty Ltd v FCT (2008) …. 12.102 —v— (2009) …. 12.102 Lind, Re; Industrials Finance Syndicate Ltd v Lind [1915] …. 14.51 Lindsay v FCT (1961) …. 3.8, 9.8, 9.9, 9.14 —v IRC (1933) …. 3.5, 3.29, 3.51 Liquidator North Sydney Investment and Tramway Co v CT (NSW) (1898) …. 2.8 Lister Blackstone Ltd v FCT (1976) …. 11.2 Lodge v FCT (1972) …. 8.7, 8.13, 8.20, 8.24, 8.54, 8.55, 8.77

Lomax (Inspector of Taxes) v Peter Dixon & Sons Ltd [1943] …. 3.63 London Australia Investment Co Ltd v FCT (1977) …. 2.8, 2.11, 2.12, 2.17, 3.44, 3.45, 3.48, 3.51, 3.52, 3.53, 3.56, 4.23, 4.25, 4.28, 6.137, 8.27, 8.57, 11.3, 11.5 London County Council v Attorney- General [1901] …. 2.1 Long Service Leave Board v Irving (1997) …. 7.14 Lunney v FCT (1958) …. 7.25, 8.7, 8.12, 8.13, 8.14, 8.55, 8.71, 8.72, 8.79 Lurcott v Wakely & Wheeler [1911] …. 9.8

M McCaughey v Commissioner of Stamp Duties (1945) …. 6.66 McCauley v FCT (1944) …. 3.66, 5.10, 5.11–5.13, 8.68, 11.10 McClelland v FCT (1970) …. 1.6 McCormack v FCT (1979) …. 16.39 MacCormick v FCT (1984) …. 1.1 McDonald v FCT (2000) …. 6.87 —v— (2001) …. 6.87 MacFarlane v FCT (1986) …. 13.21 McGuinness v FCT (1991) …. 9.18 McInnes v FCT (1977) …. 3.47, 3.50, 8.57 McIntosh v FCT (1979) …. 5.32 MacKinlay (Inspector of Taxes) v Arthur Young McClelland Moores & Co [1990] …. 14.29 McLaurin v FCT (1961) …. 3.20 Macmine Pty Ltd v FCT (1979) …. 16.39 McNally v FCT [2007] …. 14.41, 14.42, 14.43 McNeil v FCT (2004) …. 6.53 Macquarie Worsteds Pty Ltd v FCT (1974) …. 10.10 Madad Pty Ltd v FCT (1984) …. 8.13, 8.55, 9.35

Magna Alloys & Research Pty Ltd v FCT (1980) …. 8.8, 8.29, 8.30, 8.34, 8.35, 8.36, 8.52, 8.52, 9.12, 9.35 Malayan Shipping Co Ltd v FCT (1946) …. 2.40 Mansfield v FCT (1995) …. 8.14, 8.75 Marks v GIO Australia Holdings Ltd (1998) …. 6.93 Marren v Ingles [1979] …. 6.89, 6.99 Marson v Marriage [1980] …. 6.89, 6.99 Martin v FCT (1953) …. 3.26, 3.49, 8.57 —v— (1984) …. 8.15, 8.55, 8.77 —v Manchester Corporation (1912) …. 6.130 Maryborough Newspaper Co Ltd v FCT (1929) …. 9.27 Matthews v Chicory Marketing Board (1938) …. 1.1, 1.9 Maughan v FCT (1942) …. 9.47 Max Factor & Co v FCT (1984) …. 3.21 Mayne Nickless Ltd v FCT (1984) …. 8.13, 9.35 Melkman v FCT (1987) …. 3.37 Memorex Pty Ltd v FCT (1987) …. 2.11, 3.12, 3.13, 3.44, 3.52, 3.55, 4.24, 4.25, 11.3, 11.18 Metaskills Pty Ltd v FCT (2002) …. 9.86 Miley and FCT Devi and FCT [2016] …. 6.150 Mills v FCT (2012) …. 12.71 MIM Holdings Ltd v FCT (1997) …. 3.12, 3.17, 3.52 Mitchell & Egyptian Hotels Ltd [1915] …. 2.40 Modern Permanent and Investment Society (in liq) v FCT (1958) …. 11.5, 11.11 Moneymen Pty Ltd v FCT (1991) …. 3.65 Montgomery v FCT (1998) …. 3.61 Moore v Commonwealth (1951) …. 1.9 —v Griffiths [1972] …. 3.23, 3.42 Moorehouse v Dooland (1954) …. 3.43 —v— (1955) …. 3.24

Morcom v Campbell-Johnson [1955] …. 9.8, 9.14 Morris v FCT (2002) …. 8.75 Mt Isa Mines Ltd v FCT (1992) …. 3.8, 10.36 Muir v FCT (2001) …. 2.28 Mullens Investments Pty Ltd v FCT (1977) …. 17.6 Murdoch v Commr of Pay-roll Tax (Vic) (1980) …. 7.57 Murray v ICI Ltd [1967] …. 3.16, 3.66, 5.12, 5.13

N Nagle v Feilden [1966] …. 6.72 National Association of Local Government Officers v Watkins (1934) …. 3.31 National Australia Bank Ltd v FCT (1993) …. 7.9, 7.10 National Bank of Australasia Ltd v FCT (1969) …. 3.55, 8.27, 11.3 National Mutual Life Association of Australasia Ltd v FCT (2008) …. 6.110 —v— [2009] …. 6.110 National Provincial Bank Ltd v Ainsworth [1965] …. 6.69 National Westminster Bank plc v IRC (UK); Barclay’s Bank plc v IRC (UK) [1994] …. 13.107 National Trustees Executors & Agency Co of Australasia Ltd v FCT (1954) …. 6.69 Naval, Military & Airforce Club of South Australia v FCT (1994) …. 6.86 Nevill (W) & Co Ltd v FCT (1937) …. 8.6, 8.10–8.12, 8.40, 8.54, 8.71, 9.12 New York Life Insurance Co v Styles (1889) …. 3.30 New Zealand Flax Investments Ltd v FCT (1938) …. 2.6, 4.22, 8.39, 8.41, 8.44, 8.47 Newcastle Breweries Ltd v IRC (1927) …. 3.68 Newcastle Club Ltd v FCT (1994) …. 7.57

News Australia Holdings Pty Ltd v FCT [2017] …. 4.33, 4.35 Newsom v Robertson [1953] …. 8.72 Nicholas v CT (Vic) (1940) …. 13.11 Nilsen Development Laboratories Pty Ltd v FCT (1981) …. 2.6, 8.40, 8.41, 8.42, 8.44, 8.47–8.49, 9.34, 9.36 Norman v FCT (1963) …. 14.51 Norseman Amalgamated Distress and Injustices Fund v FCT (1995) …. 2.23 North Australian Pastoral Co Ltd v FCT (1946) …. 2.40, 8.27 North Ryde RSL Community Club v FCT (2002) …. 3.31

O O’Connell v FCT (2002) …. 3.61 O’Grady v Bullcroft Main Collieries Ltd (1932) …. 9.9 O’Kane (J&R) v IRC (1922) …. 3.47 Odeon Associated Theatres Ltd v Jones (Inspector of Taxes) [1972] …. 9.11 Ogilvy & Mather v FCT (1990) …. 8.43 Oram v Johnson [1980] …. 6.110 Osborne v Commonwealth (1911) …. 1.9

P Page v International Agency and Industrial Trust (Ltd) (1893) …. 6.63 Parfew Nominees Pty Ltd v FCT (1986) …. 11.25 Partridge v Mallandaine (1886) …. 3.29 Payne v FCT (1996) …. 3.4, 3.5, 3.7, 5.4, 7.2 Penn v Spiers & Pond Ltd [1908] …. 3.22, 3.39 Peabody v FCT (1993) …. 17.8, 17.11 Pearson v FCT [2006] …. 15.68 Permanent Trustee Co of NSW Ltd v FCT (1940) …. 4.32

Perron Investments Pty Ltd v FCT (1993) …. 3.58 Peterson v FCT (1960) …. 14.33, 14.34 Peyton v FCT (1963) …. 8.55, 8.59, 9.7 Philip Morris Ltd v FCT (1979) …. 11.7, 11.21, 11.22 Phillips v Wieldon Sanitary Potteries Ltd (1952) …. 9.9 Pickford v FCT (1998) …. 3.41, 5.5 Placer Pacific Management Pty Ltd v FCT (1995) …. 8.21, 8.22, 8.23, 8.26, 8.59 Platell v FCT (1992) …. 5.32 Point v FCT (1970) …. 9.21 Polla-Mounter v FCT (1996) …. 2.28 Pridecraft v FCT (2005) …. 17.14 Prince v FCT (1959) …. 3.26 Pritchard v Arundale [1972] …. 3.41 Punjab Co-op Bank Ltd v ITC [1940] …. 3.53

Q Quarries Ltd v FCT (1961) …. 10.9, 10.12 Queensland Meat Export Co Ltd v DCT (1939) …. 8.59, 9.7

R R v Barger (1908) …. 1.9 —v DCT; Ex parte Hooper (1926) …. 16.3 —v Toohey; Ex parte Meneling Station Pty Ltd (1982) …. 6.69 RAC Insurance Pty Ltd v FCT (1990) …. 3.53, 3.54 RACV v FCT (1973) …. 3.31 RACV Insurance Ltd v FCT (1974) …. 8.40, 8.44, 8.45–8.50 Raftland Pty Ltd v FCT [2008] …. 15.56, 17.4 Ramsay (WT) v CIR (1982) …. 17.4

Ramsden v FCT (2004) …. 15.77 Ransburg Australia Pty Ltd v FCT (1980) …. 8.41 RCI Pty Ltd v FCT (2011) …. 17.11 Reliance Finance Corp Pty Ltd v FCT (1987) …. 8.37 Religious Tract and Book Society v Forbes (1896) …. 3.45 Resch v FCT (1942) …. 1.10 Reseck v FCT (1975) …. 2.14, 5.30, 5.31, 5.32 Reuter v FCT (1993) …. 3.38 Rhodesia Railways Ltd v Resident Commissioner & Treasurer, Bechuanaland Protectorate [1933] …. 9.9 Riches v Westminster Bank Ltd [1947] …. 3.63 Riley v Coglan [1968] …. 3.17, 3.41 Roads & Traffic Authority (NSW) v FCT (1993) …. 7.37, 7.40, 7.57 Robert Coldstream Partnership v FCT (1943) …. 14.55 Robert G Nall Ltd v FCT (1937) …. 8.7, 8.12, 8.36, 8.37 Rolls-Royce Ltd v Jeffrey [1962] …. 3.15, 3.55 Ronpibon Tin NL & Tongkah Compound NL v FCT (1949) …. 8.6, 8.7, 8.8, 8.11, 8.12, 8.16, 8.28, 8.29, 8.30, 8.37, 8.52, 8.56, 8.71, 8.82 Rose v FCT (1951) …. 14.23, 14.24, 14.85 Rosgoe Pty Ltd v FCT [2015] …. 5.8 Rotherwood Pty Ltd v FCT (1996) …. 3.59 Rowe v FCT (1982) …. 14.24, 14.26 Rowe (J) & Sons Pty Ltd v FCT (1970) …. 4.10 —v— (1971) …. 4.11, 4.20–4.23, 4.26, 4.44 Ruhamah Property Co v FCT (1928) …. 5.8 Rustproof Metal Window Co Ltd v IRC [1947] …. 3.16 Ryde Municipal Council v Macquarie University (1978) …. 10.51 Ryan v FCT (2004) …. 17.2

S

St George County Council; Ex parte (1973) …. 3.45 St Mary’s Rugby League Club Ltd v FCT (1997) …. 2.21 Samuel Jones & Co (Devondale Ltd) v CIR (1951) …. 9.9 Saunders v Vautier (1841) …. 15.68, 15.73, 15.78 Scanlon and FCT, Re [2014] …. 6.150 Scarborough v FCT [1924] …. 5.8 Scott v CT (NSW) (1935) …. 2.9, 2.15 —v Cawsey (1907) …. 1.27, 1.28 —v FCT (1966) …. 2.17, 3.12, 3.22, 3.23, 3.24, 3.35, 3.38, 3.39, 3.42, 5.4 —v— (2002) …. 14.29 Scottish Australian Mining Co Ltd v FCT (1950) …. 3.57 Selleck v FCT (1997) …. 3.60 Seymour v Reed (1927) …. 3.24, 3.43 Sharrment Pty Ltd v Official Trustee in Bankruptcy (1988) …. 17.4 Sinclair (HR) & Son Pty Ltd v FCT (1966) …. 3.69, 5.22 Single v FCT (1964) …. 14.34, 14.35, 14.49, 15.131 Skase v FCT (1992) …. 16.73 Slutzkin v FCT (1977) …. 13.96, 13.97 Smith v Anderson (1880) …. 14.10 —v FCT (1987) …. 3.23, 3.24, 5.4, 7.2 Softwood Pulp & Paper Ltd v FCT (1976) …. 3.51, 8.55, 8.58 Sorrell v Finch (1977) …. 6.46 South Australia v Commonwealth (1942) …. 1.15 South Behar Railway Co v IRC [1925] …. 8.57 Southern Estates Pty Ltd v FCT (1967) …. 3.51, 8.58 SP Investments Pty Ltd v FCT; Perron Investments Pty Ltd v FCT (1993) …. 3.58 Spanish Prospecting Co Ltd, Re [1911] …. 2.8, 2.18 Spriggs v FCT; Riddell v FCT (2009) …. 8.8, 8.52, 8.55 Squatting Investment Co Ltd v FCT (1953) …. 2.17, 3.22, 3.23, 3.24

—v— (1954) …. 3.23 Stanton v FCT (1955) …. 3.66, 5.10, 5.11 Stapleton v FCT (1989) …. 11.15, 14.37, 14.39, 14.41 Starrim Pty Ltd v FCT (2000) …. 7.14 State Government Insurance Office v Rees (1979) …. 7.14 Steele v DCT (1997) …. 8.6, 8.58 —v DCT (1999) …. 8.2, 8.21, 8.23, 8.24, 8.54, 8.58, 8.68, 8.70 Stone v FCT (2002) …. 3.40 —v— (2003) …. 3.27, 3.40 Stow Bardolph Gravel Co Ltd v Poole (1954) …. 8.68, 11.10 Strong & Co v Woodifield [1906] …. 8.10 Studebaker Corp of A’asia Ltd v CT (NSW) (1921) …. 2.45 Sun Insurance Office v Clark [1912] …. 8.44 Sun Newspapers Ltd and Associated Newspapers Ltd v FCT (1938) …. 3.8, 3.9, 3.10, 3.61, 8.61, 8.62, 8.63, 8.64, 9.8, 9.9 Sunraysia Broadcasters Pty Ltd v FCT (1991) …. 8.67 Sydney Water Board Employees’ Credit Union Ltd v FCT (1973) …. 3.31

T Tailby v Official Receiver (1888) …. 14.51 Taras Nominees Pty Ltd v FCT [2014] …. 15.91 Tariff Reinsurances Ltd v C of T (Vic) (1938) …. 2.41 Taxpayer and FCT, Re (2004) …. 6.110 —, Re [2010] …. 6.150 Taxpayers Association of NSW v FCT (2001) …. 2.21 Taylor v FCT (1970) …. 15.78 Technical Products Pty Ltd v State Government Insurance Office (Qld) (1988) …. 7.14 Telecasters North Queensland Ltd v FCT (1989) …. 9.27

Television Broadcasters Ltd v Ashton’s Nominees Pty Ltd (No 1) (1979) …. 14.11 Temelli v FCT (1997) …. 8.58 Tennant v Smith [1892] …. 2.10, 3.4, 3.6, 5.4, 7.2 Terranora Lakes Country Club Ltd v FCT (1993) …. 2.22 Texas Co (Australasia) Ltd v FCT (1940) …. 2.11, 3.21, 8.24, 8.44, 8.46 Thomas v FCT (1972) …. 3.49, 3.50, 8.57, 8.58 Thomas (W) & Co Pty Ltd v FCT (1965) …. 9.8, 9.9, 9.10–9.12, 9.14 Thorpe Nominees Pty Ltd v FCT (1988) …. 2.41 Tinkler v FCT (1979) …. 3.19, 3.68 Tomlinson v Glyns Executor & Trustee Co (1969) …. 15.98 Toohey’s Ltd v C of T (NSW) (1922) …. 8.11, 8.29 Totledge Pty Ltd v FCT (1980) …. 15.24 Tourapark Pty Ltd v FCT (1982) …. 10.51 Traknew Holdings Pty Ltd v FCT (1991) …. 15.54 Trautwein v FCT (No 1) (1936) …. 16.38 Truesdale v FCT (1969) …. 15.59 Trustees of Earl Haig v IRC (1939) …. 3.15 Tucker v Granada Motorway Services Ltd [1979] …. 8.61, 8.63 Tweedle v FCT (1942) …. 3.47, 8.29, 8.57

U Union Fidelity Trustee Co of Aust Ltd & Mayfield v FCT (1969) …. 15.77 Union Trustee Co of Australia Ltd v FCT (1935) …. 9.27 United Collieries Ltd v IRC (1930) …. 3.10, 8.62 United Dominions Corp Ltd v Brian Pty Ltd (1985) …. 14.11, 14.12 United States v Miller (1943) …. 6.93 —v Stanley (1987) …. 6.72

Ure v FCT (1981) …. 8.35–8.37, 17.4 Usher’s Wiltshire Brewery Ltd v Bruce (1914) …. 9.7

V Vallambrosa Rubber Co Ltd v Farmer (1910) …. 8.61, 8.63 Van den Bergs Ltd v Clark (Inspector of Taxes) [1935] …. 3.18, 3.68 Vegners v FCT (1991) …. 15.74 Victorian Employers’ Federation v FCT (1957) …. 2.23 Virgin Blue Airlines Pty Ltd v FCT [2010] …. 7.45

W WD & HO Wills (Australia) v FCT (1996) …. 17.15 Walsh Bay Developments Pty Ltd v FCT (1995) …. 15.68, 15.73 Wangaratta Woollen Mills Ltd v FCT (1969) …. 10.11 Waratahs Rugby Union Football Club v FCT (1979) …. 2.21 Ward & Co v Commr of Taxes [1923] …. 8.10 Warner Music Australia Ltd v FCT (1996) …. 2.12, 3.34, 8.39 Wates v Rowland [1952] …. 9.8 Webb v FCT (1922) …. 13.9 Weight v Salmon (1935) …. 5.46 Western Gold Mines NL v CT (WA) (1938) …. 2.17 Westfield Ltd v FCT (1991) …. 3.59 Westpac Banking Corp v FCT (1996) …. 7.10, 7.34 Whitaker v FCT (1998) …. 3.63 White v FCT (1968) …. 3.47 —v— [2012] …. 6.150 Williams (AC) v FCT (1972) …. 11.11 Wong v FCT [2012] …. 11.31 Woods v DFCT (1999) …. 3.26

Workers Trust & Merchant Bank Ltd v Dojap Investments Ltd [1993] …. 6.46 WTPG and Commissioner of Taxation [2016] …. 8.79

Y Yanchep Sun City Pty Ltd v Commissioner of State Taxation (WA) (1984) …. 3.64 Yaniuk v FCT, Re [2001] …. 10.105 Yarmouth v France (1887) …. 10.9, 11.3

References are to paragraph numbers Italic numbers indicate footnote references

Table of Statutes COMMONWEALTH A New Tax System (Fringe Benefits Tax) Bill 2000 …. 7.18 A New Tax System (Goods and Services Tax) Act 1999 …. 1.23, 19.2 Div 7 …. 19.9 s 7-1 …. 19.9, 19.29 s 9-5 …. 19.10–19.12, 19.19, 19.21 s 9-5(d) …. 19.21 s 9-10 …. 19.12 s 9-10(4) …. 19.12 s 9-15 …. 19.14 s 9-15(3)(a) …. 19.14 s 9-15(3)(c) …. 19.14 s 9-17 …. 19.14 s 9-17(1) …. 19.14 s 9-17(3) …. 19.14 s 9-20 …. 19.18, 19.19 s 9-20(1)(c) …. 19.19 s 9-20(2) …. 19.18 s 9-25 …. 19.19, 19.20 s 9-25(1) …. 19.20 s 9-25(2) …. 19.20

s 9-25(3) …. 19.20 s 9-25(4) …. 19.20 s 9-25(5) …. 19.20 s 9-25(6) …. 19.20 s 9-25(7) …. 19.20 s 9-70 …. 19.30 s 9-75 …. 19.30 s 9-80 …. 19.41 Div 13 …. 19.29 s 13-5 …. 19.29 s 13-5(1) …. 19.29 s 13-10 …. 19.29 Div 19 …. 19.14 Div 23 …. 19.21 s 23-1 …. 19.21 s 23-10(2) …. 19.21 s 23-15 …. 19.22 s 23-99 …. 19.22 s 25-1 …. 19.24 s 25-5 …. 19.24 s 25-50 …. 19.24 s 25-55 …. 19.24 s 27-5 …. 19.8 s 27-10 …. 19.8 s 27-15 …. 19.8 s 29-5 …. 19.15 Div 38 …. 19.32, 19.33 Subdiv 38-A …. 19.32 s 38-2 …. 19.33 s 38-3 …. 19.33 s 38-3(1) …. 19.33

s 38-3(1)(a) …. 19.33 s 38-3(1)(b) …. 19.33 s 38-4 …. 19.33 s 38-5 …. 19.33 s 38-5(c) …. 19.33 s 38-6 …. 19.34 s 38-6(2) …. 19.34 Subdiv 38-B …. 19.32, 19.35 s 38-7 …. 19.35 s 38-7(2)(a) …. 19.35 s 38-7(2)(b) …. 19.35 s 38-7(3) …. 19.37 s 38-10(1) …. 19.35 s 38-20 …. 19.36 s 38-45(1) …. 19.37 s 38-47(1) …. 19.37 s 38-50 …. 19.35 Subdiv 38-C …. 19.32, 19.38 s 38-105 …. 19.38 s 38-185 …. 19.39 s 38-185(1) …. 19.39 s 38-190(1) …. 19.39 Subdiv 38-D …. 19.32 Subdiv 38-E …. 19.32, 19.39 Subdiv 38-F …. 19.32 Subdiv 38-G …. 19.32 Subdiv 38-I …. 19.32 Subdiv 38-J …. 19.32, 19.40 s 38-325 …. 19.40 s 38-325(1)(c) …. 19.47

s 38-325(2) …. 19.40 Subdiv 38-K …. 19.32 Subdiv 38-L …. 19.32 Subdiv 38-M …. 19.32 Subdiv 38-N …. 19.32 Subdiv 38-O …. 19.32 Subdiv 38-P …. 19.32 Subdiv 38-Q …. 19.32 Subdiv 38-R …. 19.32 Subdiv 38-S …. 19.32 Subdiv 38-T …. 19.32 Subdiv 40-B …. 19.43 s 40-35 …. 19.43 s 40-35(1A) …. 19.43 Subdiv 40-C …. 19.44 s 40-65 …. 19.44 Subdiv 40-F …. 19.45 s 40-160 …. 19.45 s 40-165(1) …. 19.45 Div 42 …. 19.29, 19.46 Div 54 …. 19.26 Div 57 …. 19.27 Div 70 …. 19.42 Div 84 …. 19.20 s 84-5 …. 19.20 s 84-10 …. 19.20 Div 87 …. 19.43 s 87-5 …. 19.43 s 87-10 …. 19.43 s 87-20 …. 19.43 Div 96 …. 19.20

s 99-5 …. 19.15 Div 100 …. 19.16 Div 102 …. 19.17 s 102-1 …. 19.17 s 102-5 …. 19.17 Div 114 …. 19.29 Div 144 …. 19.22, 19.28 Div 165 …. 19.47 s 144-5 …. 1.31 s 165-5 …. 19.47 s 165-10(1) …. 19.47 s 165-10(2) …. 19.47 s 165-15 …. 19.47 s 165-40 …. 19.47 s 165-45 …. 19.47 s 188-10 …. 19.23 s 188-15 …. 19.23 s 188-20 …. 19.23 Div 195 …. 19.11, 19.19 s 195-1 …. 19.13, 19.19, 19.35, 19.36, 19.38 Sch 1 …. 19.33 Sch 2 …. 19.33 Sch 3 …. 19.37 A New Tax System (Goods and Services Tax) Bill 1998 …. 19.4, 19.10 A New Tax System (Goods and Services Tax Imposition — Customs) Act 1999 …. 19.2 A New Tax System (Goods and Services Tax Imposition — General) Act 1999 …. 19.2 A New Tax System (Goods and Services Tax) Regulations 1999 …. 19.2

reg 23-15.01 …. 19.22 reg 23-15.02 …. 19.22 Subdiv 40-A …. 19.42 reg 40-5.09 …. 19.42 reg 40-5.12 …. 19.42 Div 70 …. 19.42 reg 70-5.03 …. 19.42 Sch 3 …. 19.37 A New Tax System (Goods and Services Tax Transition) Act 1999 …. 19.2 Acts Interpretation Act 1901 …. 1.27, 16.22 s 15AA …. 1.28 s 15AA(1) …. 1.28 s 15AB …. 1.28 s 15AD …. 1.28 Administrative Appeals Tribunal Act 1975 s 35(2) …. 16.45 s 37(1) …. 16.43 s 38 …. 16.43 s 43(1) …. 16.43 s 44(1) …. 16.46 s 44(6) …. 16.48 s 45(1) …. 16.43 s 45(2) …. 16.47 s 45(3) …. 16.43 Administrative Decisions (Judicial Review) Act 1977 …. 16.2, 16.31, 16.33 Civil Dispute Resolution Act 2011 …. 16.47 Commonwealth Electoral Act 1918 …. 9.45

Companies Code s 269(8A) …. 8.47 Constitution …. 16.2, 16.31 s 51(ii) …. 1.9, 1.11 s 55 …. 1.10 s 61 …. 16.49 s 71 …. 16.49 s 90 …. 19.2 s 96 …. 1.11 s 99 …. 1.11 s 107 …. 1.12 Corporations Act 2001 …. 12.26, 12.28, 12.76, 12.77, 13.2, 13.14, 15.12 Ch 6 …. 13.153 Pt 2J.1 …. 13.14 Pt 5.1 …. 13.153 s 46 …. 12.74 s 254T …. 12.52, 13.14, 13.35, 13.101 s 254V(1) …. 13.34 s 256B …. 13.14 s 708 …. 13.163 Corporations Amendment (Corporate Reporting Reform) Act 2010 …. 12.52, 13.2, 13.14, 13.35, 13.40 Corporations Amendment (Corporate Reporting Reform) Bill 2010 …. 13.101 Corporations Legislation Amendment (Deregulatory and Other Measures) Bill 2014 …. 13.2, 13.14 Crimes Act 1914 …. 17.2 s 4AA …. 16.19 Customs Act 1901 …. 19.29

Customs Tariff Act 1995 Sch 4 …. 19.46 Federal Court of Australia Act 1976 s 24 …. 16.46, 16.49 s 24(1) …. 16.49 s 24(1)(a) …. 16.46 s 25 …. 16.49 s 33 …. 16.49 Fringe Benefits Tax Act 1986 …. 1.10 Fringe Benefits Tax Assessment Act 1986 …. 1.10, 1.23, 2.2, 2.19, 2.24, 3.7, 5.4, 7.1, 7.4, 18.81 Pt III Divs 2–11 Subdiv A …. 7.50 Pt III Divs 2–12 …. 7.54 Pt III Div 4 …. 7.34 Pt III Div 12 …. 7.34 Pt III Div 13 …. 7.54 Pt III Div 14 …. 7.27 Pt III Div 14A …. 7.27 Pt XIA …. 7.4 s 5B(1) …. 7.7, 7.17 s 5B(1A) …. 7.7, 7.17 s 5B(1B) …. 7.7, 7.17 s 5B(1C) …. 7.7, 7.17 s 5B(1D) …. 7.17 s 5B(1E) …. 7.17, 7.54 s 5C(1) …. 7.17 s 5C(2) …. 7.17 s 5C(3) …. 7.17 s 5C(4) …. 7.17 s 5E …. 7.19

s 5E(3) …. 7.19 s 5F …. 7.20 s 7 …. 7.30 s 7(1) …. 7.29, 7.30 s 7(2A) …. 7.30 s 7(3) …. 7.30 s 7(4) …. 7.30 s 8(1) …. 7.30 s 8(2) …. 7.30 s 8(3) …. 7.30 s 9 …. 7.31 s 10(2) …. 7.32 s 10(3) …. 7.32 s 10(3)(c) …. 7.32 s 10(3A) …. 7.32 s 10(5) …. 7.31 s 10A …. 7.32 s 10B …. 7.32 s 11 …. 7.32 s 13 …. 7.31, 7.32 s 14 …. 7.33 s 15 …. 7.33 s 16 …. 7.34 s 16(2) …. 7.34 s 16(3) …. 7.34 s 17 …. 7.35 s 18 …. 7.36 s 20 …. 3.7, 9.37 s 20(a) …. 7.37 s 20A …. 7.38 s 21 …. 7.38, 7.54

s 22 …. 5.21, 7.38 s 22A …. 7.26 s 23 …. 7.38 s 24 …. 7.25, 7.38 s 26 …. 7.26 s 26(1)(b) …. 7.39 s 28 …. 7.39 s 30 …. 7.40 s 30(1) …. 7.40 s 30(2) …. 7.40 s 35 …. 7.42 s 36 …. 7.42 s 37AA …. 7.43 s 37AC …. 7.44 s 37AD …. 7.43 s 37AF …. 7.43 s 37BA …. 7.44 s 37C …. 7.44 s 38 …. 7.44 s 39 …. 7.44 s 39A …. 7.45 s 39C …. 7.46 s 39D …. 7.46 s 39DA …. 7.46 s 39FA …. 7.46 s 39GA …. 7.46 s 40 …. 7.47 s 41 …. 7.47 s 41(2) …. 7.47 s 42 …. 7.26, 7.38, 7.48

s 43 …. 7.49 s 44 …. 7.49 s 45 …. 7.38, 7.50 s 46(2) …. 7.53 s 47(1) …. 7.50 s 47(2) …. 7.50 s 47(3) …. 7.50 s 47(5) …. 7.50, 7.54 s 47(6) …. 7.50 s 47(6A) …. 7.50 s 47(7) …. 7.50 s 47(8) …. 7.50 s 48 …. 7.26, 7.38, 7.51 s 49 …. 7.38, 7.51 s 50 …. 7.51 s 51 …. 7.51 s 52 …. 7.53 s 53 …. 7.54 s 54 …. 7.54 s 55 …. 7.54 s 56 …. 7.54 s 57 …. 7.54, 7.60 s 57A …. 7.19 s 57A(1) …. 7.54 s 57A(2) …. 7.54 s 57A(3) …. 7.54 s 57A(4) …. 7.54 s 58 …. 7.19, 7.39, 7.54 s 58A …. 7.54 s 58B …. 7.54 s 58C …. 7.54

s 58D …. 7.54 s 58E …. 7.54 s 58F …. 7.54 s 58G(1) …. 7.54 s 58G(2) …. 7.54 s 58G(3) …. 7.54 s 58GA …. 7.54 s 58H …. 7.54 s 58J …. 7.54 s 58K …. 7.54 s 58L …. 7.54 s 58LA …. 7.54 s 58M …. 7.54 s 58N …. 7.54 s 58P(1) …. 7.54 s 58P(2) …. 7.54 s 58PA …. 7.54 s 58Q …. 7.54 s 58R …. 7.54 s 58S …. 7.54 s 58T …. 7.54 s 58U …. 7.54 s 58V …. 7.54 s 58W …. 7.54 s 58X …. 7.54 s 58Y …. 7.54 s 58Z …. 7.9, 7.54 s 58ZA …. 7.39 s 58ZB …. 7.54 s 58ZC …. 7.39, 7.54

s 58ZD …. 7.54 s 62 …. 7.27, 7.53 s 65CA …. 7.19 s 65CC …. 7.19 s 65J …. 7.59 s 65J(1) …. 7.59 s 65J(2B) …. 7.59 s 66 …. 7.7, 7.17 s 135Q …. 7.19 s 136 …. 7.8–7.14, 7.29, 7.34, 7.36, 7.37, 7.40, 7.42, 7.45, 7.47, 7.48, 7.49, 7.50, 7.54, 7.56 s 136(1) …. 2.24, 3.34, 5.46, 7.37 s 136(1)(g) …. 2.24 s 136(1)(h) …. 5.50 s 137 …. 7.11 s 138 …. 7.10 s 138(1) …. 7.10 s 138(2) …. 7.10 s 138(3) …. 7.10 s 138(4) …. 7.10 s 148 …. 7.15 s 148(1) …. 7.15 s 148(1)(a) …. 7.15 s 148(1)(b) …. 7.15 s 148(1)(h) …. 7.15 s 149 …. 7.18 s 149(1) …. 7.52 s 152A …. 7.25 s 152A(6) …. 7.25 s 152A(7) …. 7.25 s 152A(10) …. 7.25

s 154 …. 7.47 s 155 …. 7.47 Health Insurance Act 1973 …. 4.13, 19.35 s 3(1) …. 19.36 Health Insurance Regulations 1975 …. 19.35 reg 14 …. 19.35 reg 14(2)(ea) …. 19.35 reg 14(2)(f) …. 19.35 reg 14(2)(g) …. 19.35 High Court Rules 2004 r 41.02 …. 16.49 Higher Education Support Act 2003 …. 9.37 Income Tax Act 1986 …. 1.10 Income Tax Assessment Act 1915 …. 1.13, 14.29 s 11 …. 1.13 s 13 …. 1.13 s 14(b) …. 13.11 s 16 …. 1.13 s 18 …. 1.14 s 18(1) …. 1.13, 8.4 s 26(a) …. 1.14, 3.56 Income Tax Assessment Act (No 2) 1915 …. 1.13 Income Tax Assessment Act 1922 …. 1.10, 1.13 s 23 …. 8.6, 8.11 s 23(1)(a) …. 8.4, 8.10, 8.11 s 23(1)(e) …. 8.12 s 25 …. 8.4 s 25(e) …. 8.4, 8.10 Income Tax Assessment Act 1936 …. 1.10, 1.13, 1.15, 1.17, 1.23, 1.28,

1.29, 1.31–1.33, 2.1, 2.18, 6.106, 6.107, 6.109, 6.122, 6.141, 16.2, 18.3 Pt III Div 2 Subdiv A …. 5.35 Pt III Div 2 Subdiv AA …. 5.30, 5.35 Pt III Div 2 Subdiv D …. 13.33 Pt III Div 3 Subdiv B …. 10.39 Pt III Div 3 Subdiv BA …. 10.39 Pt III Div 3 Subdiv D …. 9.79, 17.20 Pt III Div 3B …. 3.21, 5.53 Pt III Div 5 …. 14.15, 14.41, 14.42, 14.47, 14.62, 14.68, 14.82, 14.90 Pt III Div 5A …. 14.88, 14.89 Pt III, Div 6 …. 15.24–15.26, 15.27, 15.29, 15.30, 15.55, 15.63, 15.64, 15.68, 15.75, 15.80, 15.84, 15.87, 15.96, 15.100, 15.101, 15.108, 15.109, 15.117, 15.126, 15.128, 18.26 Pt III Div 6AA …. 1.4, 15.60–15.62 Pt III Div 6AAA …. 18.34 Pt III Div 6B …. 15.136, 15.137, 15.138, 15.140, 15.141 Pt III Div 6C …. 12.18, 12.21, 12.113, 15.140, 15.141, 15.142 Pt III Div 6D …. 15.147 Pt III Div 6E …. 15.31, 15.87 Pt III Div 7A …. 7.8, 12.52, 13.17, 13.20, 13.21, 13.22, 13.23, 13.25, 13.26, 13.27, 13.28–13.30, 14.95 Pt III Div 7A Subdiv AA …. 13.27 Pt III Div 7A Subdiv B …. 13.27 Pt III Div 7A Subdiv C …. 13.27 Pt III Div 7A Subdiv D …. 13.27 Pt III Div 7A Subdiv DA …. 13.27 Pt III Div 7A Subdiv DB …. 13.27 Pt III Div 7A Subdiv E …. 13.27 Pt III Div 7A Subdiv EA …. 13.27

Pt III Div 7A Subdiv F …. 13.27 Pt III Div 7A Subdiv G …. 13.27 Pt III Div 10C …. 10.94, 10.98 Pt III Div 10D …. 10.94, 10.98 Pt III Div 11A …. 18.38, 18.50 Pt III Div 13 …. 17.4, 18.68, 18.69, 18.72, 18.82 Pt III Div 13A …. 5.44, 5.46, 5.47, 5.48, 5.49–5.51 Pt III Div 16E …. 3.34, 4.1, 4.3, 4.33, 4.43, 5.45, 6.137, 8.49, 8.50, 12.125 Pt IIIA …. 6.1, 6.29, 6.46, 6.50, 6.69, 6.73, 6.130 Pt IIIAA …. 12.88 Pt IVA …. 9.79, 9.82, 12.112, 13.97, 15.59, 17.2, 17.4, 17.5, 17.6, 17.7–17.11, 17.13–17.18, 17.24, 17.25, 18.3, 18.81, 18.81, 18.83, 19.47 Pt VI Div 2 …. 14.28 Pt X …. 13.130, 17.12, 18.22, 18.25, 18.27 Pt X Div 3 Subdiv B …. 18.26 Pt X Div 3 Subdiv C …. 18.26 Pt X Div 7 …. 18.24, 18.26 Pt X Div 8 …. 18.26 Pt XI …. 18.34 s 6 …. 1.29, 13.56, 13.68, 15.24, 18.32 s 6(1) …. 1.31, 1.32, 2.1, 2.5, 2.29, 2.37, 2.38, 2.40, 2.49, 3.62, 3.66, 4.41, 5.9, 5.13, 8.57, 11.3, 11.8, 11.11, 12.26, 12.52, 12.79, 12.82, 13.5–13.16, 13.19, 13.33, 13.34, 13.38, 13.40, 13.74, 13.75, 13.101, 13.18, 14.1, 14.2, 15.23, 16.3, 16.6, 16.9, 17.7, 18.7, 18.25, 18.36, 18.47, 19.20 s 6(1)(a)(iii) …. 2.39 s 6(4) …. 13.14, 13.15, 13.39, 13.56 s 6BA(5) …. 12.77, 12.85 s 6BA(6) …. 12.68, 12.77 s 6C …. 2.49

s 8 …. 16.2 s 17 …. 4.9 s 18 …. 4.2 s 18(1) …. 2.2 s 19 …. 3.36, 4.32, 15.69 s 20 …. 3.21, 5.53 s 21 …. 3.6, 3.7, 4.2 s 21(1) …. 1.32 s 21A …. 2.24, 3.5–3.7, 3.25, 3.34, 4.2, 5.4, 7.2, 7.55, 10.34 s 21A(2) …. 3.7 s 21A(3) …. 3.61 s 21A(4) …. 3.6 s 23 …. 2.14, 2.20, 15.146 s 23(f) …. 2.23 s 23(g) …. 2.21, 2.22 s 23(g)(i) …. 2.28 s 23(g)(iii) …. 2.22 s 23(h) …. 2.23 s 23(q) …. 2.30, 8.28, 15.53, 17.14 s 23(z) …. 2.28 ss 23AA–23L …. 2.3 s 23AB …. 2.26 s 23AD …. 2.26 s 23AF …. 2.25, 2.29, 2.30 s 23AF(11) …. 2.30 s 23AF(18) …. 2.30 s 23AG …. 2.20, 2.25, 2.29, 2.30, 2.32, 9.66, 18.5, 18.6, 18.14, 18.14 s 23AH …. 2.25, 2.29, 2.32, 9.66, 12.71, 13.53, 14.90, 18.5, 18.7, 18.8, 18.13, 18.14, 18.36, 18.40 s 23AH(2) …. 18.7

s 23AH(5) …. 18.7 s 23AH(7) …. 18.7 s 23AH(9) …. 18.9 s 23AH(10) …. 18.7 s 23AH(11) …. 18.7 s 23AH(12) …. 18.8 s 23AH(14)(c) …. 18.8 s 23AH(15) …. 18.6 s 23AI …. 2.24, 9.66, 18.10, 18.14, 18.14, 18.19, 18.31, 18.62 s 23AJ …. 9.66, 14.81 s 23AK …. 2.24, 9.66, 18.10, 18.14, 18.14, 18.19, 18.62 s 23L …. 2.20, 2.24, 5.4, 5.21, 7.1, 7.55, 7.57, 9.66 s 23L(1) …. 2.24 s 23L(1)(a) …. 7.55 s 23L(1)(b) …. 7.55 s 23L(1A) …. 2.24, 5.4 s 23L(2) …. 2.24, 3.6 s 25(1) …. 1.14, 2.10, 2.11, 2.32, 3.4, 3.20, 3.56–3.58, 3.69, 4.21, 4.22, 4.24, 4.26, 11.18, 14.40 s 25(1)(b) …. 2.43 s 25A …. 1.14, 2.18, 3.14, 5.8 s 25A(1A) …. 5.8 s 26 …. 2.32, 5.44 s 26(a) …. 1.14, 2.18, 3.14, 3.56–3.58, 4.21–4.24, 5.8 s 26(d) …. 2.18, 5.26, 5.29, 5.30, 5.32 s 26(e) …. 1.33, 2.10, 2.18, 3.4, 3.6, 3.22, 3.23, 3.34, 5.4, 5.4, 5.46, 7.2 s 26(f) …. 5.9–5.11 s 26(j) …. 5.16 s 26AC …. 5.35 s 26AAA …. 2.18, 3.14, 17.11

s 26AAB …. 5.25 s 26AAC …. 5.44, 5.46, 5.47 s 26AD …. 2.18, 5.32, 5.35, 5.37 s 26BB …. 4.33, 5.44, 5.45, 5.55 s 26BC …. 12.25 ss 27A–27H …. 5.35, 5.39 ss 27A–27J …. 2.9 s 27H …. 3.39, 3.62, 3.65, 5.43 s 27H(2) …. 5.43 ss 28–37 …. 11.1 s 31 …. 11.21 s 31(1) …. 11.20, 11.21 s 31C …. 11.31 s 36 …. 11.8, 11.9 s 36(1) …. 11.18 s 36(8) …. 11.27 s 36(9) …. 11.27 ss 38–43 …. 2.44 ss 44–47 …. 2.3, 3.62, 3.67, 13.3 ss 44–47A …. 1.4 s 44 …. 4.41, 11.11, 13.33, 17.3, 17.12 s 44(1) …. 2.18, 13.3, 13.4, 13.5, 13.17, 13.18, 13.29, 13.31–13.37, 13.38, 13.39, 13.43, 13.45, 13.48, 13.49, 13.63, 13.64, 13.74, 13.76, 13.85, 13.86, 13.89, 13.91, 14.57, 14.89 s 44(1)(a) …. 4.41, 13.14, 13.76 s 44(1)(a)(i) …. 13.33, 13.89 s 44(1)(a)(ii) …. 13.33 s 44(1)(b) …. 18.38 s 44(1)(b)(i) …. 13.29, 13.33 s 44(1)(b)(ii) …. 13.33 s 44(1)(c)(i) …. 13.33

s 44(1)(c)(ii) …. 13.33 s 44(1A) …. 13.14, 13.35 s 44(1B) …. 12.79, 13.38, 13.39 s 44(1B)(a) …. 13.37, 13.40 s 44(1B)(b) …. 13.40 s 44(2) …. 13.74 s 44(2)(b)(iii) …. 13.74 ss 45–45C …. 12.52 s 45 …. 12.52, 12.85, 12.86, 13.56 s 45(1) …. 12.85 s 45A …. 12.86–12.88 s 45B …. 12.87, 12.88, 13.27 s 45B(6) …. 12.87 s 45B(9) …. 12.87 s 45C …. 12.52, 12.88, 13.56 s 45C(3) …. 12.88 s 46 …. 11.11, 13.96, 15.141, 17.11 s 46(2B) …. 12.73 s 46A …. 13.97 s 46B …. 13.97 s 46D …. 13.100 s 46F …. 12.86 s 47 …. 13.17, 13.68 s 47(1) …. 13.7, 13.17, 13.56, 13.62–13.65, 13.67–13.76, 13.85, 13.86, 13.120 s 47(1A) …. 13.56, 13.62–13.65, 13.66, 13.67, 13.69, 13.72, 13.74, 13.77 s 47(1A)(a) …. 13.77 s 47(1A)(b) …. 13.65, 13.69 s 47A …. 12.52 s 51 …. 2.20, 8.16

s 51(1) …. 3.1, 3.56, 3.69, 4.15, 4.23, 6.111, 8.2, 8.4, 8.6–8.8, 8.11–8.13, 8.16–8.20, 8.22, 8.24, 8.25, 8.28, 8.32–8.36, 8.39–8.42, 8.44, 8.46, 8.48–8.50, 8.56, 8.57, 8.58, 8.60, 8.61, 8.72, 9.1, 9.7, 9.12, 9.34, 9.35, 9.36, 10.36, 11.1, 11.2, 11.12, 11.15, 11.31, 14.28, 14.41 s 51(2) …. 11.1, 11.2 s 51(2A) …. 11.1, 11.2 s 51(3) …. 8.41, 9.36 s 51(4) …. 9.35 s 51(6) …. 9.37 s 51AB …. 9.40, 9.41 s 51AE …. 9.54 s 51AF …. 9.76, 9.80 s 51AG …. 9.38 s 51AGA …. 9.76, 9.80 s 51AH …. 9.76, 9.81 s 51AJ …. 7.24, 9.76, 9.81 s 51AK …. 9.76, 9.81 s 51AL …. 9.61 s 52 …. 9.25 s 53 …. 9.7, 9.8, 9.13, 9.15 s 53AA …. 9.16 s 54 …. 10.2 s 54ff …. 10.2 s 63 …. 4.4, 9.1, 9.20, 9.21, 15.145 s 63E …. 15.145 s 65 …. 9.39 s 65(1A) …. 7.8 s 67 …. 9.18 s 67A …. 9.19 s 68 …. 9.17

s 69 …. 9.3 s 70B …. 4.33, 5.45, 12.125 s 71 …. 9.26 s 72 …. 9.30 s 73 …. 9.28 s 74 …. 9.29 s 78 …. 9.45, 9.46, 9.47 s 78(11) …. 9.27 s 78A …. 9.46 s 79C …. 9.43 s 79D …. 9.69 s 79E …. 9.62 s 82 …. 9.1 s 82A …. 7.36, 7.38, 8.80, 8.81 ss 82KH–82KL …. 9.76, 9.79 s 82KH …. 9.79 s 82KH(1F) …. 9.79 s 82KJ …. 9.79, 17.4, 17.20, 17.21 s 82KK …. 9.79, 17.4, 17.20, 17.22 s 82KK(2) …. 17.22 s 82KK(3) …. 17.22 s 82KK(4) …. 17.22 s 82KL …. 9.79, 17.4, 17.20, 17.23 ss 82KZL–82KZO …. 8.50, 9.76, 9.77 s 82KZL(1) …. 9.77 s 82KZM …. 9.77, 9.79 ss 82KZMA–82KZMD …. 9.78 s 82KZMF …. 9.78 s 82KZMG …. 5.19 ss 82U–82ZB …. 3.21, 5.53 s 90 …. 7.10, 10.66, 14.17, 14.24, 14.29, 14.41, 14.43, 14.44,

14.48, 14.49, 14.57, 14.68, 14.82, 14.83 s 91 …. 14.16, 14.41 s 92 …. 9.63, 14.18, 14.21, 14.24, 14.29, 14.41, 15.26 s 92(1) …. 14.29, 14.41, 14.58 s 92(1)(a) …. 14.18, 14.24 s 92(1)(b) …. 14.18 s 92(2) …. 14.19, 14.58 s 92(2)(a) …. 14.19 s 92(2)(b) …. 14.20 s 92(3) …. 2.20 s 92(4) …. 14.18 s 94 …. 14.54, 14.55 s 94D …. 14.14 s 94K …. 12.27 s 94L …. 14.89 s 94M …. 14.89 s 94P …. 14.89 s 94Q …. 14.89 s 94(10B) …. 14.54 s 95 …. 2.20, 14.21, 14.51, 14.57, 15.27, 15.80 s 95(2) …. 15.79 s 95A …. 15.57, 15.75 s 95A(1) …. 15.77 s 95A(2) …. 15.32, 15.37–15.39, 15.75 s 95AAA …. 15.31 s 95B …. 15.78 s 96 …. 15.29 s 97 …. 15.26, 15.41–15.43, 15.45, 15.46, 15.58, 15.69, 15.78, 17.3 s 97(1) …. 15.31, 15.32, 15.36, 15.37, 15.47, 15.61, 15.78, 15.109 s 97(1)(a) …. 14.58, 15.31 s 97(1)(b) …. 2.20

s 97(2) …. 15.37 s 97(2)(a) …. 15.32, 15.37 s 97(2)(b) …. 15.32 s 98 …. 2.20, 5.14, 14.58, 14.59, 15.26, 15.37, 15.41–15.43, 15.45, 15.47, 15.69, 15.78, 15.108, 15.109 s 98(1) …. 15.36, 15.37, 15.38, 15.78 s 98(2) …. 15.37, 15.38 s 98(3) …. 15.33, 15.34, 15.35, 15.36, 15.46 s 98(4) …. 15.33, 15.34, 15.35, 15.36, 15.46 s 98A …. 15.46 s 98A(1) …. 15.34, 15.35, 15.47 s 98A(2) …. 15.35 s 99 …. 2.20, 5.14, 14.59, 15.26, 15.37, 15.41, 15.42–15.49, 15.69, 15.83 s 99A …. 5.14, 14.59, 15.26, 15.37, 15.41, 15.42–15.49, 15.51, 15.56, 15.73, 15.75, 15.77, 15.78, 15.83 s 99A(2) …. 15.49–15.51 s 99A(3) …. 15.50 s 99B …. 15.52, 15.53, 15.54 s 99B(1) …. 15.52, 15.54 s 99B(2) …. 15.52 s 99B(2)(b) …. 15.53 s 99C …. 15.54 s 100 …. 15.61 s 100(1) …. 15.39 s 100(2) …. 15.40 s 100A …. 15.55, 15.56, 15.57, 17.4 s 100AA …. 15.58, 15.80 s 100AB …. 15.58, 15.80 s 101 …. 15.31, 15.33, 15.36, 15.68, 15.69, 15.74, 15.77 s 101A …. 5.42, 14.31, 14.35, 15.48, 15.129, 15.130, 15.131

s 101A(1) …. 15.48 s 101A(2) …. 15.48 s 101A(3) …. 15.48, 15.129 s 102 …. 15.55, 15.59 s 102AG(1) …. 15.62 s 102AG(2) …. 15.62 ss 102AAA–102AAZG …. 18.34 s 102J …. 15.122, 15.138 s 102L …. 15.141 s 102R …. 15.122, 15.141 s 102S …. 15.141 s 102T …. 15.141 s 103A …. 12.29 s 103A(1) …. 12.29 s 103A(2) …. 12.31 s 103A(2)(a) …. 12.29 s 103A(2)(b) …. 12.29 s 103A(2)(c) …. 12.29 s 103A(2)(d)(i)–(iv) …. 12.29 s 103A(2)(d)(v) …. 12.29, 12.32 s 103A(3) …. 12.30, 12.31 s 103A(4) …. 12.32 s 103A(4)(a)(ii) …. 12.32 s 103A(4A) …. 12.32 s 103A(4B) …. 12.32 s 103A(4C) …. 12.32 s 103A(4D) …. 12.32 s 103A(4E) …. 12.32 s 103A(5) …. 12.31, 12.32 s 108 …. 13.17, 13.21, 13.22, 13.27, 13.28 s 108(2) …. 13.28

s 109 …. 12.52, 13.17, 13.18, 13.19, 13.20, 13.27, 13.28 s 109(1) …. 13.18 s 109(2) …. 13.19 ss 109B–109ZE …. 13.17 s 109BA …. 13.27 s 109BB …. 14.95 ss 109C–109F …. 13.27 s 109C …. 13.28 s 109C(1) …. 13.27 s 109D …. 13.28 s 109E …. 13.28 s 109F …. 13.28 s 109G …. 13.27 s 109G(1) …. 13.27 s 109G(2) …. 13.27 s 109G(3) …. 13.27 s 109G(4) …. 13.27 ss 109H–109R …. 13.27 s 109J …. 13.27 s 109K …. 13.27 s 109L …. 13.27 s 109M …. 13.27 s 109N …. 13.27 s 109Q …. 13.27 s 109RA …. 13.27 ss 109RB–109RD …. 13.27 s 109RB …. 13.25 ss 109S–109X …. 13.27 s 109UB …. 12.6 ss 109XA–109XC …. 13.27

s 109XA …. 12.6 s 109XB …. 12.6, 13.28 ss 109XE–109XI …. 13.27 ss 109Y–109ZC …. 13.27 s 109Y …. 13.28 s 109Z …. 13.29 s 109ZA …. 13.29 s 109ZB …. 13.30 s 109ZC …. 13.28 ss 109ZD–109ZE …. 13.27 ss 121AA–121AT …. 3.33 s 121EG …. 2.14, 6.137 s 128A(1AB) …. 18.44 s 128AC …. 3.63 s 128AD …. 18.44 ss 128AAA–128R …. 18.38 s 128B …. 2.32, 2.45, 2.46, 2.49, 5.13, 16.63, 18.40, 18.41, 18.43 s 128B(1) …. 18.40 s 128B(2) …. 18.42 s 128B(2B) …. 18.47 s 128B(2C) …. 18.48 s 128B(3)(h) …. 18.45 s 128B(3)(ga) …. 2.46, 12.35, 12.69, 13.53, 18.40, 18.51 s 128B(3E) …. 13.53, 18.40 s 128B(4) …. 18.41 s 128B(5) …. 18.43 s 128D …. 2.24, 2.46, 5.13, 12.35, 13.53, 18.35, 18.39, 18.40 s 128F …. 18.46 s 128F(3) …. 18.46 s 128F(4) …. 18.46 ss 136AA–136AF …. 18.68

ss 139–139GH …. 5.47 s 139CD …. 5.49 s 159SA …. 5.35 ss 159GP–159GZ …. 4.33 s 159GP …. 5.45 s 159GP(1) …. 4.33 s 159GQA …. 4.33 ss 159H–160ADA …. 2.3 s 159GZZZP …. 6.137, 13.56 s 159GZZZP(1) …. 13.17 s 159GZZZQ(2) …. 13.56, 13.141 s 159GZZZQ(3) …. 13.56 s 159GZZZQ(5) …. 12.79 s 159GZZZR …. 13.56 s 159GZZZS …. 13.56 s 160A …. 6.69, 6.73 s 160A(d) …. 14.66, 14.67, 14.69, 14.72, 14.74, 14.84 s 160A(e) …. 14.66, 14.69, 14.72, 14.74, 14.84 s 160AAA …. 2.31 s 160AFD …. 9.69, 9.91 ss 160APHC–160APHU …. 12.73, 13.102 s 160APP(6) …. 12.73 s 160AQT(1AB)(ba) …. 12.73 s 160AQU …. 13.55 s 160C(3) …. 14.66, 14.70 s 160M …. 6.29 s 160M(1) …. 6.29, 6.86 s 160M(2) …. 6.29 s 160M(3) …. 6.29 s 160M(3)(b) …. 6.29

s 160M(3)(c) …. 6.29 s 160M(6) …. 6.29, 6.34, 6.35, 6.38, 6.46, 6.49, 6.50 s 160M(7) …. 6.34, 6.35, 6.46, 6.48–6.51 s 160U …. 6.87 s 160U(3) …. 6.87 s 160U(4) …. 6.29 s 160V(1) …. 15.99 s 160ZA(4) …. 14.65, 15.108, 15.109 s 160ZA(5) …. 14.66, 14.67, 14.68, 14.82 s 160ZA(6) …. 14.66, 14.67, 14.68, 14.82 s 160ZB …. 6.130 s 160ZB(1) …. 6.130 s 160ZD(1)(c) …. 6.89 s 160ZD(4) …. 6.95 s 160ZH(4) …. 6.107 s 160ZH(9) …. 13.109, 13.110 s 160ZH(9)(a) …. 13.09 s 160ZI …. 6.29 s 160ZK …. 6.122, 14.65 s 160ZK(3) …. 14.66, 14.67 s 160ZX(1) …. 15.135 s 160ZYA …. 15.108, 15.109 s 160ZZC …. 6.38, 6.46 s 160ZZC(3) …. 6.46 s 160ZZC(6) …. 6.46 s 160ZZC(12) …. 6.46, 6.47 s 160ZZC(12)(b) …. 6.46 s 160ZZQ(12) …. 6.46 s 160ZZR …. 6.74 s 160ZZS …. 12.141, 15.125 s 160ZZT …. 13.128

s 161 …. 2.3, 4.2, 16.7 s 161(1) …. 16.7 s 161(1A) …. 16.7 s 161A(1) …. 2.3 s 161AA …. 16.6 s 162 …. 16.8 s 163 …. 16.8 s 166 …. 16.8, 16.10, 16.11 s 166A …. 12.17, 16.10 s 167 …. 16.11, 16.19 s 168 …. 16.11 s 169 …. 16.11 s 169A(1) …. 16.12 s 170 …. 4.30, 16.12, 17.9, 17.17 s 170(1) …. 16.9, 16.34 s 170(9) …. 3.34, 4.3, 4.30, 9.63 s 170AA …. 9.3 s 175 …. 16.13 s 177A …. 12.112, 17.8 s 177A(1) …. 17.7 s 177A(3) …. 17.8 s 177A(5) …. 17.13 s 177B(1) …. 17.6, 17.25 s 177B(2) …. 17.6 s 177B(3) …. 17.6 s 177B(4) …. 17.6 s 177C …. 17.8, 17.10, 17.14 s 177C(1) …. 17.10, 17.12 s 177C(2) …. 17.12 s 177CB …. 17.11

s 177CB(1) …. 17.11 s 177CB(2) …. 17.11 s 177CB(3) …. 17.11 s 177CB(4) …. 17.11 s 177D …. 17.5, 17.8, 17.9, 17.13, 17.14 s 177D(b) …. 17.14, 17.15 s 177D(b)(iv) …. 17.14 s 177D(b)(v) …. 17.14 s 177D(b)(vi) …. 17.14 s 177D(b)(vii) …. 17.14 s 177D(b)(viii) …. 17.14 s 177D(2) …. 17.15 s 177D(2)(b) …. 17.15 s 177DA …. 17.5 s 177E …. 13.97, 17.5 s 177E(1)(e) …. 13.97 s 177EA …. 12.71, 13.95, 17.5 s 177EA(3)(a)–(d) …. 12.71 s 177EA(5)(b) …. 12.71 s 177EA(13) …. 12.71 s 177EA(17) …. 12.71 s 177EB …. 17.5 s 177F …. 13.97, 17.4, 17.5, 17.8, 17.11, 17.17 s 177F(1) …. 17.17 s 177F(3) …. 17.17 s 177G …. 17.17 ss 177H–177R …. 17.5 s 204 …. 16.54 s 204(1) …. 16.54 s 204(1A) …. 16.54 s 221A …. 7.37, 7.56, 7.57, 9.72

s 221A(1) …. 7.57 s 260 …. 11.31, 13.96, 17.6, 17.12 s 262A …. 16.19, 16.20 s 263 …. 16.8, 16.12 s 263(1) …. 16.22 s 264 …. 16.8, 16.12, 16.24 s 264A …. 16.25 s 265B …. 4.33 ss 316–468 …. 18.22 s 317 …. 18.25, 18.26 s 318 …. 7.12, 9.85, 13.19 s 318(1) …. 13.19 s 318(6) …. 7.12 s 318(7) …. 13.19 s 319 …. 18.26 s 320 …. 18.25, 18.27 s 332 …. 18.25 s 333 …. 18.25 s 340 …. 18.24, 18.25 s 340(c) …. 18.32 s 349 …. 18.25 s 350(6) …. 18.25 s 353(2) …. 18.25 s 361 …. 18.24, 18.29 s 362 …. 18.24, 18.30, 18.33 s 381 …. 18.26 s 384(2)(a) …. 18.32 s 384(2)(aa) …. 18.32 s 384(2)(b)–(c) …. 18.32 s 384(2)(c) …. 18.26

s 385 …. 18.26 s 385(2)(a)(i) …. 18.32 s 385(2)(a)(ii) …. 18.32 s 385(2)(b)–(c) …. 18.32 s 385(2)(c) …. 18.26 s 386 …. 18.26 s 432 …. 18.22, 18.26, 18.28 s 446 …. 18.22 s 456 …. 18.23, 18.24, 18.30, 18.32 ss 469–624 …. 18.34 s 469(3) …. 18.34 s 469(6) …. 18.34 Sch 2E s 42A-105(3) …. 10.34 Sch 2F …. 15.27, 15.145, 15.146 Div 266 …. 15.27 s 266-45 …. 15.146 Div 267 …. 15.27 s 269-50 …. 15.146 s 269-55 …. 15.146 ss 269-60–269-85 …. 15.146 s 269-95 …. 15.146 s 269-100 …. 15.146 ss 270-5–270-25 …. 15.146 s 271-105 …. 7.8 s 272-70 …. 15.146 s 272-75 …. 15.146 s 272-80 …. 15.146 s 272-85 …. 15.148 s 272-100 …. 15.146 s 272-105(1) …. 15.146 s 272-105(2) …. 15.146

s 272-105(2A) …. 15.146 s 272-115 …. 15.146 s 272-120 …. 15.146 s 272-125 …. 15.146 Sch 2H Div 326 …. 3.33 Income Tax Assessment Act 1997 …. 1.10, 1.13, 1.17, 1.23, 1.28, 1.31, 1.33, 2.1, 3.71, 6.100, 6.101, 6.102, 6.108, 6.109, 6.113, 6.121, 6.122, 6.123, 6.133, 6.137, 6.145, 6.146, 6.148, 6.155, 6.156, 6.163, 6.164, 12.112, 12.158, 16.2, 18.3 Ch 1 …. 1.17, 2.2 Ch 2 …. 1.17 Ch 3 …. 1.17 Ch 4 …. 1.17 Ch 5 …. 1.17 Ch 6 …. 1.17 Pt 2-40 …. 2.3 Pt 2-42 …. 9.82, 17.2, 17.4 Divs 84–87 …. 17.25 Pt 3-1 …. 2.33, 3.16, 6.6, 6.25, 6.123, 6.137 Pt 3-1 Div 100 …. 6.3, 6.4 Pt 3-1 Div 104 …. 6.8 Pt 3-3 …. 2.33, 6.108, 6.123, 6.162, 6.163 Pt 3-6 …. 12.37, 13.14 Pt 3-95 …. 6.93 Divs 1–8 …. 2.3 s 1-3 …. 1.28, 2.1, 8.24 ss 1-5–13-1 …. 2.2 s 2-5 …. 1.17 s 3-5 …. 9.62 Div 4 …. 1.33, 2.2 ss 4-1–13-1 …. 2.2

s 4-1 …. 2.2, 2.13, 12.17 s 4-5 …. 12.16 s 4-10 …. 2.3, 4.2, 12.17 s 4-10(1) …. 2.2 s 4-10(2) …. 2.2, 9.62 s 4-10(3) …. 2.2, 8.1 s 4-15 …. 2.2, 4.1, 4.22, 5.1, 9.62 s 4-15(1) …. 2.2, 8.1 s 5-5(4) …. 16.54 s 5-5(5) …. 16.54 Div 6 …. 1.17, 2.2, 5.2 s 6-1 …. 2.2 s 6-1(2) …. 2.2 s 6-1(3) …. 2.14 s 6-5 …. 1.4, 2.3, 2.4, 2.10, 2.11, 2.13, 2.14, 2.24, 2.32, 3.2, 3.7–3.9, 3.20, 3.21, 3.28, 3.56, 3.62, 3.66, 3.69, 3.70, 4.3, 4.5, 4.21, 4.23, 4.26, 4.28, 5.1, 5.2, 5.4, 5.7–5.10, 5.12, 5.16, 5.18, 5.22, 5.45, 5.46, 5.53, 6.53, 6.137, 7.1, 7.55, 7.57, 8.1, 8.38, 10.87, 11.2, 11.5, 11.18, 11.26, 11.30, 14.29, 14.36, 14.39, 14.41, 14.82, 15.85, 16.65 s 6-5(1) …. 2.9, 2.15 s 6-5(2) …. 1.23, 4.3 s 6-5(3) …. 4.32, 5.13, 18.38 s 6-5(3)(a) …. 2.43 s 6-5(4) …. 3.36, 4.3, 4.32 s 6-10 …. 2.3, 2.4, 2.13, 2.14, 2.18, 2.32, 4.3, 5.1, 5.2, 5.3, 6.5, 8.3 s 6-10(2) …. 2.14 s 6-10(3) …. 4.3, 4.32, 5.3 s 6-10(4) …. 2.33, 4.3, 6.5 s 6-10(5) …. 18.38 s 6-10(5)(b) …. 2.33, 6.5

s 6-15 …. 2.14, 2.32 s 6-15(1) …. 2.4 s 6-15(2) …. 2.14, 2.20, 2.24, 4.3, 8.82 s 6-20 …. 2.4, 5.2, 8.1 s 6-20(1) …. 2.14, 2.20 s 6-20(2) …. 2.14 s 6-23 …. 8.1 s 6-25 …. 5.2, 13.3 s 6-25(1) …. 2.14, 6.136, 7.55 s 6-25(2) …. 6.136 Div 8 …. 1.17, 2.2 s 8-1 …. 2.2, 2.3, 3.2, 3.8, 3.9, 3.56, 3.69, 4.23, 4.31, 5.23, 5.52, 5.53, 6.10, 6.12, 6.32, 6.109, 6.111, 8.1, 8.3–8.5, 8.7, 8.10, 8.15–8.17, 8.25–8.28, 8.32–8.34, 8.38, 8.40, 8.46, 8.48, 8.56, 8.58, 8.60, 8.70, 8.74, 8.77, 8.79–8.81, 8.83, 9.1–9.5, 9.7, 9.9, 9.12, 9.15, 9.17, 9.18, 9.24, 9.26–9.28, 9.30, 9.32, 9.34–9.38, 9.40, 9.44, 9.45, 9.54, 9.61, 9.70, 9.71, 9.77, 9.79, 10.1, 10.36, 10.60, 10.77, 10.82, 10.83, 11.1, 11.2, 11.5, 11.12, 11.15, 11.23, 11.27, 11.30, 11.31, 12.150, 14.29, 14.41, 14.82, 17.4, 18.10 s 8-1(1) …. 8.7, 8.28 s 8-1(1)(a) …. 8.4, 8.6–8.8, 8.13, 8.15, 8.17, 8.18, 8.55, 8.70 s 8-1(1)(b) …. 8.4, 8.6, 8.8, 8.17, 8.18, 8.34, 8.54, 8.56, 8.57, 8.60, 8.70 s 8-1(2) …. 8.2, 8.28 s 8-1(2)(a) …. 8.4, 8.27, 8.61, 8.70 s 8-1(2)(b) …. 8.2, 8.70 s 8-1(2)(c) …. 8.20, 8.82 s 8-1(2)(d) …. 8.5, 8.20, 8.83 s 8-5 …. 2.2, 2.3, 8.1, 8.3, 8.83, 9.1 s 8-10 …. 8.3, 8.5, 8.83, 9.1, 9.7, 9.68 s 9-1 …. 16.64

Div 11 …. 2.2 s 11-5 …. 2.14, 2.20, 2.21 s 11-10 …. 2.14, 2.20, 2.24 s 11-15 …. 2.14, 2.20, 2.25 s 12-37 …. 13.2 Div 15 …. 2.3, 4.3, 5.1, 5.3, 5.22 s 15-2 …. 2.24, 3.6, 5.3, 5.4, 5.46, 7.1, 7.2, 7.55, 7.57 s 15-2(3) …. 5.2, 5.4 s 15-2(3)(e) …. 5.46 s 15-3 …. 5.3, 5.5, 16.63 s 15-5 …. 5.3, 5.6, 9.36 s 15-10 …. 5.3, 5.7 s 15-10(b) …. 5.7 s 15-15 …. 1.14, 3.28, 5.3, 5.8, 5.10, 9.25, 10.87 s 15-20 …. 3.62, 3.66, 5.3, 5.9, 5.10, 5.12, 5.14, 18.47 s 15-22 …. 5.3, 5.14 s 15-25 …. 5.3, 5.15, 9.16 s 15-30 …. 3.70, 5.3, 5.16 s 15-35 …. 5.3, 5.17 s 15-40 …. 5.3, 5.18 s 15-45 …. 5.3, 5.19 s 15-50 …. 4.37, 5.3, 5.20, 9.31 s 15-70 …. 5.3, 5.4, 5.21 s 15-75 …. 7.55 Div 17 …. 4.46 s 17-15 …. 4.46 Div 20 …. 2.3, 5.1, 5.22 Subdiv 20-A …. 3.20, 3.70, 5.23 s 20-20 …. 5.23 s 20-20(1) …. 5.22 s 20-25(1) …. 5.23

s 20-25(3) …. 5.23 s 20-25(4) …. 5.23 s 20-30 …. 5.23, 9.6, 9.24, 9.29, 9.30 s 20-40 …. 5.23 Subdiv 20-B …. 5.24, 5.25 s 20-100 …. 5.25 s 20-110 …. 5.25 s 20-110(2) …. 5.25 s 20-115 …. 5.25 s 20-115(2) …. 5.25 s 20-120 …. 5.25 Div 25 …. 2.3, 8.3, 9.1, 9.2, 9.33, 9.44, 9.70 s 25-5 …. 5.17, 5.23, 9.1, 9.2, 9.3, 9.6, 9.88 s 25-5(1) …. 9.3 s 25-5(2)(a) …. 9.3 s 25-5(2)(b) …. 9.3 s 25-5(2)(c) …. 9.3 s 25-5(2)(d) …. 9.3 s 25-5(3) …. 9.3 s 25-5(4) …. 9.3, 9.5 s 25-5(5) …. 9.4 s 25-10 …. 3.8, 5.15, 9.1, 9.2, 9.7, 9.8, 9.9, 9.12, 9.15, 9.71, 10.39 s 25-10(1) …. 9.8 s 25-10(2) …. 9.15 s 25-10(3) …. 9.8, 9.14, 10.39 s 25-15 …. 5.15, 9.2, 9.16 s 25-20 …. 9.2, 9.17 s 25-25 …. 9.2, 9.18 s 25-25(6) …. 9.18 s 25-30 …. 6.39, 9.2, 9.19

s 25-35 …. 4.4, 4.36, 5.23, 6.32, 6.39, 8.5, 9.2, 9.20, 9.24 s 25-35(1)(b) …. 9.24 s 25-35(2) …. 9.24 s 25-35(3) …. 9.24 s 25-35(4) …. 9.24 s 25-35(5) …. 9.24 s 25-40 …. 9.2, 9.25 s 25-45 …. 5.23, 9.2, 9.26 s 25-50 …. 9.2, 9.27, 9.43 s 25-50(3) …. 9.27 s 25-55 …. 8.5, 9.1, 9.2, 9.27, 9.28 s 25-60 …. 5.23, 9.2, 9.29 s 25-70 …. 9.2, 9.29 s 25-75 …. 5.23, 9.2, 9.30 s 25-75(4) …. 9.30 s 25-80 …. 5.23 s 25-85 …. 12.25 s 25-90 …. 18.10, 18.62 s 25-95 …. 4.37, 5.20, 5.23, 9.2, 9.31, 14.43 s 25-95(3) …. 5.20, 14.43 s 25-100 …. 8.79, 9.2, 9.32 s 25-110 …. 9.2, 9.33 Div 26 …. 2.3, 8.3, 9.1, 9.34, 9.44, 9.70 s 26-5 …. 6.102, 6.124, 9.34, 9.35, 9.36 s 26-10 …. 5.6, 8.41, 9.34, 9.36 s 26-10(1)(a) …. 9.36 s 26-10(2) …. 9.36 s 26-19 …. 8.15, 8.80 s 26-20 …. 8.80, 9.34, 9.37 s 26-20(2) …. 9.37 s 26-22 …. 6.124

s 26-25 …. 18.50 s 26-26 …. 12.25 s 26-30 …. 8.79, 9.34, 9.38 s 26-30(3) …. 9.38 s 26-35 …. 9.1, 9.34, 9.39, 9.79 s 26-45 …. 8.5, 9.34, 9.40, 9.41 s 26-45(1) …. 9.40 s 26-45(2) …. 9.40 s 26-47 …. 6.124 s 26-50 …. 9.34, 9.41, 9.68 s 26-50(3) …. 9.41 s 26-50(4) …. 9.41 s 26-50(7) …. 9.41 s 26-52 …. 9.35 s 26-53 …. 9.35 s 26-54 …. 6.124, 9.34, 9.42 s 26-54(2) …. 9.42 s 26-55 …. 9.34, 9.43, 9.68 s 26-100 …. 6.124 Div 27 …. 9.1, 9.44, 9.75 s 27-5 …. 9.75 Subdiv 27-B …. 10.35, 10.60, 10.63, 10.71, 10.77 Div 28 …. 2.3, 5.21, 9.1, 9.44, 9.70, 9.71 s 28-13 …. 9.71 Subdiv 28-C …. 9.71 s 28-25 …. 9.71 Subdiv 28-D …. 9.71 s 28-45 …. 9.71 Subdiv 28-E …. 9.71 Subdiv 28-F …. 9.71

Div 30 …. 9.1, 9.43, 9.44, 9.45, 9.46, 9.68 s 30-15 …. 9.48, 11.27 Subdiv 30-B …. 9.45 s 30-45 …. 9.47 s 30-55 …. 9.48 s 30-90 …. 9.49 s 30-95 …. 9.50 s 30-100 …. 9.51 Subdiv 30-C …. 9.53 s 30-315 …. 9.45 ss 30-260–30-275 …. 9.48 Subdiv 30-F …. 9.51 Div 32 …. 2.3, 3.6, 5.52, 8.5, 8.74, 9.1, 9.44, 9.54 s 32-5 …. 9.54, 9.56 s 32-10 …. 9.54 s 32-15 …. 9.45, 9.54 Subdiv 32-B …. 9.45 s 32-20 …. 9.55 ss 32-30–32-50 …. 9.55 s 32-30 …. 9.56, 9.58 s 32-35 …. 9.57 s 32-40 …. 9.58, 9.59 s 32-45 …. 9.59 s 32-50 …. 9.60 Subdiv 32-C …. 9.55 s 32-65 …. 9.57 s 32-70 …. 5.52 s 32-70(1) …. 9.56 s 32-70(2) …. 9.56 Div 34 …. 9.1, 9.44, 9.61 Div 35 …. 9.1, 9.44, 9.69

s 35-10(4) …. 9.69 ss 35-30–35-45 …. 9.69 s 35-55 …. 9.69 Div 36 …. 2.20, 9.1, 9.44, 9.62, 14.93 s 36-10 …. 2.14, 9.63, 12.90 s 36-15 …. 9.67, 9.91 s 36-17 …. 13.91 s 36-17(5) …. 13.91 s 36-17(5)(a) …. 13.91 s 36-17(5)(b) …. 13.92 s 36-20 …. 9.66 s 36-20(3) …. 9.66 s 36-35 …. 9.69 s 36-55 …. 13.90, 13.91, 18.36 s 36-55(2) …. 13.90 Div 40 …. 2.3, 3.8, 4.25, 5.18, 5.23, 6.134, 8.3, 8.5, 8.55, 10.3, 10.4, 10.5, 10.6, 10.7, 10.8, 10.11, 10.13, 10.14, 10.15, 10.18–10.20, 10.23, 10.35, 10.39, 10.40, 10.49, 10.54, 10.64, 10.68, 10.77, 10.88, 10.93, 10.94, 10.105, 10.111, 14.44, 14.46 Subdiv 40-B …. 10.3, 10.55, 10.56, 10.79 s 40-25 …. 10.51, 10.65 s 40-25(1) …. 10.5 s 40-25(2) …. 10.5, 10.44, 10.51, 10.53, 10.65 s 40-25(3) …. 10.5 s 40-25(4) …. 10.5 s 40-25(7) …. 10.51 s 40-30 …. 10.6, 10.58, 10.78 s 40-30(2) …. 10.77 s 40-30(3) …. 10.6 s 40-30(4) …. 10.15 s 40-30(5) …. 10.15

s 40-30(6) …. 10.15 s 40-35 …. 10.20 s 40-40 …. 10.16–10.20, 10.111, 14.44, 14.46 s 40-45 …. 10.7 s 40-45(1) …. 10.7 s 40-45(2) …. 10.8 s 40-55 …. 10.15 s 40-60(1) …. 10.21 s 40-60(2) …. 10.21, 10.43 s 40-65 …. 17.12 s 40-65(1) …. 10.22 s 40-65(2) …. 10.23 s 40-65(3) …. 10.23 s 40-70 …. 10.29 s 40-70(1) …. 10.26, 10.27, 10.29, 10.30, 10.43 s 40-70(2) …. 10.23 s 40-72 …. 10.32, 10.84 s 40-72(1) …. 10.32 s 40-75 …. 10.26 s 40-75(7) …. 10.26 s 40-80(1) …. 10.24 s 40-80(2) …. 10.24 s 40-85 …. 10.44 s 40-95 …. 10.45, 10.48 s 40-95(4) …. 10.47 s 40-95(5) …. 10.111 s 40-95(6) …. 10.111 s 40-95(7) …. 10.49 s 40-100 …. 10.45, 10.46, 10.47 s 40-100(3) …. 10.46 s 40-105 …. 10.45, 10.47, 10.49

s 40-110 …. 10.45, 10.49 s 40-110(2) …. 10.49 s 40-110(3) …. 10.49 s 40-115(3) …. 10.40 s 40-130 …. 10.45 s 40-130(1)(a) …. 10.22 s 40-130(2) …. 10.22 Subdiv 40-C …. 10.3, 10.33, 11.30 s 40-180 …. 10.33, 14.45 s 40-185 …. 10.33, 10.40, 10.41 s 40-185(1)(a) …. 10.34 s 40-190 …. 10.37 s 40-195 …. 10.38 s 40-205 …. 10.33, 10.40 s 40-210 …. 10.33, 10.41 s 40-215 …. 10.39 s 40-225 …. 10.42, 10.63 s 40-220 …. 10.39 s 40-230 …. 1.31, 4.28, 10.42, 10.63 Subdiv 40-D …. 3.20, 10.3, 11.30 s 40-285 …. 10.64, 10.65 s 40-285(1) …. 10.55 s 40-285(2) …. 10.56, 10.61 s 40-285(3) …. 10.57 s 40-285(4) …. 10.57 s 40-290 …. 10.65 s 40-290(2) …. 10.65 s 40-295(1) …. 10.58 s 40-295(1)(a) …. 10.58 s 40-295(2) …. 10.33, 10.58, 10.59, 10.69, 14.45–14.47

s 40-295(3) …. 10.58 s 40-300 …. 10.59, 10.60, 10.61, 14.45 s 40-305 …. 10.42, 10.59, 10.60, 10.61 s 40-305(1) …. 10.62 s 40-305(1)(a) …. 10.60 s 40-305(2) …. 10.61 s 40-310 …. 10.61 s 40-315 …. 10.37, 10.60 s 40-320 …. 10.42, 10.63 s 40-325 …. 10.63 s 40-340 …. 10.33, 10.65 s 40-340(1) …. 10.68 s 40-340(3) …. 10.69, 14.46, 14.47, 14.49 s 40-340(8) …. 10.67 s 40-345 …. 10.67, 14.47 s 40-350 …. 14.47 s 40-365 …. 10.70 s 40-370(2) …. 10.64 Subdiv 40-E …. 10.3, 10.25, 10.71 s 40-425 …. 10.71 s 40-425(2) …. 10.93 s 40-425(5) …. 10.71 s 40-425(6) …. 10.71 s 40-430(1) …. 10.72 s 40-430(3) …. 10.72 s 40-435 …. 10.73 s 40-440 …. 10.74 s 40-440(2) …. 10.75 s 40-450 …. 10.78 s 40-455 …. 10.80 s 40-460 …. 10.81

s 40-480 …. 10.86 Subdiv 40-F …. 10.4 Subdiv 40-G …. 10.4 Subdiv 40-H …. 10.4 s 40-730 …. 5.18 Subdiv 40-I …. 10.3, 10.84, 10.87, 10.111, 12.124 s 40-830 …. 10.84, 10.86 s 40-830(3) …. 10.84 s 40-830(4) …. 10.86 s 40-830(5) …. 10.86 s 40-830(6) …. 10.86 s 40-830(7) …. 10.84 s 40-830(8) …. 10.84 s 40-835 …. 10.84 s 40-840 …. 10.84 s 40-840(2) …. 10.87 s 40-840(2)(c) …. 10.87 s 40-845 …. 10.84 s 40-880 …. 10.87, 10.90, 12.124 s 40-880(2) …. 10.89, 10.90 s 40-880(2)(c) …. 10.90 s 41-20 …. 10.91 Div 42 …. 10.2, 10.3, 10.82 s 42-15 …. 11.23 s 42-192(2) …. 10.65 Div 43 …. 6.102, 6.123, 10.2, 10.3, 10.6, 10.8, 10.11, 10.13, 10.18, 10.19, 10.94, 10.95, 10.96, 10.97, 10.99, 10.100, 10.102, 10.105, 10.106, 10.107–10.109, 10.110, 15.28 s 43-10 …. 10.95 s 43-15 …. 10.106 s 43-15(1) …. 10.106

s 43-20 …. 10.95, 10.97 s 43-20(3) …. 10.97 s 43-25 …. 10.106–10.108 s 43-40 …. 10.109 s 43-45 …. 10.110 s 43-50(1) …. 10.94 s 43-70 …. 10.8, 10.100 s 43-70(1) …. 10.100 s 43-70(2) …. 10.100 s 43-70(2)(e) …. 10.8 s 43-70(2)(h) …. 14.83 s 43-75 …. 10.101 s 43-75(1) …. 10.102 s 43-75(3) …. 10.103 s 43-80 …. 10.99 s 43-85 …. 10.104 s 43-90 …. 10.101 s 43-115 …. 10.105 s 43-140 …. 10.95, 10.108 s 43-140(2)(a) …. 10.95 s 43-145 …. 10.108 Subdiv 43-E …. 10.95 s 43-160 …. 10.98 s 43-165 …. 10.98 Subdiv 43-F …. 10.107 Subdiv 43-G …. 10.106 s 43-250 …. 10.109 Div 45 …. 14.47 s 45-40 …. 10.9, 10.12, 10.13 Div 50 …. 2.3, 12.113, 15.146 Subdiv 50-A …. 2.23

ss 50-5–50-45 …. 2.14, 2.20 s 50-10 …. 2.21 s 50-15 …. 2.23 s 50-40 …. 2.23 s 50-45 …. 2.21 Div 51 …. 2.3 s 51-5 …. 2.25, 2.26, 9.68 s 51-10 …. 2.25, 2.28 s 51-50 …. 2.25, 2.27 Div 52 …. 2.20 ss 52-1–52-150 …. 2.31 Subdiv 52-B …. 2.15 Subdiv 52-C …. 2.15 s 52-10 …. 2.31 s 52-75 …. 2.31 ss 53-10–53-25 …. 2.31 Div 58 …. 10.33, 10.71 s 58-70(3) …. 10.33 s 58-70(5) …. 10.33 s 59-35 …. 3.32 s 59-40 …. 6.43, 6.137, 13.115 s 63-10 …. 13.50 Div 67 …. 13.50 s 67-25 …. 13.50 s 67-25(1C) …. 13.91, 18.36 s 67-25(1DA) …. 13.53, 18.36 Div 70 …. 2.3, 4.3, 4.23, 8.3, 9.31, 11.1, 11.2, 11.3, 11.4, 11.5, 11.7, 11.12, 11.31, 12.126 s 70-10 …. 1.32, 3.13, 11.3, 11.5–11.8, 11.11, 11.13, 11.14 s 70-10(a) …. 11.4 s 70-15 …. 9.79, 11.2, 11.16

s 70-20 …. 11.31 s 70-25 …. 11.3, 11.15, 11.27, 11.30 s 70-30 …. 10.60, 10.62, 11.18, 11.30 s 70-30(1) …. 6.133 s 70-30(3) …. 6.133 s 70-35 …. 11.2, 11.5, 11.7, 11.16, 11.19, 11.23, 11.27 s 70-35(2) …. 10.62, 11.2, 11.23 s 70-35(3) …. 11.2 s 70-40 …. 11.2 s 70-40(1) …. 11.19 s 70-45 …. 6.133, 11.19, 11.20, 11.21, 11.25, 11.29, 11.31 s 70-45(1) …. 11.19 s 70-45(1)(b) …. 11.24 s 70-50 …. 11.19, 11.24 s 70-55 …. 11.19 s 70-80 …. 11.27 s 70-80(c) …. 11.29 s 70-80(3) …. 11.26 s 70-85 …. 11.27 s 70-90 …. 9.45, 11.9, 11.15, 11.18, 11.27, 11.28, 14.49 s 70-90(1) …. 11.27, 11.28 s 70-95 …. 11.15 s 70-100 …. 11.28, 14.48 s 70-100(4) …. 11.28, 14.48, 14.49 s 70-105 …. 11.29, 15.132 s 70-110 …. 6.133, 10.34, 11.18, 11.30 s 70-115 …. 3.20, 5.16, 11.30 s 70-120 …. 11.10 s 80-5 …. 5.27 Div 82 …. 5.1, 5.27, 5.35, 5.42

ss 82-1–82-160 …. 2.18 s 82-10 …. 5.33 s 82-130 …. 5.27 s 82-130(1)(a)(ii) …. 5.34 s 82-130(1)(b) …. 5.32 s 82-130(4)–(8) …. 5.27 s 82-135 …. 2.18, 5.27, 5.28 s 82-135(a) …. 5.39 s 82-160 …. 5.33 Div 83 …. 5.1, 5.35 Subdiv 83-A …. 2.18, 5.35, 5.36, 13.115 s 83-10 …. 2.18, 5.36 Subdiv 83-B …. 2.18, 5.35, 5.37, 13.115 ss 83-90–83-105 …. 5.37 Subdiv 83-C …. 5.35, 5.38, 13.115 s 83-175 …. 5.38 s 83-180 …. 5.38 s 83-295 …. 5.27 Div 83A …. 5.46, 5.47, 5.50, 7.8 s 83A-25(1) …. 5.51 s 83A-110(1) …. 5.51 Divs 84–87 …. 9.82 Div 84 …. 9.1 s 84-5 …. 9.83 s 84-5(1) …. 9.87 Div 85 …. 9.82, 9.87, 9.89 s 85-10(2)(a)–(h) …. 9.89 s 85-15 …. 9.89 s 85-20 …. 9.89 s 85-25 …. 9.89 Div 86 …. 9.82, 9.87

s 86-10 …. 9.87, 17.25 s 86-15 …. 9.87 s 86-20 …. 9.87 Subdiv 86-B …. 9.88 s 86-65 …. 9.88 Div 87 …. 9.82, 9.84, 17.25 s 87-18 …. 9.84 s 87-40 …. 9.85 Subdiv 87-B …. 9.86 Div 100 …. 2.3, 6.3, 6.4 s 100-10(1) …. 6.5, 6.6 s 100-15 …. 6.7 s 100-20(1) …. 6.8, 6.23 s 100-45 …. 6.9, 6.10, 6.12 Div 102 …. 3.8 s 102-5 …. 6.6, 6.13, 6.21 s 102-5(1) …. 6.5, 6.6, 6.12, 6.21 s 102-5(2) …. 6.6 s 102-10(1) …. 6.20 s 102-10(2) …. 6.21 s 102-15 …. 6.21 s 102-15(1) …. 6.13 s 102-15(3) …. 6.21 s 102-20(1) …. 6.8, 6.23 s 102-25(1) …. 6.24 s 102-25(3) …. 6.24, 6.38 s 103-5 …. 6.100, 6.108 s 103-10 …. 6.90 s 103-10(1) …. 6.90 s 103-10(2)(a) …. 6.90

s 103-10(2)(b) …. 6.91 s 103-15 …. 6.100, 6.104, 13.108 s 103-30 …. 6.101 Div 104 …. 6.8 s 104-5 …. 6.23, 6.56, 6.80, 6.140 s 104-10 …. 6.25, 6.47, 6.60, 6.61 s 104-10(1) …. 6.25 s 104-10(2) …. 6.85 s 104-10(2)(b) …. 15.92 s 104-10(3)(a) …. 6.87 s 104-10(5) …. 6.126 s 104-10(5)(b) …. 6.51 s 104-15(4) …. 6.126 s 104-20 …. 6.26 s 104-20(2) …. 6.26 s 104-20(4) …. 6.126 s 104-25 …. 6.28, 6.47 s 104-25(1) …. 6.28 s 104-25(5) …. 6.126 s 104-25(5)(b) …. 6.51 s 104-30(5) …. 6.126 s 104-35 …. 6.36, 6.37 s 104-35(5)(a) …. 12.137, 12.138 s 104-35(5)(b) …. 6.38 s 104-35(5)(c) …. 12.133, 12.134, 12.138, 13.109 s 104-35(5)(d) …. 15.93, 15.121 s 104-35(5)(e) …. 12.135, 12.137 s 104-40(1) …. 6.40 s 104-40(5) …. 6.42 s 104-40(6) …. 12.135, 15.121 s 104-55 …. 15.90

s 104-55(4) …. 15.91 s 104-55(6) …. 6.126 s 104-60 …. 15.90, 15.92 s 104-60(4) …. 15.92 s 104-60(6) …. 6.126 s 104-65 …. 15.90 s 104-65(4) …. 6.126 s 104-70 …. 15.104 s 104-70(7) …. 6.126 s 104-71 …. 15.104 s 104-71(4) …. 15.104 s 104-70(9) …. 15.101 s 104-75(4) …. 6.126 s 104-75(6) …. 6.126, 15.106 s 104-80 …. 15.107, 15.108, 15.109 s 104-80(6) …. 6.126 s 104-85 …. 15.111, 15.117 s 104-85(4) …. 6.126 s 104-85(6) …. 6.126 s 104-90 …. 15.118 s 104-95(6) …. 6.126 s 104-100(6) …. 6.126 s 104-105(1)(b) …. 15.94 s 104-115(4) …. 6.126 s 104-125(5) …. 6.126 s 104-130(5) …. 6.126 s 104-135 …. 13.56, 13.79–13.83, 13.86, 13.121 s 104-135(3) …. 13.119 s 104-135(5) …. 6.126 s 104-135(6) …. 13.83

s 104-145(1) …. 13.122 s 104-145(6) …. 6.126 s 104-150 …. 6.46, 6.47 s 104-150(3) …. 6.47 s 104-155 …. 6.51 s 104-155(5) …. 6.52 s 104-155(5)(ea) …. 6.53, 13.115 s 104-160 …. 2.34 s 104-160(5) …. 6.126 s 104-165(2) …. 6.54 s 104-165(3) …. 6.54 s 104-170 …. 6.54 s 104-170(5) …. 6.126 s 104-175(6) …. 12.139 s 104-175(7) …. 6.126 s 104-180 …. 12.139 s 104-182 …. 12.139 s 104-185(8) …. 6.160 s 104-215(5) …. 6.126 s 104-220 …. 6.133 s 104-220(4) …. 6.126 s 104-230 …. 13.127, 13.128 s 104-230(1)(a) …. 13.124 s 104-230(1)(b) …. 13.124, 13.126 s 104-230(2) …. 13.124, 13.126, 13.127 s 104-230(2)(b) …. 13.127 s 104-230(6) …. 13.126, 13.124 s 104-230(8) …. 13.125 s 104-230(9) …. 13.124 s 104-230(9)(b) …. 15.124 s 104-230(9A) …. 13.124

s 104-235(4) …. 6.126 s 104-240 …. 10.65 s 104-245 …. 10.65 s 104-250 …. 13.137 s 104-250(5) …. 6.126, 13.137 s 106-5 …. 14.70, 14.78 s 106-5(1) …. 14.70, 14.78 s 106-5(2) …. 14.70 s 106-5(3) …. 14.80 s 106-5(4) …. 14.80 s 106-5(5) …. 10.66 s 106-30 …. 6.57 s 106-35 …. 6.57 s 106-50 …. 15.22, 15.87, 15.91, 15.96, 15.98, 15.99, 15.103, 15.110, 15.114, 15.123, 15.126 s 106-60 …. 6.57 Subdiv 108-D …. 6.75, 6.84 s 108-5 …. 6.64, 6.65, 6.70, 6.71, 6.74 s 108-5(1)(b) …. 6.70 s 108-5(2) …. 6.65 s 108-5(2)(a) …. 6.73 s 108-5(2)(b) …. 6.74 s 108-5(2)(c) …. 14.72, 14.73, 14.75, 14.84, 14.85, 14.86 s 108-5(2)(d) …. 14.72–14.76, 14.84, 14.85, 14.86 s 108-7 …. 6.84 s 108-10(1) …. 6.78 s 108-10(2) …. 6.77 s 108-10(4) …. 6.78 s 108-15 …. 6.78 s 108-17 …. 6.78, 6.100 s 108-20(1) …. 6.76

s 108-20(2) …. 6.75 s 108-20(3) …. 6.75 s 108-25 …. 6.76 s 108-30 …. 6.76, 6.100 s 108-55 …. 6.84 s 108-55(1) …. 6.84 s 108-55(2) …. 6.84 s 108-60 …. 6.84 s 108-65 …. 6.84 s 108-70(1) …. 6.84 s 108-70(2) …. 6.84 s 108-70(3) …. 6.84 s 108-75 …. 6.84 s 108-80 …. 6.84 s 109-5 …. 6.80 s 109-5(1) …. 6.87 s 109-5(2) …. 6.80, 6.82 s 109-10 …. 6.81, 6.82, 13.107 Div 110 …. 11.30 Subdiv 110-A …. 6.107, 6.122 s 110-25 …. 6.100 s 110-25(5) …. 6.111 s 110-25(5A) …. 6.110 s 110-25(7)–(11) …. 6.100 s 110-35 …. 6.108 s 110-36(1) …. 6.10 s 110-36(2) …. 6.10 s 110-37(1) …. 6.100 s 110-38(1) …. 6.102 s 110-38(2) …. 6.102

s 110-38(3) …. 6.102 s 110-38(4) …. 6.102 s 110-38(5) …. 6.102 s 110-40(3) …. 6.103, 6.124 s 110-45 …. 6.124 s 110-45(1) …. 6.102, 6.123 s 110-45(1B) …. 6.101 s 110-45(2) …. 6.101, 6.123 s 110-45(3) …. 6.103, 6.124 s 110-45(4) …. 6.102, 6.123 s 110-45(5) …. 6.102 s 110-45(6) …. 6.102 s 110-54 …. 6.102 s 110-55 …. 5.45, 6.122 s 110-55(4) …. 6.121 s 110-55(5) …. 6.121 s 110-55(7) …. 6.122 s 110-55(9) …. 6.32, 6.122 s 110-55(10) …. 6.121 s 110-60(2) …. 14.83 s 110-60(7) …. 14.83 Div 112 …. 6.100 s 112-15 …. 6.113 s 112-20(1)(a) …. 6.113, 13.109 s 112-20(1)(b) …. 6.113 s 112-20(1)(c) …. 6.113 s 112-20(2) …. 6.113 s 112-20(3) …. 6.114, 13.109, 13.115, 15.121 s 112-25(1) …. 6.115 s 112-25(1)(a) …. 6.115 s 112-25(2) …. 6.115

s 112-25(3) …. 6.115 s 112-25(4) …. 6.115 s 112-30 …. 6.116 s 112-30(1) …. 6.116 s 112-30(1A) …. 6.116 s 112-30(3) …. 6.116 s 112-35 …. 6.117 s 112-36 …. 6.89, 6.118 s 112-36(1) …. 6.118 s 112-37 …. 6.44, 6.113, 13.115 s 112-80 …. 6.100 s 112-85 …. 6.100 s 114-5(2) …. 6.10 s 114-10 …. 6.10 Div 115 …. 15.31, 15.89 s 115-10 …. 6.10 s 115-20 …. 6.10 s 115-25 …. 3.17 s 115-30 …. 6.11 s 115-40 …. 6.11 s 115-45 …. 6.11 s 115-50 …. 6.11 s 115-100 …. 6.10 Subdiv 115-C …. 15.31, 15.80, 15.88 s 116-20 …. 6.89, 12.137, 13.150 s 116-20(2) …. 6.89 s 116-25 …. 6.27 s 116-30 …. 6.94, 12.134, 13.111 s 116-30(1) …. 6.27, 6.31, 6.33, 6.94 s 116-30(2) …. 6.32, 6.94, 13.56

s 116-30(2)(a) …. 6.94 s 116-30(2)(b) …. 13.56 s 116-30(2)(b)(i) …. 6.94, 13.111 s 116-30(2)(b)(ii) …. 6.94, 14.85 s 116-30(2A) …. 6.32, 13.56 s 116-30(2B) …. 6.32, 13.111 s 116-30(3) …. 6.31, 6.94 s 116-30(3)(a) …. 6.31 s 116-30(3A) …. 6.33, 14.85 s 116-30(4) …. 6.94 s 116-30(5) …. 6.94 s 116-35 …. 13.111 s 116-40 …. 6.95 s 116-40(1) …. 6.95 s 116-40(2) …. 6.95 s 116-45 …. 6.96 s 116-45(1) …. 6.96 s 116-50 …. 6.97 s 116-70 …. 6.93 s 116-55 …. 6.98 s 116-60 …. 6.93 s 116-65 …. 6.43, 6.93 s 116-70 …. 6.93 s 116-75 …. 6.93 s 116-80 …. 6.93 s 116-85 …. 6.93 s 116-95 …. 6.93 s 116-100 …. 6.93 s 116-105 …. 6.93 s 116-110 …. 6.93 s 116-120 …. 6.89, 6.99

Div 118 …. 10.68 ss 118-5–118-13 …. 6.127 s 118-5 …. 6.127 s 118-5(a) …. 14.74 s 118-10 …. 6.78, 6.128, 6.144 s 118-10(2) …. 6.78, 6.128 s 118-10(3) …. 6.76 s 118-12 …. 2.20, 6.128 s 118-13 …. 6.128 s 118-15 …. 6.128 s 118-20 …. 5.45, 5.54, 6.39, 6.135–6.138, 13.56, 13.65, 13.85, 13.86, 13.114, 14.82, 15.108, 15.109, 15.117 s 118-20(1) …. 6.137, 13.85 s 118-20(1)(b) …. 14.82 s 118-20(1A) …. 6.137, 13.85, 14.83, 15.108, 15.109 s 118-20(2) …. 6.137, 14.82 s 118-20(3) …. 14.82 s 118-24 …. 6.16, 6.27, 6.121, 6.134, 6.138, 10.65 s 118-25 …. 6.135, 13.137 s 118-25(1) …. 6.133 s 118-25(2) …. 6.133 s 118-27 …. 6.139 s 118-35 …. 6.139 s 118-37 …. 3.18, 6.129, 6.130 s 118-37(2) …. 6.129 s 118-37(3) …. 6.129 s 118-37(4)–(9) …. 6.129 s 118-40 …. 6.30 Subdiv 118-B …. 6.140, 15.132 s 118-110 …. 6.140, 6.141 s 118-110(2)(b) …. 6.47

s 118-115 …. 6.141 s 118-115(1) …. 6.141 s 118-115(1)(c) …. 6.142 s 118-115(2) …. 6.141 s 118-120 …. 6.142, 6.146 s 118-120(1) …. 6.142 s 118-120(5) …. 6.142 s 118-120(6) …. 6.142 s 118-125 …. 6.143 s 118-130 …. 6.144 s 118-135 …. 6.145 s 118-140 …. 6.145 s 118-145 …. 6.145, 6.146 s 118-147 …. 6.145, 6.146 s 118-150 …. 6.145 s 118-160 …. 6.145 s 118-165 …. 6.146 s 118-170 …. 6.146 s 118-185 …. 6.146 s 118-190 …. 6.140, 6.146 s 118-192 …. 6.146 s 118-195 …. 6.140 s 118-195(1) …. 6.86 s 118-195(2)(b) …. 6.47 s 118-245 …. 6.140, 6.145 s 118-300 …. 6.148 s 118-305 …. 6.148 Subdiv 118-F …. 6.148 Subdiv 118-G …. 6.148 Subdiv 118-I …. 6.89, 6.99, 6.148

s 118-565 …. 6.99 s 118-565(1) …. 6.99 s 118-565(2) …. 6.99 s 118-565(3) …. 6.99 s 118-565(4) …. 6.99 Div 121 …. 6.100 Div 122 …. 6.163, 6.161, 13.156 Subdiv 122-A …. 6.163, 10.68, 12.151, 12.152, 12.154, 12.157 s 122-15 …. 12.151 s 122-25(2) …. 12.152 s 122-25(3) …. 10.68, 12.152 s 122-25(4) …. 12.152 s 122-35(1) …. 12.153 s 122-35(2) …. 12.153 s 122-37(2) …. 12.153 s 122-55(6) …. 12.151 Subdiv 122-B …. 6.163, 10.68, 12.151, 12.157 Div 124 …. 6.163 Subdiv 124-A …. 6.163 s 124-10 …. 6.164 s 124-10(2) …. 6.162, 6.165 Subdiv 124-B …. 6.162, 6.163, 6.165 Subdiv 124-C …. 6.163, 6.164 s 124-150 …. 6.94 Subdiv 124-D …. 6.163, 6.164 Subdiv 124-E …. 6.163, 12.158, 15.122 Subdiv 124-F …. 6.163, 12.158 Subdiv 124-I …. 6.163, 12.158 Subdiv 124-J …. 6.163 Subdiv 124-K …. 6.163 Subdiv 124-L …. 6.163

Subdiv 124-M …. 6.163, 13.153 ss 124-784A–124-784C …. 13.155 s 124-790 …. 13.154 Subdiv 124-N …. 6.163, 12.158, 15.122 Subdiv 124-P …. 6.163 Subdiv 124-Q …. 6.163 Subdiv 124-R …. 6.163 Subdiv 124-S …. 6.163 Div 125 …. 6.163 s 125-55 …. 13.157 s 125-70(4) …. 13.157 s 125-80(1) …. 13.158 s 125-85 …. 13.157 s 125-90 …. 13.157 s 125-160 …. 13.160 s 125-165 …. 13.161 Div 126 …. 6.163 Subdiv 126-A …. 6.163, 6.166, 10.68 s 126-15 …. 6.166 Subdiv 126-B …. 6.163, 6.166, 10.68, 12.139, 12.159 Subdiv 126-C …. 6.163 Subdiv 126-D …. 6.163, 6.166 Subdiv 126-E …. 6.163 Subdiv 126-G …. 6.163 Div 128 …. 6.11, 15.95, 15.105, 15.107, 15.111, 15.118, 15.126, 15.132, 15.135 s 128-10 …. 6.85, 10.33, 15.132 s 128-15 …. 15.133 s 128-15(2) …. 15.132, 15.133 s 128-15(3) …. 10.33, 15.133, 15.135 s 128-15(4) …. 15.132, 15.133, 15.135

s 128-15(5) …. 15.133 s 128-20(1) …. 15.133 s 128-20(2) …. 15.133 s 128-50(2) …. 6.85, 15.134 Subdiv 130-A …. 15.122 s 130-20(2) …. 13.56 s 130-20(3) …. 13.56 s 130-20(3A) …. 13.56 s 130-20(4) …. 15.122 Subdiv 130-B …. 13.112, 13.114, 15.122 s 130-40 …. 6.30 s 130-40(6) …. 13.114 s 130-40(6A) …. 13.114 s 130-40(7) …. 13.114 s 130-45 …. 13.113 Subdiv 130-C …. 13.116, 15.122 s 130-60 …. 6.30 s 130-60(1) …. 13.116 s 130-60(2) …. 13.117 s 130-60(3) …. 13.117 s 130-100 …. 13.117 s 132-15 …. 6.45 Div 134 …. 6.43, 6.44, 13.114, 15.121 s 134-1 …. 6.44 s 134-1(4) …. 6.30, 6.43, 6.44 Div 149 …. 6.122, 12.23, 12.33, 12.129, 12.140, 12.141, 12.142, 12.143, 15.125 s 149-10 …. 12.141 s 149-15 …. 12.141 s 149-15(3) …. 12.141 s 149-15(4) …. 12.141, 15.125

s 149-15(5) …. 12.141, 15.125 s 149-30 …. 12.142 s 149-30(2) …. 12.142 s 149-35 …. 12.142 s 149-50 …. 12.142, 12.143 s 149-50(2) …. 15.125 s 149-55 …. 12.143 s 149-55(7) …. 12.143 s 149-60(1) …. 12.143 s 149-60(2) …. 12.143 s 149-60(3) …. 12.143 s 149-75 …. 12.143 Div 152 …. 6.150 Subdiv 152-A …. 6.149, 6.150, 6.156–6.159 s 152-10 …. 6.149, 6.150 s 152-10(1A) …. 6.150 s 152-10(1AA) …. 6.150 s 152-10(1B) …. 6.150 s 152-10(2)(b) …. 6.154 s 152-15 …. 6.150 s 152-20 …. 6.150 s 152-20(2) …. 6.150 s 152-20(2)(a) …. 6.150 s 152-20(2A) …. 6.150 s 152-20(4) …. 6.150 s 152-20(6) …. 6.150 s 152-35 …. 6.150 s 152-35(2)(b)(ii) …. 6.150 s 152-40 …. 6.151 s 152-40(1)(a)(iii) …. 6.150

s 152-40(3) …. 6.151 s 152-40(3A) …. 6.151 s 152-40(4) …. 6.152 s 152-40(4)(e) …. 6.152 s 152-40(4A) …. 6.152 s 152-47 …. 6.150 s 152-48 …. 6.150 s 152-50 …. 6.153 s 152-55 …. 6.150 s 152-60 …. 6.150, 6.153, 6.154 s 152-65 …. 6.150, 6.153 s 152-70 …. 6.150 s 152-75 …. 6.150, 6.153 Subdiv 152-B …. 6.149, 6.155, 6.156 s 152-110(2) …. 6.156 s 152-120 …. 6.156 s 152-125 …. 6.156, 12.52, 13.119 s 152-125(2) …. 6.156 s 152-125(3) …. 6.156 Subdiv 152-C …. 6.149, 6.155, 6.159 s 152-205 …. 6.157 s 152-215 …. 6.155 Subdiv 152-D …. 6.149, 6.155, 6.158, 6.159 s 152-305(1A) …. 6.158 s 152-305(1B) …. 6.158 s 152-305(4) …. 6.158 s 152-310(2) …. 6.158 s 152-325 …. 6.158 s 152-330 …. 6.155 Subdiv 152-E …. 6.149, 6.155, 6.159, 6.162 s 152-410 …. 6.159

s 152-415 …. 6.159 s 152-420 …. 6.159 s 152-430 …. 6.155, 6.159 Subdiv 160-B …. 12.90 s 164-5(1) …. 12.25 s 164-15 …. 12.25 Div 165 …. 1.28, 9.69 Subdiv 165-A …. 12.144 s 165-10(b) …. 12.97 s 165-12 …. 12.91, 12.95 s 165-12(1) …. 12.93, 12.96 s 165-12(2) …. 12.93, 12.96, 12.97 s 165-12(3) …. 12.93, 12.96, 12.97 s 165-12(4) …. 12.97 s 165-13 …. 12.91, 12.97 s 165-13(2) …. 12.97 Subdiv 165-B …. 12.105, 12.145 Subdiv 165-CA …. 12.144 s 165-96(2) …. 12.144 Subdiv 165-CB …. 12.145 Subdiv 165-CC …. 12.146 Subdiv 165-CD …. 12.150 Subdiv 165-C …. 12.107 s 165-150 …. 12.93 s 165-120 …. 12.107 s 165-120(3) …. 12.109 s 165-123 …. 12.107 s 165-150(2) …. 12.96 s 165-155 …. 12.93 s 165-155(2) …. 12.96

s 165-160 …. 12.93 s 165-160(2) …. 12.96 s 165-165 …. 12.94, 12.96 s 165-165(1) …. 12.93 s 165-165(2) …. 12.94 s 165-175 …. 12.92 s 165-180 …. 12.93 s 165-210 …. 12.97 s 165-210(1) …. 12.98 s 165-210(2)(a) …. 12.98, 12.101 s 165-210(2)(b) …. 12.98 s 165-210(3) …. 12.98 s 165-210(4) …. 12.98 s 165-211 …. 12.103 s 165-211(2) …. 12.103 s 165-211(3) …. 12.103 Div 166 …. 1.28, 9.69, 12.92, 12.95 Div 167 …. 12.93 Div 170 …. 9.64 Subdiv 170-A …. 12.106 s 170-10 …. 9.64 s 170-50(2)(d) …. 9.65 Subdiv 170-B …. 12.147 Subdiv 170-C …. 12.148 Subdiv 170-D …. 10.67, 12.149 s 170-265 …. 12.149 Div 175 …. 9.69 Div 197 …. 12.50, 12.77, 12.79, 12.82 s 197-5 …. 12.77 s 197-10 …. 12.77 s 197-15 …. 12.77

s 197-20 …. 12.77 s 197-25 …. 12.77 s 197-30 …. 12.77 s 197-35 …. 12.77 s 197-38 …. 12.77 s 197-40 …. 12.77 s 197-45 …. 12.78, 12.81–12.83 s 197-45(2) …. 12.78 s 197-50 …. 12.77, 13.14 s 197-50(3) …. 12.82 s 197-55 …. 12.80 s 197-60(2) …. 12.82 s 197-60(3) …. 12.82, 12.83 s 197-60(4) …. 12.82 s 197-65 …. 12.81–12.83 s 197-65(3) …. 12.81 s 202-5 …. 12.46, 13.43 Div 202-C …. 12.51 s 202-25 …. 13.14 s 202-35 …. 12.51 s 202-40 …. 12.25, 13.14, 13.43, 13.63, 13.101, 14.89 s 202-40(1) …. 12.52 s 202-40(2) …. 12.52, 13.32 s 202-45 …. 12.25, 12.52, 13.14, 13.32, 13.63, 13.98 s 202-45(e) …. 12.52, 13.56 s 202-45(d) …. 12.25, 13.99, 13.100 s 202-45(e) …. 12.79, 13.14, 13.101 s 202-45(f) …. 13.32, 13.105 s 202-45(g)(i) …. 13.29 s 202-45(g)(iii) …. 13.18

s 202-45(h) …. 13.103 s 202-45(i) …. 13.104 s 202-60 …. 12.49 s 202-60(1) …. 12.53 s 202-60(2) …. 12.53 s 202-65 …. 12.49, 12.53, 12.54, 12.57 s 202-70 …. 12.51 s 202-75(1) …. 12.51, 12.61 s 202-75(2) …. 12.61 s 202-75(3) …. 12.61 s 202-75(5) …. 12.61 s 202-80(3) …. 12.51, 12.61 s 202-85(1) …. 12.62 s 202-85(2) …. 12.62 Div 203 …. 12.65 s 203-15 …. 12.57, 12.65 s 203-30 …. 12.57 s 203-35(1) …. 12.57 s 203-40 …. 12.57 s 203-45 …. 12.57 s 203-50(1)(a) …. 12.59 s 203-50(1)(b) …. 12.60 s 203-50(2) …. 12.59 s 203-55 …. 12.58, 12.59 s 203-55(1) …. 12.58 s 203-55(2) …. 12.58 Subdiv 204-B …. 12.68 Subdiv 204-C …. 12.68 Subdiv 204-D …. 12.69 s 204-30 …. 12.58, 12.69 s 204-30(2) …. 12.69

s 204-30(3) …. 12.69 s 204-30(6) …. 12.69 s 204-30(8) …. 12.69 Subdiv 204-E …. 12.70 s 204-70 …. 12.70 s 204-70(2) …. 12.70 s 204-75 …. 12.70 s 204-80(1) …. 12.70 s 204-80(2) …. 12.70 s 205-15 …. 12.38, 12.40, 12.41, 12.43, 12.44, 12.45 s 205-15(4) …. 12.43 s 205-25 …. 12.45 s 205-25(1)(a) …. 12.38 s 205-25(1)(c) …. 12.38 s 205-30 …. 12.38, 12.46, 12.48, 12.49, 13.23, 13.56 s 205-40(1) …. 12.40 s 205-45 …. 12.55 s 205-45(2) …. 12.40 s 205-45(3) …. 12.55 s 205-50(2) …. 12.56, 14.61 s 205-70 …. 12.55, 13.50 Div 207 …. 2.3, 3.67, 12.69, 12.74, 13.43, 13.50, 13.53, 14.56, 14.58 s 207-20 …. 13.33, 13.43, 14.89 s 207-20(1) …. 6.137, 13.4, 13.43, 13.45, 13.47, 13.53, 13.89, 13.91 s 207-20(2) …. 13.4, 13.43, 13.47, 13.53, 13.89, 13.91 Subdiv 207-B …. 15.86 s 207-35 …. 12.69, 14.58, 14.59, 15.28 s 207-35(1) …. 6.137, 14.57 s 207-35(2) …. 14.57

s 207-35(3) …. 6.137 s 207-45 …. 14.59, 14.60 s 207-55 …. 14.58, 14.60 Subdiv 207-C …. 15.80 s 207-70 …. 13.43 s 207-70(1) …. 13.48 s 207-70(2) …. 13.48 s 207-70(5) …. 12.55 s 207-70(6) …. 12.55 s 207-75(1) …. 13.43 Subdiv 207-D …. 14.61 s 207-95 …. 14.61 s 207-95(1) …. 14.61 s 207-95(2) …. 14.61 s 207-95(3) …. 14.61 s 207-95(4) …. 14.61 s 207-95(5) …. 14.61 Subdiv 207-E …. 14.61 Subdiv 207-F …. 13.95, 13.97 s 207-145(1)(a) …. 13.108 s 207-155 …. 13.97 Div 208 …. 12.74 s 208-25 …. 12.75 s 208-25(1)(b) …. 12.75 s 208-30 …. 12.75 s 208-35 …. 12.75 s 208-40 …. 12.75 s 208-45 …. 12.75 s 208-50(1) …. 12.75 s 208-155 …. 12.75 s 210-170 …. 12.69

Div 215 …. 12.25, 13.32, 13.33 s 215-10 …. 12.52, 13.32, 13.105 s 215-15 …. 12.52, 13.32, 13.105 s 220-25 …. 12.35 s 220-35 …. 12.35 s 220-100 …. 12.35 s 220-105 …. 12.52 s 220-210 …. 13.43 Div 230 …. 4.1, 5.54, 5.55, 6.100, 6.139, 8.49, 8.51, 10.60, 12.127 s 230-505 …. 6.100, 10.60 s 240-25 …. 10.60 s 240-45 …. 10.34 s 242-90(3) …. 10.60 Div 243 …. 6.101, 6.123, 9.90 s 243-20 …. 9.90 Div 245 …. 9.91, 9.92 s 245-35 …. 9.93 s 245-40 …. 9.93 s 245-90 …. 9.94 s 245-140 …. 9.91 s 290-150 …. 9.68 Div 295 …. 6.137 s 295-325 …. 6.137 s 295-330 …. 6.137 Divs 301–307 …. 3.62, 5.1, 5.35, 5.39 s 301-25 …. 5.41 Div 302 …. 5.42 s 302-60 …. 5.42 Div 307 …. 3.65 s 307-5 …. 5.39, 5.41, 5.42

s 307-220 …. 5.40 s 307-345 …. 5.41 s 316-255 …. 6.137 s 316-275 …. 12.45 Subdiv 320-A …. 2.6 Div 321 …. 8.45 Div 328 …. 6.134, 10.39, 10.93 s 328-10 …. 6.150 Subdiv 328-C …. 6.150 ss 328-110–328-125 …. 6.150 s 328-110(6) …. 6.150 s 328-115(1) …. 6.150 s 328-120 …. 6.150 s 328-125 …. 6.150 s 328-125(1) …. 6.150 s 328-130 …. 6.150 Subdiv 328-D …. 10.3, 10.93 s 328-180 …. 10.93 s 328-180(2) …. 10.93 s 328-185 …. 10.93 s 328-215 …. 10.93 s 328-215(4) …. 10.93 s 328-220(1) …. 10.93 s 328-225 …. 10.89 Div 328-G …. 6.163 Subdiv 360-A …. 6.161 Div 373 …. 10.2, 10.82 Subdiv 385-E …. 11.1, 11.19 s 388-55 …. 6.102 s 418-50(1) …. 12.45 Div 420 …. 6.128

s 420-5 …. 6.128 Div 615 …. 6.163, 12.158, 13.156 Subdiv 615-A …. 15.122 s 615-30 …. 12.115 Div 620 …. 6.163, 12.158 s 701-1 …. 12.112 s 701-1(1) …. 12.128 s 701-5 …. 12.112, 12.120 s 701-40 …. 12.112 s 701-63(6) …. 12.125 s 703-5(2) …. 12.113 s 703-5(3) …. 12.113 s 703-10 …. 12.113 s 703-15 …. 12.113 s 703-15(2) …. 12.113 s 703-20 …. 12.113 s 703-25 …. 12.113 s 703-30 …. 12.113 s 703-50 …. 12.113 s 703-58 …. 12.113 s 703-65 …. 12.115 s 703-70 …. 12.115 Subdiv 705-A …. 12.123, 12.127 s 705-25 …. 12.125 s 705-25(5)(a) …. 12.125 s 705-25(5)(b) …. 12.125 s 705-25(5)(ba) …. 12.125 s 705-25(5)(c) …. 12.125 s 705-25(5)(d) …. 12.125 s 705-30 …. 12.126

s 705-30(1) …. 12.126 s 705-35(3) …. 12.126 s 705-40 …. 12.126 s 705-40(1) …. 12.130 s 705-40(2) …. 12.130 s 705-60 …. 12.124 s 705-65(6) …. 12.124 s 705-85(3)(a) …. 12.124 s 705-90 …. 12.124 Subdiv 705-B …. 12.127 Subdiv 705-C …. 12.127 Subdiv 705-D …. 12.127 Subdiv 705-E …. 12.127 s 707-120(1) …. 12.117 s 707-125 …. 12.118 s 707-150 …. 12.118 s 711-15(2) …. 12.128 s 711-20 …. 12.128 s 711-45 …. 12.124 Subdiv 713-C …. 12.113 s 713-510 …. 12.113 Subdiv 715-D …. 12.127 s 719-5 …. 6.108 Div 723 …. 13.129, 13.130 Div 725 …. 13.129, 13.131, 13.132, 13.136, 13.137, 13.138 s 725-65 …. 13.134 s 725-80 …. 13.135 s 725-85 …. 13.135 s 725-210 …. 13.137 s 725-245 …. 13.137 s 725-250 …. 13.137

s 725-250(2) …. 13.141 s 725-250(3) …. 13.137 s 725-335(3) …. 13.138, 13.141 s 725-335(3A) …. 13.138 s 725-365 …. 13.137, 13.138 s 725-365(3A) …. 13.138 s 725-375 …. 13.137 Div 727 …. 13.129, 13.142 s 727-5(5) …. 13.142 s 727-105 …. 13.143 s 727-110 …. 13.144 s 727-150 …. 13.143 s 727-155 …. 13.146 s 727-155(3) …. 13.146 s 727-160 …. 13.147 s 727-165(1) …. 13.148 s 727-165(2) …. 13.148 s 727-250 …. 13.150 s 727-350 …. 13.143 s 727-355 …. 13.133 s 727-400 …. 13.144 s 727-460 …. 13.145 s 727-465 …. 13.145 s 727-520 …. 13.145 s 727-525 …. 13.145 s 727-530 …. 13.145 s 727-530(2) …. 13.145 s 727-530(3) …. 13.145 s 727-620 …. 13.151 Subdiv 768-A …. 13.53, 18.5, 18.10, 18.13, 18.14, 18.40, 18.62

s 768-5 …. 6.137 s 768-5(1) …. 18.9 s 768-5(2) …. 18.9 s 768-10 …. 18.11 s 768-15 …. 18.9, 18.12 s 768-70 …. 18.7 Subdiv 768-G …. 14.81, 18.12 s 768-505 …. 13.53 Subdiv 768-R …. 6.54 s 768-900 …. 6.54 s 768-915 …. 6.54 Div 770 …. 18.14, 18.18 s 770-10 …. 18.15 s 770-10(2) …. 18.31 s 770-10(5) …. 18.18 s 770-15 …. 18.18 s 770-15(1) …. 18.18 s 770-15(2) …. 18.18 s 770-15(3) …. 18.18 s 770-70 …. 18.19 s 770-75 …. 18.19 s 770-75(2) …. 18.19 s 770-75(4) …. 18.19 s 770-80 …. 18.31 s 770-130 …. 18.16, 18.31 s 770-130(1) …. 18.17 s 770-130(2) …. 18.17 s 770-135 …. 18.17, 18.31 s 770-135(1) …. 18.31 s 770-140 …. 18.17 Div 775 …. 3.21, 5.54

Div 775-A …. 5.54 s 775-55 …. 5.54 s 802-15 …. 18.40 Div 815 …. 18.73, 18.73, 18.75 Subdiv 815-A …. 18.69, 18.70 Subdiv 815-B …. 18.70, 18.70 s 815-115 …. 18.74 s 815-115(1) …. 18.70 s 815-115(2) …. 18.70 s 815-120(1) …. 18.70 s 815-120(3) …. 18.71 s 815-125(1) …. 18.72 s 815-125(2) …. 18.72 s 815-125(3) …. 18.72 s 815-130 …. 18.72 s 815-135 …. 18.72 s 815-140 …. 18.73 Subdiv 815-C …. 18.70 Subdiv 815-E …. 18.79 Div 820 …. 1832, 18.55–18.59, 18.65, 18.82 s 820-35 …. 18.57, 18.58 s 820-37 …. 18.57 Subdiv 820-B …. 18.62, 18.63 s 820-85(3) …. 18.63 s 820-95 …. 18.63 s 820-105 …. 18.63 s 820-110(1) …. 18.63 s 820-115 …. 18.63 Subdiv 820-C …. 18.64 Div 830 …. 12.27, 14.97, 14.98

Subdiv 830-A …. 14.90 s 830-10 …. 14.90 s 830-10(1)(b) …. 14.97 s 830-15(1)(a)–(d) …. 14.90 s 830-15(2) …. 14.98 s 830-15(2)(b)(ii) …. 14.98 s 830-30 …. 14.91 s 830-60(1) …. 14.92 Subdiv 830-D …. 14.93 s 830-115(1) …. 14.93 s 830-115(2) …. 14.93 s 855-10 …. 6.54 s 855-15 …. 2.33, 2.34, 6.54 s 855-20 …. 2.33 s 855-25 …. 2.33 Subdiv 855-B …. 2.33 Div 900 …. 9.1, 9.44, 9.70, 16.19 Subdiv 900-B …. 9.70, 16.19 s 900-30 …. 9.72 s 900-35 …. 9.72 s 900-40 …. 9.72 s 900-45 …. 9.72 s 900-50 …. 9.72 s 900-55 …. 9.72 s 900-60 …. 9.72 Subdiv 900-C …. 9.70, 9.72, 16.19 Subdiv 900-D …. 9.70, 9.73, 16.19 s 900-95 …. 9.73 Subdiv 900-E …. 9.73, 9.74, 16.19 s 900-115 …. 9.74 Subdiv 900-H …. 9.74

Div 960 …. 3.21 Subdiv 960-C …. 4.2, 5.53 s 960-20(1) …. 6.21 s 960-50 …. 3.7, 3.21, 4.2, 18.20 s 960-50(1) …. 5.53 s 960-50(6) …. 18.20 Subdiv 960-D …. 4.2, 5.53 s 960-100(2) …. 6.85 s 960-115 …. 14.88, 15.143, 18.9, 18.36 s 960-120 …. 12.25, 12.52, 13.43, 14.89 s 960-130(1) …. 12.114 s 960-130(2) …. 12.114 s 960-185 …. 18.12 s 960-190 …. 18.12 Subdiv 960-H …. 12.143 Subdiv 960-M …. 6.120 s 960-275(2) …. 6.120 Div 974 …. 18.65 s 974-5(4) …. 12.25 s 974-15 …. 12.25 s 974-15(2) …. 12.25 s 974-20(1) …. 12.25 s 974-75 …. 12.25 s 974-75(1) …. 12.25 s 974-75(2) …. 12.25 s 974-85 …. 12.25 s 974-100 …. 12.25 s 974-115 …. 12.25, 13.32, 13.43 s 974-120 …. 12.25, 13.32 s 974-130 …. 12.25

s 974-135 …. 12.25, 13.99 s 974-135(4) …. 12.25 s 974-135(5) …. 12.25 s 974-160 …. 6.99 s 975-300 …. 13.14, 13.38, 13.56, 13.101 s 976-1 …. 13.53, 18.40 s 995-1 …. 1.17, 1.31, 1.32, 2.1, 2.35, 2.37, 3.13, 3.45, 5.13, 6.127, 8.6, 8.8, 9.3, 9.38, 10.18, 10.51, 10.78, 11.3, 12.16, 12.26, 12.27, 12.53, 12.74, 13.19, 13.43, 13.125, 13.163, 14.1, 16.65, 18.36 s 995-1(1) …. 6.127, 13.19, 14.1, 18.25 Income Tax (Dividends and Interest Withholding Tax) Act 1974 s 7(a) …. 18.41 s 7(b) …. 18.43 s 7(c) …. 18.49 Income Tax Rates Act 1986 …. 2.2, 12.113, 16.2 s 13 …. 15.60 s 15 …. 15.60 s 23(2)(a) …. 12.53 Sch 11 …. 15.60 Sch 12 …. 15.60 Income Tax Assessment (1936 Act) Regulation 2015 Pt 8 item 19 …. 18.27 Income Tax Regulations 1936 …. 16.2, 18.7 Income Tax Regulations 1997 …. 16.2 reg 70-55.01 …. 11.19 Income Tax (Transitional Provisions) Act 1997 s 40-345 …. 10.65 s 102-15 …. 6.21 s 110-35 …. 6.108

s 128-15 …. 15.132 s 701C-10 …. 12.113 s 701C-15 …. 12.113 s 703-45 …. 12.113 s 815-1(2) …. 18.70 s 815-15 …. 18.70 Income Tax (Untainting Tax) Bill 1998 …. 13.12 International Tax Agreements Act 1953 …. 18.41, 18.81 s 4 …. 18.81 s 4AA …. 18.81 Judiciary Act 1903 …. 16.2, 16.31 Medicare Levy Act 1986 …. 1.10, 2.2 Minerals Resource Rent Tax Repeal And Other Measures Act 2014 …. 12.90 National Rental Affordability Scheme Act 2008 …. 6.129 New Business Tax System (Capital Allowances) Act 2001 …. 10.3 New Business Tax System (Capital Allowances — Transitional and Consequential) Act 2001 …. 10.14, 10.65 New Business Tax System (Capital Allowances — Transitional and Consequential) Bill 2001 …. 10.16, 10.20 New Business Tax System (Capital Gains Tax) Act 1999 …. 13.153 New Business Tax System (Consolidation, Value Shifting, Demergers and Other Measures) Bill 2002 …. 13.134, 13.136 New Business Tax System (Debt and Equity) Bill 2001 …. 12.25 New Business Tax System (Franking Deficit Tax) Act 2002 …. 12.40 s 5(a) …. 12.55 New Business Tax System (Franking Deficit Tax) Bill 2002 …. 12.69 New Business Tax System (Imputation) Bill 2002 …. 13.45

New Business Tax System (Integrity and Other Measures) Act 1999 …. 12.92, 12.93, 12.96 New Business Tax System (Miscellaneous) Act (No 1) 2000 …. 12.64 New Business Tax System (Taxation of Financial Arrangements) Act 2003 …. 4.2, 5.53, 13.116 Pay-roll Tax Assessment Act 1941 …. 7.57 Private Health Insurance Act 2007 …. 19.36 Public Service Act 1922 …. 8.13 Small Superannuation Accounts Act 1995 …. 7.54 Social Security Act 1991 …. 2.31, 8.15 Student Assistance Act 1973 …. 19.38 Tax and Superannuation Laws Amendment (2013 Measures No 1) Act 2013 …. 7.41, 12.90 Tax and Superannuation Laws Amendment (2013 Measures No 2) Act 2013 …. 18.37 Tax and Superannuation Laws Amendment (2014 Measures No 4) Act 2014 …. 6.54, 18.356 18.37 Tax and Superannuation Laws Amendment (2015 Measures No 2) Act 2015 …. 12.93, 12.95, 12.120 Tax and Superannuation Laws Amendment (2014 Measures No 4) Bill 2014 …. 18.37 Sch 3 Pt 1 …. 18.37 Tax and Superannuation Laws Amendment (2015 Measures No 4) Bill 2015 …. 6.89, 13.57, 18.37 Tax and Superannuation Laws Amendment (2015 Measures No 5) Bill 2015 …. 18.37 Tax and Superannuation Measures (2015 Measures No 6) Act 2016 …. 6.89, 13.153, 13.157, 18.37

Tax Law Improvement Bill 1997 …. 10.99 Tax Law Improvement Bill (No 2) 1997 …. 6.46 Tax Laws Amendment (2004 Measures No 1) Bill 2004 …. 9.32 Tax Laws Amendment (2004 Measures No 2) Act 2004 …. 14.56 Tax Laws Amendment (2004 Measures No 2) Bill 2004 …. 14.58 Tax Laws Amendment (2007 Measures No 3) Act 2007 …. 13.23 Tax Laws Amendment (2008 Measures No 2) Act 2008 …. 13.111 Tax Laws Amendment (2008 Measures No 3) Act 2008 …. 6.43, 6.44, 6.53, 12.135, 13.2, 13.115 Tax Laws Amendment (2008 Measures No 4) Act 2009 …. 12.121 Tax Laws Amendment (2008 Measures No 6) Act 2009 …. 13.155 Tax Laws Amendment (2009 Measures No 2) Act 2009 …. 6.149, 6.150 Tax Laws Amendment (2009 Measures No 2) Bill 2009 …. 6.149, 6.150 Tax Laws Amendment (2009 Measures No 5) Act 2009 …. 9.69 Tax Laws Amendment (2010 Measures No 1) Act 2010 …. 12.114, 12.116, 12.123, 12.124, 12.128, 12.129, 12.130, 12.150 Tax Laws Amendment (2010 Measures No 1) Bill 2010 …. 12.124, 12.129 Tax Laws Amendment (2010 Measures No 2) Act 2010 …. 13.26, 13.27 Tax Laws Amendment (2010 Measures No 2) Bill 2010 …. 13.26 Tax Laws Amendment (2010 Measures No 4) Act 2010 …. 13.153 Tax Laws Amendment (2011 Measures No 1) Bill 2011 …. 19.42 Tax Laws Amendment (2011 Measures No 5) Act 2011 …. 15.80 Tax Laws Amendment (2011 Measures No 9) Act 2011 …. 13.157

Tax Laws Amendments (2012 Measures No 6) Act 2013 …. 7.53, 9.90 Tax Laws Amendment (2013 Measures No 1) Act 2013 …. 13.155 Tax Laws Amendment (2013 Measures No 2) Act 2013 …. 18.37 Tax Laws Amendment (2013 Measures No 2) Act 2013 …. 6.10 Tax Laws Amendment (Budget Measures No 2) Act 2009 …. 14.94 Sch 2 …. 14.94 Tax Laws Amendment (Combating Multinational Tax Avoidance) Bill 2015 …. 18.78, 18.83 Tax Laws Amendment (Countering Tax Avoidance And Multinational Profit Shifting) Act 2013 …. 18.70 Tax Laws Amendment (Cross-Border Transfer Pricing) Act (No 1) 2012 …. 18.69 Tax Laws Amendment (Foreign Source Income Deferral) Bill 2011 …. 18.7, 18.82 Tax Laws Amendment (Measures No 4) Act 2012 …. 7.40 Tax Laws Amendment (Political Contributions and Gifts) Act 2010 …. 9.46 Tax Laws Amendment (Tax Incentives for Innovation) Act 2016 …. 6.161, 13.163 Tax Laws Amendment (Tax Integrity: GST and Digital Products) Bill 2015 …. 19.29 Taxation Administration Act 1953 …. 1.26, 16.2, 16.4, 16.6, 16.33 Pt IVC …. 2.3, 16.13, 16.30, 16.33 s 3A …. 16.2 s 8AAG …. 16.53 s 8AAZC(1) …. 16.53 s 8AAZC(4) …. 16.53 s 8AAZF(1) …. 16.53, 16.55 s 8AAZH(1) …. 16.53

s 8C …. 16.24 s 8D …. 16.24 s 8K …. 17.2 s 8L …. 16.19 s 8Q …. 16.19 s 8R …. 16.19 s 8T …. 16.19 s 14S(1) …. 16.72 s 14S(2) …. 16.74 s 14S(4) …. 16.72 s 14S(5) …. 16.72 s 14T …. 16.74 s 14V(1) …. 16.73 s 14W …. 16.73 s 14Z(1) …. 16.74 s 14ZL …. 16.33 s 14ZQ …. 16.33, 16.36 s 14ZU(a) …. 16.34 s 14ZU(c) …. 16.34 s 14ZW …. 16.34 s 14ZW(1) …. 16.34 s 14ZW(2) …. 16.35 s 14ZX(2) …. 16.35 s 14ZX(4) …. 16.35 s 14ZYA(2) …. 16.35 s 14ZYA(3) …. 16.35 s 14ZZ(a) …. 16.36 s 14ZZ(a)(i) …. 16.42 s 14ZZ(b) …. 16.36, 16.42 s 14ZZ(c) …. 16.36 s 14ZZA …. 16.30

s 14ZZC …. 16.42 s 14ZZF(1)(a) …. 16.43 s 14ZZG …. 16.43 s 14ZZK …. 16.19 s 14ZZK(b) …. 16.38 s 14ZZM …. 16.40, 16.69 s 14ZZO …. 16.19, 16.31 s 14ZZO(b) …. 16.38 s 14ZZR …. 16.40, 16.69 Sch 1 …. 7.11, 7.56 Pt 2-5 …. 16.59 s 10-5 …. 16.60 s 12-1(2) …. 7.57 Subdivs 12-B–12-H …. 16.60 Subdiv 12-B …. 16.60, 16.63 s 12-35 …. 7.11, 7.56, 7.57, 16.62 s 12-40 …. 7.11, 7.56 s 12-45 …. 7.11, 7.56 Subdiv 12-C …. 16.60, 16.63 Subdiv 12-D …. 16.60, 16.63 s 12-115 …. 7.11, 7.56 s 12-120 …. 7.11, 7.56 Subdiv 12-E …. 16.60, 16.63 Subdiv 12-F …. 16.60, 16.63, 18.50 s 12-300 …. 18.50 Subdiv 12-FA …. 16.60 Subdiv 12-FAA …. 16.60 Subdiv 12-FB …. 16.60 Subdiv 12-FC …. 16.60 Subdiv 12-G …. 16.60

Subdiv 12-H …. 16.60 Pt 2-10 …. 16.59, 16.64 s 45-15 …. 16.64 s 45-110 …. 16.65 s 45-110(2) …. 16.65 s 45-125 …. 16.64, 16.65 s 45-205 …. 16.64 s 255-1 …. 16.69 s 255-5 …. 16.69 s 255-10 …. 16.69 s 260-5 …. 16.70 s 260-15 …. 16.71 s 260-20 …. 16.71 Div 284 …. 18.75 s 284-15(3) …. 16.58 s 284-75 …. 16.56 s 284-75(1) …. 16.57 s 284-80 …. 16.56 s 284-90(1) …. 16.58 s 284-140 …. 17.18 s 284-160 …. 17.18, 18.76 s 284-160(a) …. 16.58, 18.76 s 284-160(b) …. 18.76 s 284-215 …. 17.18 s 284-224 …. 16.57 Subdiv 284-E …. 18.75 s 286-75 …. 16.53 s 288-25(1) …. 16.19 s 298-10 …. 16.58 s 298-15 …. 16.58 s 298-25 …. 16.58

s 340-5 …. 16.75 s 350-10(1) …. 16.13 Div 353 …. 16.12, 16.20, 16.25 s 353-10 …. 16.24, 16.26, 16.33, 16.60 s 353-15 …. 16.21–16.24, 16.26, 16.33 s 353-15(1)(b) …. 16.22 s 353-15(2) …. 16.23 s 353-15(3) …. 16.23 s 357-105 …. 16.16 Div 360 …. 16.17 s 388 …. 2.3 s 388-50 …. 16.8 s 388-55 …. 16.7 Taxation Administration Regulations 1976 …. 16.2 reg 24 …. 16.61 reg 24 …. 16.62 Taxation (Interest on Overpayments and Early Payments) Act 1983 …. 5.17 Taxation Laws Amendment Bill (No 1) 1991 …. 14.72 Taxation Laws Amendment Act (No 4) 1992 …. 6.69 Taxation Laws Amendment Act (No 5) 2002 …. 10.66 Taxation Laws Amendment Act (No 4) 2003 …. 14.17, 14.18, 14.56, 14.58 Taxation Laws Amendment Bill (No 7) 2003 Sch 10 …. 14.90, 14.91 Taxation Laws Amendment Act (No 1) 2004 …. 14.90, 14.92 Taxation Laws Amendment (2010 Measures No 2) Act 2010 …. 14.95 Taxation Laws Amendment (2011 Measures No 5) Act 2011 …. 7.31

Taxation Laws Amendment (Company Distributions) Bill 1987 …. 13.77 Taxation Laws Amendment (Company Law Review) Act 1998 …. 13.12, 13.13 Taxation Laws Amendment (Company Law Review) Bill 1998 …. 13.12 Taxation Laws Amendment (Trust Loss and Other Deductions) Bill 1997 …. 15.145, 15.146 Trade Practices Act 1974 …. 8.55 Treasury Laws Amendment (2017 Enterprise Incentives No 1) Bill 2017 …. 12.91, 12.103 Treasury Laws Amendment (Enterprise Tax Plan) Act 2017 …. 4.34 Trust Recoupment Tax Assessment Act 1985 …. 15.57 Veterans’ Entitlements Act 1986 …. 2.31 AUSTRALIAN CAPITAL TERRITORY Partnership Act 1963 …. 14.1 NEW SOUTH WALES Business Franchise Licences (Tobacco) Act 1987 …. 19.2 Conveyancing Act 1919 s 151A …. 15.11 Gas and Electricity Act 1935 …. 4.13 Income Tax Management Act 1928 s 4 …. 13.7 s 11(b) …. 13.7 Medical Practitioners Act 1938 …. 4.13

Minors (Property and Contracts) Act 1970 s 10(1)(b) …. 15.11 Partnership Act 1892 …. 14.1 s 31 …. 14.51 NORTHERN TERRITORY Partnership Act 1997 …. 14.1 QUEENSLAND Partnership Act 1891 …. 14.1 SOUTH AUSTRALIA City of Adelaide Development Control Act 1976 …. 6.86 Income Tax Act 1884 …. 1.3 s 12 …. 8.4 Partnership Act 1891 …. 14.1 Taxation Act 1927–33 s 22(xiv) …. 4.4 VICTORIA Income Tax Act 1935 s 1(g) …. 13.11 Motor Accidents Act 1973 …. 3.68 Partnership Act 1958 …. 14.1 Supreme Court Act 1958 …. 4.11, 4.13 Unemployment Relief (Assessment) Act 1933

s 4(a) …. 13.11 WESTERN AUSTRALIA Partnership Act 1895 …. 14.1 UNITED KINGDOM Capital Gains Tax Act 1979 s 46 …. 15.99 Employer’s Liability Act 1880 …. 10.9 Income Tax Act 1842 …. 1.3 s 1 …. 1.4 Sch A …. 1.4 Sch B …. 1.4 Sch C …. 1.4 Sch D …. 1.4, 1.7 Sch E …. 1.4, 1.14 Income Tax Act 1952 …. 3.42 Partnership Act 1890 …. 14.3 Taxation of Chargeable Gains Act 1992 s 60 …. 15.99 Truck Act 1896 …. 7.5

Contents Preface How to Use Understanding Taxation Law 2018 Table of Cases Table of Statutes

CHAPTER 1 Introduction Nature of taxation Historical development of income tax The constitutional basis of taxation Federal income taxation Sources of taxation law Statutory interpretation Structure of the book

CHAPTER 2 Structure of the Acts and the Income Concept Introduction The income concept examined Income under the ITAA97 Jurisdictional matters: An overview

CHAPTER 3 Income According to Ordinary Concepts Introduction Proposition 1: Amounts not convertible into money are not

ordinary income Proposition 2: Capital amounts do not have the character of income Proposition 3: Gifts unrelated to employment, services or business do not have the character of income Proposition 4: The proceeds of gambling and windfall gains are not income Proposition 5: Mutual receipts are not income Proposition 6: To be income, an amount must be beneficially derived Proposition 7: Income is to be judged from the character it has in the hands of the recipient Proposition 8: Income generally exhibits recurrence, regularity and periodicity Proposition 9: Amounts derived from employment or the provision of services are income Proposition 10: Amounts derived from carrying on a business are income Proposition 11: Amounts derived from property are income Proposition 12: Amounts received as substitutes for or compensation for lost income are themselves income Conclusion

CHAPTER 4 The Derivation and Measurement of Income Introduction Refinements of the accrual basis Profit as assessable income Limits of specific profit Deemed derivation Conclusion

CHAPTER 5 Statutory Income Introduction Division 15: Some items of assessable income Division 20: Amounts included to reverse the effect of past deductions Retirement and termination payments The remaining ITAA36 and ITAA97 framework

CHAPTER 6 Capital Gains Tax Introduction Fundamentals of CGT CGT events Entity making the gain or loss Case study on CGT event A1

CHAPTER 7 Fringe Benefits Tax Introduction Historical background, tax policy and alternative mechanisms for taxing fringe benefits Application of the fringe benefits tax: An overview FBTAA definition of ‘fringe benefit’ Quantifying an employer’s fringe benefits tax liability General principles applicable in valuing benefits Rules for specific types of fringe benefit Exempt fringe benefits Reconciliation with income tax Rebate for tax-exempt employers Principles of salary packaging

CHAPTER 8 General Deductions Introduction The general deduction provision The provision analysed Conclusion

CHAPTER 9 Specific Deductions Introduction ITAA97 Div 25: Specific allowing and qualifying provisions ITAA97 Div 26: Specific denying provisions Deductions of particular amounts The remaining ITAA36 framework ITAA97 Pt 2-42 Divs 84–87: Personal services income Limited recourse debt: ITAA97 Div 243 Forgiveness of commercial debt: ITAA97 Div 245

CHAPTER 10 Capital Allowances Introduction Key features of the ITAA97 Div 40 regime The meaning of ‘depreciating asset’ The meaning of ‘hold a depreciating asset’ How decline in value is calculated Key concepts used in calculating decline in value The meaning of ‘taxable purpose’ Balancing adjustments Roll-over relief Relief for involuntary disposals Low-value and software development pools Project pools: Capital allowances for ‘black hole’ expenditure

Business-related costs Depreciation under the simplified tax system Capital works in ITAA97 Div 43 The basic conditions for ITAA97 Div 43 deductibility Key elements in ITAA97 Div 43 How to calculate ITAA97 Div 43 deductions Consequences of disposal of ITAA97 Div 43 capital works Uniform capital allowances: Proposed technical changes

CHAPTER 11 Trading Stock Introduction Scheme of ITAA97 Div 70 Trading stock defined Valuation of trading stock Non-business disposals Non-arm’s length transactions

CHAPTER 12 Taxation of Companies Introduction Types of corporate tax systems The company as a tax entity Classification of interests in companies under the debt and equity rules What is a company for tax purposes? The distinction between private and public companies The Australian dividend imputation system: The company’s perspective The franking account Franking a distribution Anti-dividend streaming rules

Anti-franking credit trading rules Tainting and untainting the share capital account Anti-capital benefit streaming rules Changes in corporate ownership: Tax effects other than CGT Consolidated groups CGT from a company’s perspective CGT roll-overs and companies

CHAPTER 13 Taxation of Shareholders Introduction Dividends as income under ordinary concepts The Australian dividend imputation system: The shareholder’s perspective The ITAA36 definition of ‘dividend’ Deemed dividends Non-share dividends Tax effects for shareholders of a receipt of dividends Alternative forms of corporate distribution: ITAA rules Gross-up and tax offset denied where imputation system manipulated CGT from a shareholder’s perspective Value shifting provisions CGT roll-overs and shareholders Demerger relief 2016 Tax incentives for investment in early stage innovation companies

CHAPTER 14 Taxation of Partnerships What is a partnership for tax purposes? The basic tax treatment of partnership income

Derivation of partnership income and incurring a partnership loss The tax treatment of partners’ salaries and other internal transactions The consequences of a change in the composition of a partnership Payments for work in progress on a change in composition Statutory provisions applicable on a change in composition The assignment of partnership interests Anti-avoidance provisions relevant to partnerships Partnerships and dividend imputation CGT and partnerships Taxation of limited partnerships Foreign hybrids

CHAPTER 15 Taxation of Trusts Introduction Scope of the tax provisions dealing with trusts Fundamentals of the taxation of trusts The meaning of the terms used in ITAA36 Pt III Div 6 Problems where trust income and tax income differ Trusts and dividend imputation: Receipt of franked dividends CGT and trusts Trusts of deceased estates Unit trusts which are taxed as companies Trust loss provisions Measures to curtail avoidance through chains of trusts Trusts and consolidated groups Trusts and demerger relief

CHAPTER 16 Tax Administration Introduction

Legislative overview and the Commissioner’s powers of administration The self-assessment system Income tax returns Assessments Taxpayer advice Record-keeping obligations of taxpayers Commissioner’s information-gathering powers Disputes with the Taxation Office Objections, reviews and appeals Methods to improve compliance: Penalties Collection of taxes Mechanisms for enforced collection Settlement arrangements and compromise of debt

CHAPTER 17 Anti-Tax Avoidance Measures Introduction General anti-avoidance measures Specific anti-tax avoidance measures

CHAPTER 18 International Aspects Introduction Taxation of residents Taxation of foreign residents Thin capitalisation Transfer pricing Australia’s responses to the OECD BEPS actions on transfer pricing Double taxation agreements The Multilateral Instrument Amendments to Pt IVA in response to BEPS

Other aspects of Australia’s response to the BEPS Reports and recent developments

CHAPTER 19 Goods and Services Tax Background The basics of GST Special treatment of ‘exempt supplies’ Central provisions of GST Taxable supplies Security deposits Enterprise Registration Taxable importations Liability for GST GST-free supplies Input taxed supplies Non-taxable importations Anti-avoidance Conclusion Index

[page 1]

CHAPTER

1

Introduction Nature of taxation It is one of the empirical certainties of History that no structural Society has ever arisen without taxation.1

1.1 We know that taxes have been part of life since time immemorial. The Romans may have had no fuel excise or car registration fees, but they had a wheel tax on chariots and a toll on the Appian Way. We know, too, that over the course of history, almost every conceivable object has been taxed: bricks, candles, coal, glass, newspapers, salt, soap, sugar, tobacco and windows; and tea — with disastrous results for the Crown in America. A 17th-century Irishman is said to have written on his assessment form: Take notice, I have cut the throats of all of my horses — I have shot all my dogs — I have burned all my carriages — I have dismissed all my servants except my wife, and therefore, I conceive that I cannot be liable to any assessment whatever.2

Such indirect taxes would now be called consumption taxes. Historically, the taxation of consumption has reflected a benefit theory of taxation: people should pay for what they get, and government benefits were best measured by consumption. Sir William Petty expressed the idea thus: A man is actually and truly rich according to what he eateth, drinketh, weareth, or in any other way really and actually enjoyeth; others are but potentially or imaginatively rich, who, though they may have power over much, make little use of it.3

Writers such as Petty preferred taxes on luxuries. An English tax on windows proceeded on the assumption that the richer a man, the larger his house and more numerous the windows. Such theories were frustrated when their tax advisers hit on the expedient of bricking up the windows. Hence a tax on bricks. [page 2] Other writers preferred a tax on life’s necessities. On this view: The only way to make the poor industrious is to lay them under the necessity of labouring all the time they can spare from meals and sleep in order to procure the necessities of life.4

These views represent different views of how to raise tax and how to use tax to effect social outcomes. In order to raise revenue and influence social outcomes, tax is essentially an appropriation of private resources to public use. They also reflect the different incidence of the tax burden that different types of taxes produce, and fiscal history mirrors the ongoing struggle between competing interests for the privilege of paying the least tax. Taxes are said to be the price we pay for civilisation. An American judge, Oliver Wendell Holmes (Jnr), said: ‘I like to pay taxes. With them I buy civilization’.5 The English jurist Lord Tomlin, however, thought: ‘Every man is entitled if he can to order his affairs so that the tax attaching under the appropriate Act is less than it otherwise would be’.6 This is a view that is challenged today, at least in its most extreme form. Just as different types of tax have varying impacts on individuals and sections of the community, what is understood by the word ‘taxation’ depends on one’s perspective. For Commonwealth constitutional purposes, tax has been defined as ‘a compulsory exaction of money by a public authority for public purposes, enforceable by law, and is not a payment for services rendered’: Matthews v Chicory Marketing Board (1938) 60 CLR 263 at 270.7 What is tax in a legal context is an important question because the Constitution grants the Commonwealth Government power to make laws in respect of taxation. Such a view

would exclude payments for services from government-owned enterprises and proceeds from the sale of assets. Economists conceive of taxation as leakages from the circular flow of income. This would include, for example, the profits of government enterprises. Financial accountants would see company tax simply as an expense of earning profit. Similarly, other taxes such as pay-roll tax and fringe benefits tax are costs of labour, no different in principle to workers compensation insurance payments. Individuals might regard a tax as the forcible appropriation of private financial resources and, like death, one of life’s few certainties. These perspectives of taxation are evident in formal definitions. Thus, Butterworths’ Encyclopaedic Australian Legal Dictionary8 refers to tax in its definition of ‘exaction’ in terms of the decision in Matthews v Chicory Marketing Board at 270: ‘a compulsory exaction of money by a public authority for public purposes’. Ordinary dictionaries speak in terms of a legal obligation to contribute to the state revenue. [page 3] From the viewpoint of a tax scholar, perhaps the appropriate perspective is the taxing statutes themselves: the Income Tax Assessment Acts. Their function is to divert private resources to the public sector. Specifically, an income tax Act imposes a tax on taxable income. A tax is not a pecuniary penalty — it is not something imposed on one for having broken a law but, rather, is a contribution made according to the law.9 That society permits such appropriations requires a broad consensus of the role of government in a predominantly freeenterprise economy such as Australia. Nevertheless, there will always be disagreement as to the extent to which tax appropriations are made — one person’s tax burden is another’s gain. 1.2 There is no immutable law of nature which predicates a concept of fair taxation, although there seems to be consensus with the 18thcentury view expressed by Adam Smith in Wealth of Nations, that taxes ought to be fair, efficient and simple. Economic criteria require that

taxes should also be neutral; that is, consumption and investment decisions will not be altered by tax impacts. These canons, while laudable, are intractable in practice — notions of fairness vary as between individuals, and a fair system, however conceived, would rarely if ever be adjudged simple and efficient. Conversely, a simple system is unlikely to be seen by many as fair. So, by almost any standard, our income tax system misses the targets of fairness, efficiency, simplicity and neutrality to some degree. When the question of fairness in taxation is discussed, it is useful to keep in mind two conventional notions of fairness drawn from the public finance literature: horizontal equity and vertical equity. Horizontal equity requires that, if income is to be the measure of ability to pay tax, those with the same income should in fact pay the same tax. At first glance such a proposition appears attractive but it is not without its anomalies. For example, would it be considered equitable to tax a single person receiving income of $80,000 to the same degree as one with a dependent spouse and four children? The same amount of money income may mask differing capacities to pay. In Australia, there are attempts to redress these inequities through concessional deductions, offsets and child support schemes, but such initiatives do not take into account the amount of effort required to generate the income, the degree of danger involved, the level of enjoyment or the prior costs of training. A taxpayer with a HECS obligation has incurred higher costs and faces higher tax for a given level of income than a passive recipient, such as a beneficiary of a trust. Vertical equity means that the higher-income recipient pays more tax than the lower-income recipient. Usually it implies some progression in tax such that the higher-income recipient pays relatively or proportionally higher tax. Australian income tax reflects this progression in its tax rates. Just how progressive the rates ought to be is essentially a political issue allied to questions such as the desired degree of income equalisation or redistribution. Other considerations include the likely disincentive to work that comes with high marginal rates of tax as well as the possibilities of forcing taxpayers to shift to lower tax jurisdictions or into the ‘black economy’.

[page 4] Australia’s tax system has often been the subject of much public discussion. The previously proposed ‘super profits tax’ on mining and the tax on carbon emissions (and the introduction of an early form of carbon emissions trading scheme through carbon pricing) were important aspects of debate around the 2010 election and during late 2011. Carbon tax was still under debate in the 2013 election and was repealed in 2014. The Henry Review of Australia’s tax system10 was the subject of considerable debate and a forum in late 2011. Debate preceding the introduction in 2000 of the goods and services tax (GST) was divisive and acrimonious at times. At the time of writing, Western Australian politics is dominated by a discussion of whether that state receives a fair proportion of the GST collected in Western Australia or whether too much is redistributed to other states in the Federation.11 Table 1.1 indicates the significance of tax as a percentage of GDP in the 50 years to 2000 and the increasing reliance on income tax as a source of the Commonwealth’s revenue. The relative decline in indirect taxes was also evident until the introduction of the GST. Perhaps the most striking feature is the contribution made to total taxation revenue by individual income tax, which was over half of total taxation revenue and is still nearly 40% (see below). The Australian Treasury has noted that: Australia relies heavily on individuals’ and corporate income taxes compared with other developed countries, as well as some regional competitors. Australia’s reliance on individuals and corporate income taxes remains much the same as it was in the 1950s, despite the significant change to the economy.12 Table 1.1: 1949/ 1950

Selected taxation statistics ($ million) 1959/ 1969/ 1979/ 1989/ 1960 1970 1980 1990

1999/ 2000

Income tax – individuals

392

884

2,855

15,033

50,019

83,161

– companies

167

456

1,122

3,303

12,926

23,982

– fringe benefits

n/a

n/a

n/a

n/a

1,168

3,484

– other

n/a

n/a

64

356

1,291

3,060

Total

559

1,340

4,041

18,422

65,404

113,687

85

328

569

1,865

10,132

15,643

Customs duty

155

168

414

1,629

4,011

3,799

Excise duty

132

504

940

4,965

9,094

14,679

Estate and gift duty

14

32

80

n/a

n/a

n/a

Pay-roll tax

45

110

230

n/a

n/a

n/a

Other

24

22

115

758

1,860

4,649

455

1,164

2,348

9,217

25,097

38,770

Sales tax

Subtotal

[page 5] Table 1.1: Selected taxation statistics ($ million) — (cont’d) 1949/ 1959/ 1969/ 1979/ 1989/ 1950 1960 1970 1980 1990 Total tax

1999/ 2000

1,014

2,504

6,389

27,639

90,501

152,457

Income tax as percentage of total

55.1%

53.5%

63.2%

66.6%

72.3%

74.6%

Total tax as percentage of GDP

19%

17.5%

20%

22.5%

24.4%

24.5%

Source: Reserve Bank of Australia Bulletins; Australian Bureau of Statistics Australian National Accounts. Note: Definitional and classification inconsistencies following the introduction of GST in 2001 make comparisons beyond 1999–2000 difficult so the table has not been updated. The income tax proportion of the Australian tax take can be seen in Figure 1.1 below. Income tax as a proportion of taxes is back nowadays to levels similar to those in 1969/70, which is still a relatively high proportion.

Figure 1.1:

Composition of Australian taxes

Note: Percentages may not sum up to 100 per cent due to rounding. Source: Re:Think — Better Tax, Better Australia, Our Tax System: At a Glance, Australian Government, click on ‘Menu’ (accessed 4 September 2017), drawn from ABS, Taxation Revenue, 2012–13.

Historical development of income tax 1.3 Like other forms of taxation, the taxation of income may be traced to ancient times,13 but more modern versions of income tax did not develop in Europe until the 19th century. Britain’s ‘modern’ income tax was imposed in 1842. Italy followed [page 6] suit in 1864 and Germany in 1871.14 Although a temporary income tax was imposed during the American Civil War, it was not until 1913 that income tax became a permanent feature in the United States.15 Budgetary pressures forced reluctant Australian colonies and states to introduce income tax between 1884 (in South Australia) and 1907, and

the onset of World War I pressed the Commonwealth Government into the field in 1915. The influence on Australia of British settlement and its institutions is widely appreciated but it comes as a surprise to discover that, although colonial Australia adopted a great deal of British tradition and often copied UK Acts of Parliament verbatim, it did not copy UK tax legislation (eg, South Australia’s 1884 Act drew from not only the Income Tax Act of 1842 (UK) but also an 1876 Victorian Bill, an 1878 South Australian Bill, an 1879 New Zealand Act and the previous (1883) South Australian Bill).16 Colonial and state governments borrowed freely from the statutory language of Britain’s 1842 Act, and accepted the well-entrenched distinction between income and capital in the course of developing their own judicial concept of income, but Australian tax Acts were designed along quite a different statutory scheme. There are two important consequences of this divergence that are identified against the following historical backdrop.

English taxation 1.4 Under threat of invasion from France in 1799, and facing a decline in revenue from other sources, the English Prime Minister, Pitt, was forced to impose an income tax that was immensely unpopular and was repealed following Napoleon’s defeat. It was not reimposed until 1842 (and hence the description ‘modern’). A feature of the 1842 Act was its schedular approach to income taxation under which different classes of income were taxed according to specific sets of rules. By the 1890s, when the Australian colonies were drafting quite different legislative schemes, this schedular system existed in essentially the same form as in earlier enactments and to this day forms the basis of the British statutory scheme. The scheme operated as outlined below. By s 1 of the 1842 Act, income was brought to charge under the following five headings: Schedule A: in effect, a property tax. It relates to incomes, rents, royalties, tithes, etc, derived from the ownership of freehold,

leasehold and land and buildings. (Income from mines and quarries is charged under Sch D.) Schedule B: in effect, a tax on primary production income. It relates to incomes derived from animal husbandry and from the use and occupation of the land. (Income from the hiring of farm implements and certain stud fees is charged under Sch D.) [page 7] Schedule C relates to incomes derived from interest, annuities and dividends payable out of the public funds of the United Kingdom, the colonies or any foreign state. Schedule D applies in respect of profits accruing to a person in the United Kingdom from trade, manufacture, professional practice or employment together with any income not included under the other schedules. In the case of a non-resident of the United Kingdom, it includes profits from any trade carried on in the United Kingdom and any property situated in the United Kingdom. Schedule E operates to tax annuities, salaries, pensions, fees and other employment remuneration. One reason for this schedular approach was to identify different classes of income, namely, ‘earned’ and ‘unearned’ income, and charge the latter to tax at higher rates. This principle of differential rating was adopted in Australian legislation until comparatively recent times and explains the need to define ‘income from personal exertion’ and ‘income from property’.17 It may be speculated that another justification for the schedular mechanism was the advantage perceived in separating relatively clear-cut and simple instances of income from potentially more complex operations. Thus, property income such as rent and royalties (Sch A) and interest and dividends (Sch C), together with emoluments of office (Sch E), are conveniently separated from the multifarious trading and manufacturing activities of Sch D, and it should be noted that Sch D taxes ‘profits’.

On the other hand, the Australian legislative scheme was to develop what could be described as a single-schedule approach, a feature of which is the application of the same basic framework to all classes of income. That is, the Australian scheme is to bring to charge taxable income, being assessable income minus allowable deductions. Apart from the inevitable exceptions,18 several classes of income, for example, rents (Sch A of the UK Act), primary production income (Sch B), interest (Sch C), proceeds from trading and manufacturing (Sch D) and salary and wages (Sch E), are all brought to account under the same mechanism. Each of these items is regarded as income by ordinary concepts — in the language of the Income Tax Assessment Act 1997 (Cth) (ITAA97) — and made assessable income under ITAA97 s 6-5. A second feature of the Australian scheme of taxation that should be emphasised is that assessable income is not profit (as in Sch D of the UK Act) but, rather, more in the nature of revenue from which deductions may be allowed. This often leads to difference between what accounting processes treat as ‘profit’ and what is taxable. Why the Australian colonies and later the Federal Government should adopt such a scheme of taxation is an interesting historical question, and it is no less intriguing [page 8] given that, at the time (the late 19th century), the colonies adopted, substantially without change, other English legislation such as the Sale of Goods Act.19

Australian taxation 1.5 Australia’s first (indirect) tax was imposed in 1800, a mere 12 years after the first European settlement. It took the form of duties designed to keep trading in spirits to manageable proportions. Throughout the mid-19th century, when Britain was coming to accept income tax as a fact of life, colonial Australia’s financial needs were met

through land sales primarily, as well as tariffs. Although the smaller states experienced financial difficulties, by 1870 acceptance that title to Australian land vested in the Crown (which could then dispose of it in return for revenue) meant the medium-term deferral of an income tax. Not only did the sale of land provide a major source of revenue, it was also the subject of land tax and the object of probate duties. When saleable land was exhausted and the colonies were forced to broaden their tax base they did not adopt the British scheme of taxation per se. In part, it would seem, this was by way of accident. There were some early attempts to impose an English-styled income tax. In 1866, the Tasmanian Government sent secretly to England for copies of printed forms used there in the collection of income tax with a view to introducing the scheme in that colony. The public was aghast when this was discovered and the government was thrown out of office. When, in 1883, the South Australian Treasurer sought to introduce the state’s first income tax, he freely admitted that the proposal was based on the UK Act because, as he said, ‘that was the only guide we had in the matter of an income tax’. However, the upper houses of parliaments were securely in the hands of conservatives, and while they may have disagreed on the burning issues of the time (secular versus religious education, protective versus revenue tariffs, the abolition of transportation), the conservatives were more united in protecting their wealth from direct taxation and rejected many early attempts to introduce land and income tax. The rejection of the UK model was also in part due to men such as George Higinbotham — Melbourne Argus editor, Victorian AttorneyGeneral and Supreme Court judge — who campaigned against the importation of British statutes and the ‘jumbled jurisprudence’ it created. As a result, the tax scheme that ultimately became law exhibited a hybrid of Australian invention with a refusal to reject entirely ‘the only guide we had in the matter’. When, in 1915, federal income tax was imposed, the Australian statutory scheme had become well entrenched.

[page 9]

Implications 1.6 The rejection by Australia of the UK scheme had important implications for the relevance of that country’s case law to the interpretation of Australia’s legislation. First, the differences between the schemes have not always been appreciated. As Mason J commented in FCT v Whitfords Beach Pty Ltd (1982) 150 CLR 355; 12 ATR 692; 82 ATC 4031 at 4044: Not all that was said by the Privy Council in [McClelland’s case] can now be accepted. The majority judgment [of the Privy Council] fails to differentiate between the United Kingdom and the Australian systems of arriving at taxable incomes and employs expressions derived from the United Kingdom Income Tax legislation which have no place in our legislation.

The Australian courts have warned many times that differences in the legislative schemes mean UK tax decisions should be received cautiously and the warning is reiterated here. Although many taxing statutes have much in common, and although Australia has embraced the UK judicial concept of income and its distinction from capital, there are important differences in statutory schemes that mean another country’s tax jurisprudence is not automatically relevant to Australia. 1.7 Second, although Australia rejected the UK scheme, it inherited the distinction between income and capital and copied verbatim large slabs of the English provisions. The resulting hybrid posed further problems. The development of the UK schedular scheme (and its rejection in Australia) was especially significant. The UK schedules taxed various categories of receipts and gains, and residual provisions were gradually added to pick up amounts that fell outside the broad genus of the schedule, but there was little attempt to consolidate a unified structure taxing income as a coherent concept. There was no serious questioning of whether the income concept as it had emerged from trust law was an appropriate base for a new law of income taxation. In other jurisdictions, such as the United States, less steeped in English tradition

and less constrained by the schedular scheme approach to income tax, the notion of income developed differently. Thus, judges in different jurisdictions were asking different questions when considering whether an item was ‘income’. The US courts, for example, asked whether the item was ‘income’ without regard to any particular statutory confines, whereas the UK judges asked whether an amount was a specific item — rent, interest, dividends — or whether it was ‘income’ having regard to a particular schedular genre. The outcome was rejection by the US courts of an income concept based on trust law. If income was to be the subject of taxation, what was understood by ‘income’ should be determined by taxation and economic criteria. Although Australia devised its own particular taxing scheme that differed from both the United Kingdom and United States, it adopted the UK approach to income as being dichotomous to capital. As a result, there was no attempt to distinguish between original capital and a realised enhancement of capital. That is, although income and capital are to be distinguished, there was no attempt to distinguish capital from a capital gain, the latter clearly falling within the economic concept of income. This critical difference is illustrated in the US decision of Eisner v Macomber 252 US 189 (1920): ‘Income may be defined as a gain derived from capital, from labor, [page 10] or from both combined’. The distinction between income and capital by UK and Australian courts meant that gains derived from capital were not part of the income base. It was not until 1985 that the Australian tax base was broadened to include capital gains and that widening was a specific statutory extension to income. Generally, it is legislative intervention that has been responsible for the widening of the Australian tax base. Otherwise, the judicial concept of income focuses on flows; gains will be taxed on their realisation, flows will be taxed whether or not they represent gains. This brief survey of the development of income taxation illustrates

that the UK tax legislation adopted a schedular approach, Sch D applying taxation to profits from trade — a scheme and language that has no Australian counterpart. Australian colonies and states borrowed heavily from UK legislation, including a deal of language from the tax Act, but did not adopt the schedular scheme nor did they directly make profits the object of tax. As a result, caution must be exercised in applying English authorities to Australian issues. Although the scheme of taxation was rejected, Australia inherited the distinction between income and capital and the judicial concept of income. In contrast to other jurisdictions, Australia did not reinvent the notion of income to accord with taxation criteria.

The constitutional basis of taxation 1.8 The Australian colonies and states enacted income tax legislation during the period 1884–1907, and by the end of the 19th century the colonies were firmly established as gatherers of income tax. Federal income tax arrived comparatively late on the scene when imposed in 1915.

Laws with respect to taxation 1.9 In 1901, the six colonies and the Northern Territory formed the Federation of Australia. The states were not prepared to give up their taxing rights and, under the Commonwealth Constitution (the Constitution), the Commonwealth and states have concurrent taxing powers. Section 51(ii) of the Constitution grants the Commonwealth Parliament the power ‘to make laws … with respect to … taxation’. ‘Tax’ has been defined as ‘a compulsory exaction of money by a public authority for public purposes, enforceable by law, and is not a payment for services rendered’: Matthews v Chicory Marketing Board (1938) 60 CLR 263 at 270. It has not been easy to distinguish between taxation and other forms of financial exaction and there is no definitive test of what is ‘taxation’. However, the High Court has taken the view that taxation is not limited, as the above definition might suggest, merely to

the raising of revenue. Laws in respect of a range of social and economic objectives fall within the constitutional power of the Commonwealth under s 51(ii), so long as the relevant legislation imposes an obligation to tax. For example, Commonwealth land tax imposed in 1910 with the intention of breaking up large estates was held to be constitutionally valid: Osborne v Commonwealth (1911) 12 CLR 321.20 In Fairfax [page 11] v FCT (1965) 114 CLR 1; 10 AITR 33, income tax laws designed to encourage superannuation funds to invest in public securities were held to be validly imposed laws in respect of taxation. In that case, Kitto J (at AITR 40) quoted from Higgins J’s (dissenting) judgment in R v Barger (1908) 6 CLR 41 as follows: … subject only to the limitations expressed in the Constitution the power with respect to taxation was “plenary and absolute, unlimited as to amounts, as to subjects, as to objects, as to conditions, as to machinery” so that “the Parliament has, prima facie, power to tax whom it chooses, power to exempt whom it chooses, power to impose such conditions as to liability or as to exemption as it chooses” …

Laws imposing taxation 1.10 Section 55 of the Constitution requires that laws ‘imposing taxation shall deal only with the imposition of taxation’ and that ‘laws imposing taxation … shall deal with one subject of taxation only’. This was enacted to prevent what was called ‘tacking’, a process of exploiting constitutional limitations on upper houses’ powers to amend money bills by ‘tacking’ a tax onto a bill dealing with other matters. The result is that federal revenue law comprises a number of individual Acts directed to particular aspects of assessment and rating. As Fullagar J explained in Re Dymond (1959) 101 CLR 11 at 18: By reason of the provisions of s 55 it has been the invariable practice since the establishment of the Commonwealth, when Parliament has proposed to levy a tax on any subject of taxation, to pursue that object by means of two separate Acts, the one which

actually imposes the tax and fixes the rate of tax, and the other of which provides for the incidence, assessment, and collection of tax and for a variety of incidental matters.

The practice identified by Fullagar J explains the different legislation assessing and collecting income (the Income Tax Assessment Act 1936 (Cth) (ITAA36) and Income Tax Assessment Act 1997 (Cth) (ITAA97)) and the ratings Acts, which impose taxation, such as the Income Tax Act 1986 (Cth) and Medicare Levy Act 1986 (Cth). The requirement that laws imposing taxation ‘shall deal with one subject of taxation only’ explains similar legislative practices in relation to the taxation of fringe benefits.21 However, the taxation of capital gains is incorporated into the ITAA97 rather than separate, specific legislation because it was drafted not as a separate tax but as an inclusion in assessable income. In Resch v FCT (1942) 66 CLR 198; 2 AITR 231, Dixon J said (at AITR 242): The expression “subject of taxation” appears to suppose that some recognised classification of taxes exists according to subject matter. But in fact that was never so. Economists and lawyers have for their different purposes referred taxes to categories, the one for their incidence and economic consequences and the other for the legal mechanism employed to secure their collection and for their operation upon the creation, transfer and devolution of rights. But these are not considerations to which s 55 [of the Constitution] are directed. It is concerned with political relations

[page 12] and must be taken as contemplating broad distinctions between possible subjects of taxation based on common understanding and general conceptions, rather than on any analytical or logical classification.

Rich ACJ, Starke and McTiernan JJ agreed and, as a result, the High Court took a broad view of the term ‘subject of taxation’ and dismissed an argument that the Income Tax Assessment Act 1922 (Cth), in dealing with the taxation of both income and capital, dealt with more than one subject. The distinction between profits of an income nature and those of a capital nature was not a distinction the Act maintained nor a discrimination the legislature was bound to regard.

Use the Internet or the library to identify a group of separate statutes that apply to the same tax, but which are separately enacted so as to meet the constitutional requirements. See Study help for some suggestions.

Laws must not discriminate between states 1.11 Federal taxation laws that discriminate between states or parts of states are expressly prohibited by s 51(ii) of the Constitution. This prohibition requires uniformity in taxation law and is reinforced in this regard by s 99 which disallows any law or regulation of trade, commerce or revenue giving preference to any one state or part of one state. The High Court has taken the view that discrimination or preference will arise only where different rules apply to different parts of Australia. A uniform law that has a different impact in its operation is not such a law: James v Commonwealth (1928) 41 CLR 442. On the other hand, in Cameron v FCT (1923) 32 CLR 68, the High Court held to be invalid regulations that assigned different valuations to livestock in different states. Despite these restrictions, the decision in DCT v WR Moran Pty Ltd (1939) 61 CLR 735 indicates one strategy to discriminate effectively. In that case, the High Court examined one statute that imposed a tax on flour millers throughout Australia and another statute that provided for a payment to the Tasmanian Government of an amount equal to the tax raised in Tasmania. The legislation was held to be valid. Grants to states (made under s 96) are not subject to rules against discrimination or preference.

States and taxation 1.12 Commonwealth taxing power is a concurrent power. Prior to Federation, the several colonies had enacted taxation laws pursuant to their own constitutions and s 107 of the Constitution provides that the

states inherit the legislative powers of the former colonial parliaments unless those powers are transferred to the Commonwealth. As a result, between 1915 and 1942 the states shared income taxing powers with the Commonwealth but the power to impose customs and excise duties resides exclusively with the Commonwealth. [page 13]

Federal income taxation 1.13 On 22 July 1915, 61 members of the Australian Labor Party caucus assembled for a party meeting. The purpose of the meeting was to consider a recommendation framed earlier in the day by the executive: That we recommend to the party that in order to provide the necessary funds to meet the expenditure of the Commonwealth an income tax be imposed.

The motion was carried 27:26.22 A copy of the tax schedule was ‘leaked’ and, to the caucus’s outrage, appeared in Melbourne’s The Age on 30 July. The Income Tax Assessment Acts 1915 (Cth) were assented to on 13 September 1915. Excluding Regulations, the Acts covered 23 pages and comprised 65 sections.23 The federal legislation was generally in line with that of the states. Although a good deal of terminology was copied from the British Act, the schedular scheme was rejected in favour of the following formula: 18 (1) In calculating the taxable income of a taxpayer the total income derived by the taxpayer from all sources in Australia shall be taken as a basis, and from it there shall be deducted — (a) all losses and outgoings, not being in the nature of losses and outgoings of capital, including commission, discount, travelling expenses, interest, and expenses actually incurred in Australia in gaining or producing the gross income …

‘Profit’ is not the object of the Australian scheme. Tax is imposed on taxable income being the difference between assessable income and

deductions. A view that assessable income is a gross concept is encouraged by the reference in s 18(1)(a) to ‘gross income’. Among the pressures forcing the imposition of Commonwealth income tax was the need to finance the war effort and it is significant that, under s 13, the income of persons on active service was exempted from tax. It is notable, too, that under [page 14] the first Commonwealth Act, company taxable income was reduced by amounts distributed as dividends and interest to debenture holders: s 16.24 Between 1915 and 1942, both state and Commonwealth income tax was payable. The result was that everybody was subjected to at least two income taxes. Businesses such as banks operating on a national level faced seven income taxes. In 1920, the Federal Government appointed a Royal Commission to inquire into income taxation and to report, among other things, on the harmonisation of state and Commonwealth legislation.25 A suggestion for the unification of income tax was resisted but a degree of harmony in tax laws was restored in the short term with the Income Tax Assessment Act 1922 (Cth); however, the new Act was almost double the size of the original. A further Royal Commission in 193226 resulted in the Income Tax Assessment Act 1936 (Cth), which, although subsequently the subject of hundreds of amendments, remained the operative legislation until 1997 when the Income Tax Assessment Act 1997 (Cth) became operative alongside the 1936 Act, each dealing with different aspects of the income tax.

The decision in Jones v Leeming 1.14 From a historical perspective, this UK decision has had a lasting impact on Australian income tax. In 1930, the House of Lords delivered judgment in Jones v Leeming [1930] All ER Rep 584. In this case, Leeming and others acquired options to purchase rubber estates

apparently with the intention of transferring them to a newly floated company. The issue to be decided was whether the profit arose in the course of ‘an adventure in the nature of trade’ — which would render the profit taxable under Sch E of the UK legislation — or was simply a case of purchase and resale of an asset at an enhanced price (and so a non-taxable capital gain). It was concluded that the transaction was not a concern in the nature of trade with the result that the profit was not income in nature. There was no doubt that isolated transactions could fall within the description ‘adventure in the nature of trade’. The conclusion by the House of Lords was that, on the facts, this was not the case in Jones v Leeming. It was well settled in UK and Australian revenue law that the mere realisation of an asset at an enhanced price was capital, not income. In marginal cases such as Jones v Leeming, the distinction between income and capital and characterisation of receipts has bedevilled both jurisdictions since the inception of income tax. In Australia, there were concerns that the decision might be followed by Australian courts, and parliament rushed to enact preventative legislation. In 1930, the following provision was enacted and made retrospective to 1922:27 [page 15]

26 The assessable income of the taxpayer shall include: (a) profit arising from the sale by the taxpayer of any property acquired by him for the purpose of profit-making by sale, or from the carrying on or carrying out of any profit-making undertaking or scheme.

The provision is significant in two respects. First, it is at odds with the general scheme of the Act as indicated in the tax formula spelled out in s 18, above: taxable income equals assessable income minus deductions. Section 26(a) assessed profit. Although profit enters assessable income, it does so as a net amount and the amount is to be

determined by commercial measurement criteria and not by deductions allowable under the particular tax Act. Second, although at the time of its enactment commentators thought the new provision merely stated the law as it applied in Australia, over the ensuing 50 years, s 26(a) was to develop its own judicial culture and interpretation: when must the intention of profit making be formed? Must a profit-making purpose be the dominant purpose? The relationship between s 26(a) and the general assessing provision (ITAA36 s 25(1)) was never satisfactorily resolved. The refinement of the judicial concept of income as it applied especially to isolated transactions was stifled because s 26(a) distracted attention from whether the proceeds were income by ordinary concepts.

Uniform taxation 1.15 One of many recommendations made by the Report of the Royal Commission on Taxation, 1920–24 (Warren Kerr Commission) was the unification of state and federal income taxes. The Commonwealth Government offered to collect and administer state taxes as early as 1919 but this was declined and, with the end of World War I, some states hoped the Commonwealth would vacate the income tax area. The object of the commission was unification rather than harmonisation, and amendments over the next decade compounded the problems of seven income taxes administered by different bureaucracies. The Royal Commission on Taxation, 1932–34 (Ferguson Commission) was appointed to recommend ways to harmonise the systems. The result was a dual tax system administered jointly by state and federal authorities. The Income Tax Assessment Act 1936 (Cth) was the blueprint of similar legislation enacted by the states but, within a short time, differences developed again. In the early days of World War II, the Commonwealth requested the states to give up income taxation for the duration of the war and to accept, instead, a system of grants, but the states declined. As a result, the Commonwealth adopted a strategy to crowd out the states. In 1942, a series of Acts were passed that imposed Commonwealth

income tax at rates corresponding to state and federal tax combined. In addition, taxpayers were prohibited from paying state tax until Commonwealth obligations were paid. The states complained that this legislation made it politically impossible for them to impose income tax and challenged its constitutional validity. The High Court [page 16] held that such political realities did not affect the Acts’ validity: South Australia v Commonwealth (1942) 65 CLR 373. The uniform tax legislation did not exclude the states from the field of income taxation. Under the Grants Acts, states were reimbursed for lost income tax revenue and this was an inducement that the states were free to accept or reject. At the end of World War II, the Commonwealth Government continued with the wartime system and the states have not since made serious attempts to re-enter the field. However, it seems there remains no constitutional impediment to stop them from doing so. This strategy was again employed under the Commonwealth Government’s Tax Reform Plan. A similar revenue-sharing arrangement has operated from 1 July 2000 in respect of revenue raised under the goods and services tax (GST). Under the plan, GST collections were to be returned to the states in return for their agreement to abolish a range of other taxes and charges, and this plan has largely been successfully implemented.

The tax reform process Background 1.16 With the Commonwealth Government entrenched as the dominant taxing authority, review and reform of the taxation system continued unabated. Sales tax had been introduced before World War II (1930), and both a wool tax and a flour tax operated for more than a decade until the late 1940s. In 1944, the Pay-As-You-Earn (PAYE) and

provisional tax systems of tax collection were introduced. Payroll tax was imposed by the Commonwealth in 1941 to finance childendowment payments and was transferred to the states in 1971. A hospital insurance levy (the predecessor to the Medicare levy) commenced in 1976. Committees of inquiry have regularly been established: the Spooner Committee (1950–54), Hulme Committee (1954–55), Ligertwood Committee (1959–60), Asprey Committee (1972–75) and Mathews Committee (1974–75). These reviews had little substantial effect other than grafting minor amendments onto the 1936 legislation. The Asprey Committee (1972–75), for example, made sweeping recommendations, including the introduction of a CGT and a GST, but there was no immediate action. By the mid-1980s, the reform process gathered momentum. The Economic Planning and Advisory Committee (1984–85) review of the tax system led to the 1985 Draft White Paper but its principal recommendation of a consumption tax failed to attract support. Nevertheless, CGT was imposed, effective from 20 September 1985, and fringe benefits tax in 1986. Rules limiting the deductibility of entertainment expenses were introduced in 1985, together with rules requiring the substantiation of employment, motor vehicle and travel expenses. In the international scene, amendments included the introduction of a foreign tax credit system and, from 1990–91, an accruals tax system for controlled foreign companies. Reforms extended to the taxation of superannuation funds and corresponding changes were made to the taxation of retirement payments. In 1987, an integrated system was introduced for the taxation of companies and shareholders whereby a credit for company tax paid flowed through to shareholders receiving dividends. This imputation system will be discussed in later chapters. [page 17]

Tax Law Improvement Project (TLIP)

1.17 Following the report of the Ferguson Commission, the Income Tax Assessment Act 1936 (Cth) was enacted, together with corresponding state legislation. Over the next 50 years, the 1936 Act was amended time and time again but the substantial scheme and structure remained intact. Administrative changes suggested by the many review committees, tinkering in areas such as depreciation as well as the more substantive amendments outlined above, were grafted onto the original framework. At one stage, five different depreciation systems operated concurrently. The original 1936 Act comprised approximately 100 pages but by the 1990s several thousand pages accommodated what was probably the largest piece of Commonwealth legislation. In addition, the Act employed an alpha-numeric recording system that had exploded in size as new legislation was squeezed between older sections. The original capital gains provisions, for example, all had the numerical prefix of s 160 but comprised around 150 provisions. The prospect of reading the Act from beginning to end would be daunting and, in any event, was unlikely to enlighten a reader. The Act was in danger of collapsing under its own weight. An example of how this is so may be discerned from the following activity linked to Study help.

Find copy of the Income Tax Assessment Act 1936 (Cth). How many Divisions are there in Pt III, which relates to liability for taxation?

In 1993, the government announced the Tax Law Improvement Project (TLIP), a scheme to restructure, rewrite and renumber the income tax laws. The object was to simplify and improve the existing law rather than to examine and review the policies underlying it. To date, the result is the Income Tax Assessment Act 1997 (Cth), which contains a partial rewrite of the initial legislation but, being incomplete, operates concurrently with the ITAA36. Because the TLIP is incomplete, it is necessary to describe it here.

The TLIP redesigned the legislation in the form of a pyramid, as indicated below. It is a series of layers that progress from the general to the more specific. These are designated chapters. Thus, at the first level is Ch 1, which comprises the ‘core provisions’ that include the general income assessing (Div 6) and deduction (Div 8) provisions. The same taxing scheme applies as with the ITAA36, namely taxable income is the object of tax and it is calculated by the formula: ‘assessable income minus deductions’. The second level, Ch 2, contains the general provisions applicable to a wide range of taxpayers irrespective of whether they are salary and wage earners, sole proprietors, partners in a partnership or companies. For example, Ch 2 contains the depreciation and trading stock provisions. The third level is Ch 3. It covers a number of specialist topics such as rules relating to particular entities; for example, partnerships, companies and trusts. [page 18] The fourth level comprises chapters dealing with collection and administration. Chapter 4 contains machinery provisions for the collection and recovery of tax. Chapter 5 covers administrative matters such as the Tax File Number system as well as prosecutions and penalties, and Ch 6 contains a dictionary of rules for interpreting the Act and, in s 995-1, key definitions of words and phrases used.

Figure 1.2:

How the ITAA97 is arranged

Source: ITAA97 s 2-5.

A New Tax System (ANTS) 1.18 In 1998, the Federal Government announced further reforms under a plan entitled Tax Reform — Not a New Tax — A New Tax System (ANTS). A central plank of ANTS was the goods and services tax, introduced on 1 July 2000, and this was underpinned by a new Australian Business Number (ABN) system. The tax collection system was also streamlined by the introduction of the Pay-As-You-Go (PAYG) system, which replaced the former PAYE and provisional tax systems, and other payment and reporting requirements.

[page 19]

The Ralph Report 1.19 Significant reforms were announced also to the system of business taxation. An extensive survey, the Review of Business Taxation, under the Chairmanship of John Ralph (the 1999 Ralph Report)28 generated a large number of recommendations, many of which were enacted from July 2001 and in subsequent years: the simplified tax system for small business taxpayers (see 4.34), which provides an option to calculate taxable income on a cash received/cash paid basis together with simplified depreciation and trading stock rules; the uniform capital allowances system (Chapter 10), which provides for deductibility of a range of capital expenditures, including depreciation of assets; rules for distinguishing between debt and equity such that returns on debt are treated in the same manner as interest and returns on equity are treated in the same way as dividends (see 12.25); operating from 1 July 2000, a set of rules directed against the alienation of personal services income by use of interposed entities (see 9.82ff); consolidation regime for wholly owned groups of entities operating from 1 July 2002 (see 12.112–12.131). Additional changes, such as restrictions on the deductibility of noncommercial losses (see 9.69) and ‘thin capitalisation’ rules (see 18.51), are discussed under appropriate headings. However, two initiatives that were seen as central to the Ralph Report were rejected: 1. the ‘tax value method’, also known as ‘option 2’, of measuring taxable income through net cash flows plus or minus the change in tax value of assets and liabilities; 2. the ‘entity tax’ proposal to tax all entities as companies with imputation credits flowing to members. A qualified version, to tax discretionary trusts as companies, was also abandoned.

Other recommendations were passed to the Board of Taxation, a body established in 2000 to advise the government on the operation of the tax system and to ensure there is full and effective public consultation on the tax reform process.29 The main and most recent change emanating from there and now being implemented in legislation is a reorganisation of the rules applicable in the context of international tax, discussed in Chapter 18 of this book. In addition, an Inspector-General of Taxation was established to advise the government on tax administration and to represent taxpayers’ views. Information about the Inspector-General of Taxation may be obtained from . The role is also discussed in Chapter 16 of this book, ‘Tax Administration’. The Labor Government elected in late 2007 announced another review of the tax system in the 2008 Budget. The so-called Review of Australia’s Future Tax System reported to the government in December 2009 and was publicly released in 2010, but few of its recommendations have been adopted. The review is also known as the Henry Review and is discussed next. [page 20]

The Henry Review 1.20 This review was announced as undertaking a ‘root and branch’ approach to reviewing Australia’s state and federal government taxes, as well as their relationship with the transfer system, so as to address the challenges of Australia’s changing demographics, environmental changes, and its social and economic future. It commenced work in 2008 and reported to the government in 2009 and the public in 2010. There were many submissions (around 1500) via public and invited meetings, focus groups and conferences.30 The final report made 138 recommendations and initially only a handful (eight) of these were acted on by government. The new ‘super profits’ tax applicable to mining activities was the most contentious by far. The government of the day

was criticised for its handling of the Henry Review report as there was a perception of a lack of consultation on reforms made in response. This led to the replacement of the Prime Minister (Mr Rudd was replaced by Ms Gillard although he was later reinstated) and resulted in an early federal election. The ‘super profits’ tax was watered down and became a ‘mineral resource rent tax’ applicable only to iron and coal mining companies. This was repealed in 2014. Most of the Henry Review recommendations await action.

The Re:Think Initiative 1.21 As the Henry Review reforms were not adopted, the tax system has remained largely unreformed since the big changes at the turn of the century. In 2015, a further process of consultation with a view to reform, the Re:Think Initiative, was undertaken. There are no concrete outcomes from this. Aspects of the consultation may be reviewed at .

Sources of taxation law 1.22 Two sources of taxation law can be identified in Australia: legislation (statute law), and court decisions (case law). To this could be added rulings (provided by the Australian Taxation Office (ATO)). The last-mentioned are not strictly speaking law but they operate so as to be tantamount to law for practical purposes and a lot of weight is placed on them by practitioners.

Statute law 1.23 Statute law is law made by parliament. The focus of this text is the three assessment Acts — the Income Tax Assessment Act 1936 (Cth), the Income Tax Assessment Act 1997 (Cth) and the Fringe Benefits Tax Assessment Act 1986 (Cth) — and also the A New Tax System (Goods and Services Tax) Act 1999 (Cth). Although initiatives such as the TLIP and the Tax Reform Project have attempted to design newer legislation from a user’s perspective, using clearer, simpler

language, disputes arise continually over the meaning of statutory provisions and key words within them. For example, examine the leading words of ITAA97 s 6-5(2): [page 21]

6-5 (2) If you are an Australian resident, your assessable income includes the ordinary income you derived directly or indirectly from all sources …

Several key words have been emphasised. Consider for a moment, what is ordinary income? Historically, income tax Acts have been understood to tax ordinary income, and nothing else. Whatever the items or receipts ordinary income comprises, they are brought to assessment for tax purposes. Parliament may decide to expand the range of amounts brought to tax and enact legislation to assess specific items to be regarded as statutory income. This occurred, for example, with the introduction in 1985 of CGT. Alternatively, it may legislate to exclude items, called exempt income, from tax. In this sense, statutory law is the primary source of law. Subject to constitutional limits, parliament can make or unmake laws with respect to taxation. Law that arises from another source can be overruled by statute. If the common law and statute law conflict, the latter prevails. Some of the words in s 6-5(2) (eg, ‘resident’) have been defined in the Acts and so take on a technical or statutory meaning. Others (such as ‘derived’) have been deliberately or conveniently left undefined. Where words have been defined, recurring questions arise about the meaning of the definitions. Where words are undefined, there is a vacuum that can be filled only by the courts. In either case, the interpretation of the statute or the filling in of legislative holes is the domain of the courts and this comprises case law. In this sense, case law is a secondary source of law for it derives from the statute and can be overruled by statute. At the same time, given that the meaning of ‘ordinary income’ is one

legislative hole left to the courts, the primary source of our understanding of that concept is derived from case law.

Case law 1.24 Case law is law derived from court decisions. It has several functions that, broadly, might be divided into an interpretative function and a law-making function. First, case law makes sense of statutory law. It may discern the purpose or intent of legislation, the meaning of words and provisions, resolve ambiguities and apply the relevant Act in the determination of one’s tax liability. Courts interpret the legislation when disputes arise and they determine the ambit of a law within constraints such as those contained in the Commonwealth Constitution and by principles of natural justice. In the course of resolving disputes, the courts create law. Where the legislation is silent on a particular matter, the courts must fill in the missing words. In the course of resolving the dispute before it, a court enunciates principles of more general application that are followed in subsequent cases. This is the doctrine of precedent. The principles at work are known as the ratio decidendi (the reason for the decision) and stare decisis (to stand by the decision). Increasingly, modern commercial law, and revenue law in particular, is grounded in statute law and supported by administrative rulings. This shift from taxation by principles to taxation by statute is likely to continue, but the courts’ role is unlikely [page 22] to diminish because disputes will continue to arise and because so many of the core concepts of tax remain undefined. The need for an understanding of the principles does not diminish either, and a good deal of this text is directed to developing such an understanding. Ultimately, the well-equipped tax scholar will appreciate how the principles themselves were developed by the courts and employ the

cases as authorities for propositions of law. Among other things, this will enable them to identify and advise on the assessability of receipts or the deductibility of expenditures and to advise on the tax consequences of proposed courses of action, such as a prospective investment, the liquidation of a company or the creation of a partnership. It will also provide a basis for anticipating the likely outcome of a dispute between a taxpayer and the Commissioner of Taxation.

Where do you look for case law? See Study help for suggestions.

The importance of facts and context 1.25 There are two critical elements in understanding and using case law. The first is that where the courts have performed an interpretative role, the language used in applying that interpretation is subordinate to the statute itself. That is, the statement by the court does not displace that statutory expression nor serve as a substitute for it. Considerable care must be taken to preserve the context of a particular judicial statement for there is a danger that repetition of a felicitous expression ‘elevates’ it to a principle of law, an unlegislated test or a legal formula. Principles derived from case law must be seen in context. For example, in Chapter 3, a proposition is advanced that ordinary income generally exhibits recurrence, regularity and periodicity. Most people would accept that regularity is the hallmark of wages, annuities, pensions and even workers compensation payments. But regularity will not make income of domestic allowances such as, for example, the pocket money a parent gives a child. So the proposition might be amended as follows: ‘periodicity suggests an income character when other elements do not point to a different conclusion’. However, there is a further hazard that for dramatic effect can be described as the ‘fallacy

of the inverse’ — just because regularity is a common feature of income, do not conclude that an isolated or one-off receipt cannot be income. There are good authorities that establish that, in the circumstances, isolated payments may be income. Reduced to basics, the legal process is as follows: LEGAL PRINCIPLES applied to FACTS = CONCLUSION The courts’ role in establishing legal principles has been emphasised but these principles themselves are distilled from given factual bases and must be applied to the particular facts in dispute. The importance of facts in a case cannot be overemphasised. Generally, though, the facts of a case are not the issue before the appellate courts. [page 23] Questions of fact are determined by the trial judge or tribunal. Appeals to the Full Federal Court and High Court are limited to questions of law. Different findings of fact may lead to different outcomes. Slight variations in facts that result in different conclusions mean that the principles distilled from the decisions can be expressed only as generalisations.

Rulings 1.26 There is longstanding authority that administrative practices by the Australian Taxation Office cannot displace correct applications of the law. In FCT v Wade (1951) 84 CLR 105; 5 AITR 214, Kitto J held that the Commissioner of Taxation was not estopped from relying on a provision of the Act by conduct that suggested he had not relied on the particular provision. However, the tax system would be in danger of becoming unworkable without mutually acceptable practices and procedures and a mature relationship between the ATO and the public. As a result, the ATO is an important, informal source of ‘law’. In addition, since 1992 the ATO has become a more formal source of quasi-law through a system of legally binding Taxation Rulings.

Several types of Taxation Rulings are issued under the Taxation Administration Act 1953 (Cth) (see Chapter 16): 1. Public rulings relate to classes of persons or arrangements, not specific taxpayers. They are legally binding on the Commissioner if they are favourable to a taxpayer, meaning that they result in lower tax. They are usually issued in draft form for public comment. Although they are not affected by a contrary court decision, they may be withdrawn. Public rulings cannot be appealed against (but a taxpayer may request a private ruling that can be appealed). Disregarding public rulings can attract penalties depending on whether the taxpayer’s position is ‘reasonably arguable’. 2. Private rulings are taxpayer specific and are also legally binding on the Commissioner. Applicants for private rulings must set out their particular facts and relevant authority. If the ruling is unfavourable, it may be appealed against but disregarding a private ruling will attract penalty tax. 3. Product rulings are rulings in relation to arrangements a group of taxpayers may propose; for example, a primary production or an investment scheme. Usually these arrangements are being promoted or marketed; hence the description ‘product’ ruling. 4. Oral rulings relate to basic issues affecting individual taxpayers; for example, assessable income, deductions, tax credits (or ‘tax offsets’). They are still legally binding but the Commissioner may refuse to issue such a ruling.

Where do you find rulings? Where is the status of rulings explained? See Study help for suggestions.

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Statutory interpretation 1.27 The primary sources of taxation law are the statutes and court decisions relating to them. The courts have developed several maxims for the interpretation of a statute or the filling-in of statutory holes. The three traditional principles are the literal rule, the golden rule and the mischief rule. In essence, these rules are as follows: Literal rule: As the description suggests, under the literal rule, words are given their literal meaning. Usually this means their natural, ordinary meaning. Golden rule: The golden rule holds that the ordinary meaning of the words should be followed unless that leads to an absurdity or inconsistency. Mischief rule: Essentially, the mischief approach seeks to identify the ‘mischief and defect’ of the earlier law that the new law attempts to remedy. These rules are applied to any statute but in a taxation context they proceed on the assumption that the imposition of tax must be clear and unambiguous. There can be no taxation by implication or inference. There is not even a presumption that a taxing statute has to be equitable.31 Equity in tax is a policy, design and legislative issue, not one of statutory interpretation. This fundamental, literal approach to the interpretation of taxing statutes has been stated by UK and Australian courts on many occasions.32 One of the earliest statements by the High Court appears in Isaacs J’s judgment in Scott v Cawsey (1907) 5 CLR 132 at 154. Modern tax scholars might be amused by the correspondence between penal and taxing statutes: When it is said that penal Acts or fiscal Acts should receive a strict construction I apprehend it amounts to nothing more than this. Where Parliament has in the public interest thought fit in the one case to restrain private action to a limited extent and to penalize a contravention of its direction, and in the other to extract from individuals certain contributions to the general revenue, a Court should be specially careful, in view

of the consequences on both sides, to ascertain and enforce the actual commands of the legislature, not weakening them in favour of private persons to the detriment of the public welfare, nor enlarging them as against the individuals towards whom they are directed.

The three traditional rules derive from the common law. Statutory law, specifically in the Acts Interpretation Act 1901 (Cth), has directed a more purposive interpretation than would follow from a strict, literal approach. When these approaches are examined today the fundamental matter at issue is whether a statute ought to be interpreted literally or purposively. [page 25]

Literal versus purposive approach 1.28 The literal approach operates on the understanding that the parliament’s intention is adequately expressed in the words of the statute and that it is not for the courts to infer meanings contrary to parliament’s intent. The rule also operates on the assumption that words have one, clear meaning. It suggests too that there is some underlying consistency in policy. All these assumptions may be challenged. It is interesting to note that the plain words of ITAA97 s 1-3 even suggest that it is possible to express the same idea in different words.33 The first qualification to the strict, literal rule is evident in the golden rule in that it made appropriate changes to the literal meaning of the words. While the first two rules seem to be complementary in finding the meaning of words in a statute, the mischief rule adopts a different tack in looking outside the statute to determine its purpose or intent. In its purest form, the mischief rule presupposes that an Act is directed to changing the common law (so as to cure the ‘mischief’ inherent in the common law) but in more general application it merely states that it is simpler to interpret a law when one is informed of its purpose. Thus, its focus is clearly on a purposive interpretation and there is support for a

purposive approach in, for example, s 15AA of the Acts Interpretation Act 1901 (Cth). Section 15AA provides: 15AA In interpreting a provision of an Act, the interpretation that would best achieve the purpose or object of the Act (whether or not that purpose or object is expressly stated in the Act) is to be preferred to each other interpretation.

The effect of s 15AA is to qualify the application of the literal rule to Commonwealth Acts by preferring a purposive construction. This is compatible with Isaacs J’s comment in Scott v Cawsey that taxing statutes should be interpreted strictly but not in a manner that defeats the purpose of the legislation.34 Stated this way, s 15AA merely provides statutory recognition of the traditional purposive approaches. The alternative view is that s 15AA imposes an overriding requirement such that, even if the words of the Act are clear, an interpretation that promotes the purpose of the statute should be preferred over one that does not.35 Section 15AA(1) makes a reference to express statement of the purpose or object of the Act. In this regard, the ITAA97 contrasts with the ITAA36 in that the former [page 26] contains a good deal of non-operative material such as guides and examples.36 It also contains provisions designed to ‘remove doubt’ about certain eventualities. These features reflect a more purposeful drafting style and encourage a purposive approach to the newer Act’s interpretation. However, it is one thing to make it clear that the purpose of Divs 165 and 166 is to impose more onerous requirements on private as opposed to public companies in the deductibility of past years’ losses. It is another thing to define ‘public companies’ unambiguously. Section 15AB of the Acts Interpretation Act 1901 (Cth) provides that in interpreting a statute the courts may refer to extrinsic material such

as explanatory memoranda or parliamentary debates to confirm meanings or clarify ambiguities. However, such material will not prevail over the words of the Act. For example, in Gray v FCT (1989) 24 FCR 37; 89 ATC 4640, the taxpayer sought to rely on a statement by the Treasurer in the course of a Second Reading Speech in the House of Representatives. The speech related to the imposition of CGT on assets acquired post-September 1985. The issue was the application of CGT to a lease on a property granted in March 1986. The Full Federal Court dismissed the taxpayer’s appeal. Sheppard J said (at ATC 4645): Regrettably, the material relied upon by the applicants does not assist them. In my opinion the language of the statute is clear and unambiguous. Furthermore, the consequence of giving its words their ordinary meaning, does not lead to a result which is manifestly absurd or unreasonable. To some the result may seem extremely unfair, but that is not a relevant consideration.

Judgments in the appeal courts are littered with statements offering support to both the literal and purposive approaches. The matter is unlikely to be resolved. The courts do not regard themselves as tax gatherers. The imposition of tax is parliament’s responsibility. The courts will attempt to determine parliament’s intention but they can hardly pursue a purpose that is not evident in the plain words of the statute. A very simple activity can illustrate the issue. Consider the operation of the literal and purposive approaches in the next activity.

Situation 1 Terry Plate is an investor who spends a significant sum of money on acquiring shares in a taxi co-operative operating in the Gold Coast tourist area under the logo ‘GTC Cabs’. His investment consists of shares in the co-op; a Ford Falcon motor car; a taxi meter. The rules of the co-op mean that he has the right to derive economic benefit from a particular taxi registration plate, which is then rented out to taxi drivers who pay for its use on each shift. Ideally, the car will be occupied and running 24 hours a day so that the co-op [page 27]

member has a flow of revenue (at a flat rental basis which varies according to the time of the week — but not according to revenue from taxi passengers). The drivers who rent the plate, car and meter make a profit if their rental payment and fuel costs are less than the fares they collect from passengers on a shift. Terry makes a profit if the rents he receives through the co-op from drivers exceed the costs of depreciation and repairs on the car and meter and other administrative charges imposed by the co-op. Terry has no say in where the taxi goes to pick up and drop off passengers — that is up to the driver/s. One day, Terry decides to retire and sell his shares in the co-op, the taxi, and the meter. He makes a capital gain on the sale of the shares to a new co-op member. An (imaginary) Income Tax Act permits deduction from the capital gain of an amount equivalent to 50% of the taxable gain for ‘small business owners’. Terry Plate claims this capital gain discount in his tax return, but when it is audited the ATO disallows it because Terry is not a ‘small business owner’ but a mere passive investor. The Explanatory Memorandum that accompanied the Bill introducing the special small business discount indicates that it was intended that the 50% discount would permit taxpayers engaged in small business to be taxed on less capital gain, and the Second Reading Speech in parliament at the time of its introduction suggests that this concession is to compensate small business operators for the fact that they do not have the same opportunities to amass superannuation benefits as employees do. What result would a purposive reading of the provision achieve? What result would a literal reading achieve? Situation 2 An (imaginary) New South Wales Stamp Duty Act imposes stamp duty on any ‘business property’ that changes ownership within New South Wales. The definition of ‘business property’ includes ‘any intangible property in New South Wales’. At the time of the imposition of the duty, the (imaginary) Second Reading Speech of the New South Wales State Treasurer who introduced the definition of ‘business property’ stated: ‘This measure is intended to ensure this state shares in the value of business assets changing hands in this jurisdiction’. A taxpayer company, which has its head office in Sydney, has sold its business to another taxpayer. The assets sold include the rights to a patent to manufacture surf boards. The boards are manufactured in South Australia (where costs are lowest) and sold in Queensland and Margaret River (Western Australia) where they are most popular. [page 28] The New South Wales Office of State Revenue demands that the taxpayer pay duty on the transfer of the patent calculated on the basis of the value of the patent in the contract of sale. The taxpayer argues that although contracted for sale in New South Wales there is no New South Wales property arising from the patent because: all activities relating to the patent take place outside New South Wales; and patents are registered under federal law, not state law. What result would a purposive reading achieve? What result would a literal reading of the provision achieve?

See Study help for suggested answers.

1.29 The High Court decision in FCT v Ryan (2000) 201 CLR 109; 43 ATR 694; 2000 ATC 4079 serves to underline the present-day differences in judicial opinion. The question before the court was whether a ‘Refund Notice’ declaring tax payable as ‘nil’ was a ‘Notice of Assessment’. A majority of the court (Gleeson CJ, Gummow, Hayne and Callinan JJ) held that there was no assessment until a positive sum of tax becomes due and payable. Callinan J accepted that zero is a number and that ‘it is not at all surprising’ that most people, including the taxpayer, would regard themselves as having complied with the requirements of an assessment. But, his Honour concluded, the ITAA36 ‘is concerned with the statutory imposition of taxation and its collection’. In the course of a passionate dissent, Kirby J saw the majority’s conclusion as flying in the face of a more purposive approach to interpretation that had developed over the last 40 years. His Honour said (at [82]): In the last decade, there have been numerous cases in which members of this court, referring to the statutory and common law developments, have insisted that the proper approach to the construction of federal legislation is that which advances and does not frustrate or defeat the ascertained purpose of the legislation, to the full extent permitted by the language which the Parliament has chosen. Even to the point of reading words into legislation in proper cases, courts will now endeavour … to carry into effect an apparent legislative purpose. Examples of this approach abound in Australia, England and elsewhere. This court should not return to the dark days of literalism.

Ultimately, the unsatisfactory state of the law was corrected by an amendment to the relevant definition of an ‘assessment’ to include situations where it has been ascertained that there is no taxable income or no tax is due: see para (a) of the definition of ‘assessment’ in ITAA36 s 6.

Tax avoidance schemes 1.30 When Kirby J referred to the ‘dark days of literalism’, his Honour may have had in mind several cases relating to tax avoidance, for that is an area where the literal–purposive issue has been brought

into sharpest relief. As one might imagine, attitudes to taxation, its rates and incidence will be reflected in attitudes to arrangements to [page 29] reduce or avoid tax. Throughout the 1970s, in the interpretation of anti-avoidance provisions, the High Court under the Chief Justice Sir Garfield Barwick acquired a reputation of literalism bordering on the extreme. In FCT v Westraders Pty Ltd (1980) 144 CLR 55; 11 ATR 24; 80 ATC 4357, the Chief Justice expressed the view that it was parliament’s responsibility to draft laws clearly and unambiguously and to address the issue of fairness. It was the courts’ duty to interpret that law and this was a function clearly separate from the law-making process. Such a state was basic to the maintenance of a free society. He added (at ATC 4359): Parliament having prescribed the circumstances which will attract tax, or provide occasion for its reduction, or elimination, the citizen has every right to mould the transaction into which he is about to enter into a form that satisfies the requirement of the statute. It is nothing to the point that he might have attained the same or similar result as that achieved by the transaction into which he in fact entered by some other transaction … Nor can it matter that his choice of transactions was influenced wholly or in part by its effect on his obligation to pay tax … [T]he freedom to choose the form of transaction into which he shall enter is basic to the maintenance of a free society.

The alternative view was expressed by Murphy J, in the course of his dissent (at ATC 4370): The transactions in this case are conceded to be a major tax avoidance scheme. The supporters of the scheme seize upon the bare words of [the relevant section] and claim that these should be applied literally even if for purposes not contemplated by Parliament. The history of interpretation shows the existence of two schools, the literalists who insist that only the words of an Act should be looked at, and those who insist that the judicial duty is to interpret Acts in the way Parliament must have intended even if this means a departure from the strict literal meaning … It is an error to think that the only acceptable method of interpretation is strict literalism. On the contrary, legal history suggests that strict literal interpretation is an extreme, which has generally been rejected as unworkable and a less than ideal performance of the judicial function. It has been suggested, in the present case, that insistence on a strictly literal interpretation is basic to the maintenance of a free society. In tax cases, the prevailing trend in Australia is now so absolutely literalistic that it has become a disquieting phenomenon. Because of it, scorn for tax decisions is being expressed constantly, not only by legislators who

consider their Acts are being mocked, but even by those who benefit. In my opinion, strictly literal interpretation of a tax Act is an open invitation to artificial and contrived tax avoidance. Progress towards a free society will not be advanced by attributing to Parliament meanings which no one believes it intended so that income tax becomes optional for the rich while remaining compulsory for most income earners. If strict literalism continues to prevail the legislature may have no practical alternative but to vest tax officials with more and more discretion. This may well lead to tax laws capable, if unchecked, of great oppression.

Terms and definitions 1.31 Determining the meaning of words, and especially definitions, is an obvious place to apply the rules of statutory interpretation. Generally, words are to be given [page 30] their ordinary or popular meaning.37 If the words are clear, it is unnecessary to look further for their meaning. However, legal words should be given their legal not their popular meaning and technical words take on their technical meaning. There is also a presumption (that may be displaced) that words are used consistently throughout a statute. A feature of the ITAA97 is the identification by way of an asterisk of defined or technical words. The definitions are located in ITAA97 s 995-1. Terms are not marked in this way in the ITAA36 and the reader needs to be more alert to seeking out technical words and discovering their meanings in ITAA36 s 6(1). If words are not defined — even though they might be thought of as technical words (eg, the word ‘income’) — their ordinary or popular meaning applies. As might be expected, such key, undefined terms have been the subject of considerable examination by the courts and it is probably more accurate to attribute to these words a judicial meaning rather than an unrefined ordinary or popular meaning. That is, the starting point in the search for a meaning of, for example, the word ‘income’ was indeed its

ordinary meaning, but today it must be understood in terms of ordinary judicial concepts. Where a word is defined in either ITAA36 s 6(1) or ITAA97 s 995-1, the meaning may be expressed in terms of ‘means’ or ‘includes’. These words themselves suggest that ‘means’ is intended to be exhaustive whereas ‘includes’ is intended to expand on the ordinary meaning of the word and this is indeed the meaning given to it by the courts. For example, ITAA97 s 995-1 defines a ‘car’ as follows: car means a *motor vehicle (except a motor cycle or similar vehicle) designed to carry a load of less than 1 tonne and fewer than 9 passengers.

Since motor vehicle is marked by an asterisk, it, too, is defined: motor vehicle means any motor-powered road vehicle (including a 4 wheel drive vehicle).

It is clear that a motorcycle is a motor vehicle but is not a car. A taxi38 is a car but a mini-bus is not, although both are motor vehicles. However, what would be a ‘similar vehicle’ to a motorcycle? A moped is likely to meet that description but a [page 31] bicycle would not. Is a hearse a car? These questions must be answered by reference to other sources such as case law or ATO rulings.39 1.32 Statutory holes left by phrases like ‘or similar vehicle’ must be filled by case law or administrative rulings. Definitions that proceed on an ‘includes’ basis often leave larger vacuums and, in addition, produce other problems. Although, generally, a definition couched in terms of ‘includes’ would normally build on ordinary understandings of the term, difficulties arise, for example, where a definition commences with ‘includes’, specifies some items that, by ordinary concepts, are

accommodated by ‘includes’ but then adds items that would not be so accommodated. In such instances, doubts can arise whether the definition was intended to be exhaustive, rather than expansive in the first place. Often definitions will expand beyond more than one issue. Consider the following series of definitions and related issues arising from the definition of ‘trading stock’: 70-10 Trading stock includes: (a) anything produced, manufactured or acquired that is held for purposes of manufacture, sale or exchange in the ordinary course of a *business; and (b) *live stock; … 995-1 live stock does not include animals used as beasts of burden or working beasts in a *business other than a *primary production business. 995-1 primary production business: you carry on a primary production business if you carry on a *business of: (a) cultivating or propagating plants … (b) maintaining animals for the purpose of selling them or their bodily produce … (c) manufacturing dairy produce from raw material that you produced … [etc]

At least three separate matters arise: 1. What is the ordinary concepts understanding of trading stock? 2. What is live stock? 3. What is primary production? The initial definition in ITAA97 s 70-10 is intended to expand on the normal usage of the word but the corresponding popular, commercial understanding of the term — inventory — is not used. The inclusion of live stock means that a dairy herd — being live stock and within para (b) — is trading stock, although from a commercial perspective it is a self-generating asset analogous to plant. ‘Animals’ are not defined and that legislative hole must be filled by the courts. It is instructive to examine [page 32]

McTiernan J’s judgment in Burnside and Marrakai Ltd v FCT (1957) 6 AITR 411 at 412, where his Honour considered whether the shooting of buffalo for their skins was primary production, being the maintenance of animals for the purpose of selling their bodily produce (within the context of an earlier definition in ITAA36 s 6(1)): The buffalo of the Northern Territory of Australia are, according to common law, animals ferae naturae. The Act does not define “animals”. On the question of the meaning of “animals”, the author of the article under that title in Halsbury’s Laws of England (3rd ed, vol 1, p 665), wrote: “The term ‘animals’ may be said to include all beasts, birds, reptiles, fishes and insects.” The appellant relies on the generality of the term “animals” for its contention that buffaloes are within the scope of the phrase “the maintenance of animals or poultry” etc. But it is clear here that a restricted meaning of the word “animals” is intended, because “poultry” are expressly included. Presumably, the meaning of animals is restricted to beasts. Is it restricted to domestic and tame beasts? Poultry is a term that includes various kinds of domestic birds. It does not include any that are ferae naturae. The extension of the scope of the phrase, by expressly including poultry, would seem to indicate that, by the word “animals”, only domestic and tame animals is meant, simply because poultry are not “animals” ferae naturae, but, as has been said, domestic or tame animals. It would be a strange construction to widen the activity of maintaining animals to include animals ferae naturae, notwithstanding that the activity of maintaining poultry extends only to domestic or tame animals.

McTiernan J’s reasoning adopts the noscitur a sociis rule; literally, this means something is known by its associates. That is, words of doubtful meaning may be interpreted by reference to the words with which they are coupled. Another maxim often employed is the ejusdem generis rule: ejusdem generis means ‘of the same type’; the rule, therefore, means that general words will be understood by reference to the words they follow. However, for the rule to be helpful, there must be some appropriate genus or class. In reading a provision, attention should be directed to the use of ‘shall’ or ‘may’. By its natural meaning, ‘may’ is permissive whereas ‘shall’ is mandatory and generally that is the meaning conveyed by the words. The word ‘deemed’ appears in the ITAA36 and has a stronger meaning than ‘means’. In ITAA36 s 21(1), where consideration is paid other than in cash, the monetary value of that consideration is deemed to have been paid.

Structure of the book

1.33 The preceding discussion illustrates something of the breadth of the subject area ‘taxation’. The focus of this book must necessarily be narrower but the wider context should be kept in mind. The income tax Acts are complex documents (notwithstanding reform initiatives) but it is often forgotten that the documents themselves are the product of a complex process. While the Acts have an obvious legal status, that outcome is the synthesis of competing philosophical, political, economic and social viewpoints. To this end, the orientation of this book is to emphasise taxation as: an intellectual discipline worthy of study in its own right; [page 33] a specialised (albeit, hybrid) system of legal and commercial rules; and a social force, with policy implications affecting the interests of individuals, business and government. The preceding discussion also makes it clear that although income tax has been a feature of Australian economic and social life since the late 19th century, the kernel of our current framework is the 1936 Act. From little more than 100 pages in 1936, the current legislation has grown to more than 3000 pages. Much of the ITAA36 is still operative (albeit in considerably amended form) and the rewritten version, the ITAA97, seeks to express the same ideas as the earlier legislation in simpler, taxpayer-friendly language. Over the same period, a distinctive Australian tax jurisprudence has developed, largely within the context of the ITAA36. In terms of the pyramidal representation in Figure 1.2 (see 1.17), the central provisions of the ITAA36 (generally) have become Level 1 core provisions and Level 2 is the general provisions of the ITAA97. Levels 3 and 4 contain a mixture of both Acts. So far as it is possible, this book is structured to reflect the design of the ITAA97. To that end, Chapter 2 addresses the structure of the two Acts in more detail, examines the income concept and provides an overview of the jurisdictional limits.

Pivotal provisions in Div 4 declare who must pay tax and how liability is to be calculated — the ‘tax equation’ being assessable income minus deductions. Chapter 3–Chapter 11 develop the tax equation within the framework of Levels 1 and 2. Thus, Chapter 3 examines ordinary income, Chapter 4 its derivation, and Chapter 5–Chapter 11 cover statutory income, capital gains and fringe benefits. Although fringe benefits tax (Chapter 7) is the object of separate legislation, it is also the lineal descendant of the now repealed ITAA36 s 26(e) and context is preserved by examining fringe benefits as just another element of statutory income, no different in principle (but certainly in operation) to the taxation of other employee benefits, such as those accruing under employee share acquisition schemes. It is considered that the evolutionary nature of tax legislation is an important element in cultivating students’ appreciation of perspective, especially the progress from tax by principles to tax by statute. The deduction side of the tax equation is then examined. Chapter 8 covers general deductions, Chapter 9 and Chapter 10 specific deductions and depreciation, and Chapter 11 trading stock. The specialist topics of Level 3 are the focus of Chapter 12–Chapter 15 — companies, shareholders, partnerships and trusts — while Chapter 18 examines international aspects. The ‘mechanical provisions’ of Level 4 are covered under the heading ‘Tax Administration’ in Chapter 16. Chapter 17 discusses anti-tax avoidance measures. The GST is examined in Chapter 19. It will be observed that this overview does not directly address what some texts call ‘tax accounting’. This is deliberate. In part the description is a misnomer. To business and commerce students, tax accounting means the requirements of AASB 112 Income Taxes (Taxeffect Accounting). No reference is made to ‘tax accounting’ in the legislation — other than in the context of the tax equation in ITAA97 Div 4, and the equation applies indifferently to all assessable income and deductions. The description also implies a dichotomy between law and accounting

[page 34] that is neither helpful nor borne out in the Act and leading cases. Issues concerning the timing and measurement of income and deductions are questions of law, not accounting, that ultimately will be determined by the High Court. The relationship between accounting concepts and tax jurisprudence is a central theme of this text and attention to it is distracted by ‘tax accounting’. Within the framework outlined above, the text provides a synthesis of statutes and cases in a narrative style. It is conscious of the intimidating nature of the subject area and the requirements of students studying taxation for the first time. It is particularly aware of the difficulties facing commerce students who approach the subject without a welldeveloped appreciation of jurisprudence. Instead, such students have a measurement framework grounded in the Approved Accounting Standards (AASB) and International Financial Reporting Standards (IFRS). Where possible, this framework is integrated into the discussion to highlight the common ground of accounting and tax jurisprudence, and to emphasise the differences. To this end, each chapter specifies several learning objectives that may serve as review questions. Key sections of the legislation are reproduced and extracts of the leading cases are employed to analyse the words of the statutes and to cultivate an awareness of competing legal and commercial views. Chapters are interspersed with activities, questions and examples and, in some instances, conclude with review problems. Study help provides a link to ongoing developments in the field and to more complex issues and examples. Study help also provides suggested (not necessarily definitive) solutions to activities in the text. By placing suggested solutions on Study help, the intention is to stimulate thinking and to create a dialogue with readers. Suggested solutions to questions (as distinct from activities) have not been placed on Study help. To this extent, the text may operate as a ‘stand alone’ resource but it does not pretend to be a complete statement of taxation law.

From a pedagogical viewpoint, the aims of the text are twofold. First, to reinforce and extend students’ conceptual framework beyond the perception of tax as a set of largely unrelated rules generated in a vacuum. A possible theme is ‘From Concepts to Codification’. On the one hand, it traces the shift from the study of tax as a system based on principles to one driven predominantly by statute. On the other hand, it contends that the bridge between an understanding of the two is centred in perspectives. Second, it aims to extend and develop students’ analytical and problem-solving skills such that, after successful completion of a taxation course, they will be able to solve moderately complex tax problems and present findings and recommendations in a concise and unambiguous manner. Expressed in a behavioural context, at the completion of a course centred on this text, it is expected that students should be able to: 1. identify relevant sections of the Act(s) bearing on a particular problem; 2. cite judicial and other authority governing the interpretation and application of relevant provisions of the Act(s); and 3. solve a particular problem by reference to 1 and 2. 1. 2. 3. 4. 5. 6. 7. 8. 9.

Stephen Mills, Taxation in Australia, Macmillan & Co, London, 1925, p 1. Quoted in Randolph E Paul, Taxation in the United States, Little, Brown & Co, Boston, 1954, p 77. Charles Henry Halk (ed), Economic Writings of Sir William Petty, Cambridge University Press, 1899. Quoted in William Green, The Theory and Practice of Modern Taxation, Commerce Clearing House, Chicago, 1933, p 24. Compania de Tabacos v Filipinas 275 US 87 (1927), quoted in Louis Eisenstein, The Ideologies of Taxation, Ronald Press Co, New York, 1961, p 5. IRC v Duke of Westminster [1936] AC 1 at 19–20. To these features the High Court has subsequently added that, to be valid, the tax must not be incontestable: MacCormick v FCT (1984) 158 CLR 622; 15 ATR 437; 84 ATC 4230. P Butt, P Nygh et al, Butterworths Encyclopaedic Australian Legal Dictionary, online, LexisNexis, Australia. Penalties are imposed under the income tax legislation for non-compliance with the tax laws themselves.

10. Discussed below at 1.20. 11. See ABC News at . 12. Re:Think — Better Tax, Better Australia, Our Tax System: At a Glance, Australian Government, click on ‘Menu’ (accessed 4 September 2017). 13. For a readable account of the history of taxation, see James Coffield, A Popular History of Taxation, Longman, London, 1970. 14. Charles R Metzger, ‘A Brief History of Income Taxation’ (1927) 13 American Bar Association Journal 662–3. 15. Randolph E Paul, Taxation in the United States, Little, Brown & Co, Boston, 1954, pp 99– 100. 16. P Harris, Metamorphosis of the Australasian Income Tax: 1866 to 1922, Australian Tax Research Foundation, Sydney, 2002, pp 10, 11. 17. Until 1954, a higher rate of tax applied in Australia to property income. For the 1974–75 year, a surcharge was again imposed on property income exceeding $5000. Certain ‘unearned income’ assessable under Div 6AA of the current Act is taxed at higher rates. 18. For example, dividends are brought to account under a separate code comprising ss 44– 47A of the Income Tax Assessment Act 1936 (Cth) (ITAA36). 19. Although the UK scheme of taxation was not adopted in Australia, large slabs of its language were incorporated into the Australian legislation. One observer noted, ‘Too often the process of adopting and transcribing British statutes … was carried on in a haphazard, piecemeal fashion’: A C Castles, An Australian Legal History, Law Book Co, Sydney, 1982, p 403. A contemporary newspaper, the Melbourne Argus, described colonial statutes as ‘a jumble of jurisprudence’: Argus, 30 January 1864. 20. See also Amalgamated Society of Engineers v Adelaide Steamship Co Ltd (1920) 28 CLR 129; Moore v Commonwealth (1951) 82 CLR 547; Fairfax v FCT (1965) 114 CLR 1; 10 AITR 33. 21. The Fringe Benefits Tax Assessment Act 1986 (Cth) and Fringe Benefits Tax Act 1986 (Cth). In total, there are more than 40 pieces of legislation dealing with aspects of income tax, not including matters of superannuation. 22. Patrick Weller (ed), Caucus Minutes 1901–1949, Melbourne University Press, 1975, p 416. The 27:26 vote was against an amendment seeking to model the proposal on a resolution passed at the earlier Adelaide Labor Conference. Weller indicates that no such motion was passed. There is no indication as to why eight members did not vote. 23. The Income Tax Assessment Act 1915 (No 34 of 1915) was amended by the Income Tax Assessment Act (No 2) 1915 (No 47 of 1915). The No 2 Act received assent on 15 November 1915. Under s 11, it operated from the same day as the principal Act and the Acts are collectively described by the short title Income Tax Assessment Acts 1915. The accompanying Income Tax Acts were similarly treated. 24. The taxation of companies and dividends became an important difference between the Commonwealth and states over the next 20 years, and the problem was not resolved until the adoption of the dividend imputation system in 1987. 25. Report of the Royal Commission on Taxation, 1920–24 (Warren Kerr Commission). 26. Report of the Royal Commission on Taxation, 1932–34 (Ferguson Commission).

27. In the 1936 Act, the provision became s 26(a) and, after extensive amendments, in 1984 became s 25A. It is now to be found in the 1997 Act as s 15-15. See further 3.55, 5.8. 28. See . 29. See . 30. Publications associated with the review may be found at . 31. See the reference to Gray v FCT (1989) 24 FCR 37; 89 ATC 4640 in 1.28. See also the majority judgment in FCT v Ryan (2000) 201 CLR 109; 43 ATR 694; 2000 ATC 4079. 32. See, for example, comments made by Lord Russell in IRC v Duke of Westminster [1936] 1 AC at 24–5, cited with approval by Latham CJ in Anderson v CT (Vic) (1937) 57 CLR 233 at 239. Lord Russell said (in part): ‘The subject is not taxable by inference or by analogy, but only by the plain words of a statute applicable to the facts and circumstances of his case’. 33. Section 1-3 provides that the expression of an idea in simpler, clearer style in the ITAA97 should not be taken as different from the idea expressed in the ITAA36 just because different words are used. 34. See the judgment of Mason and Wilson JJ in Cooper Brooks (Wollongong) Pty Ltd v FCT (1981) 147 CLR 297; 11 ATR 949; 81 ATC 4292. In that case, the High Court rejected a literal interpretation that was inconsistent with the provisions, circumstances and legislative history. 35. See comments by the Full Federal Court in FCT v Cripps & Jones Holdings Pty Ltd (1987) 16 ALR 619; 87 ATC 4977 at 4985. 36. The possibility of inconsistency between the text of the provision and the example is anticipated in s 15AD of the Acts Interpretation Act 1901 (Cth). It provides that the section prevails over the example. 37. It should be noted that questions such as these are not mere theoretical exercises. A contemporary debate is underway concerning whether the ‘Uber’ ride-sharing service is the provision of ‘taxi travel’ in accordance with s 144-5 of A New Tax System (Goods and Services Tax) Act 1999 (Cth) thus requiring the payment of GST on the charge for a ride. More information can be found at the ATO website. 38. There are further qualifications to the definition for specific purposes: for example, a taxi fitted out for transporting disabled persons is excluded from the car depreciation limit in ITAA97 s 40-230. 39. In TD 2006/39, a hearse is excluded from the s 40-230 car depreciation limit.

[page 35]

CHAPTER

2

Structure of the Acts and the Income Concept Learning objectives After studying this chapter, you should be able to: identify the elements of the ‘tax equation’; calculate tax liability in a simple scenario; distinguish between the accounting, economic and judicial concepts of income; distinguish in principle between ‘ordinary’ and ‘statutory’ income; identify three categories of exempt income; specify the jurisdictional limit applicable to Australia’s right to tax; identify and apply the tests of residency to an individual; state the general rules relating to the source of income.

Introduction 2.1 There are several income concepts. Three derive from the legislation: ordinary income, statutory income and exempt income. Ordinary income also derives from the normal and commercial usage as ‘income’ as it is interpreted by the courts — that is, judicial income. The

relationship between these concepts is a key element in the organisation of the tax Acts. An examination of the Acts is important at two levels. First, through the processes of amendment to laws and expansion of the tax base, the Income Tax Assessment Act 1936 (Cth) (ITAA36) became a very long and complex document, and its poor user friendliness was not enhanced by its poor organisational layout. Second, as a result of initiatives in 1993, the Tax Law Improvement Project (TLIP) was established with the aim of restructuring, renumbering and rewriting the tax legislation. The rewriting of the legislation is incomplete (although it was announced in 2009 that it would be completed that has not happened),1 but produced a new Act, the Income [page 36] Tax Assessment Act 1997 (Cth) (ITAA97), which operates concurrently with the 1936 Act. The result is two Income Tax Assessment Acts: ITAA36 and ITAA97. As additions are made to the ITAA97, consequential amendments are made to the ITAA36, but because the process is incomplete, there are, for example, two sets of definitions, one in ITAA36 s 6(1) and one in ITAA97 s 995-1, which operate in relation to each Act. In addition, the words ‘this Act’ are defined in each Act to include the other Act. One advance made by the ITAA97 was a rewrite of the ‘core’ provisions that include the principal or central sections. These provisions are examined further below, but, in summary, cover the machinery for income and deductions. They also set out the jurisdictional limitations of Australia’s taxation authority and provide for the exclusion from tax of a category of income called ‘exempt income’. The transition from the 1936 Act and the concurrent operation of the 1936 and 1997 Acts proceeds on the assumption that the process of rewriting and simplifying the language has not changed fundamental

meanings of words and concepts. This intention is made clear by ITAA97 s 1-3, which provides as follows: 1-3 Differences in style not to affect meaning (1) This Act contains provisions of the Income Tax Assessment Act 1936 in a rewritten form. (2) If: (a) that Act expressed an idea in a particular form of words; and (b) this Act appears to have expressed the same idea in a different form of words in order to use a clearer or simpler style; the ideas are not to be taken to be different just because different forms of words were used.

The vagaries of the English language alone would cast doubt on whether the same idea could be expressed in different words, especially where the different words are said to be simpler. This problem is compounded by two factors. First, a taxing statute in modern times is far from a simple document, and expressions, definitions and the imposition of a liability to tax need to be stated precisely and unambiguously. There are good reasons for expecting legislation dealing with a complex topic to be technical by nature. The translation from the complex to the simple is not without inherent difficulty. Second, the preservation of the same idea assumes the reader approaches the 1997 Act with knowledge of the 1936 Act that almost gainsays a need for rewriting the legislation. The income concept also requires examination. It is not a trivial question to ask what is income. [page 37]

Before proceeding, attempt to define income:

1. 2.

in general terms; and more exhaustively, by specifying items that are to be included and excluded.

It is more than a little surprising to those who come to study taxation for the first time to discover that the critical object of the legislation — income — is not defined, and that an understanding of the term must be gleaned from two centuries of judicial examination. The following wellknown quip from Lord Macnaghten, over 100 years ago, was a serious observation: Income tax, if I may be pardoned for saying so, is a tax upon income. It is not meant to be a tax on anything else.2

The meaning of income, especially the judicial meaning of the term, is a central focus of this chapter.

Taxing machinery 2.2 The core provisions of the ITAA97 make up Ch 1 of that Act and comprise ss 4-1–13-1. Unlike the ITAA36, the core provisions of the ITAA97 can be read sequentially. The tax formula is specified in ITAA97 Div 4. A pivotal section is ITAA97 s 4-1, which imposes an obligation to tax. 4-1 Who must pay income tax Income tax is payable by each individual and company, and by some other entities.

How one’s tax obligation is calculated is set out in ITAA97 s 4-10(1), which requires that income tax be paid for each financial year ending 30 June, called ‘the income year’.3 ITAA97 s 4-10(3) provides as follows. 4-10 (3) Work out your income tax for the *financial year as follows: Income tax = (Taxable income × Rate) – Tax offsets

[page 38] ITAA97 s 4-15 completes the basic machinery. 4-15 (1) Work out your taxable income for the income year like this: Taxable income = Assessable income – Deductions

Assessable income is identified in ITAA97 Div 6. Tax is imposed on taxable income at rates prescribed by parliament. Taxable income is assessable income minus deductions. In turn, assessable income is made up of ordinary income and statutory income: ITAA97 s 6-1. Some ordinary income and some statutory income is exempt income (s 61(2)), meaning that it is exempt from tax and excluded from assessable income. Exempt income is identified in ITAA97 Div 11. Deductions are identified in ITAA97 Div 8. They are made up of general deductions (s 8-1) and specific deductions (s 8-5). The tax rates are set out in the Income Tax Rates Act 1986 (Cth) (as amended). It is a requirement of the Commonwealth of Australia Constitution Act (the Constitution) that laws dealing with taxation deal with only one matter and that any provisions dealing with other subjects shall have no effect. As a result, income tax is imposed under the Income Tax Assessment Acts, fringe benefits tax is imposed under the Fringe Benefits Tax Assessment Act 1986 (Cth), rates of tax are found in the Rates Act, and other subject matter is addressed in relevant Acts. The general rates of tax for resident individuals for 2017–18 are set out in Table 2.1. Table 2.1: General tax rates for resident individuals 2017–18 Taxable income Tax on this income $1–$18,200

Nil

$18,201–$37,000

19c for each $1 over $18,200

$37,001–$87,000

$3,752 + 32.5c for each $1 over $37,000

$87,001–$180,000

$19,822 + 37c for each $1 over $87,000

$180,001 and over

$54,232 plus 45c for each $1 over $180,000

The rates shown do not include the 2% Medicare levy (the ‘Temporary Budget Repair’ levy which was payable at 2% for taxable incomes over $180,000 ceased from 1 July 2017). Different rates apply for foreign residents and other particular classes of taxpayers. The company tax rate is a flat rate of 30% for companies other than ‘small business entities’. These matters are covered in the ‘Tax rates’ information on the ATO website at (accessed 5 September 2017). [page 39] Tax offsets were referred to as ‘credits’ and ‘rebates’ in the ITAA36 and those descriptions identify ‘tax offsets’ in the ITAA97. An important feature of an offset is that it reduces one’s tax, as opposed to being a deduction, which reduces one’s taxable income. Thus, an offset can be more valuable to the taxpayer as it is an amount of tax that comes directly off the tax bill. One of the best-known tax offsets is the franking tax offset accompanying a franked dividend paid by a company to a shareholder. In fact, it is a refundable offset if one’s tax liability is nil. Offsets take many forms, including health insurance offsets and low income tax offsets. These matters are also covered at the ATO website at , click on ‘Income and deductions’ then ‘Offsets and rebates’ (accessed 5 September 2017).

Refer to the tax rates and codes on the ATO website.a 1. (i) Jo is a resident of Australia and has taxable income for 2017–18 of $50,000. What is her tax liability (excluding Medicare)? What is her average rate of tax?

What is her marginal rate of tax? Is she liable to pay the Medicare levy? (ii) Suppose Jo was a non-resident who derived $50,000 Australian income. What is her tax liability? (iii) Suppose Jo and Joe were partners in a partnership that derived taxable income of $50,000 in 2017–18. (Assume Jo and Joe share the income equally.) What is their tax liability (excluding Medicare)? How do you explain the difference between this amount and that determined under (i), above? (iv) Suppose Jo carries on business through Jojo Pty Ltd and the company derived taxable income of $50,000. What is the company’s liability to tax? Can you suggest a way to reduce it to: (a) $1,800; (b) $6,000? Jack is a marketing manager working in Sydney and has no children. He has taxable income of $88,000 and reportable fringe benefits of 10,000. What is Jack’s tax liability net of levies and offsets? A suggested solution can be found in Study help.

2.

a.

Go to the ‘Tax rates and codes’ link on the ATO website at and select ‘Individuals’.

[page 40]

Organisation of ITAA36 and ITAA97 2.3 As indicated above, the ITAA36 and ITAA97 operate concurrently. The ITAA97 contains the core provisions, principally Divs 1–8. These sections identify key concepts such as ordinary, statutory and exempt income together with general and specific deductions. It also includes some components of statutory income and specific deductions. The ITAA36 includes elements of statutory income and specific deductions that are yet to be rewritten (they were to be rewritten under the TLIP, which was abandoned). Rules relating to the taxation of entities, such as partnerships and trusts, are in the ITAA36. It also includes much of the administrative machinery such as the collection of tax, the appeals procedure and penalties for non-compliance with requirements of the legislation. Difficulties of transition between the two Acts are most pronounced at the initial stages of identifying elements of statutory income and

specific deductions. Table 2.2 illustrates how the Acts fit together at the elementary level. Table 2.2:

Principal components of the tax formula Assessable income

Act

s 6-5

Ordinary income

ITAA97

s 6-10

Statutory income

ITAA97

Div 15

– additional items of income

ITAA97

Div 20

– recoupments

ITAA97

Part 2-40

– employees’ retirement/termination payments

ITAA97

ss 44–47

– dividends

ITAA36

Div 207

– franking of dividends

ITAA97

Div 70

– trading stock

ITAA97

Div 100, etc

– capital gains

ITAA97

Div 51

Exempt income

ITAA97

Div 50

– exempt entities

ITAA97

ss 23AA–23L

– other exemptions

ITAA36

Deductions s 8-1

General deductions

ITAA97

s 8-5

Specific deductions

ITAA97

Div 25

– specific deductions

ITAA97

Div 26

– specific denials

ITAA97

Div 28

– car expenses

ITAA97

Div 32

– entertainment

ITAA97

Div 40

– capital allowances (depreciation)

ITAA97

Tax offsets ss 159H–160ADA

Rebates not covered elsewhere

ITAA36

Div 207

Franking credits

ITAA97

[page 41] Special rules operate to calculate a capital gain, which then enters assessable income as a net amount. Additional qualifications apply also to different entities such as partnerships, companies, trusts and

superannuation funds and to related taxpayers such as partners, shareholders and beneficiaries under a trust, although the general formula in s 4-10 holds true. The whole assessment system is activated by ITAA36 s 161, which provides as follows. 161 Annual returns Requirement to lodge a return (1) Every person must, if required by the Commissioner by notice published in the Gazette, give to the Commissioner a return for a year of income within the period specified in the notice.

ITAA36 s 161A(1) specifies that the return must be in the approved form and s 388 of Sch 1 of the Taxation Administration Act 1953 (Cth) states that the form may be approved by the Commissioner of Taxation. The Commissioner’s approved forms of return are published on the ATO website in the relevant areas. From the information set out in the return, together with any other information, the Commissioner shall make an assessment of liability to tax and, in the event, that the taxpayer is dissatisfied with an assessment, an objection process is set out in Pt IVC of the Taxation Administration Act 1953 (Cth).

Assessable income 2.4 As Table 2.2 above illustrates, two principal elements of assessable income are ordinary income (ITAA97 s 6-5) and statutory income (ITAA97 s 6-10). 6-5 Income according to ordinary concepts (ordinary income) (1) Your assessable income includes income according to ordinary concepts, which is called ordinary income. (2) If you are an Australian resident, your assessable income includes the ordinary income you derived directly or indirectly from all sources, whether in or out of Australia, during the income year. (3) If you are a foreign resident, your assessable income includes: (a) the ordinary income you derived directly or indirectly from all Australian sources during the income year; and

(b) other ordinary income that a provision includes in your assessable income for the income year on some basis other than having an Australian source.

[page 42] Section 6-5 sets out the jurisdictional limits of Australia’s right to impose income tax. It will be evident that, broadly: a resident Australian is subject to assessment on all ordinary income, irrespective of its source; whereas a foreign resident is liable only in respect of Australian source income. 6-10 Other assessable income (statutory income) (1) Your assessable income also includes some amounts that are not ordinary income. (2) Amounts that are not ordinary income, but are included in your assessable income by provisions about assessable income, are called statutory income. (3) If an amount would be statutory income apart from the fact that you have not received it, it becomes statutory income as soon as it is applied or dealt with in any way on your behalf or as you direct. (4) If you are an Australian resident, your assessable income includes your statutory income from all sources, whether in or out of Australia. (5) If you are a foreign resident, your assessable income includes: (a) your statutory income from all Australian sources; and (b) other statutory income that a provision includes in your assessable income on some basis other than having an Australian source.

It is clear from ss 6-5 and 6-10 that to enter assessable income, and ultimately become part of taxable income, an amount must be either ordinary income (being income under ‘ordinary concepts’) or statutory income (being an amount made to be income by statute). An amount that is excluded from either of these categories by statute is exempt income. 6-15 What is not assessable income (1) If an amount is not ordinary income, and is not statutory income, it is not assessable

income (so you do not have to pay income tax on it). … 6-20 Exempt income (1) An amount of ordinary income or statutory income is exempt income if it is made exempt from income tax by a provision of this Act or another Commonwealth law. …

[page 43]

1.

Read through ITAA97 s 6-5(2) and (3) and s 6-10(4) and (5), and underline the words you consider to be important. Suggest a definition of these words. Provide examples of income that satisfies your understanding of ‘exempt income’. 2. Consider the following statement: Assessable income is a subset of income and taxable income is a subset of assessable income. Is this true? A suggested solution can be found in Study help.

The income concept examined 2.5 It is surprising to those who approach the study of taxation for the first time that ‘income’ is not defined in the Acts. ITAA36 s 6(1) refers to the following terms. income from personal exertion or income derived from personal exertion means income consisting of earnings, salaries, wages, commissions, fees, bonuses, pensions, superannuation allowances, retiring allowances and retiring gratuities, allowances and gratuities received in the capacity of employee or in relation to any services rendered, the proceeds of any business carried on by the taxpayer either alone or as a partner with any other person, any amount received as a bounty or subsidy in carrying on a business … but does not include:

(a) interest, unless the taxpayer’s principal business consists of the lending of money, or unless the interest is received in respect of a debt due to the taxpayer for goods supplied or services rendered by him in the course of his business; or (b) rents, dividends or non-share dividends. income from property or income derived from property means all income not being income from personal exertion.

If ‘income from property’ was to be specified in terms similar to ‘income from personal exertion’, what would be included? That is, what is ‘all income’ that is not ‘income from personal exertion’?

[page 44] These definitions do not provide a workable definition of ‘income’. For example, what would be included in ‘income from property’? According to the definition of ‘income from personal exertion’, the answer is everything else that is income! This begs the question, ‘What is income?’ It is true that the items nominated as income from personal exertion fall within commonsense notions of that term; for instance, ‘earnings, salaries, wages, commissions’ are clearly income. However, there is nothing in ITAA36 s 6(1) to illustrate when and by what criteria items are to be adjudged ‘earnings, salaries’, and so on. In other words, s 6(1) classifies but does not define income. Originally, that function was for purposes of differential rating. In the past, income from property was subject to higher rates of tax. That is no longer the case and the classification is of limited value today. It is possible that the drafters of modern income tax Acts could provide exhaustive definitions of key concepts and it may be desirable that certain fundamental notions such as income, business and capital

be defined.4 However, that is not the way Australian tax law has developed. Accepting that the important word ‘income’ is not defined in the tax Acts, questions arise as to how an understanding of the term developed, how that understanding has been affected by judicial refinements, and how this judicial concept compares with competing views such as the accounting concept of net profit and economic perceptions of gain.

The accounting concept 2.6 The accounting approach to income definition and measurement is generally taken to be the profit and loss account, drawn up in accordance with generally accepted accounting principles and represented by revenue minus expenses. But revenue and expenses are not the same as assessable income and deductions, and although the terms may be analogous, they are far from interchangeable and net profit is not the same as taxable income. Income arises from commercial activity, and the conceptual underpinning of commercial concepts has influenced the courts from time to time even though financial reports and net profit do not determine taxable income. As Australian tax jurisprudence developed, a division grew between accounting and taxation principles. In New Zealand Flax Investments Ltd v FCT (1938) 61 CLR 179; 1 AITR 366, Dixon J drew attention to the different statutory schemes in the United Kingdom (where net profit is taxed: see 1.4–1.7) and Australia. His Honour said (at AITR 378): But, as the Income Tax Assessment Act 1922–30 has been interpreted, authority for the deduction must be found not in general [accounting] principles but under some provision of the statute … [G]enerally speaking, the gross receipts … must be taken into assessable income and therefrom the deductions allowed by the Act must be made and no others.

[page 45] In matters where the Act gives no specific direction, the courts have been prepared to examine accounting principles and practice. For

example, in Arthur Murray (NSW) Pty Ltd v FCT (1965) 114 CLR 314; 9 AITR 673 (see 4.15), the High Court accepted the accounting practice of deferring recognition of advance payments as revenue for the supply of goods or services. On the other hand, in FCT v James Flood Pty Ltd (1953) 88 CLR 492; 5 AITR 579 and Nilsen Development Laboratories Pty Ltd v FCT (1981) 144 CLR 616; 11 ATR 505 (see 8.40–8.41), it rejected a routine accounting practice of creating provisions for annual and long service leave entitlements. Accounting principles have been more influential where the concept under consideration is profit rather than income. See FCT v Slater Holdings Ltd (No 2) (1984) 156 CLR 477; 15 ATR 1299; 84 ATC 4883 and 2.18. The current accounting view of net profit is the change in net assets and the change would be recognised when it was probable and could be measured reliably. This view is similar to the economic concept: see below. However, to the extent that a gain arises through an unrealised increment in asset values, it is inconsistent with the current judicial view. In addition, the courts were unaffected by concerns expressed by accountants during the inflationary period of the 1970s over the adequacy of the historical cost model. The object of tax is nominal receipts, not amounts deflated to reflect real amounts. The ordinary/judicial concept of income remains a flow expressed in nominal terms. More modern valuation methods that explicitly recognise the time value of money have had limited impact to date.5 It seems fair to say that accounting has been most influential with its profit and loss model and that this measurement process in turn has been more persuasive in relation to timing issues (when is income derived and expenses incurred) than in refining the income concept itself.

The economic concept 2.7 Economists would approach the issue of income definition and measurement by observing that although income is undefined in the tax

Acts, that was not because a precise definition of ‘income’ was unavailable. The definition of ‘personal income’ is drawn from Henry Simons:6 Personal income may be defined as the algebraic sum of (1) the market value of rights exercised in consumption and (2) the change in the value of the store of property rights between the beginning and the end of the period in question. In other words, it is merely the result obtained by adding consumption during the period to ‘wealth’ at the end of the period and then subtracting ‘wealth’ at the beginning.

[page 46] Expressed algebraically (as is the wont of economists): Y = C + ΔW where: Y = income; C = consumption; and ΔW = change in wealth. If wealth is held constant, income is consumption; if consumption is zero, income is the change in wealth. Hicks defined the term to capture the amount a person could consume in a period while remaining as well off at the end as in the beginning.7 Thus, income is a gain. The source of the gain is irrelevant, whether it be from labour, capital, inheritance, gift or windfall. There are both operational and conceptual difficulties with this ‘accretion of wealth’ view. First, changes in wealth may be realised or unrealised. An ordinary concepts view would consider an increase in assets over time not to be income until the gain was realised. Capital gains (statutory income) operates on the assumption that no taxable gain arises until it is realised, but to capture other gains would require reconsideration of wealth or death and gift duties in addition to income and consumption taxes. The definition also challenges the tax administrator to measure nonpecuniary benefits such as household services (home produce consumed, domestic services performed, etc) as well as services supplied by

consumer durables (although it would be comparatively simple to impute a rent on owner-occupied houses). Problems are also posed in the treatment of leisure (being a form of consumption) and the issue of whether the appropriate tax unit is the individual or the household. The economic view presents a comprehensive income tax base and offers our legislators a range of policy options together with a framework to assess the impact of taxation options on broadly indorsed criteria of good taxation. No view of income can provide definitive answers to questions such as: ‘What should be the subject of tax and should it be measured in nominal or real terms?’ ‘Who should pay tax, and in what share?’ Taxation is the creation of mankind and there is no immutable law to govern it even though ‘it is one of the empirical certainties of history that no structural society has ever arisen without taxation’.8

The judicial concept 2.8 The judicial view preceded modern versions of both the accounting and economic views. From a judicial viewpoint, ‘income’ is literally ‘what comes in’. ‘My income is what actually comes in to me …’ said Darley CJ in Liquidator North Sydney Investment and Tramway Co v CT (NSW) (1898) 15 WN (NSW) 82. ‘Etymologically, the word “income” means “that which comes in or has come in” …’ said Lowe J in Re Income Tax Acts (No 2) [1930] VLR 233; [1930] R&McG 273 at 281. [page 47] When the taxing statutes made reference to company profits (rather than to income), the judicial view was consistent with the accounting measure. In the British context (where profits are taxed), consider the following statement by Fletcher Moulton LJ in Re Spanish Prospecting Co Ltd [1911] 1 Ch 92 at 98:

Profits implies a comparison between the state of a business at two specific dates usually separated by an interval of a year. The fundamental meaning is the amount of the gain made during the year. This can only be ascertained by a comparison of the assets at the two dates.

As his Lordship indicates, profit implies a gain (if the difference between the later date and the earlier one is positive) and the similarity between the judicial, accounting and economic views is evident, although they are not identical. However, the Australian courts were quick to dismiss his definition9 and made it clear that, at least under Australian tax legislation, income was to be conceived as a flow, not a gain. Impliedly, income was a gross amount and a net amount entering assessment as ‘income’ came to be accepted in Australia only gradually:10 see further 2.11. The fundamental difference between a conception of income as a flow and income as a gain is easily demonstrated. Suppose a taxpayer acquires a share, cum dividend, for $2.50. A dividend of 50 cents is then declared. In an efficient market, the value of the share would fall to $2. If income is to be a flow, the taxpayer has derived dividend income of 50 cents, but if income is a gain, the amount is zero. Of course, from a judicial point of view, not all inflows are necessarily of an income nature and this is where the ‘ordinary concepts’ notion of income becomes relevant. For this reason, the proceeds of gambling are not ordinarily regarded as income from the judicial viewpoint because they do not accord with an ‘ordinary concepts’ view of income. Where gambling is conducted as a business, as in a casino, the proceeds of gambling are stamped as income by their commercial character.

Ordinary income 2.9 The description ‘ordinary income’ appeared in the statute for the first time in the ITAA97 in s 6-5(1), but for many years it has been an accepted description of the essential, judicial understanding of the income concept. For that reason, this text refers to the concept as ‘ordinary/judicial income’. The description ‘ordinary concepts’ comes from the decision in Scott v CT (NSW) (1935) 35 SR (NSW) 215.

Scott v CT (NSW) Facts: Mr Scott was appointed chairman of a statutory body for five years at a salary of £2500. On the dissolution of the board, he was paid £7000 as compensation. This amount represented what he would have received had his services been used. [page 48] Held: No part was income under the Income Tax Act 1928–34 (NSW).a In the present context, Jordan CJ said: The word “income” is not a term of art, and what forms receipts comprehended within it, and what principles are to be applied to ascertain how much of those receipts are to be treated as income, must be determined in accordance with the ordinary concepts and usages of mankind, except in so far as the statute states or indicates that receipts which are not income in ordinary parlance are to be treated as income or that special rules are to be applied for arriving at the taxable amount of such receipts …

a.

The amount was compensation for the cancellation of a contract, and capital in nature. (See Lord Macnaghten’s dictum, above at 2.1.) The issue before the court was whether the amount represented a retiring allowance or gratuity, 5% assessable. See former ITAA36 ss 27A–27J and 5.48.

The Chief Justice makes clear references to income by ordinary concepts, or income by ordinary parlance. The need to make such observations stems from the fact that the word ‘income’ is not defined in any of the income tax Acts. 2.10 A judicial concept of income emerged with the development of trusts in English law in the 16th century. Settlors or creators of trusts would specify beneficiaries whose entitlements could be the income of the trust (a life tenant) or trust property or capital (a remainderman). As a result, a need arose to distinguish income from capital because different beneficiaries had different interests. By the 18th century, trust law was well established and when, in the 19th century, the ‘modern

income tax’ was imposed, it was natural for the courts to import trust law notions of income to refine the understanding of a term that has its origins in ‘ordinary concepts’. However, thinking of income in terms of ‘what comes in’ produced problems when the benefit literally did not come in but rather saved an outgoing — as was the case in Tennant v Smith [1892] AC 150 — or could not come in because it could not be converted into money — as was the case in Tennant v Smith and FCT v Cooke & Sherden (1980) 10 ATR 696; 80 ATC 4140. First, consider Tennant v Smith.

Tennant v Smith Facts: Mr Tennant was a bank officer who occupied rent-free premises, owned by a bank, where he lived and from which he transacted after-hours business. He could not sublet the house and was obliged to leave the premises on ceasing employment. The relevant English Tax Act imposed tax on ‘salaries, fees, wages, perquisites or profits’ arising from office and the Surveyor of Taxes included in [page 49] Mr Tennant’s income a sum of £50 representing the annual value of the rent-free accommodation. The House of Lords held the amount was not taxable because it could not be converted into money and that requirement was an ordinary understanding of the term. Held: The amount was not liable to tax. Lord Watson said (at 159): I do not think [the rent-free accommodation] comes within the category of profits … because that word in its ordinary acceptation, appears to me to denote something acquired which the acquirer becomes possessed of and can dispose of to his advantage in other words, money or what can be turned to pecuniary account. Lord Macnaghten said (at 164): [Income tax] is a tax on income in the proper sense of the word. It is a tax on what “comes in” on actual receipts … No doubt if the [taxpayer] had to find lodgings for himself he might have to pay for them. His income goes further because he is relieved from that expense. But a person is chargeable for income tax … not on what saves his pocket, but on what goes into his pocket.

The ordinary judicial concept of income in late 19th-century England was that a perquisite of office that was not convertible into money was not income for tax purposes. What would be the case in Australia almost 100 years later? Consider the decision in FCT v Cooke & Sherden (1980) 10 ATR 696; 80 ATC 414.

FCT v Cooke & Sherden Facts: Two partnerships were engaged in selling soft drinks on a door-to-door basis. They leased vehicles from the drink manufacturer and sold to regular customers on a prescribed round purchased from a previous operator. The manufacturer introduced an incentive scheme, comprising free holidays, to successful operators. The holiday rights were not assignable and there was no entitlement to alternative compensation if the holidays were not taken. The two taxpayers were awarded such holidays and the Commissioner of Taxation included a proportion of the value in each individual’s assessable income.a Held: The holidays did not represent income. The Full Federal Court said (at ATR 703–5): [page 50] The notion that the items of income are money or are to be reckoned as money accords with the ordinary concepts of income as “what comes in to [the] pocket” to adapt Lord Macnaghten’s phrase in Tennant v Smith [1892] AC 150 at p 164. That is not to say that income must be received as money; it is sufficient if what is received is in the form of money’s worth … Nor is it necessary that an item of income be paid over to the taxpayer; it is sufficient according to ordinary concepts and usages, that it be dealt with on his behalf or as he directs … [T]he respondents in the present cases could not have turned the benefits in fact received by them to pecuniary account. It is immaterial that the respondents would have had to expend money themselves had they wished to provide the holidays for themselves. If the receipt of an item saves a taxpayer from incurring expenditure, the saving is not income; income is what comes in, it is not what is saved from going out. A non-pecuniary receipt can be income if it can be converted into money; but if it be inconvertible, it does not become income merely because it saves expenditure.

a.

The amounts were assessed under the former ITAA36 s 25(1) as ordinary income (see ITAA97 s 6-5) and also under ITAA36 s 26(e).

One might have expected that the ordinary concept of income was not static. While rent-free accommodation in the 19th century did not fit that description, by the end of the 20th century when perquisites (‘perks’) of office had become routine, ordinary usage of the word ‘income’ was probably wide enough to capture the benefits enjoyed in the circumstances of Cooke & Sherden’s case. There are two concerns with an ordinary/judicial concepts notion of income that arise out of the decisions in Tennant v Smith and Cooke & Sherden. First, are the judiciary, in fact, good judges of what is ordinary income and what is perceived to be such income by ordinary people?11 Second, there is the ‘freezing’ effect of precedents. To this day, amounts that are not convertible into money remain outside the judicial concept of ordinary income: see further 3.5. The ordinary/judicial concept of income needs to be understood in this context. The courts’ object is certainty and reasonable predictability of outcome in the course of settling disputes. The doctrine of precedent is an important part of this objective. The accountant’s concern with the information content of the measure is largely irrelevant. [page 51]

Profit, gains and income 2.11 To proceed on the understanding that the judicial concept of income as ‘what comes in’ represents the last word on the matter would be a mistake. There are circumstances where a measure of ‘income’ as ‘net profit’ has been seen as appropriate. Usually the profit that is brought to account is the profit (or loss) from a particular transaction, not the overall profit for the year determined in a profit and loss account. That is, although, in general, income is conceived as a flow, on occasions the courts have decided that what is income can be determined only by calculating net profit.12 Whether to be taxed on a

flow or a net profit is not a choice open to a taxpayer.13 It depends on what amount — the gross receipt or the net profit — has the character of income. In Commercial and General Acceptance Ltd v FCT (1977) 137 CLR 373; 7 ATR 716; 77 ATC 4375 at 4380, Mason J said:14 There is a problem in accommodating the language of [the former ITAA36] s 25(1) to the notion that an amount of net profit forms part of gross income. Is the reference in the subsection confined to the gross receipts only of the taxpayer which possess the character of income or does it also include a net amount having that character, provided that the net amount is not itself derived from gross income? The expression “gross income” in relation to a taxpayer conveys the sense of entire income of a taxpayer. No doubt in the context of the Act that income is to be ascertained in the first instance by reference to the gross income receipts of a taxpayer, but in my view it also includes a net amount which is income according to the ordinary concepts and usage of mankind when the net amount alone has that character, not being derived from gross receipts that are revenue receipts.

Similarly, in International Nickel Australia Ltd v FCT (1977) 137 CLR 347; 7 ATR 739; 77 ATC 4383, a gain arose when, as a result of a devaluation of the pound sterling, the amount payable for nickel products purchased on account was less than the amount recorded in the company’s books of account. The company argued that as nothing had ‘come in’, there was no income derived, merely a reduction in liabilities. The High Court held that the gain was assessable income. Gibbs J said: It is not correct to say, in the case of a trader who carries on a continuing business, that there can be no income unless there is a receipt.15

If the gross receipts are themselves income, the ordinary scheme of the Act applies: Taxable income = Assessable income − Deductions

[page 52] But if the gross receipts are not of an income nature, it may be appropriate to consider whether a measure of net profit has the character of income, and if it does: Taxable income = Net profit

It follows that, in such circumstances, there can be no relevant

deductions.16 2.12 On the occasions when the courts have considered the assessability of a net profit, it is largely the accounting notion rather than the economic concept that has been relevant if for no other reason than that accounting provides a more operational framework. Thus, in London Australia Investment Co Ltd v FCT (1977) 138 CLR 106; 7 ATR 757; 77 ATC 4398, the assessable profit was the proceeds from the sale of shares less the average cost of the shares. In FCT v Whitfords Beach Pty Ltd (1982) 150 CLR 355; 12 ATR 692; 82 ATC 4031, the profit on the subdivision and sale of land was the sale proceeds minus the market value of the land at the time it was ventured for subdivision (plus development costs). In these cases, the courts did not begin by asking if there was a gain in an economic (or any other) sense and then attempt to measure it for tax purposes. They asked whether there was an amount that had the character of income. There is an important difference between saying that gains may be income in nature and the proposition that, to be income, there must be a gain. Another instance when income is something other than ‘what comes in’ is illustrated by the decision in Warner Music Australia Ltd v FCT (1996) 34 ATR 171; 96 ATC 5046.

Warner Music Australia Ltd v FCT Facts: The taxpayer was a distributor of pre-recorded music. The Commissioner of Taxation assessed the taxpayer for a sales tax liability that the taxpayer contested. However, the Commissioner allowed a deduction for the disputed amount for income tax purposes (that was brought to account as a current liability). The sales tax issue was resolved in the taxpayer’s favour and the Commissioner released the taxpayer of the liability to pay that tax but included the amount so extinguished in the taxpayer’s assessable income on the grounds that the benefit derived from the reduction of a liability was income according to ordinary concepts. Held: The taxpayer’s appeal was dismissed. Hill J said (at ATC 5052):

The real issue between the parties is whether the release of Warner from its liability to pay sales tax constituted income in ordinary concepts by virtue of that release constituting a gain or profit forming part of its business income … [page 53] It is now too late to argue in the case of a taxpayer carrying on a continuing business and thus required to account on an accruals basis, that income is confined to that which comes in. Gains, at least if they are capable of being converted into money in a practical and commercial sense, may clearly constitute assessable income.

The concluding statement that gains convertible into money may clearly constitute income provides the key. Whether an amount — be it a receipt, a gain or in the nature of a net profit — is income in nature is to be determined by reference to the ordinary judicial concept of income. It should be noted that, in relation to statutory income, there are several specific parts of the ITAA that bring to account a gain. The capital gains tax provisions are an obvious example.

Summary 2.13

This above discussion has established the following: Section 4-1 of the ITAA97 imposes tax on individuals and companies. Tax is payable on taxable income, which is ordinary income plus statutory income minus deductions, at rates set out in the various Rating Acts. Australia’s jurisdictional limits to taxation are stated in ITAA97 ss 6-5 and 6-10. Income is not defined in the Acts but derives its meaning from ‘the ordinary concepts and usages of mankind’ as they have been distilled by the courts and, hence, may be more appropriately described as ‘judicial income’. Ordinary/judicial income is a flow as opposed to a gain concept and in its basic form is ‘what comes in’. Ordinary/judicial income is to be distinguished from capital

and, in addition, items have the character of income only if they are convertible into money. The ordinary/judicial concept of income is to be contrasted with accounting measures of profit and the economic concept of a gain. In refining the ordinary income concept, the courts have been influenced by accounting only occasionally, but have been more susceptible to accounting practice and the matching principle in relation to timing issues of when income is derived and when an expenditure is incurred. The economic concept of a comprehensive gain presents operational difficulties. On the occasions when net profit has been assessable income, the courts have held it is the net profit rather than the gross receipts that possesses the income character. It is not a prerequisite of income that there be a gain.

Income under the ITAA97 2.14 Taxable income is assessable income minus deductions. Under the ITAA97, in the case of a resident taxpayer, assessable income includes ordinary income (ITAA97 s 6-5) and statutory income (s 6-10) from all sources. A foreign resident [page 54] is assessable only for ordinary and statutory income from Australian sources. If an amount is both ordinary and statutory income, it is taxable only once (s 6-25(1)) and the rules relating to statutory income prevail over ordinary income. By virtue of the definition of statutory income in ITAA97 s 6-10(2), an amount should not be both ordinary and statutory income. Statutory income is defined as amounts that are not ordinary income but that are included in assessable income. This suggests that an amount that is ordinary income cannot be treated as statutory income. However, s 6-

25(1) clearly states that an amount can be both ordinary and statutory income. Tax scholars must learn to live with these minor irritations. In the event of conflict between provisions of the ITAA36, the decision in Reseck v FCT (1975) 133 CLR 45; 5 ATR 538; 75 ATC 4213 applied the principle of interpretation that more specific provisions prevail over more general provisions. Arguably, if an amount potentially falls within two statutory provisions, this principle should apply. Although the ITAA97 does not specifically provide for a reconciliation should this occur, the application of the more specific provision accords with normal conventions of interpretation of statutes. An amount that is neither ordinary nor statutory income cannot enter assessable income and so is not taxable: ITAA97 s 6-15. An amount that is neither ordinary nor statutory income should not be called exempt income. The items are not income at all. As will be demonstrated, a mere gift is not income in the first place so it cannot be called exempt income. It is an important task to identify items that fall within this category of non-income items and to develop some signposts for recognition of ordinary income. As the description implies, statutory income is more easily recognised.17 Exempt income is an item specifically excluded from either ordinary or statutory income: ITAA97 ss 6-1(3) and 6-15(2). This exempt income category is fundamentally income by ordinary concepts or statutory extension — so to be excepted from assessable income and, consequently, taxable income requires a specific provision of the Act: s 6-20(1).18 There are three categories concerned with exempt income: 1. entities that are exempt (ss 11-5 and 50-5–50-45); 2. certain income that is exempt (s 11-10); and 3. certain income derived by certain entities (s 11-15 and ITAA36 s 23). The key concepts of ordinary, statutory and exempt income are represented below. [page 55]

Figure 2.1:

Income under the ITAA97*

* This diagram is a simplified representation of the relationship between statutory and ordinary income. For this reason, it has not fully captured the categories of income that may be subject to withholding tax nor the concept of ‘non-assessable non-exempt income’, which are more appropriately dealt with elsewhere.

Is the item ordinary income? 2.15 The ITAA97 is careful not to use the word ‘income’ without a qualifying adjective. Ordinary income is income according to ordinary concepts: ITAA97 s 6-5(1). As was demonstrated above, it may be appropriate in principle to describe ordinary income as emerging from the ordinary concepts and usages of mankind but, in reality, ordinary income is a judicial construct that emerged from trust law and has been elaborated and refined by the courts over the past 150 years. Each case has been decided on its own facts and it is important to keep this in

mind. In Keily v FCT (1983) 83 ATC 4248, the taxpayer appealed against the assessment of her age pension. In holding that the pension was income by ordinary concepts,19 White J expressed some surprise that, until that case, nobody had challenged the view. His Honour said (at 4249): The characteristics of income of whatever kind are said to include recurrence, regularity and periodicity but these characteristics were developed in relation to other fact situations. They are helpful by way of analogy only.

[page 56] Even if they are useful only by way of analogy, it will be helpful to determine the characteristics of income and non-income amounts and to identify the authorities that establish that features such as recurrence, regularity and periodicity are common (but not necessary) elements of income. Generally, income is understood as arising from three pursuits: 1. as remuneration for personal services; 2. as the rewards from carrying on a business; 3. as a return on investments. Each of these activities typically provides an inflow in the form of a salary, revenue or return such as rent, interest or dividend. It is understandable that the tax Act should be structured around the formula: income less deductions. Items 2 and 3 require some type of investment or commitment of capital. When the activity is terminated, the initial investment is recovered but ordinarily that would not be regarded as a reward or return in the nature of income. It is a return of one’s investment, not a return on investment. If the initial investment has grown, it is likely to be described as a capital gain or an increment representing goodwill. Such a gain is not universally regarded as ordinary income. If the overall venture is appraised, it might be judged to be profitable and the aggregate profit would contain elements of the income flow and

the capital gain but, in Australia, assessable income is not the same as profit and ordinary income does not include capital or capital gains. Statutory income includes certain capital gains but whether the amount is statutory income is another question. A metaphor often used to illustrate this relationship is that of the tree and its fruit. The tree represents the capital or profit-making structure. The fruit is the reward, the product of one’s endeavours and has the character of income. Where a payment is evidently remuneration for personal services, such as a salary from employment, or a reward from carrying on business, such as a sales receipt or a dividend on an investment, the amount accords with ordinary concepts of income. In cases where it is not immediately obvious whether an amount is remuneration for personal services, it is necessary to examine whether the receipt accrues to a taxpayer in his or her capacity as an employee, or whether it falls on the taxpayer in some other capacity as, say, a loyal friend. In other activities, it is necessary to determine if the event amounts to a hobby or is a windfall gain, such as a gambling win, and is, therefore, outside the scope of ordinary income. In other words, these general understandings are useful only in the general cases. While all would agree that a brick manufacturer is carrying on a business and liable to tax, not all need agree in the case of an owner–builder who disposes of surplus handmade mud bricks. Even if it is admitted that a particular activity amounts to a business, the question may arise as to whether an isolated action is part of the business, is to be viewed as a natural extension of the business, or is a windfall or capital gain separate from the business. Consider the three following scenarios relating to receipts in the course of employment, business and a dividend that illustrate the essential judicial nature of income and profit: 1. remuneration for personal services (FCT v Rowe (1997) 187 CLR 266; 35 ATR 432; 97 ATC 4137); [page 57]

2.

rewards from carrying on a business (FCT v Cooling (1990) 22 FCR 42; 21 ATR 13; 90 ATC 4472); 3. a dividend paid from profits arising from a gift (FCT v Slater Holdings Ltd (No 2) (1984) 156 CLR 477; 15 ATR 1299; 84 ATC 4883). Ask yourself whether the payment would be income ‘in accordance with the ordinary usages and concepts of mankind’ (Scott’s case: see 2.9), in the first two cases, and whether a gift would ordinarily be regarded as profit, in the third case.

Remuneration for personal services 2.16 An employee’s salary is clearly income. A range of benefits, bonuses and allowances arising from employment or the provision of personal services is also ordinarily understood to be income. Is it possible that some payments in connection with employment or the provision of services do not have an income character? That was an issue before the High Court in FCT v Rowe (1997) 187 CLR 266; 35 ATR 432; 97 ATC 4137.

FCT v Rowe Facts: The taxpayer was employed by a shire council as an engineer. In 1985, the Queensland Government conducted an inquiry into several complaints made against the taxpayer and his threatened dismissal from employment. Mr Rowe incurred legal costs of around $25,000 over the course of the inquiry that dismissed the charges of misconduct. The council refused to reimburse Mr Rowe his legal costs and he was dismissed from employment in 1986. The taxpayer claimed and was allowed a tax deduction for his legal costs. In 1989, the Queensland Government made an ex gratia payment of $25,000 as reimbursement and the Commissioner of Taxation assessed the amount as ordinary income.a A majority of the Federal Court (95 ATC 4691) held that the payment was not assessable. Special leave was granted for the Commissioner to test whether there was a general principle of law that an amount paid as compensation or reimbursement of a deductible expense is income according to ordinary concepts. Held: The High Court held unanimously (at ATC 4321) that there was no general

principle contended by the Commissioner: One consideration [against the general principle] is that the Court has said that what a taxpayer has done with an amount received “is in general of no materiality in determining whether his receipt of the amount was a receipt of income or of capital”: Carapark Holdings Ltd v FCT (1967) 14 ATD 402 at 404; (1966–67) 115 CLR 653 at 660; see also GP International Pipecoaters Pty Ltd 90 ATC 4413; (1989– 90) 170 CLR 124. But [page 58] the fundamental difficulty in the way of the “general principle” is that it diverts attention from the inquiry demanded by the Act, as that inquiry has generally been understood, namely, is the receipt income by ordinary concepts? A majority (Brennan CJ, Dawson, Toohey and McHugh JJ) held the payment was not income (at ATC 4322): It is true that, in support of his claim for a deduction, the respondent had argued that the expenditure was “incidental and relevant to the gaining of assessable income” … But that claim, which originally was rejected by the appellant then later allowed, does not determine the character of the money received from the Government. In the case of money received for which no consideration was given … [a]n inquiry into the “how and why” of the receipt may show a common understanding between payer and payee which will identify the matter in respect of which the payment was received: Federal Coke Co Pty Ltd v FCT 77 ATC 4255 at 4273. However, no common understanding was demonstrated in the present case. As Beaumont J observed (95 ATC 4691 at 4698): In deciding to make the ex gratia payment, the Treasury could have been seen as acting so as to vindicate the public interest in ensuring that fair and liberal treatment is afforded to those citizens who participate in those inquiries. It may be that the respondent could have taken legal action against the council in respect of the invalid suspension of his employment. But that does not help to identify the character of the receipt in the hands of the respondent. Furthermore the payment by the government did not place the respondent in the same position as an order of costs in his favour. Interest had been claimed and the respondent was not fully indemnified for the expenses he incurred. We are in agreement with Burchett J in the Full Federal Court when his Honour said (95 ATC 4691 at 4703): The payment was in no sense a reward for his services during his employment by the Council, which had long since been determined. It was a recognition of the wrong done to him and also of the fact that he had been forced to shoulder the task of sharing in an inquiry undertaken by the government for public purposes. The payment was not a remuneration, but a reparation. Of course, it was far from being a complete reparation, since

he had to bear the costs, which were reimbursed without interest in the currency of some years later. [page 59] Gaudron, Gummow and Kirby JJ dissented, holding that the reimbursement was, in the circumstances, the ordinary income of Rowe for the following reasons: 1. Although Rowe was not employed by the State of Queensland, there was an essential connection between the responsible Minister, Rowe’s reinstatement and the inquiry that cleared him. 2. This connection meant that, although the payment was not made by the employing council, that did not determine the question. 3. There was a ‘common understanding’ that payment by the government had the same effect as litigation by Rowe against the council. 4. The practical effect of the payment was a recoupment of Rowe’s deductible expenditure.

Rewards from carrying on a business 2.17 Fees for the provision of services or revenue from the sale of goods are also clearly income in nature, being the proceeds of business. Would payments arising from unusual or isolated transactions also be regarded as business income? That question has been before the courts in a number of different factual settings, many involving the sale of property. In FCT v Cooling (1990) 22 FCR 42; 21 ATR 13; 90 ATC 4472, the issue was examined but, interestingly, the unusual receipt did not arise from the sale of any property.

FCT v Cooling Facts: The taxpayer was one of several partners in a firm of solicitors that over many years had operated from various leased premises in Brisbane. In 1985, the firm received an offer to take up a lease in a new building. The offer was accompanied by an incentive payment, a common practice at the time. Ultimately, the firm was paid $162,000 to take up a 10-year lease in a new office block. The Commissioner assessed Mr Cooling on his share of the lease incentive.

Held: The Full Federal Court held that the amount was assessable income. Hill J said (at ATC 4479, 4483–4): The cases make it quite clear that whether an amount is income in ordinary concepts depends upon its quality in the hands of the recipient: Scott v FCT (1966) 117 CLR 514 at p 526; Hayes v FCT (1956) 96 CLR 47 at p 55; Federal Coke Co Pty Ltd v FCT (1977) 7 ATR 519; 77 ATC 4255 at p 4273. This is not to say, as Fullagar J pointed out in Hayes at p 56, [page 60] that the motive of a donor in making a payment is necessarily irrelevant, but it will not be determinative … The test to be applied will be objective rather than subjective (Hayes at p 55). Where a taxpayer carries on a business, the proceeds of that business will be income in his hands and thus assessable: Squatting Investment Co Ltd v FCT (1952– 53) 86 CLR 570 at p 620 per Fullagar J. It will often be necessary to make a “wide survey” and “an exact scrutiny of” a taxpayer’s activities: Western Gold Mines NL v CT (WA) (1938) 59 CLR 729 at p 740, cited with approval by Gibbs J in London Australia Investment Co Ltd v FCT (1977) 138 CLR 106; 77 ATC 4398 at p 4403 to determine whether a particular profit derives from the business operation or is part of the business operations of a taxpayer … What then is the result on the facts of the present case? If the transaction can properly be said to have been entered into by the firm in the course of carrying on its business and if it can be said that the arrangement is a profit-making scheme in the sense that those words are used by the High Court in [FCT v Myer Emporium Ltd 87 ATC 4363], then it will follow that the amount received by the parties will be income and it will matter not that vis-à-vis the firm, the transaction was extraordinary … In my view the transaction entered into by the firm was a commercial transaction; it formed part of the business activity of the firm and a not insignificant purpose of it was the obtaining of a commercial profit by way of the incentive payment. This result accords with common sense. The firm had the alternative of paying less rent and therefore obtaining a smaller tax deduction for its outgoings or paying a higher rent … And therefore obtaining a larger tax deduction but receiving an amount in the form of assessable income.

These cases illustrate the difficulties in determining whether a payment falls within category 1 as remuneration for personal services or category 2 as the rewards from carrying on a business. But they also suggest a number of propositions that have been distilled from decisions that may provide a framework for analysing situations of fact. Thus, it

emerges that the character of a payment is to be judged in the hands of the recipient; that the donor’s motive may be a factor in characterising an amount, but it will not be decisive; that recurrence, regularity and periodicity are common elements; that where, in the course of carrying on its business, a taxpayer enters into a profit-making arrangement, it does not matter that the transaction is [page 61] extraordinary. These propositions require embellishment and authority. Chapter 3 develops a series of propositions drawn from the authorities that creates a framework for determining whether amounts fall within ordinary/judicial income.

Dividends, profits and gifts 2.18 The following case example, FCT v Slater Holdings Ltd (No 2) (1984) 156 CLR 447; 15 ATR 1299; 84 ATC 4883, has unusual facts and the issues concern specific statutory provisions rather than the general question of whether an amount is income (as in Rowe and Cooling). However, it is possible to examine the central question: What is a profit according to ordinary concepts? A gift would be regarded as income under the economic concept. How would accountants record a gift arising from the forgiveness of a debt? The case highlights the essential judicial aspect of an ordinary/commercial concept.

FCT v Slater Holdings Ltd (No 2) Facts: The essential facts were that William Ogg made a gift of $36,000 by forgiving a loan owed to him by a family company, Ogg Holdings Ltd. The amount was recorded in the company’s books as Members’ Funds. After William Ogg’s death, his three children (the other members of Ogg Holdings) decided to distribute to themselves one-third of

the assets. A daughter’s company, Slater Holdings, received a dividend of $26,900 paid from the following three sources: Revenue profits

$2,569.68

Capital reserves

$12,330.32

Members’ Fund (Gift)

$12,000.00

Total

$26,900.00

ITAA36 s 44(1) assesses ‘dividends’ paid out of ‘profits’. The Commissioner assessed the full amount of $26,900 but the taxpayer contended the amount of $12,000 was not a profit such that only the payment of $14,900 was a dividend paid out of profits in terms of s 44(1). Held: The High Court upheld the assessment. Any increase in assets, including an increase resulting from a gift, was profit. The fact that a distribution is itself of a capital nature does not mean that it did not have its source in profits. Gibbs CJ delivered the leading judgment: Although profit in its ordinary sense often means the excess of returns over the outlay of capital … the question whether there are profits available for distribution is to be answered according to the circumstances of each particular case, the nature of the company and the evidence of competent witnesses.

[page 62] Gibbs CJ referred to statements made by Fletcher Moulton LJ in Re Spanish Prospecting Co Ltd [1911] 1 Ch 92 (see 2.8) as well as expert accounting evidence that a gift to a company is not paid-in capital and is, therefore, a profit of a capital nature.

Is the amount statutory income? 2.19 An amount that is not ordinary income may be assessable income if it is statutory income. Statutory income is so described because it owes its existence to the Act itself. If ordinary income can be said to derive from ordinary concepts, statutory income derives from the statute. If an item is both ordinary and statutory income, the rules relating to statutory income prevail. ITAA97 s 6-10 does not consider the question of whether an item may potentially fall within two or more statutory income concepts, but there are specific reconciliations

throughout the Acts. For example, in relation to the ITAA36, a payment made to a retiring employee for accrued long-service leave entitlements is part of statutory income under ITAA97 s 83-10. It also potentially falls within a range of retirement payments called eligible termination payments in ITAA97 ss 82-1–82-160. However, the definition of ‘employment termination payment’ specifically excludes a Subdiv 83-A or Subdiv 83-B amount: ITAA97 s 82-135. In the event that two provisions apply, arguably the more specific provision will apply. The growth of statutory income has been a feature of Australia’s fiscal history. Sometimes this growth has accompanied genuine tax reform but, frequently, it has arisen out of deliberate policy decisions to broaden the tax base, and views are divided over the outcome. Many statutory extensions to income evolved in the original 1936 Act. For example, the capital gains tax (CGT) provisions operate from 20 September 1985 and provide a significant expansion of the tax base but they may be traced to earlier provisions like ITAA36 s 26(a) (later s 25A) and s 26AAA. The Fringe Benefits Tax Assessment Act 1986 (Cth), a separate statute, was enacted to address defects in ITAA36 s 26(e). The machinery referred to above in relation to ‘eligible termination payments’ and ITAA36 s 26AD have a common predecessor in the former ITAA36 s 26(d). To be statutory income, an amount must fall within a specific provision of the Acts. There is no equivalent to the ordinary concepts understanding of statutory income; if the amount does not clearly fall within the statute, it is not taxable. It cannot be taxed by inference or analogy. It is a feature of the modern drafting style that the circumstances of an amount’s assessment and the calculation of the amount are specified. For example, the CGT provisions nominate around 50 occasions or events when a capital gain or loss can arise. The fringe benefits tax legislation specifies more than a dozen types of fringe benefits and sets out formulae to determine their value. In contrast, ordinary income is judged by reference to what the High Court in Rowe’s case called the ‘imprecise criterion’ of ordinary concepts. The

determination of statutory income is much more an exercise in applying the words of the Acts than applying principles. This should not imply that statutory income does not derive its meaning from case law. The interpretation of any statute is the province of the courts. What it means [page 63] is that the source of the law is the statute rather than ‘ordinary concepts’ and its meaning is to be gleaned from the words and phrases and inferred from the intention of parliament. Statutory income is examined in Chapter 5.

Is the amount exempt income? 2.20 An amount of ordinary income or statutory income is exempt income if it is made exempt from income tax by a provision of the Act: ITAA97 s 6-20(1). If an amount is exempt income, it is not assessable income: ITAA97 s 6-15(2). It follows that exempt income is a category of ordinary or statutory income items that are specifically exempted from tax. An amount of exempt income cannot enter assessable income. It follows, too, that expenses connected with the derivation of exempt income cannot satisfy criteria that link deductibility to assessable income generation. Exempt income is a creation of the statute. No income is exempt by ordinary concepts. An amount that is not income by ordinary concepts cannot be exempt income. It must first be income before it can be exempted: FCT v WE Fuller Pty Ltd (1959) 101 CLR 403; 7 AITR 559; 12 ATD 85. As a result, a range of non-income items such as mere gifts or windfall gains are not liable to tax because they are not income. They cannot be described as ‘exempt income’ because they are not income in the first place. Where an item is made exempt, the exemption extends only to the original or specified recipient of the income and not to payments made

out of that income unless the Acts make specific provision for the exemption to continue. This means that dividends paid by a company out of exempt profits are fully assessable in the hands of shareholders. In the case of partnerships and trusts, shares in exempt income retain that character as they flow to the partner or beneficiary.20 Classification of income items as exempt is not the end of the story. Although an exempt item is tax free, there are a variety of taxation consequences that may follow that classification. For example, domestic losses incurred in past years may be carried forward under ITAA97 Div 36 and recouped against later years’ income but exempt income is taken into account in calculating such a loss and in the course of recoupment, past losses must first be offset against net exempt income: see 9.60ff. In addition, exempt income is part of ‘adjusted taxable income’ for the purpose of the dependent spouse rebate.21 Different consequences follow in the case of foreign earnings exempt under ITAA36 s 23AG. There, the rate of tax applicable to non-exempt income is calculated as if the exempt income were taxable: see 2.30. For CGT purposes, gains or losses made from assets used wholly for the generation of exempt income are themselves exempt from tax: ITAA97 s 118-12. [page 64] The statutory coverage of exempt income is only partially rewritten with the result that many items of income rely on ITAA36 s 23 for their exemption. There are three avenues to exemption: 1. Entities that are exempt (ITAA97 s 11-5): That is, certain entities are categorically exempt from all types of ordinary and statutory income. These entities are nominated in ITAA97 ss 50-5–50-45 and cover charitable, religious and educational institutions as well as employer and employee associations, hospitals, local government and certain non-profit sporting and cultural organisations. 2. Certain income that is exempt (ITAA97 s 11-10): This category relates to ITAA36 s 51 and a number of provisions in ITAA36 s

23, the most significant being ITAA36 s 23L covering fringe benefits. 3. Certain income derived by certain entities (ITAA97 s 11-15): A range of social security payments is covered by ITAA97 Div 52. The major items in these categories are examined below.

Entities that are exempt: ITAA97 s 11-5 2.21 Institutions that are established primarily for the advancement of religion, charitable institutions for the relief of the aged, sick or poor, and public educational and scientific institutions are entities that are exempt from tax. So, too, are employer, employee and trade union organisations, public hospitals and a range of non-profit organisations promoting aviation, tourism, agricultural and manufacturing pursuits. An understanding of what bodies qualify for this exemption is derived from ordinary/judicial concepts and administrative rulings. In holding that a church practising Scientology was a religious institution, the High Court in Church of the New Faith v Commr of Pay-roll Tax (Vic) (1983) 14 ATR 769; 83 ATC 4652 offered a number of insights, such as whether there is belief in a supernatural being, whether the beliefs and practices resemble earlier cults, as well as observance of certain codes of conduct of supernatural significance. In Commr for ACT Revenue Collections v Council of Dominican Sisters of Australia (1991) 22 ATR 213; 91 ATC 4602, the Full Federal Court held that the critical question was whether the order’s dominant object was the promotion of religion or education. Thus, while a church itself may be a religious institution, schools and colleges run by religious orders are not themselves religious institutions: Taxation Ruling TR 92/17. To be ‘scientific’ is to be distinguished from an entity that is essentially a professional association: Australian Dental Association (NSW) v FCT (1934) 3 ATD 114. To be a public educational institution, a body must make education available to the public or a part of it. The courts have held that organisations merely providing information (Taxpayers Association of NSW v FCT (2001) 46 ATR 1213; 2001 ATC 2096), or a national association of surveyors acting in a co-ordinating role (AAT Case 9723 (1994) 29 ATR 1102; Case 46/94 94 ATC 412), were not

public educational institutions. The High Court case of FCT v Word Investments Ltd [2008] HCA 55 established that an entity may still be exempt as a charitable institution if it engages in business but hands all of its earnings to a charitable entity for charitable purposes. [page 65] The government has in recent years changed the definition of charity to encompass an entity that is not for profit and has a dominant purpose of the advancement of health, education, social and community welfare, religion, culture, the natural environment and other purposes beneficial to the community. From 1 July 2004, these institutions have required ATO endorsement, and registration with the Australian Charities and Not-for-profits Commission (ACNC) in order to enjoy tax concessions. (Note: The Commonwealth Government said it will disband the ACNC. But these plans seem, at the time of writing, to have been abandoned.) Under ITAA97 s 50-10, a not-for-profit society or association established for community services (apart from political or lobbying purposes) is exempt. The Explanatory Memoranda mentioned ‘traditional service clubs’ such as Apex, Lions, Rotary, Zonta and service organisations, such as the Country Women’s Association. Under ITAA97 s 50-45, non-profit societies or associations established for the promotion of animal racing, a game or sport, and art, literature and music are specifically exempt. This exemption was formerly granted under ITAA36 s 23(g). In Cappid Pty Ltd v FCT (1971) 2 ATR 319; 71 ATC 4121 at 4124, the Full High Court per Barwick CJ said of that provision: Section 23(g) exempts from tax the income of certain bodies which are not carried on for the purposes of profit or gain to their individual members. The concept of this provision is of bodies, either corporate or unincorporated which are carried on for the benefit of their members but not for the profit or gain of their members severally or individually.

In determining whether a body has been established for former ITAA36 s 23(g) purposes, it was relevant to examine its constituent

documents and activities since formation but especially in the year of income. In this respect, it is the association’s main purpose that is critical. In Farmer v Juridical Society of Edinburgh (1914) 6 TC 467, it was held that where a society’s objects were partly scientific and partly professional, the exemption would apply only if the objectives were mainly scientific. In Cronulla-Sutherland Leagues Club Ltd v FCT 89 ATC 4936, Hill J made the following points in the course of finding that the leagues club was not exempt: The purpose for which the company was carried on in the relevant income year should be considered rather than a purpose expressed at formation. No particular significance should be given to a particular paragraph of the memorandum of association. Financial evidence alone was not conclusive of the extent of the taxpayer’s activities. In ascertaining the main or real object of the taxpayer, it was necessary to take into account all evidence of the nature and extent of activities. On appeal ((1990) 21 ATR 300; 90 ATC 4215), a majority of the Federal Court (Lockhart and Beaumont JJ) agreed that a professionally managed leagues club did not fall within the former exempting provision because its true character was that of a licensed club. Foster J dissented, taking the view that the real test was how the club’s funds were employed rather than how they were generated. Where social club facilities are provided to members, it must be shown that they are only incidental to the predominant purpose of encouraging sport and, in reaching [page 66] this conclusion, all evidence relating to the nature and extent of social activities is to be taken into account: Waratahs Rugby Union Football Club v FCT 79 ATC 4337. In St Mary’s Rugby League Club Ltd v FCT

(1997) 36 ATR 281; 97 ATC 4528, Hill J distinguished the CronullaSutherland Leagues Club Ltd case and held that, although the club conducted considerable gambling and social activities, they were subordinate to the promotion of 32 rugby league teams in the area, particularly for children. 2.22 The nature of a game or sport was examined in Terranora Lakes Country Club Ltd v FCT (1993) 25 ATR 294; 93 ATC 4078.

Terranora Lakes Country Club Ltd v FCT Facts: The club was established to promote games and pastimes and to acquire land to be used for recreational purposes. It had approximately 4000 members, owned a sporting complex, playing fields and promoted a range of sporting activities such as cricket, clay target shooting, tennis, golf and fishing. The club also had extensive social facilities, bars, restaurants and poker machines that attracted around 1000 visitors per day. The club sought exemption under the former ITAA36 s 23(g). The Commissioner conceded that, except for clay target shooting and deep-sea fishing, the club’s activities fell within the exemption but contended that these activities were subordinate to the provision of social facilities. The Commissioner argued that this was supported by the fact that 90% of the club’s income was from poker machines, bar trading and catering. Held: Hill J held that the club was established for the promotion of sport not for the carrying on of an entertainment business. Although the social activities were extensive, they were conducted with a view to financing the sporting activities. Whether the club was exempt or not did not turn on clay target shooting or deep-sea fishing being sports. On the question of games, pastimes and sports, Hill J said (at ATC 4087): To the extent that much assistance is to be gleaned from the statement of objects in the memorandum of association, I do not think that much significance should be placed upon the reference to “games” and “pastimes”. Whatever these words cover (and they could certainly cover on the facts of the present case, darts, snooker, squash or swimming), they do not seem, in the context in which they appear, particularly apt to describe dining, poker machine playing etc. But even if they do, the question is still at the end whether the [page 67] encouragement and promotion of athletic sport is the main or predominant object. On the facts of the present case, the other activities carried on by the club,

although vital to the financial survival of the club, were neither predominant to the sporting activity nor equal in importance to it in their own right. They accordingly do not disqualify the club from obtaining the exemption. In relation to clay target shooting and deep-sea fishing, his Honour said: However, I should not be thought [as saying] these activities did not qualify as athletic sports. It could hardly be said that either shooting or fishing was not a sport. Interestingly, the Macquarie Dictionary illustrates both shooting and fishing as sports. In both, human beings are the sole participants. It seems somewhat artificial to classify fish as participants in fishing or clay pigeons as participants in clay pigeon shooting. The distinction which the legislation drew is a distinction between sports where humans participated with animals and those where only humans participated. The argument presumably was that both fishing and clay pigeon shooting lacked the necessary element of athleticism to fall within the language of [the former ITAA36] s 23(g)(iii). Clearly, shooting involves considerable coordination between hand and eye. The evidence discloses that competition shoots are held at a number of levels and that the club’s training programme is affiliated with the Australian Institute of Sport. To participate, a shooter needs to be reasonably physically fit and mentally alert. Training is undertaken to improve the shooter’s skill and prowess. No doubt, deep-sea fishing is less physically demanding. However, it too is the subject of competitions, from local competition level to international competition level for which prizes are awarded. It does, so the evidence discloses, require an interplay of senses with physical ability and stamina. According to the Shorter Oxford English Dictionary (3rd ed) the word “athlete” derived from the Latin “athleta” or the Greek word meaning “contend for a prize” … Nowadays, athleticism is accepted as involving muscularity, robustness, physical strength or speed … I think in the present context that clay pigeon shooting should clearly be seen as an athletic sport. I have more difficulty with deep-sea fishing. As presently advised, I think it would fall outside the exemption as lacking the necessary athleticism.

[page 68] It would be expected that a sport exhibits some degree of skill and athleticism and a game some system, organisation and rules. Sports such as cricket, tennis and football qualify, as do horse riding, motor cycling and motor car racing. Downhill and cross-country skiing are sports; so, too, are some types of fishing. Squash and swimming are also sports. Games include chess, bridge, darts and snooker but not making model trains.

Consider whether the following would be ‘games or sports’ for the purposes of ITAA97 s 50-45 and what conditions must be satisfied to secure exemption: ballroom dancing; bushwalking; birdwatching; fly-fishing; synchronised swimming.

2.23 ITAA97 s 50-15 replaces the former ITAA36 s 23(f) in providing an exemption for the income of trade unions and employer associations. The income of trade unions is exempted categorically, subject to ITAA97 Subdiv 50-A. In Norseman Amalgamated Distress and Injustices Fund v FCT (1995) 30 ATR 356; 95 ATC 4227, it was held that a fund established by a trade union to provide financial assistance to its members was not itself a trade union for ITAA36 s 23(f) purposes. The income of employer or employee associations is exempt if the body is registered under a relevant Act for the settlement of industrial disputes. To secure exemption under ITAA36 s 23(f), the association previously had to show that (a) it was an employers’ association; and (b) that at the relevant time it was registered. Both requirements still need to be satisfied under ITAA97 s 50-15. In Associated Newsagents Co-operative Ltd v FCT (1970) 1 ATR 609; 70 ATC 4030, the High Court considered the application of ITAA36 s 23(f) to a cooperative trading society registered under the Industrial Arbitration Acts (NSW). The court relied on Victorian Employers’ Federation v FCT (1957) 11 ATD 266 to find that the exemption of ‘trade unions’ does not include employers’ associations and that, at any rate, the association was not an employers’ association, as Owen J explained (at ATC 4032): The words “association of employers” in [former ITAA36] s 23(f) are, in my opinion, confined to a combination of persons who associate in their capacity as employers of

labour and do not cover an association of persons merely because they pursue the same calling.

In reaching this conclusion, it was significant that the taxpayer’s rules indicated that the status of an employer was not a condition of membership. It follows that, to come within the exemption, it is necessary for the association to demonstrate that, as a matter of fact, it is an association of employers and that it is registered for the settlement of disputes. [page 69] ITAA97 s 50-40 provides for an exemption, formerly available under ITAA36 s 23(h), of non-profit organisations established to promote the development of aviation, agricultural, manufacturing or industrial resources in Australia. Its application was considered in Australian Insurance Association v FCT 79 ATC 4569,22 when an insurance association contended that its objects of promoting insurance underwriting and expertise were industrial resources. The Supreme Court of New South Wales rejected the argument that the resources were ‘industrial’. The court also held that the reference to ‘purpose’ is a reference to principal or dominant purpose. Of the industries specified, Sheppard J observed (at 4574): There is a degree of specificity in the words used in the section. It refers to aviation, then to four resources of primary industry, then to manufacturing and finally to industrial resources. The use of these various expressions does not suggest that the draftsman intended to give the word “industrial” any wide meaning intended to embrace business or commercial resources …

Refer to ITAA97 Div 50 ‘Exempt entities’. Which of the following are exempt? And under which sections? 1. Ballarat City Council; 2. Melbourne Bowling Club;

3. Australian Dental Association; 4. The University of Western Australia; 5. Chartered Accountants Australia and New Zealand. A suggested solution can be found in Study help.

Certain income that is exempt: ITAA97 s 11-10 2.24 The principal exemption under ITAA97 s 11-10 is for amounts that are fringe benefits or would be fringe benefits but for the fact that they are exempt fringe benefits. This exemption is covered by ITAA36 s 23L. This exemption provides an important reconciliation between the Income Tax Assessment Acts and the Fringe Benefits Tax Assessment Act 1986 (FBTAA). If the amount is a fringe benefit, it is exempt from assessable income and, therefore, it escapes double taxation: If the amount is a fringe benefit within the meaning of FBTAA s 136(1), then it is exempted from tax under ITAA36 s 23L(1). If the amount would be a fringe benefit but for the fact that it is exempted from the definition of ‘fringe benefit’ by FBTAA s 136(1)(g), then it is exempted under ITAA36 s 23L(1A). [page 70] Broadly speaking, an amount is not a fringe benefit if it is a salary or wage: see further 7.23ff. It follows that: a salary or wage is assessable under ITAA97 s 6-5 as ordinary income; employment benefits that are fringe benefits are exempt income under ITAA36 s 23L and, therefore, excluded from assessable income by ITAA97 s 6-15(2); and employment benefits that are exempt fringe benefits are similarly exempted. It might be noted in passing that an amount that is a fringe benefit (or

an exempt fringe benefit) is also excluded from assessment under ITAA97 s 15-2 but is not classified as exempt income. ITAA36 s 23L(2) provides an exemption for non-cash business benefits, defined in ITAA36 s 21A, if the amount does not exceed $300. This category also covers ‘attributed foreign income’ exempted under ITAA36 ss 23AI and 23AK as well as Australian source income derived by foreign residents and the subject of withholding tax: ITAA36 s 128D. See further Chapter 18.

Certain income derived by certain entities: ITAA97 s 11-15 2.25 This exemption covers a range of payments, including the following: defence force allowances (ITAA97 s 51-5); maintenance payments to a spouse or child (ITAA97 s 51-50); educational allowances (ITAA97 s 51-10); certain foreign source income (ITAA36 ss 23AF, 23AG and 23AH); certain pension payments.

Defence force allowances: ITAA97 s 51-5 2.26 A range of exemptions are provided under ITAA97 s 51-5 to members of the Australian Defence Force. For example, pay and allowances for part-time service in the defence force reserves and emergency reserve forces are exempt. Payments to members serving in ‘operational areas’ or with the United Nations Armed Forces are also exempt under ITAA36 ss 23AB and 23AD.

Maintenance payments to a spouse or child: ITAA97 s 51-50 2.27 Payments made to a former spouse or to a child of the payer or of the payer’s past or present spouse for the benefit of that child are exempt under ITAA97 s 51-50. The exemption does not apply to the income of any property that a payer may have divested in order to make the payment. That is, a periodic maintenance payment to a former

spouse is exempt in the recipient’s hands but the creation of a trust to make equivalent payments would not be.

Educational allowances: ITAA97 s 51-10 2.28 Scholarships, allowances or assistance for full-time students at a school, college or university (ITAA97 s 51-10) are exempt subject to certain conditions. [page 71] In Taxation Ruling TR 93/39 (about predecessor provisions ITAA36 ss 23(z) and 23(g)(i)), the Commissioner states that a scholarship is a reward for merit granted on a competitive basis according to specified criteria. A critical consideration for exemption is that the scholarship is not provided on the condition that the student will enter into or continue in an employment contract with the payer or the authority making the payment. The payments must be principally for educational purposes. It would seem that a payment made in the capacity of an employee is simply not a scholarship anyway. Payments made to research assistants and the like are simply salaries. To fall outside the conditions of exemption does not require that there be any formal agreement in relation to an employment contract. It is enough that, as a matter of ordinary construction or language, there is a condition that a person continue, or enter into, a contract for labour: FCT v Ranson (1989) 20 ATR 1652; 89 ATC 5322. The matter of employment contracts was examined in Polla-Mounter v FCT (1996) 71 FCR 570; 34 ATR 447; 96 ATC 5249. In that case, a professional footballer received payments under a scholarship scheme conducted by a leagues club, a condition being that a candidate had to be a playing member. The Full Federal Court held that the fact that the scholarship would continue even if the recipient ceased to play football was irrelevant. What was important was whether it was an initial condition that services be rendered. The rendering of services was not the critical consideration provided there was no condition to do so.

Besides, in the circumstances of the case, it could be doubted whether the services rendered to the particular football club amounted to services rendered to the scholarship provider. The court upheld the exemption. To be exempt under s 51-10, the scholarship, allowance, etc must be in respect of full-time education at a school, college or university. In Muir v FCT (2001) 47 ATR 1006; 2001 ATC 2143, an anaesthetist was paid $120,000 over two years to study pain management. The Administrative Appeals Tribunal accepted the study was full-time education but, because it was undertaken at a hospital (as opposed to a college or university), the payment did not satisfy s 51-10.

Tom is employed by Ajax Ltd and is studying for a BCom part-time. His employer offers him the opportunity to study the final year full-time during which period he would be paid a ‘scholarship’ by Ajax amounting to two-thirds of his normal salary, paid on the usual paydays. Ajax also pays for prescribed reference books. There is no agreement that Tom continue employment with Ajax. Advise Tom whether the payment is exempt. A suggested solution can be found in Study help.

[page 72]

Certain foreign source income: ITAA36 ss 23AH, 23AF and 23AG 2.29 ITAA36 s 23AH provides an exemption for certain income of branches of resident Australian companies carrying on business through a ‘permanent establishment’ (see ITAA36 s 6(1)) in a listed or unlisted country. A listed country is one that has a tax regime comparable to Australia’s. There are exceptions to this exemption and it does not

apply to passive income that is not taxed in the foreign country in a way comparable to the way it is taxed in Australia, unless the income in question is merely incidental to the main business operations of the foreign branch. So if the permanent establishment is in a listed country, the foreign branch income exemption does not apply if the permanent establishment does not derive ‘active income’ and fails two other tests (ie, the foreign income in question falls into the two categories of both ‘adjusted tainted income’ and ‘eligible designated concession income’). If the permanent establishment is in an unlisted country, the exemption does not apply if it fails the ‘active income’ test and the foreign income is ‘adjusted tainted income’. As a result, Australian revenue authorities would not differentiate between assessing the income derived by a branch of an Australian company (in, say New Zealand — a listed country) and providing a credit for the tax paid in New Zealand. If the tax rates are equivalent, the outcome would be approximately the same and it would seem a simpler matter to exempt the income in the first place. 2.30 For more detail on this, see 18.7. Until the mid-1980s, Australia’s approach to foreign source income derived by residents was to exempt the income if it had been the subject of foreign tax (the former ITAA36 s 23(q)). This was replaced by a system of crediting foreign tax against the Australian liability and, to counter the nonrepatriation of income shifted to tax havens, by a system of attributing foreign income to the controlling residents in Australia: see Chapter 18. Elements of the earlier approach are preserved in ITAA36 ss 23AF and 23AG. In general terms, these sections provide for the exemption of income derived by Australian residents from overseas employment (s 23AG) or approved overseas projects (s 23AF). Specifically, s 23AG exempts from Australian tax foreign earnings derived by what is now a narrow category of Australian resident when the foreign service is for at least 91 days’ continuous service and the earnings are taxed in the country of source: see 18.5. Section 23AF applies the same broad exemption to 91 days’ continuous service on an approved overseas project which is exempt from tax, as defined in s

23AF(11) and (18). The exemption extends to contractual payments in addition to salary and wages.

Certain pension payments 2.31 Most social security payments are assessable income, although recipients may pay no tax as a result of rebates (tax offsets) under ITAA36 s 160AAAA. However, ITAA97 ss 52-1–52-150 and ss 53-10– 53-25 provide for a range of specific exemptions. Section 52-10 lists exempt payments under the Social Security Act 1991 (Cth) and s 52-75 lists payments wholly or partly exempt under the Veterans’ Entitlements Act 1986 (Cth), for example: carer payments, if both the carer and care receiver are under pension age; [page 73] the disability support pension, if the recipient is under pension age; the Veterans’ Affairs disability pension and allowances; the war widow’s or widower’s pension.

Jurisdictional matters: An overview 2.32 The core provisions ITAA97 ss 6-5 and 6-10 provide common jurisdictional limits to Australia’s claim to tax. Australian residents are liable to tax on worldwide income; foreign residents’ liability is limited to Australian source income. Residency is an important concept for any revenue code because the capacity of a government to impose tax on its subjects is limited in a practical, if not a theoretical, sense. Revenue authorities can attach tax obligations to a right of citizenship, or they can limit jurisdiction to residents, whatever their citizenship, and rely on competent courts to enforce their jurisdiction. There is a longstanding principle that one

nation will not enforce another’s tax laws. For income tax purposes, Australia has adopted a strategy whereby residents are assessable on worldwide income and foreign residents’ obligations are limited to income from Australian sources. Similar limitations apply to liability for capital gains; residents are assessable on the sale of worldwide assets and foreign residents’ liabilities are limited to gains from capital gains tax events in relation to assets having the necessary connection with Australia.23 Australia’s tax jurisdiction is based on ‘residency’ and ‘source’. This is a common limitation. When an Australian resident derives income from a foreign source and the income is taxed in that country (either unilaterally or under a double tax treaty), the income is either exempt in Australia (eg, under ITAA36 s 23AG (see 2.30) or s 23AH (see 2.29)) or a tax credit is provided for the foreign tax paid. These jurisdictional limits are declared in ITAA97 s 6-5, in relation to ordinary income, and s 6-10, in relation to statutory income. Exempt income is excluded from both provisions by ITAA97 s 6-15. This structure is an important improvement on the 1936 Act. Although former ITAA36 s 25(1) provided for the exclusion of exempt income and declared jurisdictional limits consistent with ITAA97 s 6-5, the supplementary framework (principally in ITAA36 s 26) contained no equivalent declarations. Unless the former ITAA36 s 25(1) was regarded as the central provision of the Act through which all assessments passed, there was no categorical exclusion of exempt income and the Australian revenue authorities conceivably laid claim to tax foreign residents on non-Australian source income.24 [page 74]

Capital gains tax and jurisdictional limits 2.33 The capital gains tax (CGT) provisions comprise Pt 3-1 (general topics) and Pt 3-3 (special topics) of the ITAA97. They provide particular rules for the calculation and treatment of capital gains and

losses, including exemptions: see Chapter 6. For a resident, under the rule in ITAA97 s 6-10(4) (discussed above), CGT applies to all CGT events, regardless of the location of an asset or the source of a payment. If the gain is also taxable in another country, relief from double taxation is provided through Australia’s double tax agreements or through a system of foreign tax credits: see Chapter 18. If there were complete symmetry between the income and the capital gains provisions, then a foreign resident would be subject to CGT on all capital gains having an Australian source. In fact, a foreign resident’s liability is considerably restricted. Capital gains, a form of statutory income, are included via s 6-10(5)(b) in a foreign resident’s assessable income on a basis other than having an Australian source. Foreign resident individuals, companies or trustees can make a capital gain (or loss) only if the event relates to ‘taxable Australian property’: s 855-15. In other words, a foreign resident’s exposure to Australian CGT is limited to property specified in s 855-15. The principal category of ‘taxable Australian property’ is ‘taxable Australian real property’ as defined in s 855-20, although some other items may also be ‘taxable Australian real property’ such as indirect interests in ‘taxable Australian real property’ and assets that have been used by a foreign resident in carrying on a business through a permanent establishment in Australia. The definition of ‘taxable Australian real property’ is therefore important and it includes: real property situated in Australia (including a lease of land, if the land is situated in Australia); and mining, quarrying or prospecting rights if the minerals, petroleum or quarry materials are situated in Australia. These are extended to include indirect interests in Australian real property through share holdings etc: see s 855-25. The effect of these rules is intended to make Australia more attractive as a destination for investment; the intention being that a foreign resident could disregard a capital gain or loss unless the relevant CGT asset is a direct or indirect interest in Australian real property, or relates to a business carried on by the foreign resident through a permanent establishment in Australia.

A change in residency can trigger CGT consequences. When a foreign resident individual, company or trust becomes resident, the taxpayer is taken to have acquired all assets owned at the date of becoming a resident and their cost base is the market value at that time: Subdiv 855B. Assets identified above as taxable Australian property are already within Australia’s jurisdiction and, accordingly, are outside this rule. The subsequent sale of assets may generate a capital gain.

Changing residency 2.34 For taxpayers ceasing to be Australian residents, ITAA97 s 85515 assets constituting taxable Australian real property remain within Australia’s jurisdiction. [page 75] In respect of other assets, however, CGT event I1 occurs25 and the taxpayer, in effect, is taken to have disposed of each relevant asset at market value with the result that an assessable capital gain may occur. There is an important qualification to this situation. If the taxpayer so chooses, the CGT event may be disregarded and the assets in question are simply regarded as being taxable Australian property until either the taxpayer becomes an Australian resident again or, if the taxpayer chooses to wait, until another CGT event involving a cessation of their ownership of the asset occurs, whichever is the sooner. Thus, an individual can elect to treat all assets as having the necessary connection with Australia with the result that any tax is deferred until a future CGT event. The CGT events relevant to a change in residency are discussed in more detail at 6.54.

Trusts and CGT 2.35 Residency considerations discussed above in relation to individuals and companies remain relevant for CGT purposes. CGT event I2 applies if a trust ceases to be an Australian resident. In the case

of a trust, residency for CGT purposes derives from the ITAA97 s 995-1 definition of ‘resident trust for CGT purposes’. The language is similar to the definition of a resident company and, indeed, the trustee may be a company. A unit trust is a resident for CGT purposes if: either any property of the trust is situated in Australia or the trustee carries on business in Australia; and either the central management and control of the unit trust are in Australia or beneficial interests in the trust of more than 50% are held by Australian residents. A non-unit trust is a resident if either the trustee is a resident or the central management and control of the trust are in Australia: see Chapter 15.

Basic jurisdictional concepts 2.36 A more detailed examination of the aspects of residency, source and foreign residents’ liability to Australian tax is provided in Chapter 18. Since 1990–91, the situation has become quite complex. This chapter provides an overview of residency and source in order to establish a working appreciation of Australia’s jurisdictional limits.

Residency of individuals 2.37 ‘Resident’ or ‘resident of Australia’ is defined in ITAA97 s 995-1 to take the meaning in ITAA36 s 6(1) and covers both individuals (natural persons) and companies. Partnerships and trust estates have their own rules in relation to residency that in the main depend upon the residency status of the controlling partners, [page 76] the trustee and beneficiaries. These matters are dealt with under the chapters on partnerships and trustees. The definition is as follows:

resident or resident of Australia means: (a) a person, other than a company, who resides in Australia and includes a person: (i) whose domicile is in Australia, unless the Commissioner is satisfied that his permanent place of abode is outside Australia; (ii) who has actually been in Australia, continuously or intermittently, during more than one-half of the year of income, unless the Commissioner is satisfied that his usual place of abode is outside Australia and that he does not intend to take up residence in Australia; or (iii) who is: [A contributing member (and family) of the superannuation fund for Commonwealth government officers] (b) a company …

The definition purports to be exhaustive but, because it depends on the term ‘reside’, it is tautological — ‘a resident is a person who resides in Australia’. It also contains such terms as ‘domicile’ and ‘permanent [or ‘usual’] place of abode’, which themselves need further elaboration. Nevertheless, it is possible to distil four tests: 1. Common law test: This test focuses on where a person resides. This is the primary test of residency: whether a person resides in Australia according to the ordinary meaning of ‘resides’. People entering Australia as migrants will have their status determined under this common law test (but residency for tax purposes should not be confused with residency for immigration purposes). So, too, will people whose likely stay is less than permanent in the sense of being everlasting. This group includes students studying in Australia or visitors holidaying or visitors such as teachers. If a person resides in Australia in this ordinary sense, it is unnecessary to consider the additional statutory tests. 2. Domicile test: Under the definition, a person is a resident of Australia if domiciled in Australia — unless a permanent place of abode is outside Australia. ‘Domicile’ connotes a legal relationship between a person and a country, and a person is ordinarily, but not necessarily, domiciled in the place where he or she is considered by the law to have their permanent home and, therefore, subject to the laws of that place.

In Australia, there are basically two legal notions of domicile. At birth, everyone is attributed a domicile of origin. The common law rule was that this was determined by a person’s father’s domicile at the time of his or her birth. The Commonwealth legislation modifies this in the case where a person’s parents [page 77]

3.

4.

are living apart at the time of birth: his or her domicile of origin is the domicile of the parent with whom he or she lives and that is preserved until such time as he or she elects to alter that domicile by choice. A domicile of choice is achieved when a person demonstrates an intention to reside permanently in a new country. A change in nationality, for example, would signal a change in domicile. 183-day stay test: This test refers to the relevant year of income; it is necessary to be in Australia, continuously or intermittently, for more than six months. This test is qualified by two requirements: the Commissioner must be satisfied that the usual place of abode is outside Australia and that the person does not intend to take up residence in Australia. One would suspect that, if a permanent place of abode is outside Australia, the person does not intend to take up permanent residence in Australia. It would seem that for a person who is a resident by ordinary concepts (under the first test), the 183-day test would not apply or at least would be qualified by the provisos. For example, a migrant arriving on 1 March would be a resident despite being in Australia for only 120 days (ie, the remaining days of the tax year) because the common law test would apply. As a result, it is possible to contemplate part-year residency without a need for physical presence for six months. On the other hand, a person in Australia for a short stay and never intending to remain would be a foreign resident even though here for more than 183 days. Superannuation test: This is a test for government and diplomatic

personnel. 2.38 Regardless of which of the first three tests applies, it is necessary to examine the meaning of key words and phrases. What do ‘reside’ or ‘permanent place of abode’ mean? Dictionaries make such statements as ‘have one’s home’ and ‘be in residence’. Thus, the s 6(1) definition of ‘resident’ in providing that it ‘means a person who resides in Australia’ is not all that helpful. Neither is Viscount Sumner’s witty observation:26 A man is taxed where he resides. I might almost say he resides wherever he can be taxed.

As a result, it is necessary to examine what the courts have said of the concepts. Broadly, the question of one’s residency, or place of usual or permanent abode, is a matter of fact and the subjectivity of para (a)(i) of the definition is resolved, on balance, giving weight to various matters for determination, such as the following guidelines: Where does the person’s family live? Does the person reside with his or her family? Where was the person physically present during the year of income? Does the person own a home in Australia? What is the person’s nationality? Does the person plan to remain in Australia? [page 78] If the person is temporarily overseas, is the absence of an indefinite period? Where are the person’s investments located? Where are the person’s business interests located? Two cases address central aspects of an individual’s residency: FCT v Applegate (1979) 9 ATR 899; 79 ATC 4307 and FCT v Jenkins (1982) 12 ATR 745; 82 ATC 4098. The cases suggest that where a person who is domiciled in Australia has a home (abode) outside Australia then, so long as the stay outside Australia is indefinite, the ‘permanent place of

abode’ and, therefore, residency is outside Australia. In cases such as these, the facts are vitally important.

FCT v Applegate Facts: The taxpayer was a solicitor employed by a Sydney firm that wanted to expand its operations in the Pacific region. The taxpayer was to establish and operate an office in Vila (formerly capital of the New Hebrides, now Vanuatu) until such time as it could be operated from Sydney. It was expected that the taxpayer would return to Australia in due course but his stay was indefinite. With that object, the taxpayer: acquired a 12-month residency permit (that was extended for a further two years); surrendered the lease of his Sydney flat and left for Vila in November 1971; leased a house in Vila for 12 months with a one-year option; arranged to practise law in Vila. In December 1971, the taxpayer’s wife returned to Australia for the birth of their child. She applied for and received Australian child endowment. Due to ill-health, the taxpayer returned to Australia in May 1973 for treatment. After finalising his affairs in Vila, he returned permanently to Australia in September 1973. Held: The Supreme Court of New South Wales held that the taxpayer was a non-resident during the relevant period. The Full Federal Court dismissed the Commissioner’s appeal. The court held that the phrase ‘permanent place of abode’ meant something less than absolute permanency. It held that, as the Act imposed tax on an annual basis, residency must be determined on an annual basis. It also held that the taxpayer’s intention was only one factor to be considered and that it was unacceptable to decide residency issues on the basis of whether there was a definite intention to return in the immediate or foreseeable future. These conclusions followed from the way in which the phrase ‘permanent place of abode’ appeared with the word ‘domicile’. Franki J said (at ATR 901–2): [page 79] Considering the [definition] in relation to an adult male person whose domicile of origin was Australia, it would be difficult to regard such a person as domiciled in Australia if his permanent place of abode was outside Australia in the sense that he intended to remain forever in that other country unless perhaps it could be said that he had no intention to abandon his domicile of origin. In the case of an adult male whose domicile of choice was Australia it is difficult to see how he could be

domiciled in Australia if he had left Australia with the intention of residing elsewhere permanently in the sense of for the rest of his life … Accordingly, in my opinion, the phrase “permanent place of abode outside Australia” is to be read as something less than permanent place of abode in which the taxpayer intends to live for the rest of his life. Northrop J said (at ATR 906–7): “Permanent” is indeed a relative term, and is not synonymous with “everlasting”. The word “permanent” must be construed according to the context in which it appears … In the present case the phrase “permanent place of abode” appears in a taxing statute by which income tax is levied on income derived during a financial year … The tax is assessable on gross income received on an annual basis and is assessed on an annual basis. The word “permanent” as is used in para (a)(i) of the extended definition of “resident” must be construed as having a shade of meaning applicable to the particular year under consideration. In this context it is unreal to consider whether the taxpayer has formed the intention to live or reside or to have a place of abode outside of Australia indefinitely, without any definite intention of ever returning in the foreseeable future. The Act is not concerned with domicile except to the extent necessary to show whether a taxpayer has an Australian domicile. What is important is whether the taxpayer has abandoned any residence or place of abode he may have had in Australia. Each year of income must be looked at separately. If in that year the taxpayer does not reside in Australia in the sense in which the word has been interpreted, but has formed the intention to, and in fact has, resided outside Australia, then truly it can be said that his permanent place of abode is outside Australia during that year of income. This is to be contrasted with a temporary or transitory place of abode outside Australia. [page 80] In any event the extended meaning of “resident” becomes relevant only when, during the year of income under consideration, the taxpayer does not reside in Australia. Paragraphs (a)(i) and (ii) of the definition are complementary provisions enlarging the group of persons who do not reside in Australia but become liable to pay income tax in Australia.

FCT v Jenkins Facts: The taxpayer was an accountant employed by the ANZ Bank. In 1976, he accepted

an appointment in Vila (New Hebrides, now Vanuatu) for three years but returned within 18 months due to ill-health. Before departing, the taxpayer attempted to sell his Australian home but was unsuccessful and, ultimately, the bank leased the premises for a one-year period. His furniture was stored at the bank’s expense and he kept open an account at his former branch. The taxpayer cancelled membership of his medical benefits fund and wrote to the Department of Social Security advising of his departure for three years. There was no guarantee the term would extend beyond that time. Held: The Supreme Court of Queensland dismissed the Commissioner’s appeal. The taxpayer had a permanent place of abode outside Australia. Although he had formed no intention to remain in Vila longer than the initial appointment of three years, that did not make his stay temporary as compared with ‘permanent’. Sheahan J said (at ATC 4100): It is not and could not be suggested that the taxpayer in question had, at any relevant time, a domicile outside Australia. The question is whether, during any period in 1977 and 1978 he had a permanent place of abode outside Australia. After referring to Applegate’s case, his Honour continued (at ATC 4101): It seems to me that the question then arises how long a stay is a temporary one? If a stay of ten years cannot sensibly be described as “temporary”, why should a period of three years be so regarded? True it is that in the Shorter Oxford Dictionary one of the primary meanings of “temporary” is “lasting for a limited time”. To limit means, inter alia, to assign within limits but I baulk at the notion that a stay out of Australia by a person on transfer for a fixed period of ten years must be regarded as temporary simply because the limits of the stay are fixed and ascertainable. [page 81] His Honour concluded: [I] regard the taxpayer as having a permanent place of abode outside Australia. He was then in anticipation that until February 1980 he would be living in Vila and nowhere else. As for the year ending June 1978 I am unable to discern from the evidence before me whether prior to that date the taxpayer knew that the duration of his stay at Vila was going to be curtailed.

2.39 The decisions in Applegate and Jenkins establish that ‘permanent’ does not mean everlasting, merely indefinite, and so Applegate’s departure for an indefinite but short (three years) period was enough to demonstrate his permanent place of abode was outside Australia despite his being of Australian domicile. Similarly, in Jenkins’s case, the taxpayer had an Australian domicile but the court declined to accept that a three-year period with no definite plans beyond that time

frame was not enough to establish a permanent place of abode outside Australia. Both cases concerned the question of whether the taxpayer was a non-resident at the relevant time but the rules seem to be reversible and concepts of foreign residence can be adopted to determine residency as well. For example, the third test requires that if a person is in Australia for more than six months during a year of income and their stay is for an indefinite period, the tests of the two cases above would class the person as a resident for the year of income. Paragraph (a)(iii) of the definition of ‘resident’ in s 6(1) stipulates that any person employed by the Commonwealth Government, and who contributes to its superannuation scheme, is a resident regardless of where they may be located. For example, all diplomatic appointees would be residents of Australia for income tax purposes.

1.

2.

Jock is an English professional cricketer. He contracts to play cricket for Queensland in the State Cup competition and arrives in Australia on 1 September 2012 for six weeks ‘acclimatisation’ before the start of the competition on 18 October. His wife accompanies him; he has no children. He returns to England on 29 March 2013 after signing an agreement to return in August 2013 for a coaching engagement before playing in the 2013–14 competition. Is Jock a resident for tax purposes? Martin was born in Australia. He trained as an electronic engineer and went overseas in September 1997. For nine months he moved around, working in European countries. In 1998, he worked for [page 82] six months in Malaysia where he met a woman who was working in Kuala Lumpur to support her children living in the Philippines. He entered into a de facto relationship with her and she bore his child in late 1999. Martin’s partner returned to Manila soon after that and they rented an apartment together there in February 1999. Martin paid for the rent, food and schooling costs of all the children (his own child and his partner’s other children). Martin could not find work and started contracting around the world to support his partner and the children. He worked in Poland for six

months in 1999 and then in Turkey and Italy, briefly. Martin returned to Australia several times for various periods, staying with his parents in his childhood bedroom. He also visited the Philippines for short periods to visit his partner and the children. Between early 2000 and January 2002 he worked in various countries, including South Africa and China, visiting Australia and the Philippines several times. On 29 January 2002, he returned to Australia when his relationship with his partner in Manila ended. Martin did not purchase any real estate or other investments overseas. He used an Australian bank account at all times and used this for his living expenses and to send money to his partner in Manila. Prior to leaving Australia, he had sold an apartment in Brisbane and, in 1999, he sold his former personal residence. He retained a vacant block of little value in rural Queensland. Between 1 July 1998 and 30 June 2002, he spent a total of 468 days in Australia. The taxpayer did not pay income tax in any country on his overseas earnings and he did not include his foreign earnings in any of his Australian taxation returns for the 1999–2002 tax years. (i) What common law tests and considerations are relevant in determining Martin’s status? (ii) Applying those tests and considerations, what is Martin’s residential status for tax purposes during the periods to 2002? (iii) If Martin is an Australian resident, how would his foreign-sourced salary be treated? Suggested solutions can be found in Study help.

Residency of companies 2.40 The definition of ‘resident’ for companies is in ITAA36 s 6(1) and reads as follows: [page 83]

resident or resident of Australia means: … (b) a company which is incorporated in Australia, or which, not being incorporated in Australia, carries on business in Australia, and has either its central management and control in Australia, or its voting power controlled by shareholders who are residents of Australia.

The definition makes incorporation in Australia conclusive proof of Australian residency. If not incorporated in Australia, a company may yet be a resident if it carries on business in Australia and either its central management and control are in Australia or it is controlled by shareholders who are Australian residents. Shareholders are those whose names appear on the share registry: FCT v Patcorp Investments Ltd (1976) 140 CLR 247; 6 ATR 420; 76 ATC 4225. If the shareholder is itself a company, the definition in para (b) recurs but there is no provision for tracing through to natural shareholders. If the shareholders are natural persons, the definition in para (a) applies: see 2.37. At general law, a company resides where its real business is carried on and that is where its central management and control are. These elements are included in the s 6(1) definition of ‘resident’ for companies but the definition extends the notion. A company that is incorporated in Australia is conclusively an Australian resident irrespective of the locus of its management and control. For other companies, regard will be had to where the company carries on business and whether either its central management and control are in Australia, or its voting power is controlled by shareholders who are resident in Australia. In Malayan Shipping Co Ltd v FCT (1946) 71 CLR 156; 3 AITR 258; 8 ATD 75 (Malayan Shipping case), it was held that, if central management and control is in Australia, then that means the company is carrying on business in Australia. There are two possible interpretations, one being that expressed by Williams J in the Malayan Shipping case (at ATD 77), that the definition requires there to be the carrying on of business in Australia and, if this condition exists, then one needs to examine where the company’s central management is or where its controlling voters reside. The other view is that, if a company’s central management and control exist in a particular location and if the company is a trading corporation, then it follows that it is carrying on business at the place of its central management and control. In Mitchell v Egyptian Hotels Ltd [1915] AC 1022, Lord Parker of Waddington said (at 1037): Where the brain which controls the operation from which the profits and gains arise is in

this country, the trade or business is, at any rate partly, carried on in this country.

Where central management and control are is largely a question of degree: North Australian Pastoral Co Ltd v FCT (1946) 71 CLR 623; 3 AITR 314; 8 ATD 121. Generally, where the directors meet to do the business of the company resolves the matter: Koitaki Para Rubber Estates Ltd v FCT (1941) 64 CLR 241; 2 AITR 167. However, there are circumstances where that need not be so and, where real [page 84] control is exercised elsewhere, that factor will be decisive: Malayan Shipping case. The decision in Esquire Nominees Ltd v FCT (1973) 129 CLR 177; 4 ATR 75; 73 ATC 4114 suggests that Australian authority perhaps inclines more to formal control than does UK authority. In Esquire Nominees, control was fixed by the place of the directors’ meeting despite the fact that their decisions conformed with the wishes of interests resident elsewhere. However, it remains a question of degree. If central management and control are not in Australia, inquiry is directed to the residency of shareholders. Thus, it must be possible for a company to carry on business and not have central management and control in Australia if the alternative test is to be relevant. In summary: A company incorporated in Australia is conclusively a resident. A company whose central control and management are in Australia is prima facie carrying on business in Australia and, therefore, is a resident. In the absence of central management and control, a company may yet carry on business in Australia and is a resident if, in addition, its shareholders are resident in Australia.

Is the income of an Australian source?

2.41 The source of income connotes a geographical origin. Residents are assessed on their worldwide income, excluding that which is exempt, and they are entitled to tax credits for foreign tax paid on nonAustralian income. The question of source is critical for foreign residents who are assessed for Australian tax only on income having an Australian source. Income derived by foreign residents from sources outside Australia is exempt. It was said by Rich J in Tariff Reinsurances Ltd v CT (Vic) (1938) 59 CLR 194 at 208: [The] question [of the source of income] is “a hard, practical matter of fact”. This means, I suppose, that every case must be decided on its own circumstances, and that screens, pretexts, devices and other unrealities, however fair may be the legal appearance which on first sight they bear, are not to stand in the way of the court charged with the duty of deciding these questions.

In other words, as the Full Federal Court said in Thorpe Nominees Pty Ltd v FCT 88 ATC 4886, the question must be decided in accordance with the practical realities of the situation without giving undue weight to matters of form. In that case, it was held that Australia was the source of the proceeds of the sale of land situated in Australia sold by an Australian resident under options which had been assigned offshore.

Source rules 2.42 The traditional source rules can be summarised under the headings below.

Wages, salaries and contractual payments 2.43 The source of payments for physical work is generally where the work is done, rather than where the contract is executed or where the payment is made: [page 85] compare CT (NSW) v Cam & Sons Ltd (1936) 36 SR (NSW) 544; 4 ATD 32 and FCT v French (1957) 98 CLR 398; 7 AITR 76; 11 ATD

288. However, in FCT v Mitchum (1965) 113 CLR 401; 9 AITR 559; 13 ATD 497, the High Court held that there was no rule of law that, where payment is for performance of work or provision of services, the source of the income is where the work is performed or the services performed. This suggests that where physical performance is not the dominant contractual aspect then it is necessary to look to the dominant feature to determine the source of the related payments. An illustration of the implications of decisions such as French and Mitchum is provided by Case X78 90 ATC 571. The case concerned a non-resident seconded to Australia under an agreement whereby he was subject to a tax equalisation scheme — meaning that the Australian subsidiary paid his Australian income tax liability. The payments were made in arrears with the result that, when the final payment was made, the employee had returned home. The amount was assessable under the former ITAA36 s 25(1)(b) (ITAA97 s 6-5(3)(a)) only if the amount was derived from an Australian source. The Administrative Appeals Tribunal accepted that there was a connection between the payment and the performance of duties in Australia but considered that other factors — particularly the equalisation scheme — added weight to a view that the place where the contract was made was of paramount importance.

Income from trading activities 2.44 The source of trading income is generally determined by the place of the sale contract. Where there are several stages, such as extraction, processing, sale, etc, source will be apportioned on the basis of where the various activities were performed: see further ITAA36 ss 38–43. For businesses conducted other than by sale of goods, or by the sale of property other than trading stock, the same basic considerations apply. One needs to look to where the contracts are made: CT (NSW) v Meeks (1915) 19 CLR 568; Australian Machinery & Investment Co Ltd v DCT (1946) 8 ATD 81. Property income, such as rent or royalties, is probably sourced where the relevant property is situated: FCT v United Aircraft Corp (1943) 68 CLR 525; 7 ATD 318.

Interest

2.45 The question of the source of interest is without established precedent. In general, the source of interest is the place where the credit is provided and this will be either: (a) the place where the obligation to repay the debt arose; or (b) where the loan or credit was given. There is support in the New Zealand case IRC (NZ) v Philips Gloeilampenfabrieken (1954) 10 ATD 435 for both of these alternatives. An alternative view would be that the source of interest is where the borrowed moneys were employed. In Studebaker Corp of A’asia Ltd v CT (NSW) (1921) 29 CLR 225 (Studebaker case), the High Court held that the source of interest was not to be determined exclusively by the locality of the obligation to pay. Rather, all the facts had to be examined and, as was so in the Studebaker case, where the obligation arose out of other activities transacted outside Australia, the interest had that source. For example, where interest arises on trade debts relating to overseas [page 86] sales, it seems that such interest has an ex-Australian source. In practical terms, Australia reserves (under the withholding tax provisions: ITAA36 s 128B) the right to tax any interest payment emanating from within Australia, and in this way avoids any esoteric debate as to where the legal source of such interest may be.

Dividends 2.46 The source of dividends is the origin of the profit from which the dividends are paid. Thus, the source of a dividend paid by an Australian trading company (from Australian sources) to a foreign resident company is Australia. Similarly, when that company passes on its profit, which originated from the Australian source dividend, such dividend will have an Australian source. However, should a second foreign resident company receive such a dividend then it has a nonAustralian source because its profit, in the form of dividends received, came from another non-Australian company.

In Esquire Nominees Ltd v FCT (1973) 129 CLR 177; 4 ATR 75; 73 ATC 4114 at 4117, Barwick CJ said: Further a company may make profits without trading in goods or commodities or for that matter in securities. It may make profits simply by investment and may do so though its investment portfolio consists only of shares in one other company or even of all the shares in one other company. In such a case its net income from its investment will be its profits. Further, in my opinion, the place where the company makes its investment income will be the place where it has its central management and control. It will, of course, be different in the case of a company conducting manufacturing or trading activities. In the case of such companies the place where these activities are carried on can be seen in fact to be the geographical source of the profits these activities yield.

Evidently there is a distinction to be made between trading profits and investment profits for the purpose of attributing source. However, as is the case with interest derived by foreign residents, dividends paid by Australian companies to foreign resident shareholders are the subject of withholding tax which is the final obligation to Australian tax: ITAA36 ss 128B and 128D. Dividends bearing imputation credits are exempt from withholding tax to the extent they are franked: s 128B(3) (ga).

Trading income (from the sale of securities) 2.47 Where a taxpayer is in the business of buying and selling securities, such items are capable of being trading stock: Investment and Merchant Finance Corp Ltd v FCT (1971) 125 CLR 249; 2 ATR 361; 71 ATC 4140. As a result, the traditional source rules relating to the sale of goods apply. Both CT (NSW) v Meeks (1915) 19 CLR 568 and DCT v Kirk [1900] AC 588 support a view that, where there is a series or repetition of activities, the location of such activities determines the source of the profits.

Capital profits 2.48 The references to ‘profits’ in cases concerning source is understood to be a reference to items of both an income and capital nature. It would follow that [page 87]

the same broad considerations are relevant to both classes of earnings or receipts. In essence, source is a question of fact. Given that the event causing capital profits is generally a sale, the source of the profits is usually the place of the contract. However, special rules have arisen in regard to specific types of property. In relation to the sale of shares, reference should be made to Australian Machinery & Investment Co Ltd v DCT (1946) 3 AITR 359; 8 ATD 81. In that case, the taxpayer acquired mining interests in Western Australia and then sold the interests to Australian companies for shares in those companies. The shares in the Australian companies were then sold in the United Kingdom for both cash and other shares, which were subsequently sold in the United Kingdom. The company also purchased and sold in the United Kingdom options relating to shares in an Australian company. Essentially what was at issue was the source of the profit on the sale in the United Kingdom of the Australian companies’ shares. The High Court was unanimous in deciding that the profit on the options was of a UK source. The court approached the other issue by characterising the taxpayer’s activities as a series of operations carried on partly in Australia and partly in the United Kingdom, and so the profit had to be apportioned between these two sources. As a result, it would seem that all members of the court would have attributed a UK source to profits arising if the relevant shares had been both purchased and sold in the United Kingdom. In reaching that conclusion, the court rejected a view expressed at first instance by Rich J that the source of the profits was where the shares were situated (namely, Australia).

Royalties 2.49 As normally understood, royalties are payments made for having been granted permission to exploit another’s asset, and would ordinarily be sourced where the relevant property right or asset was sited: FCT v United Aircraft Corp (1943) 68 CLR 525; 2 AITR 458; 7 ATD 318. For example, an invention patented in France may be licensed to an Australian manufacturer to use in its production of the

invention. Unless it was licensed, the Australian manufacturer would be breaking the law. However, where a foreign property right is used by an Australian business then the royalty may well have an Australian source. Its source may be determined by several factors: the situs of the patent registration, the place where it is exploited and, possibly, the place of execution of the licence agreement. The situation is resolved by deeming royalties paid by an Australian business to a foreign resident patent holder to be sourced in Australia: ITAA36 s 6C. As with interest and dividends, royalties (as defined in ITAA36 s 6(1)) are the subject of a final withholding tax: s 128B. 1. 2. 3.

4. 5.

6. 7. 8. 9. 10. 11. 12.

13. 14.

See N Sherry, Assistant Treasurer, Treasury Forward Work Program for Tax Measures, media release, Commonwealth Government, 2009. London County Council v Attorney-General [1901] AC 26 at 35. Except for a company, the financial year is the income year. For a company, the income year is the previous financial year: ITAA97 s 4-10(2). It is possible, with the Commissioner’s permission, to adopt a substituted accounting period (SAP) where a 30 June balance date is impractical: ITAA36 s 18(1). See Taxation Rulings IT 2360, IT 2497 and IT 2360. See J Waincymer, ‘If At First You Don’t Succeed … Reconceptualising the Income Concept in the Tax Arena’ (1994) 19 MULR 977. See FCT v Mercantile Mutual Insurance (Workers Compensation) Ltd (1999) 42 ATR 8; 99 ATC 4404, where the face value (not the present value) of future claims was held to be deductible. ITAA97 Subdiv 320-A now provides that, for an insurance business, provisions for future claims are to be calculated on a present value basis: see 8.45. H Simons, Personal Income Taxation: The Definition of Income as a Problem of Fiscal Policy, University of Chicago Press, Chicago, 1938, p 50. J R Hicks, Value and Capital, Oxford University Press, Oxford, 1946, p 172. S Mills, Taxation in Australia, Macmillan & Co, London, 1925, p 1. See, for example, Re Income Tax Acts (No 2) [1930] VLR 233; [1930] R&McG 273. See London Australia Investment Co Ltd v FCT (1977) 138 CLR 106; 7 ATR 757. Refer back to the question in 2.1. Was the value of employment benefits, such as free or subsidised accommodation, part of your definition of ‘income’? See London Australia Investment Co Ltd v FCT (1977) 138 CLR 106; 7 ATR 757; 77 ATC 4398; FCT v Whitfords Beach Pty Ltd (1982) 150 CLR 355; 12 ATR 692; 82 ATC 4031; Memorex Pty Ltd v FCT (1987) 77 ALR 299; 19 ATR 553; 87 ATC 5035. FCT v Citibank Ltd (1993) 44 FCR 434; 93 ATC 4691. ITAA36 s 25(1) was the predecessor to ITAA97 s 6-5. It assessed ‘gross income’ derived. There was some difficulty with accepting that ‘net profit’ could be ‘gross income’. In

15.

16. 17.

18.

19. 20.

21. 22. 23.

24.

25. 26.

ITAA97 s 6-5, the difficulty is not so apparent, but it needs to be appreciated that, in appropriate circumstances, the word ‘income’ in s 6-5 can be net profit. It is also well settled that such losses are allowable deductions where they are on revenue account: Texas Co (Australasia) Ltd v FCT (1940) 63 CLR 382; 2 AITR 4; Armco (Australia) Pty Ltd v FCT (1948) 76 CLR 584; 4 AITR 116; Caltex Ltd v FCT (1960) 106 CLR 205; 8 AITR 25. Commercial & General Acceptance Ltd v FCT (1977) 137 CLR 373; 7 ATR 716 at 721; 77 ATC 4375 per Mason J. This distinction is not trivial. If an amount is exempt income, it must be taken into account in determining whether there is a loss that may be carried forward to a later year of income. That is, for there to be a loss, deductions must exceed assessable income plus net exempt income: ITAA97 s 36-10. An amount of ordinary income may also be exempt to the extent that the Act excludes it expressly or by implication from being assessable income (ITAA97 s 6-20(2)); for example, ITAA36 s 121EG dealing with offshore banking. Some pensions (but not the aged pension) are specifically exempted: for example, ITAA97 Subdivs 52-B and 52-C in relation to certain veterans’ entitlements. The exemption is preserved in the case of a partnership by the operation of ITAA36 s 92(3). In the case of a presently entitled beneficiary of a trust deriving exempt income, the exemption is preserved by ITAA36 s 97(1)(b). Assessments to the trustee under ITAA36 s 98 or s 99 refer to the ‘net income of the trust’, which is calculated as if the trustee were a taxpayer: ITAA36 s 95. See the ATO website at ‘Tax rates and codes’ for individuals at (accessed 15 September 2017). See also Boating Industries Association of NSW v FCT (1985) 85 ATC 4224. These jurisdictional limitations are mirrored in Divisions of the Acts concerned with the taxation of partners in a partnership, beneficiaries in a trust and shareholders in a company. For foreign resident recipients of dividends, interest and royalties, liability to Australian tax is limited to a final withholding tax: ITAA36 s 128B. This required an interpretation of the words ‘gross income’ in former ITAA36 s 25(1) to mean ‘total income’ and for all income to enter assessment through that provision. For a long time, ‘gross income’ was taken to mean ‘not net income’ as conventional wisdom relied on the accepted structure of the Act as taxing gross income minus allowable deductions. For an examination of the argument and issues, see R W Parsons, Income Taxation in Australia, Law Book Co, 1985, Ch 1. See ITAA97 s 104-160. CGT event I1 happens when an entity ceases to be an Australian resident. Levene v IRC [1928] AC 234 at 244. In Gregory v FCT (1937) 57 CLR 774; 1 AITR 201, the High Court endorsed the English principle that, for tax purposes, a person may be a resident of two countries.

[page 89]

CHAPTER

3

Income According to Ordinary Concepts Learning objectives After studying this chapter, you should be able to: specify items that in general are and are not income by ordinary concepts; identify criteria for distinguishing income from capital receipts; apply the income/capital distinction to given fact situations; distinguish income from mere gifts; characterise receipts as income from employment or provision of services; list factors pointing to the existence of a business; characterise payments arising from isolated transactions; apply the income propositions to given fact situations.

Introduction 3.1 The nature of ‘a tax on income’ and the notion of income by ordinary/judicial concepts were introduced in Chapter 2. In the context of the Income Tax Assessment Act 1936 (Cth) and Income Tax Assessment Act 1997 (Cth) (ITAA36 and ITAA97 respectively),

assessable income is made up of ordinary income plus statutory income. Assessable income does not include exempt income. The nature and ambit of statutory income is developed in subsequent chapters. This chapter examines in detail the concept of ordinary income. Decisions such as FCT v Rowe (1997) 187 CLR 266; 35 ATR 432; 97 ATC 4317 (see 2.16) and FCT v Cooling (1990) 22 FCR 42; 21 ATR 13; 90 ATC 4472 (see 2.17) demonstrate that in determining the character of an item, it is necessary to examine ‘the whole of the circumstances’ and the ‘how and why’ of the receipt. One method of analysing receipts is to look for certain attributes that like items of income commonly possess. From an examination of the authorities, it should be possible to deduce a number of statements or propositions about what is, and what is not, ordinary income. The income propositions outlined in this chapter are advanced with that object in mind but, by their nature, not all these propositions are universal statements or laws. No receipt must necessarily exhibit all the features mentioned and, in any given set [page 90] of circumstances, no single element need be decisive. As the courts have warned on numerous occasions, these characteristics were developed in relation to other fact situations. They are helpful by way of analogy only. That even common factual circumstances can produce different outcomes is demonstrated by the decisions in Just v FCT (1949) 4 AITR 185; 8 ATD 419 and Colonial Mutual Life Assurance Society Ltd v FCT (1953) 89 CLR 428; 5 AITR 597, which are examined below. In addition to illustrating the point, these cases underscore a critical aspect of characterising receipts: whether they are in the nature of income or not depends on the character they have in the hands of the recipient.

Just v FCT Facts: The Just Brothers sold a property valued at £17,500 to the CML Assurance Society for consideration of 90% of certain rents for 50 years from tenants of new buildings erected on the land. Held: The amounts were income. Webb J said (at AITR 187–8): If £17,500 were indicated in the agreement … as the purchase price of the land, and not merely as its value for stamp duty purposes, the payments under the encumbrance might be held to be instalments of the purchase and interest on the balance of the purchase price outstanding although the instalments would be uncertain and might over the period of 50 years amount to more or less than £17,500 … But no purchase price is so indicated. I think the substance of the transaction is that the Justs bargained to have not a capital sum but an income.

Colonial Mutual Life Assurance Society Ltd v FCT Facts: CML Assurance acquired property from the Just Brothers in the circumstances outlined above. The company claimed a deduction for the proportion of rent paid to the vendors. Held: The expenditure was not deductible under the former ITAA36 s 51(1) as it was an outgoing of capital being simply a series of payments constituting the price of land purchased as a capital asset. Fullagar J (with whom Kitto and Taylor JJ agreed) said (at AITR 608–10): For the purposes of income taxation, such payments as the company engaged to make in this case have commonly a double aspect. In Australia the form which the questions take is conditioned by the fact that the tax is imposed on [page 91] assessable income less specific categories of allowable deductions. The first question which is raised is whether the amounts paid constitute, as and when

received, assessable income in the hands of the payee. The second is whether, for the purpose of ascertaining the taxable income of the payor, the amounts paid are allowable deductions from assessable income. Although it will not seldom happen that payments that are assessable income of the payee will be allowable deductions of the payor, this is by no means necessarily so, and the truth is that different considerations govern the two questions. In the first case the question will generally be simply whether the receipt in question is of an income nature or of a capital nature: a constantly recurring and often very difficult question, which depends on general principles which have been laid down by the courts. In the second case the question generally will be whether the case falls within s 51(1) of the Act [ITAA36], which, so far as material, allows the deduction of all losses and outgoings to the extent to which they are incurred in gaining or producing the assessable income or are necessarily incurred in carrying on a business for the purpose of gaining or producing such income except to the extent to which they are losses or outgoings of capital or of a capital nature. The issue of the “capital nature” of the payments is seen to be possibly relevant to both questions but the considerations which must guide one to an answer are themselves different in the two cases. It is, however, the second aspect of the transaction in 1934 that is material for present purposes, and the present question is whether the monthly payments to Just Brothers are allowable deductions from the assessable income of the company. Considerations which are relevant to the other aspect of the transaction appear to me to be irrelevant here. For it is incontestable here that the moneys are paid in order to acquire a capital asset. The documents made it quite clear that these payments constitute the price payable on a purchase of land, and that appears to me to be the end of the matter.

3.2 The sale of a capital asset generates a capital receipt: see Proposition 2 in 3.8. Ordinarily, the proceeds from the sale of property by the Just Brothers would have been capital but the terms of the sale converted the amount into an income stream or annuity. No doubt influenced by the conclusion that the payments were revenue in the hands of the Just Brothers, CML Assurance sought a deduction of what would ordinarily be regarded as a capital outlay only to have the High Court confirm that [page 92] the payment was indeed capital.1 There is no natural symmetry between

the tax treatment of a receipt and its payment. As Gaudron, Gummow and Kirby JJ said in FCT v Rowe (1997) 187 CLR 266; 35 ATR 432; 97 ATC 4317, the operation of the Act turns on the identification of income by the imprecise criterion of the ordinary concepts and usages of mankind. While that state of affairs remains, it is not to be expected that there would be symmetry between amounts assessable under ITAA97 s 6-5 and deductible under s 8-1. It is necessary to look at each amount from the perspective of both parties to the transaction. The payment by CML was capital; the receipt by the Just Brothers was income.

Income propositions 3.3 As the following propositions are considered, it should be kept in mind that no amount must possess all the following characteristics and, in any given set of factual circumstances, no single element need be decisive. Negative propositions: Items that are not income by ordinary concepts 1. Amounts not convertible into money are not ordinary income. 2. Capital amounts do not have the character of income. 3. Gifts unrelated to employment, services or business do not have the character of income. 4. The proceeds of gambling and windfall gains are not income. 5. Mutual receipts are not income. Positive propositions: Characteristics of income by ordinary concepts 6. To be income, an amount must be beneficially derived. 7. Income is to be judged from the character it has in the hands of the recipient. 8. Income generally exhibits recurrence, regularity and periodicity. 9. Amounts derived from employment or the provision of services are income. 10. Amounts derived from carrying on a business are income. 11. Amounts derived from property are income. 12. Amounts received as substitutes or compensation for lost income are themselves income.

As these propositions are examined, it should be remembered that many items excluded from ordinary income under the negative

propositions are now addressed by specific provisions. This is particularly so of Proposition 1 (see 3.4) and Proposition 2 (see 3.8). [page 93]

Proposition 1: Amounts not convertible into money are not ordinary income 3.4 To be ordinary income, an amount must be in money or capable of conversion into money. The leading cases, Tennant v Smith [1892] AC 150 and FCT v Cooke & Sherden (1980) 10 ATR 696; 80 ATC 4140, are discussed at 2.10. They show that it is not enough that a benefit is valuable in money or, in fact, saves a taxpayer from expenditure. The amount must be convertible into money in a practical sense. In Cooke & Sherden, the Federal Court said (at ATC 4148): If a taxpayer receives a benefit which cannot be turned to pecuniary account, he has not received income as that term is understood according to ordinary concepts and usages.

The court speculated that if the benefits the taxpayers received could be surrendered for cash, the benefits would have been income. However, the court continued (at ATC 4148): The conversion of an item into money may occur, of course, in a variety of ways. It is not desirable (even if it be possible) to define in advance the ways in which conversion may possibly occur in order that a non-pecuniary item of receipt might be treated as an item of income. However, it will not often occur that a benefit to be enjoyed by a taxpayer cannot be turned to pecuniary account if the benefit be given up, or if it be employed in the acquisition of some other right or commodity.

There will be circumstances where a benefit cannot be used to acquire some other right or property. It might be illegal to deal in property without a licence. The terms of the contract might prevent the assignment of the benefit or its surrender or use in ways other than as stipulated. Consider the Federal Court decision in Payne v FCT (1996) 32 ATR 516; 96 ATC 4407.

Payne v FCT Facts: The taxpayer was employed by accounting firm KPMG and was obliged to travel regularly for business purposes. In 1991, she joined the Qantas Frequent Flyers Program under the terms of which points were accumulated that could be redeemed for travel by the member or a person in the member’s family. Tickets could not be sold or exchanged and points could not be pooled or assigned. The majority of points accumulated by the taxpayer resulted from travel paid for by KPMG. In 1993, the taxpayer surrendered points for airline tickets for her parents. The Commissioner contended the tickets were income under (the former ITAA36) s 25(1).a Held: The tickets were not transferable and, if sold, were subject to cancellation. They were not money and could not be converted into money and so were not income. After referring to the decision in Cooke & Sherden, Foster J said (at ATC 4413): [page 94] The analogy with the present case is obvious. The reward tickets available because of the accrual of the required number of points could be used only by the Program member or his or her permitted nominee. They were not transferable and if sold were subject to cancellation. They were not money and could not be turned to pecuniary account. They could not therefore be regarded as income within the meaning of [ITAA36] s 25(1).b

a.

b.

The Commissioner also contended that the tickets were assessable under ITAA36 s 26(e), which provided that assessable income included the value to the taxpayer of benefits granted directly or indirectly in relation to employment or services rendered. This provision, being a statutory extension to ordinary income, did not require convertibility to money and assessed the ‘value to the taxpayer’: see 3.6 and Chapter 5. The benefit was held not to be assessable under ITAA36 s 26(e) because it arose from a personal entitlement arising from a contractual relationship between the taxpayer and Qantas, not because of her employment with KPMG.

Foster J left open the question whether the tickets constituted a benefit within the meaning of ITAA36 s 26(e): at ATC 4416.

Convertibility issues 3.5 A question arises whether a non-convertible amount is denied the quality of income because of legal or contractual restrictions (eg, the sale of an item is illegal), or whether the problem is fundamental inconvertibility (in the sense that income is what comes in, not what is saved from going out). In Cooke & Sherden, the Federal Court observed (at ATC 4148) that ‘it will not often occur’ that a benefit cannot be converted into money or exchanged for some other right or commodity. Contractual restrictions on saleability or transfer, such that the benefit is cancelled, provide one instance where convertibility cannot occur. There is a suggestion in Payne’s case that an undetected transfer in breach of the terms of the contract would be fraudulent and not remove the fundamental inconvertibility. If legality was the issue, all benefits would be non-convertible in the hands of the recipient in cases where conversion was prohibited by law or (in the hands of the unlicensed) where licences were required for sale. However, there is longstanding UK authority that an amount may be income notwithstanding the illegality of the transaction. In Lindsay v IRC (1933) 18 TC 43, the profits from selling whisky in the United States during the prohibition era were held to be taxable.2 So if legality is not the issue, it must be fundamental inconvertibility. It seems that ITAA36 s 21A (see below) was enacted on that assumption. [page 95] In Abbott v Philbin [1961] AC 352, Lord Radcliffe asked rhetorically (at 378): Must the inconvertibility arise from the nature of the thing itself or can it be imposed merely by contractual stipulation? Does it matter that the circumstances are such that

conversion into money is a practical, though not a theoretical, impossibility; or, on the other hand, that conversion, though forbidden, is the most probable assumption?

The Federal Court declined to answer these questions in Cooke & Sherden, leaving open the issue of whether there are principles universally applicable or the issue depends on the facts of a particular case.

Statutory responses 3.6 There have been three statutory responses to the convertibility issue. First, ITAA36 s 26(e) attempted to overcome the decision in Tennant v Smith [1892] AC 150. It provided: 26 The assessable income of a taxpayer shall include: … (e) the value to the taxpayer of all allowances, gratuities, compensations, benefits, bonuses and premiums given or granted to him in respect of, or for or in relation directly or indirectly to, any employment of or services rendered by him, whether so allowed, given or granted, in money, goods, land, meals, sustenance, the use of premises or quarters or otherwise …

This provision (and ITAA97 s 15-2) is examined further under Proposition 9: see 3.38 and Chapter 5. For present purposes, it should be noted that the provision did not apply in Cooke & Sherden because the taxpayers, being contractors, were not employees and had not rendered services to the manufacturer in the sense required by s 26(e). It was a relationship of buyer and seller not of rendering of services. In Payne’s case, s 26(e) did not apply because, although the taxpayer was an employee, employment was not wholly or partly the reason for the benefit. Qantas granted the benefit because of the taxpayer’s membership of the frequent flyers scheme. Second, to overcome the decision in Cooke & Sherden, ITAA36 ss 21 and 21A were introduced in 1988. Section 21 provides as follows. 21 Where consideration not in cash (1) Where, upon any transaction, any consideration is paid or given otherwise than in

cash, the money value of that consideration shall, for the purposes of this Act, be deemed to have been paid or given. (2) This section has effect subject to section 21A.

[page 96] Section 21A provides: 21A Non-cash business benefits (1) For the purposes of this Act, in determining the income derived by a taxpayer, a noncash business benefit that is not convertible to cash shall be treated as if it were convertible to cash. (2) For the purposes of this Act, if a non-cash business benefit (whether or not convertible to cash) is income derived by a taxpayer: (a) the benefit shall be brought into account at its arm’s length value reduced by the recipient’s contribution (if any); and (b) if the benefit is not convertible to cash in determining the arm’s length value of the benefit, any conditions that would prevent or restrict the conversion of the benefit to cash shall be disregarded. … (5) In this section: … non-cash business benefit means property or services provided after 31 August 1988: (a) wholly or partly in respect of a business relationship; or (b) wholly or partly for or in relation directly or indirectly to a business relationship.

There are important differences between ITAA36 ss 21 (which operates subject to s 21A), 21A and 26(e). Section 26(e) was an assessing provision that included in assessable income the ‘value to the taxpayer’ of certain benefits, allowances, etc. Section 21A is not an assessing provision. It overrules the convertibility principle in relation to non-cash business benefits and provides for the valuation of benefits. If an amount is income but for its inconvertibility to money, that restriction is disregarded.3 3.7 Taxation legislation requires that amounts be expressed in Australian currency: ITAA97 s 960-50. The effect of ITAA36 s 21 is to

convert into money the non-money consideration passing in a transaction. For example, in a barter transaction, money consideration will be deemed to have been paid. However, s 21 does not make the consideration income if it is not so already. If the barter transaction is a non-cash business benefit, ITAA36 s 21A will remove any problems of non-convertibility to money and, if the barter occurs in the course of business, it will have an inherent income nature assessable under ITAA97 s 6-5 at the value determined under s 21A(2). [page 97] But s 21A will not apply in the circumstances of Payne’s case, even if the taxpayer was self-employed, because the benefits are not in respect of a business relationship.

1.

Neighbours Felix and Oscar are retired and devote their spare time to gardening. Felix grows marrows that are the envy of the neighbourhood. Oscar’s rhubarb has won him many admirers. On a regular basis, they exchange surplus stocks. Would ITAA36 s 26(e) [ITAA97 s 15-2], s 21 or s 21A apply to the exchange? 2. Designa-Kitchens manufactures kitchen cupboards. During the course of Kitchen Expo, it offered prizes of kitchen units to the value of $5000 to the 5000th visitor and the most successful consultant at its booth. (a) Would ITAA97 s 6-5 apply to either of the transactions? (b) Would ITAA36 s 26(e) [ITAA97 s 15-2], s 21 or s 21A apply to the award to the consultant? (c) Would there be any difference if the prize to the consultant was airline tickets? A suggested solution may be found in Study help.

The third response was the adoption of a new strategy to tax benefits arising from employment: the Fringe Benefits Tax Assessment Act 1986 (Cth). Fringe benefits are discussed in Chapter 7.4 The fringe benefits

legislation introduced formulae to value-specified benefits provided by employers (or their associates) to employees (or their associates).

Proposition 2: Capital amounts do not have the character of income 3.8 The evolution of the ordinary/judicial income concept has established a fundamental dichotomy between income and capital that is not evident in economics or accounting.5 Ordinary income does not include a capital receipt. Some statutory [page 98] extensions to income, notably the taxation of capital gains, have reduced the practical importance of the distinction, at least in relation to assessable income. There are three reasons to distinguish income from capital for taxation purposes. Two relate to income matters: 1. Ordinary income assessable under ITAA97 s 6-5 does not include capital. It follows that if an item of capital is to be assessable to tax, it must enter through statutory income. 2. Capital receipts that generate capital gains are assessable under ITAA97 Div 102, and specific rules operate to determine the amount of taxable capital gains. Specific exemptions apply and the gain may be discounted by 50%. The third reason relates to issues of deductibility (examined in detail in Chapter 8 and Chapter 9): 3. Losses and outgoings of capital are not allowable deductions under the general deduction provision ITAA97 s 8-1. Also, expenditure of a capital nature is not an allowable deduction under certain specific provisions such as ITAA97 s 25-10, a specific provision allowing a deduction for repairs. Write-off of

depreciating assets may be allowable deductions as capital allowances in Div 40: see Chapter 10. The identification of criteria to distinguish income from capital both for income and outlays is a critical step in appreciating principles of taxation. In relation to losses and outgoings, it may be stated that expenditure to expand or enhance a profit-making structure will be on capital account (Sun Newspapers Ltd and Associated Newspapers Ltd v FCT (1938) 61 CLR 337; 1 AITR 353 (Sun Newspapers); Mt Isa Mines Ltd v FCT (1992) 176 CLR 141; 24 ATR 261; 92 ATC 4755), whereas repair or restoration of the profit-yielding structure or the acquisition or replacement of working or circulating capital (as opposed to fixed capital) will be on revenue account (FCT v Western Suburbs Cinemas Ltd (1952) 56 CLR 102; 5 AITR 300; John Fairfax & Sons Pty Ltd v FCT (1959) 101 CLR 30; 7 AITR 346). The application of the revenue/capital distinction to deductions is considered in Chapter 8.6 The application of the income/capital dichotomy to employment or the provision of services or from carrying on a business is considered under Propositions 9 and 10: see 3.38 and 3.44 respectively. On the income side, it may be stated at the outset that capital receipts and profits arising from the mere realisation of a capital asset are not income, but where what is done is truly the carrying on of a business the proceeds will be on revenue account: California Copper Syndicate Ltd v Harris (Surveyor of Taxes) (1904) 5 TC 159 (California Copper Syndicate); FCT v Myer Emporium Ltd (1987) 163 CLR 199; 18 ATR 693; 87 ATC 4363. Payments for the loss or sterilisation of a profitmaking structure will be on capital account but payments for nonperformance of a contract or compensation for the loss of profits will be on revenue account: Heavy Minerals Pty Ltd v FCT (1966) 115 CLR 512; 10 AITR 140. An isolated transaction entered into with the intention of making a profit will produce a revenue [page 99] amount: FCT v Myer Emporium Ltd; FCT v Whitfords Beach Pty Ltd

(1982) 150 CLR 355; 12 ATR 692; 82 ATC 4031.

The income/capital dichotomy 3.9 Criteria for distinguishing capital and revenue outlays in terms of s 8-1 derive from the decision in Sun Newspapers and are well settled, even though their application is often difficult. The position in relation to receipts compares unfavourably with outlays in that there is no one equivalent authority in relation to s 6-5. The authorities adopt several lines of inquiry. As a prelude to examining a series of cases where the distinction has been applied, four approaches to distinguishing income and capital are identified: 1. ‘Dixon’s criteria’ from Sun Newspapers; 2. ‘mere realisation’ from California Copper Syndicate; 3. nature of consideration given for the receipt; 4. fixed and circulating capital. The approaches are not mutually exclusive and aspects of each of them are reflected in the cases discussed in 3.10–3.13.

‘Dixon’s criteria’ 3.10 In Australia, the test for distinguishing outgoings on revenue as opposed to capital account derives from Sun Newspapers Ltd and Associated Newspapers Ltd v FCT (1938) 61 CLR 337; 1 AITR 353.

Sun Newspapers Ltd and Associated Newspapers Ltd v FCT Facts: Sun Newspapers (Sun) was the publisher of a number of journals. Associated Newspapers (Associated), which held nearly all the shares in Sun, entered into an agreement to pay a rival publisher £86,500 if it agreed not to publish within 300 miles of Sydney for three years and to pass over control of plant and equipment. As a result, the rival went out of business. The payment was claimed as a deduction allowable to either Sun or Associated.

Held: The High Court found no part of the outgoing was allowable as it was an outgoing of capital. In a widely quoted judgment, Dixon J said (at AITR 410–13): The distinction between expenditure and outgoings on revenue account and on capital account corresponds with the distinction between the business entity structure or organisation set up or established for the earning of profit and the process by which the organisation operates to obtain regular returns by way of regular outlay, the difference [page 100] between the outlay and returns representing profit or loss. The business structure or entity or organisation may assume any of an almost infinite variety of shapes and it may be difficult to comprehend under one description all the forms in which it may be manifested. In a trade or pursuit where little or no plant is required, it may be represented by no more than the intangible elements constituting what is commonly called goodwill … On the other hand it may consist in a great aggregate of buildings, machinery and plant all assembled and systematised … But in spite of the entirely different forms, material and immaterial, in which it may be expressed, such sources of income contain or consist in what has been called “a profit yielding subject”, the phrase of Lord Blackburn in United Collieries Ltd v IRC (1930) 12 TC 1248…. There are, I think, three matters to be considered: (1) the character of the advantage sought, and in this its lasting qualities may play a part; (2) the manner in which it is to be used, relied upon or enjoyed and in this and under the former head recurrence may play its part; and (3) the means adopted to obtain it; that is by providing a periodical reward or outlay to cover its use or enjoyment for periods commensurate with the payment or by making a final provision or payment so as to provide future use or enjoyment.

Although Sun Newspapers was concerned with capital outgoings, the tests and considerations nominated by Dixon J suggest a working hypothesis for incomings:7 receipts arising in the ordinary operation of a business will be on revenue account; receipts relating to the loss or destruction of the profit-making structure will be capital in nature. The process–structure distinction is often illustrated by reference to the US decision Eisner v Macomber 252 US 189 (1920), where capital was compared to a tree and income to the fruit. A receipt relating to the

tree, such as consideration for its sale or compensation for its loss or destruction, would be capital. Compensation for the loss or sterilisation of the income-producing base or of the right or ability to earn income would be a capital receipt. Payments for the sale of the fruit are income and compensation for its loss or damage is to be seen as a substitute for income. These receipts relate to the process of earning income, not the structure or apparatus [page 101] through which income is earned. Conversely, on the expenditure side, the acquisition cost of an orchard would be on capital account and the cost of tending the trees would be process related.

California Copper principle 3.11 In California Copper Syndicate Ltd v Harris (Surveyor of Taxes) (1904) 5 TC 159 (California Copper Syndicate), the company acquired copper-bearing land in California but had insufficient funds to mine the copper. The land was sold to another company at a profit in consideration of an allotment of shares in that company. The profit was held to be income in nature because it was always the company’s intention to profit from the sale of the land. It was not the substitution of one investment for another but a trading transaction. In a frequently quoted statement of the law, the Lord Justice Clerk said (at 165–6): It is quite a well-settled principle, in dealing with questions of assessment of income tax, that where the owner of an ordinary investment chooses to realise it, and obtains a greater price for it than he originally acquired it at, the enhanced price is not profit … assessable to income tax. But it is equally well established that enhanced values obtained from realisation or conversion of securities may be so assessable where what is done is not merely a realisation or change of investment, but an act done in what is truly the carrying on, or carrying out, of a business … What is the line which separates the two classes of cases may be difficult to define, and each case must be considered according to its facts; the question to be determined being — is the sum of gain that has been made a mere enhancement of value by realising a security or is it a gain made in the operation of business in carrying out a scheme of profit making?

The principle in California Copper Syndicate is that the mere

realisation of an asset does not produce an income amount. The test is: Is the gain that has been made a mere enhancement of value by realising an asset? Is the gain made in the operation of a business in carrying out a scheme of profit making? In FCT v Myer Emporium Ltd (1987) 163 CLR 199; 18 ATR 693; 87 ATC 4363, the Full High Court restated the principle in California Copper Syndicate, adding that the important proposition that derived from that decision was that a receipt may constitute income from an isolated transaction entered into otherwise than in the ordinary course of income production so long as the taxpayer entered into the transaction with the intention of making a profit. On the question of a ‘mere realisation’ of an asset, the court said (at CLR 213): The proposition that a mere realisation or change of investment is not income requires some elaboration. First, the emphasis is on the adjective “mere” … Secondly, profits made on a realisation or change of investments may constitute income if the investments were initially acquired as part of a business with the intention or purpose that they be realised subsequently in order to capture the profit arising from their expected increase in value …

These decisions make it clear that the proceeds from a ‘mere realisation’ of an asset are not income by ordinary concepts. The proceeds do not become income simply because expert advice is sought in connection with the sale or, in the case of the sale of land, subdivision, road building and the provision for services is carried out in the [page 102] course of realising the asset advantageously.8 However, as the High Court pointed out in Myer Emporium, the emphasis is on the adjective ‘mere’. In FCT v Whitfords Beach Pty Ltd (1982) 150 CLR 355; 12 ATR 692; 82 ATC 4031, Mason J said (at CLR 385): I do not agree with the proposition … that sale of land which has been subdivided is necessarily no more than the realization of an asset merely because it is an enterprising way of realizing that asset to the best advantage. That may be so in the case where an

area of land is merely divided into several allotments. But it is not the case such as the present where the planned subdivision takes place on a massive scale, involving the laying-out and construction of roads, the provision of parklands, services and other improvements. All this amounts to development and improvement of the land to such a marked degree that it is impossible to say that it is a mere realization of an asset.9

Nature of the consideration given for a receipt 3.12 An alternative approach to distinguishing income and capital is to examine the consideration provided by the recipient of money. This approach contains elements of tests discussed under Proposition 7: Income is to be judged from the character it has in the hands of the recipient (see 3.35), which are grounded in Hayes v FCT (1956) 96 CLR 47; 6 AITR 248 and Scott v FCT (1966) 117 CLR 514; 10 AITR 367. However, the test adapts well to income/capital distinctions, as Brennan J indicated in Federal Coke Co Pty Ltd v FCT (1977) 34 FLR 375; 7 ATR 519 at 539; 77 ATC 4255: When a recipient of moneys provides consideration for the payment, the consideration will ordinarily supply the touchstone for ascertaining whether the receipt is on revenue account or not. The character of an asset which is sold for a price, or the character of a cause of action discharged by a payment will ordinarily determine, unless it be a sham transaction, the character of the receipt of the price or payment. The consideration establishes the matter in respect of which the moneys are received. The character of the receipt may then be determined by the character, in the recipient’s hands, of the matter in respect of which the moneys are received. Thus, when moneys are received in consideration of surrendering a benefit to which the recipient is entitled under a contract, it is relevant to enquire whether or not that benefit was a capital asset in his hands.

As a result, consideration for the sale of a capital asset that was not acquired for profit making by sale or relevantly used in a business10 is on capital account. This conclusion is consistent with the outcome that would result from applying the ‘California Copper principle’ or ‘Dixon’s criteria’. In Federal Coke Co, the payment was voluntary from the taxpayer’s perspective and, in that case, as well as cases involving non-contractual receipts, Brennan J suggested an examination of the ‘how and why’ of the receipt may reveal the matter [page 103]

for which the amount is received. It may be that this approach is most useful in situations where payment arises out of an unusual or special contractual arrangement. For example, in MIM Holdings Ltd v FCT (1997) 36 ATR 108; 97 ATC 4420, payments received by a holding company to ensure a subsidiary company supplied electricity were described in the contract as non-refundable capital contributions as compensation for a permanent reduction in the value of its investment in its subsidiary. However, the Full Federal Court held the payments were on revenue account. The consideration given by the taxpayer was to ensure supply of electricity and that was an ordinary incident of carrying on its business. Similar reasoning is illustrated in GP International Pipecoaters Pty Ltd v FCT (1990) 170 CLR 124; 21 ATR 1; 90 ATC 4413. In that case, the High Court held that costs of the construction of plant paid by the State Energy Commission of Western Australia to the contractor taxpayer were made in the ordinary course of the taxpayer’s business and were revenue in nature. The court said (at CLR 142): But it cannot be accepted that an intention on the part of a payer and a payee or either of them that a receipt be applied to recoup capital expenditure of the payee determines the character of a receipt when the circumstances show that the payment is received in consideration of the performance of a contract, the performance of which is the business of the recipient or which is performed in the ordinary course of the business of the recipient.

Fixed and circulating capital 3.13 The accounting distinction between fixed and working or circulating capital provides a workable but imperfect basis for applying the income/capital distinction. In the accounting literature, a current asset consists of cash, or other assets of the entity that would, in the ordinary course of the operations of that entity, be consumed or converted into cash within 12 months of the end of the last financial year of the entity. Fixed (or non-current) assets are all assets other than current assets and working capital is current assets minus current liabilities. The courts have referred to the circulating–fixed asset distinction a number of times and nominated several items that fall within the ambit

of each term but there is no definitive statement of its relevance and application to the broader distinction between income and capital. Fixed capital is that from which a return on operations is expected. The return from operations is in the form of working or circulating capital: BP Australia Ltd v FCT (1965) 112 CLR 386; 9 AITR 615; AGC (Advances) Ltd v FCT (1975) 132 CLR 175; 5 ATR 234; 75 ATC 4057. Losses of circulating capital, such as debts and expenditure to acquire items of circulating capital — for example, trading stock — are on revenue account. Receipts from transactions that are made in the ordinary course of a business are clearly on revenue account and receipts arising from the mere realisation of an investment are on capital account: California Copper Syndicate Ltd v Harris (Surveyor of Taxes) (1904) 5 TC 159; FCT v Myer Emporium Ltd (1987) 163 CLR 199; 87 ATC 4363. Thus, the sale of (fixed) capital assets will generate a capital receipt. Sale of trading stock and revenue assets will produce an income receipt. Whether an item of circulating capital is a capital or revenue asset depends on the nature and scope of a particular business. [page 104] Consider these distinctions in the circumstances of Memorex Pty Ltd v FCT (1987) 19 ATR 553; 87 ATC 5034.

Memorex Pty Ltd v FCT Facts: Memorex was in the business of selling and leasing computer equipment. Leased equipment was either sold directly to a customer’s financier or leased directly to customers. Equipment leased directly to customers was depreciated and a deduction was allowed for tax purposes. Such formerly leased equipment was then sold to the lessee or to a finance company and, where the sale price was in excess of the acquisition cost, the company treated such profit as abnormal and of a capital nature. Before the Full Federal Court, the taxpayer made three submissions:

The Act did not tax profit but taxable income, being assessable income less deductions. Separate codes of the Act operated to cover particular items such that depreciated plant was exclusively covered by the depreciation provisions and the profit was not taxable under that code. 2. To be taxable, it must be shown that the equipment was acquired for the purpose of resale at a profit and that Memorex had acquired the equipment to lease not to sell. 3. Memorex was, in fact, carrying on two businesses: selling computers and leasing computers. The proceeds from the sale of leased computers generated a capital receipt. Held: 1. The depreciation provisions did not operate as an exclusive code. 2. The profits were assessable as they were derived in the ordinary course of the taxpayer’s business. 3. The leasing activity was not a separate business but rather was part of the overall business operation. Davies and Einfeld JJ (Pincus J concurring) said (at ATC 5043–4): 1.

The evidence shows that the usual method of distribution undertaken by the applicant was distribution by sale but that during the years in question … the applicant offered to its customers the option of purchase or lease of the computer equipment. It was the customers who decided the form that the transaction would take. The evidence shows that the applicant had only one business, that of distributing computer equipment, the distribution involving not only the supply of equipment but also advice as to the nature of the equipment required … [page 105] The applicant did not have a business in which it held standard pieces of equipment in stock and hired that equipment out to one customer after another. It normally supplied equipment for a particular requirement and supplied that equipment, at the customer’s option, either by outright sale or by lease. There is no analogy between this case and the case of plant or equipment that a taxpayer may have and may use as part of the structure of an enterprise. The subject goods were part of the goods in which the applicant was dealing. When it was profitable or financially convenient to do so and the customer agreed, the goods were leased or sold outright. But they were destined for sale or other disposal by the taxpayer sooner or later, either to the customer, another customer, an overseas affiliate or perhaps if they had no value at all, by scrapping.

In the circumstances, the sale of equipment that might otherwise have been regarded as fixed capital was held to be on revenue account because of the conclusion that ultimate disposal of the computers was

inevitable and formed part of the taxpayer’s usual business. In general, the broader the scope of the taxpayer’s business, the more likely the receipt is to be characterised as income.11 The characterisation of assets as revenue (current) or capital (fixed) is the outcome of business characterisation rather than the accounting measure of liquidity or likely conversion to cash. At the same time, if the accountants for Memorex had concluded that the company was in the business of selling computers, that would stamp the equipment as inventory and the sales part of operating profit.12

The income/capital dichotomy applied 3.14 Historically, the distinction between income and capital has been a critical element in Australia’s acceptance of British tax jurisprudence and the development of its own. Subject to limited statutory extensions, capital receipts remained tax free in Australia until the enactment of capital gains taxation, effective from 20 September [page 106] 1985.13 The distinction persists post-1985 and, due to exemptions and concessional tax treatment, capital receipts remain a preferred form of return.14 In addition, the distinction hones an understanding of the income concept, identifies items subject to separate statutory regimes and develops an appreciation of the dynamic in Australian tax policy and jurisprudence and the broadening of the tax base. The issue of capital versus income arose again in a recent decision by the High Court, Blank v FCT [2016] HCA 42; 2016 ATC 20-587.

Blank v FCT

Facts: The appellant taxpayer was employed by Glencore International or one of its subsidiaries between November 1991 and 31 December 2006. Whilst being employed by Glencore, the taxpayer participated in a number of employee profit participation agreements, which included: (1) a Shareholder Agreement; and (2) a Profit Participation Agreement. Both agreements were amended and subsequently revised during the relevant period and the taxpayer participated in the profit participation arrangements. On 31 December 2006, the taxpayer terminated his employment arrangements with Glencore. Pursuant to the Profit Participation Agreement, the taxpayer became entitled to receive from Glencore an amount of US$160,033,328.25 payable in 20 quarterly instalments. The taxpayer did not return the amount as ordinary income but instead chose to declare it as proceeds from the disposal of a capital asset. The Commissioner argued at both first instance and on appeal to the Full Federal Court that the amount was deferred compensation and to be assessable as ordinary income upon receipt. The taxpayer sought and received special leave to appeal to the High Court. Held: The High Court unanimously agreed with the Federal Court at first instance and the majority of the Full Federal Court. The High Court held that the amount received by the taxpayer upon the termination of his employment was deferred compensation for [page 107] services rendered as an employee. As such, the amount was properly characterised as income according to ordinary concepts. According to the High Court, the fact that the amount was paid to the taxpayer after termination of his contract of service, by someone other than the taxpayer’s employer, and separately to ordinary wages, salary or bonuses, did not alter this characterisation.

Licence and know-how payments 3.15 Special skills or knowledge may be exploited in a number of ways: in the course of employment or provision of services, through sale or hire to another, or through agreement to restrict its use. If the first course is adopted, the payment will be income under Propositions 9 or 10: see 3.38 and 3.44 respectively. If the information or knowledge is sold or hired, the payment may be income or capital or in the nature of a royalty under Proposition 11: see 3.62. If a contract is entered to restrict one’s use of the information, the consideration may be capital. Knowledge itself is not property, unless it can be attached to an item of property such as a patent or copyright. One’s brains may be picked

but not sold. So, in Brent v FCT (1971) 125 CLR 418; 71 ATC 4195, the wife of Ronnie Biggs, the great train robber, was paid $65,250 to sell the exclusive rights of her ‘life story’. She was obliged to be available for interview and to cooperate in providing information and, in contesting the Commissioner’s assessment, argued she was selling a capital asset in the form of a copyright. The High Court held the payment was for personal services rendered. Perhaps if Ms Brent had sold a diary her argument would have succeeded. That was the outcome in Trustees of Earl Haig v IRC (1939) 22 TC 725, where the trustees, who had the right to publish the Earl’s war diaries, sold the copyright for a capital sum. The important difference, as Gibbs J pointed out in Brent’s case, was that the trustees had a copyright, ‘which was indubitably property, and they did not merely sell information to the author, but in effect partially realised their copyright’. Where knowledge attaches to a patent or copyright and the owner sells the exclusive rights, the proceeds will normally be capital but where the right is qualified in some way such that others may also exploit it, the question is more difficult, as the following two English cases illustrate. In Evans Medical Supplies v Moriarty [1957] 1 All ER 336 (Evans Medical Supplies), the taxpayer was a pharmaceutical manufacturer and wholesaler. Its agency in Burma was closed down by the Burmese Government who paid the taxpayer a lump sum to provide information regarding confidential processes. As a consequence, the drugs were thereafter manufactured in Burma and the taxpayer lost its right to export pharmaceuticals to that country. By a 3:2 majority, the House of Lords held the amount was capital. Contrast that decision with Rolls-Royce Ltd v Jeffrey [1962] 1 All ER 801 (Rolls-Royce). Like the taxpayer in Evans Medical Supplies, RollsRoyce had accumulated technical knowledge. The company exploited its know-how by manufacturing and exporting jet engines. Several countries (including France and Australia), preferring to [page 108]

encourage domestic industry, refused to purchase the engines and instead negotiated to acquire technical data and training for personnel. The House of Lords held the receipts were income assessable to RollsRoyce. The key to distinguishing Evans Medical Supplies and Rolls-Royce lies in the following passage from Lord Radcliffe’s speech in RollsRoyce (at 805): I have not been able to see why these “capital” receipts should not be brought into account in the assessment of the appellant’s trading profits. It seems to me that, so long as they kept their “know-how” to themselves, they used it for the manufacture of their own engines and its value was expressed in the successful sales which they achieved from those products. I dare say they would have preferred, ideally, to reserve their “knowhow” solely for the purpose of their own manufacture … However that may be, it is clear that they saw that, having the “know-how”, they could derive profit from the manufacture of their engines, even by others, in parts of the world where they either could not or would not manufacture them themselves, provided only that they equipped those others with requisite expertise.

What distinguishes Evans Medical Supplies and Rolls-Royce is the different classification of the transactions as being structural in the former case (and giving rise to capital) and revenue in the latter. The matter is oversimplified but, nonetheless, the point is illustrated by characterising Evans Medical Supplies as a manufacturer that gave up the right to sell its products in a given market. On the other hand, Rolls-Royce gave up nothing; it merely exploited its structure in the best possible manner, and that process was income producing. 3.16 A common method of exploiting know-how or property such as patents and trademarks is by the grant of a licence. On the basis of Lord Denning’s judgment in Murray v ICI Ltd [1967] 2 All ER 980, it is possible to divide licences into three categories: 1. Ordinary (non-exclusive) licence: The grantor grants permission for the grantee to do something which it could not lawfully do otherwise (eg, it grants a franchise). There could be a multiplicity of ordinary licence holders. The receipts would be income in the hands of the grantor. 2. Exclusive licence: The grantor excludes itself from exploiting the property the subject of the licence. Unless the grantor can be seen

to be trading in the grant of licences or know-how, the consideration is capital (subject to how it is calculated and payment made). 3. Sole licence: The grantor grants permission to a single grantee but leaves the grantor at liberty to exploit the knowledge also. This is the inevitable grey area. If the grant sufficiently restricts the grantor’s right to earn income, it is likely to be a capital receipt. Otherwise, it approaches an ordinary licence. The grant of a non-exclusive licence will normally produce a revenue receipt: for example, Rustproof Metal Window Co Ltd v IRC [1947] 2 All ER 454. The outright sale of a capital asset for a lump sum will generate a capital receipt. A sale in return for an annuity will generate a revenue receipt (as the decision in Just v FCT (1949) 4 AITR 185; 8 ATD 419 illustrates: see 3.1). Lord Denning nominated four circumstances relating to the assignment of patent rights and the grant of an exclusive licence: [page 109] 1.

an outright disposal of patent rights in return for royalties (see Proposition 11 at 3.62), calculated by reference to actual use, clearly produces revenue receipts; 2. a disposal for annual payments that can be regarded as compensation for the use during the period is on revenue account; 3. a disposal for a lump sum, calculated by reference to some anticipated quantum of use, will normally be income; 4. a disposal for a lump sum, calculated by no reference to anticipated use, will normally be capital. In Kwikspan Purlin Systems Pty Ltd v FCT (1984) 15 ATR 531; 84 ATC 4282, the taxpayer entered into several arrangements described as ‘exclusive licences’ to manufacture patented purlin systems. The Supreme Court of Queensland (per Campbell J) held that payments received for the use of a patent fell within Lord Denning’s ‘exclusive

licence’ and so were of a capital nature. After noting that the taxpayer ‘was not in the business of dealing in patents’, his Honour said (at ATC 4286–7): [The taxpayer] was the owner of an invention which was sold under a trade name and the fact that several licences were granted for different places in Australia is the same as if one licence had been granted for the whole of Australia.

Broadly, the same considerations extend to private information which, in contrast to patents, designs or copyrights, cannot be registered. Know-how or information will retain an essentially capital character so long as it is not dominated by the utilisation of a service to render it useful. Thus, provision of assistance to put the know-how to work may characterise the exchange as the provision of a service generating an income receipt. To the extent that the sale of assets such as patents or copyrights generate capital receipts, they fall squarely in the capital gains tax provisions of ITAA97 Pt 3-1. Thus, in the circumstances, dealing in know-how may generate income by ordinary concepts, royalties or gains subject to capital gains tax. Recently, the High Court of Australia in Ausnet Transmission Group Pty Ltd v FCT (2015) 255 CLR 439, re-examined the distinction between capital and revenue in the context of certain expenditures that were incurred by the taxpayer. Although the decision of the High Court in Ausnet is relevant to the discussion of general deductions in Chapter 8, the High Court’s decision in Ausnet highlights the importance of the capital/revenue distinction in general, including the tests that are applied by the High Court to make the distinction. In delivering a joint judgment, French CJ, Kiefel and Bell JJ in Ausnet stated (at 450): The distinction between capital and revenue expenditure is readily discerned in cases close to the core of each of those concepts. A once and for all payment for the acquisition of business premises would be treated as an outlay of capital. A rental payment under a lease of the same premises would be treated as an outgoing on revenue account. The distinction is not so readily apparent in penumbral cases. They may require a weighing of factors including form, purpose and effect of the expenditure, the benefit derived from it and its relationship to the structure, as distinct from the conduct, of a business. Some of those factors may point in one direction and some in another.

[page 110] In a separate majority judgment, Gageler J similarly concluded (at 476): In my view, from a practical and business perspective, the expenditure was expenditure which AusNet was required to make in order to acquire the Transmission Licence and other assets. It was a component of AusNet’s cost of the acquisition; it was part of the price AusNet had to pay.

Ultra-tech Ltd is an Australian company that invented and patented a Complexor, a component that provides clarity of images on computer screens. Four licences described as ‘exclusive’ are sold to companies manufacturing computer equipment in South-East Asia, including one in Australia. For a payment of $100,000, the licensee acquires the right to stamp products ‘Contains Complexor’ and for $5/unit acquires the right to manufacture the component. How would these amounts be classified?

Restrictive covenants 3.17 An alternative to communicating or licensing know-how is to contract not to divulge it. Payments received for performance of contracts or provision of services clearly give rise to income amounts but payments for giving up an income-producing pursuit relate to structure and are capital. More difficult questions arise where one contracts to restrict one’s earning capacity. In Dickenson v FCT (1958) 98 CLR 460; 7 AITR 257, a majority of the High Court held to be capital amounts paid to a petrol station proprietor to sell only Shell products for the next 10 years from that site and, for the next five years, to sell only Shell within a five-mile radius of his premises. The payments were not a normal or natural incident of carrying on such a business. In Dixon CJ’s view, the

payments represented a restriction of the taxpayer’s profit-yielding structure and so were on capital account. The weight of authority suggests that the restriction should be substantial but may be something less than permanent. In the UK decision Beak v Robson [1943] AC 352, a lump sum in consideration of a five-year restriction of competition was on capital account. In Higgs v Olivier [1951] Ch 899; (1952) 33 TC 136, a payment made to Laurence Olivier to refrain from acting in films for a period of 18 months was held to be capital. In an Australian context, 18 months might be a marginal time frame as compared to Dickenson’s case. In Hepples v FCT (No 2) (1992) 173 CLR 492; 22 ATR 852; 92 ATC 4013, the Commissioner sought to bring within the capital gains tax provisions a payment made to an employee to continue after termination to be bound for two years to confidentiality concerning trade secrets and not to set up a business in competition.15 [page 111] Where the restriction operates during a period of current employment or is in reality only advance payment for services rendered, the amount is ordinary income: Riley v Coglan [1968] 1 All ER 314.16 The description of obligations that are written in a contract will not determine the character of the payments. In MIM Holdings Ltd v FCT (1997) 36 ATR 108; 97 ATC 4420, the taxpayer entered into a contract with the North Queensland Electricity Board and the State Electricity Commission (SEC) in which, in consideration of $15m payable over three years, it ensured that its subsidiary (Mt Isa Mines Ltd) would keep a specified amount of electricity-generating capacity available for SEC use. The taxpayer treated the payment as a restrictive covenant, describing it as compensation for a permanent reduction in the value of its investment in its subsidiary. The Full Federal Court rejected this characterisation, holding that where consideration is made for a payment it will almost always be on revenue account. The effect of the capital gains tax (CGT) provisions (CGT event D1

at 6.35) is that on entering into a restrictive covenant, legal rights are created and transferred to the purchaser. A capital gain arises equal to the consideration minus incidental costs and no discount can apply: ITAA97 s 115-25.

Cancellation of agreements and damages 3.18 The characterisation of amounts received as consideration for the cancellation or variation of agreements or as damages also demonstrates application of the process–structure test. For example, where a supply agreement is cancelled but the organisational structure remains intact, the compensation is simply a substitute for income and itself has that character: Proposition 12 at 3.68. However, payments made as compensation for the loss or sterilisation of the profit-making structure are of a capital nature. In Heavy Minerals Pty Ltd v FCT (1966) 115 CLR 512; 10 AITR 140, the taxpayer acquired rights to mine rutile, installed plant and machinery for that purpose, and entered into several supply contracts. Following a worldwide fall in demand, buyers requested to be released from their contracts and a total of £243,500 compensation was paid. Before the contracts were cancelled, the taxpayer had decided to close its plant and its obligations were met through the purchase of rutile from other miners. Windeyer J in the High Court held that the payments were income. The cancelled contracts were not capital assets. If the profit-making structure is permanently impaired, the compensation will be capital: Van den Berghs Ltd v Clark (Inspector of Taxes) [1935] AC 431; Glenboig Union Fireclay & Co Ltd v IRC (1922) 12 TC 427. Where the cancellation results in termination of the taxpayer’s business, the payment will be capital: California Copper Products Ltd (in liq) v FCT (1934) 52 CLR 28. However, where a cancelled agency or supply contract is one of many, or is a comparatively minor component of the taxpayer’s wider business, the compensation is a substitute for income. In Kensall Parsons & Co v IRC (1938) [page 112]

12 TC 608, the taxpayer held a number of agency agreements. One such three-year agreement, cancelled after two years, was described as a normal incident of business and the compensation was on revenue account: see also Allied Mills Industries Pty Ltd v FCT (1989) 20 FCR 288; 20 ATR 457; 89 ATC 4365. Compensation for personal injury is not ordinary income: see 3.19. Damages awarded for defamation were also held not to be ordinary income, even if calculated solely by reference to lost profits: FCT v Sydney Refractive Surgery Centre Pty Ltd (2008) 253 ALR 59; [2008] FCAFC 190. In that case, a television station was sued following reports that the company performing laser eye surgery had acted unethically. The Full Federal Court considered the character of the payment was determined by the quality it had in the recipient’s hands (see 3.35) rather than the way the damages were calculated. Reputation is a capital asset of a business and an injury to that reputation diminishes earning capacity. On the other hand, in Liftronic Pty Ltd v FCT (1996) 66 FCR 175; 32 ATR 557, compensation for a temporary setback or a mere restriction of trading opportunities calculated to fill a ‘hole in profits’ was assessable as income. The characterisation of such amounts is critical because compensation or damages received for any wrong or injury in an occupation are excluded from CGT: ITAA97 s 118-37. If the payment is not income, it is not taxable. Capital compensation for the forfeiture or surrender of rights under an agency or supply contract fall within the CGT provisions: CGT event C2 at 6.29.

Quizco is a market research firm which specialises in market surveys for the tobacco industry. The company has contracts with four cigarette manufacturers. As a result of amendments to state laws concerning cigarette advertising, one contract was terminated. The contract had four years to run and provided up to 60% of Quizco’s gross income. The cigarette company obtained a release from the contract for a payment of $150,000. Advise Quizco whether the amount of $150,000 is income.

A suggested solution may be found in Study help.

Compensation for injury 3.19 In a sense, a person’s income-earning capacity corresponds to a business entity’s structure and is capital in nature. Economists would describe it as ‘human capital’. As a result, compensation for injury is capital if it is paid to compensate for destruction or permanent impairment of that capacity: Tinkler v FCT 79 ATC 4641; FCT v Slaven 84 ATC 4077. Conversely, compensation received for a relatively short period of incapacity, in effect, is a substitute for income and has that character. The decision in FCT v Smith (1981) 147 CLR 578; 81 ATC 4114 supports this view. In FCT v Inkster 89 ATC 5142, the Federal Court held that regular payments made pursuant to a workers compensation Act were income in nature: see also [page 113] Allman v FCT 98 ATC 2142 and, further, Proposition 12 at 3.68. Compensation for personal injury is excluded from the CGT provisions. Characterising the payment as income or capital is, therefore, critical. If, and to the extent that a payment is income, it is assessable but, if it is capital, it escapes tax under both the income and capital provisions.

Unliquidated damages:17 McLaurin and Allsop 3.20 Some difficulties arise where a composite of income and capital is paid. In general, a lump sum will be dissected where the elements can be identified and quantified. This will be so, for example, where a log of claims is itemised and specific sums are allocated.18 On the other hand, where unliquidated damages are paid in respect of several claims, the courts have not been prepared to apportion: McLaurin v FCT (1961) 104 CLR 381; 8 AITR 180; Allsop v FCT (1965) 113 CLR 341; 9 AITR 724.

McLaurin v FCT Facts: A grazier suffered damages to property and livestock as a result of a fire sparked by a railway engine. Damages under several heads of both revenue and capital losses amounted to £30,240. A valuer for the railways made an assessment and the taxpayer was offered £12,350 to settle the case. The taxpayer accepted the amount without knowing how it had been calculated. The Commissioner assessed £10,640 as representing revenue losses or, alternatively, the full amount as income by ordinary concepts. Held: The lump sum was not apportionable and no part of it was assessable. Acceptance of the sum of £12,350 was not assent to any particular item in the claim. In a joint judgment, Dixon CJ, Fullagar and Kitto JJ said (at AITR 191): It is difficult in these circumstances to see how the dissection which the respondent has made can possibly be justified. All that has been urged in support of it is that the Commissioner for Railways should be considered to have paid the £12,350 as the total of the separate amounts … and that each of these amounts must be separately included in or excluded from the appellant’s assessable income upon consideration of the nature of the item to which it related on the [Railways Commissioner’s] list. The submission neither accords with fact nor squares with legal principle. It does not accord with [page 114] fact [because] the offer that was made was not of a total of itemised amounts but was of a single undissected amount. And in point of law it would plainly be unsound to allow a determination of the character of a receipt in the hands of the recipient to be affected by a consideration of the uncommunicated reasoning which led the payer to agree to pay it. It is true that in a proper case a single payment or receipt of a mixed nature may be apportioned amongst the several heads to which it relates and an income or non-income nature attributed to portions of it accordingly … But while it may be appropriate to follow such a course where the payment or receipt is in settlement of distinct claims of which some at least are liquidated … it cannot be appropriate where the payment or receipt is in respect of a claim or claims for unliquidated damages only and is made or accepted under a compromise which treats it as a single, undissected amount of damages.

In McLaurin’s case, the High Court held that apportionment could be

appropriate where settlement is for distinct claims, at least some of which are liquidated. Such circumstances were not present in Allsop’s case. There, the taxpayer claimed compensation for an amount of permit fees held to be invalidly imposed but which were deductible at the time of payment. In an out-of-court settlement, the taxpayer accepted a lesser sum in full settlement of all claims of any nature which the taxpayer had or might have had against the responsible body. The High Court held the amount was capital, that ‘no part of it can be attributed solely to a refund of the fees paid by the appellant for permits’: Allsop’s case at AITR 733. In FCT v CSR Ltd (2000) 45 ATR 559; 2000 ATC 4710; [2000] FCA 1513, the Full Federal Court held that Allsop’s case required a conclusion that an undissected lump sum paid by an insurance company as consideration for the settlement of a number of claims was neither ordinary income (in terms of ITAA36 s 25(1); ITAA97 s 6-5) nor income by way of insurance or indemnity. The fact that an amount was paid by an insurer did not necessarily mean that the payment was by way of insurance. The Commissioner’s application for special leave to appeal to the High Court was refused. McLaurin’s case has been countered by the capital gains legislation in that the cancellation or surrender of a right to sue is a CGT event C2: see 6.29. A specific provision applies to compensation (by way of insurance or indemnity) for the loss of trading stock: see ITAA97 s 70115 and 11.28. For the destruction of depreciating assets, a ‘balancing adjustment’ may arise under ITAA97 Subdiv 40-D: see 10.53ff. In addition, recoupments (again, by way of insurance or indemnity) of a deductible loss or outgoing are assessable income under ITAA97 Subdiv 20-A: see 5.23. See also 5.16. [page 115]

Thingo Ltd is a wholesaler of Doovers. It commences action against its insurance company in respect of damages to a warehouse and stock as a result of severe flooding. The amount of the claim is $500,000: half relating to destroyed trading stock, the balance to structural damage to the warehouse. The matter was settled out of court. It was agreed that the insurer would pay Thingo $250,000, which was in ‘full and final satisfaction, settlement and discharge of actions, costs, claims, charges, demands and expenses which Thingo may have against the insurer arising out of their insurance contract’. How would the amount of $250,000 be characterised? A suggested solution may be found in Study help.

Exchange rate gains (losses) 3.21 An exchange rate gain (loss) arises when contracts or debts are expressed in terms of a foreign currency that depreciates (appreciates) against the Australian dollar. ITAA36 s 20 (ITAA97 s 960-50) required that transactions be expressed in Australian currency and the resulting conversion generates a gain: see 5.54. There must be different currencies involved if there is to be an exchange rate gain. Merely issuing debt instruments (say) in US dollars will not generate an exchange gain or loss when they are redeemed in US dollars: FCT v Energy Resources Australia Ltd (1996) 185 CLR 66; 96 ATC 4536. There must also be an external transaction. Dealings between branches of the same legal entity do not create a debt that can be affected by exchange rate variation: Max Factor & Co v FCT 84 ATC 4060. The income/capital distinction is relevant to such gains and losses in that foreign transactions on revenue account are assessable as ordinary income under ITAA97 s 6-5: Texas Co (Australasia) Ltd v FCT (1940) 63 CLR 382; 2 AITR 4. Those on capital account were assessable only by virtue of statutory extensions to income (formerly ITAA36 ss 82U– 82ZB (Pt III Div 3B)): see 5.54. The leading Australian authorities are International Nickel Australia Ltd v FCT (1977) 137 CLR 347; 77 ATC 4383 and Avco Financial

Services Ltd v FCT (1982) 150 CLR 510; 82 ATC 4246 (Avco). In the former case, the taxpayer purchased trading stock from associated companies in the United Kingdom. Contracts were expressed in sterling. Devaluation of that currency in 1967 meant that in Australian dollars the amount remitted was less. Being related to trading stock, the gain was on revenue account. In Avco, a finance company borrowed sums expressed in US dollars to fund loans to customers. A number of gains and losses arose between 1972 and 1977. The High Court held that for a finance company such borrowings were an integral part of business and distinguishable from loans arranged to enhance its profit-making structure. In FCT v Hunter Douglas Ltd (1983) 14 ATR 629; 83 ATC 4562, this distinction was invoked to hold that an exchange loss incurred on borrowings to expand the taxpayer’s business was on capital account, and in [page 116] Commercial and General Acceptance Ltd v FCT (1977) 137 CLR 373; 7 ATR 716; 77 ATC 4375, loans that had as their principal purpose the strengthening of the taxpayer’s asset base were held to be on capital account. ITAA97 Divs 775 and 960 provide statutory rules for the tax treatment of exchange gains/losses post-2003–04 and are discussed at 5.54.

Proposition 3: Gifts unrelated to employment, services or business do not have the character of income 3.22

The Australian Legal Dictionary defines a gift as:

A gratuitous transfer of property from one person to another. To be valid there must be: an intention to transfer the property; acts which give effect to that intention; no

obligation on the donor to make the transfer; and no return to the donor of material advantage: Leary v FCT (1980) 32 ALR 221.19

In ordinary parlance, it might be accepted that a gift and income are mutually exclusive and that the issue was whether a particular payment was in the nature of a gift or accrued by virtue of some employment, services, or business relationship. However, judicial language is often imprecise on this point. In Laidler v Perry [1966] AC 16, certain gift vouchers were held to be income.20 In Squatting Investment Co Ltd v FCT (1953) 86 CLR 570; 5 AITR 496 (HCA), Kitto J contrasted gifts and ‘mere gifts’— the latter being unrelated to earning activities or occupations and having no significant character other than a desire to benefit the donee. Clearly, the issue is whether the payment is sufficiently related to income-producing activities to be a reward for those activities or whether it arises merely by virtue of some employment or business connection that is otherwise remote or coincidental; for example, the recipient is a workmate. Natural incidents of employment will be income. So, tips and gratuities to a waiter,21 taxi-driver22 or porter23 are income because they arise from a service relationship and because they are an expected incident of such occupations.24 Ultimately, it is the character of the payment in the hands of the recipient that is determinative (Proposition 7)25 and it does not matter that the payment falls within the above definition of ‘gift’. [page 117] In determining whether a receipt is a ‘mere gift’ or income, the presumption is that it is not income. This proposition emerges from the decision in Hayes v FCT (1956) 96 CLR 47; 6 AITR 248.

Hayes v FCT

Facts: The taxpayer had been an employee, co-director, adviser and company secretary to a company controlled by Richardson. The company prospered under Richardson’s direction but after he sold a majority interest to several people (including Hayes), it deteriorated. Richardson resumed control, buying back shares held by Hayes who was reluctant to sell. Richardson assured Hayes: ‘You won’t lose anything. I will make it up to you some day’. After his success, Richardson made a series of dispositions of shares to public bodies, his sons and Hayes. At all times, Hayes had been fully remunerated. Held: The value of the shares was not income (nor assessable under ITAA36 s 26(e)). Fullagar J said (at AITR 253–4): A voluntary payment of money or transfer of property by A to B is prima facie not income in B’s hands. If nothing more appears than that A gave to B some money or a motor car or some shares, what B receives is capital and not income. But further facts may appear which show that, although the payment or transfer was a “gift” in that it was made without legal obligation, it was nevertheless so related to an employment of B by A, or to services rendered by B to A, or to a business carried on by B, that it is in substance and in reality, not a mere gift but the product of an income earning activity on the part of B, and therefore to be regarded as income from B’s personal exertion. While I would not say that the motive of the donor in making the payment or transfer is, in cases of this type, irrelevant, motive, as such will seldom, if ever, in my opinion be a decisive consideration. In many cases, perhaps in most, a mixture of motives will be discernible. On the one hand, personal goodwill may play a dominant part in motivating a voluntary payment, and yet the payment may be so related to an employment or a business that it is income in the hands of the recipient. On the other hand, the element of personal goodwill may be absent — the dominant “motive” may have been of the most purely selfish and “commercial” character — and yet it may be impossible to find any connection with anything that can make it income.

[page 118] 3.23 It is not the donor’s motive that makes a payment a mere gift. Neither is it the degree of volition. Voluntary payments will be income when they are sufficiently related to income-earning activities. Squatting Investment Co Pty Ltd v FCT (1954) 88 CLR 413; 5 AITR 664 (PC) considered whether a voluntary payment made by a marketing authority to its suppliers was income. The circumstances of the case are simplified but, nonetheless, are illustrated by the following example from Fullagar J’s dissenting judgment (1953) 86 CLR 570; 5 AITR 496 at 515:26

If a wholesale merchant gave a substantial Christmas present to his best customer, the value of the present would not be income. But if A bought goods from B for £1000, expecting to resell them for £1500, and in fact resold them for £2500 and if A’s heart was so softened by this happy event that he sent to B a cheque for £1500 instead of £1000, B would properly take the extra £500 into his profit and loss account as part of the proceeds of the goods and that sum would be liable to assessment as income. It would be part of the proceeds of his business.

The proximity of a services or employment relationship, the importance of the donor’s motive and the status of gratuitous payments were all considered in Scott v FCT (1966) 117 CLR 514; 10 AITR 367.

Scott v FCT Facts: The taxpayer practised as a solicitor and had a longstanding professional association with the Freestones. Following the death in 1958 of Mr Freestone, Scott was responsible for a grant of probate and administration of the estate. The estate was largely real estate valued at £191,000 for probate purposes and attracting £94,000 in probate duties. To discharge these duties, the taxpayer was successful in securing rezoning of a parcel of land and negotiating its sale. In fact, 82 acres of land called ‘Greenacres’ valued at £15,000 for probate was rezoned and 48 acres sold for £170,000. Later, Mrs Freestone made several gifts, including one of £10,000 to Scott. In evidence, Scott said he was ‘astounded’ and Mrs Freestone confirmed he was ‘speechless’. In evidence, she said Scott protested and she consistently indicated the payment was made out of friendship. She said: ‘I wanted to do things while I am well, while I am alive to do them, not wait until I am dead and leave them in a will’. In due course, a bill of costs was received and paid by Mrs Freestone. The Commissioner assessed the amount as income by ordinary concepts but argued principally that it was a benefit relating directly or indirectly to services rendered, for the purposes of ITAA36 s 26(e). [page 119] Held: The amount of £10,000 was a gift. It was gratuitous, not made in discharge of an obligation and not taken by the recipient as discharging an obligation, and not income by ordinary concepts. Neither was it assessable under s 26(e).a Windeyer J said (at AITR 375–6): I return to the general concept of income. Whether or not a particular receipt is income depends on its quality in the hands of the recipient. It does not depend on whether it was a payment or provision that the payer or provider was lawfully

obliged to make. The ordinary illustration of this are gratuities regularly received as an incident of a particular employment. On the other hand, gifts of an exceptional kind, not such as are a common incident of a man’s calling or occupation, do not ordinarily form part of his income. Whether or not a payment is income in the hands of the recipient is thus a question of mixed law and fact. The motives of the donor do not determine the answer. They are, however, a relevant circumstance. It is apposite to quote here a passage from the judgment of Kitto J in Squatting Investment Co Pty Ltd v FCT (1953) 5 AITR 496 at p 520. His Honour said: It is a commonplace that a gift may or may not possess an income character in the hands of the recipient. The question whether the receipt comes in as income must always depend for its answer upon a consideration of the whole of the circumstances; and even in respect of a true gift it is necessary to inquire how and why it came about that the gift was made. An unsolicited gift does not, in my opinion, become part of the income of the recipient merely because generosity was inspired by goodwill and the goodwill can be traced to gratitude engendered by some service rendered. It was said for the Commissioner that if a service was such as the recipient was ordinarily employed to give in the way of his calling, and the gift was a consequence, however indirect, of the donor’s gratitude and appreciation of that service, then it must necessarily be part of the donee’s income derived from the practice of his calling, and caught by s 26(e). But as thus expressed, this proposition is, I think, a mistaken simplification. It was based upon the fact that in Hayes v FCT (1956) 6 AITR 248 at p 255, Fullagar J regarded as decisive that it was impossible to relate the receipt of the shares there given to any income-producing activity on the part of the recipient. In the present case the taxpayer was engaged in an income-producing activity, his practice as a solicitor, [page 120] to which it was said the gift could be related. But because the absence of a particular element was decisive in favour of the taxpayer in one case it does not follow that the presence of that element is decisive in favour of the Commissioner in another case. The relation between the gift and the taxpayer’s activities must be such that the receipt is in a relevant sense a product of them.

a.

In relation to ITAA36 s 26(e), Windeyer J said the provision did not bring into the tax gatherer’s net money or money’s worth that was not income by ordinary concepts. Rather, it prevented items that were in fact income slipping through the net. This view was rejected by some members of the Full High Court in Smith v FCT 87 ATC

4883, discussed under Proposition 9: Amounts derived from employment or the provision of services are income. In Hayes’s and Scott’s cases, the payments were ‘one-off’. So, too, was the payment in Moore v Griffiths [1972] 3 All ER 399, where a member of the successful 1966 English World Cup soccer squad was paid £1000 gratuitously by the Football Association. Like Scott’s case, the payment was in addition to entitlements under service agreements; the donor’s motive was to make a personal tribute and the payment was unexpected. While income generally exhibits recurrence, regularity and periodicity, it would be wrong to conclude they were necessary elements and that a ‘one-off’ payment in the nature of a ‘gift’ cannot be income, as the decision in the Squatting Investment Co case demonstrates. Contrast Scott’s case with Brown v FCT (2002) 49 ATR 301; 2002 ATC 4273; [2002] FCA 318. In Brown, the taxpayer, a former Federal Minister, introduced the principal of a construction company (Monacorp) to prospective purchasers and lent his name to a purchaser’s application to the Foreign Investment Review Board. He also acted as an intermediary when a dispute arose over a sale contract. The taxpayer expressed an interest in a townhouse constructed by an associate of Monacorp and authorised the company to apply a $1m commission payable to him against the cost of the townhouse and fittings. The taxpayer contended the benefits were a mere gift. The Full Federal Court held that although gratitude for what a person had done did not convert a mere gift to income, the benefits in this case were a reward for services. 3.24 The question whether a receipt is, in a relevant sense, a product of employment, services or business and how remote or proximate that connection must be in terms of time frame has been before the courts on many occasions. More difficult questions arise where the payments are regular, recurrent and periodic. Was a series of unsolicited payments, made to a former employee, income: FCT v Dixon (1952) 5 AITR 443; FCT v Harris (1980) 10 ATR 869; 80 ATC 4238; FCT v Blake (1984) 15 ATR 1006; 84 ATC 4661? But even one-off payments arguably in the nature of prizes present difficulties. Was a payment made by a third party to a professional footballer income: Kelly v FCT 85 ATC 4283?

How are testimonials to retired sportsmen and women treated: Moorehouse v Dooland (1955) 36 TC 12; Seymour [page 121] v Reed (1927) 11 TC 625? The treatment of employer-sponsored scholarships, ‘pursuit of excellence’ awards or ‘encouragement to study’ schemes (Smith v FCT (1987) 164 CLR 513; 19 ATR 274; 87 ATC 4883) all turn on whether the receipt is, in a relevant sense, a product of services, past, present or future. As Windeyer J said in Scott’s case, the issue is a mixed question of fact and law. Prima facie, a payment from A to B is not income: Hayes’s case. But that presumption may be displaced if, in substance and reality, the payment was a product of services. Whether a payment is a product of services is considered under Proposition 9: Amounts derived from employment or the provision of services are income (3.38).

1.

Martha is George’s solicitor and they both reside in Sycamore Street. As part of a road-widening plan, the local council wishes to demolish three houses, including George’s. The Sycamore Street Residents’ Association is formed to fight the plan and Martha is elected president. The association engages Martha to represent its interests and organises petitions and protests. In the face of opposition, the council abandons its plan. George gives Martha $10,000 in appreciation of her efforts. What factors would be important in characterising the payment? 2. Jock is employed on GMH’s car assembly line and makes a suggestion through the Employees’ Suggestion Plan to modify a strapping device. GMH adopts his suggestion and pays him $5000. At the time of receipt, Jock has retired from work. How would the payment be characterised? A suggested solution can be found in Study help.

Proposition 4: The proceeds of

gambling and windfall gains are not income 3.25 A comprehensive income base, such as the economic view of income as expenditure plus the change in wealth (see 2.7), would not distinguish income from capital nor other increments whether they arise from inheritances or by chance. The ordinary/judicial concept excludes windfall gains from income because, generally, they lack the commercial element evident in other income-producing activities. Windfalls are the product of luck or good fortune. Seldom are they recurrent and regular; they are not seriously expected or relied on, except in particular circumstances;27 they are not the product of employment, service or business; and the character they possess in the hands of the winners is evidently distinguishable [page 122] from an income amount. Winnings from lotteries, punting or gambling and raffle prizes are common forms of windfalls that are not ordinary income. Prizes, grants and awards received by a sportsperson who was carrying on a business were held by the High Court in FCT v Stone (2005) 222 CLR 289; 59 ATR 50; [2005] HCA 21 to be assessable income. Where the recipient is engaged in a business activity, prizes and grants are income. Sponsorship payment and appearance money are also income, being rewards for the rendering of services: see 3.40.

Gambling and punting 3.26 The leading Australian case on whether punting can give rise to assessable income (or to allowable deductions for losses) is Martin v FCT (1954) 90 CLR 470; 5 AITR 548. In that case, the Full High Court described the taxpayer, who owned several racehorses but was ‘not by

occupation a bookmaker or trainer or jockey’, as ‘merely a keen follower of the turf’, one of many who ‘derive pleasure from betting on the racecourse and racing under their own colours’. In Evans v FCT (1989) 20 ATR 922; 89 ATC 4540, a very successful punter who in one year won nearly $430,000 was held not to be in the business of gambling. To be classified as a business, the activities need to exhibit systematic keeping of records and a high level of organisation. A large volume of betting is not sufficient. In Babka v FCT (1989) 20 ATR 1251, the Federal Court held that large-scale betting was merely a pastime, and in Brajkovich v FCT (1989) 20 ATR 1570; 89 ATC 5227, the Full Federal Court dismissed an appeal for a deduction by an unlucky punter. If the taxpayer is connected to the industry in the capacity of bookmaker, breeder or trainer of racing animals, this would strengthen the suggestion that gambling was an ancillary business or part of a broader business, but an ordinary member of the public will rarely be treated as a ‘professional punter’ or characterised as carrying on a business even where the gains or losses are large.28

Quiz show contestants 3.27 Appearances on television quiz shows will not normally result in the derivation of income because the activity does not amount to a business. This is so even if a contestant is successful and returns several times. The situation could be different though if the contestant enters into an agreement to attend regularly or is paid appearance money in addition to (or instead of) a chance to win prizes. The Commissioner’s view is set out in IT 167, in part as follows: In the absence of any unusual features, it is considered that no liability to tax would ordinarily arise where a member of the general public participates casually in a competition and wins a prize. A windfall gain of this nature would not have the character of income.

[page 123]

On the other hand, if a taxpayer makes regular appearances in radio or television programmes (whether as an artist or a participant in some form of competition), the reward received would form part of his assessable income. In this situation, the taxation position would be the same whether the award for appearing is paid directly in the form of a fee or indirectly through the opportunity to win valuable prizes, either in cash or kind.

The assessability of prizes arising in the recent phenomenon of reality television shows has not been before the courts and is to be determined by traditional criteria. In the Full Federal Court in Stone v FCT (2003) 130 FCR 299; 53 ATR 214; [2003] FCAFC 145 (discussed below at 3.40), the Commissioner’s argument that there was some intermediate category between a hobby and a business was rejected. In the High Court in Stone, it was the finding that Ms Stone was carrying on a business that rendered the prize assessable.

Financial spread betting 3.28 Unlike recreational gambling where gains are not considered to be assessable income, the Commissioner has expressed a different view with gains derived from financial spread betting. According to ATO ID 2010/56, the Commissioner considers that gains derived from financial spread betting are assessable income under ITAA97 s 6-5 or s 15-15. Financial spread betting where the taxpayer may hold a financial services licence is more likely to be conducting a profit-making activity where the degree of control is another factor that distinguishes financial spread betting from recreational gambling. According to the Commissioner in ATO ID 2010/56, ‘the winnings tend to be the rewards for skill and judgment rather than purely betting on chance’.29

Illegal activities 3.29 Although the proceeds from gambling or lotteries are not income, it is well established that gains from illegal or ultra vires activities are ordinary income. In Partridge v Mallandaine (1886) 2 TC 179, illegal bookmaking was described as a ‘vocation’ within the meaning of the UK Income Tax Act and the profits taxable. In Lindsay v IRC (1933) 18 TC 14, the proceeds of whisky smuggling during the

American prohibition era were also liable to tax. In FCT v La Rosa (2003) 53 ATR 1; 2003 ATC 4150; [2003] FCAFC 124, money received from drug-dealing operations was assessable income and relevant losses and outgoings deductible: see 9.42.

Proposition 5: Mutual receipts are not income 3.30 The basis of the mutuality principle is that one cannot derive income from dealing with oneself; nor can one incur an expense with oneself. Such receipts are described as ‘mutual receipts’ and they are non-income amounts. They are not income by ordinary concepts and cannot be classified exempt income because they are not income in the first place. [page 124] The effect of this principle is that members’ subscriptions and payments for services (bar or dining facilities, etc) are not income of a non-profit club or association formed to pursue a common object. The principle requires that any surplus not be distributed or, if it is, that it be distributed in substantial proportion to individual members’ contributions. In other words, the distribution must be a return of their subscriptions, not a return on subscriptions. Where trading activities extend to non-members (like visitors to such a club), it is necessary to identify the proceeds that fall outside mutuality and to apportion expenses for the purpose of determining taxable income.30 A gain made from outside the mutual entity, such as bank interest on surplus funds, is income by ordinary concepts. That unincorporated associations do not derive assessable income derives from the decision in Bohemians Club v Acting FCT (1918) 24 CLR 334 at 337: [Members’] contributions are, in substance, advances of capital for a common purpose

which are expected to be exhausted during the year for which they are paid … If anything is left unexpended, it is not income or profits but savings which the members may claim to have returned to them. The notion that such savings are taxable income is quite novel and quite inadmissible.

It would seem that excess contributions of capital in circumstances referred to by Griffith CJ in the Bohemians Club case would themselves be capital and that to describe them as ‘mutual receipts’ does nothing to change their non-income character. Several UK decisions preceding the Bohemians Club case suggest that the critical aspect of mutuality is whether there is a trade or business that has as its objective the generation of profits or whether a number of persons have simply associated for a common purpose and contributed to a common fund in which they are all interested.31 Accepting that dealing and trading with non-members will generate income amounts, mutuality must extend to dealings between members that would otherwise have the character of income but is not so on the basis that one cannot profit through dealing with oneself. There is authority, too, in IRC v Eccentric Club Ltd [1924] 1 KB 390, that mutuality extends to profits derived from its members by an incorporated body. 3.31 There is a point, however, where even dealing with members is on such a scale or in such circumstances that some or all of the association’s operations are stamped with an income character. In Fletcher v IRC [1972] AC 414 at 421, Lord Wilberforce described the difference thus: … is the activity … a trade, or an adventure in the nature of trade, producing a profit, or is it … a mutual arrangement which, at most, gives rise to a surplus?

The decision by the Full Federal Court in FCT v Australian Music Traders Association 90 ATC 4536 reviewed the principle. [page 125]

FCT v Australian Music Traders Association Facts: The Music Traders was formed in 1977 with the objective of protecting and advancing the interests of a variety of music industry members generally and to organise music trade fairs and exhibitions specifically. In the event of dissolution, the association’s property was not to be distributed to members but was to be paid to a similar organisation, as determined by the then membership. Some little weight was attached to this point. Until 1984, the association itself conducted the annual music fair with the assistance of voluntary labour. It charged members a fee for the right to display their wares and the Commissioner accepted that these receipts, together with members’ subscriptions, were not to be included in assessable income under the mutuality principle. Only amounts derived from non-members were assessable. From 1985, the fairs were conducted by a professional organiser who undertook to pay to the association an amount representing fees from members. It was this sum of $19,000 which the Commissioner assessed and the taxpayer objected to. Held: A majority of the Federal Court allowed the Commissioner’s appeal. Davies and Wilcox JJ considered that the payment was a result of trading activities by individual members. Davies J cast doubt on the status of the receipts before 1985. His Honour relied on Sydney Water Board Employees’ Credit Union Ltd v FCT 73 ATC 4129 and RACV v FCT 73 ATC 4153 in pointing out that although an association may be a mutual association, that does not mean that all its receipts from members are necessarily mutual receipts. Wilcox J identified two impediments to the taxpayer’s claim. First, the decision made by individual members and the amount of their payment depended not on any wish or need to make contributions as members but on the display space they wished to occupy. Second, the association’s constitution did not provide for a return or contributions of surplus to members in the event of dissolution. Foster J’s dissent centred on the first of these issues. His Honour relied on National Association of Local Government Officers v Watkins (1934) 18 TC 499 to support a view that it was not necessary that all members contributed to the association. The money was paid by those who chose to participate in the fair and this was entirely analogous to members of a club choosing to use or not to use dining facilities.

[page 126] A similar conclusion was reached in North Ryde RSL Community

Club v FCT (2002) 49 ATR 579; 2002 ATC 4293. In that case, commission was paid to the club under an agreement between the club and the licensee for the conduct of Keno. The Full Federal Court characterised the payment as a trading receipt. In addition, payment by a member to participate in Keno was not a payment to a common fund and so was not a mutual receipt. The critical issue, therefore, is not in the classification of the association but, rather, the characterisation of the association’s receipts and, in this respect, traditional indicia of income and business should be examined. 3.32 The essence of the mutuality principle is identified in the following propositions:32 Where contributions are made to a common pool and any excess is returned to (substantially the same) contributors, it is unnecessary to invoke the mutuality principle. The payments and receipts are capital not income. The mutuality principle operates to prevent amounts that otherwise bear an income likeness from becoming income. Thus, in dealings confined exclusively to members, prima facie an entity does not generate an income amount. Where an entity extends its activities beyond the immediate group, there are dealings out of which a profit may be made. In circumstances where a business or commercial venture is undertaken, it does not matter that the contributors are members of the entity. Registration and incorporation of mutual clubs and societies and ATO practice requires the entities’ constituent documents prohibit distributions to members and include a dissolution clause that on windup, surplus funds be donated to another club with similar interests. In Coleambally Irrigation Mutual Co-Operative Ltd v FCT 2004 ATC 4126; [2004] FCA 2, the Federal Court held that such requirements breached the essence of mutuality, making it impossible to say members’ contributions remained the property of the members. As a result, ITAA97 s 59-35 was enacted. It provides that if an amount

would be a mutual receipt but for the fact that constituent documents prevent distributions to members, the amount is not assessable income and not exempt income.

Suburban Street is a cul-de-sac containing 10 houses. The area has a high rate of break and enter and burglary, so a resident proposes that instead of paying escalating insurance premiums to commercial insurance companies, the neighbours pool their resources and ‘self insure’. It is proposed to maintain a working fund to meet insurance losses, and surplus funds will be invested and proceeds distributed equally between participating households. [page 127] Is the surplus of the group of an income character? Are the interest or other investment proceeds income? Suppose, instead, that surplus funds are lent to participants at low-interest rates to finance the installation of alarm systems. Is the interest income? Suppose further that the group employs a security guard. Is the guard’s salary income? What if one of the properties was rented and the levy was paid by the owner not the tenant. Would it be deductible? A suggested solution can be found in Study help.

Demutualisation 3.33 During the 1990s, a number of mutual organisations underwent restructuring to operate on a more commercial footing and exploit attendant commercial advantages. This involved a process of ‘demutualisation’. The entities concerned were a number of mutual insurance and life assurance companies, as well as other (non-insurance) associations. The relinquishment of mutual status meant the surrender of members’ rights in the mutual company in exchange for shares with potential capital gains issues arising on the subsequent sale of the shares. The treatment of mutual insurance companies is covered in ITAA36 ss 121AA–121AT.

The demutualisation of non-insurance mutual organisations is covered by ITAA36 Sch 2H Div 326. The process involves the substitution of shares for members’ rights with the result that there is continuing member ownership of any surplus. No assessable income arises in this process. Division 326 provides machinery to determine the cost base and status of the shares.

Proposition 6: To be income, an amount must be beneficially derived 3.34 Ordinary income is distinguishable from capital, a mere gift and a mutual receipt and, but for a deeming provision, ITAA36 s 21A, it must be convertible into money. To be income, an amount must have ‘come in’ in the sense that it is beneficially derived.33 Precisely when income is derived depends generally on the application of a mixture of legal and commercial rules and occasionally on statutory direction.34 The courts recognise a cash receipts basis as appropriate for some classes of income [page 128] and taxpayers and some aspects of accrual accounting for others.35 For amounts derived on receipt, a taxpayer who has merely a right to income has no beneficial derivation of income. It follows that unrealised gains cannot be derived either. For taxpayers on an accrual basis, as Hill J observed in Warner Music Traders Pty Ltd v FCT (1996) 70 FCR 96; 96 ATC 4117, it is now too late to argue in Australia that income is confined to ‘that which comes in’. Gains represented by reduced liabilities may clearly constitute assessable income. Unrealised gains do not represent income derived by an accruals base taxpayer either. Some of the nuances of Proposition 6 are illustrated by the decision in Constable v FCT (1952) 86 CLR 402; 5 AITR 371.36

Constable v FCT Facts: An employee taxpayer was a member of a superannuation fund to which he and his employer both contributed. Constituent documents of the fund provided that members had no right or claim to any payment while employed by a company contributing to the fund. However, there was one exception. In the event that rights under the fund were changed or obligations increased, members could, upon written notice, withdraw amounts standing to their credit. Such an event occurred and the taxpayer lodged written notice and was paid £403. The Commissioner subtracted the member’s own contributions and assessed him on the balance under ITAA36 s 26(e). Held: The Full High Court held that no amount was an allowance allowed, given or granted. It also expressed an opinion that payments to the fund by the taxpayer’s employer did not, in the year in which they were paid, form part of the taxpayer’s assessable income. Dixon CJ, McTiernan, Williams and Fullagar JJ said (at AITR 374–5): On these facts we are of opinion that, whether or not the payment or any part of it may be described as an allowance, gratuity, compensation, benefit, bonus or premium in respect of or for or in relation to the taxpayer’s employment or services rendered by him, it cannot correctly be said that it was such an allowance, etc, “allowed, given or granted to him” during the year of income under assessment. [page 129] It appears to us that the taxpayer became entitled to a payment out of the fund by reason of a contingency (viz, an alteration of the regulations …) which occurred in that year enabling him to call for the amount shown by his account. It was a contingent right that became absolute. The happening of the event which made it absolute did not, and could not, amount to an allowing, giving or granting to him of any allowance gratuity [etc]. The Fund existed as one to a share in which he had a contractual, if not a proprietary, title. His title was future, and indeed contingent or, at all events, conditional. All that occurred in the year of income with respect to the sum in question was that the future and contingent or conditional right became a right to present payment and payment was made accordingly. This, in our opinion, cannot bring the amount or any part of it within s 26(e) … While we prefer to place our decision of the case upon the simple ground stated, that does not mean that we think that the actual payment by the company to the Fund in respect of the taxpayer, formed in the year in which they were so paid, any part of his assessable income. It is not, of course, a matter that arises for decision in the present case, but to avoid misunderstanding it is, we think, desirable to say that, on the frame of the regulations, we find it by no means easy to see how the sums so contributed can

be regarded as allowed, granted or given to the employee when they are paid to the administrators of the Fund. It is only after the administrators have exercised their discretion that any moneys paid to the special account are reflected in the member’s (employee’s) account and even then that does not mean that the member becomes presently entitled to the moneys credited to that account.

Constable’s case is authority for the non-assessability of employers’ contributions to superannuation funds. The payments are not fringe benefits either.37 In the present context, Constable’s case is also authority for saying that an amount that would have been income, had the necessary derivation existed at some earlier period of time, does not become income at some later time when it is derived unless, in the circumstances of the later derivation, it has an income character. The employer’s contributions to the fund were not allowed, given or granted to the taxpayer. When [page 130] the benefits were paid out at a later time, they were not income. An amount has to be characterised at the point of its derivation.

Proposition 7: Income is to be judged from the character it has in the hands of the recipient 3.35 The decisions in Hayes v FCT (1956) 96 CLR 47; 6 AITR 248 and Scott v FCT (1966) 117 CLR 514; 10 AITR 367 (see 3.22 and 3.23) provide authority for Proposition 7. That the character of a receipt is not determined by the character of the expenditure was demonstrated in Just v FCT (1949) 4 AITR 185; 8 ATD 419 and Colonial Mutual Life Assurance Society Ltd v FCT (1953) 89 CLR 428; 5 AITR 597: see 3.1. It was reiterated by a majority of the High Court

in FCT v McNeil (2007) 233 ALR 1; 2007 ATC 4223; [2007] HCA 5: see 6.53. The majority stated that, as a general principle: Whether a particular receipt has the character of the derivation of income depends upon its quality in the hands of the recipient, not the character of the expenditure by [the other party].

In that case, although a payment made to a shareholder under a share buy-back arrangement arose out of the capital restructuring of the company, that did not determine its character. The proposition is well illustrated by the High Court decision in GP International Pipecoaters Pty Ltd (see 3.12) and the Federal Court decision in Federal Coke Co Pty Ltd v FCT (1977) 7 ATR 519; 77 ATC 4255.

Federal Coke Co Pty Ltd v FCT Facts: Bellambi Coal Co Ltd (Bellambi) was a coal producer that used its subsidiaries for the purpose of producing coke. Federal Coke Co was one such subsidiary. The coke was sold by Bellambi, which paid a fee for services to subsidiaries. Bellambi entered into several contracts to supply coke overseas but, due to an economic downturn, one company, Le Nickel, was unable to accept the full amount contracted. After negotiations, Le Nickel’s contract was varied on agreement to pay $1m compensation to Federal Coke Co whose activities then ceased. At the time, Federal Coke Co was experiencing difficulty meeting requirements of the Clean Air Act 1961 (NSW). The Commissioner assessed Federal Coke Co for the amount of $1m as income by ordinary concepts, arguing that the amount would have been income had it been paid as originally agreed to Bellambi and that the character was unaltered by directing the payment to Federal Coke. [page 131] Held: The compensation was in the nature of capital, a gift or a windfall in the hands of Federal Coke Co even though, if paid to Bellambi, the amount would have been income. Bowen CJ said (at ATR 529–30): When one is considering the character of an amount received by a taxpayer, the inquiry must start with the question: what is the character of the receipt in the hands of the taxpayer? It appears to me to be wrong to ask: what would have

been the character of the amounts had they been received by Bellambi? and then to pose the question: has their character been changed by the fact that they were paid to Federal? One must, I think, pose the essential question and start from that question: what is the nature of the receipts in the hands of Federal? It then becomes less than decisive to observe that, in their origin, and if they had been received by Bellambi, they may have been of an income character. Each receipt in the hands of Federal is broadly in the nature of a gift, being a sum received without consideration. Certainly Federal, although it suffered economic detriment as one of the consequences of the compromise arrived at between Bellambi and Le Nickel, was not a party to the amending deed and gave no consideration either to Bellambi or Le Nickel. Le Nickel, by reason of the amending deed entered into with Bellambi, was no doubt obliged to make the payment and Bellambi could have enforced it … But so far as Federal was concerned, each payment was received by that company on a voluntary basis. In my view, for purposes of income tax, the same principles apply in determining whether an amount received without consideration is income as apply in determining that question in relation to a gift proper. After referring to the Hayes, Scott and Squatting Investment Co (see 3.22) cases to identify the nature of a gift, his Honour said: In the present case, and regarding the matter from Federal’s point of view, it is seen that the two receipts were part of one large unprecedented sum; that they were received without any consideration passing from that company; and that they were in no sense the product of any business or income producing activities which it carried on. Federal’s business was the production of coke and even this had ceased by the time the payments were received. Federal did not carry on any business of receiving payments or acting as banker or financial repository on behalf of Bellambi or the [page 132] Bellambi group. Furthermore the receipts did not constitute a compensatory equivalent for any loss suffered by Federal in its business. They were treated in the accounts as capital receipts.

3.36 It should not be concluded that tax can be avoided simply by directing that money be paid to a third party. The question becomes, who has derived the income? It well may be that in Federal Coke Co the wrong taxpayer was assessed. Given that the supply agreement was between Bellambi and Le Nickel, compensation for variation or cancellation of the agreement may have been derived — beneficially if

not in fact — by Bellambi. That the parent directs payment be made to a subsidiary cannot change the constructive derivation by the parent but Bellambi was not assessed. The doctrine of constructive receipt holds that income is deemed to be derived by a person for whose benefit the amount has been dealt with or in whose favour it has been applied.38 In the ITAA97, constructive receipt is deemed by s 6-5(4), which provides as follows: 6-5 (4) In working out whether you have derived an amount of ordinary income, and (if so) when you derived it, you are taken to have received the amount as soon as it is applied or dealt with in any way on your behalf or as you direct.

Had the Commissioner assessed Bellambi instead of Federal Coke Co, he could have argued that the doctrine of constructive receipt applied and that the amount was derived by Bellambi because it was applied or dealt with on the parent’s behalf.

Proposition 8: Income generally exhibits recurrence, regularity and periodicity 3.37 Common items of income exhibit the features of recurrence, regularity and periodicity. Wages, interest, royalties, dividends, profits, pensions and payments under an annuity all, usually, have that characteristic. Typically, dictionaries define income as one of a series of periodical receipts. However, one should not conclude that it is sufficient to render an item ‘income’ only because it is periodical. Gifts may be received regularly; a housekeeping allowance is not income, neither are instalments of capital. On the other hand, a one-off payment paid in compensation for the loss of income (as opposed to the loss of a right to earn income) will take on the character of the receipt it substitutes. Thus, it is necessary to keep in mind an [page 133]

important qualification: periodicity will suggest an income character when there are no elements pointing to a different conclusion. The decision in Just v FCT (1949) 4 AITR 185; 8 ATD 419 demonstrates that periodicity can be a dominant consideration. In that case, the consideration for the sale of property, which would ordinarily be capital — even if periodically paid — was held to be income because regular payments were made for an uncertain period in discharge of an indeterminate amount. Most social security pensions are income, being regular and periodic: Keily v FCT 83 ATC 4248; Melkman v FCT 87 ATC 4855. Periodical payments of workers compensation for whole or part loss of wages are also assessable as income: FCT v Inkster 89 ATC 5142. The fact that the amounts paid were calculated by reference to specified percentages of award rates of pay and made regularly was enough to stamp them as income. The recurrence and regularity of pension supplements paid to a former employee was an important element in finding the payments income in FCT v Blake 84 ATC 4661: see further Proposition 9 at 3.38. In FCT v Stone (2005) 222 CLR 289; 59 ATR 50; [2005] HCA 21, the Commissioner advanced an argument grounded in FCT v Dixon (1952) 86 CLR 540; 5 AITR 443 (see 3.38) that an amount had the character of income because it was expected and periodical and because it was relied on by the taxpayer for personal and family expenditure. In Stone, the High Court remarked that these observations in Dixon should be viewed in light of the question there being identified; namely, were the payments incidental to the taxpayer’s past or present employment?

The Lotteries Commission conducts an instant lottery called ‘Set for Life’ under which a winner who scratches three ‘set for life’ panels wins $50,000 per year for 20 years. The first $50,000 is payable on verification of the coupon and subsequent amounts are payable on the anniversary of the first payment. In the event of the death of the winner, the commission may pay any outstanding amounts to the deceased’s estate.

Is the annual payment income? A suggested solution may be found in Study help.

Proposition 9: Amounts derived from employment or the provision of services are income 3.38 Ordinary income is typically regarded as including salary and wages, and fees connected with employment or the provision of services. The critical element is the connection with an earning activity. This is evident also in Proposition 3: Gifts unrelated to employment, services or business do not have the character of income [page 134] (3.22ff). For both these propositions to be valid, it must be possible to show that payment may be a mere gift because, even though it passes from an employer to an employee, the circumstances of its payment are unrelated to employment or services rendered. The employer–employee relationship is coincidental. On the other hand, for Proposition 9 to hold, it must be possible to show that, even if the payment is voluntary and driven by the most honourable of motives, it may yet be income in the hands of the recipient if there is a sufficient employment–services connection. The decision in Scott v FCT (1966) 117 CLR 514; 10 AITR 367 demonstrates the first case. In relation to the second, consider the situation in FCT v Dixon (1952) 86 CLR 540; 5 AITR 443.

FCT v Dixon

Facts: In 1940, the taxpayer enlisted in the Australian Imperial Forces and served until discharged in 1945. Prior to his enlistment, his employer had undertaken that for employees who enlisted it would ‘make up the difference’ between Army and usual salary. This arrangement was not uncommon. After the war, Dixon returned to his former employment but was not obliged to do so nor was his employer under any obligation. In the relevant year, the taxpayer was paid £104 and the Commissioner assessed it as income according to ordinary concepts. Held: A majority of the High Court (Dixon CJ, Williams and Fullagar JJ; McTiernan and Webb JJ dissenting) held the amount was assessable income. Dixon CJ and Williams J said (at AITR 448): In the present case we think the total situation of the taxpayer must be looked at to see whether the receipts … are of an income character. He was employed at a salary. The war placed him, in common with many others, in a position in which he felt it was incumbent on him to enlist. At the same time to do so meant that the earnings upon which he and possibly his dependants subsisted would be much reduced. His employers recognised this fact and intimated that they would do their best to see that, if he decided to join the fighting forces, his military pay and allowances would be supplemented so that it would not mean a financial loss. The motives of his employers for doing this were, no doubt, predominantly patriotic, but their patriotic motives were doubtless reinforced by considerations of what was right and proper in relation to the staff … From the taxpayer’s point of view, it is not unlikely that, when he decided to enlist in the Armed Services, he relied to some extent on the intimation he received from his employers. The result was to keep his income up to the standard that would have been [page 135] maintained had he not enlisted … From [the taxpayer’s] point of view, therefore, the word “income” would be clearly applicable to the total receipts from his military pay and allowances and from his civilian employers … It does not seem to matter whether these employers are regarded as his former employers, as his future employers or as the other party to a suspended employment … Indeed, it is clear that, if payments are really incidental to an employment, it is unimportant whether they come from the employer or from somebody else and are obtained as of right or merely as a recognised incident of the employment or work. Their Honours concluded (at AITR 449): Because the £104 was an expected periodical payment arising out of circumstances which attended the war service undertaken by the taxpayer and because it formed part of the receipts upon which he depended for the regular expenditure upon himself and his dependants and was paid to him for that purpose, it appears to us to have the character of income … McTiernan J’s dissent relied on the conclusions that the payments were voluntary and could be stopped at any time, that in no way were they an augmentation of Dixon’s civilian pay and that they were extraneous to his military employment. Thus, his Honour

differed from the majority view that ‘the total situation must be looked at’ and instead sought a contemporaneous connection between a payment and a particular employment. Webb J saw the payments as a reward for enlisting and not arising out of employment. His Honour made the observation at AITR 453: ‘The quality of the reward is not determined by the yardstick used to measure it’.

It is clear from Dixon’s case, that if, in reality, a payment is income, it does not matter who pays it. In Reuter v FCT (1993) 27 ATR 256; 93 ATC 5030, the Full Federal Court examined the ‘total situation’ in characterising as income an amount of $8m paid to the taxpayer. Documentation described the amount as capital in consideration for the taxpayer relinquishing all claims to payment of fees against Rothwells, a company then in financial difficulty. Even though the payment was arranged by Bond Media Ltd, the court found that the nexus between the $8m and services provided by the taxpayer to Rothwells stamped it as income by ordinary concepts. In Dean v FCT (1997) 37 ATR 52; 97 ATC 4762, it was held that payments designed to induce employees to continue their employment were in the nature of a salary and it did not matter that they were paid by a related company rather than their employer. [page 136] 3.39 The majority decision allowing the Commissioner’s appeal in Dixon’s case demonstrates the difficulty of characterising amounts paid voluntarily. Clearly, amounts paid under an employment or services contract are income, and authorities indicate there are a range of occupations where payments such as tips and gratuities are natural incidents of office.39 The problem may be illustrated as follows in Figure 3.1.

Figure 3.1:

Income spectrum

The problem is to identify the dividing line between A and B that separates sufficient from insufficient connection between employment and/or the provision of services. Then it is necessary to establish whether the circumstances of a particular case lie to the left or right of that dividing line. So, a tip to a waiter lies close to A; a wedding present to an employee lies near B. Dixon’s case is to the left of the dividing line; Scott’s case is closer to B. Two cases with similar facts and different conclusions might be thought to highlight considerations critical to identifying the dividing line. Consider FCT v Harris (1980) 10 ATR 869; 80 ATC 4238 and FCT v Blake (1984) 15 ATR 1006; 84 ATC 4661 in relation to the above spectrum and the decision in Dixon’s case.

FCT v Harris Facts: The taxpayer retired from the ANZ Bank in 1974 and was entitled to a pension under the bank’s staff pension scheme. In 1976, he received $450 after the bank decided that, as a result of inflation, the pension was inadequate and, accordingly, the bank would make an ex gratia payment. The payment was unsolicited and unexpected. It was made on the clear understanding that there was no commitment to payments in future years. Subsequent payments were made up to 1979. The Commissioner assessed the first payment.

[page 137] Held: A majority of the Full Federal Court (Bowen CJ and Fisher J, Deane J dissenting) allowed the taxpayer’s appeal. Bowen CJ said (at ATC 4243): This is not a case where the motives of the donor throw much light on the character of the receipt in the hands of the donee. As has been stated the Bank was concerned with the problems caused to its pensioners by high rates of inflation … It was not its motive to reward its pensioners for previous faithful service. The only underlying business consideration was one which concerned the Bank not the pensioner, that was that it was in the business interests of the Bank in relation to existing employees to be seen as treating pensioners, who were former employees, with fairness and liberality. The Chief Justice treated the relevance of the subsequent payments as follows (at ATC 4244): The most that one can derive from consideration of later payments is that the $450 was likely to be for Mr Harris the first of a succession of payments of uncertain amount arrived at by separate decisions of the bank taken from year to year. It is true to say, that a lump sum payment of uncertain and varying amount paid in each of five successive income years, may in a sense be described as a “periodic” payment. But it is not periodic in any sense which is of much help in determining whether the payment is, or is not, of an income nature. In particular, I consider that the fact that $450 was the first of such a series insufficient to lead to the conclusion that it should be regarded as being income.

Bowen CJ saw three critical elements in Dixon’s case as being absent in Harris: the payment was not periodical, not incidental to an employment, and not relied on for regular expenditure. In dissent, Deane J said the combination of three considerations led to the conclusion that the amount was income according to ordinary concepts: first, the former employment relationship — the payment was received only because the taxpayer was one of a class of ex-employees; second, the amount was one of a series of payments; and, third, the payment was made to supplement income. All members of the court held that the payment was not a product of past services rendered to the bank, but Deane J considered past services were the cause of the payment. [page 138]

FCT v Blake Facts: The taxpayer was a retired officer of the Commercial Bank of Australia. Since 1971, he had received regular, fortnightly, ex gratia payments. The payments were unsolicited and the bank was under no obligation to pay them. A Board of Review applied Harris’s case to conclude the payments were not income and the Commissioner appealed. Held: Carter J of the Supreme Court of Queensland distinguished Harris’s case and held the payments were income. His Honour said (at ATC 4664): [T]he directors of the Bank voluntarily took a series of decisions which were designed to protect to some extent the standard of living of those former employees now living in retirement. There was no attempt to discriminate between them. Irrespective of their individual financial status, those in receipt of a pension payment from the Fund had their payment increased or supplemented … As a result of it, the amount of money available to the taxpayer for his daily living was increased. In my view it accords with ordinary concepts and usages to include it in that which one normally regards as one’s income …

His Honour considered his conclusion was in accord with Dixon CJ and Williams J in Dixon, Fullagar J in Hayes, and Deane J’s dissent in Harris. He thought several factual differences distinguished the majority view in Harris where the payment was a lump sum, was made for the first time in 1976, and Harris had no expectation of it, or future payments, and did not rely on it in order to support himself. The similarity to Deane J’s finding is evident. A critical difference between the majority in Harris, on one hand, and Deane J (in dissent) and Carter J (in Blake), on the other, lies in an assessment of what is periodic. A payment that is not periodical can scarcely be relied on for regular expenditure. Clearly, the link with employment is also a factor and in relation to the spectrum above, Harris would lie to the right of Blake but the dividing line between income and non-income amounts is no clearer.40 Regularity and periodicity are common attributes of income but there are cases involving one-off payments that turn on whether there is a sufficient employment–services nexus. In Hochstrasser v Mayes [1960]

AC 376, the taxpayer was an employee of a company that operated a scheme whereby compensation was paid [page 139] when, as a result of a change in employment location, a loss was sustained on the sale of employees’ houses. The taxpayer was paid £350 under the scheme and the amount was assessed as a profit accruing from employment. Lord Denning held the amount was not income because there was, in fact, no gain but, in the Australian context, the conclusion of other members of the House of Lords is more relevant. What was important in their view was that although employment was an essential precondition to the payment, it was not a cause of the payment. The payment was compensation for a capital loss.41 In the language of Harris’s case, the payment was not a product of employment, nor was it caused by employment. On the other hand, there are occasions where, despite regularity and recurrence, payments are not income. This is best illustrated in family arrangements such as in FCT v Groser (1982) 13 ATR 445; 82 ATC 4478. In that case, $2 per week ‘rent’ paid by the taxpayer’s parents and brother was not income. The amounts were paid under a family arrangement that lacked the necessary commercial reality to stamp the activity as income producing.

Sports-related payments 3.40 Payments made to sportspersons in the nature of salary or the proceeds of carrying on professional activities are clearly assessable as ordinary income. Match payments to a professional footballer or stakes won by a professional golfer arise out of the participant’s involvement in the sports. Although the distinction between amateur and professional sportspersons is blurred, prizes paid to the former would not normally be income because the activity lacks any underlying commercial basis. The activities are essentially hobbies, although

sponsorship payments are in the nature of income because of the service contract with the sponsor. The distinction between professional and non-professional is therefore vital and will depend on the facts of the particular case. The issue was considered by the High Court in FCT v Stone (2005) 222 CLR 289; 59 ATR 50; [2005] HCA 21.

FCT v Stone Facts: The taxpayer was employed full-time as a policewoman and in her spare time achieved world ranking as a javelin thrower. Her interest developed in 1987, and by 1994 she had competed in a number of local and state athletic competitions. In 1998–99, her salary was around $40,000 and the following amounts were received from sporting activities: [page 140]

Prize money (local and international events) Grants: Qld Academy of Sport AOC Medal Incentive Scheme Appearances Sponsorships

$93,429 5,400 22,500 27,900 2,700 12,419 $136,448

At first instance (Stone v FCT (2002) 51 ATR 297; [2002] FCA 1492), the principal question was whether Ms Stone was carrying on a business as a ‘professional athlete’ in addition to her police duties. The court considered the case was ‘on the borderline’ but concluded ‘not without some doubt’ that by 1998–99 the taxpayer had begun to turn her talent to account for money and was carrying on a business with the result that all the rewards incidental to that business were assessable income. The view was also expressed that the payments from the Medal Incentive Scheme and appearances were income, on the assumption that Ms Stone was not engaged in a business. The Full Federal Court ((2003) 130 FCR 299; 53 ATR 214; [2003] FCAFC 145) held that,

although the appearance and sponsorship moneys were income (being rewards for services), Ms Stone did not carry on a business. The Commissioner appealed to the High Court. Held: Taken as a whole, the taxpayer’s activities amounted to a business with the result the amounts were assessable income. Gleeson CJ, Gummow, Hayne and Heydon JJ said (at [50]–[55]): Once it is accepted, as the taxpayer did, that the sums paid by sponsors to her, in cash or kind, formed part of her assessable income, the conclusion that she had turned her sporting ability to account for money is inevitable. The sponsorship agreements cannot be put into a separate category marked “business”, with other receipts being put into a category marked “sport”. Nor can some receipts be distinguished from others on the basis that the activity producing a receipt was not an activity in the course of carrying on what otherwise was to be identified as a business. Agreeing to provide services to or for a sponsor in return for payment was to make a commercial agreement. What the taxpayer received from her sponsors were fees for the services she provided. But when these arrangements are set in the [page 141] context of her other activities during the year, it is evident that the sponsorship arrangements she made were but one way in which she sought to advance the pursuit of her athletic activities. No doubt, as the taxpayer pointed out, pursuit of her athletic activities was expensive. And it must be accepted that her principal motivations were the pursuit of excellence and the pursuit of honour for herself and her country. But the sponsorship arrangements show not only that the taxpayer made those arrangements to assist her pursuit of athletic activities but also that she was able to make them because of her pursuit of those activities. Having this dual aspect, the sponsorship agreements cannot be segregated from other aspects of her athletic activities. All of the receipts now in question were related to the taxpayer’s athletic activities. Some of those amounts (in particular, the sponsorship amounts) were paid in return for the taxpayer’s agreement to provide services; some (like the Medal Incentive Scheme payments) were not. Perhaps the appearance fees may fall into that former class rather than the latter. Apart from appearance fees, and apart from the amount paid to the taxpayer by the QAS for being selected in the Australian Commonwealth Games Team, the other payments made to her appear in each case to have been paid in accordance with, or subject to, her undertaking contractual obligations or inhibitions … What is clear, however, is that at least some of the amounts which the taxpayer received during the 1998–1999 year in connection with her athletic activities were payments made and received in accordance with a contract which stipulated obligations undertaken by the taxpayer. Even if it is right to see payments made to the taxpayer under the Medal Incentive Scheme as unsolicited by her, they were made available only upon her undertaking

certain inhibitions not only on her future sporting conduct but also on her future commercial exploitation of success in competition. Taken as a whole, the athletic activities of the taxpayer during the 1998–1999 year constituted the conduct of a business. She wanted to compete at the highest level. To do that cost money for equipment, training, travel, accommodation. She sought sponsorship to help defray those costs. She agreed to accept grants that were made to her and agreed to the commercial inhibitions that came with those grants so that she might meet the costs that she incurred in pursuing her goals. Although she did not seek to maximise her [page 142] receipts from prize money, preferring to seek out the best rather than the most lucrative competitions, her pursuit of excellence, if successful, necessarily entailed the receipt of prizes, increased grants, and the opportunity to obtain more generous sponsorship arrangements. That other sports and other athletes may have attracted larger rewards is irrelevant.

Kirby J agreed with the above conclusion but expressed the view that intermittent prize money and special grants viewed individually did not possess the character of ordinary income. His Honour said (at [106]– [107]): Prizes, in particular, depend on providence, are usually intermittent and ordinarily lack periodicity and regularity. They depend upon so many chance factors that they would not normally take on the character of “income” without some additional unifying ingredient. It is the imposition of the postulate of the taxpayer’s “business” that affords that additional ingredient …

In addition to the threshold question of whether the activity is ‘professional’, three specific categories of payments have been considered by the courts: 1. preliminary or signing-on payments; 2. performance awards; and 3. retirement or testimonial payments.

Preliminary or signing-on payments 3.41 The character of signing-on payments is determined by applying the income/capital distinction. While advance payments for services to

be performed are income, it has been argued that payments for giving up some former status are capital in nature. In Jarrold v Boustead (1964) 41 TC 701, a Rugby Union player’s £3000 signing-on fee to play Rugby League was described as capital compensation for giving up his amateur status. The payment was distinct from match payments he subsequently received and held to be capital in consideration for renouncing valuable rights.42 In FCT v Woite (1982) 13 ATR 579; 82 ATC 4578, the taxpayer was a South Australian footballer. He was paid $10,000 by North Melbourne (Kangaroos) Football Club for agreeing to play with no Victorian club other than North Melbourne. As it transpired, the taxpayer never played outside South Australia. The Supreme Court of South Australia held the amount to be capital in nature. It was not an incident of playing football in South Australia but, rather, payment for restricting himself from playing elsewhere. However, there is a strong suggestion in the course of Mitchell J’s judgment that if, in fact, Woite had played for [page 143] North Melbourne, it would be more difficult to argue the payment was not income in nature. As it was, the payment was for entering into a restrictive covenant.43 The more common such arrangements become, the more difficult it is to argue they are not products or incidents of employment or service contracts. In addition, demonstrating that valuable rights are given up is not easy. Professional athletes have already renounced amateur status so payments to transfer from one code to another are income in nature.44

Performance awards 3.42 Professional sportsmen and women who compete for prize money will derive income when successful even though the payments may be irregular. The character of an unexpected award won by a footballer who had already been paid match payments was considered in Kelly v FCT (1985) 16 ATR 478; 85 ATC 4283.

Kelly v FCT Facts: The taxpayer was a university student who played Australian Rules with East Perth Football Club. He did not have a contract but received a set match payment. In 1978, he won the Sandover Medal for the fairest and best player in the WANFL together with a payment of $20,000 from television station, Channel 7. The taxpayer was aware that the prize would be offered and Channel 7’s motive was to attract viewers to its telecasts and cement its relationship with the WANFL in 1979. The Commissioner assessed the amount as income. Held: The Supreme Court of Western Australia held the payment was income. Channel 7’s motive was relevant but not decisive in characterising the payment. Franklyn J said (at ATR 483–4): In my view, the overall circumstances show in this case that Channel 7 was providing for a period of years a sum of money which in the end result would in each year be paid to a footballer in the league competition as a consequence of him playing in that year to such a standard that he would receive sufficient votes to win the Sandover Medal. From the point of view of the recipient it was a sum which he was eligible to [page 144] receive … by virtue of his employment if he could play well enough to secure the most votes from umpires as fairest and best player … This is not a case such as that of Scott v FCT … where the payment was referable to the attitude of the donor personally to the donee personally … In my opinion the payment to and receipt by the appellant of the sum of $20,000 was directly related to his employment by the club as a footballer … It cannot be fairly said, as was submitted by counsel for the appellant, that this is a case such as that considered in Hochstrasser v Mayes … in which the moneys were not paid to the employees in their capacity as employees and for no consideration other than their services, but were paid under a separate and collateral contract as entered into between them and the employer. Here the payment is directly related to the performance by the recipient of his duty as an employee of the club which performance itself secures the votes of umpires and results in receipt of the payment. Further it can be distinguished from the facts of Moore v Griffiths … because that case is a decision based on the provisions of the United Kingdom Income Tax Act 1952 and is not necessarily determinative of the law in Australia.

Testimonial payments 3.43 Some older UK cases suggest that the proceeds of benefit matches and testimonials paid to retiring professionals may be capital or in the nature of a mere gift. In Seymour v Reed (1927) 11 TC 625, a cricket club held a benefit match for the taxpayer, a professional cricketer. The proceeds, together with money raised by public subscription, were eventually used to purchase a farm for the taxpayer and the revenue authority assessed the taxpayer for an amount corresponding to the net gate receipts of the benefit match. The House of Lords held that the payment was not income because the match represented an expression of gratitude by the cricket-loving public, and such matches were usually one-off at the time of retirement and the terms of employment did not entitle the taxpayer to such a benefit. In these circumstances, the proceeds were a gift no different from the spontaneous subscriptions from the public. On the other hand, in Moorehouse v Dooland (1954) 36 TC 1, a professional cricketer’s terms of employment provided that collections could be made following a meritorious performance. Such payments were held to be income because they accrued by virtue of employment and because they were expected and recurrent rather than in the nature of a testimonial. In today’s sporting environment, it may be doubted that testimonials can escape assessment as ordinary income. Such payments are a common and expected incident [page 145] of employment or service contracts and decisions such as Kelly’s case support a view that they are income. In FCT v Dixon (1952) 86 CLR 540; 5 AITR 443, Dixon CJ and Williams J said (at AITR 448) that ‘if payments are really incidental to an employment, it is unimportant whether they come from the employer or from somebody else and are obtained as of right or merely as a recognised incident of the

employment or work’. The Commissioner’s Ruling IT 2647 lists several considerations bearing on the nature of a testimonial payment, and it is instructive to note how these considerations are drawn from the authorities discussed above and under Proposition 3: Gifts unrelated to employment, services or business do not have the character of income: 1. How, in what capacity and for what reason is the payment made? 2. Is it a common incident of the recipient’s vocation? 3. Is the payment voluntary? 4. Is the payment unsolicited? 5. If the payment can be traced to gratitude, was the recipient already fully remunerated for services?

How would the following payments be characterised? [Ripping yarn] Nigel Pomegranate is an English sailor attempting to be the first ambidextrous freemason to circumnavigate the world backwards. In the Southern Ocean south of Western Australia, he collides with a left-handed pygmy attempting a similar feat while blindfolded and tied upside-down to the mast. He is rescued by HMAS Preposterous. Channel 5 Perth pays Nigel $200,000 — half payable in 2000–01 and the balance one year later — for a series of exclusive appearances on its Late Nite Show. [True story] In 1991, the oil tanker Kirki was foundering off the coast of Western Australia and the tug Lady Kathleen was sent to assist. It arrived to find the evacuated Kirki drifting towards the coast threatening risk of substantial damage to the environment together with loss of cargo and the ship itself. In an act of considerable bravery, a tow-line was connected and the vessel and cargo saved. A share of the salvage reward was divided among the crew of the Lady Kathleen. A suggested solution may be found in Study help.

Proposition 10: Amounts derived from carrying on a business are income 3.44

The proceeds from business activities are income by ordinary

concepts but whether the activities amount to a business is not so easily resolved. In London [page 146] Australia Investment Co Ltd v FCT (1977) 138 CLR 106; 7 ATR 757; 77 ATC 4398, Barwick CJ (dissenting) said (at ATR 759): [W]hat is produced by a business will in general be income. But whether it is or not must depend on the nature of the business, precisely defined, and the relationship of the source of the profit or gain to the business. Everything received by a taxpayer who conducts a business will not necessarily be income. As I have said, it must depend on the essential nature of his business and the relationship of the gain to that business and its conduct.

Barwick CJ’s statement suggests the following three-step analysis: 1. Is there a business? 2. What is the business exactly? 3. Is a particular transaction within that business as precisely defined? An assertion that all business proceeds were income would be contrary to the income/capital dichotomy and Proposition 2: Capital amounts do not have the character of income (3.8). The UK decision California Copper Syndicate Ltd v Harris (Surveyor of Taxes) (1904) 5 TC 159 nicely states the distinction between a mere realisation of an asset and an act in the carrying on of a business.

California Copper Syndicate Ltd v Harris (Surveyor of Taxes) Facts: The company was incorporated in 1901 with objects that included acquiring copper-bearing land in California. Much of the company’s capital was expended acquiring land and it had insufficient funds to proceed with mining. As a result, it sold the relevant land to another company in consideration of shares and realised a profit. The company argued that it had merely substituted one capital asset (land) for another (shares) and had not realised any profit. Held: The profits were income in nature because from its formation the company intended to sell the land. It never had sufficient funds to mine the land. The sale was not a mere substitution of assets, it was a trading enterprise. In a statement of what has come to be called the ‘California Copper principle’, the Lord Justice Clerk said: It is a quite well settled principle in dealing with questions of assessment to Income Tax, that where the owner of an ordinary investment chooses to realise it, and obtains a greater price for it than he originally acquired it at, the enhanced price is not profit … assessable to Income Tax. But it is equally well established that enhanced values from realisation or conversion of securities may be so assessable, where what is done is not merely a realisation or change of investment, but an act done in what is truly the carrying on, or carrying out, of a business.

[page 147] It follows that precise specification of what is the operating process is a critical step in characterising a receipt as income or capital. So, too, is the determination of whether a particular transaction, especially an unusual or isolated one, is part of the business and therefore on revenue account, or whether it is a mere realisation of an asset. The broader the definition of business, the wider the scope of revenue receipts. This was evident in Memorex Pty Ltd v FCT (1987) 19 ATR 553; 87 ATC 5034.45 In that case, the profits on the sale of certain computer equipment were assessable as they were derived in the ordinary course of the taxpayer’s business. Contrast that decision with Hyteco Hiring

Pty Ltd v FCT (1992) 24 ATR 218; 92 ATC 4216. There, the taxpayer was in business hiring forklifts. Some were owned outright by the taxpayer, others were leased. At the end of their useful life (about five to eight years), the forklifts were sold. If the taxpayer’s business was hiring and selling forklifts, the proceeds of the sale would be part of its ordinary income. But if its business is hiring forklifts, the sale of the equipment would be the disposal of a fixed asset and capital in nature because it was structure-related. The Federal Court held that Hyteco was not engaged in selling forklifts. The equipment was bought with the intention of hire not sale and the decision in Memorex was distinguished on the facts of the cases.46 What is to be viewed as part of a business structure is dependent on business definition. In FCT v Merv Brown Pty Ltd (1985) 16 ATR 218; 85 ATC 4080, a clothing wholesaler held certain import quotas. Following government changes to the system and a review by the company of its activities, it sold several new quotas representing a fraction of its overall entitlements. The Commissioner assessed the taxpayer on the sales arguing that although the taxpayer was not a dealer in quotas, their sale was ‘occasioned by the exigencies of trading’. A majority of the Full Federal Court held that the sales were part of restructuring and represented sale of part of the profit-making structure.

Is there a business? 3.45 The ITAA97 does not provide a comprehensive definition of business. Section 995-1 defines the term as follows. business includes any profession, trade, employment, vocation or calling, but does not include occupation as an employee.

[page 148] The definition is inclusive rather than exhaustive. In FCT v St

Hubert’s Island Pty Ltd (1978) 138 CLR 210; 8 ATR 453 at 455, Stephen J said of it: [A] meaning which is expressed in terms of “includes” and which may be seen to be at least partially expansive in its operation should not, I think, be treated as an exclusive definition but rather as operating cumulatively upon the ordinary meaning of the word or phrase in question and conferring added meaning for the purpose of the Act.

The definition makes it clear that business is to be contrasted with the occupation of an employee but it does not nominate any test or criteria. As a result, the matter has been left to the courts but, as Jacobs J said in London Australia Investment Ltd v FCT (1977) 138 CLR 106; 7 ATR 757 at 771; 77 ATC 4398: ‘It is not possible exhaustively to enumerate the facts or circumstances which will support the inference that a course of activity is a business’. In a revenue law context, whether or not a business exists is a question of fact and degree. To gain some appreciation of the nature of business one could begin with ordinary concepts or dictionary definitions. In FCT v Bivona 89 ATC 4183, Burchett J cited dictionary meanings of a business (at 4190–1): — The Oxford English Dictionary: a pursuit or occupation demanding time and attention; a serious employment as distinct from a pastime … trade; commercial transactions or engagements. — Webster’s Third New International Dictionary: a usually commercial or mercantile activity customarily engaged in as a means of livelihood and typically involving some independence or judgment and power of decision … a commercial or industrial enterprise.

These definitions support the distinction drawn between hobbies or pastimes and serious commercial activity that formed the basis of Proposition 4: The proceeds of gambling and windfall gains are not income (3.25ff). They refer to ‘commercial transactions’ and ‘commercial enterprise’, and suggest the answer to the question ‘Is there a business?’ is to be found in an evaluation of traditional business indicia. By any realistic definition, in a revenue law sense, business is a purposeful activity of a commercial or mercantile nature, engaged in as a means of livelihood. Stripped of its glosses, business is about making a profit — cases cited to the contrary from other jurisdictions notwithstanding.47 That is not to say that a profit must emerge in order for there to be a business. Rather, it is the motivation of profit or

commercial viability which must be established. It follows that to say a profit is not necessary is a very different proposition to asserting there need be no profit motive. The circumstances would need to be exceptional to establish that there is a business if there is no profitmaking intention, however remote. All other tests serve as evidence of that [page 149] intention. Indeed, following the High Court decision in FCT v Myer Emporium Ltd (1987) 163 CLR 199; 18 ATR 693; 87 ATC 4363, it can be said that where a taxpayer enters into a transaction with a view to a profit, that stamps the amount as income. The court said (at ATC 4366): Because a business is carried on with a view to profit, a gain made in the ordinary course of carrying on the business is invested with the profit-making purpose, thereby stamping the profit with the character of income.

3.46 Indicia such as the ‘badges of business’ are occasionally helpful in resolving the question of whether a business exists but they may better serve to illustrate that there are no determinative rules, no single consideration need be present, and no combination of elements is conclusive. Consider the Federal Court decision Ferguson v FCT (1979) 9 ATR 873; 79 ATC 4261.

Ferguson v FCT Facts: The taxpayer was a naval officer who intended to buy a property and breed cattle on his retirement. Several years before his retirement, he entered into agreements to lease five cows and have them held on a property under an arrangement whereby he kept the progeny and, over time, built up a herd. The taxpayer argued that he was carrying on a business of cattle production and claimed appropriate deductions. Held: The Full Federal Court held that the taxpayer was carrying on a business. The size of

activities was a factor but not decisive. What is important is that the activities are commercial in nature and are regular and recurrent. Bowen CJ and Franki J said (at ATR 876–7): There are many elements to be considered. The nature of the activities, particularly whether they have the purpose of profit-making, may be important. However, an immediate purpose of profit-making in a particular year does not appear to be essential. Certainly it may be held a person is carrying on a business notwithstanding his profit is small or even where he is making a loss. Repetition and regularity of activities is also important. However, every business has to begin, and even isolated activities may in the circumstances be held to be the commencement of carrying on business. Again, organisation of activities in a businesslike manner, the keeping of books, records and the use of system may all serve to indicate a business is being carried on. The fact that, concurrently with the activities in question, the taxpayer carries on the practice of a profession or another business, does not preclude a finding that the additional activities constitute the carrying on of a business. The volume of his [page 150] operations and the amount of capital employed by him may be significant. However, if what he is doing is more properly described as the pursuit of a hobby or recreation or an addiction to a sport, he will not be held to be carrying on a business, even though his operations are fairly substantial.

Several considerations may be distilled from the above passage that need to be taken into account in determining the existence of a business: profit-making purpose; repetition and regularity; organisation and system; size and scale of operations; and other factors, such as the nature of the activity.

Profit-making purpose 3.47 Commercial viability generally forms an important element of a business: Babka v FCT (1989) 20 ATR 1251; 89 ATC 4963. In White v FCT (1968) 10 AITR 709 at 711, Barwick CJ said: Merely to realise a capital asset may involve money making as distinct from profit

making but a business in the relevant sense of necessity involves the earning or the intention to earn profits.

The prospect of short- or even medium-term losses does not deny a business but there should be some prospect of long-term viability. In Tweddle v FCT (1942) 180 CLR 1; 2 AITR 360 at 364, Williams J said: I am satisfied that the appellant is seeking to establish himself at Winlaton as a recognised breeder of high class stud stock and that while he is prepared to take losses to achieve this ambition, he has a genuine belief that he will be able eventually to make the business pay.

Thus, the taxpayer in Ferguson’s case was successful because of his long-term plans for commercial viability. In McInnes v FCT (1977) 7 ATR 373, the taxpayer was unsuccessful because the activity lacked any existing or prospective commercial character. It follows, generally speaking, that activities with little prospect of commercial success would be better described as hobbies. Gambling would be so described because losses are a likely outcome, as the decision in Brajkovich v FCT 89 ATC 5227 testifies. In FCT v Stone (2005) 222 CLR 289; 59 ATR 50; [2005] HCA 21 (see 3.40), an athlete who received sports-related payments of over $136,000 was held to be carrying on a business as a professional sportswoman. On the issue of profit motive, the court said (at [55]): No doubt it is necessary to take account of the taxpayer’s statement that she did not throw javelins for money. There are, however, two things to say about that statement.

[page 151] First, it is not to be understood as some failure by the taxpayer to recognise that success in her sport would bring financial reward. The AOC had repeatedly drawn her attention to the financial consequences of success — especially success at an Olympic Games. Continued payments under the Olympic Athlete Programmes were conditional upon maintaining or improving performances in the arena. Secondly, the state of mind or intention with which a taxpayer undertakes activities giving rise to receipts is relevant, but it is only one fact to take into account, in deciding whether the receipts are properly to be classed as income. If a taxpayer has a view to profit, the conclusion that the taxpayer is engaged in business may easily be reached. If a taxpayer’s motives are idealistic rather than mercenary, the conclusion that the taxpayer is engaged in a business may still be reached. The “wide survey and exact scrutiny” of a taxpayer’s activities that

must be undertaken may reveal, as it does in this case, that the taxpayer’s activities constituted the carrying on of a business.

An absence of profit and commercial viability resulted in the taxpayer’s failure in Hart v FCT [2003] FCA 105 to establish a business was in operation. In Hart, the activities in question were aerobatic competitions and the provision of joyrides in aircraft. Over the years, the taxpayer had amassed a considerable stable of aircraft but, in an eight-year period, income of only $6190 was earned whereas expenses amounted to $357,381. In Spender J’s view, the continuing disparity between income and outgoings was difficult to reconcile with an intention to carry on a business. A similar conclusion was reached in Ell v FCT 2006 ATC 4098; [2006] FCA 71. A claim to be carrying on boat-charter business evidenced by business plan projections of considerable losses for a number of years was rejected. Emmett J concluded (at [118]): However, even assuming that the business plans were brought into existence in the course of 1997, the complete absence of analysis projections or demonstrating a commercial rationale for the venture, namely a profit, suggests the alternative purpose postulated on behalf of the Commissioner, namely, obtaining tax deductions in the context of having a luxury yacht available for private use.

The reference to a profit-making purpose is principally a reference to an objective purpose. ‘The intention of a man cannot be considered as determining what it is that his acts amount to’: J & R O’Kane v IRC (1922) 12 TC 303. Thus, in Inglis v FCT (1980) 10 ATR 493, the Federal Court held the business had ceased even though the taxpayer always intended to resume pastoral activities, but did not in fact do so.

Repetition and regularity 3.48 Business is usually evidenced by sustained and regular activity: London Australia Investment Co Ltd v FCT (1977) 138 CLR 106; 7 ATR 757; 77 ATC 4398 per Jacobs J. In FCT v Radnor Pty Ltd 91 ATC 4689, the Full Federal Court held that the volume and frequency of share transactions (and the nature of the taxpayer’s activity) stamped the taxpayer as an investor rather than a dealer. However, as Bowen CJ and Franki J said in Ferguson v FCT (1979) 9 ATR 873; 79 ATC 4261, ‘every business has to begin’ and an isolated transaction may be the

commencement of a business or may amount to a business in its own right: FCT v Whitfords Beach Pty Ltd (1982) 150 CLR 355; 82 ATC 4031. [page 152]

Organisation and system 3.49 In Hyde v Sullivan (1955) 73 WN (NSW) 25 at 29, the Supreme Court said: Speaking generally, the phrase “to carry on a business” means to conduct some form of commercial enterprise systematically and regularly with a view to profit and implicit in this idea are features of continuity and system.

In Ferguson v FCT (1979) 9 ATR 873; 79 ATC 4261, Fisher J was impressed by the fact that ‘the venture as a whole had a commercial flavour, was conducted systematically and … in a business-like manner’: at ATR 884. Organisation and system have been important elements in distinguishing businesses and hobbies such that a taxpayer who owned one angora goat was held to be in the business of breeding because of his business-like manner: FCT v Walker 85 ATC 4179. Of course, the level of system and organisation may vary depending on the nature of the activity and the taxpayer’s ability and the fact that an enterprise is run in an inefficient manner by a taxpayer with limited business skill will not preclude the activity from a business classification: Thomas v FCT (1972) 3 ATR 165; 72 ATC 4094. The degree of organisation and system are important considerations in distinguishing a business from a hobby. If smallness of scale and irregularity suggest a hobby, system and organisation might suggest a business. In the case of gambling and punting, however, there is a long line of authority suggesting these activities do not amount to a business whatever the degree of system and organisation: Jones v FCT (1932) 2 ATD 16; Martin v FCT (1953) 90 CLR 470; 5 AITR 548. There are occasional exceptions. The former Commonwealth Taxation Board of Review considered the case48 of a taxpayer who attended practically every racing and trotting meeting and punted heavily. In one year, he

placed around 2000 bets amounting to $270,000 and collected nearly $300,000 in dividends. He leased an office, installed a computer and several telephone lines, and employed some secretarial assistance. The taxpayer’s system and organisation impressed the tribunal to a degree and the taxpayer was partly successful in his claims. More recently, in Evans v FCT (1989) 20 ATR 922; 89 ATC 4540, the Commissioner’s attempt to assess a punter’s winnings as business proceeds failed because, in the absence of an office, staff, computer and subscription to information services, the Federal Court held the taxpayer’s activities lacked the essential system and organisation. In Babka v FCT (1989) 20 ATR 125; 89 ATC 4963, large-scale betting activities were classified as a pastime, not a business.

Size and scale of operations 3.50 In Thomas’s case, Walsh J said that a man may carry on a business even though in a small way. However, the smaller the activity, the greater the importance of system, organisation and business-like behaviour: FCT v Walker 85 ATC 4179. In McInnes v FCT (1977) 7 ATR 373, the small scale of cattle breeding and the lack of significant commercial purpose indicated there was no business. Clearly, a specific number cannot be assigned to activities. In Walker’s case, the taxpayer had one goat; [page 153] in McInnes, the taxpayer averaged four or five head of cattle on hand. The size of profit is not a factor and it is not to the point that a venture fails: Gaillie & Davidson Motors Pty Ltd v FCT (1985) 17 ATR 74. What is important is commercial viability or purpose and potential for such viability.

Other factors 3.51 Factors that have been important in determining a business include the type and quantity of goods traded: Edwards v Bairstow

[1956] AC 14. At times, there have been suggestions that the use of a company to conduct an activity may indicate that there is a business (Lewis Emanuel & Son Ltd v White (HM Inspector of Taxes) (1965) 42 TC 369),49 whereas the use of a trust is less likely to be a business (FCT v Radnor Pty Ltd (1990) 21 ATR 608). In London Australia Investment Co v FCT (1977) 138 CLR 106; 7 ATR 757; 77 ATC 4398, Jacobs J said (at ATR 771): It would seem that a course of activity on the part of a company otherwise engaged in commercial activity may more readily be termed a business than one on the part of an individual but no great emphasis should be given to this feature.

The fact that an activity is illegal is no impediment to business: Lindsay v IRC (1933) 18 TC 43. A business may be conducted parttime and the fact that a taxpayer has other full-time employment presents no barrier to a business: Ferguson’s case. Similarly, the fact that the taxpayer has no other occupation does not mean a particular activity is, therefore, a business: Babka’s case. All businesses must start somewhere but it is often a critical question as to exactly when a business may be said to have commenced. This issue has more relevance to the allowance of deductions and the courts have employed a ‘stage of development’ test. In Softwood Pulp & Paper Ltd v FCT (1976) 7 ATR 101 at 114, Menhennitt J said: The critical point is that the company has not reached a stage remotely near the carrying on of a business. Even assuming that at some stage prior to the mill turning, the company could be said to be carrying on a business, in this stage the company has not even approached the stage of making a decision about carrying on a business.

It is clear, though, that a business need not have reached an optimal, economical or desirable level of development before it can be said to have commenced: Cannop Coal Co Ltd v IRC (1918) 12 TC 31; Ferguson’s case. In Southern Estates Pty Ltd v FCT (1967) 117 CLR 481, it was held that mere preparation of land was not ‘actually carrying on primary production’. In FCT v Osborne 90 ATC 4889, the Federal Court held that, in general, in the case of plantations of fruit or nut trees, the costs up to at least the stage of establishing seedlings in the ground were preparatory capital expenses: see also Dalton v DCT 98 ATC 2025.

[page 154]

What exactly is the business? 3.52 Having established that a business exists, it becomes necessary to identify what proceeds are income in nature and what are not, for, as Barwick CJ observed in London Australia Investment Co, not everything received from a business is income. Routine proceeds from the sale of stock in trade or from the provision of services are income by ordinary concepts but, as cases such as FCT v Merv Brown Pty Ltd (1985) 16 ATR 218; 85 ATC 4080, Memorex Pty Ltd v FCT (1987) 19 ATR 553; 87 ATC 5034, FCT v GKN Kwikform Services Pty Ltd (1991) 21 ATR 1532; 91 ATC 4336 and Hyteco Hiring Pty Ltd v FCT (1992) 24 ATR 218; 92 ATC 4216 have shown, whether a particular proceed arises from the business process or from the sale of assets depends on an exact specification of what the business is. For example, in GP International Pipecoaters Pty Ltd v FCT (1990) 170 CLR 124; 21 ATR 1; 90 ATC 4413, the taxpayer contracted with the State Energy Commission of Western Australia (SECWA) to supply coatings for pipes to be used in a natural-gas pipeline. The operation required the construction of expensive plant that would be scrapped on completion of the project. The contract provided that SECWA pay $4.675m ‘establishment costs’. Ultimately, the plant cost $5.35m and was sold for its salvage value of $500,000 such that the taxpayer made a net loss on that part of the contract. The taxpayer argued that the payment was capital in nature because its business was the coating of pipes, not the construction of plant. The High Court rejected this submission. In entering into a contract to construct the plant and coat the pipes, the payment was made in and by reason of the ordinary course of the business which it carried on. The taxpayer also argued that the construction of the plant was a severable part of the contract, no more than a means to an end, but this too was rejected by the High Court because the contract provided for the entire venture.50 There are some businesses where the sale of assets that do not form

part of the stock in trade will routinely produce income receipts. One such group has been called the ‘banking and insurance’ cases.

Banking and insurance cases 3.53 The nature of banking requires the maintenance of liquid reserves either to satisfy statutory or prudential obligations as well as to meet the day-to-day needs of customers. The sale of investment assets by banks and life insurance companies may, therefore, be seen as part of the ordinary operations of the businesses and the tax consequences may be distinguished from the treatment of the sale of similar assets held by investment companies. For example, in Colonial Mutual Life Assurance Society Ltd v FCT (1946) 73 CLR 604; 3 AITR 450, the company’s dominant if not sole objective in investing in a range of securities was to maximise its yield. To this end, it ‘switched’ investments from time to time by selling some securities and immediately reinvesting the funds. The Full High Court held that the investment [page 155] and subsequent realisation of funds was a normal step in the carrying on of a life assurance company. In a joint judgment, the court said (at AITR 457): But an insurance company, whether a mutual insurance company or not, is undoubtedly carrying on an insurance business and the investment of its funds is as much a part of that business as the collection of the premiums. The purpose of investing the funds of the appellant is to obtain the most effective yield of income. This view is in line with that of the Privy Council in Punjab Co-op Bank Ltd v Income Tax Commissioner [1940] AC 1055. In our opinion there is no substantial distinction between the business of an insurance company and that of a bank in this respect.

In Australasian Catholic Assurance Co Ltd v FCT (1959) 100 CLR 502; 7 AITR 440, a similar issue arose in relation to the sale of real estate. In that case, the taxpayer acquired blocks of flats as long-term investments at such a price as to return approximately 10%. Following World War II, heavy repair costs and rent controls forced the company

to sell the flats and the Commissioner assessed the company on the profits. The appeal was dismissed. Menzies J said (at AITR 442): The main argument for treating the profits in question as assessable income is that they were profits from the carrying on of the taxpayer’s life assurance business and were accordingly income according to ordinary concepts and properly taxable as such. That they were profits from the carrying on of that business is, I think, an inescapable conclusion. The flats were bought as good investments and were sold to avoid their becoming bad investments, which was what was intended from the very first, although it was hoped and, indeed, expected, they would not have to be sold until a long time after 1951.

His Honour went on to dismiss an argument that the profits arose outside the taxpayer’s normal business because they were forced upon the company by unexpected developments. When investments are bought to be sold eventually, the particular reason for deciding to sell cannot be decisive of whether the profit was income.51 This principle extends to general insurance companies: Ipec Insurance Ltd v FCT (1975) 5 ATR 387; RAC Insurance Pty Ltd v FCT (1990) 21 ATR 709; 90 ATC 4737. In Employers’ Mutual Indemnity Association Ltd v FCT 91 ATC 4850 at 4854, Burchett J observed: As regards the application of the general principle [the ‘California Copper principle’] a line of cases has established that the business of banks and insurance companies generally stand in a special position. The nature of the undertaking carried on by a bank or an insurance company requires it to deal in money, and in the investment of money. Its investments are an integral part of its business. The consequence is that, unless there is something to set a particular investment aside as not falling within the business of banking or insurance, a gain or loss realised by a bank or insurance company upon its sale will be upon revenue account.

[page 156] 3.54 In the 1990s, there were several insurance cases that tested whether it was possible to quarantine investments serving different functions. That is, accepting that the authority of the ‘banking and insurance’ cases meant that investments providing daily funds or satisfying statutory and prudential liquidity ratios were on revenue account, could it be said that other investments were on capital account? The courts answered in the negative. In RAC Insurance Pty

Ltd v FCT (1990) 21 ATR 709; 90 ATC 4737, surplus funds were invested in negotiable short- to medium-term investments. In 1982, a subsidiary was formed to manage investments and on maturity the investments were transferred (at market value) to the subsidiary for reinvestment. The Federal Court held the proceeds were on revenue account whether or not they were used to satisfy customer claims. The funds were a necessary reserve and realisation part of the business. In Employers’ Mutual Indemnity Association Ltd, the taxpayer conducted its insurance business under two separate headings of employment. Funds surplus to immediate needs were transferred to a general fund, the profits from which were apportioned between the two headings. Ultimately, claims could be made against the general fund, although this was uncommon. The Full Federal Court held the profits assessable because the unlikelihood of claims did not exclude the reserve from its integral place in the taxpayer’s business. The question also arose as to whether funds held and invested by subsidiaries of an insurance group were similarly on revenue account. The courts’ response was more equivocal. In CMI Services Pty Ltd v FCT (1990) 21 ATR 445; 90 ATC 4428, the taxpayer, a wholly owned subsidiary of Chamber of Manufactures Insurance Ltd, was incorporated to invest surplus funds. The Full Federal Court held that the company activities amounted to a business of investing and profits from the sale of real estate were assessable. This conclusion meant it was unnecessary to consider whether the activities of the subsidiary were inextricably linked with the parent’s insurance business and income as a result of that connection. However, in GRE Insurance Ltd v FCT (1992) 23 ATR 88; 92 ATC 4089, a subsidiary was acquired to hold the taxpayer’s equity investments. Sales of shares by GRE to the subsidiary were held to be assessable as were profits on the sale of some shares by the subsidiary. The Full Federal Court held that, although the subsidiary was a separate legal entity, its activities formed part of the overall business of GRE. The equities formed part of GRE’s reserves and were not sufficiently quarantined from the ordinary operations of the insurance business to be regarded as investments on capital account. On the other hand, in AGC (Investments) Ltd v FCT (1992) 23 ATR

287; 92 ATC 4239, the taxpayer was a wholly owned subsidiary of AGC Insurance that carried on the group’s investments. The taxpayer held a share portfolio and engaged in small-scale buying and selling. In 1987, in the expectation that the share market was overvalued, the company sold its portfolio at a profit of $45m. At first instance (91 ATC 4239), Hill J followed GRE Insurance Ltd to find the amount income but on appeal the Full Federal Court distinguished GRE Insurance Ltd on the basis that AGC (Investments) did not need to buy and sell on a regular basis to maintain the parent’s liquidity. As a result, the investments were long term and on capital account. 3.55 Not all investments held by banking and insurance companies must necessarily be on revenue account. In National Bank of Australasia Ltd v FCT (1969) 118 CLR 529; 1 ATR 53, the taxpayer took over the Queensland National [page 157] Bank (QNB) in 1948 and acquired shares bought by QNB as part of its business strategy of identifying itself with rural Queensland. In 1963, the shares were sold. The High Court found the shares were held to secure the bank’s base of operations and were, therefore, structure related. The sale was not part of the bank’s day-to-day operations. In Equitable Life and General Insurance Co Ltd v FCT 90 ATC 4438, the taxpayer was part of the QBE group and, until 1977, carried on the insurance business. Between 1977 and 1984, the taxpayer retained an investment portfolio and from time to time bought and sold shares. A majority of the Federal Court held that the taxpayer was not a dealer in shares nor did it hold the investments as part of an insurance business. The investments were long term and on capital account. The characterisation of the proceeds of the sale as income (Memorex Pty Ltd v FCT (1987) 19 ATR 553; 87 ATC 5034) and loss of assets (FCT v GKN Kwikform Services Pty Ltd (1991) 21 ATR 1532; 91 ATC 4336) was a consequence of findings that the disposals were in the ordinary course of the taxpayers’ businesses. The same principle applies

in the ‘banking and insurance’ cases. Decisions such as FCT v Cooling (1990) 22 FCR 42; 21 ATR 13; 90 ATC 4472 (assessability of a lease incentive) demonstrate the assessability of unusual transactions arising as ordinary incidents of business. Where a taxpayer enters into a different type of arrangement or diversification of its business, the proceeds will be income: Jennings Industries Ltd v FCT (1984) 15 ATR 577; 84 ATC 4288. Exploiting a profit-making structure in a different or innovative manner will generate an ordinary income receipt: RollsRoyce Ltd v Jeffrey [1962] 1 All ER 801; Kosciusko Thredbo Pty Ltd v FCT (1984) 80 FLR 290; 15 ATR 165; 84 ATC 4043. All of these conclusions follow from identifying precisely what is the business and what would be regarded as a natural consequence or incident of carrying on that activity.

Is a particular transaction within that business as precisely defined? 3.56 The ‘California Copper principle’ is that the mere realisation of an asset is an enhancement of capital but where what is done is truly the carrying on, or carrying out, of a business, the amount is income. The test is: is the sum of gain that has been made a mere enhancement of value; or is it a gain made in an operation of business in carrying out a scheme for profit making? Beginning in 1977 with London Australia Investment Co Ltd v FCT (1977) 138 CLR 106; 7 ATR 757; 77 ATC 4398, a series of High Court decisions were handed down that reinvigorated the general assessing provision and reaffirmed the ‘California Copper principle’. The Australian courts were quick to adopt relevant principles enunciated in UK decisions but, until the time ITAA36 s 26(a) was enacted, the High Court, sitting as a Full Court, had not definitely decided whether a profit on an isolated transaction entered into for the purpose of profit making was income. In Blockey v FCT (1923) 31 CLR 503, the dicta of

the majority indicated that, if it arose, the question would be decided in the affirmative (per Isaacs J at 508–9): A mere realization of property though producing profit does not, as I have said, produce income. It is a mere enlargement of capital. But if a man, even in a single instance risks capital in a commercial venture — say in the purchase of a cargo of sugar or a flock

[page 158] of sheep for the purpose of profit making by resale, and makes a profit accordingly, I do not for a moment mean to say that he has not received “income” which is taxable. I intimated during the argument that this was possible, and I leave it open.

The former s 26(a) was inserted into the principal Act in 1930. It provided: 26 The assessable income of a taxpayer shall include — (a) profit arising from the sale by the taxpayer of any property acquired by him for the purpose of profit making by sale, or from the carrying on or carrying out of any profit making undertaking or scheme;

Baldwin and Gunn said of the provision: Section 26(a) [is] merely a statutory declaration of what has for many years been accepted as settled law in Australia, namely, that a profit derived from any transaction or scheme entered into for the purpose of profit making is assessable income notwithstanding that the transaction or scheme does not amount to, or is not part of, a trade or business.52

Twenty-five years later, Gunn was to add to a view expressed in words similar to those above: However, the statutory criterion provided by s 26(a) must be applied directly and cannot be treated as going no further and producing no different result than would a criterion expressed as “exercising trade” or “carrying on a business”.53

The effect of ITAA36 s 26(a) was to introduce a statutory test based on the taxpayer’s purpose of acquiring property and the interpretation of the provision developed its own culture independently of income by ordinary concepts. For around 50 years, s 26(a) became the primary mechanism for

assessing isolated transactions. In retrospect, throughout that period the general assessing provision, ITAA36 s 25(1) (ITAA97 s 6-5) was in suspended animation. Its reinvigoration is evident in the following three decisions: London Australia Investment Co v FCT (1977) 138 CLR 106; 7 ATR 757; 77 ATC 4398; FCT v Whitfords Beach Pty Ltd (1982) 150 CLR 355; 12 ATR 692; FCT v Myer Emporium Ltd (1987) 163 CLR 199; 18 ATR 693; 87 ATC 4363.

London Australia Investment Co Ltd v FCT Facts: The company was incorporated in New South Wales with the object of investing in stocks and shares and was listed on the London Stock Exchange. The company pursued a policy of investing to earn [page 159] a consistent yield and, when returns dropped below a benchmark rate, shares were sold and others acquired. The purchase and sale of shares was on a large scale and profits were used to reinvest, not to pay dividends. The Commissioner assessed the taxpayer on the profits under ITAA36 s 25(1) or s 26(a). Held: A majority of the High Court (Gibbs and Jacobs JJ; Barwick CJ dissenting) held the profit was ordinary income assessable under ITAA36 s 25(1) (ITAA97 s 6-5). There are several different lines of argument evident in the three judgments. Barwick CJ said (at ATR 759–60): It must appear, certainly at first sight, extremely odd that an accretion to capital derived from the sale of an asset, not forming part of circulating capital and not held as a trading asset, should be accounted income. But the question is whether, none the less, the decisions and settled doctrine in the law of income tax require such a conclusion…. In holding that gains upon the realization of securities by banking and insurance companies constitute income by the banking and insurance business, the Court relied upon the particular nature of those businesses and the relationship which investment realization bore to that nature…. That the appellant carried on investment in Australian shares as a business or business activity cannot be doubted. The essence of that business was the receipt of dividends in order to service the dividend to be paid by the appellant to its UK shareholders. Quite clearly, it was no part of that business to traffic in shares.

Accordingly, no shares were acquired with the purpose of making profit by their resale…. In my opinion, nothing in the banking and insurance cases … requires the conclusion that the gains or losses on the realization of shares by this company formed part of, or in the case of a loss, a reduction of, its assessable income. Gibbs J said (at ATR 762–3): When a taxpayer sells one of its investments, the question whether the profit on the sale should be treated as capital or income is to be answered by applying the tests stated in California Copper Syndicate Ltd v Harris … [I]t is in my opinion established by [Colonial Mutual Life Assurance Society Ltd v FCT (1946) 73 CLR 604; 3 AITR 450] and the many other cases in which California Copper Syndicate Ltd v Harris has been applied that if the sale in question is a business operation, carried out in the course of profit-making, the profit arising on the sale will be of an income character…. [page 160] The present case is in my opinion indistinguishable from the decision in Colonial Mutual Life Assurance Society Ltd v FCT … The test [in California Copper Syndicate] is applicable to any business and if the sale of the shares is an act done in what is truly the carrying on of an investment business the profits will be taxable just as they would have been if the business had been that of banking and insurance. Jacobs J said (at ATR 771–2): The cases referred to are some of what may be described as the “banking” and “insurance” cases, upon which naturally the Commissioner relies quite strongly on this appeal. But there is a significant difference between the banking or insurance business which involves investment activity and the course of investment activity in the instant case. The nature of a banking or insurance business, as part of its putting of money as circulating capital to use, involves not only occasional acquisition of property in satisfaction of advances … but also and more commonly the purchase and sale of various kinds of property whereby moneys which are obtained as part of the business but which form no part of the original capital structure of the bank or insurance company or of that structure enhanced by accumulated net profits, are put to use short-term or long-term. All profits arising from that activity are profits of the business of banking and insurance. At any time and from time to time the property acquired may need to be sold, in whole or in part, to meet requirements of the banking or insurance business and the hope and expectation is that in the meantime not only will the property have earned income but that it will have risen in value. The scale of activity coupled with the source of funds leads to an inference that a purpose or intention of the acquisition is eventual resale at a profit. But in so far as the original capital enhanced by accumulated profits is laid out in investment in property and not in the business activity of banking or insurance, the investments will have the character of capital

and profits or losses on a sale thereof will not be the profits of the business of banking or insurance. The banking and insurance cases thus do not provide an answer to the question which arises in the instant case. The source of moneys for the activities of the appellant company is not money of a kind that can be described as circulating capital. It is essentially investment and reinvestment of moneys which originally were part of, or which were added out of capital profits to, the capital structure of the appellant.

[page 161] For Jacobs J, the answer was not to be found in the banking and insurance cases but in an exact scrutiny of the taxpayer’s business: The massive scale of activities … practically compels the inference that the investment policy … would require frequent and regular realizations of shares whenever they rose in market price …

The proper conclusion in his Honour’s opinion was that large-scale buying and selling of shares was part of a business of acquisition and disposal. Like Jacobs J, Barwick CJ saw the banking and insurance cases as inapplicable. Indeed, the Chief Justice doubted that the Australasian Catholic Assurance Co case was properly decided. On the other hand, Gibbs J was compelled in his finding by the banking and insurance cases. They were decided in accordance with the California Copper principle and he saw the taxpayer’s position no differently. Apart from the disparate views expressed by members of the court, the decision in London Australia Investment Co is significant in that it held the profit on the sale of the shares to represent ‘gross income derived’ in terms of ITAA36 s 25(1).54 The shares were not treated as the company’s stock in trade — a point Barwick CJ considered militated against holding the gains as income in nature. The proceeds from sale were not income, as would usually be the case under the Australian scheme of taxation. The cost of acquired shares was not deductible under the general deduction provision ITAA36 s 51(1) (ITAA97 s 8-1). The income character attached to a net amount. Profit was calculated by subtracting the average cost of shares sold in the year from the

proceeds of sale.55 The circumstances when it is profit rather than proceeds that have an income character were not addressed by the court. 3.57 As noted above, early High Court decisions indicated a preparedness to treat as ordinary income the profit on isolated transactions that were entered into with a profit-making intention. The problem was not with ITAA36 s 25(1) but with ITAA36 s 26(a), which eroded the effect of the general income provision, as the decision in Scottish Australian Mining Co Ltd v FCT (1950) 81 CLR 188; 4 AITR 443 illustrated, and criticisms of that decision by the High Court in FCT v Whitfords Beach Pty Ltd (1982) 150 CLR 355; 12 ATR 692 confirm. In the Scottish Australian Mining Co case, the taxpayer mined between 1865 and 1924 an area of nearly 1800 acres. After 1924, the company began subdivision and sale of the land on a large scale. Considerable expenditure was incurred in subdivision, provision of roads and the construction of a railway station. The Commissioner assessed the profits under ITAA36 s 25(1) or s 26(a). In the High Court, Williams J held that neither provision applied. His Honour said (at AITR 450–1): [page 162] The facts would, in my opinion, have to be very strong indeed before a Court could be induced to hold that a company which had not purchased or otherwise acquired land for the purpose of profit-making by sale was engaged in the business of selling land and not merely realizing it when all that the company had done was to take the necessary steps to realize the land to the best advantage, especially land which had been acquired and used for a different purpose which it was no longer businesslike to carry out. The plain facts of the present case are that the appellant purchased the Lambton lands for the purpose of carrying on the business of coal mining, and carried on that business on the land until it was no longer businesslike to do so. It then had the land on its hands, and it was land which because of its locality and size could only be sold to advantage in subdivision. A sale in subdivision inevitably requires the building of roads. If it is advantageous to the sale of the land as a whole to set aside part of the land for parks and other amenities, this does not convert the transaction from one of mere realisation into a business. It is simply part of the process of realizing a capital asset.

FCT v Whitfords Beach Pty Ltd (1982) 150 CLR 355; 12 ATR 692

also involved the subdivision and sale of land acquired for other purposes but there were important factual differences, especially the alteration of the company’s articles. Gibbs CJ saw this factor as critical and Wilson J saw it as significant. Yet both Wilson and Mason JJ also expressed difficulty with the decision in Scottish Australian Mining Co.

FCT v Whitfords Beach Pty Ltd Facts: In 1954, a group of fishermen formed the company to hold a piece of real estate adjacent to their beach shacks. The land was acquired to secure access to the shacks. In December 1967, developers acquired the shares in the company, changed the company’s articles to permit the conduct of a commercial venture and proceeded to arrange rezoning and subdivision of the land.a The Commissioner assessed the profit under ITAA36 s 25(1) or s 26(a). Held: The Full High Court held that the activities amounted to more than the realisation of an asset and, in fact, there was a business venture. Gibbs CJ, Mason and Wilson JJ considered ITAA36 s 25(1) applied; Murphy J s 26(a). There are some differences in the reasons given by members of the court for this decision. Gibbs CJ considered the change in articles and the taxpayer’s intention in December 1967 were critical. In the light of these circumstances, the extensive development was more than a mere realisation (at ATR 701): In the present case I gravely doubt whether the profits resulting from the development, subdivision and sale of the land would have been taxable if it had not been for the events that occurred on 20 December 1967. Had those events not occurred, the situation of the taxpayer would have been analogous to that of the company in Scottish Australian Mining Co v FCT. However, on 20 December 1967, the taxpayer was transformed from a company which held land for the domestic [page 163] purposes of its shareholders to a company whose purpose was to engage in a commercial venture with a view to a profit. Mason J (at ATR 711) was critical of the decision in the Scottish Australian Mining Co case: Like Wilson J, I have difficulty with the decision of Williams J in Scottish Australian Mining Co … The taxpayer there, after giving up its mining business in 1924, devoted itself to the subdivision of its land. This entailed the construction of roads, the building of a railway station, the granting of land to public institutions such as

schools and churches and the setting aside of land for parks. I should have been inclined to the view that the taxpayer had ceased to carry out its mining business and that it had commenced to carry on the business of land development. Wilson J (at ATR 720–1) also considered the events of December 1967 of critical importance: The events of 20 December 1967 were of great significance. The taxpayer did not remain unaffected by those events. The change in its articles gave it a new purpose, a new orientation. True enough, it remained throughout the owner in fee simple of the subject land … But I am drawn to the conclusion that after that date its purpose was the business of developing, subdividing and selling land, a business in which the subject land was ventured as the capital of the business. The decision in the Whitfords Beach case provides another instance of the assessability of profit. In this regard, Mason J said (at ATR 702): In the United Kingdom the legislation taxes the net profits or gains of a business. Our Act proceeds by an entirely different method taking the taxpayer’s gross income ([ITAA36] s 25(1)), adding to it other receipts of which [ITAA36] s 26(a) is an atypical example (because it catches net profit), thereby arriving at his assessable income from which are subtracted allowable deductions where appropriate … resulting in the ascertainment of his assessable income … Despite the existence of this statutory scheme it is accepted that s 25(1) includes a net amount which is income according to the ordinary concepts and usages of mankind when the net income alone has that character, not being derived from gross receipts that are revenue receipts (see Commercial and General Acceptance Ltd v FCT (1977) 131 CLR 373 at 381).

a.

Had the developers simply purchased the land, ITAA36 s 26(a) or s 25(1) would have clearly applied. By acquiring the shares, ownership of the land did not change and it could be plausibly argued that the ensuing subdivision was no more than a ‘mere realisation’ of an asset. [page 164]

An examination of the circumstances surrounding the purchase of the land in 1954 and the change in shareholding and the company’s articles in 1967 sheds some light on why it was necessary to assess the profit rather than the gross receipts minus allowable deductions. Soon after its incorporation, the taxpayer company paid $47,520 for the relevant

land. Between 1954 and 1967, the value of the land rose such that in 1967 the shareholders were offered $1.6m for their interests in the company. At that date, as Wilson J observed, ‘the subject land was ventured as the capital of the business’. The issue of calculating the assessable income was remitted to the Federal Court (83 ATC 4277), which held that 20 December 1967 was the relevant date on which the land was committed to the business. Clearly, gross receipts from the sale of subdivided land minus the (1954) cost of the land (plus sub-development costs, etc) would generate an inflated measure of the taxpayer’s true income. It, therefore, became necessary to value the land at the time it was ventured in the business. Initially, the Commissioner had argued that the cost of the land should be taken as $1.6m but, ultimately, it was accepted that the land value at that date was $3.1m. The third significant case in the reinvigoration of the general assessing provision (ITAA36 s 25(1)) was FCT v Myer Emporium Ltd (1987) 163 CLR 199; 18 ATR 693; 87 ATC 4363.

FCT v Myer Emporium Ltd Facts: The taxpayer was a retailer that developed an extensive plan for diversification that required external finance. However, the company was restricted in its ability to raise additional debt finance by debt–equity ratios specified in its debenture trust deed so the company devised the plan whereby it lent $80m to a subsidiary at 12.5% for seven and a half years. Total interest was $72m. The taxpayer then assigned the right to the interest to a finance company for $45m, being the discounted value of the interest over the relevant period. In effect, Myer exchanged a right to future interest income of $72m for $45m, being the present value of the future right. The Commissioner assessed the taxpayer on $45m as income from a business deal even if it was outside the taxpayer’s ordinary business. The taxpayer contended the gain was capital from the realisation of an asset not made in the ordinary course of business. Held: The Full High Court held the amount was income by ordinary concepts. The court said (at ATC 4366–7): Although it is well settled that a profit or gain made in the ordinary course of carrying on a business constitutes income, it does not follow that a profit or gain

made in a transaction entered into otherwise than in the ordinary course of carrying on the taxpayer’s business is not income … [A] gain [page 165] made otherwise than in the ordinary course of carrying on the business which nevertheless arises from a transaction entered into by the taxpayer with the intention or purpose of making a profit or gain may well constitute income. Whether it does depends very much on the circumstances of the case. Generally speaking, however, it may be said that if the circumstances are such as to give rise to the inference that the taxpayer’s intention or purpose in entering into the transaction was to make a profit or gain, the profit or gain will be income, notwithstanding that the transaction was extraordinary judged by reference to the ordinary course of the taxpayer’s business.

In the view of the Full Court, the important proposition to be derived from the California Copper Syndicate case was that receipts from isolated transactions may be income when the operation is entered into with the intention or purpose of making a profit. 3.58 It is generally said that there are two grounds to the decision in Myer Emporium. The first is centred on the above restatement of the California Copper principle. The second is grounded in Proposition 12: Amounts received as substitutes for or compensation for lost income are themselves income (3.68ff). That is, the payment of $45m for the assignment of the right to interest of $72m is merely a substitute for income since the lender converts future income into current income. Stated more broadly, except in the case of the assignment of an annuity, the assignment of income from property without an assignment of the underlying property itself will generate an income receipt and this is consistent with cases involving compensation for rights to income: Henry Jones (IXL) Ltd v FCT (1991) 31 FCR 64; 22 ATR 328; 91 ATC 4663. The decision in Myer Emporium, that the assignment of the right to interest generated a profit of $45m, was on the basis that for an outlay of $80m the company had an asset represented by a debt for $80m plus $45m cash, representing the present value of the interest stream. This

was assessable either by virtue of the California Copper principle or as a substitute for income. The reason given by Mason J in Whitfords Beach for the assessment of profit was that the net amount was income according to the ordinary concepts and usages of mankind, not the gross receipts. Under the first ground in Myer Emporium, the gross receipts of $45m had an income character and it was unnecessary even to refer to profit so far as ITAA36 s 25(1) was concerned. Argument that the amount was alternatively assessable under ITAA36 s 26(a) meant that the assessable amount was a profit. The amount of profit was taken to be $45m calculated as $80m loan, minus $80m debt, plus $45m — the same amount as the receipt. A conclusion that a receipt is equal to a profit is not without its difficulties. The outcome of this reasoning was illustrated in SP Investments Pty Ltd v FCT; Perron Investments Pty Ltd v FCT (1993) 41 FCR 282; 25 ATR 165; 93 ATC 4170. [page 166] In that case, the assignment of rights to royalties was held not to be income under the first ground in Myer Emporium because there was no profit. That is, the present value of the income stream of royalties was represented by a reduction in the value of the asset. However, the amount was held to be income under the second ground, being a substitute for income.

Post-Myer Emporium 3.59 Not all amounts received by a business are income. While capital receipts may well generate a capital gain, to say all receipts are of an income nature would deny Proposition 2: Capital amounts do not have the character of income (3.8ff). The decision in Myer Emporium is authority for saying that, in relation to unusual, extraordinary or isolated transactions, the profit will not be assessable unless the transaction is ‘commercial’ and that at the time of its contemplation the taxpayer had a profit-making intention: Westfield Ltd v FCT (1991) 28

FCR 333; 21 ATR 1398; 91 ATC 4234. There is a view that the profitmaking purpose must attach to a particular operation. In Westfield, the taxpayer engaged in the design, construction and management of shopping outlets (and not the purchase and sale of land). To prevent a development project by a rival, the taxpayer acquired land but then sold the land to AMP on the understanding that the taxpayer would carry out the design and development work. The profit on the sale of the land was held not to be assessable as income. An overall profit-making purpose of Westfield was not sufficient to cover a particular transaction. Profit-making purpose must attach to a particular operation. There are alternative views. In a pre-Myer Emporium context, reference should be made to Jennings Industries Ltd v FCT (1984) 2 FCR 273; 15 ATR 577; 84 ATC 4288. In that case, the company was engaged in the construction industry and was not a share dealer. In an agreement with the Investment and Merchant Finance Corporation Ltd (IMFC), the taxpayer and the finance company each took up 50% of the shares in a company that was to be used as a vehicle to acquire and develop a building site. The taxpayer was to be responsible for the development and IMFC arranged a lease for the completed building. It transpired that the shares were sold to the prospective lessee before completion of the project and the Full Federal Court held the proceeds were assessable as ordinary income. The court said that the share dealing ‘was an integral part of a wider transaction’. It did not matter that the taxpayer had not previously entered into such transactions. The court said (at ATR 585): All the profit from the project … including profit on the sale of shares … was profit from the taxpayer’s diversified business. The sale of shares was not a mere realisation of an investment at a profit but a step taken in the course of a new part of the taxpayer’s ordinary business.

In a post-Myer Emporium context, reference should be made to Rotherwood Pty Ltd v FCT (1996) 64 FCR 313; 32 ATR 276; 96 ATC 4203. In that case, as part of the reorganisation of a professional practice, the trustee of a service trust was paid $6m in return for the surrender of a long-term lease. The Full Federal Court followed the decision in Myer Emporium to hold that it was part of the service

trust’s business to dispose of property as required in order to serve the practice. It was irrelevant that [page 167] the particular transaction was unusual or extraordinary. Lee J (with whom Spender and O’Loughlin JJ agreed) said (at ATC 4213–14): In the words used in [Myer Emporium], by no stretch of the imagination is it possible to describe the arrangement, or the surrender of the lease standing on its own, as the mere realisation of a capital asset … The surrender was … one step in a set of integrated steps designed … to take advantage of extraordinary market conditions and provide to [the service trust] a sum described as a fee payable for the surrender of the lease.

The Myer Emporium principle was applied in Glennan v FCT (1999) 41 ATR 413; 99 ATC 4467 to hold that gains made from commercial transactions outside the taxpayer’s business were assessable as income. A barrister received an amount of $1.365m in settlement of a dispute concerning research he conducted on the feasibility of a tunnel under Sydney Harbour. Under the agreement, he was to be paid if the project went ahead. The Full Federal Court held that the taxpayer entered into the arrangement with the intention and hope of making money and the character of the payment did not change because it arose out of settlement of the dispute.

Lease incentives 3.60 Some recent decisions relating to lease incentives, similar to that illustrated in FCT v Cooling (1990) 22 FCR 42; 21 ATR 13; 90 ATC 4472 (see 2.17), have also introduced a degree of uncertainty into the wider application of what could be called the ‘Myer Emporium–Cooling principle’. In Cooling, the taxpayer was one of several partners in a firm of solicitors that over many years had operated from various leased premises in Brisbane. In 1985, the firm received an offer to take up a lease in a new building. The offer was accompanied by an incentive payment, a common practice at the time. Ultimately, the firm was paid $162,000 to take up a 10-year lease in a new office block. The Commissioner assessed Mr Cooling on his share of the lease incentive.

The Full Federal Court held that amount was assessable income. Hill J said (at ATC 4479): In my view the transaction entered into by the firm was a commercial transaction; it formed part of the business activity of the firm and a not insignificant purpose of it was the obtaining of a commercial profit by way of the incentive payment. This result accords with common sense. The firm had the alternative of paying less rent and therefore obtaining a smaller tax deduction for its outgoings or paying a higher rent … and therefore obtaining a larger tax deduction but receiving an amount in the form of assessable income.

In Lees & Leech Pty Ltd v FCT (1997) 73 FCR 136; 97 ATC 4407, as part of an arrangement for a retailer to lease new premises, the lessor paid the taxpayer $36,690 towards an amount of $90,000 to fit out the shop. Subject to certain conditions, the taxpayer was entitled to remove the fittings and fixtures at the end of the lease. Hill J held the payment was not assessable. In his Honour’s view, even if it could be said the taxpayer had a profit-making purpose, the part reimbursement produced no gain (other than of ‘valueless’ fittings) and the payment was not in form or substance paid a cash incentive to take up the lease. This was so, even though it was clear that, without the payment, the taxpayer would not have taken up the lease. [page 168] Similarly, in Selleck v FCT (1997) 78 FCR 102; 36 ATR 558; 97 ATC 4856, the lessor made a payment of $1m towards the fitting out of office premises. On completion, the lessee arranged a sale and leaseback of the fit-out with a bank for a consideration of $1.5m. The Full Federal Court distinguished Cooling and held that the need to find new premises was ‘a capital occasion’. A merger between two firms prompted the move in order to accommodate all the staff and the firm was not influenced to shift to particular premises by the incentive. The shift did not become a ‘revenue occasion’ just because the firm was able to negotiate an increased incentive offer.

Montgomery’s case

3.61 It was against this background that the character of lease incentives was considered by the High Court. Over the course of the decade following Cooling’s case, some doubt had arisen over the matter and, in fact, before the Full Federal Court decision in Montgomery v FCT (1998) 38 ATR 186; 98 ATC 4120, the taxpayer argued that Cooling was wrongly decided. In relation to the issue in New Zealand, the Privy Council declined to follow Cooling and held that a lease incentive was a ‘negative premium’ and, therefore, of a capital nature: IRC (NZ) v Wattie [1999] 1 WLR 873. In Montgomery’s case, a firm of solicitors occupied premises in BHP House and Nauru House. Extensive renovations had been undertaken by the firm in BHP House in the expectation of remaining there for some time. However, advice was received that the owner intended to gut the building in order to remove asbestos. This would require the firm moving to other floors. Several options were considered but, ultimately, the choice was reduced to remaining in BHP House or shifting to new premises in Collins Street. In the course of its deliberations, the taxpayer was aware that a substantial lease premium was available for Collins Street and, after relocating to those premises, received $29m. The Federal Court unanimously held the payment was on capital account, distinguishing Myer Emporium and Cooling. The firm was not in the business of acquiring leases and the arrangement was not an ordinary incident of its business. The incentive related to the structure of the business rather than the process of its operation and the making of a profit was not a significant element in entering into the transaction. On appeal, a majority of the High Court (Gaudron, Gummow, Kirby and Hayne JJ; Gleeson CJ, McHugh and Callinan JJ dissenting) held that the premium was assessable as ordinary income: FCT v Montgomery (1999) 198 CLR 639; 42 ATR 475; 99 ATC 4749. In the majority’s view, the firm obtained the incentive through the use or exploitation of its capital structure in the course of carrying on its business. Even though the arrangement was singular or extraordinary, the payments could not be regarded as an increment in its profityielding structure.

In relation to the decision in Wattie’s case, which was favoured by the minority, the majority considered that, although by an application of ‘Dixon’s criteria’ in [page 169] Sun Newspapers56 the payment of a lease premium to acquire premises was on capital account, the weight of authority (including the High Court’s own decision in FCT v Rowe (1997) 187 CLR 266; 35 ATR 432; 97 ATC 4317) was against an assumption of exact congruence between the capital or revenue character of a sum as a receipt and its character as expenditure. Reasoning that relied on such congruence to hold that a lease incentive is a ‘negative premium’ and on capital account was unacceptable. In O’Connell v FCT (2002) 50 ATR 331; 2002 ATC 4628, an incentive of $8m paid to an accounting firm to lease new premises was held to be income because a substantial and motivating factor in the decision to enter the lease was the payment of the lease incentive. As was the case in Cooling, the agreement was a commercial transaction entered into with a view to profit. In IT 2631, the ATO expresses the following view of lease incentives: cash payments are fully assessable; free fit-outs or plant (owned by the tenant) are also assessable but depreciable; free fit-outs owned by the lessor are tax free; and rent-free periods (or rent discounts) are not taxable if higher rent would have been deductible to the tenant: ITAA36 s 21A(3).

1.

Dorian acquired 25 ha of land in the Southern Highlands. He investigated the cultivation of an exotic nut-bearing tree, the fruit of which allegedly provides the

2.

elixir of life. After conducting feasibility studies, Dorian ordered the seedlings. However, due to a nitrogen deficiency in the soil, he was advised first to sow a crop of lupins, briefly graze sheep and then plough the crop back into the soil. Dorian proceeded in this manner, but before planting the trees a predicted drought and decline in world prices forced him to abandon the plan. Advise Dorian whether, for taxation purposes, he can be said to be carrying on a business. Stirling is an accountant. In the mid-1990s, he purchased a Holden (cost $5000) and converted it for racing (cost $15,000) and began competing in motor races. Over two years he competed in 18 events, was placed four times and won $1290. He sold the car and sought to claim a tax deduction for his losses. Advise Stirling whether for taxation purposes his activities are a hobby or he can be said to be carrying on a business. [page 170]

3.

4.

5.

Kerry operates a newsagency. In an attempt to boost circulation, a metropolitan daily newspaper offered a prize to the newsagent who achieved the highest percentage increase in sales. Kerry won a 4WD vehicle and sold it for $30,000. Is the amount assessable income? Would the position be different if he did not sell the vehicle? Holmes and Gardiner carry on an accounting business as partners from premises in High Street. The building is condemned by the city council because of its asbestos content. As a result of a high level of commercial vacancies, the partnership is offered the choice of generous (ie, discounted) rental terms or an upfront cash payment of $20,000 (and ordinary rental rates) to sign a long-term lease. The $20,000 is the present value of the rental discount. Would the amount of $20,000 be ordinary income of the partnership? Lucky has a BA majoring in probability statistics. He has applied his knowledge in this discipline to devise a scheme (model) to win at baccarat at the All-Class Casino. Before he ventured any bets, he tested his theoretical model over a four-month period by observing, recording and making hypothetical bets according to his model’s predictions. The model proved to be reliable in that it produced a win–loss ratio of 3:1. Based on this research, he then resolved to allocate 10% of his gross fees from his consulting practice to invest at the casino. His firm policy was to limit each bet to $200 and only three bets would be made on any one daily visit. He adhered strictly to this policy, visiting the casino three times each week to play baccarat. He maintained separate records of all bets and their outcomes, banking winnings into his business bank account. He did not engage in any other form of gambling nor risk any of his ‘private’ capital. By 30 June, his records show that he had net winnings of $13,000. Lucky has been approached by a syndicate that has offered to buy exclusive rights to his betting model together with exclusive access to all relevant codes and working papers. The offer requires Lucky to cease using the model and not to disclose to any person the identity of the purchaser. He is not required to do anything else to meet

the conditions of the offer. Payment details are yet to be organised. Lucky prefers a lump sum payment of $120,000 but the syndicate is interested in a lump sum payment of $70,000 plus 20% of winnings for 10 years. [page 171] (i)

What is the income tax status of the gambling investment outcome for the year ended 30 June? (ii) What would be the relevant tax treatment should Lucky accept the syndicate’s offer? (iii) Does any significance attach to the method of payment? A suggested solution can be found in Study help.

Proposition 11: Amounts derived from property are income 3.62 ‘Income from property’ is defined in ITAA36 s 6(1) to mean all income other than income from personal exertion. In turn, the definition of ‘income from personal exertion’ specifically excludes interest (other than business interest from the lending of money or arising from trade debts), rent and dividends. By inference, rather than specific exclusion, income from property also includes royalties and annuities. Thus, income from property is taken to mean interest, rent, dividends, royalties and annuities, and each of these items rests easily with an ordinary concepts view of income. Paradoxically, with the exception of rent, each of these items is subject to statutory extension and qualification. Special rules relate to a range of financial instruments, such as deferred interest securities and traditional securities, and items often regarded as in the nature of interest, such as exchange rate gains and losses. These specific provisions are principally concerned with timing issues; that is, when is a particular item derived? In the case of dividends, ITAA36 ss 44–47 may operate as an exclusive code. Although an annuity is income by ordinary concepts, the assessability of annuities (including purchased annuities) and pensions is

governed by ITAA36 s 27H or, in the case of superannuation income streams, ITAA97 Divs 301–307. A royalty that is income by ordinary concepts is assessable under ITAA97 s 6-5 but an amount that is a royalty by ordinary concepts (other than capital amounts made royalties by virtue of the extended definition in ITAA36 s 6(1)) is assessed under ITAA97 s 15-20. Income from property that is not qualified might, therefore, be described as ‘ordinary’ interest and rent.

Interest 3.63 Interest is not defined in the Act. Its ordinary meaning is the amount generated from the use or employment by others of a capital amount: Federal Wharf Co Ltd v DCT (1930) 44 CLR 24. It is compensation to an owner for the lost opportunity to use an asset: Riches v Westminster Bank Ltd [1947] AC 390. In the case of ‘interest only’ loans under which the principal is repaid at the end of a specified period, [page 172] the interest will be paid periodically. Where a loan is repaid by instalments that include both interest and principal, it is necessary to dissect the interest element.57 Not every payment in excess of the principal is interest. In FCT v Northumberland Development Co Ltd (1995) 59 FCR 103; 95 ATC 4483, a company that had certain coal interests under land that was compulsorily acquired by the Crown was paid compensation according to a formula comprising a rental element and a royalty element that was then multiplied by an ‘incremental factor’. The Commissioner assessed the ‘incremental factor’ as representing interest but the Full Federal Court held the full amount was compensation for the disposal of a capital asset. Conversely, where an amount is interest, it is assessable

regardless of how it is described or the payment structured: Lomax (Inspector of Taxes) v Peter Dixon & Sons Ltd [1943] KB 671. In the case of compensation for personal damages awarded by the courts, two types of interest are recognised: ‘pre-judgment’ and ‘postjudgment’ interest. The former is included in the damages payment and relates to the period from the cause of the action to the date of judgment. The latter accrues on unpaid damages after the date of judgment. In Whitaker v FCT 98 ATC 4285, the Full Federal Court held that the pre-judgment interest was part of a capital receipt whereas the post-judgment interest was in the nature of ordinary interest since it accrued on an outstanding debt. Where discounts and premiums are given or paid to alter the effective rate of return on a debt instrument, statutory extensions operate to quantify the amount and determine the timing of its derivation: see 4.33.

Rent 3.64 Rent is not defined, but at common law it means a payment received by a lessor in return for the use by a lessee of real or personal property: Yanchep Sun City Pty Ltd v CT (WA) (1984) 15 ATR 1165. In relation to the definitions of ‘income from personal exertion’ and ‘income from property’ referred to above, the court made a distinction, in the case of interest, between interest derived from carrying on a business and ‘other’ interest. No similar distinction is made in relation to rent, although it is clear that one may derive rental income from the business of chattel leasing and, being business income, it is income from personal exertion. It is useful, therefore, to distinguish income from the business of leasing chattels from passive property rental. The former is income by virtue of Proposition 10: Amounts derived from carrying on a business are income: see 3.44ff. As with interest, whether or not a payment is rent depends on the substance of the matter rather than the description given by the parties. For example, in FCT v Groser (1982) 13 ATR 445; 82 ATC 4478, an amount of $2 per week paid by the taxpayer’s parents and brother was

described as ‘rent’ but was held not to be so because the amounts were paid under a family arrangement that lacked the necessary commercial reality.58 [page 173] An amount paid by a prospective lessee to induce a lessor to grant or assign a lease is described as a ‘lease premium’, is distinguishable from rent, and will usually be of a capital nature and taxable under the CGT provisions. However, an amount may be income if in reality it is a disguised rent payment: Australian Mercantile Land and Finance Co Ltd v FCT (1929) 42 CLR 145. Characterisation of amounts as capital premiums or rent is essentially a question of fact and regard will be had to the term of the lease and periodicity of the payments.

Annuities 3.65 An annuity is a series of payments made under a contractual obligation for a specified number of years or for life: EdgertonWarburton v FCT (1934) 3 ATD 40. It is clearly of an income nature. In Moneymen Pty Ltd v FCT 91 ATC 4019, Hill J confirmed the description that to be an annuity, a payment does not need to be referable to the recipient’s life. It is enough that it is an annual, periodical sum — even if for a fixed term. In recent years, annuities have become a common form of retirement payment (or superannuation pension) and specific provisions govern their taxation: see ITAA97 Div 307 and 5.43. Annuities other than superannuation income streams are taxed under ITAA36 s 27H. Arrangements described as ‘purchased annuities’ are widely available. With a purchased annuity, a person pays a fixed instalment to acquire an actuarially calculated income stream for a specified time period or for life. In effect, an annuity converts capital into income. Tax legislation recognises that purchased annuities comprise two elements: a return of some part of the capital cost of purchase and the interest, and

this is reflected in specific provisions taxing such payments. ITAA36 s 27H provides a deduction calculated by reference to a formula that amortises the purchase price of the annuity over the relevant period.

Royalty 3.66 A royalty is an amount paid to the owner of property for the right to use the property or to take a commodity: Stanton v FCT (1955) 92 CLR 630; 6 AITR 216. Royalties sit comfortably with Proposition 11. The manner in which a royalty is taxed depends on whether it is in the nature of a royalty by ordinary concepts or by virtue of an extended definition of the term in ITAA36 s 6(1): see Chapter 5. At common law, a royalty usually involves a payment calculated by reference to the quantity taken or is linked to the use of property in a manner proportionate to the benefits derived: McCauley v FCT (1944) 69 CLR 235; 3 AITR 67; see also Murray v ICI [1967] 2 All ER 980, discussed in 3.16. A payment for services rendered is not a royalty at common law: Aktiebolaget Volvo v FCT (1978) 36 FLR 334; 8 ATR 747. Neither is ‘know-how’ that does not involve the grant of a right. This is illustrated in FCT v Sherritt Gordon Mines Ltd (1977) 137 CLR 612; 7 ATR 726. In that case, the taxpayer supplied technical information relating to the construction of a nickel refinery. Although the payment was expressed in terms of a percentage of sales over 15 years, a majority of the High Court held the payments were not royalties. Mason J (Gibbs J concurring) said (at ATR 734): [page 174] Here the substantial, if not the sole, consideration for the payments was not the grant of a right but for the provision of technical assistance and information which Western Mining was entitled to use once it was supplied, without the grant of any additional right to do so.

A royalty that is of an income nature will be assessable under ITAA97 s 6-5. An amount that is a royalty by ordinary concepts (which

may include a capital payment) is assessable under ITAA97 s 15-20: see 5.9.

Dividends 3.67 Dividends paid to a shareholder out of profits derived by a company also sit comfortably with Proposition 11 and such payments would normally be income by ordinary concepts. Separate codes comprising ITAA36 ss 44–47 and ITAA97 Div 207 cover the taxation of dividends and franking credits.

Proposition 12: Amounts received as substitutes for or compensation for lost income are themselves income 3.68 In Proposition 2 at 3.8ff, it was established that capital does not have the character of income and that a payment made for the loss of a right to earn income was a capital payment. Thus, in the case of a business, payments made for the loss or sterilisation of a profit-making structure are capital and, for an individual, payments for the loss of a right or capacity to earn income are capital receipts. Proposition 12 makes a different assertion. It states that payments in substitution for income are themselves income. The second ground in FCT v Myer Emporium Ltd (1987) 163 CLR 199; 18 ATR 693; 87 ATC 4363 is authority for saying that compensation for the loss or assignment of future income is itself income. As a result, social security payments such as unemployment benefits would be income under Proposition 12. So, too, would be payments made to an employee on sick leave or in receipt of workers compensation. In Tinkler v FCT 79 ATC 4641, as the result of a motor accident, the taxpayer was unable to work and was entitled under the Motor Accidents Act 1973 (Vic) to payments for the loss of income calculated as a proportion of average earnings. The taxpayer argued that the payments were for the loss of earning capacity — a capital asset. The Full Federal Court held the payments were a

substitute for income. The principle in Tinkler’s case, as in other compensation cases, was stated by Brennan J as follows (at 4643):59 Where a taxpayer gives up his income in exchange for other payments, the other payments take on the character of income for which they were exchanged (CT (Vic) v Phillips (1936) 55 CLR 144 at 157). And where payments are made pursuant to a statute as compensation for an asset acquired by the State or sterilized in the hands of the taxpayer in order to serve the public interest, those payments take their character from the character, in the taxpayer’s hands, of the asset acquired or sterilized (see, for

[page 175] example, Newcastle Breweries Ltd v IRC (1927) 43 TLR 476 … FCT v Wade (1951) 84 CLR 105 …).

Thus, in Allman v FCT 98 ATC 2142, a payment made for income lost through wrongful dismissal was assessable income because it was a substitute for income that would have been earned. Compensation paid for the cancellation of business contracts or agreements (when the profit-making structure is left intact) will be a substitute for income: Heavy Minerals Pty Ltd v FCT (1966) 115 CLR 512; 10 AITR 140. If the profit-making structure is permanently impaired, the compensation will be capital: Van den Berghs Ltd v Clark (Inspector of Taxes) [1935] AC 431; Glenboig Union Fireclay & Co Ltd v IRC (1922) 12 TC 427. Where the cancellation results in termination of the taxpayer’s business, the payment will be capital (California Copper Products Ltd (in liq) v FCT (1934) 52 CLR 28) but, where a cancelled agency or supply contract is one of many or is a comparatively minor component of the taxpayer’s wider business, the general proposition holds — the compensation is a substitute for income (Kensall Parsons & Co v IRC (1938) 12 TC 608). These authorities suggest the question is, at least in part, one of degree. The more serious the inconvenience caused or the more substantial the impairment of structure, the more likely it is that the payment is capital, but where the disruption is an incident of that type of business, the payment is a substitute for income lost. Consider the

decision in Liftronic Pty Ltd v FCT (1996) 66 FCR 175; 32 ATR 557; 96 ATC 4425.

Liftronic Pty Ltd v FCT Facts: The taxpayer sold, installed and maintained lift systems. Deficiencies in equipment produced by Hyundai Elevator Co Ltd caused disruption and led to the loss of profits. In an action for breach of contract, the Supreme Court of New South Wales awarded damages of $2.23m for ‘loss of profits’. The Commissioner indicated the amount was assessable and the taxpayer appealed.a Held: The appeal was dismissed. The damages were for ‘lost profits’ rather than the destruction of goodwill or earning capacity. Foster J said (at ATC 4442): Here the breaches of Hyundai did not destroy the goodwill or earning capacity of Liftronic. They did not take away “the whole structure, [its] profit making apparatus” (per Lord McMillan Van den Berghs v Clark …) Those income earning assets of Liftronic were not “sterilized and destroyed” [Glenboig Union Fireclay & Co] by Hyundai’s breaches. They were temporarily impaired during the period in which, through efforts made on the company’s behalf, they were restored. There was [page 176] no destruction of these assets but “a mere restriction of … trading opportunities”. This restriction created a “hole in profits” which the award in damages was intended to fill.

a. The appeal was against a private ruling. Compensation for the loss of revenue assets, such as livestock and trading stock, are income in nature: FCT v Wade (1951) 84 CLR 105; 5 AITR 214. So, too, were charges made by the taxpayer in FCT v GKN Kwikform Services Pty Ltd (1991) 21 ATR 1532; 91 ATC 4336 for the non-return of hired scaffolding equipment; charges the Federal Court described as ‘additional fees’ arising as an ordinary incident of the taxpayer’s business.

Ted is injured in an industrial accident and receives the following payments:

(i) Workers compensation: $450 × 7 weeks (ii) Compensation for loss of little finger (iii) Ted’s employer pays the cost of the ambulance (iv) Social security disability support pension 7 weeks

$3150 $5000 $650 $945

Advise Ted on how these items are treated for taxation purposes. A suggested solution can be found in Study help.

Correspondence principle or ‘symmetry’ 3.69 Although amounts received as substitutes for income or compensation recovered for the loss of income are themselves income, there is no corollary to Proposition 12 that would assert the recovery of an amount formerly deductible is income. There is no necessary symmetry between ITAA97 s 6-5 ordinary income and ITAA97 s 8-1 general deductions (or their predecessors, ITAA36 ss 25(1) and 51(1)). This does not mean that such recoveries will never be assessable income. What it means is that they are not assessable income simply because a corresponding amount was an allowable deduction. In FCT v Rowe (1997) 187 CLR 266; 97 ATC 4317, the Commissioner was granted special leave to appeal to the High Court to test whether there was a general principle of law that an amount paid as a reimbursement or compensation for a tax deductible outgoing was income according to ‘the ordinary concepts and usages of mankind’: Scott v CT (NSW) (1935) 35 SR (NSW) 215 (see 2.9). The court rejected the proposition unanimously. A principal difficulty with the proposition that recovery of a formerly deductible amount was income was that it diverted attention away from the issue of whether the amount was income by ordinary concepts. That is, the answer to the question ‘Is the amount ordinary income?’ is not provided in the satisfaction of deductibility

[page 177] criteria. A second difficulty was that the proposition was contrary to what was said in H R Sinclair & Son Pty Ltd v FCT (1966) 114 CLR 537; 10 AITR 3.

H R Sinclair & Son Pty Ltd v FCT Facts: The taxpayer was a timber merchant who acquired timber from state forests on payment of royalties. The company maintained the amounts were incorrectly calculated but paid them nonetheless. Ultimately, a refund was received and the Commissioner assessed the amount. Held: The refund formed part of the proceeds of the taxpayer’s business and was assessable as such. Taylor J said (at AITR 5): The question, therefore, resolves itself into a consideration of the character of the receipt in question. There was a suggestion that the payment was made and received, not merely as a voluntary refund, but was of a compromise of past and future claims. In my opinion, however, there is no substance in this suggestion; the payment represents no more than a voluntary refund of part of the royalties which had been legally extracted. The refund was made because after protracted representations and negotiations the Commission conceded that it had, from time to time, incorrectly applied the formula so far as the appellant was concerned and decided that, apparently, in common fairness it should make the refund in question. In these circumstances I can see no reason why the amount should not be regarded as properly taken into account in determining the proceeds of the appellant’s business of the year in which it was paid. Its attempts which in the end were successful to obtain the refund of amounts which it contended had been exacted as a result of the misapplication of the formula were just as much an activity of the business as would have been an attempt to avoid an overcharge in the first instance, and the amounts recovered in the year ended under review must be taken to have formed part of the appellant’s income for that year. The basis of the court’s conclusion that the amounts were income was that the taxpayer’s attempts to recover the overpayments were as much a part of its business as sawmilling. This is evident in Owen J’s judgment (at AITR 7): The company’s business was that of a saw-miller. It was in that capacity that it paid royalties for the timber cut by it for the purposes of its business and it was in that capacity that it received the amounts refunded.

[page 178] In other words, the amount was income because it arose in the course of the business, not because the payments were formerly deductible. This is clear in Owen J’s judgment. His Honour dismissed submissions made by the Commissioner that because the earlier payments had been assessable income, it necessarily followed that the refund was income. Owen J said (at AITR 6): This, I think, is not the right approach. The real question is whether the amount received by way of refund was part of the company’s assessable income for the year in which it was received.

Statutory extensions 3.70 An amount received as a substitute for income will be assessable under ITAA97 s 6-5 as ordinary income. If a payment is not ordinary income, it falls potentially within ITAA97 s 15-30 if it is by way of insurance or indemnity for a lost amount or is a recoupment of a deductible loss or outgoing pursuant to ITAA97 Subdiv 20-A: see Chapter 5.

Conclusion 3.71 The ordinary/judicial concept of income developed because the key term ‘income’ is not defined in the ITAA97 or the predecessor legislation. While, initially, the concept may have emerged from ordinary concepts, judicial refinements over the past 150 years have been a dominant factor in its contemporary meaning. Very early in its development, ordinary income was taken to mean that the item must be convertible into money. Income is ordinarily conceived as arising from three pursuits: 1. as remuneration for personal services; 2. as the rewards from carrying on a business; and 3. as a return on investments. With these activities as a basis, a number of propositions were advanced that attempted to distil the judicial refinements to and

exclusions from the income concept. As the propositions are considered, it should be kept in mind that no amount must possess all the characteristics and, in any given set of factual circumstances, no single element need be decisive. Proceeding on the understanding that, to be income, an amount must be convertible into money, and that there is no general principle of symmetry between what is assessable as income and allowable as a deduction, income could be distinguished from capital, from a mere gift, from windfall gains and from items that are covered by the mutuality principle. To be income, an amount must be beneficially derived and a critical consideration is that income is to be judged from the character it has in the hands of the recipient [page 179] without regard to how it might be judged in another’s hands. So, although the donor’s motive might be a relevant factor on occasions, it will not be determinative and would seem only to assist in characterising the amount from the recipient’s perspective. Income is generally recurrent, regular and periodical. It is derived from employment or the provision of services, but there will always be occasions where payments will arise independently of employment or service relationships. The critical issue becomes the degree to which the employment relationship is the motivating factor. Profit is the raison d’être of business, and amounts derived from carrying on a business are income, including isolated or unusual transactions that are entered into with the intention of making a profit. Amounts derived from property are income and amounts received as substitutes or compensation for lost income take on the character of the lost amount. 1.

The general deduction provision (ITAA97 s 8-1) disallows a deduction for losses and

2.

3.

4.

5.

6.

7.

8. 9. 10. 11.

12.

13.

14.

outgoings of capital or of a capital nature. In FCT v La Rosa (2003) 53 ATR 1; 2003 ATC 4510; [2003] FCAFC 124, the Full Federal Court allowed a deduction for money stolen from a drug supplier. Carr J expressed the view that ‘income’ had been accepted as including the proceeds of criminal activities for too long for that court to rule otherwise. Note that ITAA36 s 23L(2) exempts from assessable income the first $300 of a s 21A noncash business benefit. Note, too, that s 21A would not apply to the particular benefit provided in Cooke & Sherden because of s 21A(4) and ITAA97 Div 32: see 9.54. Frequent flyers programs are not considered to be fringe benefits (Taxation Ruling TR 93/2) but payment by an employer of an employee’s joining fee will be a s 20 expense payment benefit. On the income side, capital gains would be included in the economic view of income. Gains on the sale of assets are not excluded from accounting net profit (although they may be classified separately). On the expenditure side, the decision to capitalise or treat a payment as an expense is an obvious application of the distinction, albeit using criteria that may differ from legal criteria. The distinction does not transfer directly to the question of repairs and capital improvements. See Kitto J’s judgment in Lindsay v FCT (1961) 106 CLR 377; 8 AITR 458, discussed in Chapter 9. In Dickenson v FCT (1958) 98 CLR 460; 7 AITR 257 at 267, Dixon CJ employed this analysis to hold that payments by a petrol company to a garage proprietor to buy and sell only one brand of petrol represented a capital amount for restricting the taxpayer’s profityielding organisation. See comments by Gibbs J in FCT v Williams (1972) 127 CLR 226; 3 ATR 283 at 291; 72 ATC 4188; see also Casimaty v FCT (1997) 37 ATR 358; 97 ATC 5135. See also comments by Wilson J at CLR 399. The decision is examined under Proposition 10 at 3.44 and 3.57. See, for example, the discussion of Memorex Pty Ltd v FCT (1987) 19 ATR 553; 87 ATC 5034 in 3.13. For example, in GRE Insurance Ltd v FCT (1992) 34 FCT 160; 23 ATR 88; 92 ATC 4089, a gain on the sale of shares by a subsidiary of an insurance company was held to be income because the subsidiary was an integral part of the parent’s broader business. Contrast that decision with AGC (Investments) Ltd v FCT (1992) 23 ATR 287; 92 ATC 4239, where the adoption of a narrower categorisation meant that the subsidiary’s activities were not part of the parent’s business. To be inventory for accounting purposes under the former accounting standard AASB 19, it is not necessary to be trading stock for the purposes of the Act: see ITAA97 ss 995-1 and 70-10. The definition requires the items to be acquired and held for the purpose of sale. See further Chapter 11. ITAA36 s 26(a) (later ITAA36 s 25A) operated (retrospectively to 1922) to assess the profit made on the sale of property acquired with the intention of resale at a profit, and ITAA36 s 26AAA operated between 1973 and 1988 to assess the profit made on the sale of property sold within 12 months of purchase. For example, certain compensation payments such as for personal injury are not income if they are made for loss of the right or capacity to earn income. They are also exempt from

15. 16.

17. 18. 19. 20.

21. 22. 23. 24. 25. 26.

27.

28.

29. 30. 31.

32. 33.

capital gains tax and so remain tax free, provided the payment is capital. Post-September 1999, qualifying capital gains have been able to be discounted by 50%. The payment in Hepples’s case escaped capital gains tax due to a technicality. Redrafted capital gains tax legislation is designed to capture consideration for restrictive covenants. See also FCT v Woite (1982) 13 ATR 579; 82 ATC 4578, where there is a strong suggestion that if a professional footballer who entered into a restrictive covenant to play in the Victorian Football League only with North Melbourne but in fact played for North Melbourne, it would be more difficult to argue the payment was not income in nature. Unliquidated damages are damages for a loss that is certain but by its nature cannot be calculated exactly, only estimated. See Case W40 89 ATC 399, where compensation for the resumption of land was split into principal and interest elements. Australian Legal Dictionary, LexisNexis Butterworths, Sydney, 1997, p 524. The case involved an annual £10 voucher given by an employer to employees and certain past employees. The payment was made because it helped maintain good relationships between management and staff, and that this was considered to be to the ultimate benefit of the company. It was held that the vouchers, being convertible into money, were emoluments of employment assessable as income. Penn v Spiers & Pond Ltd [1908] 1 KB 766. See also Taxation Ruling TR 95/11 where the Commissioner states a view that tips in the hospitality industry are income. Calvert (Inspector of Taxes) v Wainwright [1947] KB 526. Great Western Railway Co v Helps [1918] AC 141. Kelly v FCT (1985) 16 ATR 478; 85 ATC 5283: see 3.42. Scott v FCT (1966) 10 AITR 367 (see 3.23); Federal Coke Co Pty Ltd v FCT (1977) 7 ATR 519; 77 ATC 4255. A majority of the High Court held the payment was not income. Fullagar and Kitto JJ dissented: (1953) 86 CLR 570; 5 AITR 496. On appeal, the Privy Council reversed the decision: (1954) 88 CLR 413; 5 AITR 664. Prizes that are a normal incident of income-producing activities, such as in the case of professional athletes (Kelly v FCT (1985) 16 ATR 478) are an obvious exception. Non-cash business benefits are deemed to be convertible into money by ITAA36 s 21A. See below. See Ruling IT 2655 where the Commissioner accepts this position. See also Prince v FCT (1959) 7 AITR 505, where the facts led to a contrary conclusion. In Ruling TR 93/26, the Commissioner indicates that racing of horses will not be regarded as a business unless it is connected with breeding or training activities. See also Woods v DCT (1999) 43 ATR 491; 99 ATC 5306; [1999] FCA 1598, where a taxpayer failed to establish he was engaged in the horse-racing business. See also Brajkovich v FCT 20 ATR 1570; 89 ATC 5227. See Taxation Determination TD 93/194. New York Life Insurance Co v Styles (1889) 14 App Cas 381; Grove v Young Men’s Christian Assoc (1903) 88 LT 696; 4 TC 613; Carlisle & Silloth Golf Club v Smith [1912] 2 KB 177; (1912) 6 TC 48. See F M Gilders, ‘A Matter of Mutual Interest’ (1992) 21 Australian Tax Review 77. A beneficial interest means there is a right of use and enjoyment.

34. For example, ITAA36 Pt III Div 16E in relation to certain deferred interest and ITAA36 s 170(9) in relation to long-term construction projects. 35. Generally, accrual accounting is taken to mean the derivation of income when a legally enforceable debt arises. This is consistent with the recognition as revenue of credit sales in accounting. However, with limited exceptions, the courts have not accepted accounting earning criteria. See Chapter 4. 36. This case concerned ITAA36 s 26(e). A benefit, bonus, allowance etc, is ‘derived’ under that provision when it is ‘allowed, given or granted’. 37. See Fringe Benefits Tax Assessment Act 1986 (Cth) s 136(1), definition of ‘fringe benefits’, para (j). 38. Gair v FCT (1944) 71 CLR 388; 3 AITR 143 in the context of ITAA36 s 19. 39. Penn v Spiers & Pond Ltd [1908] 1 KB 766. See also Taxation Ruling TR 95/11, where the Commissioner states a view that tips in the hospitality industry are income: Great Western Railway Co v Helps [1918] AC 141; Calvert (Inspector of Taxes) v Wainwright [1947] KB 526. 40. Payments of the type made in Harris and Blake are now specifically assessable as statutory income: ITAA36 s 27H. 41. The decision is authority for saying the reimbursement of an employee for a loss is not income. Reimbursement or compensation payments will be income when they substitute income: Proposition 12 (3.68ff). In a business (as opposed to an employment) context, there is Australian support in Lees & Leech Pty Ltd v FCT (1997) 73 FCR 136; 97 ATC 4407. However, in GP International Pipe-Coaters Pty Ltd v FCT (1990) 170 CLR 124; 21 ATR 1; 90 ATC 4413, payments designed to reimburse the taxpayer for the costs of plant were held to be income. 42. In Pritchard v Arundale [1972] Ch 229, a partner in an accounting firm was offered shares in a client’s company as an inducement to give up his partnership and accept a position with the former client. The amount was held to be capital compensation for giving up his position. 43. There was no provision for a refund in Woite’s case in the event that he did not play with North Melbourne. In Riley v Coglan [1968] 1 All ER 314, a similar signing-on fee was held to be an advance payment even though part of it was refundable in the event of nonperformance. 44. Contrast the decision in Pritchard v Arundale with Glantre Engineering Ltd v Goodhand [1983] 1 All ER 542, where an employee accountant (rather than a partner) who was induced to change positions struggled to show the renunciation of valuable rights. In Pickford v FCT 98 ATC 2268, a lump sum payment designed to compensate a new employee for the loss of benefits under a former employer’s share acquisition scheme was held to be assessable because it was an integral part of the salary package. 45. Discussed under Proposition 2 at 3.13. 46. See also FCT v GKN Kwikform Services Pty Ltd (1991) 21 ATR 1532; 91 ATC 4336, which was also distinguished on the facts. In that case, the taxpayer hired scaffolding equipment. The company charged customers for losses of equipment, such amounts representing from 3% to 5% of total receipts. The Full Federal Court held that the nonreturn of equipment was a normal incident of the taxpayer’s business and the charge for lost scaffolding was ordinary income.

47. It is submitted that, whatever the finding for trade practices (Ex parte St George County Council (1973) 130 CLR 533) or local government purposes (Cooney v Kuring-gai Municipal Council (1963) 114 CLR 582), the activities in these cases would be businesses for taxation. It is clear, too, that UK decisions such as Religious Tract and Book Society v Forbes (1896) 3 TC 415 and Grove v YMCA (1903) 4 TC 613 support a view of business as being about profit — despite the fact that they are sometimes cited as exceptions. Of course, this is not to say that no business exists because there is a loss or the activities are unprofitable. 48. See (1975) 22 CTBR(NS) Case 45; Case K25 78 ATC 243, a decision by the Commonwealth Taxation Board of Review, the predecessor of the Administrative Appeals Tribunal. 49. See also FCT v Total Holdings (Aust) Pty Ltd (1979) 9 ATR 885. Contrast with IRC v The Korean Syndicate Ltd (1921) 12 TC 181, where Rowlett J said (at 197): ‘If all [the company] does is simply to receive this interest and this rent, that is no more carrying on a business in the case of a company than it would be in the case of an individual’. On appeal, the Court of Appeal held that a holding company was a common form of carrying on a business. 50. In MIM Holdings Ltd v FCT (1997) 36 ATR 108 at 118; 97 ATC 4420, the Federal Court speculated in relation to GP International Pipecoaters that ‘perhaps had there been separate contracts a different result may have followed’. 51. Note that in neither Colonial Mutual Life Assurance Society Ltd nor Australasian Catholic Assurance Co Ltd were the items in question characterised as trading stock. Acceptance by the courts that, in the hands of dealers, shares and real estate could be trading stock did not eventuate until Investment and Merchant Finance Corp Ltd v FCT (1971) 2 ATR 361 and FCT v St Hubert’s Island Pty Ltd (1978) 8 ATR 452. Note too that the assessable income was the profit on the sale: see London Australia Investment Co Ltd v FCT (1977) 138 CLR 106; 7 ATR 757; 77 ATC 4398 at 3.56. 52. A J Baldwin and J A L Gunn, The Income Tax Laws of Australia, Butterworths, Sydney, 1937, p 173. 53. J A L Gunn et al, Commonwealth Income Tax Law and Practice, 7th ed, Butterworths, Sydney, 1963, p 340. 54. See also Commercial and General Acceptance Ltd v FCT (1977) 137 CLR 373; 77 ATC 4375, a Full High Court decision handed down the same day, where Mason J said (at ATC 4380) that ‘gross income’ in terms of ITAA36 s 25(1) could include a net (profit) amount when it is the net amount that has the character of income rather than the gross receipts. 55. Per Helsham J’s decision at first instance: (1974) 4 ATR 638 at 642–3. For example, 80,000 BHP shares were acquired between 1962 and 1966 at an average cost of $5.24790. In 1967, 25,000 were sold: cost therefore $131,197.50. Proceeds were $353,743.14. Profit: $222,545.64. A secondary issue arose as to the valuation of bonus shares. The company had introduced them at nil but the High Court said their ‘cost’ was the par value. 56. Sun Newspapers Ltd and Associated Newspapers Ltd v FCT (1938) 61 CLR 337; 1 AITR 353, discussed at 3.10. 57. This may be done by actuarial calculations or by commercial expedients such as the ‘rule of 78’ or the ‘sum of the years digits’. For example, to determine the interest element in a hirepurchase instalment (for instance, under ITAA36 s 128AC) payable over four years, the sum of the years is 10; the interest component in the first year is 4/10th of the payment, in

the second, 3/10th, and so on. 58. See also Case M96 80 ATC 683. 59. See also FCT v Smith (1981) 147 CLR 578; 81 ATC 4114; FCT v Inkster 89 ATC 5142; and contrast FCT v Slaven 84 ATC 4077, discussed under Proposition 2 at 3.19.

[page 181]

CHAPTER

4

The Derivation and Measurement of Income Learning objectives After studying this chapter, you should be able to: identify and apply the ‘tax equation’; distinguish between the ‘cash basis’ and ‘accrual basis’ for taxation purposes; determine whether the cash or accrual basis applies in a given fact situation; advise on the factors relevant to adopting an alternative basis, and the consequences of a change; recognise when ‘net profit’ as opposed to a ‘gross amount’ is assessable income; calculate assessable income in a given fact situation.

Introduction 4.1 The measurement of income and the timing of its derivation are critical issues in applying the Income Tax Assessment Act 1997 (Cth) (ITAA97) s 4-15 tax equation: Taxable income = Assessable income – Deductions

The application of s 4-15 is an exercise in tax accounting, although that description is often used in the very narrow sense of concerning only derivation and trading stock issues. The determination of an assessable amount in FCT v Whitfords Beach Pty Ltd (1982) 150 CLR 355; 12 ATR 692; 82 ATC 4031 (see 4.24), or when and how much of an amount is deductible, as in Coles Myer Finance Ltd v FCT (1993) 176 CLR 640; 25 ATR 95; 93 ATC 4214 (see 8.49), are just as much applications of s 4-15 as the calculation of depreciation or the measurement of the cost of trading stock on hand at year’s end. Although accounting concepts and techniques have exerted influence in the measurement of taxable income, ultimately the matters will be determined by the courts.1 [page 182] The measurement of ordinary income is governed by statute only to a limited degree. Measurement and timing issues are resolved by a hybrid of legal, accounting, commercial and administrative rules. Commerce students will appreciate better than most how tentative all economic measurements are. ITAA97 Div 230 (see 5.55) contains extensive rules as to recognition and timing of gains and losses from financial arrangements (TOFA rules). Such arrangements include debt instruments like loans, bonds and debentures; risk-shifting derivatives such as swaps; and equity interests. The intent of the provisions was to better align tax treatment with the economic substance and commercial treatment of financial arrangements. The rules generally only apply to large taxpayers: authorised deposit-taking institutions with an aggregate turnover of at least $20m per year and other entities satisfying threshold asset values or turnover of at least $100m per year. Accordingly, while TOFA would impact in some circumstances on the discussion in this chapter — especially of Div 16E (see 4.33) and of interest (see 4.43) — this chapter does not explore TOFA in detail. While it is possible to elect in to TOFA and while TOFA will also automatically apply to qualifying

securities of more than 12 months’ duration, the Coalition Government announced in the 2016–17 Budget that the TOFA rules are to be reformed to reduce their scope and to remove the majority of taxpayers from the rules.2 Derivation of income is about timing and measurement. The timing issue arises because it is necessary to divide economic life into a series of discrete time periods and to levy tax annually. This practice is consistent with commercial and accounting conventions and it is the approach adopted by the Income Tax Assessment Acts. The following definitions and provisions outline the framework.

Definitions 4.2 Under the Income Tax Assessment Act 1936 (Cth) (ITAA36) s 161, every person must (if required by the Commissioner) submit an income tax return for the year of income. The year of income is typically the financial year ended 30 June and, under ITAA97 s 4-10, you must pay tax for each financial year.3 The submission of a tax return initiates the assessment process that ultimately leads to the payment of tax or to an appeal against the assessment. As indicated in 4.1, the subject of assessment is taxable income and, in general, taxable income is determined for the financial year ended 30 June. In special circumstances it is possible through ITAA36 s 18 to arrange a substituted accounting period. Special circumstances will need to be demonstrated, such as in the case of an Australian subsidiary of an overseas company that operates on an accounting period ending other than 30 June.4 [page 183] ITAA97 s 960-505 requires that amounts be expressed in Australian currency. ITAA36 s 21 operates to convert non-money consideration into a monetary equivalent. ITAA36 s 21A deems non-cash business benefits to be convertible into money and thus substitutes an arm’s

length value where property and services are exchanged in the course of carrying on a business. 4.3 Subject to some important exceptions, however,6 the statute does not formulate rules for the derivation of ordinary income in the way that it does for many items of statutory income. Theoretically, a taxpayer is free to adopt any recognised accounting method that is not inconsistent with the Acts but, in reality, that choice has been circumscribed by the courts. A starting point for an examination of the question ‘When is income derived?’ is the central provisions of the ITAA97. Note the important difference between the central assessing provision for ordinary income (ITAA97 s 6-5) and for statutory income (ITAA97 s 6-10). Consider the following extracts: 6-5 (2) If you are an Australian resident, your assessable income includes the ordinary income you derived directly or indirectly from all sources … 6-10 (4) If you are an Australian resident, your assessable income includes your statutory income from all sources …

1. 2.

When is ordinary income included in your assessable income? When is statutory income included in your assessable income and why might the timing of its assessment be different (if it is) from ordinary income?

In considering these questions, it will be observed that s 6-5 includes income derived whereas s 6-10 only includes. The short answer to the first question is: ‘When it is derived’. There is no evident short answer to the second question.7 However, in working out whether you have derived ordinary income and, if so, when, you are taken to have received the amount when it is applied or dealt with on your behalf or

[page 184] as you direct: s 6-5(4). If an amount would be statutory income apart from the fact that it has not been received, it is taken to be statutory income when it is applied or dealt with on your behalf or as you direct: s 6-10(3). There is another interesting difference between the two provisions. Section 6-5 has a single focus — its object is to assess ordinary income derived. The thrust of s 6-10 is different. It is not an assessing provision at all. Statutory income is made assessable under a particular provision. The role of s 6-10 is to collect a range of items made assessable income by statute and channel them through a central section. How the statutory items are to be calculated and when they are liable to assessment is the object of particular sections and Divisions. Section 610(4) performs the important function of stipulating a common set of jurisdictional limits (centred on residency and source). Section 6-15 provides for the exclusion from both ss 6-5 and 6-10 of items that are exempt income or non-assessable non-exempt income.

Derivation examined 4.4 The Acts have not defined the word ‘derived’ and the courts have held it is not a technical word. Accordingly, its meaning is grounded in ordinary (commercial, including accounting principles and practice) and legal concepts. Although English authorities have limited application to the specifics of the Australian legislative scheme, both jurisdictions have addressed questions of derivation, measurement and timing. In ordinary usage ‘derived’ means ‘attributable to; emanating from; arising from’.8 All income must emanate or arise from, or be attributable to some time or place. The first reported (South) Australian decision on income tax was concerned, among other things, with the meaning of ‘derived’: Ivanhoe South Goldmining Co v CT (SA) [1896] R&McG 299. Initially, Boucaut J was inclined to regard the words ‘derived, arising or accruing’ as used in the relevant Act as meaning ‘receiving’ but resisted the temptation. The court could not substitute

‘receive’ for ‘accrue’. Those two words are in no sense convertible. In CT (NSW) v Kirk [1900] AC 588, the Privy Council thought that ‘derived’ had no technical meaning, a view the Full High Court later endorsed in Harding v FCT (1917) 23 CLR 119 at 131, wherein ‘derived’ was treated as synonymous with ‘arising’ or ‘accruing’. In FCT v Thorogood (1927) 40 CLR 454, Isaacs ACJ said (at 458): ‘“Derived” is not necessarily actually received, but ordinarily that is the mode of derivation’. Acceptance that ‘derived is not necessarily actually received’ opens up several possibilities. First, there will be occasions where ‘derived’ coincides with received; second, income might be derived before it is received; and third, an amount might be received before it is treated as income derived. The first instance corresponds with a cash receipts basis of accounting and the other possibilities fall under the generic description ‘accrual’ basis. The description is generic because, although the term shares a number of accounting and commercial principles, it cannot be said that the derivation of income is governed by generally accepted accounting principles. In general, by accrual accounting, the courts mean the derivation of income at the [page 185] point of sale (or rendering of service) and the existence of an enforceable debt.9 There are variations on this general rule that extend the time of derivation to a point after an enforceable debt has come into existence.

Which basis? 4.5 By the 1930s, practices had developed whereby the income of manufacturers and traders was derived on an accrual basis. This was the practice in the United Kingdom and it was largely adopted by Australian courts. For those deriving employment income (such as salaries and wages) and property income (such as interest), income was derived when it was received. In the case of professional men and women (such as medical practitioners and accountants), there was no

set practice and Australian evidence indicates both methods were accepted at times and that taxpayers switched between the two. There was UK authority that an accrual basis was appropriate for the professions.10 Commencing in 1938, with the decision in CT (SA) v Executor Trustee and Agency Co of South Australia Ltd (1938) 63 CLR 108; 1 AITR 416; 5 ATD 98 (Carden’s Case), there has been a protracted argument over the appropriate basis for the professions. There was also argument over how closely the accrual basis should reflect generally accepted accounting principles in relation to both the earning of income and the deductibility of expenditure. Running parallel to this debate, although largely ignored, was a series of decisions following Colonial Mutual Life Assurance Society Ltd v FCT (1946) 73 CLR 604; 3 AITR 450 that examined the circumstances when it was appropriate to tax net profit as gross income (or as ordinary income in terms of ITAA97 s 65).

The leading authorities Carden’s Case 4.6 The decision in Carden’s Case is among the ‘classic’ older authorities that provide the starting point of investigations and often the final word. In relation to derivation issues and demarcation between cash and accrual bases, the decision is authority for the proposition that the object is to determine the method that ‘is calculated to give a substantially correct reflex of the taxpayer’s true income … the object [being] to discover what gains have during the period of account come home to a taxpayer in a realised or immediately realisable form’. In the course of a judgment leading to that conclusion and the specification of factors relevant to deciding the appropriateness of the method to be used, Dixon J examined the [page 186]

structure of the legislation, UK authority and commercial realities. He also offered a view whether there is a choice of method open to a taxpayer (or Commissioner) and on the tax consequences of changing from one method to another.

CT (SA) v Executor Trustee and Agency Co of South Australia Ltd (Carden’s Case) Facts: The respondent was the executor of the will of the late Dr Carden, a medical practitioner who died on 15 November 1935. Until the tax year before his death (30 June 1935), Dr Carden returned on a cash basis, although he had changed from an accrual basis in 1929–30. Following Dr Carden’s death, the executor continued in this practice and included as assessable income for the period 1 July 1935 to 15 November 1935 only cash receipts for the services rendered. The Commissioner sought to make several amended assessments that had the effect of including in Dr Carden’s assessable income outstanding debts at 30 June 1935 and assessing the executor on an earnings basis. Held: A majority of the Full High Court (Rich, Dixon and McTiernan JJ; Latham CJ dissenting) held that, except in the ‘broken period’ between 1 July and 15 November 1935, the outstanding debts should not be included as assessable income. Dixon J delivered the leading judgment and in the following series of extracts addresses three issues: 1. the substantive issue of whether a cash or accrual basis is appropriate for a medical practitioner in Dr Carden’s circumstances; 2. whether the Commissioner of Taxation has power to insist on one particular method; and 3. whether the legislation itself provides an answer to the substantive issue. Dixon J said (at AITR 440): The question [whether the Commissioner ought to have amended assessments to the executors for the period ending 30 June 1935 to include book debts] depends on the substantive question whether Dr Carden’s professional income on the basis of receipts was not in accordance with the law. For the broken period, the Commissioner clearly had power to assess the executors. But the substantive question for that period may perhaps be more accurately stated to be whether it is wrong on the part of the Commissioner to compute the [page 187]

professional income upon an earnings basis. For one view suggested is that a choice between the two methods is permitted by law and that choice lies with the Commissioner. The question whether one method of accounting or another should be employed in assessing taxable income derived from a given pursuit is one the decision of which falls within the provenance of the Courts of law possessing jurisdiction to hear appeals from assessments. It is, moreover, a question which must be decided according to legal principles. In the dichotomy between questions of fact and of law upon which Courts so continually insist on dealing with the problems of income tax they are called upon to solve there are thus grounds enough for placing it under the category of questions of law. But it is, I think, a mistake to treat such a question as depending on a search for an answer in the provisions of the legislation, a search for some expression of direct intention to be extracted from the test, however much it may be hidden or obscured by the form of the enactment.

The central issue was whether Dr Carden should return on a cash or accrual basis. That was not a choice open to the Commissioner. Being a question of law, ultimately it will be resolved by the courts and it is a mistake to expect to find a solution hidden in the statute. To paraphrase Dixon J’s view, in the world of commercial endeavour, business principles have developed that measure in money terms the success or failure of the myriad of undertakings. This is understood by legislators and the nature of income and the taxation of income is imbued with this appreciation. This evolution of commercial principles and the courts’ drawings from them invariably leads to the development of law itself and the acceptance by the courts of an accounting principle enshrines it in the law. On other occasions, it has not been possible to formulate principles and the matter must be left to discretionary judgment. Dixon J continued (at AITR 442): In the present case we are concerned with rival methods of accounting directed to the same purpose, namely the purpose of ascertaining the true income. Unless in the Statute itself some definite direction is discoverable, I think the admissibility of the method which in fact has been pursued must depend on its actual appropriateness. In other words, the inquiry should be whether in the circumstances of the case it is calculated to give a substantially correct reflex of the taxpayer’s true income. We are so accustomed to commercial accounts of manufacturing or trading operations, where the object is to show the gain upon a comparison of the respective positions at the beginning and end of a period of production or trading, that it is easy to forget the reasons that underlie the

application of such a method of accounting to the purpose of ascertaining taxable income. Although the field of profit-making which

[page 188] it covers in practice is probably much greater than any other among the manifold forms of income or revenue, it is a system of accounting which does not represent the primary or basal form from which an investigation of income for taxation purposes begins. Speaking generally in the assessment of income the object is to discover what gains have during the period of account come home to a taxpayer in a realised or immediately realisable form.

In relation to a manufacturing or trading business, accounting principles, experience and good sense lead inevitably to an accrual method based on a profit and loss account as adjusted for the specific requirements of the legislation. Dixon J concluded that there was no specific requirement in the legislation in regard to the choice between a cash and accrual basis and so it was necessary to develop considerations that established whether professional income derived in Dr Carden’s circumstances was appropriately reflected by a cash basis. His Honour specified the following (at AITR 444–5): The considerations which appear to me to affect any such question are to be found in the nature of the profession concerned and indeed the actual mode in which it is practised in a given case. Where there is nothing analogous to a stock of vendible articles to be acquired or produced and carried by the taxpayer, where outstandings on the expenditure side do not correspond to, and are not naturally connected with, outstandings on the earnings side, and where there is no fund of circulating capital from which income or profit must be detached for actual enjoyment, but where, on the contrary, the receipts represent in substance a reward for professional skill and personal work to which the expenditure on the other side of the account contributes only in a subsidiary or minor degree, then I think according to ordinary conceptions the receipts basis forms a fair and appropriate foundation for estimating professional income. But this is subject to one qualification. There must be continuity in the practice of the profession.

Accordingly, the majority held that a receipts basis was appropriate for Dr Carden’s income until 30 June 1935. If in any professional practice there is little certainty about payment of fees,11 a receipts basis alone would reflect the true income. For the broken period to 15 November 1935, the assessment to the executors was appropriately

made on an accrual basis because it was an incomplete period covering the period between the last accounting year and the date of death. This was the reason for the qualification Dixon J made above, ‘there must be continuity in the practice of the profession’.

Considerations examined 4.7 The several considerations nominated by Dixon J may be represented by way of the familiar accounting cycle. [page 189]

Figure 4.1:

Accounting cycle

An accrual basis is appropriate in the first three of the following four circumstances: 1. There is a stock of inventory purchased or produced. Trading, manufacturing and construction businesses adopt an accrual basis for financial accounting purposes and that is appropriate for

2.

3.

4.

taxation purposes too. While long-term construction projects present particular difficulties, there is nothing that cannot be accommodated by a broader view of accrual accounting. Outstandings on the earnings side corresponding to outstandings on the expenditure side implies a relationship between debtors and creditors that is illustrated in the above cycle. Inputs are purchased on credit, converted to saleable goods and sold for credit. The proceeds from debtor collection are then used to settle credit purchases and the process continues. It also suggests (as with 3 below) a connection between incomings and outgoings, especially where the outgoings represent employees’ salaries such that employees are an important part of the earning process. The clear implication here is that an accrual basis is appropriate when it is the business (through its employees) which earns the income rather than the payments representing a proprietor’s personal efforts. The implication can be extended to the use of capital assets to earn income in a business, especially where expenses relating to the capital items relate to the income earned. There is a fund of circulating capital from which profit must be detached. The surplus arising from the above cycle is gross profit. After the deduction of employment and administrative costs, net profit is appropriated to a proprietorship account and may be said to be ‘detached’ in a manner that contrasts, for example, with an employee’s or a sole practitioner’s enjoyment of income. As in 2 above, it implies a separation of the taxpayer (proprietor) and the earning process. On the other hand, a cash basis is appropriate where these factors are absent and the payment is in substance a reward for professional skill or personal work. In these situations, there is no inventory and receivables and payables are only remotely connected. The nature and source of the income is in contrast with manufacturing and trading. [page 190]

On the basis of Carden’s Case, when is s 6-5 ordinary income derived by the following? 1. an employee; 2. a brick manufacturer; 3. a bank; 4. a freelance journalist; 5. a sole practitioner accountant. A suggested solution may be found in Study help.

Changing methods 4.8 A change from a cash to an accrual basis or, as occurred in Carden’s Case (1938) 63 CLR 108; 1 AITR 416; 5 ATD 98, from 30 June 1929, from accrual to cash, presents particular problems. A change from cash to accrual would mean that outstanding debtors would escape taxation while a change in the opposite direction would lead to double taxation. Would it be appropriate to make a ‘one-off’ adjustment? In Carden’s Case, Dixon J said (at AITR 435): A little consideration will show that, when, as at 30 June, 1929, the change was made in the mode of return and of assessment, a rigid adherence to the receipts basis of assessment would have resulted in the inclusion of the same fees in two different assessments, fees earned before 1 July, 1929 but paid on or after that date. If this was done the Commissioner was, so to speak, providing in advance against the future contingency of Dr Carden ceasing to be a taxpayer at a time when professional earnings were outstanding and unpaid. To adhere rigidly to the receipts basis disregarding the fact that some of the receipts represent fees which had been included as earnings in the prior assessment, would, I think, have been by no means indefensible. For the two methods of ascertaining the income of a professional man are rival systems of account, each put forward by its supporters as an appropriate and satisfactory basis of computation. There is, therefore, no abstract reason why, when a change from one to the other is made, an adjustment should be attempted by excluding from the later assessments receipts in respect of fees already included in earlier assessments made on an earnings basis. Indeed there is authority of the [UK] Court of Sessions for the view that such an adjustment must not be made. See IRC v Morrison 1932 SC 638; 17 TC 325.12 [Emphasis added.]

Henderson’s case

4.9 The question of changing methods and ‘one-off’ adjustments was considered again by the Full High Court in Henderson v FCT (1970) 119 CLR 612; 1 ATR 596; 70 ATC 4016, because, following the decision in Carden’s Case, taxpayers felt at liberty to change the basis of their return from cash to accrual. [page 191]

Henderson v FCT Facts: The appellant was a member of a large firm of accountants comprising 19 partners, approximately 65 associates and 295 employees, of whom 150 were qualified accountants. Until 30 June 1965, the partnership returned on a cash basis. As a result of changes in the nature of the work performed and the growth of work performed on a credit basis, as well as internal reorganisation occasioned by the imminent retirement of several partners, the partnership changed from a cash to an accrual basis. A result of the change was that outstanding debtors amounting to $179,530 escaped taxation because, in the year before the change they were not received, and in the year after the change, although received, they were not derived. The Commissioner rejected as incorrect the returns by the partnership and the taxpayer and insisted on the cash basis. Four issues were before the High Court: (i) what was the appropriate basis for a partnership in these circumstances; (ii) was the Commissioner at liberty to insist on a method of returning that was not inconsistent with the Act; (iii) was some adjustment warranted in the year of change if the change was accepted; and (iv) how was work in progress of professional taxpayers to be treated? Held: At first instance ((1970) 1 ATR 133), Windeyer J held the Commissioner was not justified in insisting on a cash basis for the partnership but that an adjustment ought to be made in the year of change to include as assessable income the outstanding debtors. His Honour also held that professional work in progress was not trading stock. The taxpayer and the Commissioner issued cross appeals, the former against the one-off adjustment and the latter against the conclusion that an accrual basis was appropriate. The Full Court allowed the taxpayer’s appeal. Barwick CJ (with whom McTiernan and Menzies JJ agreed) said (at ATR 598): It is apparent, in my opinion that what such a business earns in a year will represent its income derived for the purposes of the Act. The circumstances which led the majority of the Court to conclude in Carden’s Case that a cash basis was

appropriate to determine the income of a professional practice carried on by the taxpayer personally are not present in this case. One of the submissions made by the Commissioner was that the Act gave an ‘initiative’ to determine the assessable income of a taxpayer by a method not inconsistent with the Act. The argument [page 192] proceeded that, given the decision in Carden’s Case that a cash basis was appropriate for a professional practice, it was not enough for the taxpayer to show that an accrual basis might also be appropriate. The taxpayer needed to establish that the Commissioner’s method was inconsistent with the Act. Barwick CJ said (at ATR 599): This argument … is, in my opinion, clearly untenable. The Act by [former ITAA36] s 17 levies income tax upon the amount of taxable income derived by the taxpayer in the year of tax … That assessable income when ascertained must be expressed in a figure. There cannot in fact be alternative figures for such assessable income. The figure determined as that income may be the result of estimation as well as of calculation and its determination may involve the acceptance of opinions, expert or otherwise. But however arrived at, the result is a figure, the assessable income in fact of the particular taxpayer for the year of tax.

The Chief Justice went on to say that unless a method of computation yields what is in fact the correct figure for that income, it cannot be said to be appropriate. Ultimately, what is the appropriate method will be determined by the opinion of the High Court. In respect to the taxpayer’s appeal against the adjustment of $179,530 for the outstanding debtors, it will be recalled that in Carden’s Case, Dixon J considered there was no abstract reason for an adjustment. At first instance in Henderson’s case, Windeyer J distinguished Carden’s Case on the ground that it was concerned with the opposite situation — a change from accrual to cash and the prospect of double taxation. His Honour considered it ‘a mistaken use of analogy’ to argue that it followed from Dixon J’s view that tax could be avoided by a reverse change in method. On appeal, Barwick CJ disagreed (at ATR 600): But, with due respect to [Windeyer J], there cannot be any warrant in a scheme of annual taxation upon the income derived in each year of taxation for combining the results of

more than one year in order to obtain the assessable income for a particular year of tax. Of course, the experience of a prior year may be reflected in the opening figures of the relevant year, but they become and are figures for that year and not figures of two years in combination. Once it is decided that the partnership income derived in the year in question will be the net amount of its earnings of that year, it is, in my opinion, only the earnings of that year that can be included in the computation.

The effect of the decision in Henderson’s case was to remove the element of choice between the cash and accrual bases. There was only one correct method in each case. Where a taxpayer’s circumstances changed, such as the method of organisation, the nature of the incomeearning activity and the manner in which it was practised, there will be grounds for contending that the former method of returning is no longer [page 193] appropriate. As Barwick CJ reminded taxpayers and the Commissioner, ultimately the appropriateness of a method will be determined by the High Court. The decision in Dormer v FCT (2002) 51 ATR 353; 2002 ATC 5078 should be considered when a change in methods is contemplated. In that case, the taxpayer was a sole practitioner accountant returning on a cash basis. In July 1997, he formed a partnership with two others, transferring a one-third interest (other than debtors) to each. The new partnership returned on an accrual basis and the taxpayer relied on Henderson’s case to exclude from assessable income amounts of $76,000 collected in 1997–98 and $4695 collected in 1998–99 from debts owing before July 1997. The Full Federal Court distinguished Henderson in that there was a continuing business whereas, in Dormer’s case, there was a new venture that held no relationship with the old business. The court held that the amounts were assessable as received:13 see also 4.19.

Carden’s Case and Henderson’s case are sometimes cited as authority for saying that only one method of returning is appropriate for a particular taxpayer. Is that statement strictly correct? A suggested solution may be found in Study help.

4.10 The decisions that a medical practitioner in Dr Carden’s circumstances should return on a cash basis and that the partnership of which Mr Henderson was a member should return on an accrual basis are not incompatible or in conflict. Certainly, it cannot be said that Henderson’s case overruled Carden’s Case. The passages from Dixon J’s judgment cited above indicate a considered appraisal of all the issues and culminate with a statement of principle that ‘the inquiry should be whether in the circumstances of the case [the method] is calculated to give a substantially correct reflex of the taxpayer’s true income’. Several considerations relevant to applying that principle were presented. The decision does not turn on the fact that Dr Carden incurred a few bad debts and Henderson’s case does not overrule Carden’s Case. In Henderson’s case, both Windeyer J (at first instance) and Barwick CJ (on appeal) make decisive statements that the circumstances of Henderson’s case were in ‘sharp contrast with the operations of the medical practitioner’.14 The partnership in Henderson’s case employed 295 people, had fees and disbursements exceeding $1m, virtually no bad debts, and was the largest firm in Western Australia and among the largest in Australia. The scale of operations in Henderson’s case, the nature and [page 194] sophistication of the in-house accounting system and the nature of the

remuneration all distinguish the case, and Carden’s Case remains the authoritative exposition of the Act.15 One of the legacies of Carden’s Case was a basis for distinguishing between different classes of the professions. Dixon J said (at AITR 446): But to a great degree the question whether income of a particular kind can be properly calculated on one basis alone or upon either, must depend on the nature of the source of income. [Emphasis added.]

Arguably, this statement provided support for distinguishing taxpayers who, like Dr Carden, could be said to provide personal services, and those whom Mr Henderson represented, who could be said to be carrying on a business. The former group would appropriately return on a cash basis and the latter on an accrual basis and the actual decisions in Carden’s Case and Henderson’s case supported these bases. Whatever the merit in the distinction, in the Commissioner’s historic view,16 barristers, doctors and dentists belonged to one class of professionals and they should use a cash basis while solicitors and accountants belonged to another class that should use an accrual basis.

Firstenberg’s case 4.11 Predictably, in due course, the issue was again before the court in the instance of FCT v Firstenberg (1976) 6 ATR 297; 76 ATC 4141.

FCT v Firstenberg Facts: The taxpayer was a solicitor in sole practice with one employee. His books of account were maintained on a cash basis and for 20 years his tax returns were lodged on that basis. The Commissioner requested information from the taxpayer in relation to book debts and issued an assessment on an accrual basis. Before the Supreme Court of Victoria, accountants for the Commissioner and the taxpayer provided contradictory evidence concerning the appropriateness of the alternative methods. Held: McInerney J dismissed the Commissioner’s appeal, holding that a cash basis was appropriate. There was ‘no fund of circulating capital from which income or profit must be detached’. Although it would be prudent for a professional to record work performed

and debts outstanding and that would enable the compilation of accounts on an accrual basis, that did not make such a base appropriate. His Honour said (at ATR 313): [page 195] This is not necessarily to say, however, that the “accrual basis” ascertains “income derived” during any given year of income. Indeed, from many points of view it might be a very misleading guide as to what “income” was “derived” during the relevant period by a professional man practising on his own account. The tax position of such a man is, in my view, more readily assimilated with that of a wage earner or salaried man who would ordinarily be understood as having derived only the income which he had received into his hands or which he had under his control.a In his Honour’s view, this conclusion was entirely consistent with the authorities: Carden’s Case, Henderson’s case and Rowe (J) & Sons Pty Ltd (1971) 124 CLR 421; 2 ATR 497; 71 ATC 4157. He said (at ATR 310): It is apparent, from a review of the cases cited that the concept of “income derived” is one which will often take its content from the context in which it has to be applied, and that it may have very different content and significance when applied to the financial operations of a huge multi-national corporation, or a large trading company or business, or a large professional partnership respectively than it would in the case of a one man professional practitioner.

a.

On the issue of receivability, McInerney J was clearly influenced by requirements pursuant to the Victorian Supreme Court Act 1958, that meant (in general) that a solicitor’s account was not legally recoverable until one month after the delivery of a signed bill: at ATR 308. It can only be speculated whether this factor influenced his Honour’s reluctance to express a view as to the appropriate basis for a large partnership of solicitors: at ATR 312. Arguably, solicitors would be in no different a position than a trader who sold on 30-day terms. In itself, that would not determine the derivation issue. See also Barratt v FCT (1992) 36 FCR 222; 23 ATR 339.

4.12 On the facts of Firstenberg’s case — sole practitioner, no professional employees — it was a simple conclusion that a cash basis was appropriate. Payments in such circumstances may be described as rewards for professional skill. None of the factors suggested in Carden’s Case as pointing to an accrual basis were present in Firstenberg’s case. Unfortunately, the decision did little to resolve the distinction between taxpayers who could be described as providing personal services and those carrying on a business. Did Firstenberg’s case mean that all sole

practitioners should return on a cash basis? The matter was again before the courts in the case of FCT v Dunn (1989) 20 ATR 356; 89 ATC 4141. Dunn’s case concerned an accountant in sole practice. Although he had a number of employees, only seldom did he employ professionally qualified staff. Until 1970, he returned on a cash basis but thereafter he adopted an accrual basis until 1977 [page 196] when he reverted to a cash basis. The Commissioner assessed post-1977 years on an accrual basis and the Administrative Appeals Tribunal held that Firstenberg’s case meant that sole practitioners were to be assessed on a cash basis. The Commissioner’s appeal to the Federal Court was dismissed. Davies J said (at ATC 4151): The Tribunal referred to the principal relevant authorities and, in my opinion, no error in law is expressed in the reasons for decision. Perhaps some doubt arises from the statement by the Tribunal that “the effect of Firstenberg’s case is that sole practitioners are assessed on a ‘cash receipts’ basis.” This was an overstatement. There is no principle of law or binding authority to the effect that a sole practitioner is to be assessed on a cash receipts basis. The matter depends on the nature and incidents of the income earning enterprise, upon current accounting principles and practice and upon current perceptions in the field in which the taxpayer gains his income. These matters may differ from time to time. There may be relevant differences between different occupations, between different periods and between different taxpayers in the same field of occupation.

Davies J’s statement suggests that the appropriate basis may change depending on the particular income-earning activities and, indeed, may change with changes in commercial and accounting practice over time.

Is a partnership of medical practitioners (providing ‘personal services’) distinguishable

from a partnership of accountants (‘a business’) for the purpose of determining when the partnership income is derived?

The decision in Dunn’s case makes it clear that a blanket classification of sole practitioners or a particular professional group is inappropriate and it casts further doubt on a division between occupations that may be described as carrying on a business as compared with those providing personal services as a basis for resolving derivation issues. Carden’s Case established that a cash basis was appropriate for a medical practitioner in sole practice and Firstenberg’s case reached the same conclusion for an accountant in sole practice. Dunn’s case held there is no rule of law that sole practitioners adopt a cash basis and Henderson’s case provides authority for, and an example of, the circumstances where a sizeable professional practice ought to use an accrual basis. In Barratt v FCT (1992) 36 FCR 222; 23 ATR 339; 92 ATC 4275, the question of the appropriate method was examined in a case involving a partnership of five medical practitioners generating $2m in fees and employing a number of technical staff through a service trust. The practice provided pathology services requiring sophisticated equipment and qualified technicians who operated under the supervision of the partners. Evidence showed a considerable growth in size and activity that the Commissioner argued was a ‘far cry’ from the practices in Carden’s Case, Firstenberg’s case and Dunn’s case. In the Full Federal Court, Gummow J (with [page 197] whom Northrop and Drummond JJ agreed) held the circumstances pointed to an accrual basis as the appropriate method.

Bloggs is an accountant who practised as a sole proprietor until 28 February 2017, at which time he joined the partnership Bloggs, Cloggs & Doggs, a large accounting firm with national affiliations. Financial information for the year ended 30 June 2017 is as follows: A Bloggs — Public Accountant

Fees received 2016–17 $52,000 Accounts receivable 01/07/16 6,000 28/02/17 11,000 Expenses 10,000 By 30/06/17, accounts receivable stand at $9000 (ie, another $2000 was received). BC&D — Chartered Accountants Fees received 2016–17 $150,000 Accounts receivable 01/03/17 nil 30/06/17 25,000 Unbilled work in progress 01/03/17 nil 30/06/17 3,000 Expenses 25,000 Partners in BC&D share profits and losses equally. Calculate Bloggs’s taxable income for the year ended 30 June 2017. A suggested solution can be found in Study help.

Legal recoverability 4.13 One issue raised in Firstenberg’s case was the legal barrier to recovery of a debt. Under the Supreme Court Act 1958 (Vic), costs were

not recoverable until one month after the delivery of a signed bill of costs. Was it possible to argue that impediments of this kind deferred the point of derivation? If so, arguably a cash basis was more appropriate and further questions would arise concerning other legal or practical obstacles. The argument was pressed in Barratt’s case. There were provisions of the Medical Practitioners Act 1938 (NSW) (and the Health Insurance Act 1973 (Cth)) that meant [page 198] no action for the recovery of medical fees could be commenced until six months after a bill had been sent. In general, where there is a debt presently recoverable, but not subject to some contingency, the creditor has a right that is both earned and quantified. In support of his argument, the taxpayer relied on remarks made by Barwick CJ in Henderson v FCT (1970) 119 CLR 612; 1 ATR 596; 70 ATC 4016, as well as the decision in FCT v Australian Gas Light Co (1983) 52 ALR 691; 15 ATR 105; 83 ATC 4800. In Henderson’s case, Barwick CJ had said in relation to unbilled work in progress of a professional person that no amount was income earned until the task was completed and payment could properly be demanded. In Barratt’s case, Gummow J rejected an argument that this applied to a debt for services rendered. The ‘truth and reality’ of the taxpayer’s position was that payment was regularly billed and received without regard to the six-month period. In the Australian Gas Light Co case, the taxpayer supplied gas to domestic and commercial users pursuant to regulations contained in the Gas and Electricity Act 1935 (NSW). Regulations required the supply of gas on a quarterly basis and prohibited the taxpayer from demanding payment until an account was rendered following the reading of a meter. The taxpayer did not bring to account at 30 June ‘unbilled gas’, being gas supplied between the last meter reading and 30 June. The Commissioner assessed the taxpayer on the ‘unbilled gas’ and placed

particular emphasis on the fact that the property had passed irretrievably to customers. The valuation of the gas did not present any problems and the Commissioner contended that the taxpayer had done all that was required of it to earn the unbilled amounts. The Full Federal Court (Bowen CJ, Fisher and Lockhart JJ) dismissed the Commissioner’s appeal, holding (at ATC 4806): The registration of a customer’s gas meter is prima facie evidence of the quantity of gas supplied and determines the quantitative basis on which he is obliged to pay. The reading of the meter and the giving of notice to the customer of what is registered are more than mere procedure. They are conditions precedent to the making of demand for payment.

The distinction made in Barratt’s case may be stated this way: in the Australian Gas Light Co case, no debt could come into existence until conditions precedent were satisfied. In Barratt (and Firstenberg), procedural obstacles may stand in the way of collection but there was a legally enforceable debt. Credit sales made on 30-day (or other) terms are easily accommodated into this framework. There is an enforceable debt at the point of sale or the point of rendering of services. The fact that contractual arrangements may prevent immediate recovery does not deny derivation. This is clear from Barwick CJ’s judgment in Henderson’s case (at ATR 601): I have used the word recoverable to describe the point at which income is derived by the performance of services. I ought to add that fees would be relevantly recoverable though by reason of special arrangements between the partnership and the client, time to pay was afforded.

A slightly different position arises where goods are sold and the amount of payment is the subject of dispute. In BHP Billiton Petroleum (Bass Strait) Pty Ltd [page 199] v FCT (2002) 51 ATR 520; 2002 ATC 5169, the Full Federal Court held that where there was a significant dispute involving both liability and quantum, income was derived when the dispute was settled, not when property passed.

1.

Dr Why is a sole medical practitioner. She provides the following financial information for the year ended 30 June 2017. Calculate her taxable income.

Cash received from patients Accounts receivable 30/06/2016 Accounts receivable 30/06/2017 Medicare reimbursements Salaries paid Drawings Sundry expenses 2.

$130,000 25,000 30,000 45,000 40,000 10,000 30,000

Corner Pharmacy is a chemist shop. It provides no credit sales but accepts major credit cards. It sells items off the shelf and the proprietor fills prescriptions for cash and for payments made under the Pharmaceutical Benefits Scheme (PBS). Three assistants are employed. The following financial data is provided:

Cash sales Credit card sales Credit card reimbursements

$300,000 150,000 160,000

PBS:

Opening balance Closing balance Billings Receipts

$25,000 30,000 200,000 195,000

Stock:

Opening stock Purchases Closing stock Salaries

$150,000 500,000 200,000 60,000

Rent

50,000

On the assumption that cost of sales and other outlays are allowable deductions for tax purposes, calculate the pharmacy’s taxable income. A suggested solution can be found in Study help.

[page 200]

Refinements of the accrual basis 4.14 The accrual basis recognised by the courts centres on the existence of a legally enforceable debt that is free of contingencies. No legally enforceable debt can exist where there are conditions precedent to the making of a demand for payment. There have been occasions where the courts have adopted a broader appreciation of accrual accounting that has come close to equating derivation of income with the earning of income.

The Arthur Murray (NSW) Pty Ltd v FCT decision 4.15 Consider the decision in Arthur Murray (NSW) Pty Ltd v FCT (1965) 114 CLR 314; 9 AITR 673 (Arthur Murray).

Arthur Murray (NSW) Pty Ltd v FCT Facts: The taxpayer provided dancing tuition for fees of varying amounts calculated on an hourly basis. A course of instruction in basic dancing consisted of a specified number of hours and private tuition was available by appointment. Fees were often in advance and a discount scheme operated to encourage prepayment. Alternatively, payment was by instalments. Students were given no contractual right of a refund for courses abandoned but in practice refunds were sometimes given. In the company’s accounts, fees received were credited to an account entitled ‘Unearned Deposits Untaught Lessons Account’. As tuition was provided, amounts were debited to

that account and credited to ‘Earned Tuition Account’ and the company prepared its taxation return on the same basis; that is, that prepaid fees did not constitute income derived. The Commissioner assessed the taxpayer on the basis that the fees represented income at the point of receipt.a Held: The Commissioner’s view was rejected. Whether an amount received but not yet earned (or ‘earned’ but not yet received) is income must depend basically on the judicial understanding of what the word ‘income’ means to practical business people whose concern it is to make the necessary judgments. Barwick CJ, Kitto and Taylor JJ said (at AITR 688–90): As Dixon, J, observed in Carden’s Case …: Speaking generally, in the assessment of income the object is to discover what gains have during the period of account come home to the taxpayer in a realised or immediately realisable form. The word “gains” is not here used in the sense of the net profits of the business, for the topic under discussion is [page 201] assessable income, that is to say gross income. But neither is it synonymous with “receipts”. It refers to amounts which have not only been received but have “come home” to the taxpayer; and that must surely involve, if the word “income” is to convey the notion it expresses in the practical affairs of business life, not only that the amounts received are unaffected by legal restrictions, as by reason of a trust or charge in favour of the payer — not only that they have been received beneficially — but that the situation has been reached in which they may properly be counted as gains completely made, so that there is neither legal nor business unsoundness in regarding them without qualification as income derived. The ultimate inquiry in either kind of case, of course, must be whether that which has taken place, be it the earning or the receipt, is enough by itself to satisfy the general understanding among practical business people of what constitutes a derivation of income. A conclusion as to what that understanding is may be assisted by considering standard accountancy methods, for they have been evolved in the business community for the very purpose of reflecting received opinions as to the sound view to take of particular kinds of items. This was fully recognised and explained in Carden’s Case, especially in the judgment of Dixon J; but it should be remarked that the Court did not there do what we were invited to do in the course of the argument in the present case, namely, to treat the issue as involving nothing more than an ascertainment of established book-keeping methods. A judicial decision as to whether an amount received but not yet earned or an amount earned but not yet received is income must depend basically upon the judicial understanding of the meaning which the word conveys to those whose concern it is to observe the distinctions it implies. What ultimately matters is the concept; book-keeping methods are but evidence of the concept. It was Dixon J’s understanding of the concept that is reflected in his Honour’s

judgment in Carden’s Case where he said: If in a given medical practice there is but little certainty about the payment of fees, I should have thought that a receipts basis of accounting would alone reflect truly the income and for most professional incomes it is the more appropriate. Thus, in determining whether in such a case actual receipt had to be added to earning in order to find income, [page 202] uncertainty of receipt, inherent in the circumstances of the earning, appeared to his Honour to be decisive. Likewise, as it seems to us, in determining whether actual earning has to be added to receipt in order to find income, the answer must be given in the light of the necessity for earning which is inherent in the circumstances of the receipt. It is true that in a case like the present the circumstances of the receipt do not prevent the amount received from becoming immediately the beneficial property of the company; for the fact that it has been paid in advance is not enough to affect it with any trust or charge, or to place any legal impediment in the way of the recipient’s dealing with it as he will. But those circumstances nevertheless make it surely necessary, as a matter of business good sense, that the recipient should treat each amount of fees received but not yet earned as subject to the contingency that the whole or some part of it may have in effect to be paid back, even if only as damages, should the agreed quid pro quo not be rendered in due course. The possibility of having to make such a payment back (we speak, of course, in practical terms) is an inherent characteristic of the receipt itself. In our opinion, it would be out of accord with the realities of the situation to hold, while the possibility remains, that the amount received has the quality of income derived by the company. For that reason, it is not surprising to find, as the parties in the present case agree is the fact, that according to established accountancy and commercial principles in the community the books of a business either selling goods or providing services are so kept with respect to amounts received in advance of the goods being sold or of the services being provided that the amounts are not entered to the credit of any revenue account until the sale takes place or the services are rendered: in the meantime they are credited to what is in effect a suspense account, and their transfer to an income account takes place only when the discharge of the obligations for which they are the prepayment justifies their being treated as having finally acquired the character of income. The paragraph of the case stated in which the established principles are described does not leave to inference why it is that books are kept in this manner. It is there specifically stated, as an agreed fact, that according to established accounting and commercial principles, in the case of a business either selling goods or supplying services, amounts received in advance of the goods being delivered or the [page 203]

services being supplied are not regarded as income. We have not been able to see any reason which should lead the courts to differ from accountants and commercial men on the point … In so far as the Act lays down a test for the inclusion of particular kinds of receipts in assessable income it is likewise true that commercial and accountancy practice cannot be substituted for the test. But the Act lays down no test for such a case as the present. The word “income”, being used without relevant definition, is left to be understood in the sense which it has in the vocabulary of business affairs. To apply the concept which the word in that sense expresses is not to substitute some other test for the one prescribed in the Act; it is to give effect to the Act as it stands. Nothing in the Act is contradicted or ignored when a receipt of money as a prepayment under a contract for future services is paid not to constitute by itself a derivation of assessable income. On the contrary, if the statement accords with ordinary business concepts in the community and we are bound by the case stated to accept that it does it applies the provisions of the Act according to their true meaning.

a.

The amended assessments related to the 1954, 1955 and 1956 income years. Until that time, the Commissioner accepted the taxpayer’s accounting method. A decision in 1953 by the High Court in FCT v James Flood Pty Ltd (1953) 88 CLR 492; 5 AITR 579 held that the accounting practice of raising provisions for annual leave and long service leave did not satisfy deductibility tests under the former ITAA36 s 51(1). On that basis, it might be argued other accounting practices were inappropriate, particularly the method in Arthur Murray.

Is the gravamen of Arthur Murray’s case the element of contingency that attaches to the advance payments because they might have to be refunded or that, according to established accounting and commercial principles, advance payments for the supply of goods or services are not income? Does the decision turn on refundability?

4.16 One factor that distinguishes the decision in Arthur Murray from the cases previously discussed is that the other cases proceeded on the understanding that the fees were inherently income in nature. The issue in dispute was when they should be brought to assessment for tax purposes. It is arguable that an accrual basis will always give a ‘correct reflex of the taxpayer’s true income’ but that, in circumstances such as

those illustrated in Firstenberg’s and Dunn’s cases, it may be unreasonable to expect taxpayers to incur the cost or inconvenience occasioned by an accrual system [page 204] and a ‘substantially correct reflex’ is provided by a cash basis. Carden’s Case and Arthur Murray addressed a more fundamental issue. As was said in Arthur Murray of Carden’s Case: … the Court did not there do what we were invited to do in the course of the argument in the present case, namely, to treat the issue as involving nothing more than an ascertainment of established book-keeping methods.

At a fundamental level, the issue in Arthur Murray was whether the advance payment was income. In the broadest interpretation, the decision provides that, as an overriding requirement, an amount must be earned before it is income. Fundamentally, that is what underpins the accounting conceptual framework — an amount that is not earned is not income (revenue). Under the Framework for the Preparation and Presentation of Financial Statements (Framework),17 prepayments represent liabilities, not revenue items, because a liability is defined as ‘a present obligation … arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits’. Such obligations include both legally enforceable obligations as well as those arising from ‘normal business practice, custom and a desire to maintain good business relations or act in an equitable manner’. The obligation may be to pay a refund in the event of non-performance or to consume resources in discharging the prepaid services through normal performance. This is not a principle that has always been recognised judicially and, ultimately, the issues will be resolved by jurisprudential analysis, although the development of that analysis may be influenced by an accounting method that is evidential not determinative. BHP Billiton Petroleum (Bass Strait) Pty Ltd v FCT (2002) 51 ATR 520; ATC 5169 provides an example of the evidential influence of accounting principles. Recall that the case concerned a

bona fide dispute as to liability and quantum of amounts to be paid for the sale of gas. Hill and Heerey JJ explicitly referred to accounting evidence on the principles applying to the recognition of revenue.18 As set out in the Framework, those principles require, for instance, the recognition of an increase in an asset — so it must be probable that future economic benefits will be received — and that the asset has a value that can be measured reliably. As there was a significant dispute as to both liability and quantum, neither of those requirements could be met. 4.17 The Arthur Murray principle applies to advance payments for goods and services. Whether it applies to all prepayments is yet to be endorsed judicially. It applies to advance subscriptions for journals and magazines (Country Magazine Pty Ltd v FCT (1968) 117 CLR 162; 10 AITR 573), and the Commissioner accepts that it applies to advance deposits for goods to be manufactured and supplied at a later date as well as maintenance contracts and other fixed-term service contracts (Taxation Ruling TR 96/5). Income from ‘lay-by’ arrangements is derived when the last payment is made and delivery is taken: Taxation Ruling TR 95/7. [page 205] The decision in Country Magazine Pty Ltd is significant in two respects. In the first place, it illustrates the hazard Dixon J anticipated in Carden’s Case. His Honour said (at AITR 435): There is, therefore, no abstract reason why, when a change from one [method] to the other is made, an adjustment should be attempted by excluding from the later assessments receipts in respect of fees already included in earlier assessments made on an earnings basis.

In Country Magazine Pty Ltd, the taxpayer was a magazine publisher. In its internal accounts, subscriptions received in advance were credited to a suspense account ‘Subscriptions in Advance’ and the payments were brought to account as income over the course of the subscription period. However, for tax purposes, the taxpayer returned

on a cash basis and added back the advance subscriptions. Following the decision in Arthur Murray, for the year ended 30 June 1966, the company sought to return on the same method as it kept its accounts with the result that $10,480 was twice assessed. In 1965, the amount, which was subscriptions in advance, was added to assessable income. In 1966, the magazines were supplied and the amount was earned. The taxpayer contended that an amount could not be income in more than one year and that that was implied in the Act, but in the High Court, Kitto J rejected the argument as groundless and the adjustment sought as illogical.

Consider ITAA97 s 6-25: 6-25 Relationships among various rules about ordinary income (1) Sometimes more than one rule includes an amount in your assessable income: the same amount may be ordinary income and may also be included in your assessable income by one or more provisions about assessable income; or the same amount may be included in your assessable income by more than one provision about assessable income.

However, the amount is included only once in your assessable income for an income year, and is then not included in your assessable income for any other income year. Does s 6-25 address the problem at issue in Country Magazine Pty Ltd specifically? Does s 6-25 support the view that it is implied by the Act that an amount is assessable only once? Does s 6-25 address the problem of ‘one-off’ adjustments of the type at issue in Henderson’s case? A suggested solution can be found in Study help.

[page 206]

4.18 The second significant aspect of Country Magazine Pty Ltd is that it suggests the decision in Arthur Murray is limited by the facts of that case. Consider the following passage from Arthur Murray (at AITR 689): It is there specifically stated, as an agreed fact, that according to established accounting and commercial principles, in the case of a business either selling goods or supplying services, amounts received in advance of the goods being delivered or the services being supplied are not regarded as income. [Emphasis added]

There is no doubt that, according to established accounting and commercial principles, prepayment of rent or interest or other items of property income would be similarly treated but that extends the decision in Arthur Murray beyond the agreed facts. In Country Magazine Pty Ltd, Kitto J cited the above passage in a manner that suggests the decision is limited to cases of the supply of goods or the supply of services. At any rate, there is a view that Arthur Murray is limited to goods or services that are apportionable into discrete units. Prepaid rent, the argument would run, relates to a leasehold right that is not so apportionable. In general, rent or interest relating to passive investments is derived when received and, if a cash basis is appropriate, the Arthur Murray principle is irrelevant. Where a taxpayer conducts a business that involves money lending or where rent is part of some wider business activity, an accrual basis will be appropriate. Rent paid for chattel leasing will be assessable on an accrual basis. Prepaid insurance received by a mortgagee insurance company was appropriately returned according to the Arthur Murray principle: see Commercial Union Australia Mortgage Co Ltd v FCT (1996) 69 FCR 331; 96 ATC 4854 and 4.19. In regard to rent received as investment income, there are conflicting Board of Review decisions. Where a prepayment of rent was made under a lease agreement that provided for a refund, one year’s rent only was assessable but a similar prepayment under a lease that specifically excluded a refund was fully assessable.19 Arthur Murray does not turn on refundability except insofar as refundability demonstrates an outstanding obligation or liability. If there is a distinction to be made, it is on the basis of business as distinct from property income or, even less convincingly, between the supply of goods

and services as opposed to legal rights that are not divisible into discrete elements, such as a leasehold right. Advance payments returned under the Arthur Murray principle cannot escape tax because circumstances change: for example, if the contracted services are not supplied. Arguably, the advance payment will become income earned as if the goods or services were supplied in the normal course of the contract (unless the amount is refundable).

Changed earning rate of goods or services 4.19 Although non-supply of goods or services will not normally change the earning rate under the Arthur Murray principle, the earning process may change for reasons such as those illustrated in the following example. [page 207]

Alpha Insurance Co is an insurance company providing coverage in return for prepaid premiums. For accounting and tax purposes, it apportions the premium over its five-year term on a straight line basis on the basis of the Arthur Murray principle. An actuarial review of the company’s exposure to risk recommended it change its method such that more premiums were treated as earned in the first two years and correspondingly lesser amounts in later years: Yr 1

Yr 2

Yr 3

Yr 4

Yr 5

Existing method

100

100

100

100

100

Proposed method

200

120

70

60

50

At the end of year 2, the company changed to the proposed method with the result that income of $120 relating to existing policies was not recognised. Would Henderson’s case preclude a one-off adjustment for taxation purposes?

The simplified facts in the above example were the substance of the

issue before the Federal Court in Commercial Union Australia Mortgage Co Ltd v FCT (1996) 69 FCR 331; 96 ATC 4854. The taxpayer argued that the new apportioning method should be accepted for tax purposes (with the result that some income escaped tax) while the Commissioner contended it was not permissible to depart from the original method for existing contracts (although the company could do so for new contracts). Lindgren J dismissed the taxpayer’s appeal on the basis that it could not be the intention of the legislation to permit income amounts to escape taxation. A change in method for existing contracts could be accepted only if assessable income in earlier years was increased.

1.

2.

A life insurance agent sells life policies on a commission basis. Commissions are paid by the insurance company on receipt from the insured of the first year’s premium. However, if the policy is surrendered within four years the agent is obliged to repay part of the commission as determined by a formula which is based on the period the policy has been in force. When is the commission derived and how would you suggest repayments be treated for taxation purposes? Pegasus Pty Ltd is in the business of thoroughbred horse breeding. Rather than buy thoroughbred stallions, Pegasus buys [page 208]

and owns a number of ‘rights to service’ (nominations) with various stallions. During the period 31 March to 30 June, the following events occurred: (i) Amounts of $100,000 were received as non-refundable deposits of 10% on certain nominations. The balance would be payable in the next financial year on confirmation of pregnancy. (ii) An amount of $20,000 was received for the outright sale of a nomination. No refund was payable other than in the event that the service could not be performed. Advise Pegasus what amounts are derived in the year ended 30 June. Suggested solutions may be found in Study help.

Payments received over time 4.20 The Arthur Murray principle applies to payments received in advance of the supply of goods or services. The decision illustrates that the receipt of cash is not necessarily determinative of the time of income derivation. The decision in FCT v Australian Gas Light Co (1983) 52 ALR 691; 15 ATR 105; 83 ATC 4800 illustrates that the passing of title is not necessarily determinative of the question either. In general, under the accrual basis, income in respect of credit transactions is derived at the point of sale or the point of rendering services. A common element in all the relevant authorities is the absence of a necessary connection between the receipt of cash and the derivation of income. An obvious variation on the theme is a contention that, in certain types of sale, the receipt of cash is critical and that income recognition ought to be deferred until cash is received. This was considered in J Rowe & Sons Pty Ltd v FCT (1971) 124 CLR 421; 2 ATR 497; 71 ATC 4157. Prior to the development of present-day consumer financing arrangements, retail sales credit was available either through hirepurchase or under instalment sales plans. A common feature of these schemes was deferral of the recognition of the gross profit element (and interest charges). Gross profit might be recognised on the last payment in the case of a hire-purchase arrangement (when title passed) or progressively over the instalment period. This latter method is often described as the ‘profit emerging basis’. Under most present-day credit arrangements, the retailer is paid in full by a credit company and income is derived at the point of sale.

Retail Co sells doodahs under an instalment credit plan. The list price is $10,000, cost $6000 and the terms of sale require a deposit of $2000 plus four payments of $2000 (interest charges are ignored). [page 209]

Gross profit

$10,000 − 6000 = $4000

The profit of $4000 is then recognised according to the formula:

That is: Period 1:

Period 2:

Period 3:

Period 4:

4.21 In J Rowe & Sons Pty Ltd v FCT, the company was a retailer of household goods and one of its terms of sale involved an instalment plan whereby the customer paid a small deposit and a series of payments for up to five years, plus interest at 11%. The company claimed a deduction for the items sold but brought to account as assessable income only the instalments received. Alternatively, the company contended that the assessable income ought to be calculated as in the above example. Both methods were dismissed. Menzies J delivered the leading judgment and dismissed the first method as follows (at ATR 499): In a system of annual accounting, ordinary business considerations would indicate that what becomes owing to a company for trading stock sold during a year should, in some way, be brought into account to balance the reduction of trading stock which the transaction effects. Any other method of accounting would lead to a misrepresentation of the trader’s financial position. Furthermore, the taxpayer’s system of accounting produces the odd result that, as turnover increases by the sale of more and more trading stock, income falls, because, when regard is had to receipts only, then but a small proportion of the proceeds of each sale on terms is brought into account in the year of sale. The value of an item of trading stock would disappear to be replaced, for instance, merely by the deposit paid by the purchaser. We were informed that, if the turnover of

the taxpayer were to increase at a rate of 20% per annum, its method of accounting would ensure a continually falling annual income.

His Honour went on to say that acceptance of the taxpayer’s method would largely destroy the accepted basis of taxation of most trading and business concerns and was inconsistent with both Carden’s Case and Henderson’s case. [page 210] In relation to the taxpayer’s second contention that the ‘profit emerging basis’ was appropriate, Menzies J said (at ATR 501): It seems to me, however, that the basic scheme of the Act is that taxable income is calculated by deducting allowable deductions from assessable income. It is only when it is expressly authorised that outgoings are taken into account in determining what is to be included in assessable income. An instance where a procedure of this sort is expressly required is [former ITAA36] s 26(a) where it is provided that a calculated profit is to be treated as assessable income. In my opinion, however, the fundamental scheme of the Act is inconsistent with attempts to calculate the profit element in each transaction undertaken by a taxpayer in the course of its business and to aggregate those profits to arrive at taxable income, or, at something which is neither taxable income nor assessable income, but is a sum from which further deductions would have to be made to arrive at taxable income.

Menzies J’s rejection of the taxpayer’s first contention — that it should return on a cash basis — is clearly consistent with authority. His rejection of the second argument is on the basis of inconsistency with the basic scheme of the Act. However, it may be doubted that his Honour intended to make a categorical statement concerning the incompatibility of profit and assessable income. It was Menzies J himself who held in Australasian Catholic Assurance Co Ltd v FCT (1959) 100 CLR 502; 7 AITR 440 that the profit on the sale of real estate was income by ordinary concepts and accordingly assessable under the former ITAA36 s 25(1): ITAA97 s 6-5. Barely two weeks before the decision in J Rowe & Sons, Menzies J implied strongly in Investment and Merchant Finance Corp Ltd v FCT (1971) 125 CLR 249; ATR 361; 71 ATC 4140 that there will be cases where profit is assessable income.20

In J Rowe & Sons, Gibbs J made the following qualification (at ATR 501): I have had the advantage of reading the judgment of my brother Menzies and need not repeat what he has said in relation to this appeal. However, since in some respects I do not find it necessary to go quite as far as he has gone in his judgment, I would briefly state my reasons for agreeing with his conclusion.

In relation to the question of profit and assessable income, Gibbs J said (at ATR 502): Profit may be ascertained on an emerging basis in appropriate cases arising under s 26(a) of the Act [the former ITAA36], but I need not consider whether the income of a trader who sells on terms may ever appropriately be determined on such a basis because the evidence did not show that the method suggested by the appellant would produce a satisfactory result or would lead to a more accurate determination of the appellant’s income in the present case than the method adopted by the Commissioner.

Profit as assessable income 4.22 The cases discussed above make it clear that the general operation of the Acts is driven by the ITAA97 s 4-15 tax equation (see 4.1) but they also suggest [page 211] that there are times when only a net profit is assessable income. This possibility was foreshadowed by Dixon J in the 1930s.21 J Rowe & Sons v FCT (1971) 124 CLR 421; 2 ATR 497; 71 ATC 4157 was not such an occasion, but Gibbs J was prepared to leave open the wider question. One earlier decision when profit was assessable income was Colonial Mutual Life Assurance Society Ltd v FCT (1946) 73 CLR 604; 3 AITR 450. In that case, the taxpayer pursued a policy of buying securities and holding them until maturity. Often investments were ‘switched’ in order to maximise the yield. This meant selling securities prior to their maturity and immediately reinvesting in other securities. Prima facie, the accretion or depreciation in the value of a security is on capital account but this is subject to the important

qualification in California Copper Syndicate v Harris (1904) 5 TC 159 that such gains are income where what is done is not merely a realisation or change of investment but truly the carrying on of a business. The court in Colonial Mutual Life Assurance Society held that the gains were as much a part of the taxpayer’s business as the interest payable on the investments from which the profit was derived. Accordingly, the profit was derived from the carrying out of a profitmaking scheme under the second limb of the former ITAA36 s 26(a) or, alternatively, was income by ordinary concepts.22 4.23 The former ITAA36 s 26(a) specifically assessed profit. In holding that the gains in Colonial Mutual Life Assurance Society were assessable as profit under s 26(a), the court was saved from exploring the confines of the ordinary scheme of assessment, namely, assessable income minus deductions. If the profit was assessable under s 26(a), it was unnecessary to investigate how a net profit might be calculated and accommodated in the term ‘gross income’. This was not the case in Australasian Catholic Assurance Co Ltd v FCT (1959) 100 CLR 502; 7 AITR 440, where Menzies J specifically rejected the application of the former ITAA36 s 26(a) to the profit made by an insurance company on the sale of real estate.23 The profit was income by ordinary concepts. [page 212] The question of why it was that the net amount possessed the character of income rather than the proceeds of sale was not discussed.24 However, if the view was taken that the cost of the land was capital in nature, some part of the proceeds of sale would represent a recoupment of that capital outlay and only the net profit of the transaction would be income. This would make the sales one of the ‘instances of special businesses and transactions’ that did not characterise J Rowe & Sons. It would also leave it open to argue that any given set of circumstances was special where non-deductible capital expenditure was incurred and that, accordingly, only the net profit was income in nature.25 Alternatively, it might be suggested that payment

made for the relevant property (real estate in Australasian Catholic Assurance Co Ltd; shares in London Australia Investment Co Ltd v FCT (1977) 138 CLR 106; 7 ATR 757) is a non-deductible outlay for the purposes of ITAA97 s 8-1 rather than a deductible outgoing. As a result, it is the specific profit or loss of the transactions that is brought to account.26 One of the clearest cases of specific profit assessment was London Australia Investment Co Ltd. The taxpayer was an investment company that pursued a strategy of selling securities, when their yield fell below a benchmark rate, and reinvesting the funds. It is important to appreciate that the taxpayer was not in the banking and insurance business, it was not a dealer in shares and the shares were not its trading stock.27 A majority of the High Court held that the profits on the sale of the shares constituted income by ordinary concepts. The former s 26(a) did not apply. In the majority’s view, the profit was income by ordinary concepts. Profit was computed by offsetting against sale proceeds the average cost of shares sold. Barwick CJ dissented. In his view, the shares were assets not forming part of the company’s circulating capital or held as trading stock so any accretion in the value of the shares was on capital account. The Chief Justice also expressed his own doubts about the decision by Menzies J in the Australasian Catholic Assurance Co case. Gibbs J considered the case indistinguishable from the Colonial Mutual Life Assurance Society case and, as with the investmentswitching strategies of the banking and insurance companies, ‘the sale of the shares was a normal operation in the course of carrying on the business of investing for profits’. Jacobs J considered the ‘banking and insurance’ cases were significantly different but that, nonetheless, the company’s strategy and scale of activities compelled a conclusion that the buying and selling of shares was part of the taxpayer’s business. In Barwick CJ’s opinion, the shares in London Australia Investment Co were capital assets and any accretion in their value a capital gain. Jacobs J considered [page 213]

that the source of the funds invested by the company could not be described as circulating capital but, rather, reinvestment of the original capital structure. Gibbs J rejected the taxpayer’s contention that the shares were on capital account. Lack of agreement on the classification of the shares, disagreement over the assessability of the gains and differing grounds for holding the profit to be income do not augur well for a unified principle governing the circumstances of specific profit assessment. There is support both for a view that the purchase of the shares was not deductible under the general deduction provision, former ITAA36 s 51(1) (now ITAA97 s 8-1) because it was capital in nature and that, although there was an outlay, it was not a deductible outgoing. In either case, the proceeds of sale were not income. That character attached only to the profit. 4.24 Specific profit assessment is also illustrated in FCT v Whitfords Beach Pty Ltd (1982) 150 CLR 355; 12 ATR 692; 82 ATC 4031. In that case, a group of fishermen formed a company in 1954 to hold a piece of real estate adjacent to their beach shacks. The land was acquired to secure access to the shacks. In 1967, developers acquired the shares in the company, changed the company’s articles to permit the conduct of a commercial venture and proceeded to arrange rezoning and subdivision of the land. The Commissioner assessed the profit under ITAA36 s 25(1) or s 26(a). The Full High Court held that the activities amounted to more than the realisation of an asset and, in fact, was a business venture. Gibbs CJ, Mason and Wilson JJ considered ITAA36 s 25(1) applied to assess the profit as ordinary income. Murphy J held s 26(a) applied. The issue in Whitfords Beach Pty Ltd was complicated by the elapse of time between the purchase of the land in 1954 by the company and the sale of shares in the company (and subsequent development of the land) in 1967. In the hands of a company owned by the original shareholders, the land was clearly a capital asset. The outlay or outgoing to acquire the land was capital. Following the change in share ownership, the land was ventured in a business. The difficulty with the basic scheme of the Act is exposed when it becomes necessary to impute some profit of an income nature to the subdivision of land acquired as a

capital asset. The High Court did not have to deal with the assessable quantum but the value of the land when it was ventured for subdivision might reasonably be taken as the starting point of the venture and it makes good sense to bring to account as income only the profit on the undertaking. None of these cases state when net profit had the necessary income character or why it was that the basic scheme of the Act was inappropriate. The matter was touched on by Mason J in Commercial and General Acceptance Ltd v FCT (1977) 137 CLR 373; 7 ATR 716; 77 ATC 4375. His Honour said (at ATC 4380–1): No doubt in the context of the Act that income is to be ascertained in the first instance by reference to the gross income receipts of the taxpayer, but in my view it also includes a net amount which is income according to the ordinary concepts and usages of mankind when the net amount alone has that character, not being derived from receipts that are revenue receipts.

A specific profit was also assessed in Memorex Pty Ltd v FCT (1987) 77 ALR 299; 19 ATR 553; 87 ATC 5034. In that case, the Federal Court held that profit on the sale of formerly leased computer equipment was assessable. Assessability arose [page 214] because of a finding that the taxpayer’s business was dealing in the equipment and that the sale of formerly leased computers was an integral part of that business. The relevant property sold in Memorex was depreciable plant and it cannot be doubted that the purchase price of the equipment was a loss or outgoing of a capital nature and the property represented fixed assets. The sale of such property would not normally constitute assessable income. In the Memorex case, assessability arose out of a conclusion that what was done was not merely the realisation of an asset but the carrying on or carrying out of a business.

The Cyclone Scaffolding case

4.25 The difficulties of income and profit measurement and tax accounting are illustrated by the decision in FCT v Cyclone Scaffolding Pty Ltd (1987) 77 ALR 319; 19 ATR 674; 87 ATC 5083.

FCT v Cyclone Scaffolding Pty Ltd Facts: The taxpayer carried on the business of hiring scaffolding equipment and this component of its business generated approximately 80% of gross receipts. The balance of receipts arose from the sale of equipment either directly or through ‘deemed’ sales in cases where equipment was lost or damaged. Under the hire agreement, damaged or unreturned property was chargeable at a price that exceeded the cost price. The large quantity of scaffolding in use made it impractical to identify particular items. In 1946, the taxpayer and the Commissioner agreed to a system whereby new equipment purchased was treated as trading stock in the first year and thereafter as depreciable plant. As a result, if sales of equipment exceeded purchases in a given year, all new equipment was taken as sold and the remaining sales were taken to be plant. In effect, this represented a last-in, first-out assumption. If sales were made from the plant category, the taxpayer returned as assessable income under the depreciation provisions the amount previously claimed as depreciation but not the amount by which the chargeable price exceeded the cost price.a For example: suppose the taxpayer had two items that cost $10 to purchase. One was new and one unsold (and therefore depreciated) to a written down value (or book value) of $8. The sale or charge price was $15. If one item was sold, assessable income was $5. If two were sold, assessable income was $7, not $10 or $12. This practice was followed until the late 1970s, when the Commissioner issued assessments for the profit on the sale of equipment in both the first and subsequent years. The taxpayer argued that the dominant purpose of acquiring the plant was to hire it, not sell it. It also contended that, [page 215] given the quantity of material in circulation, the method of accounting agreed to in 1946 produced a substantially correct reflex of its profit. Held: The Supreme Court of New South Wales upheld the taxpayer’s appeal and a majority of the Federal Court (Bowen CJ and Beaumont J; Wilcox J dissenting) dismissed the Commissioner’s appeal. The taxpayer was not assessable on the profit it made on the sale of equipment that it treated as plant as it was acquired with a substantial purpose of hire. The majority also held that the accounting method employed was realistic in the

circumstances and that the Commissioner was inconsistent in accepting that the equipment was plant or fixed capital at the end of the first year but then seeking to treat it as circulating capital. Besides, if the Commissioner accepts one treatment, it is not then open to him to disregard it. This inconsistency is evident in the majority judgment (at ATC 5088): If the system of accounting, which until relatively recently had been accepted by the taxpayer and Commissioner as giving a substantially true reflection of income, does not give a true reflection, then the system requires alteration. But the Commissioner did not seek to suggest an alternative accounting treatment was appropriate. On the contrary, he was content to accept the taxpayer’s accounting method. His real contention is that all equipment acquired by the taxpayer should be treated, for all purposes, as if it were acquired for sale. He says that it is enough that the taxpayer was prepared to sell its equipment if asked. In so contending, the Commissioner is really saying that the whole of the equipment is trading stock at all times and that none of it is ever plant, that is, part of the taxpayer’s profitmaking apparatus. It should be noted that there is no authority to support a view that only gains on the sale of trading stock are assessable as income, or of the alternative proposition, that if it is to be assessable, it must be trading stock. The ‘banking and insurance’ cases make this much clear. The decision in London Australia Investment Co assessed the specific profit on the sale of assets of uncertain character and in Memorex profit on the sale of plant was also assessable. The majority distinguished Memorex and the judgment is rather more underpinned by the appropriateness of the recording system than statements of principle. The majority continued: The Commissioner can hardly accept the taxpayer’s treatment of the equipment as plant or fixed capital at the end of the first financial year and at the same time contend that it should be regarded as trading stock or circulating capital. [page 216] Once it is acknowledged, as it must be, that the taxpayer’s income had to be estimated rather than calculated, the question becomes one as to the appropriate method of computation of its income (see Henderson’s case …). If a new system were to be devised, one which might be suggested is that the figures which showed the relationship of items for which money is received on disposal as against items used truly as plant in the hiring business could be quantified in some way as a percentage. For example, on the basis of estimation from the figures from past years, it might be said that X% of equipment purchased by the company from the beginning and thereafter should be treated as trading stock and Y% from the beginning and thereafter should be treated as plant. In the latter case, of course, depreciation would be allowed from the beginning. It would be a matter of some nicety to arrive at percentages which would give a true reflection of the taxpayer’s income. Indeed, it might prove impractical to arrive at appropriate figures. However, to alter the system in that way would eliminate the contradiction which is involved in the Commissioner’s contention that the taxpayer’s present method

should be accepted as correct but that the taxpayer should be taxed on sales or disposal of plant as if on revenue account. Wilcox J dissented on the basis that the company’s accounting method was not determinative of the equipment’s character. While hiring scaffolding was the primary objective of the taxpayer, loss, destruction and non-return of equipment was a normal incident of that business and profits attaching to and incidental to hiring were themselves income. The decision in Memorex was indistinguishable.

a.

It will be appreciated that that corresponded to the position in Memorex. Gains on the sale of formerly leased (and depreciated) computer equipment were held to be assessable in that case. Note that the balancing adjustment provisions in ITAA97 Div 40 would now address the assessability of a profit made on the disposal of depreciating assets.

Which would yield the ‘more appropriate’ reflex of the taxpayer’s ‘true income’, the method adopted by Cyclone Scaffolding or the method suggested by the majority? If the Commissioner had sought to substitute the method suggested by the majority, would the decision have been decided differently?

[page 217] 4.26 The courts have rejected the assessment of profit under ITAA36 s 25(1) (ITAA97 s 6-5) in J Rowe & Sons and FCT v Citibank Ltd (1993) 26 ATR 423; 93 ATC 4691 (see 4.28), but had accepted it in several cases discussed above. Whether profit (as opposed to gross proceeds) is assessable income will depend on which element has the character of income — proceeds or profit. It is not a choice open to the Commissioner or the taxpayer.

Limits of specific profit

4.27 There will be occasions when the same data generates a net profit that is less than taxable income. This will arise, for example, because accounting principles permit the amortisation of capital expenditure that is not deductible for tax purposes. It will also occur when the Act imposes arbitrary limits on an amount deductible for tax purposes. Consider the following example.

Assume a taxpayer has the option of selling an item outright to a customer or renting it for three years. Assume further that the sale price is $9000, cost $6000, and it has an effective life of three years. Ignore residual values. A comparison between the options is as follows: Sale

Rent

Yr 1

Yr 1

Yr 2

Yr 3

$

$

$

$

Sales

9000

Rent

3000

3000

3000

Cost

6000

Depreciation

2000

2000

2000

Profit

3000

Profit

1000

1000

1000

Apart from the timing difference, the two methods produce identical results. However, consider the position if the depreciation allowance was limited to $1000 pa over the same period. Total profit under the rental option would then be $6000 and, if there was a choice between the methods for tax purposes, economically rational taxpayers would opt for the sale method.

Citibank Ltd case 4.28 If the sale and rental methods in the example above are taken as representing the finance and operating lease methods in terms of Australian Accounting Standards in operation at the time, the substance of the dispute before the court in FCT v Citibank Ltd (1993) 26 ATR 423; 93 ATC 4691 is represented. Under a finance lease, the lessee has the right to acquire the item at the end of the lease. In such cases, the lease is, in substance, a sale (or purchase) financed by a loan repayable by

[page 218] instalments that produces a profit made up of gross profit on the sale plus interest income. In contrast, an operating lease is basically a rental agreement for a specified period of time and the property remains an asset of the lessor. The assessable income is the rental payment and deductions are allowable for depreciation. In the context of the above example, if depreciation on the item was capped, the finance lease is a preferred arrangement from the seller’s viewpoint. In the case of motor vehicles, depreciation is limited under ITAA97 s 40-230 to a cost of $57,581 (2017–18). Thus, in the case of a car costing $100,000 and depreciable, deductions amounting to ($100,000 – $57,581) $42,419 are lost. The attraction of the finance method, where the full cost would be deductible, is evident.

FCT v Citibank Ltd Facts: The taxpayer was a bank that, among other things, engaged in leasing motor vehicles. In 1988, it purchased for the purpose of leasing 772 luxury vehicles. (A ‘luxury vehicle’ is a car that costs more than the depreciation cost limit.) Although the vehicles remained the property of the taxpayer and there was no option to the lessee to purchase the vehicles at the end of the lease, the company treated the arrangement as a finance lease and prepared its account in accordance with AAS 17 and ASRB 1008 and sought to return on that basis for tax purposes. The Commissioner treated the leases as rentals. Held: The Full Federal Court upheld the Commissioner’s appeal. Although it was appropriate to prepare the company’s accounts on the basis of a finance lease basis for the purposes of the Companies Code, that was inappropriate for tax purposes. The gross rental receipts were assessable income and depreciation was an allowable deduction. Hill J (with whom Jenkinson and Einfeld JJ agreed) reviewed the cases discussed above in relation to the taxation of specific profit and concluded (at ATC 4701): What all these cases have in common, and what indeed is a necessary requirement of bringing into assessable income a net profit, is that the gross receipts used in the calculation of net profit was itself not income in ordinary concepts. That this is a requirement of a net profit being treated as gross income emerges clearly from the judgment of Mason J, initially in Commercial and General Acceptance Ltd v FCT … and subsequently in Whitfords Beach …

The respondents’ submissions can only succeed therefore if the rent derived by them from the leases is not of itself gross income. It is conceded by the respondents that only one amount can be gross income and that the Act does not [page 219] permit a choice between, alternatively, bringing into account, in a case such as the present, the rental receipts or bringing into account the net profit. It may be conceded as the respondents submit, that characterisation of an amount as income may well in a particular case require a careful analysis of the business of the taxpayer said to derive that income: London Australia … It may also be accepted that in determining whether a particular case has the character of income the question in each case will be the character of the income in the hands of the recipient: Hayes v FCT (1956) 96 CLR 47 … But neither of these propositions compel the conclusion that the periodical reward received by the taxpayer, whose business is borrowing and turning funds to account by lending them or otherwise engaging in financial transactions of the present kind, will not be income.

The decision in Citibank Ltd confirms that, if the proceeds of a business activity are income in nature, they are assessable under ITAA97 s 6-5 and allowable deductions are offset. If the proceeds are not income but that character attaches to a net amount, that net amount will be assessable under ITAA97 s 6-5. In a case where net profit is assessable as income, deductions are irrelevant. As Mason J said in Commercial and General Acceptance Ltd v FCT (1977) 137 CLR 373; 7 ATR 716 at 721; 77 ATC 4375: And if it is the net profit only which is taken into assessable income there is no deduction which has been incurred in relation to that figure which can be deducted.

Special contractual payments 4.29 In GP International Pipecoaters Pty Ltd v FCT (1990) 170 CLR 124; 21 ATR 1; 90 ATC 4413, the High Court held that ‘establishment costs’ for the construction of plant paid to the taxpayer by the State Energy Commission of WA (SECWA) were income in nature. The issue before the court was whether the payment was income or capital but the decision serves to illustrate that, just because a payment may be

described as a recoupment of capital expenditure, it does not become capital itself nor lead to the taxation of a lesser, net amount. The taxpayer contracted with SECWA to supply coatings for pipes to be used in a natural gas pipeline. The operation required the construction of expensive plant that would be scrapped on completion of the project. The contract provided that SECWA pay $4.675m ‘establishment costs’. Ultimately, the plant cost $5.35m and was sold for its salvage value of $500,000 such that the taxpayer made a net loss on that part of the contract. The taxpayer argued that the payment was capital in nature and that the construction of the plant was a severable part of the contract, no more than a means to an end. The argument was not made that, where a company is incorporated with [page 220] a sole purpose of performing a particular contract, its true income would be reflected only in the profit of the venture. The Commissioner contended the construction of the plant was an integral part of the contract as a whole. The taxpayer’s appeal was dismissed. The payments were income being part of the payments to which the taxpayer was entitled under the terms of the contract. The court could not accept that an intention by either the payer or the payee that payments be applied to recoup capital expenditure determined the character of the payment. That may be so when an amount is received by way of gift or subsidy to replenish the payee’s capital because, in those circumstances, the payment is unlikely to be an incident of the taxpayer’s income-producing activities.

Long-term construction projects 4.30 One instance of an attempt to measure earnings independently of other derivation criteria is provided by long-term construction projects. As the name implies, these contracts extend over more than

one year. The approach to questions of derivation in these circumstances is grounded in ITAA36 s 170(9), which provides as follows: 170 (9) Notwithstanding anything contained in this section, when the assessment of the taxable income of any year includes an estimated amount of income, or of profits or gains of a capital nature, derived by the taxpayer in that year from an operation or series of operations the profit or loss on which was not ascertainable at the end of that year owing to the fact that the operation or series of operations extended over more than one or parts of more than one year, the Commissioner may at any time within 4 years after ascertaining the total profit or loss actually derived or arising from the operation or series of operations, amend the assessment so as to ensure its completeness and accuracy on the basis of the profit or loss so ascertained.

ITAA36 s 170 is concerned with the amendment of assessments and, except for cases involving fraud and evasion, the time limit for amendments is four years for taxpayers other than individuals and small businesses. The effect of s 170(9) is to measure the four-year period from the completion of a long-term project, but it also specifically caters for the estimation of taxable income in the case of operations extending beyond one year of income. Ruling IT 2450 sets out the Commissioner’s view on how taxable income may be estimated in such circumstances. Two bases are acceptable: 1. the ‘basic method’, which is no more than the application of standard derivation criteria; namely, assessability of all progress payments billed less all allowable deductions incurred in a given year; or 2. a ‘percentage completed’ method of spreading the profit over the life of the project. The ultimate profit/loss in effect is a notional taxable income expected [page 221] to arise. The basis for spreading the profit must be grounded in

accounting principles and so IT 2450 refers to Australian Accounting Standard AAS 11 as providing alternative appropriate bases. Presumably the revised bases articulated in Australian Accounting Standards AASB 15 and AASB 111 would now be applicable. The taxpayer may select the method best suited to its circumstances but once a method is selected it must be applied consistently to all similar contracts. Group companies must return on the same basis. The ‘completed contract’ method of deferring assessment until the contract is completed is not acceptable. Ruling IT 2450 distinguishes between long-term projects and what are, in fact, sales of trading stock over an extended time period. The ruling does not apply to minor subcontractors who will return on an earnings basis and bring to account stock on hand, including work in progress. 4.31 Upfront payments or advance payments are often features of long-term projects. They form part of the recipient’s assessable income, however described or regardless of the use to which they are put: GP International Pipecoaters Pty Ltd v FCT (1990) 170 CLR 124; 21 ATR 1; 90 ATC 4413. Only costs likely to be incurred over the period of the contract can be taken into account in calculating notional taxable income. The costs of tendering for such contracts are deductible when incurred under ITAA97 s 8-1 and are not part of the cost of the project itself: see TD 92/131.

Deemed derivation Constructive receipt 4.32 ITAA97 s 6-5(4) (in relation to ordinary income) and ITAA97 s 6-10(3) (as well as some more specific provisions, in relation to statutory income) operate to deem constructive receipt. Note the language of s 6-5(4): 6-5 (4) In working out whether you have derived an amount of ordinary income, and (if

so) when you derived it, you are taken to have received the amount as soon as it is applied or dealt with in any way on your behalf or as you direct.

This provision replaces the former ITAA36 s 19 that had the same object but was expressed in language that led to suggestions the section was an assessing provision. It will be clear that ITAA97 s 6-5(4) is a construction provision only. It does not make anything income. It provides only that derivation of an income amount cannot be denied through non-receipt when the amount is applied for a taxpayer’s benefit. An amount that would be ordinary (or statutory) income, but for the fact that it is not received, is effectively deemed to be received when applied to a taxpayer’s benefit or dealt with as directed by the taxpayer. [page 222] Constructive receipt applies, for example, to an employee’s contributions to a superannuation fund. A percentage of salary is deducted from an employee’s entitlement and paid to a nominated fund. A proportion of salary transferred to a loan account provides another instance. It would be nonsense to argue that these amounts were not income derived and this is confirmed by ITAA97 s 6-5(3). Similarly, interest on a bank deposit is income derived when it is credited to the account. Of the former ITAA36 s 19, the High Court said in Permanent Trustee Co of NSW Ltd v FCT (1940) 2 AITR 109; 6 ATD 5 per Rich J (at AITR 110–11): The object [of former ITAA36 s 19] is to prevent a taxpayer escaping though his resources have actually been increased by the accrual of the income and its transformation into some form of capital wealth or its utilisation for some purpose.

Where a taxpayer agreed to work for a series of payments to be made over a period of time, the amounts were income derived when received: Brent v FCT (1971) 125 CLR 418; 2 ATR 563. In that case, the taxpayer, the wife of an escaped criminal, agreed to tell her life story under a contract that provided for periodic payments. The

Commissioner assessed her for the full contracted amount on the basis that she had requested the deferral of payments. In the High Court, Gibbs J held that what the taxpayer received was a reward for personal services appropriately assessable on a cash basis. In his Honour’s view, the former ITAA36 s 19 did not apply ‘when all that happens is that a debtor refrains from paying his debt at the request of the creditor’: at ATR 571–2. On the face of it, ITAA97 s 6-5(4) (and s 6-10(3) in relation to statutory income) seems directed to income derived on a cash basis. A notion of constructive receipt that applied to an accrual of income would need to be expressed in terms of the particular accounting method.

ITAA36 Pt III Div 16E 4.33 For taxpayers whose business does not involve the lending of money, interest is generally, although not always,28 derived on a cash basis. Special rules apply to certain discounted or deferred interest securities with the effect that the deferred interest element is accrued over the life of the security. The rules are contained in ITAA36 Pt III Div 16E ss 159GP–159GZ. A security is defined as a bond, debenture, stock, bill of exchange, promissory note, etc (but not shares), a bank deposit or secured loan. In other words, the Division covers debt instruments but not equities. Such a security will become a ‘qualifying security’ for the purposes of Div 16E when the term exceeds one year and it is reasonably likely that the sum of all payments (other than periodic interest) will exceed the issue price of the security. This excess is the ‘eligible return’. An ‘eligible return’ may arise because the security is acquired at a discount or pays interest on maturity. To qualify, the eligible return must exceed 1.5% of the sum of all payments due multiplied by the number of years. Under ITAA36 s 265B, the holder of a security may apply to the issuer for information as to whether a particular security is a ‘qualifying security’. If a security does not have an eligible return, or if it is impossible to establish its

[page 223] eligible return, Div 16E does not apply. However, ‘traditional securities’, defined in terms of ITAA36 s 159GP(1) to exclude qualifying securities and securities held as trading stock, fall within ITAA36 s 26BB. As a result, a debenture or promissory note that has an eligible return will fall within Div 16E but one that does not will fall within s 26BB. Under s 26BB, any gain on redemption is assessable income and, under ITAA36 s 70B, a loss is an allowable deduction. See further 5.45. The mechanism in Div 16E operates on the present-value calculations of yield to maturity. The following example illustrates how the accrual system operates under Div 16E. For simplicity, the calculations are made on a yearly rather than the six-monthly basis required by s 159GQA.

Suppose a five-year security of face value $10,000 @ 10% is redeemable in five years for $14,500. The interest element ($1000 pa) is derived annually, as it is received according to normal criteria. In addition, the ‘notional accrual amount’ of $4500 is amortised according to the effective interest rate: 1 = 5√1.45 = 7.714% pa (ie, $14,500 discounted at 7.714% over 5 yrs = $10,000) Year

1

2

3

4

5

771

831

895

964

1038

= $4500

Thus, if the instrument is a ‘qualifying security’, the holder is assessable on the annual interest plus the amortised gain. If it is a ‘traditional security’, the holder is assessable on the annual interest and an amount of $4500 on redemption.

Small business concessions 4.34 From 1 July 2001 to 30 June 2007, a simplified tax system (STS) could be adopted by qualifying small businesses. Initially, the system provided an alternative cash accounting method for the

calculation of taxable income and in later versions permitted an ‘appropriate’ accounting system. In addition, qualifying STS taxpayers could utilise tax concessions in the form of simplified depreciation and trading stock rules. Special rules also applied for prepaid expenditure. From 2007–08, ‘small business entities’ can access a range of income tax, capital gains tax, and goods and services tax concessions, including those formerly available under the STS system. To be eligible, an entity must carry on business and, for most concessions, have an annual aggregate turnover less than $10m.29 [page 224]

Conclusion 4.35 The derivation rules are summarised in 4.36–4.45. The ATO guidelines for choosing the appropriate method are set out in Taxation Ruling TR 98/1. Broadly, a cash basis will apply to income derived by an employee, from non-business income derived from the provision of knowledge or exercise of skill and income from investments. For business income from providing knowledge or skill, a cash basis may also be appropriate. However, where the taxpayer relies on staff, equipment or circulating capital to produce income, or where there is sale of trading stock or correspondence between outgoings and incomings, an accrual basis is appropriate. Manufacturing and trading activities will generally be returned on an accrual basis and, where there are separate earning activities, they should be evaluated separately. While these summary points provide useful guidance, it is useful to bear in mind Pagone J’s comment (News Australia Holdings Pty Ltd v FCT [2017] FCA 645 at [6]) that the relevant inquiry concerns ‘when an item of ordinary income can be said to have come home to the taxpayer in a realised or immediately realisable form’ and that the inquiry: … may, in respect of some items of income, be determined by the nature of the business, or of the other relevant income earning activities, of the taxpayer; but it may also be

relevant to consider the nature of the receipt and the nature of the receipt in the context of the activities, or business, by which the taxpayer derives income.

Debtors 4.36 For a taxpayer carrying on a business of supplying goods or services, income is generally derived on the arising of an enforceable debt. This corresponds most closely to the accounting ‘point-in-time’ criteria of revenue recognition. Arguably, where this accounting treatment is appropriate, there is a good, if not compelling, argument for its applicability to taxation matters, but the accounting method does not dictate the taxation method. Debtors will not be assessable in circumstances illustrated by Firstenberg30 or Dunn31 or where the considerations outlined by Carden’s Case32 or Henderson33 are not present. It should be noted though that Firstenberg and Dunn were decided before accounting software packages became available. Where payments are received in advance for the supply of goods or the provision of services, the Arthur Murray34 principle will apply. Where the terms of a credit sale are ‘net 30 days’ the assessable amount will be the amount billed. Contra amounts for items such as doubtful debts cannot be deducted. The gross amount is assessable. Bad debts are allowable deductions under ITAA97 s 25-35. The position with ‘sales returns and allowances’ is not so clear cut, as the decision in Ballarat Brewing Co Ltd v FCT (1951) 82 CLR 364; 5 AITR 151; 9 ATD 254 illustrates. [page 225]

Ballarat Brewing Co Ltd v FCT Facts: The taxpayer brewery sold to customers on terms that provided a ‘prompt payment’ discount as well as a rebate for complying with certain conditions. Rarely were

the rebates not given and the amount of the discount denied was insignificant. The company credited its revenue account with ‘net sales’. The Commissioner assessed the taxpayer on gross sales and argued the discounts should be brought to account only when they were allowed; that is, at the time of payment. Held: In the High Court, Fullagar J upheld the taxpayer’s appeal. After reviewing the principle in Carden’s Case, his Honour said (at AITR 155): What I have said provides, in my opinion, the only proper approach to the question in the present case. And, when the question is so approached, the answer seems to me to be plain. Which figure the Commissioner’s or the company’s represents or more nearly represents, the truth and reality of the situation? The company’s figure brings into account what the company will, in the light of all past experience and policy, almost certainly receive in respect of book debts no more and no less. The Commissioner’s figure brings into account sums which the company will certainly, or almost certainly, not receive in respect of book debts. A trading account and profit and loss account based on the latter figure would be misleading, and there is nothing in the Act which requires the assessment of income on the basis of accounts which would be misleading in this respect.

In Taxation Ruling TR 96/20, the Commissioner states that the full invoice price for a credit sale is assessable unless the transaction offers a prompt payment discount in circumstances on ‘all fours’ with Ballarat Brewing Co Ltd. This strict interpretation obscures the important point in Fullagar J’s judgment: ‘Which figure — the Commissioner’s or the company’s — represents or more nearly represents, the truth and reality of the situation?’

Professional fees 4.37 Fees for services are derived when they give rise to recoverable amounts in instances where the taxpayer is carrying on a business and the circumstances correspond to the considerations nominated by the authorities. Otherwise, the cash basis is appropriate. Note that members of a partnership will derive their share on an annual basis when the partnership accounts are closed and profit is determined and appropriated. That is, although the partnership may return on an accrual basis, the partners will derive a share of that income on its allocation, not on some progressive basis.

[page 226] The decision in Henderson’s case (see 4.9) establishes that work in progress of professional taxpayers does not represent income derived. Payments made to retiring partners for a share of work in progress are specifically assessable under ITAA97 s 15-50 (and payments deductible: s 25-95).

Property rent 4.38 Property rent (as distinct from chattel leasing) is derived when it is received. It follows that (as with other property income) rent in arrears is not derived. It may be possible to demonstrate that one’s rental activities are sufficiently extensive to establish that one is carrying on a business of renting and that an accrual basis is appropriate. It is difficult to see how the Arthur Murray principle can apply to income appropriately returned on a cash basis. In addition, it may be argued that prepaid rent cannot be deferred on the Arthur Murray principle because the benefit — a leasehold right — is distinguishable from a series of discrete, if homogeneous, services such as dance lessons or newspaper subscriptions. There are conflicting decisions by the tribunals. Rental income received by joint owners of property will usually be shared in proportion to their interests in the rental property.

Chattel leasing 4.39 On the other hand, chattel leasing is to be contrasted with passive derivation of income from property. The hiring out of plant or equipment is clearly the carrying on of a business and so an accrual basis applies. In IT 2594, the Commissioner has indicated that taxable income is gross fees less deductions such as depreciation. The finance method of accounting for leases is unacceptable: FCT v Citibank Ltd (1993) 44 FCR 434; 93 ATC 4691.

Prepayments 4.40 Under the Arthur Murray principle, prepayments for goods or services are derived when that service to which they relate is provided or, if no service is required (say, in respect of a retainer or maintenance agreement), when the service would have been provided, the time period has elapsed or there is no longer provision for a refund. As indicated above, property rental relates to a right of occupancy, not a discrete supply of services. Income derived from lay-by arrangements is governed by Arthur Murray. Non-refundable deposits may be derived when received: Taxation Ruling TR 97/15. Forfeited amounts are arguably income earned when the contract expires or there is no longer a contractual right of refund.

Dividends 4.41 Dividends are derived when paid.35 ITAA36 s 44 assesses dividends ‘paid’ and ITAA36 s 6(1) defines ‘paid’ to include ‘credited or distributed’. It is clear that [page 227] ‘credited’ means more than simply a credit entry recording the creation of a debt. In Brookton Co-operative Society Ltd v FCT (1981) 11 ATR 880; 81 ATC 4346 at 4355, Mason J said: The reference to “dividends” in s 44(1)(a) must be read as a reference to dividends the payment of which is enforceable because they have been declared so as to create a debt, or to dividends which are no longer revocable because, as between company and shareholder, they have been satisfied by payment. When s 44(1)(a) is so read, the purpose of the extended definition becomes clear — it is to guard against the possibility, perhaps remote, that the word “paid” might be so narrowly construed that dividends credited or distributed to shareholders in circumstances where they can no longer be revoked or rescinded by the company could not constitute assessable income in the hands of the shareholders.

Wages and salaries (including directors’ fees, commissions, bonuses, etc) 4.42 Payments of this nature are derived when received: Brent v FCT (1971) 125 CLR 418; 2 ATR 563. This includes back-pay and advances. For example, holiday pay paid in advance is derived when received and arrears in pay are not derived until received. Attempts to defer derivation by non-banking of cheques, etc, have not been successful.36

Interest 4.43 Interest is also generally derived when received unless the lender is in the business of lending money, in which case an accrual basis applies. Interest credited to an account is constructively received.37 Banks, finance companies and similar financial institutions that carry on business as financial intermediaries return on an accrual basis. Where a loan agreement provides that interest will be charged quarterly, it is derived on that basis but otherwise interest accrues on a daily basis. Where a supplier of goods or services provides credit facilities, the interest will be derived on an accrual basis because the lending activity is seen as an integral feature of the taxpayer’s business. Similarly, where a business actively manages its funds on deposits, the interest is derived as it accrues: Taxation Ruling TR 98/1. On the other hand, where a supplier invests in interest-bearing securities unrelated to its business, it would seem a cash basis is appropriate. Similarly, interest charged on overdue accounts (as distinct from a credit facility) would seem to be derived when received, but it should be noted that the ATO expresses a contrary view: TR 98/1. More difficult questions arise in relation to interest on doubtful loans made by lending institutions. There is New Zealand authority that interest is derived when it is debited to a borrower’s account: CIR (NZ) v National Bank of New Zealand [page 228]

(1977) 7 ATR 282; 77 ATC 6001. However, it may be possible to demonstrate that likelihood of ultimate recovery determines derivation. At the end of the day, ‘the inquiry should be whether in the circumstances of the case [the method] is calculated to give a substantially correct reflex of the taxpayer’s true income’: Carden’s Case (see 4.6). Special rules set out in ITAA36 Pt III Div 16E relate to deferred interest securities.

Instalment sales 4.44 Instalment sales and profit-emerging basis methods of deferring recognition of the profit element until the instalments are received (or become due) are not accepted on the basis of J Rowe & Sons Pty Ltd v FCT (1971) 124 CLR 421; 2 ATR 497; 71 ATC 4157. As indicated above, trading income is derived at the point in time of sale of goods or of rendering of services.

Specific profit assessment 4.45 The scheme of the Act is to assess income derived and offset deductions allowable. Generally, gross receipts will represent income. When the gross receipts do not possess an income character but a net amount does, the courts have been prepared to admit the net amount. It will be appreciated that neither the choice of method nor changing the basis of returning is at the taxpayer’s discretion. If the circumstances of income generation alter, it is open to argue that the previous method of returning assessable income no longer provides that substantially correct reflex of true profit. Where doubt arises then the courts will decide the matter. It will be clear, too, that to say that there is only one correct basis of returning for a particular taxpayer is not quite correct. Apart from the fact that circumstances may change, a taxpayer may return business income on an accrual basis and interest or rent on a cash basis. It is closer to the mark to say that there is only one appropriate basis for returning a particular class of income.

1.

Matthew is a consultant engineer. Although he practises as a sole proprietor, he employs a qualified draftsman (salary $70,000 pa) and an office assistant ($25,000). From time to time, he employs part-time professionals and also subcontracts tasks to other engineers. Some details of his finances for the 2016–17 year are as follows: Debtors 1/7/16

$32,000

Debtors 30/6/17

54,000

Billings 2016–17

375,000

Provision for bad debts 1/7/16

13,000 [page 229]

Provision for bad debts 30/6/17 Bad debt recovered 2016–17

38,000 6,000

During the year, Matthew provided consulting services to Eastern Home Improvements (EHI). No account was rendered. Instead, EHI completed an extension to Matthew’s private residence and met all relevant costs. Matthew had previously submitted specifications for the extension to reputable builders and received quotes as follows: Builder #1

$41,000

Builder #2

35,000

Builder #3

72,000

Required (you should cite relevant court cases and sections of the Acts): Should Matthew return his consulting income on a cash or accrual basis? What factors are relevant to deciding that issue? What is his assessable income? You should discuss this with regard to: the fees generally; the bad debts provision and the bad debts recovered; and the EHI matter. 2.

Paladin Pty Ltd is a private company incorporated in 1995 and engaged in the development and sale of computer hardware. The company makes sales on terms that require a 10% deposit and the balance payable in equal monthly instalments over three years at 10% interest pa. Income in respect of term sales is brought into accounting income over the term of the agreement. This is the first year that sales have been made on this basis. Previously terms were ‘net 30 days’.

This year (2016–17) the company commenced to provide a facility whereby customers can enter into a maintenance agreement in respect of new hardware purchased. The agreement is for three years and Paladin undertakes to provide maintenance servicing when required at no additional cost to the customer. The cost of the agreement is $10,000 pa, payable in advance. The agreement provides that it is non-assignable and non-refundable in the event of disposal of the hardware. However, the company’s sales representatives state that there will be an abatement of the maintenance agreement charges if equipment, the subject of the [page 230] agreement, is traded in for new equipment with Paladin during the term of the agreement. In the company’s books of accounts, income in respect of term sales is brought into accounting income over the term of the agreement. Deferred income at 30/6/17 is $225,000 which amount includes interest of $82,500. Income in respect of maintenance agreements is brought into accounting income over the period of the maintenance agreement. Deferred income liability at 30/6/17 is $74,500. It has been estimated that, of this amount, possibly $30,000 of contracted service will not be met because customers have disposed of equipment to third parties. Required: Advise the company whether its deferral of term sales income is acceptable for tax purposes. Advise whether the Arthur Murray principle applies to the maintenance agreement payments. Advise how the $82,500 interest and the estimated amount of $30,000 are to be treated for tax. A suggested solution can be found in Study help.

GST and income 4.46 ITAA97 Div 17 sets out the effects of the goods and services tax (GST) on income: see Chapter 19. In general terms, the GST is disregarded in calculating assessable income. Section 17-15 provides that in calculating an entity’s assessable income, GST components are excluded. Similarly, where an input tax credit arises, deductions allowable are 10/11ths of the amount paid. 1.

See, for example, Barwick CJ’s comments in Henderson v FCT (1970) 119 CLR 612; 1 ATR 596; 70 ATC 4016 (see 4.9). It should be noted that there are statutory prescriptions

2.

3. 4. 5.

6.

7.

8. 9.

10.

11. 12. 13.

14. 15. 16.

for the measurement of many items of statutory income and specific deductions, such as depreciation. Treasury (Cth), Budget Paper No. 2: Budget Measures 2016–17, Commonwealth of Australia, Canberra, 2016, pp 37–8. At the time of writing, this remained an announced but unenacted reform. For a company, the year of income is the financial year preceding the year of tax but under current Pay-As-You-Go (PAYG) arrangements, the difference is of no consequence. The Commissioner’s guidelines are set out in Practice Statement Law Administration PS LA 2007/21. The New Business Tax System (Taxation of Financial Arrangements) Act 2003 (Cth) enacted ITAA97 Subdivs 960-C and 960-D, which contain new rules for foreign currency conversion retrospectively from 1 July 2003: see 5.53. Special rules apply in ITAA97 Div 70 for the valuation of trading stock and the calculation of deductible/assessable amounts. ITAA36 Pt III Div 16E prescribes rules for the derivation of interest on certain securities: see 4.33. The Commissioner of Taxation relies on ITAA36 s 170(9) to specify acceptable methods of accounting for long-term construction projects. See IT 2450 (4.30). An examination of ITAA97 Div 15 (Some items of assessable (statutory) income) will indicate that, generally, the items of statutory income are assessable when received. Other statutory income provisions have their own timing or activating rules. See Chapter 5. Australian Legal Dictionary, Butterworths, Sydney, 1997, p 350. See Henderson v FCT (1970) 119 CLR 612; 1 ATR 596 at 601 per Barwick CJ. Note that under the Taxation Act 1927–33 (SA), deductions for bad and doubtful debts were covered by s 22(xiv.a). In the ITAA36 and ITAA97, bad debts are treated according to ss 63 and 25-35 respectively. See Latham CJ’s (dissenting) judgment in CT (SA) v Executor Trustee and Agency Co of South Australia Ltd (1938) 63 CLR 108; 1 AITR 416; 5 ATD 98 (Carden’s Case). One of the reasons for the Chief Justice’s dissent in Carden’s Case was that there was no material difference between the South Australian statute and the UK Acts on the issue of derivation and that the UK authorities held an accrual basis appropriate to non-property income. Compare the comments in Barratt v FCT (1992) 36 FCR 222; 23 ATR 339 about the likelihood of recovery of fees for medical services. An illustration of the hazard Dixon J anticipated was provided by Country Magazine Pty Ltd v FCT (1968) 117 CLR 162; 10 AITR 573; see 4.17. On Henderson’s case, the court said (at [19]): The statement made by Barwick CJ in Henderson about there being no warrant “for combining the results of more than one year in order to obtain the assessable income for a particular year of tax” strikes us as curious. It might have been thought, on the facts of Henderson, that the results of one year comprised both the cash received in that year … and the income earned in the later year … However, the correctness of Henderson is not an issue before us. We are bound by the decision. If it is in point, we must apply it to this case. Henderson v FCT (1970) 1 ATR 596 at 598. See Henderson v FCT (1970) 1 ATR 133 per Windeyer J at 140–1; J Rowe & Sons Pty Ltd v FCT (1970) 2 ATR 121 per Walsh J at 130–1. See Taxation Ruling TR 98/1 for a more contemporary view.

17. Australian Accounting Standards Board, ‘Framework for the Preparation and Presentation of Financial Statements: Compiled Framework’ (AASB, Melbourne, March 2016) (formerly included in Statement of Accounting Concepts SAC 4 ‘Definition and Recognition of the Elements of Financial Statements’). 18. BHP Billiton Petroleum (Bass Strait) Pty Ltd v FCT (2002) 51 ATR 520; 2002 ATC 5169 at [31], [76]. 19. Contrast (1970) 15 CTBR(NS) Case 109; Case B47 70 ATC 236 with (1970) 15 CTBR(NS) Case 113; Case B51 70 ATC 253. 20. Discussing the relationship between the former ITAA36 ss 25(1) and 26(a), Menzies J said (at ATR 369): ‘In most cases items of assessable income are gross receipts …’. 21. In New Zealand Flax Investments Ltd v FCT (1938) 61 CLR 179; 1 AITR 366 at 378, Dixon J said: ‘There may be other similar examples and perhaps … instances of special businesses and transactions may be found where nothing but net profit could be regarded as a revenue item’. 22. In FCT v Whitfords Beach Pty Ltd (1982) 150 CLR 355; 12 ATR 692; 82 ATC 4031, Gibbs CJ and Mason J held that the second limb of former ITAA36 s 26(a) applied only to profit not assessable under former ITAA36 s 25(1). Wilson J considered the construction of s 26(a) not to be settled by existing authority but, unlike the court in Colonial Mutual Life Assurance Society Ltd, considered that if the amount was assessable under s 25(1) it was unnecessary to consider s 26(a). On s 26(a), see 1.14 and 5.8. 23. Menzies J said in Australasian Catholic Assurance Co Ltd at AITR 445: ‘I am not disposed to rely on s 26(a) at all because I doubt whether it applied to the taxpayer’s life assurance business as a whole and, if it does not, I doubt, further, whether it would be proper to extract from such business a series of transactions such as the purchase and sale of the flats and label them “the carrying on or carrying out of” a “profit-making undertaking or scheme”’. 24. There is a clue, though not in Australasian Catholic Assurance Co Ltd but in Investment and Merchant Finance Corp Ltd v FCT (1971) 125 CLR 249; 2 ATR 361; 71 ATC 4140, where Menzies J said in relation to the purchase of shares at ATR 368: ‘The expenditure incurred in buying the shares was, I have no doubt, in a sense a capital expenditure …’. 25. For example, in the circumstances illustrated by GP International Pipecoaters Pty Ltd (1990) 170 CLR 124; 21 ATR 1; 90 ATC 4413; and see 4.29. 26. This is a generalised statement of the view expressed by R W Parsons, Income Taxation in Australia, Law Book Co, Sydney, 1985, pp 609–11. 27. If shares (or other property) are trading stock, ITAA97 ss 6-5, 8-1 and Div 70 apply with the effect that an amount analogous to the financial accounting gross profit is assessable. 28. See, for example, News Australia Holdings Pty Ltd v FCT [2017] FCA 645. 29. Lower aggregate turnover thresholds apply for the small business income tax offset ($5m) and the CGT concessions ($2m). The changes to eligibility arose from the Treasury Laws Amendment (Enterprise Tax Plan) Act 2017 (Cth). 30. FCT v Firstenberg (1976) 6 ATR 297; 76 ATC 4141 (4.11). 31. FCT v Dunn (1989) 20 ATR 356; 89 ATC 4141 (4.12). 32. CT (SA) v Executor Trustee and Agency Co of South Australia Ltd (1938) 63 CLR 108; 1 AITR 416; 5 ATD 98 (Carden’s Case) (4.6). 33. Henderson v FCT (1970) 119 CLR 612; 1 ATR 596; 70 ATC 4016 (4.9).

34. Arthur Murray (NSW) Pty Ltd v FCT (1965) 114 CLR 314; 9 AITR 673 (4.15). 35. In ABB Australia Pty Ltd v FCT (2007) 162 FCR 189; 2007 ATC 4765; [2007] FCA 1063, it was held that, where a shareholder wholly owns and actively controls a company, a dividend is derived when it is declared. The case concerned dividend withholding tax. 36. See Case D62 72 ATC 376; (1972) 18 CTBR (NS) Case 31. In Hannavy v FCT (2001) 47 ATR 1018; 2001 ATC 2162, an advance payment for leave could not be apportioned into two years. 37. (1954) 4 CTBR (NS) Case 75.

[page 231]

CHAPTER

5

Statutory Income Learning objectives After studying this chapter, you should be able to: distinguish between ‘ordinary’ and ‘statutory’ income; apply ITAA97 Div 15 to particular fact situations; distinguish between a royalty by ordinary concepts and a statutory royalty; apply ITAA97 Subdiv 20-A to recoupments; calculate assessable amounts under ITAA97 Subdiv 20-B; dissect retirement payments into constituent elements; identify the tax consequences of various employment termination and allied payments; determine rates of tax and calculate the appropriate tax offset for retirement and allied payments; identify the elements of an employee share acquisition scheme.

Introduction 5.1 This chapter addresses elements of statutory income. To be statutory income, a receipt, amount or gain must be so deemed by a specific provision of the Income Tax Assessment Act 1936 (Cth) (ITAA36) or the Income Tax Assessment Act 1997 (Cth) (ITAA97).

That is, statutory income extends the income concept for tax purposes beyond the ordinary concepts understanding. Ordinary income is judicial income; statutory income is legislated income. Between them, ITAA97 ss 6-5 and 6-10 bring into the tax equation all amounts that are income for the purposes of the ITAA97. Sections 6-5 and 6-10 may be described as central provisions in that they operate in tandem to bring all assessable income into the s 4-15 tax equation. They apply common jurisdictional limits to ordinary and statutory income and provide for the exclusion of exempt income. However, s 6-10 is not an assessing provision. The assessment mechanisms are in the specific sections themselves and the specific provisions may be said to operate as parallel provisions, each directed to the exclusive treatment of a particular object of taxation. In the ITAA97, this organisational structure has been deliberately adopted. In terms of the ITAA36, the relationship [page 232] between what have been described as central provisions and parallel provisions has been the subject of some academic debate.1 Key elements of statutory income are discussed elsewhere: capital gains are examined in Chapter 6, fringe benefits in Chapter 7 and dividends in Chapter 13. This chapter outlines the statutory income contained in: ITAA97 Div 15 — some items of assessable income; ITAA97 Div 20 — amounts included to reverse past deductions; ITAA97 Divs 82 and 83 — certain employment termination payments; ITAA97 Divs 301–307 — superannuation payments; and ITAA36 and ITAA97 — remaining elements.

Construction issues

5.2 ITAA97 Div 6 has been deliberately structured to avoid the flaws exposed by Professor Parsons’s analysis of the ITAA36.2 Section 6-5 assesses ordinary income; s 6-10 brings statutory income into assessable income. Section 6-20 provides for the exclusion of exempt income. A general reconciliation is provided in s 6-25. It provides that, where an item potentially falls within both ordinary and statutory income, the rules relating to statutory income prevail. There are also a number of specific reconciliations throughout the statutory income provisions; for example, s 15-2(3): see 5.4.

Division 15: Some items of assessable income (Note: All references are to the ITAA97 except where indicated.) 5.3 The jurisdictional limits of Div 15 are set out in s 6-10 and mirror those of ordinary income. An Australian resident’s assessable income includes statutory income derived from all sources, whether in or out of Australia. A non-resident’s assessable income includes statutory income from all Australian sources and statutory income included by a provision on some basis other than Australian source. Under s 6-10(3), statutory income is deemed to be derived when it is applied to a taxpayer’s benefit or dealt with as directed by a taxpayer. Non-receipt of statutory (or ordinary) income is no barrier to derivation in such circumstances. Division 15 comprises a number of operative provisions that include in assessable income some specific items, some of which would be income according to ordinary concepts. In general, the amounts are derived when received. The leading provisions are as follows: [page 233] 15-2

Allowances and other things provided in respect of employment or services

15-3

Return-to-work payments

15-5

Accrued leave transfer payments

15-10

Bounties and subsidies

15-15

Profit-making undertaking or plan

15-20

Royalties

15-22

Payments made to members of a copyright collecting society

15-25

Amount received for lease obligation to repair

15-30

Insurance or indemnity for loss of assessable income

15-35

Interest on overpayments and early payments of tax

15-40

Providing mining, quarrying or prospecting information

15-45

Amounts paid under forestry agreements

15-50

Work in progress amounts

15-70

Reimbursed car expenses

Section 15-2: Allowances in respect of employment or services 5.4 Section 15-2 derives from the former ITAA36 s 26(e), a provision that attempted to override the convertibility issue of ordinary income and tax non-money benefits arising from employment or the provision of services. The leading words of the section bring into assessable income ‘the value to you’ of all allowances, gratuities, bonuses provided to you in respect of employment or services rendered. The provision has only residual application. Benefits of employment are covered by the Fringe Benefits Tax Assessment Act 1986 (Cth) and are excluded from assessable income of the employee by ITAA36 s 23L. Non-cash business benefits that are otherwise of an income nature but for their nonconvertibility to money are deemed by ITAA36 s 21A to be convertible into money (and thereby assessable under s 6-5). Specifically excluded from s 15-2 are a superannuation lump sum, an employment termination payment, payments in lieu of leave, a dividend or an amount that is ordinary income in terms of s 6-5: s 15-2(3). Section 15-2 applies to allowances, gratuities, compensation, benefits, bonuses and premiums. In general terms, an allowance is distinguishable from a reimbursement in that the former is a

predetermined, discretionary sum paid to meet estimated expenses. Most allowances are in the nature of wages and salaries for Pay-AsYou-Go (PAYG) purposes and are probably ordinary income and so are excluded from s 15-2 by s 15-2(3). A reimbursement is compensation for an exact amount already expended. Reimbursements to employees are generally (see s 15-70 discussed in 5.21 for an exception) expense payment fringe benefits for the purposes of the fringe benefits tax legislation and non-assessable non-exempt income to the employee. Allowances that are not ordinary income are assessable under s 15-2. [page 234] While the term allowance may have a restricted ambit, a number of the other terms, especially benefits, do not. A benefit has been referred to as an ‘advantage, profit, good’ in Case L54 79 ATC 399.2 There were conflicting judicial views of the ambit of ITAA36 s 26(e) (from which s 15-2 derives). Early judicial views were represented by Windeyer J’s statement in Scott v FCT (1966) 117 CLR 514 at 526; 10 AITR 367 that the provision:3 … does not bring within the tax-gatherer’s net moneys or moneys’ worth that are not income according to general concepts. Rather it prevents receipts of moneys or moneys’ worth that are in reality part of a taxpayer’s income from escaping the net.

Accordingly, one view of the operational roles of ss 6-5 and 15-2, so far as emoluments of office are concerned, is to apply s 6-5 to cash (and convertible) amounts whether described as salary or allowances and to ‘mop up’ with s 15-2 the non-money amounts that had the necessary employment nexus. An alternative approach would assess under s 15-2 all allowances. This seems to be the ATO’s preference. For example, in IT 2543, the view is expressed that travel allowances are assessable under s 15-2. In Smith v FCT (1987) 164 CLR 513; 19 ATR 274; 87 ATC 4883, the Full High Court considered whether an amount paid to a bank officer under an ‘encouragement to study’ scheme was assessable either as ordinary income or under ITAA36 s 26(e). A majority found the

payment was assessable under s 26(e). In the course of judgment, Brennan J addressed two questions considered in Hayes v FCT (1956) 96 CLR 47; 6 AITR 248 and Scott v FCT (see 3.22–3.23), namely: When will an employment or services relationship bring an unsolicited payment within s 26(e)? Does s 26(e) bring to account only those benefits that are income according to ordinary concepts? In answer to the first question, Brennan J (Smith at ATR 278) considered a payment may well be an assessable amount under ITAA36 s 26(e) ‘if the employment (or some aspect of the employment) is the reason or one of the reasons why the allowance is paid’. In other words, there must be a causal link between the employment or services rendered and the provision of the allowance or benefit. The employment or services relationship need not be a sufficient condition for the allowance or benefit, but both Smith and Payne v FCT (1996) 66 FCR 299; 32 ATR 516, indicate that the relationship must be a real or substantial cause. Of the second issue, his Honour considered that ITAA36 s 26(e) did more than address the defects exposed in Tennant v Smith [1892] AC 150 (the convertibility issue). He concluded (Smith at ATR 282) that: ‘If an allowance is paid to an employee in consequence of his employment, s 26(e) is attracted whether or not the allowance is of an income nature’. [page 235] The effect of subs (3) is that s 15-2 is not applicable to amounts of an ordinary income nature. If Windeyer J’s view in Scott’s case is applied to s 15-2, the provision is otiose. On Brennan J’s view, s 15-2 seems now to apply only to non-income amounts having the necessary employment nexus that are not fringe benefits (or exempt fringe benefits — ITAA36 s 23L(1A)). Business benefits are now covered by ITAA36 s 21A.

In addition to the incentive paid in Smith’s case and the school fees paid in Case L54, amounts held to be assessable under ITAA36 s 26(e) include an award paid under an employee suggestion scheme (Case V76 88 ATC 538) and compensation for the loss of a rostered day off (Case Z9 92 ATC 144). In contrast, in Blank v FCT (2016) 258 CLR 439; 338 ALR 533, certain entitlements under profit participation plans were found to constitute executory and conditional promises to pay money as deferred compensation for employee services and hence not benefits to which ITAA36 s 26(e) applied.

Section 15-3: Return to work payments 5.5 Payments made to induce a person to resume work or provide services, such as strike-breaking payments, are assessable when received. Assessability extends to payments made under any type of agreement, whether enforceable or not, by any person whether an employer or not. Usually, payments made (for example) in the settlement of industrial disputes or as an inducement to enter a new employment (Pickford v FCT 98 ATC 2268) are ordinary income.

Section 15-5: Accrued leave transfer payments 5.6 These payments arise when an employee with accumulated entitlements to leave (such as annual and long service leave) changes employment and the former employer pays the new employer to assume responsibility for the accrued entitlements. Under s 15-5, the recipient is assessable on the amount and the payment is deductible under s 26-10.

Section 15-10: Bounties and subsidies 5.7 This provision assesses bounties and subsidies received in relation to carrying on a business and it would seem such amounts would typically fall within s 6-5, such that s 15-10 has only residual application. This is recognised in s 15-10(b), which limits assessability to amounts that are not ordinary income.

Section 15-15: Profit-making undertaking or plan 5.8 Section 15-15 is a relic of the 1936 Act, its utility largely ceasing with the enactment of the capital gains tax (CGT) provisions from September 1985 and the enactment of the ITAA97. Its predecessors, ITAA36 ss 26(a) and 25A, have a rich and fascinating history. In effect, the former provisions assessed the profit arising on the sale of property acquired for the purpose of resale at a profit (first limb) or from the carrying on of a profit-making undertaking or scheme (second limb). There is [page 236] a view that for more than 50 years, ITAA36 s 26(a) (later s 25A) was the only provision that assessed profits from isolated sales.4 When CGT was introduced in 1985, the first limb of the former ITAA36 s 26(a) (and s 25A) relating to the sale of property acquired for purposes of resale at a profit was unnecessary at least in relation to property acquired after September 1985. Accordingly, the provision was amended by the insertion of former ITAA36 s 25A(1A). It stated that the provision had no application to property acquisitions after 20 September 1985. However, the provision still applied to property acquired before September 1985 and subsequently sold at a profit. This earlier 1936 legislation has no application from 1997–98 onwards. The rewritten provision is s 15-15. It provides as follows: 15-15 Profit-making undertaking or plan (1) Your assessable income includes profit arising from the carrying on or carrying out of a profit-making undertaking or plan. (2) This section does not apply to a profit that: (a) is assessable as ordinary income under section 6-5; or (b) arises in respect of the sale of property acquired on or after 20 September 1985.

The effect of these exclusions is as follows:

Section 15-15 does not apply to a profit arising out of a profitmaking undertaking or scheme that falls within s 6-5. Significantly, it does not apply to the sale of property acquired after 20 September 1985, whatever the purpose of its acquisition. It does not even apply to property purchased with the requisite profit-making by resale intention before 20 September 1985 unless the subsequent disposal amounts to the carrying on or carrying out of a profit-making undertaking or plan. For a recent example of a disposal of property following the abandonment of a profit-making undertaking, see Rosgoe Pty Ltd v FCT [2015] FCA 1231. Potentially, s 15-15 may apply to the sale of property acquired before 20 September 1985, whatever the intention of its purchaser, when the sale goes beyond a ‘mere realisation’ of an asset. It also potentially applies to a non-income profit arising out of a profit-making plan that does not involve the sale of property. [page 237]

In 1965, Farmer Brown purchased and operated a dairy farm on the outskirts of Metropolis. Over the years, urban development spread to the edge of the property and Farmer Brown’s declining health and rising debt forced him to subdivide and sell a large portion of the property. Over a number of years, from 1990, eight subdivisions were made comprising approximately 90 allotments with the construction of access roads and connection of mains water as required by municipal authorities for planning approval. Advise Farmer Brown whether ITAA97 ss 6-5 and 15-15 or ITAA36 s 25A applies. A suggested solution can be found in Study help.

Section 15-20: Royalties 5.9

Section 15-20 provides:

15-20 Royalties (1) Your assessable income includes an amount that you receive as or by way of royalty within the ordinary meaning of ‘royalty’ (disregarding the definition of royalty in subsection 995-1(1)) if the amount is not assessable as ordinary income under section 65. (2) Subsection (1) does not apply to an amount of a payment to which section 15-22 or 15-23 applies.

The assessment process may be illustrated diagrammatically.

Figure 5.1:

Section 15-20 assessment process

In effect, an amount that is a royalty and has an income character is assessable under s 6-5 but an amount that is capital is assessable under s 15-20 only if it is a [page 238] royalty by ordinary concepts and not by virtue of the extended definition of the term in ITAA36 s 6(1). The predecessor to s 15-20 was ITAA36 s 26(f) and it provides an example of a provision that taxes a capital amount before the introduction of CGT in 1985.

It will be evident that there are two notions of royalty. The first arises from ordinary concepts; the second from the definition in ITAA36 s 6(1).

Ordinary concepts royalty 5.10 Section 15-20 refers to an amount ‘as or by way of royalty’ and ‘the ordinary meaning of royalty’. An amount ‘by way of a royalty’ extends the understanding of the term: McCauley v FCT (1944) 69 CLR 235; 3 AITR 67. If, within that expanded understanding, a payment is income in nature, it is assessable under s 6-5. However, s 15-20 imposes a limit on how far the terms may be extended and, if it is a royalty only because of the expanded definition in ITAA36 s 6(1), the amount is capital and outside s 15-20 (and s 6-5). By ordinary concepts, a royalty is an amount paid to the owner of property for the right to use the property or to take a substance — and made in respect of the extent of that use or taking: Stanton v FCT (1955) 92 CLR 630; 6 AITR 216. In terms of the propositions developed in the previous chapter, royalties are income from property. The nature of a royalty was discussed by Latham CJ in McCauley’s case.

McCauley v FCT Facts: A dairy farmer who owned land with standing trees entered into a contract with a timber miller to cut and remove the timber for a consideration described as ‘at or for a price or royalty of three shillings for every 100 superficial feet of such milling timber so cut’. The payments were to be made monthly and the timber was to be removed within a period of 12 months. The taxpayer contended that the total payment was consideration for the disposal of a capital asset. The Commissioner argued that, although the payments represented prices paid for capital assets, they were royalties nevertheless, assessable under former ITAA36 s 26(f). Held: A majority of the High Court (Latham CJ and McTiernan J) dismissed the taxpayer’s appeal. Even accepting that the payments were consideration for the sale of a capital asset, they were royalties. Rich J (dissenting) held that the payments represented

consideration paid by instalments for the sale of a capital asset. On the nature of royalties, Latham CJ said (at AITR 70–1): The word “royalty” is most commonly used in connection with agreements for the use of patents or copyrights and in [page 239] relation to minerals. In the case of patents a royalty is usually a fixed sum paid in respect of each article manufactured under a licence to manufacture a patented article. Similarly the publisher of a work may agree to pay the author royalties in respect of each copy of the work sold … In the case of mineral leases, a rent is reserved by the lease and frequently royalties are also made payable, being sums calculated in relation to “the quantity of minerals gotten” … In the case of mining royalties, the person who pays the royalty acquires the property in the minerals which he gets. Use of the term “royalty” is not, however, limited to patents, copyrights and minerals. The term has been used to describe payments for removing furnace slag from land … and to payments for flax cut … the person paying the royalties becoming the owner of the slag or of the flax. In Commissioner of Taxes (NZ) v The Kauri Co [1913] AC 771; 31 NZLR 617, there is a reference to timber royalties calculated as in the present case, per 100 feet cut … In Australia payments for the right to cut and take away timber are commonly described as royalties in the Statutes of the States which relate to the matter … The provisions in these Statutes relate to payments made to the Crown or to some public authority, but the word “royalties” is obviously not used in its primary sense of jura regalia, which exists independently of any agreement or dealing between the Crown and its subjects. The payments referred to in the Statutes are simply payments under licences to cut and remove timber. In my opinion the word “royalty” is properly used for the purpose of describing payments made by a person for the right to enter upon land for the purpose of cutting timber of which he becomes the owner, where those payments are made in relation to the quantity of timber cut or removed. Thus I am of the opinion that the moneys received by McCauley were royalties and accordingly were part of his assessable income. Latham CJ added that ‘much is to be said’ for construing the words ‘as or by way of royalty’ (appearing in both ITAA36 s 26(f) and ITAA97 s 15–15) as extending to payments that were not in fact royalties. This led the Chief Justice to conclude that even though the payments were the price of goods sold, they were described in the agreement as ‘price or royalty’ and received as or by way of royalties.

[page 240]

5.11 The decision in Stanton v FCT (1955) 91 CLR 630; 6 AITR 216 illustrates the benefits of hindsight and the lessons that can be learned from others’ misfortunes.

Stanton v FCT Facts: The taxpayer was a grazier who owned (as tenant in common) land on which a quantity of timber stood. The owners entered into an agreement with a timber miller to sell around three million superficial feet of timber, together with the right to cut and remove the timber, in consideration of £17,500, payable in quarterly instalments. There was provision for a rebate in the event that the timber taken was less than specified. The Commissioner relied on McCauley’s case to assess the payment as a royalty under ITAA36 s 26(f). The taxpayer argued that the payments did not depend on the quantity of timber cut but was simply consideration for the sale of a capital asset. Held: The Full High Court (Dixon CJ, Williams, Webb, Fullagar and Kitto JJ) allowed the taxpayer’s appeal, finding that the payments did not depend on the quantity of timber removed and that this was a ‘marked difference’ between the facts of the present case and McCauley’s case. The court said (at AITR 217): It will be seen that in substance the agreement amounts to a sale of standing timber, with a limitation as to quantity, at a lump sum price based in the end upon the amount of timber found to be standing upon the land, whether the timber was cut or removed or not. It will be seen, too, that the price was payable in quarterly instalments which became due independently of the amount of timber removed, so that the full price remained payable without regard to the extent to which the purchaser might exercise his right to cut and remove the timber. The Full Court considered that an inherent feature of the word ‘royalty’ was that the payments should be made in respect of the particular exercise of the right to take the substance and therefore be calculated either in respect of the quantity or value taken or the occasions on which the right is exercised. Their Honours concluded (at AITR 221): In the present transaction between the graziers and the sawmiller this element is lacking. The transaction enabled the sawmiller and indeed bound him to take stands of timber for defined prices which were payable whether he exercised the right or not and the price was not calculated upon the [page 241] amount taken but only upon the amount of timber of the prescribed kind and girth found to be standing upon the land.

It follows that the payments were not royalties and ought not to have been included in the assessable income.

5.12 At common law, therefore, a royalty usually involves a payment calculated by reference to the quantity taken or is linked to the use of property in a manner proportional to the benefits derived: McCauley’s case; see also Murray v ICI Ltd [1967] 2 All ER 980, discussed in 3.16. A payment for services rendered is not a royalty at common law (Aktiebolaget Volvo v FCT (1978) 36 FLR 334; 8 ATR 747); however, it may potentially be a payment ‘by way of royalty’. A payment for use of ‘know-how’ that does not involve the grant of a right is not a royalty either. This is illustrated in FCT v Sherritt Gordon Mines Ltd (1977) 137 CLR 612; 7 ATR 726; 77 ATC 4365. In that case, the taxpayer supplied technical information relating to the construction of a nickel refinery. Although the payment was expressed in terms of a percentage of sales over 15 years, a majority of the High Court held that the payments were not royalties. Mason J (Gibbs ACJ concurring) said (at ATR 734): Here the substantial, if not the sole, consideration for the payments was not the grant of a right but for the provision of technical assistance and information which Western Mining was entitled to use once it was supplied, without the grant of any additional right to do so.

An amount paid as or by way of a royalty that is of an income nature will be assessable under s 6-5. An amount that is a royalty by ordinary concepts (which may include a capital payment) is assessable under s 15-20.

Statutory royalty 5.13 The definition of a royalty in ITAA36 s 6(1) (ITAA97 s 995-1) is relevant only for the purposes of withholding tax.5 The definition extends the term beyond payments for the use of materials or rights to also include payments for the use or supply of scientific, industrial or commercial knowledge, visual and sound images, as well as payments made whereby the other party agrees not to make the rights available to

third parties. The following example illustrates how several concepts interact.

Brickies Ltd, an Australian company manufacturing bricks in Western Australia, enters into a licensing agreement with Springbok Inc, a company incorporated in Johannesburg. The agreement provides for Springbok to communicate information and provide technical [page 242] assistance for the manufacture of a special high-tech building material. Brickies is to pay a once-and-for-all, non-refundable amount of $100,000 in consideration for the grant of a licence and $1 per unit of sales expected to be one million units per year. The agreement provides that Brickies is to meet all federal and state taxes and charges. 1. Payment of $100,000 Is the payment income or capital? Refer to Murray v ICI Ltd [1967] 2 All ER 980, discussed at 3.16. Lord Denning suggested licences be divided into three categories: Ordinary licence: The grantor grants permission for the grantee to do something which it could not lawfully do otherwise (eg, it grants a franchise). There could be a multiplicity of ordinary licence holders. The receipts would be income in the hands of the grantor. Sole licence: The grantor grants permission to a single grantee but leaves the grantor at liberty to do it also. This is the grey area. If the grant sufficiently restricts the grantor’s right to earn income, it is likely to be a capital receipt. Otherwise, it approaches an ordinary licence. Exclusive licence: The grantor excludes itself from exploiting the property the subject of the licence. Unless the grantor can be seen to be trading in the grant of licences or know-how, the consideration is capital (subject to how it is calculated and payment made). The decision in Kwikspan Purlin Systems Pty Ltd v FCT (1984) 15 ATR 531; 84 ATC 4282 (see 3.16) supports a view that the payment is capital, being for a sole or exclusive licence: not assessable under s 6-5. Is it a royalty by ordinary concepts? In FCT v Sherritt Gordon Mines Ltd (1977) 137 CLR 612; 7 ATR 726, it was held that payments for the supply of technical information were not royalties: not assessable under s 15-20. Is it a royalty under ITAA36 s 6(1)? The expanded definition would include the term and it would be subject to withholding tax of 30%: see point 2. 2. Payment of $1/unit

The payment is a royalty by ordinary concepts and income in nature: McCauley v FCT (1944) 69 CLR 235; 3 AITR 67. The amount is also within the expanded definition. Being a non-resident, the amount would be assessable under s 6-5(3) but for the fact that royalties are subject to withholding tax [page 243] and thereafter exempt (ITAA36 ss 128B, 128D). Brickies will be liable to withholding tax of 30% which, under the terms of the agreement will be calculated on: $1.00 ÷ ($1.00 − 0.30) = $1.42/unit (ie, to pay a net $1/unit, the royalty will be $1.42, less 30% = $1.00). Note: The 30% withholding tax rate would likely be reduced to 5% by the Australian/South African double taxation treaty.

Section 15-22: Payments to members of a copyright collecting society 5.14 An amount in respect of a copyright that would ordinarily be a royalty in terms of s 15-20 is instead assessable under s 15-22. That section applies to assess the member on a payment made by a copyright collection society (except where the directors of the society have been assessed as trustees under ITAA36 s 98, s 99 or s 99A). Copyright income (and certain non-copyright income) derived by the copyright collection society is exempt from tax.

Section 15-25: Amount received for lease obligation to repair 5.15 Where a lessee is obliged by the terms of a lease to repair the leased property and makes a payment to the lessor in breach of that obligation, the lessor is assessable under s 15-25 and the lessee receives a deduction under s 25-15: see 9.16. As a result, the outcome is neutral. Repairs made by the lessor would then be deductible under s 25-10: see 9.7ff.

Section 15-30: Insurance or indemnity for loss of

assessable income 5.16 An amount received by way of insurance or indemnity for an amount that would have been assessable income is assessable under s 15-30 if it is not assessable as ordinary income under s 6-5. Payments received as substitutes for income or as compensation for lost income are themselves income. The former ITAA36 s 26(j) made reference also to losses of trading stock. Amounts received by way of insurance or indemnity for such losses are now assessable under s 70-115.

Section 15-35: Interest on overpayments and early payments of tax 5.17 The Taxation (Interest on Overpayments and Early Payments) Act 1983 (Cth) provides that where, as a result of a successful appeal against an assessment, an amount of tax is refunded, a taxpayer is entitled to interest on the refunded amount. ITAA97 s 15-35 assesses that interest amount. Some early payments of tax also attract interest that is assessable. A general interest charge payable by taxpayers on overdue tax and the shortfall interest charge are deductible under s 255. [page 244]

Section 15-40: Providing mining, quarrying or prospecting information 5.18 Assessable income includes an amount received for providing mining, quarrying or prospecting information to another entity if the amount is not ordinary income in terms of s 6-5 and the provider continues to hold the information. Deductions for expenditure of this nature are available under Div 40 ‘Capital Allowances’: s 40-730.

Section 15-45: Amounts paid under forestry agreements 5.19 Certain prepayments by investors in forestry plantations are deductible under ITAA36 s 82KZMG. The effect of s 15-45 is to make the payment assessable in the year in which the investor claims a deduction, rather than in the year in which the work is done on the investor’s behalf.

Section 15-50: Work in progress amounts 5.20 A work in progress payment is defined in s 25-95(3) (see 9.31) as an amount in respect of partly performed services (as opposed to goods) for which no recoverable debt has arisen. A series of court decisions on the consequences of variations in the membership of partnerships meant that payments made to retiring partners for their share of work in progress were assessable as ordinary income but that payments by incoming partners for a share of work in progress were on capital account: see 14.35ff. The effect of s 15-50 (and s 25-95) is to make the payments specifically assessable (and deductible).

Section 15-70: Reimbursed car expenses 5.21 Where an employee is reimbursed on a distance-travelled basis for the use of a car, the reimbursement is an exempt car payment expense benefit in terms of s 22 of the Fringe Benefits Tax Assessment Act 1986 (Cth). But for that exemption, the reimbursement would be a fringe benefit and ITAA36 s 23L would render it non-assessable nonexempt income of the employee. The effect of ITAA97 s 15-70 is to make the payment assessable and bring related deductions within the car expense substantiation requirement of Div 28. In the simplest scenario, the employee would be entitled to a deduction on a ‘cents per kilometre’ basis for the business use of the car.

Division 20: Amounts included to reverse the effect of past deductions

Introduction (Note: All references are to the ITAA97 except where indicated.) 5.22 Division 20 is directed to recouping amounts that were formerly deductible. The Division operates independently in that there is no underlying principle of revenue law that the recovery of an amount that was previously deductible is, [page 245] ipso facto, of a revenue nature. There is no necessary symmetry between assessability and deductibility. This proposition derives from FCT v Rowe (1997) 187 CLR 266; 35 ATR 432; 97 ATC 4317: see 2.16. While a substitute for income is itself income (FCT v Myer Emporium (1987) 163 CLR 199; 18 ATR 693; 87 ATC 4363: see 3.57), compensation for lost income is also income (Heavy Minerals Pty Ltd v FCT (1966) 115 CLR 512; 10 AITR 140: see 3.18) and amounts arising in the course of business are income (such as the refund in HR Sinclair & Sons Pty Ltd v FCT (1966) 114 CLR 537; 10 AITR 3: see 3.69) (Sinclair’s case), the High Court in Rowe’s case unanimously refused to accept that there was a more universal principle of law. Nevertheless, in the ITAA36 there were more than 20 specific provisions that assessed recoupments, repayments or recoveries of previously allowable deductions. Division 20 brings many of these provisions together and provides a uniform treatment of the items. It will be appreciated that Div 20 differs from Div 15 in that, while both may be described as ‘statutory extensions’, Div 15 acknowledges that many of the items there addressed are in whole or part assessable under s 6-5 as ordinary income. Division 20 is not underpinned by a general rule of symmetry between income and deductions. Indeed, one telling factor leading to the rejection in Rowe’s case of such a rule was that there were so many specific recoupment arrangements in the ITAA36. This implied the absence of the principle.6

Scope of Subdiv 20-A 5.23 Subdivision 20-A applies to amounts that are not ordinary income or statutory income under provisions outside Subdiv 20-A. So, for example, an insurance recovery for the loss of a depreciating asset would trigger a balancing adjustment under Div 40. For the Subdivision to apply, there must first be a recoupment. Section 20-25(1) provides that this includes: (a) any kind of recoupment, reimbursement, refund, insurance, indemnity or recovery, however described; and (b) a grant in respect of the loss or outgoing.

A recoupment of a loss or outgoing thus has a very wide scope. An assessable recoupment arises under s 20-20. [page 246]

20-20 Assessable recoupments … Insurance or indemnity (2) An amount you have received as recoupment of a loss or outgoing is an assessable recoupment if: (a) you received the amount by way of insurance or indemnity; and (b) you can deduct an amount for the loss or outgoing for the current year, or you have deducted or can deduct an amount for it for an earlier income year, under any provision of this Act. Other recoupment (3) An amount you have received as recoupment of a loss or outgoing (except by way of insurance or indemnity) is an assessable recoupment if: (a) you can deduct an amount for the loss or outgoing for the current year; or (b) you have deducted or can deduct an amount for the loss or outgoing for an earlier income year; under a provision listed in section 20-30.

Therefore, an amount may be recouped under one of two mechanisms: an amount is received by way of insurance or indemnity in respect of a loss or outgoing for which you have or can deduct an amount; an amount is received in respect of a loss or outgoing for which you have or can deduct an amount under a provision listed in s 20-30. Section 20-30 lists a number of provisions of the ITAA97 (as well as their predecessors in the ITAA36), principally: s 8-1 — rates and taxes and bad debts; s 25-5 — tax-related expenses; s 25-35 — bad debts; s 25-45 — embezzlement and larceny by an employee; s 25-60 — election expenses; s 25-75 — rates and taxes; the former s 25-80 — upgrading assets to meet GST obligations; s 25-95 — work in progress amount; Div 40 — capital allowances.

Would the amount paid to the taxpayer in Rowe’s case be an assessable recoupment under the ITAA97? (The case is discussed in 2.16.) A suggested solution can be found in Study help.

[page 247] In Batchelor v FCT (2014) 219 FCR 453; 142 ALD 1 at [13], the Full Federal Court made the following observations:

The “recoupment” of a loss or outgoing is one of the conditions for the operation of s 20-20(2). Recoupment is defined broadly (as may be seen by the definition in s 20-25(1)) but, however broad “recoupment” may be, a receipt will only be an “assessable recoupment” if it satisfies the additional conditions in s 20-20(2)(a) and (b). One of those conditions is that the recoupment be capable of bearing the description of being received “by way of insurance or indemnity”. An amount will not satisfy that requirement merely by satisfying the definition of recoupment. It may be accepted that the words “by way of insurance or indemnity” are, and are intended to be, wide, but they must be applied as intended. Generally speaking a payment will not be regarded as an indemnity (whether the word is taken alone or in combination in the composite phrase “by way of insurance or indemnity”) unless the entitlement to its receipt precedes the event in respect of which it is paid. An ex gratia payment, for example, is not apt to be regarded as indemnification of a loss or outgoing notwithstanding that its receipt may be said, from the point of view of economic equivalence, to compensate the recipient for a loss which had been suffered or an outgoing which had been incurred. Similarly, a refund would not ordinarily be regarded as an indemnification notwithstanding that its receipt may be said to have rendered a taxpayer harmless, from an economic point of view, for an antecedent loss.

However, the mere fact that a payment is described or structured as an ex gratia or act of grace payment will not prevent the payment from being by way of indemnity. For instance, if it is in substance made for discontinuing an application for legal costs and releasing the payer from legal costs claims: Re Falk and FCT [2015] AATA 392. Further, Denmark Community Windfarm Ltd v FCT [2017] FCA 478 shows that government grants made pursuant to a pre-existing agreement to pay rebates for capital expenditure on construction of a wind farm, can be characterised as being made by way of indemnity for those expenses. A recoupment includes an amount received for disposing of the right to receive a recoupment: s 20-25(3). If an amount is received for recoupment, but the extent to which it is for recoupment is unspecified, a ‘reasonable’ amount is taken to be the recoupment: s 20-25(4). However, to be an assessable recoupment, the payment must be by way of insurance or indemnity or, if it is not by way of insurance or indemnity, assessment is limited to items specified in s 20-30. Whether recoupments of amounts other than those specified in s 20-30 are assessable income will depend on general revenue law principles: see 5.22. If the compensation, etc, received is of a capital nature, the CGT provisions may apply. Specifically, a C1 event arises on the loss or destruction of a CGT asset and a C2 event arises on the cancellation,

forfeiture or surrender of an intangible asset (including a right): see 6.28. If the amount is, or was, deductible over more than one year (as is the case with a number of capital write-offs), s 20-40 states the method for calculating the assessable recoupments. Where an amount is deductible over several years, any assessable recoupment is limited to the total deduction to that point in time. Excess amounts may be recouped in future years, provided more amounts are deductible. An example is provided by Denmark Community Windfarm Ltd v FCT [2017] FCA 478. [page 248]

Subdivision 20-B: Disposal of a formerly leased car 5.24 In FCT v Reynolds (1981) 11 ATR 629; 81 ATC 4131, a taxpayer who was a cartage contractor leased a prime mover. Before the expiry of the lease, he proposed to ‘upgrade’ and, with the permission of the lessor, sold the old truck for an amount that exceeded the payout figure by $8570. In accordance with normal practice, the taxpayer retained the surplus. The Commissioner assessed the profit as ordinary income. In the Supreme Court of Tasmania, Neasey J upheld the assessment for three reasons: 1. Although there was no legal obligation on the finance company to make the payment, there was a well-founded business expectation held by the taxpayer that he would receive the excess of the sale price over the residual value. 2. The motive of the finance company in allowing the taxpayer to retain the surplus was wholly commercial and had regard to its own business interests. 3. The dominant consideration was the close relationship between the receipt of the money and the taxpayer’s business activities. The leasing of equipment is a common practice and the decision in

Reynolds is authority for saying there will be circumstances where the profit on its sale is income by ordinary concepts. The question arises whether the sale of a formerly leased motor vehicle that is wholly or partly used for income purposes will generate an assessable amount.

Dr How is a medical practitioner deriving income from an appointment at the Great Public Hospital and a private practice. He leases a motor vehicle that is used 75% for income-related purposes and claims a deduction for 75% of the lease payments. At the expiry of the lease, he acquires the car for its agreed residual value, uses it as a ‘second car’ for 18 months, and then sells it for a profit (calculated as the sale price less the residual value). Would all, or some (75%), of the profit represent income by ordinary concepts?

5.25 Since 1979, profit on the sale of a formerly leased motor vehicle for which the lease payments were wholly or partly deductible has been assessable. The assessable amount is limited to the extent that it exceeds the deductible payments (or the notional depreciation). The machinery of former ITAA36 s 26AAB has been rewritten in Subdiv 20-B. In simple terms, the object of the legislation is to place the lessee of a motor vehicle in the same situation as a taxpayer who purchased a motor vehicle and claimed deductions as depreciation. The aim of Subdiv 20-B is to recoup formerly deductible expenditure. Section 20-100 states that the object of the Subdivision is to assess the profit on the sale of a motor vehicle acquired from the lessor up to the lesser of: [page 249] (a) total deductible lease payments; or (b) the amount that could be claimed as depreciation if the car was owned and used solely for income-producing purposes.

For the purposes of Subdiv 20-B, a car means a motor vehicle (other than a motorcycle), designed to carry fewer than nine passengers, leased by a taxpayer or an associate. In the normal case, the assessment operates as follows: s 20-110

your assessable income includes the profit you make on disposing of a car; the car was leased by you and the lease payments have been deductible; and you acquire the car from the lessor and at any time sell it for a profit.

s 20-115

profit is the amount by which consideration exceeds the cost of acquiring the car (consideration is usually the sale price minus selling expenses: s 20-115(2)).

s 20-110(2)

assessable income cannot exceed the lesser of: (a) deducted lease premiums; (b) notional depreciation.

s 20-120

notional depreciation (generally speaking) is the cost of the car to lessor minus termination value.

Dr Why leases a car for three years at $400 per month; it is used 60% for incomeproducing purposes. The cost of the car was $32,000. Agreed residual value is $20,000. Dr Why acquires the car at its agreed residual and sells it for $26,000. How much is assessable under s 20-110? profit: 26,000 − 20,000 = $6000 deductible amounts: 400 × 36 × 0.6 = $8640 notional depreciation: 32,000 − 20,000 = $12,000 The amount of $6000 is assessable. Note: If the lessor owned the car for a longer period, the notional depreciation is reduced proportionally. For example, if in the above case the lessor purchased the car on 1 July Y1 and leased it for three years on 1 July Y2, notional depreciation is:

Notional depreciation is $9000. If Dr Why sold the car for $30,000: profit: 30,000 − 20,000 = $10,000

The assessable amount is $8640, being the lesser of the deductible amounts or notional depreciation.

[page 250]

Retirement and termination payments (Note: All references are to the ITAA97 except where indicated.) 5.26 In 1978, a process commenced of breaking down retirement and allied payments into specific categories. Until that time, the only assessment of lump sums paid in consequence of termination of employment was ITAA36 s 26(d). That provision assessed 5% of the payment; that is, 95% was tax free. A legacy of the former s 26(d) is what are known as ‘grandfather clauses’. These are arrangements that preserve the existing rules for entitlements that accrue before the date of change. The rationale for these arrangements lies in appreciating that retirement benefits accumulate over a working life and significant changes in taxing schemes disadvantage taxpayers who retire after the date of change compared with those who retire before the change. As a result, under grandfathering, the altered scheme applies only to entitlements that accrue after the specified date. This means that it becomes necessary to apportion the payment into the ‘pre-change’ and ‘post-change’ elements. This apportionment process is a feature of determining the assessable amount of a range of retirement payments but, clearly, its significance diminishes with the passage of time and subsequent reforms. In 1978, payments in lieu of annual leave and long service leave were brought into assessable income and, in 1983, other retirement payments including superannuation received specific statutory attention and grandfathering arrangements. From 1 July 2007, assessing mechanisms have been substantially rewritten. The rates discussed below ignore the Medicare levy, which is also added, as applicable.

Employment termination payments (ETPs) 5.27 Division 82 addresses ETPs. By virtue of s 82-130, a payment is an ETP if you receive it: (i) in consequence of the termination of your employment; or (ii) after another person’s death, in consequence of the termination of the other person’s employment; …

These payments are respectively described in the legislation as a ‘life benefit termination payment’ and a ‘death benefit termination payment’. The provision stipulates that, to qualify as an ETP, the payment must be received within 12 months of termination. An amount received after 12 months is assessable income (s 83-295), unless the Commissioner determines otherwise having regard to circumstances set out in s 82130(4)–(8). Section 82-135 specifies a range of payments that are not ETPs. ‘Employment’ includes the holding of an office: s 80-5. [page 251]

Section 82-135: Payments that are not ETPs 5.28 Section 82-135 specifically excludes a range of payments from taxation as ETPs. Principal among these are: superannuation benefits; pension or annuity payments; payments in lieu of leave; and the tax-free part of a genuine redundancy payment or an early retirement scheme. In addition, arm’s length advances or loans, certain deemed dividends and certain capital payments for personal injury and restraint of trade are also excluded.

Termination of employment 5.29 A number of cases have considered the meaning of the words ‘in consequence of’ the termination of employment in the context of the former ITAA36 s 26(d). Those cases are relevant to a life benefit ETP.

‘In consequence of’ the termination of any employment … 5.30 The former ITAA36 s 26(d) required that the payment be: (i) a lump sum, and (ii) in consequence of the termination of employment. Under former ITAA36 Pt III Div 2 Subdiv AA, payments made after 1 July 1983 need not be a lump sum but must be in consequence of termination of employment. The interpretation of the words ‘in consequence of’ was considered by the High Court in Reseck v FCT (1975) 133 CLR 45; 5 ATR 538; 75 ATC 4213.

Reseck v FCT Facts: The taxpayer was employed by a construction company that operated several construction sites in Queensland. The taxpayer’s employment was terminated on a Friday because there was no work available at a particular site and he was re-employed by the same company at another site on Monday. His employment was again terminated around five months later. One week’s wages in lieu of notice and severance pay was paid on both occasions and the taxpayer contended only 5% of the amount was assessable under the former ITAA36 s 26(d). Significantly, the Board of Review had earlier held that the taxpayer’s position had been terminated, a finding that was not challenged on appeal. Held: A majority (Gibbs and Jacobs JJ; Stephen J dissenting) held the amounts were termination payments within the ordinary meaning of the words ‘paid in consequence of termination of employment’. [page 252] Gibbs J said (at ATR 541–2): Within the ordinary meaning of the words a sum is paid in consequence of the termination of employment when the payment follows as an effect or result of the termination … It is not in my opinion necessary that the termination of the services should be the dominant cause of the payment … In the present case the allowance

was paid in consequence of a number of circumstances, including the fact that the taxpayer’s service had been satisfactory and that the industrial agreements provided for the payment, but it was none the less paid in consequence of the termination of the taxpayer’s employment. On this point, Jacobs J said (at ATR 545): It was submitted that the words “in consequence of” import a concept that the termination of employment was the dominant cause of the payment. This cannot be so. A consequence in this context is not the same as a result. It does not import causation but rather a “following on”.

5.31 In Reseck’s case, the question of whether there had been a termination of employment was not before the court. On the matter, Gibbs J observed (at ATR 541): In most cases in which a workman ceased his employment on a Friday and commenced employment again with the same employer on the following Monday it would be impossible to say that his employment had ever been terminated … I of course do not cast any doubt on the correctness of the finding of the Board of Review in the present case, but I do think it necessary to emphasise that we have before us an unchallenged finding by the Board and that it is not open to us to hold that the services of the taxpayer were not terminated. Accordingly, our decision cannot be regarded as authority for holding in similar circumstances that there was a termination of the employment of the taxpayer.

The comments by Gibbs J on the issue of whether there was in fact a termination were taken by the Federal Court in Grealy v FCT (1989) 24 FCR 405; 89 ATC 4192 to mean that a short gap between two contracts will not ordinarily be regarded as a termination of employment. In Grealy’s case, the conversion of a fixed-term appointment to a tenurable appointment for a (university) lecturer was not a termination. Although the contractual relationship had changed, there was ongoing employment. The ATO view expressed in Taxation Ruling TR 2003/13 adopts Gibbs J’s interpretation that a payment is in consequence of termination of employment when it follows as an effect or result of the termination. That is, a causal connection is required (contrary to Jacobs J in Reseck’s case). 5.32

The phrase ‘in consequence of’ was further considered by the

Federal Court in McIntosh v FCT (1979) 10 ATR 13; 79 ATC 4325. In that case, the taxpayer [page 253] advised his superannuation fund seven days after his retirement that he wished to commute 50% of his pension entitlement into a lump sum. He then argued that the former ITAA36 s 26(d) did not apply as the payment was not in consequence of retirement but as consideration for the commutation of the right to a pension. The court dismissed the appeal. The amount was in consequence of termination because the taxpayer’s retirement was the occasion of and a condition of entitlement to the payment. Until retirement, there was neither entitlement to the pension nor subsequent commutation of it. The retirement was a prerequisite to payment. Reference to the occasion and condition of entitlement incorporates temporal and causal elements. Applying the same principles produced a different outcome in Freeman v FCT (1983) 14 ATR 457; 83 ATC 4456. In that case, former company directors received allowances 12 months after their retirement and the cessation of business by the company. The directors had no enforceable entitlement to receive the payments. The Federal Court said that the period of time between retirement and payment was a relevant circumstance in such cases but that, in Freeman’s case, the taxpayers had failed to show that termination of employment was the occasion of the payments: see also Haggarty v FCT (1989) 20 ATR 538; 89 ATC 4485. In Le Grande v FCT (2002) 51 ATR 139; 2002 ATC 4907, a payment arising out of wrongful dismissal and a claim for misleading and deceptive conduct was held to be a termination payment, being ‘interwoven and intertwined’ with the termination. In Forrest v FCT (2010) 78 ATR 417; [2010] FCAFC 6, the Full Federal Court applied a causal test, but in a context where it had been agreed by the parties as the relevant test. That is, ‘a payment is made “in consequence” of a particular circumstance when the payment

follows on from, and is an effect or result, in a causal sense, of that circumstance’: at [79]–[81], quoting Le Grande, per Goldberg J, at [33]. These authorities suggest that, in general, where a payment is made at the time of or shortly after retirement, it will likely be ‘in consequence of’ termination. While the cases are clear that a mere temporal link will not suffice by itself, temporal proximity will likely help highlight a causal connection or a ‘following on’ and ensure that it is not too remote. When payments are made in advance of or subsequent to retirement, the period of time separating the events will be a relevant factor. Damages for wrongful dismissal are also ‘in consequence of’: Atlas Tiles Ltd v Briers (1978) 144 CLR 202; 9 ATR 142; 78 ATC 4536. In Dibb v FCT (2003) 53 ATR 290; 2003 ATC 4613; [2003] FCA 673, ‘a substantial lapse in time’ between the termination and settlement of claims was due to delays in litigation, the subject matter of which was clearly the termination and the allegedly wrongful way Dibb’s employer acted. In these circumstances, the taxpayer may apply to the Commissioner for relief from the 12-month rule in s 82-130(1) (b). Retirement from an office or employment is established when the taxpayer has in fact relinquished the office or employment, and, at the time it was relinquished, the taxpayer has no intention of ever returning to it or resuming it: Platell v FCT 92 ATC 2018; Case C103 (1953) 3 TBRD 602. However, it is not correct to say that there can be no termination if a taxpayer has an intention of resuming employment at some time in the future: Hilton v FCT 92 ATC 4534. [page 254] Employment includes the holding of an office. An office usually refers to a position which has existence independent of the person filling it: Case U75 87 ATC 453; Case U163 87 ATC 498. In FCT v Sealy (1987) 78 ALR 387; 87 ATC 5076, the position of managing partner of a substantial grazing partnership was an ‘office’ for the purposes of ITAA36 s 26AD. In Grealy v FCT (1989) 24 FCR 405; 89 ATC 4192,

the Federal Court held that an ‘office’ usually connotes a position of defined authority in an organisation, such as director of a company, president of a club or a position with statutory powers. The holder of a professional employment is not an office holder merely because the position has a name.

Life benefit termination payments 5.33 A life benefit termination payment comprises two parts: 1. a tax-free component (which is non-assessable non-exempt income: s 82-10); and 2. a taxable component (which attracts a tax offset on the ‘ETP cap amount’, being $200,000 in 2017–18: ss 82-10, 82-160). The ‘ETP cap amount’ ($200,000) is indexed annually and rounded downward to $5000 increments. From 2012–13, a non-indexed ‘wholeof-income cap amount’ of $180,000 operates in conjunction with the ETP cap amount. It applies to ETPs that are not ‘excluded payments’ (s 82-10(6)) — essentially retirement gratuities such as ‘golden handshakes’. The tax-free component is so much of the payment as consists of an invalidity segment and a pre-July 83 segment. In turn, the invalidity segment is a payment made due to ill-health, attested by two medical practitioners, which prevents employment in a capacity for which the person is reasonably qualified by way of education, training and experience. The payment comprises compensation for the loss of employment until the person’s ‘last retirement day’ (generally, the person’s 65th birthday). The pre-July 83 segment is the amount attributable to the period of employment before 1 July 1983. The tax-free status of this segment recognises that under previous rules, only 5% of the payment was assessable income.

Doggs has been employed since 1982. In 2017, he received an invalidity payment of $40,000. He would have retired in 2022 (a total of 40 years, of which 35 have been completed). (i) 40,000 × 5/(35 + 5) = $5000 (ii) 40,000 − 5000 = 35,000 35,000 × 1/35 = $1000 Tax free $6000 Note: The formulae in ss 82-150 and 82-155 require the calculation to be made in the number of days. There are 5 years to retirement; 1 year between 1982 and 1983.

[page 255] The taxable component is assessable income but a tax offset applies to cap the rate of tax on the ‘ETP cap amount’ (s 82-160), which for 2017–18 is $200,000: if the taxpayer has reached preservation age, the rate of tax cannot exceed 15%; if the taxpayer is below preservation age, the rate of tax cannot exceed 30%; if the payment exceeds $200,000, normal rates of tax apply. In addition, from 1 July 2012, the whole-of-income cap amount of $180,000 applies such that the concessional rates above apply only to that portion of the taxable component of the life benefit termination payment that does not exceed the cap of $180,000, after counting a person’s annual taxable income (disregarding the taxable component of the life benefit termination payment) towards the cap. The effect is that normal rates of tax apply to the taxable component of an ETP that brings a person’s taxable income above $180,000. The whole-of-income cap does not apply to certain ‘excluded payments’.

Death benefit termination payments 5.34 A death benefit termination payment is an ETP received after another person’s death: s 82-130(1)(a)(ii). The tax-free components (being the invalidity segment and the pre-July 83 component) are

determined in the same manner as life benefit termination payments. The taxable component is assessable income but a tax offset operates to cap the rate of tax that may apply to the ETP cap amount ($200,000 for 2017–18): if the payment is made to a dependant, the rate of tax is 0%; if the payment is to a non-dependant, the rate of tax cannot exceed 30%; if the payment exceeds $200,000, normal rates of tax apply. A dependant is the deceased person’s spouse, child aged less than 18 or other person who had an interdependency relationship. If the payment is made to the trustee of the deceased person’s estate, it is taxed in the hands of the trustee as if it was paid to the dependent or non-dependent beneficiary.

Division 83: Other termination payments 5.35 In 1978, the taxation of payments in lieu of accumulated annual leave and long service leave were included in assessable income via ITAA36 ss 26AC and 26AD. These provisions were part of ITAA36 Pt III Div 2 Subdiv A. Sections 27A–27H of Subdiv AA were inserted in July 1983 to provide for the taxation of ‘superannuation, termination and kindred payments’. A feature of those provisions was the grandfathering arrangements that preserved the assessment of only 5% of ‘pre-change’ payments. In addition, ITAA36 s 159SA provided for rebates of tax (tax offsets) that, in general, kept maximum marginal rates to 30%. The July 2007 reforms rewrote provisions relating to all retirement payments but separated what were previously called ‘eligible termination payments’ into: employment termination payments (Div 82); payments in lieu of accumulated leave (Subdivs 83-A and 83-B); [page 256]

‘concessional’ components of genuine redundancy payments and early retirement schemes (Subdiv 83-C); and superannuation benefits (Divs 301–307).

Subdivision 83-A: Unused annual leave payments 5.36 Payments in lieu of unused annual leave are now dealt with under ITAA97 Subdiv 83-A. Payments in lieu of annual leave are fully assessable under s 83-10. They are taxed at normal, marginal rates except: where the payment is in respect of employment before 18 August 1993; or where the payment is part of a genuine redundancy payment or bona fide early retirement scheme or is an invalidity segment of an ETP or a superannuation benefit. In such cases, a tax offset applies to cap the rate of tax at 30%.

Subdivision 83-B: Unused long service leave payments 5.37 Payments in lieu of long service leave accruing after 15 August 1978 are fully assessable. Entitlements that accrued before 16 August 1978 continue to be assessable as to 5%. Normal marginal rates of tax apply except for: payments in respect of employment between 16 August 1978 and 17 August 1993; payments that are part of a genuine redundancy payment or bona fide early retirement scheme or an invalidity segment of an ETP or a superannuation benefit. In such cases, a tax offset applies to cap the rate of tax at 30%. Sections 83-90–83-105 determine how to make the requisite apportionments. The formula produces the same result as the former ITAA36 s 26AD. It also provides for situations where some accrued leave has been taken.

Kay commenced employment on 16 August 1977 and retired on 15 August 2017 (40 years). She received $50,000 in lieu of unused long service leave (LSL). The amount is assessable as follows:

Note: The Act requires the apportionment be made in terms of whole days.

Subdivision 83-C: Genuine redundancy payments and early retirement scheme payments 5.38 The taxation arrangements for such payments are largely unchanged. To the extent that the payments come within threshold amounts, they are tax free. Beyond that, the payments are treated as ETPs. [page 257] Under s 83-175, a payment for genuine redundancy is so much of a payment that exceeds what would have been paid for normal (voluntary) retirement. For early retirement, the scheme must relate to the employer’s reorganisation and be approved by the Commissioner. Conditions determining early retirement schemes and redundancy are set out in ss 83-175 and 83-180. A payment cannot be both a genuine redundancy payment and paid pursuant to an early retirement scheme. There are two elements: 1. a tax-free amount; and

2. an ETP (being the remainder). The tax-free amount is calculated by reference to a ‘base amount’ and a ‘service amount’, the latter multiplied by the years of service. Each of the amounts is indexed. For 2017–18, the relevant amounts are: base amount: $10,155; service amount: $5078 for each year of service.

Cloggs worked in the car industry and was made redundant following an industry restructure. Under a negotiated redundancy package, Cloggs received $5000 plus $2000 for each year of completed service in 2017. Cloggs worked with the firm for 25 years and received $55,000. (i) The amount is below the 2017–18 threshold and is tax free in Cloggs’s hands. (ii) Suppose instead that Cloggs receives $140,000: Base amount = $10,155 Service amount = 25 × $5078 = $126,950 $10,155 + $126,950 = $137,105 (tax free) The balance, $2895, is an ETP subject to cap limits, as above.

Divisions 301–307: Superannuation benefits 5.39 Superannuation benefits are excluded from the definition of ETPs: s 82-135(a). Two milestones have occurred in the taxation of these retirement payments: in 1983 — when taxation of superannuation funds commenced and payments (‘taxed elements’) from such funds were concessionally taxed; and in 2007 — when the ITAA36 legislation (ss 27A–27H) was displaced by ITAA97 Divs 301–307. Before 2007, common rules applied to ‘eligible termination payments’, irrespective of whether they were from employers or superannuation funds. The payments attracted different tax rates

depending on whether they were ‘taxed elements’ (from complying superannuation funds) or ‘untaxed elements’ and whether the amounts [page 258] were within ‘reasonable benefit limits’ (RBLs). RBLs were abolished from 1 July 2007. Employer or individual contributions in excess of the relevant caps are subject to tax, but with the option of releasing excess non-concessional contributions from the superannuation fund. Superannuation benefits are listed in s 307-5. Benefits may be paid to: a fund member (‘superannuation member benefit’); another person upon the death of a member (‘superannuation death benefit’); and they may be paid as: a lump sum; or an income stream benefit (basically a pension or annuity). The components of a superannuation member benefit include: a tax-free component; and a taxable component. As with other retirement and allied payments, the tax-free component largely reflects amounts formerly only 5% assessable or otherwise ‘tax exempt’ or attracting concessional tax treatment. The tax-free component is made up of: the contribution segment, being post-July 2007 (non-deductible) contributions non-assessable to the superannuation fund (s 307220); and the crystallised segment, being the amount of the several components of the ETP assuming it was paid just before 1 July 2007. The crystallised segment components are essentially the CGT-exempt component, the pre-July 83 component, undeducted post-1983 5.40

contributions, post-June 1994 invalidity component and certain pre-July 1994 concessional components. The taxable component is the superannuation interest less the tax-free component. Generally, it will be an element taxed in the superannuation fund (but if the 15% contribution tax has not been paid, it is ‘untaxed’). 5.41 The table in s 307-5 illustrates what a superannuation benefit is. In general, it comprises: column 2: benefits paid to members of a fund; and column 3: superannuation death benefits. These benefits are taxed according to the age of the member and the low rate cap, with the following table assuming that the taxable component has been taxed in the superannuation fund: Age

Lump sum

Income stream

60+

Tax free

Tax free

Preservation age — 59

$200,000 at 0% up to ‘low rate cap’ amount: s 307-345 Amounts above $200,000 receive an offset so that the maximum rate is 15%

Marginal rates with offset equal to 15% of taxable component: s 301-25

[page 259] Age Below preservation age

Lump sum Normal rates apply to the taxable component, subject to an offset such that the maximum rate is capped at 20%

Income stream Marginal rates: to maximum no offset

Medicare levy and Temporary Budget Repair levy are added as applicable.

In 2017–18, Jay, aged 57, receives a lump sum superannuation benefit of $450,000. The tax-free component (post-2007 contributions and the crystallised component) is $110,000. The taxable component is therefore: $450,000 − 110,000 = $340,000 The low rate cap is $200,000, meaning $340,000 is assessable at marginal rates of tax, but with a tax offset reducing the tax rate on the first $200,000 to 0% and with $140,000 subject to a tax offset that caps the maximum marginal rate at 15%. That is: 2017–18 tax on $340,000 = $126,232, being $63,232 on the first $200,000 and $63,000 on the remaining $140,000* Income up to $18,200 is tax free Income $18,201 to $37,000 taxed @ 19% → tax offset [$37,000 − $18,200] × 0.19 = $3572 Income $37,001 to $87,000 taxed @ 32.5% → offset $50,000 × 0.325 = $16,250 Income $87,001 to $180,000 taxed @ 37% → offset $93,000 @ 0.37 = $34,410 Income $180,001 to $200,000 taxed @ 45% → offset $20,000 @ 0.45 = $9000 Total offset in respect of the first $200,000: $63,232 Tax on the first $200,000 is $0 (and no Medicare levy applies: ITAA36 s 251S(1A)) Income $200,001 to $340,000 taxed @ 45% → offset $140,000 @ 0.30 = $42,000 Total offset in respect of the further $140,000: $42,000 Tax on further $140,000: $63,000 − 42,000 = $21,000 (+ Medicare; *the ‘Budget Repair levy’ of 2% on income > $180,000 does not apply from 1 July 2017).

[page 260] 5.42 Under Column 3 of s 307-5, superannuation death benefits are payments made after another person’s death. A superannuation lump sum death benefit paid to a dependant is tax free: s 302-60. An income stream benefit paid to a dependant from a tax element is tax free if either the deceased or the dependant is aged 60 or more. If both the dependant and the deceased are less than 60, the tax-free component is tax free and the taxable component is assessed at marginal rates with a tax offset equal to 15% of the taxable component. Post-2007, under superannuation industry regulations, nondependants can receive only lump sum benefits. The taxable component

is assessable at marginal rates with a tax offset to cap maximum rates at 15%. Any untaxed element is capped at 30%. For the trustee of a deceased estate, benefits paid are taxed the same way if the benefit flows to a dependant. If not, the benefit is taxed as if it flows to a non-dependant. Note, Div 82 ETPs and Div 302 superannuation death benefits are deemed to be income to which no beneficiary is presently entitled: ITAA36 s 101A.

Non-superannuation annuities 5.43 ITAA36 s 27H continues to apply to non-superannuation annuities and pensions (such as foreign-sourced pensions or purchased annuities). The provision includes a portion of those payments in assessable income. In the case of purchased annuities, the assessable income includes the payment less the ‘deductible amount’ which represents the undeducted purchase price of the annuity, based on the recipient’s life expectancy, calculated in accordance with s 27H(2):

Where: A = share of the annuity (usually 100% or 1, unless jointly received: 0.5). B = undeducted purchase price. C = the value specified in the agreement as the residual capital value. There is no payment in the case of a life annuity, so C = 0. D = number of years of the annuity or the life expectation factor for a life annuity.7

Elle retired in 2017 aged 65 and became entitled to an annuity for life of $14,000 pa. Assume an undeducted purchase price of $20,000. The life expectation factor for a female aged 65 is 22.05 (19.22 for a male). 1 × $20,000/22.05 = $907 Assessable income is $14,000 − 907 = $13,093.

[page 261]

John has been employed by Big Co Ltd since 1982. As a result of tariff cuts and industry restructuring, John’s employment is terminated on 30 June 2018. He is 57 years of age. He receives the following payments:

Salary 2017–18 Approved early retirement scheme: Payment in lieu of 4 weeks AL* Payment in lieu of LSL** Payment from (taxed) superannuation fund

$85,000 75,000 1,650 31,250 350,000

(John’s post-July 2007 contributions to the employer-sponsored fund were $20,000. His crystallised component at 1 July 2007 was $135,000.) * Assume all the annual leave entitlements accrued in 2017–18. ** Assume no long service leave has been taken. Indicate how the amounts are taxed and determine his tax liability. A suggested solution is in Study help.

The remaining ITAA36 and ITAA97 framework 5.44

Several survivors of ITAA36 s 26, or the additions to and

descendants from this framework, continue to operate albeit in modified form and some with limited or residual effect. The chief provisions are: ITAA36 s 26BB (gains on disposal of traditional securities); ITAA36 Pt III Div 13A (employee share acquisition schemes — formerly ITAA36 s 26AAC).

ITAA36 s 26BB: Gains on disposal of traditional securities 5.45 Where a taxpayer carries on a business that involves dealing in securities, gains made on the realisation of the securities are of an income nature, assessable under ITAA97 s 6-5. Similarly, in the case of financial intermediaries, commercial houses or insurance companies, gains made in the reorganisation of investments or even the shifting of investment activity to a subsidiary are likely to be income in nature. In the hands of dealers in securities and shares, the items are trading stock. Where a taxpayer merely invests in securities, the traditional return is in the form of interest which is income from property. A gain made on the sale of investments by a passive investor is a capital receipt: California Copper Syndicate v Harris (1904) 5 TC 159. Such gains fall within the CGT provisions: see Chapter 6. [page 262] ITAA36 Pt III Div 16E provides machinery to accrue over the life of the instrument any additional return on discounted or deferred interest securities (other than trading stock) rather than taxing the additional gain on maturity: see 4.33. Thus, in respect of ‘qualifying securities’ to which Div 16E applies, there are two components of ‘interest’: the nominal return on face value; and the accrued gain on redemption. ‘Qualifying securities’ are defined in ITAA36 s 159GP to mean debt

instruments (as opposed to equity) such as stock, bonds, debentures and promissory notes that have an ‘eligible return’. A security to which Div 16E applies has an eligible return if the sum of payments other than periodic interest exceeds 1.5% of the payments multiplied by the term of the security. ITAA36 s 26BB applies to ‘traditional securities’ being bonds, debentures, etc, but not securities to which Div 16E applies and not shares or trading stock. In effect, a traditional security is any instrument that is not a qualifying security. It follows that s 26BB applies to gains made on the disposal of securities that do not have an ‘eligible return’ or the return is less than the 1.5% benchmark. Its effect is to assess any gain realised on redemption.

A invests in a two-year inflation-indexed security with a face value of $1000 at 10% interest pa. Assume the inflation factor is identified as 5% pa. The security has an ‘eligible return’ (excluding periodic interest) exceeding 1.5%, being: 5% × $1000 × 2 = 100/1000 = 10% Therefore, ITAA36 Div 16E applies. The eligible return is deemed to be derived over the life of the security. B invests in debentures with a face value of $1000 at 12.5% interest pa for five years. A debenture is a ‘traditional security’. When interest rates fall to 7.5% the debentures are redeemed at the end of year 2 at a premium of $100. There is no eligible return. Section 26BB(2) applies to assess the gain of $100 on redemption.

For securities redeemed at a discount, ITAA36 s 70B provides a deduction. Gains and losses also fall within the capital gains provisions. However, a gain assessable under s 26BB is excluded from the CGT provisions by ITAA97 s 118-20 and losses are accommodated through the reduced cost base: ITAA97 s 110-55. It is easy to imagine circumstances where gains on traditional securities would be of a capital nature. For example, where a taxpayer invests in an interest-bearing security that does not have an ‘eligible

return’ and it is redeemed at a premium, the gain on its realisation is capital in the classic mould of California Copper Syndicate v Harris (1904) 5 TC 159. Therefore, the objects of Div 16E and s 26BB are not [page 263] the same. In the general case, the former simply advances the point of derivation of an income amount; the latter extends assessment to capital. That is, s 26BB is a statutory extension to ordinary income.

Employee share schemes (ESS) 5.46 Employee share schemes cover arrangements where employees can acquire shares at discounts or rights to acquire shares at a price less than their market value. At first blush, these arrangements appear to yield benefits that are either income by ordinary concepts or a benefit of employment within the ambit of the former ITAA36 s 26(e) or ITAA97 s 15-2. Alternatively, they seem to be benefits within the meaning of the Fringe Benefits Tax Assessment Act 1986 (Cth) (FBTAA).8 Instead, for reasons discussed below, specific provisions have been drafted: first, ITAA36 s 26AAC, then ITAA36 Div 13A and, from 2009–10, ITAA97 Div 83A. In simple cases, such as where an employee is given rights to take up shares at less than market value, the benefit represents money’s worth and is assessable: Weight v Salmon (1935) 19 TC 174. However, where restrictions are attached either to the exercising of the rights or the subsequent sale of the shares, questions arise as to when the benefit arises and how it is to be valued. The problem is illustrated in Abbott v Philbin [1961] AC 352, where a company secretary acquired for £20 in October 1954 an option to take up 2000 shares at 68s 6d per share. The option was nontransferable and expired at the earliest of 10 years, the taxpayer’s retirement or his death. There was no restriction on the transfer of the shares. In March 1956, the taxpayer exercised his option in respect of

250 shares. At the time, the market value of the shares was 82s. The taxpayer was assessed on the profit of £148-15-0 (that is [250 × 13s 6d] − £20) as arising in March 1956. The taxpayer contended that the assessable amount was the value of the option and that the gain arose in October 1954 when the option was granted. The Inspector of Taxes argued that, since the option was non-transferable, it was not convertible into money until it was exercised. A majority of the House of Lords allowed the taxpayer’s appeal. To come within Sch E of the UK statute, there had to be a perquisite or profit from employment. The gain on the sale of the shares was not such a gain from office. The only gain that arose from employment was the initial grant of the option. The relevant profit arose in October 1954 when the option was granted. The fact that it was non-transferable did not mean that it could not be converted into money. It did not have to be sold to be so converted. It could be turned to pecuniary account by exercising the option and selling the shares. The importance of the decision in Abbott v Philbin becomes clear when the majority’s two-step reasoning is examined. The first step was the grant of a right [page 264] to acquire shares. This was a benefit of employment, but the value of the benefit is likely to be low. The second step was the exercise of the right. An economically rational taxpayer will exercise the right when the share price differential is greatest. This is the real gain, but the House of Lords considered that this gain was insufficiently connected with Abbott’s employment. In an Australian context, it follows that, where restrictions apply to the exercise of rights, ITAA97 s 6-5 may not apply because the benefit is not convertible into money. However, there was a benefit in terms of the former ITAA36 s 26(e). The Commissioner of Taxation applied the principle in Abbott v Philbin to assess the taxpayer under former ITAA36 s 26(e) in Donaldson v FCT [1974] 1 NSWLR 627; 4 ATR 530; 74 ATC 4192. In

that case, a share acquisition scheme operated to reward employees for satisfactory performance. The taxpayer acquired a number of options that were exercisable at different times on completion of three successive periods of satisfactory performance. The facts differ from Abbott v Philbin, therefore, in that the benefit could not be converted to money through the hypothetical acquisition and sale of the shares in the year the right was acquired. However, it will be recalled that s 26(e) assessed the ‘value to the taxpayer’ and did not rely upon convertibility for its application. The Commissioner assessed the options at a value determined by a fairly arbitrary process. The value was disputed by the taxpayer who argued in addition that there was no benefit, only a future expectation. In the Supreme Court of New South Wales, Bowen CJ was not convinced that rights to shares that were traded on the Stock Exchange had no immediate value or were incapable of valuation, although there was room for argument as to what that value might be. The Chief Justice said (at NSWLR 645–6): If by placing a value on options one means stating a precise figure which will prove to be correct, then one would agree that in the case of a complex set of rights involving a multiplicity of contingencies the task is an impossible one. But if by placing a value on rights one refers to the formation of a judgment of what the rights might be worth, or what some willing but not anxious person might be prepared to give, rather than fail to obtain them, then I do not think it can be said that valuation in this sense is impossible. The courts are accustomed to dealing with difficult questions of valuation where opinions may differ, but where a figure has to be arrived at. Again, in the ordinary affairs of life, the multiplicity of contingencies which renders precise valuation impossible does not deter people from laying out their money, whether it is a premium for insurance, a bet on a racehorse, the purchase of wool futures or the acquisition of convertible notes. I am not convinced that it is impossible to place a value on the option rights in the present case.

Former ITAA36 s 26AAC 5.47 The result of these decisions was that (in pre-CGT days) the profit on the exercise of the option would escape taxation. ITAA36 s 26AAC was enacted in 1974 to counter this. The taxable event was made the exercise of the option, not the grant of the option. Under s 26AAC, where a taxpayer acquired a share under an ESS, the excess of the value of the share over the amount paid was assessable in the year

of acquisition. If the taxpayer disposed of a right to a non-associate, the excess of the consideration over the price paid was assessable in the year of disposal. [page 265] A share or right to acquire a share is part of an ESS if acquired by a taxpayer or relative ‘in respect of, or for or in relation directly or indirectly to, any employment of or services rendered’. Some difficulties are immediately apparent. By extending the operation of s 26AAC to relatives (and the scheme of the provision would be largely unworkable if it did not cover relatives), income splitting was sanctioned. It is evident too that shares or rights issued other than to the taxpayer or a relative (such as a company or trust) fell outside s 26AAC: Fraunschiel v FCT (1989) 20 ATR 955; 89 ATC 4616.9 In 1995, ITAA36 Pt III Div 13A (ss 139–139GH) was enacted to cover employee share acquisition schemes. Section 26AAC continued to apply as a transitional measure. ITAA97 Div 83A applies from 2009– 10.

Former ITAA36 Pt III Div 13A 5.48 ITAA36 Div 13A applied from 28 March 1995 to 30 June 2009. It continues to apply to arrangements entered into before July 2009. It applied where an employee (or associate) acquired a share or right in respect of employment or provision of services for an amount less than the market value of the share or right. The assessable amount was the discount. Subsequent sale of the share would be a CGT event A1: see 6.61. The Division provided machinery to value shares and rights and also provided concessional tax treatment for ‘qualifying shares and rights’ as to either the taxable amount or the taxing point in time.

Qualifying shares or rights 5.49

The thrust of ITAA36 Div 13A was to assess the discount on

shares or rights acquired. ‘Qualifying’ shares (or rights) provided two concessions: 1. the opportunity to defer assessment of the discount (for up to 10 years) on shares where the sale was restricted or there was the possibility of forfeiture; and 2. an election to have the discount assessed, subject to a $1000 annual exemption. Shares or rights were considered to be ‘qualifying’ when they were ordinary shares or rights to acquire ordinary shares acquired by an employee in the employer company (or a holding company) and, immediately after the acquisition, the employee did not directly or indirectly hold more than 5% of the votes at a general meeting. Further, at least 75% of permanent employees must have been entitled to acquire shares or rights under the scheme or under another employee share scheme: ITAA36 s 139CD. Where these conditions were satisfied, there was an automatic deferral of the point of taxation unless the employee elected to be assessed on the discount at the time of acquisition. By so electing, the employee may have been eligible to be taxed on a reduced amount. That is, the advantage of qualifying shares or rights was that the point of taxation could be deferred for up to 10 years or the amount taxable could be reduced by $1000 per employee. [page 266] Deferral: If the point of taxation was deferred, the assessable amount was the market value of the share or right at the cessation time reduced by any consideration paid for the share and the right. (The cessation time is the earliest of: the lifting of restrictions to sell, when forfeiture conditions expire, an actual disposal, cessation of employment or after 10 years.) Reduced assessable amount: Where an employee elected to be

taxed at the point of acquisition (on all shares and rights acquired in a particular year), subject to further conditions, the assessable amount could be reduced by a maximum of $1000 per employee. The election could be made annually in relation to new rights or shares. (Further requirements were that no forfeiture conditions exist, no disposal occurred for three years (or cessation of employment) and the ESS plus any financial assistance to acquire shares or rights must be non-discriminatory.)

ITAA97 Div 83A 5.50 ITAA97 Div 83A applies where ESS interests are acquired at a discount from 2009–10 onwards. The discussion below relates to Div 83A as amended in 2015 to apply to ESS interests acquired from 1 July 2015. An ESS is a scheme under which interests are provided to employees or their associates. Such interests are specifically excluded from the definition of fringe benefits: FBTAA s 136(1)(h). The taxation of ESS interests under Div 83A is similar to ITAA36 Div 13A, but there is no choice of taxing points: Deferral: Taxation of the discount is deferred where there is a real risk of forfeiture or where the interest is acquired under a salary sacrifice arrangement. Upfront: Taxation of the discount upfront is the general or default position.

Deferral or upfront taxation Deferral of taxation can occur only where there is: a real risk of forfeiture; or a salary sacrifice arrangement. An ESS interest is at real risk of forfeiture if a reasonable person would consider there to be a genuine risk that the employee would lose or forfeit the interest. In this case, the ‘ESS deferred taxing point’ is the earliest of: the real risk of forfeiture has come to an end and any restrictions on disposal have lifted, the employee’s cessation of 5.51

employment, 15 years after the acquisition of the shares or, if the interests are rights and the rights have been exercised, there is no real risk of forfeiture of the shares acquired and any restrictions on disposal of the shares have lifted. Deferral of taxation also applies where: shares (but not rights) are acquired under a salary sacrifice arrangement and the total market value of the interests does not exceed $5000; and rights (but not shares) are acquired under a scheme whose rules state that Subdiv 83A-C (deferral) applies and that genuinely restricts the acquirer from immediately disposing of the right. [page 267] Under the deferred tax arrangement, assessable income includes the market value of the ESS interest reduced by its cost base: ITAA97 s 83A-110(1). In the general case, the discount on an ESS interest is taxable at the point of acquisition. The discount is the market value of the interest less any consideration paid by the employee and it is assessable in the year of receipt: s 83A-25(1). Similarly to schemes covered by ITAA36 Pt III Div 13A, there is a $1000 exemption if the following conditions are satisfied: the ESS interests are not at real risk of forfeiture; the employee’s taxable income (including reportable fringe benefits and superannuation contributions and total net investment losses) does not exceed $180,000; the ESS interests relate to ordinary shares; the employee is employed by the company, or a subsidiary of the company, issuing the ESS interests; the scheme operates in a non-discriminatory way in relation to at least 75% of employees with three years or more service; the scheme is operated so that every acquirer of an ESS interest is

not permitted to dispose of the interest (or shares acquired as a result of the interest) for three years (or such lesser period as the Commissioner allows), or until employment ends; and the employee does not hold more than 10% ownership of the company. Further concessions are available for eligible start-up companies.

Other matters In-house dining facilities 5.52 ITAA97 s 32-70 includes in assessable income an amount of $30 for each meal provided to non-employees in an in-house dining facility. This provision is part of a broader Div 32 ‘Entertainment expenses’, discussed in 9.54ff. The effect is that an election may be made to deduct the excess over $30 of costs of providing the meal to non-employees (that would otherwise satisfy s 8-1) in an ‘in-house dining facility’.

Foreign exchange gains/losses 5.53 Foreign exchange gains (losses) on revenue account were assessable (deductible) under the general provisions: ITAA97 s 6-5 (s 81): see 3.21. Until the enactment of the New Business Tax System (Taxation of Financial Arrangements) Act 2003 (Cth) (applying from 1 July 2003), exchange gains (losses) on capital account arising under an ‘eligible contract’ were assessable under ITAA36 Pt III Div 3B: ss 82U– 82ZB. To fall within Div 3B, the gain must have been of a kind that, had it been a loss, would not have been deductible under ITAA97 s 8-1 only because it was of a capital nature. Until the enactment of the above legislation, ITAA36 s 20 required the income and expenses (wherever derived or incurred) to be converted into Australian currency. [page 268]

New conversion rules are contained in ITAA97 Subdivs 960-C and 960D. Essentially, this means that all amounts and values relevant to calculating an entity’s tax liability are to be converted to Australian currency and rules specify the exchange rate to be used: ITAA97 s 96050(1). 5.54 The taxation of financial arrangements legislation introduced new rules for the taxation of foreign exchange gains/losses: ITAA97 Div 775. The thrust of Subdiv 775-A is that all foreign currency gains and losses (‘forex gains/losses’) are brought to account as assessable income/deductions when realised, irrespective of whether they are on revenue or capital account. The new legislation generally prevails over assessing/deducting provisions elsewhere in the Acts (though not over Div 230, as to which, see 5.55 below). The gain (loss) is not assessable to the extent that it is of a private or domestic nature (unless the CGT provisions apply, having regard to the fact that foreign currency is a CGT asset). Forex realisation gains or losses arise from the happening of ‘forex realisation events’ (FREs). There are five main FREs: 1. Forex realisation event 1: Occurs when an entity disposes of foreign currency (or a right to receive it). This is a CGT event A1 (see 6.25) and the realisation gain/loss is calculated under the CGT provisions (disregarding ITAA97 s 118-20). 2. Forex realisation event 2: Occurs when an entity ceases to have a right to receive foreign currency, for example, where the right is discharged by receipt of payment. A gain arises where the receipt in respect of the event exceeds the forex cost base. 3. Forex realisation event 3: Happens when an entity ceases to have an obligation to receive foreign currency; typically where an entity fulfils such an obligation or where an option to sell expires or is cancelled. 4. Forex realisation event 4: Occurs where a taxpayer ceases to have an obligation (of the type listed in s 775-55) to pay foreign currency. 5. Forex realisation event 5: Occurs if a taxpayer ceases to have a

right to pay foreign currency.

Taxation of financial arrangements stages 3 & 4 5.55 The next stage in the taxation of financial arrangements was ITAA97 Div 230. It sets out the timing and methods by which gains and losses from ‘financial arrangements’ will be brought to account for tax purposes and applies from 1 July 2010. ‘Financial arrangements’ include a range of debts, such as loans, promissory notes and debentures, as well as risk-shifting derivatives, such as swaps and options. Generally, Div 230 applies to deposit-taking institutions with an aggregate turnover of more than $20m per year and other entities satisfying threshold asset values or turnover of $100m per year. Division 230 would impact in some circumstances on the discussion in this chapter — especially of 26BB (see 5.45) and of foreign exchange gains and losses (see 5.53). The TOFA rules are discussed further at 4.1. 1.

2. 3.

4.

5.

6.

7. 8.

Analysis of the 1936 Act in terms of central and parallel provisions derives from the work of Professor Parsons: see R W Parsons, Income Taxation in Australia, Law Book Co, Sydney, 1985, Ch 1, for an outline of the issues; R W Parsons, ‘The Meaning of Income and the Structure of the Income Tax Assessment Act’ (1978) 13 Taxation in Australia 378– 409. The payment of school fees for the child of a managing director was held to be a benefit for the managing director under ITAA36 s 26(e). Windeyer J’s statement of the purpose of ITAA36 s 26(e) was endorsed in Blank v FCT (2016) 258 CLR 439; 338 ALR 533 at [71] per French CJ, Kiefel, Gageler, Keane and Gordon JJ. Several High Court decisions before the enactment of ITAA36 s 26(a) and the decision in FCT v Myer Emporium Ltd (1987) 163 CLR 199; 87 ATC 4363 suggest this is not so: see Blockey v FCT (1923) 31 CLR 503; Scarborough v FCT [1924] R&McG 48; Ruhamah Property Co v FCT (1928) 41 CLR 148; Jolly v FCT (1933) 50 CLR 131. Withholding tax is a final liability to Australian tax imposed on non-residents on three classes of income: dividends, interest and royalties. It requires residents remitting such income to ‘withhold’ tax at specified rates: see ITAA36 s 128B. This is so despite the exclusion in s 20-20(1) that an amount is not an assessable recoupment to the extent that it is ordinary income (or statutory income under another provision). There will be circumstances where a recovery of a formerly deductible amount is ordinary income: Sinclair’s case. The point is that there is no rule of law that makes a recovered amount ordinary income just because it was previously deductible. Life tables are published by the Australian Government Actuary: . A benefit constituted by the acquisition by a person of a share or right under an employee

9.

share scheme within the meaning of ITAA36 s 26AAC, ITAA36 Pt III Div 13A or ITAA97 Div 83A was or is excluded from the definition of ‘fringe benefit’ by para (h) or (ha) of that definition in s 136(1) of the FBTAA. Proposals in 1994 to include the benefits in FBT were withdrawn in favour of new machinery in ITAA36 Pt III Div 13A. ESS are excluded from ITAA97 s 15-2 by s 15-2(3)(e). Assuming the entity does not provide services to the employer or that the benefit is constructively received. In the latter case, Abbott v Philbin applies and, in a pre-CGT situation, any gain on the sale of the shares remains tax free. Other difficulties are illustrated in FCT v McArdle (1988) 19 ATR 1901; 89 ATC 4051.

[page 269]

CHAPTER

6

Capital Gains Tax Learning objectives After studying this chapter, you should be able to: outline the fundamentals of capital gains tax (CGT); locate a CGT event that is relevant to a given set of facts; work out how CGT rules apply to certain CGT events; identify a CGT asset; calculate the cost base of a CGT asset; determine what the capital proceeds are for a CGT event; list some major CGT exemptions; explain how roll-over provisions work.

Introduction Australian capital gains tax: A very brief history 6.1 We saw in Chapter 2 and Chapter 3 that under the ordinary concept of income used in Australia a distinction was drawn between capital and income receipts. Income receipts were taxable, while capital receipts, in the absence of specific statutory provisions to the contrary, escaped taxation. In Chapter 2, we noted that under the economists’ gain notion of

income all increases in a taxpayer’s net wealth in a fiscal period would be regarded as income. The failure of the Australian income tax system to adopt such a comprehensive concept of income was regarded in the Treasury Draft White Paper of 1985 as leading to a lack of horizontal equity, modifications of taxpayer behaviour and, thus, an inefficient income tax.1 Prior to 1985, statutory provisions had been enacted that taxed certain short-term and speculative gains. These were regarded as inadequate in the 1985 Treasury Draft White Paper. The short-term gains provision was criticised because it applied only to profits made on the realisation of assets held for less than one year. The speculative gains provision was criticised because its first limb required ascertaining the subjective dominant purpose of the taxpayer and was, thus, uncertain. Furthermore, [page 270] the interpretation of the speculative gains provision by the courts left little scope for its operation independently of the ordinary concept of income from an isolated business venture.2 A general capital gains tax (CGT) was introduced in 1985 in answer to these and other criticisms of the previous Australian system. A new Part, Pt IIIA, was inserted into the Income Tax Assessment Act 1936 (Cth) (ITAA36). The broad effect of Pt IIIA was to include certain net capital gains in the assessable income of the taxpayer who made them. The CGT provisions were rewritten as part of the Tax Law Improvement Project (TLIP). This rewrite involved major changes to the fundamental structure of CGT. Most notably, the rewrite introduced the concept of CGT events, which is discussed in detail in 6.24–6.56. As a consequence of recommendations by the 1999 Review of Business Taxation, A Tax System Redesigned (the Ralph Review), significant changes to CGT were made effective from 21 September 1999. These changes included:

the removal of averaging; the freezing of CGT indexation; the introduction of CGT discounts for natural persons, superannuation funds and trusts; and the exclusion of most gains on plant from the CGT regime. One of the recommendations of the 2009 Review of Australia’s Future Tax System (the Henry Review)3 was that a 40% savings income discount be provided to individuals for non-business-related: (a) net interest income; (b) net residential rental income (including related interest expenses); (c) capital gains (and losses); and (d) interest expenses related to listed shares held by individuals as non-business investments. In conjunction with introducing the discount, the Henry Review recommended that further consideration should be given to how the boundaries between discounted and non-discounted amounts best be drawn to achieve certainty, reduce compliance costs, and prevent labour and other income being converted into discounted income. The Henry Review also recommended that further consideration be given to addressing existing tax law boundaries related to the treatment of individuals owning shares in order to address uncertainties about when the shares are held on capital account (and are subject to capital gains tax) and on revenue account (and are taxed as ordinary income). A further recommendation of the Henry Review was that the CGT regime should be simplified by: [page 271] (a) increasing the exemption threshold for collectables and exempting all personal use assets; (b) rationalising and streamlining the current small business

capital gains tax concessions; (c) removing current grandfathering provisions relating to assets acquired before the commencement of capital gains tax, with a market value cost base provided for those assets when the exemption is removed, or before the end of previous indexation arrangements; … and (d) rewriting the capital gains tax legislation using a principlesbased approach that better integrates it with the rest of the income tax system.4 The Rudd Government’s response to the Henry Review recommendations included a specific statement that it would not at any stage: Reduce the CGT discount, apply a discount to negative gearing deductions, or change grandfathering arrangements for CGT (see Rec 14 & 17c).5

Neither the Rudd nor Gillard governments made further comment in relation to the other recommendations, set out above, made by the Henry Review in relation to CGT. The Gillard Government’s Tax Forum Discussion Paper, released on 28 July 2011 in the lead-up to the Tax Forum held in Canberra on 4 and 5 October 2011, stated that the then government’s policy was not to apply a discount to negative gearing deductions.6 The Tax Forum Discussion Paper does not contain specific comments on any of the other proposals by the Henry Review mentioned above. The Abbott Government, elected in 2013, announced that a White Paper on tax reform would be produced during the term of the current parliament. The government released a tax discussion paper titled Re:Think on 30 March 2015. The government indicated that it intended to issue a Green Paper setting out tax reform options later in 2015, and that, following consultation, a White Paper containing policy proposals would be released in 2016. A Green Paper was not released in 2015. At the time of writing, neither a Green Paper nor a White Paper has yet been released.

Approaches to taxing capital gains in OECD countries

6.2 Ault has identified three major approaches to the taxation of capital gains that are used in OECD countries.7 Under what Ault describes as the continental approach, all business gains are regarded as taxable without any distinction being made between capital and income receipts. When this approach is taken, however, a sharp distinction is drawn between the capital and income receipts of taxpayers who are not in business. In continental [page 272] systems, these results are a consequence of the basic concept of income used in the system rather than the product of specific statutory provisions. By contrast, under what Ault describes as the commonwealth approach, case law drew a sharp distinction between income and capital receipts for both business and non-business taxpayers. In the absence of specific statutory provisions, income was regarded as taxable whereas capital receipts were not. When countries coming from this tradition decided to tax capital gains they tended eventually to tax capital gains comprehensively for both business and non-business taxpayers. To do this, they needed to enact extensive and detailed statutory provisions that deemed certain capital gains to be assessable. In countries that adopted what Ault describes as a global approach, courts had developed a basic concept of income that was broad enough to include all realised gains. Somewhat ironically, these systems then tended to develop statutory rules that distinguished between income and capital gains. The statutory distinction between ordinary income and capital gains was drawn for the purpose of giving preferential treatment to capital gains. Prior to the changes resulting from the Ralph Review effective from 21 September 1999, the general capital gains tax in Australia clearly was an example of the commonwealth approach. The need for its enactment can be traced to the inadequate concept of income developed by the courts. If the possible broadening of that concept of income by

the decision in FCT v Myer Emporium Ltd (1987) 163 CLR 199; 18 ATR 693; 87 ATC 4363 had happened earlier, that need might not have been so apparent. As it happened, very detailed and comprehensive statutory provisions were enacted with the aim of including certain net capital gains in assessable income. Since 21 September 1999, the removal of most CGT preferences for companies means that the Australian CGT system is now somewhat similar to a continental system.

Scope of this chapter 6.3 This chapter begins by outlining the fundamentals of the Australian CGT rules. This is done by working through Pt 3-1 Div 100 of the Income Tax Assessment Act 1997 (Cth) (ITAA97), which is a guide to capital gains and losses. This section of the chapter will explain how a net capital gain is calculated, how it is included in your assessable income, and how to determine the correct tax rate that applies to a net capital gain. The chapter then explains the concept of CGT events, which is central to the operation of the CGT provisions in the ITAA97. You will be asked to refer to the Study help and to read through a summary of CGT events that is contained in the ITAA97. We shall work through some short problems to assist you in developing skills in finding the most appropriate CGT event. Then we shall examine in detail some of the CGT events that can affect all types of taxpayers. The events examined will include: the disposal of an asset; the loss or destruction of an asset; the cancellation or surrender of an asset; and the creation of contractual or other rights. For each of these events, we shall examine the elements of the event and how a capital gain or loss from the event is calculated. [page 273] The balance of the chapter is a detailed examination of the

constituent elements in CGT event A1 — disposal of a CGT asset — by using an extended case study. Suggested solutions to the various elements in the extended case study can be found in the Study help. CGT event A1 is probably the most common CGT event. In our examination of CGT event A1, we will discuss most of the important concepts that are used in the CGT provisions in the ITAA97. This chapter does not discuss all the CGT provisions in the ITAA97. In particular, it does not discuss the following provisions: provisions relevant only to companies and shareholders (see Chapter 12 and Chapter 13); provisions relevant only to partners (see Chapter 14); provisions relevant only to trustees and beneficiaries (see Chapter 15); the effects of death (see Chapter 15); certain roll-over provisions; the general value shifting regime (see Chapter 13); or the application of CGT to foreign residents (see Chapter 18).

Fundamentals of CGT 6.4 ITAA97 Div 100 of Pt 3-1 is a guide to CGT. Under this heading, we will work through Div 100 and refer to relevant operative provisions to explain the fundamentals of CGT. This should help you to appreciate: how CGT fits into the ITAA97; and what is meant by some of the basic concepts used in CGT.

Where CGT fits in the ITAA97 6.5

ITAA97 s 100-10(1) explains that:

CGT affects your income tax liability because your assessable income includes your net capital gain for the income year. …

The operative provision that includes a net capital gain in your assessable income is s 102-5(1), which says: Your assessable income includes your net capital gain (if any) for the income year. …

As we saw in earlier chapters, capital gains and capital receipts are not income under ordinary concepts. Hence, a net capital gain that is not ordinary income, [page 274] but which is included in your assessable income via s 102-5(1), will be statutory income for the purposes of s 6-10. This means that the different jurisdictional rules set out in s 6-10(4) and (5)(b) that apply to residents and foreign residents will apply to net capital gains that are included in assessable income. See the discussion in 2.32.

Review the discussion in 6.2 of the different approaches that countries take to taxing capital gains. What effect, if any, do you think the ordinary concept of income in Australia had on the type of capital gains tax that Australia ultimately adopted?

How is a net capital gain calculated? 6.6 Note that the amount included in your assessable income by ITAA97 s 102-5(1) is ‘your net capital gain (if any) for the income year’. Section 100-10(1) contains the following brief explanation of what a net capital gain is: … Your net capital gain is the total of your capital gains for the income year, reduced by certain capital losses you have made.

A more detailed explanation of how to calculate a net capital gain is contained in the operative provision s 102-5(1),8 which explains how this is done in a series of steps. 102-5 Assessable income includes net capital gain (1) Your assessable income includes your net capital gain (if any) for the income year. You work out your net capital gain in this way: Working out your net capital gain Step 1 Reduce the capital gains you made during the income year by the capital losses (if any) you made during the income year. Note 1: You choose the order in which you reduce your capital gains. You have a net capital loss for the income year if your capital losses exceed your capital gains: see section 102-10. [page 275] Note 2: Some provisions of this Act (such as Divisions 104 and 118) permit or require you to disregard certain capital gains or losses when working out your net capital gain. Subdivision 152-B permits you, in some circumstances, to disregard a capital gain on an asset you held for at least 15 years. Step 2 Apply any previously unapplied net capital losses from earlier income years to reduce the amounts (if any) remaining after the reduction of capital gains under step 1 (including any capital gains not reduced under that step because the capital losses were less than the total of your capital gains). Note 1: Section 102-15 explains how to apply net capital losses. Note 2: You choose the order in which you reduce the amounts. Step 3 Reduce by the discount percentage each amount of a discount capital gain remaining after step 2 (if any). Note: Only some entities can have discount capital gains, and only if they have capital gains from CGT assets acquired at least a year before making the gains: see Division 115. Step 4 If any of your capital gains (whether or not they are discount capital gains) qualify for any of the small business concessions in Subdivisions 152-C, 152-D and 152-E, apply those concessions to each capital gain as provided for in those Subdivisions. Note 1: The basic conditions for getting these concessions are in Subdivision 152-A. Note 2: Subdivision 152-C does not apply to CGT events J2, J5 and J6. In addition,

Subdivision 152-E does not apply to CGT events J5 and J6. Step 5 Add up the amounts of capital gains (if any) remaining after step 4. The sum is your net capital gain for the income year. Note: For exceptions and modifications to these rules: see section 102-30.

To understand ITAA97 s 102-5(1), you need to refer to explanations in Pt 3-1 of several of the terms that are used in s 102-5. These are capital gains, capital losses, net capital losses, discount percentage and discount capital gains.

How to calculate a capital gain and a capital loss: A diagram 6.7 The legislation contains two explanations of how to calculate a capital gain and a capital loss. One uses a diagram to illustrate the concepts while the other explanation proceeds via a series of steps. We will examine both explanations. [page 276] ITAA97 s 100-15 contains a diagrammatic overview of the steps involved in calculating a capital gain or a capital loss, reproduced below in Figure 6.1.

Figure 6.1:

How to calculate a capital gain and a capital loss

Calculating a capital gain: Explaining the diagram 6.8 In the first box on the left-hand side of the diagram, ‘How to calculate a capital gain and a capital loss’, you are asked: ‘Did a CGT event happen in the income year?’ ITAA97 s 102-20(1) states: ‘You can make a capital gain or loss only if a CGT event happens’. In all cases, there will need to be at least some relevant connection between you and the CGT event before you will make a capital gain or loss from it. A list of all CGT events is set out in Div 104 of Pt 3-1. Each operative provision that sets out the details of the CGT event explains how to calculate any capital gain or loss that arises when that CGT event occurs. Selected CGT events will be discussed in detail in 6.24–6.56. In the second box on the left-hand side of the diagram, you are asked: ‘Does an exemption apply?’ There are several types of exemption from CGT. The effect of some exemptions will be that no capital gain arises when a CGT event occurs. Under other exemptions, what would

otherwise be a capital gain is disregarded. In the case of other exemptions, the amount that would otherwise be regarded as capital gain is reduced. Selected exemptions from CGT will be discussed in detail in 6.125–6.148. In some cases, you are able to apply an exemption only after you have determined that a capital gain would exist otherwise. In the third box on the left-hand side of the diagram, you are asked: ‘Do the capital proceeds exceed the cost base?’ For most CGT events, this will be the next question that you have to ask in calculating a capital gain. This is because most CGT events involve a CGT asset in some way. For example, probably the most common CGT event will be CGT event A1 which arises when you dispose of a CGT asset. What [page 277] constitutes a CGT asset is discussed in 6.62–6.74. Some CGT events, however, do not involve a CGT asset. In these and some other cases, something other than cost base is deducted from the capital proceeds in determining whether a capital gain or loss is made. Note, also, that for some CGT events it is not possible to make a capital loss.

Calculating a capital gain: A step-by-step approach 6.9 ITAA97 s 100-45 contains a step-by-step explanation of how to calculate the capital gain for most CGT events involving a CGT asset.9 Note that the explanation is also relevant in calculating a capital loss. The application of these steps in calculating a capital loss will be examined in 6.15–6.18. 100-45 How to calculate the capital gain or loss for most CGT events 1. Work out your capital proceeds from the CGT event. 2. Work out the cost base for the CGT asset. 3. Subtract the cost base from the capital proceeds. 4. If the proceeds exceed the cost base, the difference is your capital gain. 5. If not, work out the reduced cost base for the asset.

6. 7.

If the reduced cost base exceeds the capital proceeds, the difference is your capital loss. If the capital proceeds are less than the cost base but more than the reduced cost base, you have neither a capital gain nor a capital loss.

Note that the first step in s 100-45 involves working out the capital proceeds from the CGT event. In general, these will be the amounts that you receive or are entitled to receive in respect of the CGT event. For example, if you sell some land that is a CGT asset, thus giving rise to CGT event A1, the sale price of the land will usually be the capital proceeds for the CGT event. The meaning of ‘capital proceeds’ is discussed in detail in 6.89–6.98. 6.10 The next step in s 100-45 is to work out the cost base for the CGT asset. Each CGT asset will have a cost base. You will note from the steps set out in s 100-45 that the concept of cost base is only relevant in calculating a capital gain. Generally, the cost base of a CGT asset will be the total of the costs associated with acquiring and, in some cases, holding the asset. For example, if you acquire land that is a CGT asset, its cost base will include: the price you paid for the land; incidental costs relevant to its acquisition (such as stamp duty or legal costs); and costs of owning the land (such as interest on money borrowed to acquire non-income-producing land). [page 278] Note that for assets acquired after 13 May 1997, as a general rule, expenditure does not form part of an asset’s cost base to the extent that you have deducted it or can deduct it, for example, under ITAA97 s 81. Prior to 13 May 1997, this requirement applied only to incidental costs and to non-capital costs of ownership. For assets acquired after 13 May 1997, amounts which have been deducted are included in the cost

base if you receive a recoupment for them that is included in your assessable income. Significant amendments were made to the cost base rules in 2006. The amended rules apply to all CGT events occurring after 1 July 2005. For this reason, only the rules as amended in 2006 will be discussed in this chapter. The concept of ‘cost base’ will be discussed in more detail in 6.100–6.120. Under ITAA97 s 110-36(1), in the case of assets acquired prior to 21 September 1999, for many but not all CGT events, each amount included in cost base may be indexed to inflation. Subject to exceptions set out in s 114-10, expenditure is indexed only if more than 12 months have elapsed since the time when you acquired the asset and the time when the CGT event occurred. Indexation has now been frozen and a taxpayer disposes of a pre-21 September 1999 asset; after that date, indexation is only allowed up to 30 September 1999. How the elements of cost base are indexed is discussed in 6.119–6.120. In relation to assets acquired on or before 21 September 1999, individuals, trusts and complying superannuation funds can choose between indexation and discounting the capital gain (as discussed in more detail in 6.11). Indexation is only relevant for individuals, trusts and complying superannuation funds if they choose, under s 114-5(2), indexation of pre-21 September 1999 assets instead of applying the relevant discount percentage in calculating the capital gain. In addition, s 110-36(2) states that for these entities indexation is only taken into account in calculating a capital gain from a post-21 September 1999 CGT event if the entity chooses that the cost base includes indexation. No taxpayer is entitled to indexation in relation to assets acquired on or after 11.45 am on 21 September 1999. Note that companies10 are automatically entitled to indexation in relation to pre- 21 September 1999 assets and do not have to make a choice. The reason for this rule is that companies are not entitled to a CGT discount. In calculating net capital gains for individuals, trusts and complying superannuation funds in respect of most CGT events11 occurring on or after 11.45 am on 21 September 1999, the capital gain that would otherwise arise is reduced by the appropriate discount percentage. If a

taxpayer has elected, under ITAA97 s 114-5(2), to index the cost base of a pre-21 September 1999 asset then, under s 115-20, discounting is not available in respect of any net capital gain that may arise. In the 2012–13 Federal Budget, the government announced that the CGT discount would be removed for foreign resident and temporary resident individuals on taxable Australian property. The concept of ‘taxable Australian property’ was discussed at 2.33 and the taxation of capital gains derived by foreign residents is discussed in more detail in Chapter 18. [page 279] Amendments giving effect to the government’s announcement were passed by the Commonwealth Parliament as Tax Laws Amendment (2013 Measures No 2) Act 2013 (Cth) and received the Royal Assent on 29 June 2013. These changes are discussed in Chapter 18. The discount percentage for an individual or a trust is 50%, while the discount percentage for a complying superannuation fund is 33⅓% see ITAA97 s 115-100. 6.11 A capital gain that qualifies for a discount is called a ‘discount capital gain’. ITAA97 s 115-40 provides that a capital gain on a CGT asset from a CGT event will not qualify as a discount capital gain if the CGT event occurred under an agreement the taxpayer made within 12 months of acquiring the CGT asset. In applying this rule, where the taxpayer acquired the asset via a same asset or replacement asset rollover provision (see 6.164ff), or as a result of the provisions in ITAA97 Div 128 relating to death (discussed in Chapter 15), s 115-30 substitutes an earlier date of acquisition for the actual date of acquisition. In the case of roll-overs, the deemed date of acquisition will generally12 be the date when the entity that rolled the asset over first acquired it (in the case of a same asset roll-over) or when the acquirer first acquired the original asset (in the case of a replacement asset rollover). Post-CGT assets passing on the death of their owner to a legal personal representative or a beneficiary are deemed, for purposes of the

12 months ownership rule, to have been acquired when the deceased acquired the asset. Pre-CGT assets passing on death are deemed to have been acquired as at the date of the deceased’s death. The CGT discount is not available in respect of several CGT events namely: D1, D2, D3, E9, F1, F2, F5, H2, J2, J5, J6 and K10. Under ITAA97 s 115-45, if the CGT asset is a share in a company or an interest in a trust a taxpayer will be denied the CGT discount where: the taxpayer and associates beneficially owned at least 10% by value of the shares13 in the company or at least 10% of the voting interests, issued units or fixed interests in the trust; the total of the cost bases of the CGT assets acquired by the company or trust for less than 12 months before the CGT event is more than half of the total of the cost bases of the CGT assets that the company or trust owned at the time of the CGT event; and the net capital gain that would arise if all assets acquired by the company or trust within the 12 months preceding the CGT event were disposed of for their current market values would be more than half of the net capital gains that would have arisen if the company or trust had disposed of all its assets at their current market values. [page 280] Where a company has 300 or more shareholders or a fixed trust has 300 or more beneficiaries, s 115-50 will mean that s 115-45 will not prevent the discount from being available to the shareholders or beneficiaries. An exception to s 115-50 applies where ownership in the company or fixed trust is concentrated. Ownership will be concentrated where 20 or fewer persons own between them (directly or indirectly through interposed entities) shares in the company or interests in the trust carrying between them: (a) fixed entitlements to 75% of the income or capital of the company or trust; or (b) 75% of the voting rights in relation to the company or trust.

6.12 Under step 4 in ITAA97 s 100-45 (extracted at 6.9), where the capital proceeds from the CGT event exceed the cost base of the CGT asset, the excess is your capital gain. Note that a separate capital gain is calculated in respect of each CGT event that you are involved with in the year of income. If you have no capital losses in the year of income and no net capital losses carried forward from an earlier year, then, under s 102-5(1), the sum of the capital gains that you make in respect of each CGT event that you are involved with in that year will be your net capital gain for the year. It is this amount that is included in your assessable income via s 102-5(1).

Alpha, an Australian resident individual, purchases some land for $100,000 on 1 January 1997. Alpha paid $2000 in stamp duty on the purchase and paid $1000 in legal costs. Alpha sold the land (CGT event A1) on 1 September 1999 for $180,000. Alpha incurred $500 in legal costs and $10,000 in agent’s commission on the sale of the land. Interest on the money borrowed to purchase the land was $30,000. Alpha did not obtain ITAA97 s 81 deductions for the interest or for rates of $2000 paid on the land. Assume that the legal costs and stamp duty on the purchase were incurred on 1 January 1997. Assume that the legal costs and agent’s commission on the sale were incurred on 1 September 1999. The cost base of the land is:

$100,000 $2,000 $1,000 $500 $10,000 $30,000 $2,000

being money that Alpha paid for the land being stamp duty (this is included in the incidental costs of acquisition) being legal costs on the purchase (included in the incidental costs of acquisition) being legal costs on the sale (included in the incidental costs that relate to the CGT event) being agent’s commission (included in the incidental costs that relate to the CGT event) being non-deductible interest on moneys borrowed to purchase the land (included in costs of owning) being rates (included in costs of owning)

[page 281]

$721 $146,221

being indexation of the purchase price, the stamp duty and the legal costs on the purchase Cost base

Note: Indexation is included in the cost base as the asset was owned for more than 12 months before the CGT event took place and the CGT event took place before 21 September 1999. The costs of ownership of the land are included in the cost base but are not permitted to be indexed. The legal costs on the sale and the agent’s commission on the sale will not be indexed as they were incurred in the same quarter as the CGT event took place. The way in which indexation is calculated will be discussed in 6.119–6.120. The capital proceeds are $180,000; hence, Alpha makes a capital gain of $33,779 on the sale. If Alpha had sold the land on or after 21 September 1999 and had chosen a discount over indexation, the position would have been as follows. The cost base would have been $145,500 as no indexation would have been included. The capital gain (prior to discounting) would have been $34,500. Capital losses would have then been offset. Assuming there were no capital losses, a net capital gain of $34,500 would have been produced. The 50% discount for individuals would have reduced this to $17,250.

6.13 Any capital gains that you make in the income year are reduced, under ITAA97 s 102-5, by any capital losses that you made in the income year. If you have made several capital gains from different CGT events in the income year, you choose the order in which you reduce your capital gains. If your capital losses for an income year exceed your capital gains for that year, then you have a net capital loss. The calculation of net capital losses is discussed in more detail in 6.20–6.21. After applying your capital losses for the year against your capital gains for the year, you then apply any previously unapplied net capital losses against capital gains for the income year. Under s 102-15(1), net capital losses must be applied in the order in which you made them. That is, the oldest net capital losses must be applied first. However, as explained in a note in Step 2 of the method statement in s 102-5, you can choose the order in which you reduce capital gains by net capital losses. In other words, although you must apply the oldest net capital losses first, you may choose which capital gains of the income year you first apply

them against. After you have applied net capital losses against capital gains for the income year, you then reduce each amount of discount capital gain that remains by the appropriate discount percentage. Note that, as losses have been applied against capital gains before the discount percentage is applied, the discount means that not only is any capital gain discounted, but the value of capital losses and net capital losses applied against capital gains is also discounted. After the discount, if relevant, has been applied you then apply any small business concessions [page 282] (discussed in 6.149–6.160) to each capital gain where they are applicable. After you have completed all these steps, you then add the amounts of capital gains, if any, that remain. The sum is your net capital gain for the income year. Note that individuals, trustees and complying superannuation funds have a choice, in the case of post-21 September 1999 events occurring in relation to pre-21 September 1999 assets, between indexation (frozen as at 30 September 1999) of the cost base of the asset and the CGT discount. While choosing the discount will usually be the most favourable option, it is possible that where an asset has been owned during periods of high inflation, indexation may produce a lower taxable gain. Thus, in any given year, an individual may have: 1. capital gains where neither indexation nor a discount is available (eg, because the CGT event occurred within 12 months of the acquisition of the asset); 2. capital gains on which you have chosen indexation rather than a discount; 3. capital gains on which you have chosen to obtain a discount; 4. capital gains where only a discount is available because the asset was acquired after 21 September 1999. It is important to remember that, as discounting reduces the value of

capital losses and net capital losses, a taxpayer who has capital losses or net capital losses will legitimately minimise his or her net capital gain for the year if the losses are applied in the following order: against capital gains where neither indexation nor a discount is available; against capital gains where the taxpayer has chosen indexation; and against capital gains where the taxpayer has chosen a discount.

In the year ending 30 June 2017, Sigma makes a capital gain, after allowing for indexation, of $150,000 from the sale on 1 August 2016 of Blackacre, a CGT asset that Sigma acquired on 1 January 1990. Assume that Sigma chose frozen indexation rather than the 50% discount in calculating this capital gain. In the year ending 30 June 2017, Sigma also makes a capital loss of $100,000 from the sale of another asset, Whiteacre, acquired on 1 January 1990. Sigma also sells another asset, Yellowacre, on 1 February 2017. Yellowacre was acquired on 1 January 2002. Prior to applying the discount percentage, the capital gain from Yellowacre is $150,000. Calculate whether Sigma would be better advised to offset the capital loss from Whiteacre against the capital gain from Blackacre or against the capital gain from Yellowacre.

[page 283] 6.14 Special rules apply to the treatment of capital losses that are made on ‘collectables’. Collectables include artworks, jewellery, antiques and postage stamps that are kept mainly for the personal use and enjoyment of the taxpayer and their associates. Capital losses on collectables can only be offset against capital gains on collectables. The CGT treatment of collectables is discussed in more detail in 6.77–6.78 and 6.128.

Calculating a capital loss: A step-by-step approach

6.15 The steps involved in working out a capital loss are similar to those used in calculating a capital gain. A capital loss can occur only if a CGT event happens and if an exemption, other than a partial exemption, is not applicable. First, the capital proceeds from the CGT event are worked out. The meaning of ‘capital proceeds’ is discussed in detail in 6.89–6.98. The second step in calculating a capital loss involves working out the reduced cost base for the CGT asset. Generally, the reduced cost base of a CGT asset will be the sum of all costs associated with acquiring the asset reduced by so much of any of its constituent elements as is deductible under another part of the ITAA97. It also includes certain amounts that are included in your assessable income as balancing adjustments under another part of the ITAA97 and certain amounts that would be included as balancing adjustments but for relieving provisions. Recouped expenditure is included in the reduced cost base only if the recoupment is included in your assessable income. Note that, unlike cost base, reduced cost base does not include non-deductible costs of ownership. So, for example, interest paid on moneys borrowed to acquire a non-income-producing asset will be included in the cost base of the asset but will not be included in the reduced cost base of the asset. 6.16 Between 21 September 1999 and 30 June 2001, ITAA97 s 11824 provided that a capital gain or capital loss that you made from a CGT asset was disregarded where the asset was your plant. In this period, however, determination of the reduced cost base of plant was necessary for purposes of the depreciation balancing adjustment provisions. A discussion of the position during this period is contained in Study help. Section 118-24 was amended with effect from 30 June 2001. The broad effect of the amended s 118-24 is that a capital gain or loss made from a CGT event that is also a balancing adjustment event that happens to your plant is disregarded. The amended s 118-24 is discussed at 6.134 and 10.65. In the case of an asset that was acquired before 21 September 1999, an important difference between reduced cost base and cost base is that reduced cost base is not indexed for inflation. This difference does not

exist where the asset was acquired on or after 21 September 1999 or where an individual, a trustee or a complying superannuation fund chooses a CGT discount over indexation in calculating the net capital gain from CGT events occurring on or after 21 September 1999 in respect of assets acquired before that date. The concept of ‘reduced cost base’ is discussed in more detail in 6.121–6.124. 6.17 The third step in calculating a capital loss is to compare the capital proceeds with the reduced cost base. If the reduced cost base exceeds the capital proceeds, then the excess is your capital loss. [page 284]

Alpha purchased some land for $100,000 on 1 December 2009. Alpha paid $2000 in stamp duty on the purchase and $1000 in legal costs. Alpha sold the land on 1 January 2018 (hence triggering CGT event A1) for $90,000. Alpha incurred $500 in legal costs and $10,000 on agent’s commission on the sale of the land. Interest on money borrowed to purchase the land was $30,000. Alpha did not obtain ITAA97 s 8-1 deductions for the interest and did not obtain any deductions for rates paid on the land. The reduced cost base of the land is:

$100,000 $2,000 $1,000 $500 $10,000

$113,500

being the money that Alpha paid for the land being stamp duty (this is included in the incidental costs of acquisition) being legal costs on the purchase (this is included in the incidental costs of acquisition) being legal costs on the sale (this is included in the incidental costs that relate to the CGT event) being agent’s commission on the sale (this is included in the incidental costs that relate to the CGT event)

None of the constituent elements of the cost base of the land were deductible to Alpha. The interest and rates paid are included in the cost base of the land but are not included in the reduced cost base. The capital proceeds of the sale of the land are $90,000. Hence Alpha makes a capital loss on the sale of the land of $23,500.

6.18 As mentioned in 6.8, some CGT events do not give rise to capital losses. It should also be noted that capital losses are not allowable on what are known as ‘personal use assets’ unless those assets are collectables. If the assets are collectables, then capital losses on them can be offset only against capital gains on collectables. See the discussion of the CGT treatment of personal use assets in 6.75–6.76 and 6.128, and the discussion of the CGT treatment of collectables in 6.77–6.78 and 6.128.

Neither capital gain nor capital loss 6.19 If the capital proceeds are less than or equal to your cost base but are more than or equal to your reduced cost base, you have neither a capital gain nor a capital loss. There are no CGT consequences when this result occurs.

How to calculate a net capital loss 6.20 The steps involved in calculating a net capital loss are set out in ITAA97 s 102-10(1). [page 285]

102-10 How to work out your net capital loss (1) You work out if you have a net capital loss for the income year in this way: Working out your net capital loss Step 1. Add up the capital losses you made during the income year. Also add up the capital gains you made. Step 2. Subtract your capital gains from your capital losses. Step 3. If the Step 2 amount is more than zero, it is your net capital loss for the income

year. Note: For exceptions and modifications to these rules: see section 102-30.

6.21 Section 102-10(2) states that you cannot deduct a net capital loss from your assessable income for any year. However, a net capital loss can be carried forward to a later year under s 102-15(3) and offset against your capital gains in that income year under s 102-5(1). You will recall that Step 2 (see s 102-5 in 6.6) in calculating a net capital gain in s 102-5(1) involves applying any unapplied net capital losses from previous years against the excess of the sum of your net capital gains for the current year less the sum of your capital losses for the current year. More details about the application of net capital losses are provided in s 102-15. 102-15 How to apply net capital losses In working out if you have a net capital gain, your net capital losses are applied in the order in which you made them. Note 1: A net capital loss can be applied only to the extent that it has not already been utilised: see subsection 960-20(1). Note 2: For applying a net capital loss for the 1997-98 income year or an earlier income year, see section 102-15 of the Income Tax (Transitional Provisions) Act 1997.

The following example illustrates how s 102-15 operates.

Sigma acquired CGT asset No 1 in 1989 for $300,000. Sigma acquired CGT asset No 2 in 1992 for $400,000. Sigma acquired CGT asset No 3 in 1994 for $30,000. [page 286] Sigma sold CGT asset No 1 in 2001 for $150,000. Assume that no part of the cost base of this asset was deductible under another part of the ITAA97. Assume that no other CGT events affected Sigma in 2001.

Sigma sold CGT asset No 2 in 2005 for $390,000. Assume that no part of the cost base of this asset was deductible under another part of the ITAA97. Assume that no other CGT events affected Sigma in 2005. Sigma sold CGT asset No 3 in 2005 for $150,000. Assume that, after allowing for indexation, the cost base of CGT asset No 3 at the time of the sale was $60,000. Assume that no other CGT events affected Sigma in 2005. Assume that Sigma elects to receive the CGT discount rather than indexation. In January 2017, Sigma enters into a contract which gives rise to CGT event D1. The capital gain that arises from this CGT event is $200,000. In 2001, Sigma incurs a capital loss of $150,000. Sigma has no capital gains against which this capital loss can be offset so Sigma incurs a net capital loss which can only be carried forward to be offset against future capital gains. In 2005, Sigma makes a capital gain of $120,000 (prior to allowing for the discount) on the disposal of CGT asset No 3. Sigma also incurs a capital loss of $10,000 on the sale of CGT asset No 2. This current year capital loss of $10,000 is offset against the capital gain of $120,000. The net capital loss carried forward from 2001 of $150,000 is then offset against the remaining $110,000 of the capital gain. This leaves $40,000 of the net capital loss which can only be carried forward to be offset against capital gains in future years. In 2018, Sigma makes a capital gain of $200,000. The previously unapplied part ($40,000) of the net capital loss incurred in 2001 is applied against the capital gain. This means that Sigma makes a net capital gain of $160,000 in 2018.

In Example 6.3, would Sigma have been better off choosing indexation rather than a discounted capital gains treatment in 2005?

Averaging provisions 6.22 Prior to 21 September 1999, the Australian CGT provisions attempted to provide relief against a problem known as ‘bunching’ through a form of five-year [page 287]

averaging. Bunching occurs when an asset increases in value over several years. When CGT is applied on a realisation basis, all this increase in value is taxed in the year of realisation. This can mean that, as gains, which (in effect) were made over several years, are recognised as income in one year, lower marginal rate taxpayers are pushed into higher marginal rates. The Review of Business Taxation found that the five-year averaging provisions were used by a section of the assetholding community to reduce capital gains to, or near, zero, while others who were not in a position to engineer the same benefit carried the burden of taxation at close to their full marginal rate. At the same time, investors who faced high marginal rates of tax tended to retain their assets rather than realise them; and when they realised their assets, the high marginal rate of tax payable meant that they had to secure a much higher rate of return when reinvesting the reduced capital that they had available. Hence, the Review of Business Taxation recommended14 that the CGT averaging provisions be abolished. The government accepted this recommendation, which was implemented as from 21 September 1999. An explanation of the averaging provisions that applied up to 21 September 1999 is contained in Study help.

CGT events Concept of CGT events 6.23 We noted in 6.8 that ITAA97 s 102-20(1) states that you can only make a capital gain or a capital loss if a CGT event happens. The concept of CGT events was an innovation in the ITAA97. The capital gains tax provisions in the ITAA36 were based on a model that required that an asset be disposed of before a capital gain or loss could arise. The ITAA36, however, did try to tax, as capital gains, certain capital receipts that did not involve an actual disposal of an asset. Applying a model based on the disposal of an asset to capital receipts that did not involve actual disposals required several, extremely artificial, deeming provisions. For example, the creation of certain

contractual rights in another person was deemed in the ITAA36 to be the creation and disposal of an asset. The ITAA97 abandoned the model that required that an asset be disposed of before a capital gain or loss could arise. Instead, the ITAA97 requires that a CGT event take place before a capital gain or loss can arise. The difference in approach is significant. For example, in the ITAA97, creating contractual or other rights is a CGT event and can give rise to capital gains or capital losses. All that is needed under the approach used in the ITAA97 is to say that the creation of contractual or other rights is a CGT event, and to say how a capital gain or loss is calculated when this CGT event takes place. Under the approach used in the ITAA97, there is no need to deem the creation of contractual or other rights to be the creation and disposal of an asset. The summary of CGT events as set out in ITAA97 s 104-5 is contained in Study help. Read through the list of CGT events in s 1045. You will note that some [page 288] of the CGT events arise only when an asset is disposed of. Other CGT events in the list, however, occur even though no asset has been disposed of. A good example of a CGT event that arises although no asset has been disposed of is CGT event D1. CGT event D1 arises when contractual or other rights are created. CGT event D1 will be discussed in more detail in 6.34–6.39. Note also that in the case of some CGT events, typically those that do not involve the disposal of an asset, only a limited range of expenditures are allowed to be taken into account in calculating a capital gain or loss. For example, in CGT event D1 the only costs that are allowed in calculating a capital gain or loss are the incidental costs of creating the contractual rights. These costs would include, for example, legal fees paid to a legal practitioner who drew up the contract that created the rights. No allowance is made, however, for the value of any liabilities that the person creating the rights assumes under the contract.

It is worth noting that some CGT events cannot give rise to capital losses. The CGT events that cannot give rise to capital losses are all identified in s 104-5.

Read through ITAA97 s 104-5, and: identify those CGT events that do not involve the disposal of an asset; list those CGT events that do not allow the cost base of a CGT asset to be taken into account in calculating capital gains from the CGT event; note the CGT events that do not give rise to capital losses.

After reading through ITAA97 s 104-5, identify the CGT events that could have potential application in each of the situations listed below. In each case, identify what you believe to be the most appropriate CGT event: 1. Peter enters into a contract to sell pre-CGT land to Denise. 2. Effie enters into a contract to sell post-CGT land to Anne. 3. Anne grants Bill an option to purchase post-CGT shares. 4. Bill exercises the option to purchase post-CGT shares that Anne granted to him. 5. Michael defaults on a contract to purchase post-CGT land from Alex and forfeits the deposit that he paid under the contract.

[page 289]

A CGT event must occur before a capital gain or loss will arise. Because of this, the first

thing that you should do in deciding whether a set of facts creates CGT issues is to review the list of CGT events in s 104-5. If none of the events listed in s 104-5 has happened, then no capital gain or loss can arise. To be confident that no CGT event has happened, however, you may need to read carefully the provision that sets out the details of the CGT event.

Details of selected CGT events 6.24 At the time of writing this chapter, there were over 50 CGT events in total. Some of these, such as those that arise when companies or unit trusts return capital, will be discussed in more detail in later chapters. Other CGT events apply only in very specific circumstances, such as CGT event K2, which occurs when a bankrupt pays an amount in relation to a debt. A brief description will now be given of some CGT events that have more general application. It is conceivable that more than one CGT event could be applicable to the same set of facts. If this is the case, ITAA97 s 102-25(1) directs you to use the event that is most specific to your situation. There are three exceptions to this rule. First, circumstances giving rise to CGT event J2 may also constitute another CGT event. In this case, CGT event J2 applies in addition to the other event. Second, CGT event K5 can happen in addition to any one of CGT events A1, C2 or E8. This is because CGT event K5 (capital loss from a collectable that has fallen in market value) depends on one of CGT events A1, C2 or E8 (disposal by beneficiary of capital interest in a trust) occurring. Third, CGT events may produce capital gains or losses which are taken into account in determining whether there is a ‘foreign hybrid loss amount’. The foreign hybrid loss amount may trigger CGT event K12. In these circumstances, CGT event K12 happens in addition to the other CGT events which produced the capital gains or losses. Importantly, special rules, set out in s 102-25(3), govern the application of CGT events D1 and H2. CGT event D1 (dealing with the creation of contractual or other rights) will arise only if no other CGT event (other than CGT event H2) occurs. CGT event H2 (dealing with receipts for events relating to CGT assets) will arise only if no other CGT event (including CGT event D1) occurs.

Disposal of a CGT asset — CGT event A1: s 104-10 6.25 The most common CGT event is likely to be CGT event A1. Under ITAA97 s 104-10(1), CGT event A1 occurs if you dispose of a CGT asset. The only disposals that CGT event A1 applies to are those that involve a change of ownership of the CGT asset from you to another entity. You make a capital gain if the capital proceeds from the disposal are more than the asset’s cost base. You make a capital loss if the capital proceeds from the disposal are less than the asset’s reduced cost base. If you acquired the asset before 20 September 1985, then any capital gain or [page 290] loss that you make on its disposal is disregarded. A CGT event does not occur if the disposal of the asset was made to provide or redeem a security. As it involves the disposal of a CGT asset involving a change in its ownership to another person, CGT event A1 is relatively complex. The reason why many of the provisions in ITAA97 Pt 3.1 exist appears to be to provide for complications that arise in ascertaining whether the constituent elements of s 104-10 have been satisfied. Similar issues arise in the case of other CGT events that involve the disposal of an asset. For these reasons, issues relating to the constituent elements in CGT event A1 will be discussed in detail in 6.58ff.

Loss or destruction of a CGT asset — CGT event C1: s 104-20 6.26 It is possible for a taxpayer to cease owning a CGT asset without disposing of it to another entity. One way in which this can occur is when an asset is lost or destroyed. CGT event C1 deals with this situation. Under ITAA97 s 104-20(2), the time of the event depends on whether or not you receive compensation for the loss or destruction of the CGT asset. If you receive compensation, then the event takes place when you first receive the compensation. If you do not receive

compensation, then the time of the event is when the CGT asset was lost or destroyed. You make a capital gain if the capital proceeds are more than the asset’s cost base. If the reduced cost base of the asset is more than the capital proceeds then you make a capital loss. Any capital gain or loss that you would otherwise make is disregarded where you acquired the asset before 20 September 1985. 6.27 Where compensation is received for the loss15 or destruction of the asset (eg, as damages or under an insurance policy), then the compensation will be the major component in the capital proceeds received or receivable because of CGT event C1. Where there are no capital proceeds from a CGT event, usually the rule is that ITAA97 s 116-30(1) deems the capital proceeds to be the market value of the asset at the time of the CGT event. However, the table in s 116-25 indicates that this rule does not apply to CGT event C1. Thus, when an asset is lost or destroyed there may be no capital proceeds and, if so, you normally would make a capital loss. Where the item destroyed is a depreciating asset then, as from 30 June 2001, provided the prerequisites for the s 118-24 exception are met (see the discussion at 10.65), any capital gain or loss that arises under CGT event C1 is disregarded. Note, however, that a capital gain or loss may arise under CGT event K7: see the discussion at 6.134 and 10.65. A discussion of the position where CGT event C1 happened to depreciable plant between 21 September 1999 and 30 June 2001 is contained in Study help. [page 291]

Cancellation, surrender or similar endings — CGT event C2: s 104-25 6.28 Legal and equitable rights are regarded as assets for CGT purposes. They are intangible CGT assets. ITAA97 s 104-25(1) states that CGT event C2 takes place when an intangible CGT asset ends by:

(a) (b) (c) (d) (e) (f)

being redeemed or cancelled; or being released, discharged or satisfied; or expiring; or being abandoned, surrendered or forfeited; or if the asset is an option — being exercised; or if the asset is a convertible interest [such as an unsecured note which can be converted into ordinary shares] — being converted.

These are all examples of ways in which you can cease to be the owner of an intangible CGT asset without disposing of it to another entity. The time when CGT event C2 takes place depends on whether or not you entered into a contract that resulted in the asset ending. If you entered into such a contract, then the time of the CGT event is the time that you entered into the contract. If you did not enter into such a contract, then the time of CGT event C2 is when the asset ends. You make a capital gain if the capital proceeds from the asset ending are more than its cost base. You make a capital loss if those proceeds are less than the reduced cost base of the asset. Where the CGT asset is a lease, it is taken to have expired even if it is extended or renewed. 6.29 Following the High Court decision in FCT v Orica Ltd (1998) 194 CLR 500; 38 ATR 66; 98 ATC 4494, it is important to recognise that the discharge of a contractual obligation by its performance will trigger CGT event C2. In Orica, the High Court held that a discharge of a contractual obligation by performance amounted to a disposal under ITAA36 s 160M(3)(b) of the contractual rights of the party to whom the obligation was owed.

FCT v Orica Ltd Facts: The taxpayer, Orica (then known as ICI Australia Ltd), issued debentures with a

nominal value at maturity of $98,622,800. Orica entered into a debt defeasance arrangement because restrictions, contained in the debentures, on ratios of total liabilities to total tangible assets inhibited its commercial operations. [page 292] Orica entered into a Principal Assumption Agreement with the Melbourne Metropolitan Board of Works (MMBW) on 6 June 1986. Under this agreement, MMBW agreed to assume Orica’s obligations to repay the principal amounts of the debentures on their respective maturity dates. Orica paid MMBW $62,309,546 for agreeing to do this. For financial accounting purposes for the year ended 30 September 1986, Orica treated the difference between its original obligation to pay $98,622,800 on the maturity of the debentures and the amount of $62,309,546 it paid to MMBW as an extraordinary profit of $36,353,254. Details of the history of the appeal are contained in Study help. Issues: The Commissioner appealed to the High Court. On appeal, the Commissioner argued that the gain was ordinary income and was derived as each of the debentures was redeemed. Extracts from the judgments in the High Court on this point are contained in Study help. Alternatively, the Commissioner argued that a capital gain arose when Orica’s rights under the Principal Assumption Agreement were disposed in whole or part when MMBW performed its obligations under the agreement. Held: Brennan CJ, Gaudron, McHugh, Kirby and Hayne JJ (Gummow and Callinan JJ dissenting on this point) held that performance by MMBW of its obligations and discharge of those obligations by performance was a disposal of part of Orica’s rights against MMBW under the Principal Assumption Agreement which triggered a capital gain for Orica. The following are extracts from the judgments on whether discharge by performance was a disposal. Brennan CJ (at [39]): When MMBW paid the Trustee or the debenture holders in accordance with its obligation under cl 3, the deemed debt was discharged. ICI’s chose in action was satisfied. Thus a “change … in the ownership: of the deemed debt was taken to have occurred pursuant to s 160M(3)(b) which reads: Without limiting the generality of sub-section (2), a change shall be taken to have occurred in the ownership of an asset by … (b) in the case of an asset being a debt, a chose in action or any other right, or an interest or right in or over property the cancellation, release, discharge, satisfaction, surrender, forfeiture, expiry or abandonment, at law or in equity, of the asset. [page 293] The change in ownership is then deemed by s 160M(1) “to have effected a

disposal of the asset”. As s 160ZI requires apportionment of the cost base attributable to any part of an asset disposed of, there is no problem in dissecting the aggregate of the Present Values paid by ICI under cl 2 of the Principal Assumption Agreement in order to ascertain the cost base attributable to the payments made by MMBW during the 1987 income year. The indexing of the cost base and the calculation of the net capital gain to be included in ICI’s assessable income for the 1987 income year should be made by the Commissioner. Gaudron, McHugh, Kirby and Hayne JJ (their Honours quoted ITAA36 s 160M as it stood in 1986 and 1987) (at [92]–[100]): … The Commissioner submitted that s 160M(3)(b) applied to deem performance by MMBW of its obligations under the Principal Assumption Agreement to be a change in the ownership of the taxpayer’s asset (its rights under that agreement). It was submitted that MMBW’s performance of its obligations was the “discharge” or “satisfaction” of the asset being the “chose in action or any other right” constituted by the taxpayer’s rights under the Principal Assumption Agreement. The Full Court held that “discharge” and “satisfaction”, when used in s 160M(3), were not to “be construed as extending to a the performance of obligations under an agreement giving rise to the rights in accordance with the terms of the agreement” and were words which “must be confined to cases where the rights are satisfied or discharged otherwise than by performance of the obligations which give rise to the rights by the other party to the contract”. There is no basis for confining “discharge” or “satisfaction” in this way. First, as a matter of ordinary language, “discharge” can be used in the sense of “[t]he act of clearing off a pecuniary liability; payment” or “[f]ulfilment, performance, execution (of an obligation, duty, function, etc)”. Secondly, it is common for lawyers to speak of a contractual obligation being discharged by performance. No doubt there are other ways in which the obligation can be discharged but performance is one. There is nothing in the ordinary usages in the law of the terms the “discharge” or the “satisfaction” of an obligation which would suggest that the use of the terms in s 160M(3) is to be confined in the manner suggested. [page 294] Thirdly, when the subsection speaks, as it does, of the “discharge” of a debt it is plainly using the word “discharge” in a way that at least includes payment of the debt according to the terms of the obligation incurred by the debtor. Fourthly, far from the other provisions of Pt IIIA (or s 160M in particular) providing a sound basis for reading down the apparent generality of s 160M(3)(b), the context in which the provision sits discloses an intention to give it a very wide operation. … [Their Honours then referred to ITAA36 s 160M(1), (2), (3)(c) and (6) as they stood in 1986 and 1987.] It was submitted that unless the provision was read down by confining “discharge” and “satisfaction” to discharge or satisfaction otherwise than by performance of the obligation undertaken, performance of every executory contract would be

brought within the reach of the capital gains provisions. No doubt that is so but it does not mean that a party to an executory contract will always be liable to tax. It is necessary to recall that tax will be payable only if there is a capital gain, that is, only “if the consideration in respect of the disposal exceeds the indexed cost base to the taxpayer in respect of the asset”. If what the taxpayer receives on performance of the obligation undertaken by the other party to an executory contract does exceed the indexed cost base to the taxpayer in respect of the acquisition of the right to have the obligation performed, we see no incongruity in concluding that the taxpayer has made a capital gain. Accordingly, there is no basis for confining the word “discharge” (or, for that matter, the word “satisfaction”) to discharge or satisfaction otherwise than according to the tenor of the obligation incurred. In all these circumstances it follows that for the purposes of Pt IIIA performance by MMBW of its obligations under the Principal Assumption Agreement, and discharge pro tanto of those obligations by performance, is a disposal of part of the taxpayer’s asset (being its rights against MMBW under the Principal Assumption Agreement). [Footnotes omitted] Gummow J and Callinan J delivered separate dissenting judgments on this point. Extracts from their judgments can be found in Study help.

[page 295] In FCT v Dulux Holdings Pty Ltd (2001) 48 ATR 588, the Full Federal Court held that the deemed disposal under ITAA36 s 160M(3) (b) of Orica’s and Dulux’s rights under Principal Assumption Agreements when MMBW performed its obligations was not ‘under a contract’. Hence, the time of the disposal was determined under ITAA36 s 160U(4) and was each occasion when MMBW performed its obligations rather than when the Principal Assumption Agreement was entered into. 6.30

There are several exceptions to CGT event C2. These include: capital gains and losses on assets (other than leases) acquired before 20 September 1985; capital gains and losses on leases granted, renewed or extended before 20 September 1985; the expiry of a lease that was not used mainly to produce

assessable income (ITAA97 s 118-40); where rights to acquire shares in a company or units in a unit trust are exercised (ITAA97 s 130-40); where shares in a company or units in a unit trust are acquired by converting a convertible interest (ITAA97 s 130-60); where an option is exercised (ITAA97 s 134-1(4)); and capital gains or losses made by a demerging entity from CGT event C2 happening as a result of a demerger (see the discussion of the demerger provisions in 13.159–13.163). Note that, in many of the above instances, CGT event C2 happens but the capital gain or loss is disregarded. 6.31 If there are no capital proceeds for CGT event C2, the possible operation of the market value substitution rule in ITAA97 s 116-30(1) needs to be considered. Note that, under s 116-30(3)(a), this rule does not apply to the following examples of CGT event C2: the expiry of a CGT asset you own; and the cancellation of your statutory licence.

Beta enters into a restrictive covenant with Delta. Delta pays Beta $50,000 for entering into the restrictive covenant. The term of the restrictive covenant is five years. Delta’s rights under the restrictive covenant will be a CGT asset to Delta. When the restrictive covenant expires, CGT event C2 will happen. There will be no capital proceeds for the event and ITAA97 s 116-30(3) will mean that the market value substitution rule does not apply to the event. Hence the capital proceeds will be zero. This should mean that Delta makes a capital loss of $50,000 on the expiry of the restrictive covenant.

[page 296] Note, however, that in other circumstances where CGT event C2

happens, and there are no actual capital proceeds, s 116-30(1) will substitute the market value of the asset at the time CGT event C2 happened for the actual consideration. This will mean that a capital loss that would otherwise occur is likely to be either prevented entirely or reduced. 6.32 ITAA97 s 116-30(2) will also substitute market value for the actual capital proceeds of CGT event C2 if the capital proceeds are more or less than the market value of the asset.16

Scrooge lends $1000 to Cratchett. Cratchett is unable to repay the debt in full but offers Scrooge $500 instead. Because it is Christmas, Scrooge refuses the $500 and for $1 releases Cratchett from all further obligations to repay the debt. This will give rise to CGT event C2. Under ITAA97 s 116-30(2)(b)(ii), the capital proceeds of the debt will be the market value of the debt if the actual proceeds are more or less than the market value. The problem here, however, is that, given that Cratchett is unable to repay the debt in full, the market value of the debt prior to its release may be less than its face value. If Scrooge and Cratchett are dealing at arm’s length then the market value of the debt immediately prior to the CGT event is likely to be $500. This should mean that Scrooge, assuming that the release has generated neither a bad debt deduction nor a s 8-1 loss deduction, should make a capital loss of $500. Note, however, that if the debt did not arise in the course of gaining or producing Scrooge’s assessable income or in carrying on business for that purpose, it will be a personal use asset. This will mean that any capital loss that Scrooge makes on the debt will be disregarded. See the discussion in 6.75–6.76. If the debt did arise in the course of gaining or producing Scrooge’s assessable income or in carrying on business for that purpose, then it is likely that the loss that Scrooge makes on the debt will be deductible under either s 8-1 or s 25-35. If the debt was acquired before 13 May 1997, then the amounts deductible under other parts of the ITAA97 will be subtracted in calculating its reduced cost base. This should mean that Scrooge does not incur a capital loss when the debt is cancelled. Where the debt is acquired after 13 May 1997, then, as discussed in 6.101, any expenditure that is deductible under another part of the ITAA97 will not be included in its cost base. It would appear, however, [page 297] that any amount deductible under s 8-1 or s 25-35 would not be an expenditure. By

contrast, the reduced cost base of the debt in these circumstances will be reduced by s 110-55(9) by the amount deductible under s 8-1 or s 25-35, being $999, namely the face value of the debt of $1000 less $1 received from Cratchett. This should mean that the cost base of the debt remains $1000 with the result that Scrooge does not make a capital gain from CGT event C2. The reduced cost base of the debt will be $1 which will mean that Scrooge will not make a capital loss from the CGT event C2.

6.33 Under ITAA97 s 116-30(3A), where the market value substitution rule applies to CGT event C2, you calculate the market value of the CGT asset ‘as if the event had not occurred and was never proposed to occur’.

Alpha owes her mother a debt of $10,000. Out of natural love and affection, Alpha’s mother forgives the debt and releases Alpha from all obligations to repay it. Assume that at all times Alpha had the financial means to repay the debt in full. This gives rise to CGT event C2. There are no actual capital proceeds for the event. ITAA97 s 116-30(1) will mean that the market value of the debt will be substituted for the actual capital proceeds. Section 116-30(3A) will mean that the market value of the debt will be calculated as if CGT event C2 had not occurred and was never proposed to occur. This should mean that the market value of the debt is equal to its face value of $10,000. Hence, Alpha will not make a capital loss on the forgiveness of the debt. Note that unless the debt arose in gaining or producing Alpha’s assessable income or in carrying on business for that purpose, it will be a personal use asset to Alpha. This will mean that, as discussed in 6.76, any capital gain or capital loss that arises in relation to it will be disregarded.

Are the following true or false? 1. CGT event C2 happens when an option expires. 2. The market value substitution rule will always prevent a taxpayer from making a capital loss on the expiry of a restrictive covenant. 3. If a creditor agrees to release a debtor from his/her obligation to repay a debt CGT

event C2 happens at the time the contract of release is entered into. [page 298] 4. 5.

CGT event C2 applies to a lease that was renewed before 20 September 1985. CGT event C2 does not apply to the discharge by performance of a contractual right where the contract was entered into before 20 September 1985. Answers can be found in Study help.

Creating contractual or other rights: CGT event D1 6.34 No capital gains tax issue caused more difficulty under the ITAA36 than attempts to treat the creation of contractual rights as the creation and disposal of an asset. Parliament was clearly intent on taxing capital amounts that taxpayers received for entry into contractual obligations such as restrictive covenants. In tax policy terms, this made sense as such receipts clearly were additions to the taxpayer’s wealth. The problem was that the capital gains tax provisions in the ITAA36 were based on a model which required that an asset be disposed of before a capital gain or loss could be recognised. When a taxpayer created contractual rights in another person, it was arguable that the taxpayer was not disposing of any asset. In the case of a restrictive covenant, for example, a taxpayer may have been regarded as disposing of his or her liberties to work or trade but there were real doubts about whether such liberties could be regarded as CGT assets. The original CGT provisions enacted in the ITAA36 contained specific provisions, s 160M(6) and (7), which were probably intended to tax capital amounts received when contractual rights were created. These provisions proved to be ineffective in Hepples v FCT (1992) 173 CLR 492; (1991) 22 ATR 465; 91 ATC 4808.17 6.35 ITAA36 s 160M(6) and (7) were amended in 1992 in an effort to ensure that capital amounts received on the creation of contractual or other rights gave rise to CGT consequences. These amendments, particularly those made to s 160M(6), involved the introduction of several very artificial deeming provisions. For example, s 160M(6) and

associated sections, in effect, deemed the entry into a liability to be the creation and disposal of an asset. Apart from its artificiality, the problem with this approach was that, once something was deemed to be something other than what it actually was, it was necessary to ensure that deeming provisions were in place for every relevant aspect of the transaction. For example, some argued that the amended s 160M(6) and associated sections failed to say what the consideration in respect of the deemed disposal of the asset was. It was argued that the consideration could not be the actual consideration for entry into the contract as this amount actually was received for entry into a liability not for the creation and disposal of a fictional asset.18 [page 299] 6.36 CGT event D1 appears to overcome most of the difficulties that were associated with the attempts in the ITAA36 to tax capital amounts received on the creation of contractual and other rights. However, some problems may remain in the interpretation and application of CGT event D1. Because of the tortured history of attempts to tax capital receipts for creating contractual rights, it is useful to read all of ITAA97 s 104-35, which sets out when CGT event D1 happens. 104-35 Creating contractual or other rights: CGT event D1 (1) [Application] CGT event D1 happens if you create a contractual right or other legal or equitable right in another entity. Example: You enter into a contract with the purchaser of your business not to operate a similar business in the same town. The contract states that $20,000 was paid for this. You have created a contractual right in favour of the purchaser. If you breach the contract, the purchaser can enforce that right. (2) [Time of the event] The time of the event is when you enter into the contract or create the other right. (3) [Capital gain and capital loss] You make a capital gain if the capital proceeds from creating the right are more than the incidental costs you incurred that relate to the event. You make a capital loss if those capital proceeds are less.

Example: To continue the example: If you paid your lawyer $1,500 to draw up the contract, you make a capital gain of: $20,000 − $1,500 = $18,500 (4) [Costs include giving property] The costs can include giving property: see section 103-5. However, they do not include an amount you have received as recoupment of them and that is not included in your assessable income, or an amount to the extent that you have deducted or can deduct it. Exceptions (5) [Exclusions from CGT event D1] CGT event D1 does not happen if: (a) you created the right by borrowing money or obtaining credit from another entity; or (b) the right requires you to do something that is another CGT event that happens to you; or (c) a company issues or allots equity interests or non-equity shares in the company; or [page 300] (d) the trustee of a unit trust issues units in the trust; or (e) a company grants an option to acquire equity interests, non-equity shares or debentures in the company; or (f) the trustee of a unit trust grants an option to acquire units or debentures in the trust; or (g) you created the right by creating in another entity a right to receive an exploration benefit under a farming farmout arrangement. Example: You agree to sell land. You have created a contractual right in the buyer to enforce completion of the transaction. The sale results in you disposing of the land, an example of CGT event A1. This means that CGT event D1 does not happen.

Note that CGT event D1 does not pretend that by entering into a contract you were creating and disposing of the other party’s rights under that contract. No disposal of an asset needs to happen for CGT event D1 to take place. Rather, s 104-35 says that CGT event D1 happens when you create contractual rights. The time of the event is when you enter into the contract. 6.37 ITAA97 s 104-35 tells us that you will make a capital gain if the capital proceeds from creating the rights are more than the non-

deductible incidental costs that you incurred that relate to the event. This raises the question: How do we identify the capital proceeds for creating contractual or other rights? When you enter into a contract, you commonly accept obligations and give rights to the other party to the contract. Is the money you receive for entering into the contract properly described as being for creating contractual rights in the other party? Is it properly described as being received because of the creation of those contractual rights? The money would be more naturally described as being received for accepting your obligations. However, it is a fact that the other party’s rights under the contract are merely the reverse side of your obligations. Hence, it is probably reasonable enough to describe the amount you receive as actually being for the creation of contractual rights. 6.38 ITAA97 s 102-25(3) states that CGT event D1 will apply only to a given set of facts if no other CGT event (other than CGT event H2) applies. Note also that s 104-35(5)(b), in effect, tells us that CGT event D1 will not apply where your performance of your obligations, under the contract that created the right, will itself amount to a CGT event. Thus, if you enter into a contract which requires you to dispose of an asset (CGT event A1),19 destroy a CGT asset (CGT event C1), release a debt (CGT event C2), create an option (CGT event D2) or do anything else that amounts to another CGT event, then CGT event D1 will not apply to the rights that you created by entering into the contract. Hence, in deciding if CGT event D1 happens when you create contractual or other rights you must: [page 301] determine whether the creation of rights itself amounted to any other CGT event (other than CGT event H2); and determine whether performance of your obligations under the contract will amount to a CGT event that happens to you. 6.39

The interaction of CGT event D1 with other CGT events can be

complex. So, too, can be the relationship between CGT event D1 and the ordinary income. The complexity is illustrated in the following example.

Grant is a contract house painter. He enters into a contract to paint Camille’s house for $10,000. When the contract is completed, Camille pays Grant the $10,000. By entering into the contract, Grant has created contractual rights for Camille. When Grant completes the work, he will also acquire a CGT asset, namely the debt of $10,000 that Camille owes him. The $10,000 will also be ordinary income to Grant. Depending on whether Grant is a cash or accruals basis taxpayer, the $10,000 will be derived at the time of receipt or at the time that the debt is recoverable respectively. CGT event D1 happens when Grant creates the contractual rights for Camille. Prima facie, Grant makes a capital gain of $10,000 from this event. Probably, however, the antioverlap provision, ITAA97 s 118-20 (discussed in detail in 6.135–6.138), will reduce this capital gain to nil. The reduction will take place because the $10,000 is assessable income to Grant. It is likely that the cost base of the debt that Camille owes Grant will be nil. This is because all that Grant did to acquire the debt was perform services. It is likely that a performance of services by a taxpayer will not be included in the cost base of an asset. (This issue is discussed in 6.104.) The payment of $10,000 to Grant in satisfaction of the debt will amount to CGT event C2. The time that CGT event C2 takes place will depend on whether or not the contract to paint the house is regarded as a contract that resulted in CGT event C2 occurring. If it is, then the time of CGT event C2 will be when Grant entered into the contract with Camille. If not, then the time of CGT event C2 will be when Camille pays Grant. The capital proceeds from CGT event C2 will be $10,000. This will mean that Grant will make a prima facie capital gain of $10,000 when CGT event C2 happens. Hopefully, though, ITAA97 s 118-20 will reduce the capital gain to nil on the basis that the $10,000 is ordinary income to Grant. (Section 118-20 is discussed in detail in 6.135–6.138.) [page 302] Say that Camille refused to pay Grant. Assume that Grant sues Camille for the $10,000. Has CGT event D1 happened for Camille? It may have, in that Camille could, by breaching her contract, be seen as creating Grant’s right to sue her. Arguably, the time of the CGT event is when Camille breaches the contract rather than when she enters into it. This is because there needs to be a breach of contract before Grant obtains the right to sue. That is, the right to sue is created by Camille’s breach of contract, not by her entry

into the contract. However, Camille will not make a capital gain on CGT event D1 as she will not be entitled to receive any capital proceeds for creating the rights. Say that Grant and Camille then settled Grant’s court action for a payment to Grant of $8000 on the basis that each party would bear his or her own costs. Consistently with Taxation Ruling TR 95/35 (extracted in 6.130), either CGT event A1 or CGT event C2 would take place in relation to Grant’s right to sue Camille. Grant would make a prima facie capital gain of $8000. If Grant had written off Camille’s debt prior to settlement of the court action, then he would have obtained a bad debt deduction under ITAA97 s 2535 at the time of the write-off. The settlement moneys would then be included in Grant’s assessable income as a recoupment under s 20-30. Hopefully the inclusion of the $8000 in Grant’s assessable income under s 20-30 would mean that s 118-20 would reduce the capital gain of $8000 to nil.

Provisions relating to options 6.40 Another CGT event that occurs without involving the disposal of an asset is CGT event D2. This event happens when you grant an option. Under ITAA97 s 104-40(1), CGT event D2 happens when you grant an option to an entity, or renew or extend an option that you had granted previously. The event takes place when the option is granted, renewed or extended. Note that, although you create rights in the grantee when you grant an option, CGT event D1 does not take place. This is because the grant of an option is specifically deemed to be CGT event D2. CGT event D1 takes place only if another CGT event (other than CGT event H2) does not happen. 6.41 CGT event D2 does not apply to call options granted, renewed or extended by a company or a unit trust to acquire shares or units or debentures in the entity that granted the option. In response to the High Court decision in FCT v McNeil (2007) 229 CLR 656; 2007 ATC 4223, amendments were introduced in 2008 which altered the position of grantees of company-issued put and call options. The grantee shareholder’s position in relation to options granted by a company is discussed at 13.112–13.115. The position in relation to options granted by a unit trust is discussed at 15.122. CGT event D2 does not apply to options granted in relation to personal use assets or collectables. For a discussion of personal use assets, see 6.75–6.76 and 6.128, and of collectables, see 6.77, 6.78 and 6.128.

[page 303] 6.42 You make a capital gain if the capital proceeds from the grant, renewal or extension of the option are more than the expenditure that you incurred in the grant, renewal or extension. If the capital proceeds are less than that expenditure, then you make a capital loss. Note that, as was the case with CGT event D1, you are allowed only an extremely limited cost base for CGT event D2. The expenditure you incur to grant, renew or extend an option would normally be limited to items such as legal fees associated with drawing the option documents and to any stamp duty or other similar duty imposed on the option documents. If the option is exercised, then, under ITAA97 s 104-40(5), any capital gain or loss the grantor makes from the grant, release or extension of the option is disregarded. This shows that the rationale behind CGT event D2 is to catch amounts received by the grantor of an option where the grantee fails to exercise the option.

Discuss what the policy might be behind recognising capital gains or losses resulting from the granting of an option that fails to be exercised.

6.43 ITAA97 Div 134 deals with some of the consequences that arise if the other entity exercises the option. The ITAA97 makes a distinction between ‘call options’ and ‘put options’. A ‘call option’ is one that binds the grantor of the option to dispose of an asset to the grantee if the grantee exercises the option. Usually the obligation to dispose of the asset arises only if the grantee pays what is known as an exercise fee (or strike price). When the option is exercised, CGT event C2 takes place in relation to the grantee when his or her rights under the option end. However, under s 134-1(4), any capital

gain or loss that a grantee makes on the exercise of an option is disregarded.20 Division 134 states that when a call option is exercised the cost base of the asset that the grantee acquires on exercising the option will be the option fee (or premium) paid on the grant of the option and the amount paid to exercise the option. Notice that the sum of the option fee and the exercise fee (or strike price) may be less than the market value of the asset acquired by exercising the option. If the asset is subsequently disposed of for more than its cost base, the grantee will make a capital gain. If the capital proceeds of the asset are less than its reduced cost base the grantee will make a capital loss. When a call option is exercised, the grantor will dispose of a CGT asset to the grantee. This will give rise to CGT event A1. Under s 11665, the grantor’s capital proceeds for the disposal will include the fee (or premium) received for granting the option. The fee (or strike price) received on exercise of the option will be included in the capital proceeds as an amount received because of the disposal. In response to the High Court decision in FCT v McNeil (2007) 229 CLR 656; 2007 ATC 4223, Tax Laws Amendment (2008 Measures No 3) Act 2008 (Cth) [page 304] inserted new s 59-40 which, subject to certain conditions discussed at 13.115, deems the market value at the time of issue of company-issued call options to be non-assessable non-exempt income to the grantee shareholder. The operation of CGT in relation to the granting and exercise of a call option is illustrated in the following example.

Arthur grants an option to Xanthe that obliges him to transfer to her 5000 shares in XYZ Ltd on payment of an exercise fee of $4500. Xanthe pays a fee of $500 for the grant of the option. Assume that the shares are post-CGT assets to Arthur and that their cost base is $5000. CGT event D2 takes place for Arthur on the grant of the option. The capital proceeds for the grant are $500 and Arthur’s cost will be limited to expenditure incurred in granting the option. Xanthe exercises the option by paying the exercise price of $4500. Assume that at the time Xanthe exercises the option the shares are worth $7000. CGT event C2 will occur for Xanthe on the exercise of the option but under s 134-1(4) any capital gain or loss that Xanthe makes on the exercise of the option is disregarded. The cost of the shares to Xanthe will be $500 + $4500 = $5000. Thus, if Xanthe sold the shares for $7000 immediately after she acquired them she would make a capital gain of $2000. CGT event A1 will take place for Arthur when he disposes of the shares to Xanthe. The capital proceeds for the disposal will be the $4500 received on the exercise of the option and the $500 received on granting the option. As the cost base of the shares to Arthur was $5000, he will make neither a capital gain nor a capital loss on the disposal of the shares. The capital gain that Arthur made on granting the option will be disregarded when the option is exercised.

6.44 A ‘put option’ is one that obliges the grantor of the option to acquire an asset from the grantee. Here, the grantor will receive an option fee on granting the option but when the option is exercised will be required to pay an amount to the grantee. When a put option is exercised, CGT event C2 takes place in relation to the grantee when his or her rights under the option end. However, under s 134-1(4), any capital gain that a grantee makes on the exercise of the option is disregarded. Under Div 134, the first element of the cost base of the asset that the grantor acquires on the exercise of a put option will be the amount paid on the exercise less the option fee previously received from the grantee. In the case of put options acquired as a result of CGT event D2 happening to the issuing company, s 112-37, inserted by Tax Laws Amendment (2008 Measures No 3) Act 2008 (Cth), deems the cost base of the option to the grantee to be the sum of the amount included [page 305]

in the grantee’s assessable income as ordinary income as a result of the grantee’s acquisition of the option and any amount that the grantee paid to acquire the option. Section 112-37 was inserted in response to the decision in FCT v McNeil (2007) 229 CLR 656; 2007 ATC 4223, where the majority of the High Court held that the market value of put options issued to a trustee for shareholders in the company at a record date was ordinary income to a shareholder who did not exercise the options. Tax Laws Amendment (2008 Measures No 3) Act 2008 (Cth) also made consequential amendments to the operation of the market value substitution rule and to CGT event H2. The combined effect of these amendments is discussed at 13.115. The second element of the grantee’s cost base and reduced cost base of the asset disposed of to the grantor of a put option is deemed by s 134-1 to include the fee paid on the grant of the option. The operation of CGT in relation to the granting and exercise of a put option is illustrated in the following example.

Li Ming grants an option to Susan that requires Li Ming to purchase Susan’s yacht for $30,000. Susan pays Li Ming $5000 to grant the option. Assume that the yacht is a CGT asset for Susan and has a cost base of $20,000. CGT event D2 takes place for Li Ming on the grant of the option. The capital proceeds will be the option fee of $5000 and Li Ming’s costs will be limited to expenditure she incurred on granting the option. Susan exercises the option and Li Ming pays Susan $30,000 for the yacht. CGT event A1 takes place for Susan on the disposal of the yacht to Li Ming. The capital proceeds for Susan will be the $30,000 she receives on the exercise of the option less the $5000 that she paid Li Ming to grant the option. As the cost base of the yacht to Susan was $20,000 she will make a capital gain of $25,000 − $20,000 = $5000. The cost base of the yacht to Li Ming will be the $30,000 she paid when the option was exercised less the $5000 she received when she granted the option. Because the option has been exercised the capital gain that Li Ming made when she granted the option is disregarded.

Provisions relating to leases 6.45 There are several CGT events that are specifically relevant to leases. These are: CGT event F1, which occurs when a lessor grants, renews, or extends a lease; CGT event F2, which arises on the grant, renewal or extension of a lease of land for at least 50 years;21 [page 306] CGT event F3, which happens when a lessor incurs expenditure to obtain the lessee’s consent to vary or waive a term of the lease; CGT event F4, which occurs when a lessee receives money to consent to a variation or waiver of a term of the lease; and CGT event F5, which arises when a lessor receives payment for agreeing to vary or waive a term of the lease. A discussion of these CGT events, together with a consideration of the CGT position of a lessee on a grant of a lease, is contained in Study help.

Forfeiture of deposit: CGT event H1 6.46 CGT event H1 arises when a deposit paid to you is forfeited because a prospective sale or other transaction does not proceed. Under ITAA97 s 104-150, the time of the CGT event is when the deposit is forfeited. You make a capital gain if the deposit is more than the expenditure you incurred in connection with the prospective sale or other transaction. If the deposit is less than the expenditure you make a capital loss. Under amendments introduced in 2000, the deposit is reduced by any non-deductible part that is either repaid by you or by compensation which can be reasonably be regarded as a repayment of all or part of the deposit. CGT event H1 arises only in relation to a prospective sale. Two Full

Federal Court decisions have considered what was meant by ‘in respect of a prospective purchase’ in ITAA36 s 160ZZC(12) (the predecessor to s 104-150). In FCT v Guy (1996) 67 FCR 68; 137 ALR 193; 32 ATR 590, the Full Federal Court held that a normal deposit paid under a standard contract for sale of land was not ‘in respect of a prospective purchase’. The Full Federal Court commented that the section may apply to a deposit paid in respect of the grant of an option or of a negative pledge or of a right of pre-emption. The Full Federal Court also held that, even if s 160ZZC(12) had applied, the forfeiture of the deposit on the sale of the taxpayer’s principal place of residence would be exempt from CGT because of the principal place of residence exemption. In Brooks v FCT (2000) 100 FCR 117; 44 ATR 352, the Full Federal Court overruled the decision in Guy and held a normal deposit paid on a purchase of land was within ITAA36 s 160ZZC(12). In the view of the Full Federal Court in Brooks, the existence of a contract for sale did not mean that a deposit paid under it was not ‘in respect of a prospective purchase’. A purchase of land was prospective until the full purchase price was paid and a deed of transfer was executed. An alternative basis for the Full Federal Court’s decision in Guy was that the forfeited deposit was part of the consideration in respect of the disposal of the taxpayer’s principal residence. This was on the ground that the initial sale, the forfeiture of the deposit and the subsequent sale formed part of the one ‘continuum of events’. As the forfeited deposit was characterised as forming part of the consideration in respect of the disposal of the taxpayer’s principal residence, any capital gain that arose on that disposal was exempt. The Full Federal Court in Brooks (at ATR 364–5) referred to this aspect of the judgment in Guy with approval. [page 307]

Brooks v FCT Facts: Two companies, as trustees of two family trusts, owned land as joint tenants at Narrabeen in Sydney. At all relevant times, the land was let to parties who were unrelated to the companies. The companies entered into a standard formal agreement for sale of the land to a Mr and Mrs Masters. A deposit was paid by Mr and Mrs Masters on exchange of contracts. Mr and Mrs Masters did not complete the purchase and the companies forfeited the deposit. The vendor companies did not bring proceedings for damages for breach of contract against Mr and Mrs Masters but did not release them from any liability for such damages. Issues: The issues before the Full Federal Court were whether each company’s share of the forfeited deposit, or each company’s share of the forfeited deposit less its share of expenses of $888 associated with forfeiting the deposit, or any other amount should be brought to account as a net capital gain for the purpose of determining the net income of the respective family trusts. Held: The court concluded that the forfeited deposit would give rise to a capital gain under ITAA36 s 160M(6) if s 160ZZC did not apply. The court then considered whether ITAA36 s 160ZZC applied and found that it did. The court held that the amount to be included in each company’s assessable income was its share of the forfeited deposit less its share of the expenses of $888 incurred in connection with the prospective purchase. Hill, Nicholson and Sundberg JJ (at [46]–[49]): Before considering the terms of s 160ZZC(12) it is useful to say something about the policy of the legislation in its application to dispositions of land, so far as that can be gleaned from the ITAA 1936 … One thing emerges clearly from the provisions of Pt IIIA of the [ITAA36]. It was the Parliamentary intention that if a sale of land, not being land on which there was erected a dwelling used as the principal residence of the taxpayer, produced a profit, that profit would, subject to indexation and incidental expenses, be included in assessable income. That being the case it would seem strange that Parliament would have intended that, where a contract of purchase and sale of such land was terminated and the deposit paid under it forfeited, the result produced would be that no such amount be included in assessable income. It is less clear what one might expect Parliament to have intended where there was a forfeiture of a deposit under a contract for the [page 308] purchase and sale of residential land to which the provisions of s 160ZZQ(12) applied. On the one hand, where the situation as in Guy was that the vendor,

following termination, proceeded to sell the residential land, it might be concluded, as was held in Guy as an alternative basis for the decision, that the whole amount, deposit and ultimate sale price, was properly to be characterised as being “in respect of” the one disposition, viewing the initial uncompleted contract and the ultimate completed contract as part of the one transaction. Such a policy would make sense. Where there was not one transaction involving a disposition, but rather there was but an original contract that was terminated and as a result the vendor of the residential land became entitled to the forfeited deposit, it would not be unlikely that Parliament would take the view that the putative vendor had made a profit upon which tax should be payable for the vendor still retained the dwelling and the ability to dispose of it without the disposition attracting the provisions of Pt IIIA. The language of s 160ZZC(12) is, to say the least, far from elegant or, worse, clear. The subsection uses two words which seem rather at opposition to each other, namely “forfeiture” and “prospective purchase or other transaction”. The opposition can clearly be seen by contrasting two cases, the one said by the court in Guy to be included within the subsection and the other the present case. Where money is paid under a contract entered into prior to and in anticipation of a subsequent contract of sale, it is clearly apposite to refer to the purchaser under the proposed contract as being a “prospective purchaser”. However, it is not so clear that what is paid under the initial contract is “forfeited”. It is interesting to examine a number of the cases referred to in Guy, a number of which derive from Stonham, The Law of Vendor and Purchaser, 1964, pp 343–4 and consider the extent to which the provisions of s 160ZZC(12) might apply to them on the basis of what is said by the Full Court. Their Honours then examined the cases referred to in Guy, and continued (at [57]–[58]): We would not suggest that the full court in Guy used these cases as examples of circumstances to which s 160ZZC(12) could apply, for certainly they were all cases to which it could not. They were used as authority for the obvious proposition that the right to retain or forfeit a deposit depended upon all the circumstances. However, what the cases do illustrate, as common experience tells, is that in the normal case before [page 309] a formal contract eventuates a deposit paid would, unless there were express provision to the contrary, have to be repaid to the proposed purchaser. A class of case to which the full court in Guy referred in its discussion, and presumably as a class of case to which s 160ZZC(12) would apply, was what the court referred to as “a negative pledge or a right of pre-emption”. Their Honours then discussed the nature of a negative pledge and concluded that while it would be possible to refer to the consideration that was paid for a negative pledge as a ‘deposit’, what was paid could never be ‘forfeited’ as on payment it immediately became the property of the prospective vendor (at [59]–[61]):

On the view taken by the full court, but excluding cases where there is no forfeiture, the only case to which s 160ZZC(12) would seem to apply would be a pre-contract contract where the parties had agreed that the prospective vendor would, if the contract did not proceed, become entitled to forfeit the deposit. Forfeiture could only arise where the amount paid was not immediately and unconditionally the property of the prospective vendor. That would generally only be the case where the deposit (or earnest paid for the performance of the contract: cf Workers Trust & Merchant Bank Ltd v Dojap Investments Ltd [1993] AC 573 at 578–9 referred to in Guy) had, in some circumstance, to be refunded. What then is the difficulty with applying s 160ZZC(12) to a deposit paid under an ordinary contract of sale? First, what is paid is clearly a deposit on any view. Second, if the contract is terminated it is correct, and precisely correct, to refer to there being a forfeiture of the deposit. The forfeiture will arise where the contract has been cancelled or abandoned by the purchaser. The only obstacle, therefore, lies in the use of the phrase “prospective purchase”. It was upon this phrase that the court in Guy rested its decision. In doing so it referred to the dictionary meaning of “prospective”, the case of Drewery v Ware-Lane [1960] 1 WLR 1204, the case of Sorrell v Finch (to which reference has already been made) and to an extract from Mr Stonham’s work. The dictionary meaning of “prospective” quoted (the quotation is from the Macquarie Dictionary, 2nd ed, 1991) is “potential, likely expected”. The first meaning given in that dictionary is not inconsistent with that quoted by the full court, which was “in the future”. But the meaning of the phrase “prospective purchase” falls to be determined, not merely by reference to the word “prospective”, but by reference to [page 310] the complete phrase and in particular the word “purchase”. No doubt it is correct to refer to a pre-contract contract as a contract prior in time to a purchase in the future and thus as a prospective a purchase. However, the real question is whether it is correct or incorrect to refer to a contract which calls for completion in the future as a prospective purchase. We do not find the same difficulty as the full court in Guy did. A purchase of land is not completed until the purchase money is paid and an executed transfer handed over. That is when the sale actually takes place. Until completion, it is not inaccurate to treat the purchase as being in the future. Once the purchase money is paid the payer becomes a bona fide purchaser for value, but not before. Their Honours then distinguished Drewery v Ware-Lane. Their Honours then considered whether regard should be had to statements made in the Explanatory Memorandum that accompanied Tax Law Improvement Bill (No 2) 1997 (Cth), which introduced ITAA97 s 104-150, in interpreting ITAA36 s 160ZZC. Their Honours concluded that, whether or not this was appropriate, whatever was said in the Explanatory Memorandum would not change what the law was prior to 1997. The judgment then continued (at [69]–[71]): It should by now be clear that we are of the view that Guy was plainly wrong. The

present is a case where error should not be perpetuated. Both the policy of the legislation and its language lead to the conclusion that the forfeiture of a deposit under a contract of sale which has been terminated for breach gives rise to a gain which, subject to such adjustments as are required to be made, is to be included in assessable income. Although, in the view we take, all of ss 160M(6), 160M(7) and 160ZZC(12) have application, because both ss 160M(6) and 160M(7) are subject to the other provisions of Pt IIIA, the consequence is that the provisions of s 160ZZC(12) will apply to bring into operation s 160ZZC(3). We are firmly of the view that the court should not be quick in declining to follow prior authority. This is so particularly where that prior authority may have been relied upon: cf John v FCT (1989) 166 CLR 417 at 438–40; 20 ATR 1 at 13–14; 89 ATC 4101 at 4112. Although it may be said that taxpayers might, in the relatively short time since Guy was decided, have omitted from their returns gains arising from the forfeiture of deposits, and thus become liable to penalty, that is not, in reality, likely to give rise to any great difficulty. [page 311] It is not as if there has been shown to be reliance upon the decision in the sense that steps were taken to forfeit a deposit because of the taxation consequences which Guy espoused. We are accordingly of the view that Guy should not be followed. Conclusion The questions in the stated case raise not merely the issue of whether Pt IIIA of the [ITAA36] operates to include any amount in assessable income, but also the question of the quantum of the amount. Neither the applicants nor the respondent addressed this question. By force of s 160ZZC(6), the cost base to a taxpayer of an option is taken to comprise the expenditure incurred by the taxpayer in respect of the grant and not any other amounts. By force of s 160ZZC(12) (b), the costs incurred in connection with the prospective purchase are to be taken to be the expenditure incurred in respect of the deemed grant of the option to which para (a) of the same subsection refers. According to the facts as stated, the expenditure incurred was $888.

How, if at all, would the amount brought to tax in Brooks v FCT have differed if the assessment had been under ITAA36 s 160M(6) (the ITAA36 equivalent of ITAA97 CGT event D1) rather than under ITAA36 s 160ZZC (the ITAA36 equivalent of ITAA97 CGT event H1)?

6.47 Prior to the Full Federal Court decision in Brooks v FCT (2000) 100 FCR 117; 44 ATR 352, an indication of the Commissioner’s views on the operation of CGT event H1 could be found in Taxation Ruling TR 1999/19 ‘Income Tax: Capital Gains: Treatment of Forfeited Deposits’. On 11 October 2000, the Commissioner issued an Addendum (TR 1999/19A) to TR 1999/19 indicating how the ruling had been affected by the Full Federal Court decision in Brooks. Paragraphs 4–8 of the Addendum summarise the effect of the decision on the ruling as follows. TR 1999/19A: Addendum to TR 1999/19 4. Accordingly, the main effect of the decision in the Brooks case on TR 1999/19 is that it clarifies that if the forfeiture of a deposit under a contract for the sale of real estate does not occur within a ‘continuum of events’ as that expression is used in TR 1999/19, the forfeited deposit is assessable under CGT event H1 in section 104-150 of ITAA 1997 [page 312]

5.

6.

(or subsection 160ZZC(12) of ITAA 1936 if the forfeiture occurred before the beginning of the 1998–99 income year). This is the case whether the contract is for the sale of pre-CGT real estate, post-CGT real estate or a main residence. The deposit (to the extent that it is more than any expenditure the vendor incurs in connection with the sale) is assessable as a capital gain in accordance with subsection 104-150(3) of ITAA 1997. This alters the position taken in TR 1999/19 (paragraphs 7, 12, 15 and 25) that the forfeited deposit in this situation was assessable as a result of CGT event C2 in section 104-25 of ITAA 1997 happening to the vendor’s contractual rights and not under CGT event H1 in s 104-150 of ITAA 1997. If a deposit is forfeited under a contract for the sale of a main residence or pre-CGT real estate where the forfeiture occurs within a continuum of events constituting a later disposal of the main residence or pre-CGT real estate, the position taken in TR 1999/19 (paragraphs 9, 10 and 25) remains that the deposit is not assessable. In the ITAA 1997, this principle has, in the context of the main residence exemption, been given express statutory recognition in paragraphs 118-110(2)(b) and 118-195(2)(b). It also continues to apply (although by reference to general principles) for pre-CGT real estate. If a deposit is forfeited under a contract for the sale of post-CGT real estate where the forfeiture occurs within a continuum of events constituting a later disposal of the post-CGT real estate, the position taken in TR 1999/19 (paragraphs 9, 11 and 25) remains that the deposit forms part of the capital proceeds from CGT event A1 in section 104-10 of ITAA 1997 happening to the post-CGT real estate. Paragraph 47 of the judgment in the Brooks case supports, by way of obiter dicta, this position: 2000

7. 8.

ATC at 4373; 44 ATR at 364. Apart from these aspects, no other change to TR 1999/19 is necessitated by the decision in the Brooks case. In this addendum ‘pre-CGT real estate’ means real estate acquired before 20 September 1985 and ‘post-CGT real estate’ means real estate acquired on or after 20 September 1985.

A summary of situations where CGT event H1 will and will not arise taken from TR 1999/19 is located in Study help.

Receipt for event relating to CGT asset: CGT event H2 6.48 The background to CGT event H2 is found in the complex High Court decision in Hepples v FCT (1992) 173 CLR 492; (1991) 22 ATR 465; 91 ATC 4808. The High Court considered the possible operation of ITAA36 s 160M(7) in the context of a payment to an employee for entering into a restrictive covenant in a [page 313] service agreement. The facts in Hepples are summarised in Study help. ITAA36 s 160M(7), as it then stood, read as follows: 160M (7) [Consideration in relation to act, transaction or event] [Prior to 1992 amendments] Without limiting the generality of subsection (2) but subject to the other provisions of this Part, where: (a) an act or transaction has taken place in relation to an asset or an event affecting an asset has occurred; and (b) the person has received, or is entitled to receive, an amount of money or other consideration by reason of the act, transaction or event (whether or not any asset was or will be acquired by the person paying the money or giving the other consideration) including, but not limited to, an amount of money or other consideration: (i) in the case of an asset being a right in return for forfeiting or surrendering the right or for refraining from exercising the right; or (ii) for use or exploitation of the asset, the act, transaction or event constitutes a disposal by the person who received, or is entitled to receive, the money or other consideration of an asset created by the disposal and, for the purposes of

the application of this Part in relation to that disposal; (c) the money or other consideration constitutes the consideration in respect of the disposal; and (d) the person shall be deemed not to have paid or given any consideration, or incurred any costs or expenditure, referred to in paragraph 160ZH(1) (a), (b), (c) or (d), (2) (a), (b), (c) or (d) or (3)(a), (b), (c) or (d) in respect of the asset.

6.49 A majority of the High Court in Hepples held that s 160M(7) did not apply to the entry into the restrictive covenant by Hepples. Of the majority judges on this issue, Brennan J (with whom Mason CJ agreed on this point) held that s 160M(7) did not apply because the entry into the restrictive covenant did not relate to an existing asset owned by any person. The entry into the restrictive covenant added to the existing assets of Hunter Douglas but did not relate to an existing asset. Similarly, McHugh J held that s 160M(7) did not apply because the receipt of the payment by Hepples and the expenditure by Hunter Douglas did not affect any existing asset owned by anyone. In particular, the expenditure did not affect Hunter Douglas’s existing goodwill but merely added to sources of earning which would be sources of goodwill when the service contract terminated.22 Deane J held that s 160M(7) [page 314] did not apply because, in his Honour’s view, s 160M(7) should be confined to the situation where the taxpayer owned the relevant asset immediately before the deemed disposal effected by the act, transaction or event. Dawson and Gaudron JJ held that s 160M(7) did not apply because, in their view, s 160M(6), to which s 160M(7) was subject, did apply. 6.50 ITAA36 s 160M(7) was amended in 1992. The amendments, in conjunction with amendments to s 160M(6), had the effect of clarifying the potential scope of s 160M(7). The 1992 amendments made it clear that s 160M(7) could apply only where the taxpayer owned the asset at

the time of the act, transaction or event. However, the amendments expressly stated that the act, transaction or event, while required to be in relation to the taxpayer’s asset, need not affect the asset. Consistently with the disposal of an asset paradigm used in ITAA36 Pt IIIA, under the amended s 160M(7), the act, transaction or event in relation to the asset was still deemed to amount to a disposal of an asset which was taken to have been acquired and owned by the taxpayer immediately before the act, transaction or event. As noted previously, in the CGT provisions in the ITAA97, the disposal of an asset paradigm has been abandoned. Instead, the concept of CGT events has been used. CGT event H2 covers the same field as ITAA36 s 160M(7) following the 1992 amendments but does so without resort to the fiction of deeming there to be the acquisition and disposal of a notional asset. 6.51 Under ITAA97 s 104-155, CGT event H2 happens if an act, transaction, or event occurs in relation to a CGT asset that you own. Note that, as was the case for ITAA36 s 160M(7) following the 1992 amendments, for CGT event H2 to take place you must own the asset in relation to which the act, transaction or event takes place. Note also that, while the act, transaction or event must relate to the asset, it need not affect the asset. CGT event H2 applies only if the act, transaction or event does not result in an adjustment being made to the asset’s cost base, or reduced cost base. CGT event H2 does not apply where any other CGT event applies. The time that CGT event H2 takes place is when the act, transaction or event occurs. In determining whether a capital gain or loss is made from CGT event H2, the incidental costs, such as legal fees, that you incurred that relate to the CGT event are subtracted from the capital proceeds from the CGT event.

CGT event H2, like ITAA36 s 160M(7) following the 1992 amendments, will apply only in limited circumstances. In Taxation Ruling TR 95/3, examples given of the possible application of the amended s 160M(7) were where a payment is received in consideration

of the payee agreeing to refrain from exercising a right which does not result in other rights vesting in the payer. The comment is made in TR 95/3 that s 160M(7) will have only a residual operation in relation to restrictive covenants and that, in relation to exclusive trade ties and exclusive dealing contracts, s 160M(7), in practice, only rarely applies. [page 315] In TR 1999/18 at para 14, the view was expressed that s 160M(7) would apply to receipts by a lessor for accepting a surrender of a lease. The lessor’s agreement to the surrender of the lease is regarded as an act, transaction or event in relation to the lessor’s reversionary interest in the land. Ruling TR 1999/18 commented that the lessor’s reversionary interest in the land changes to an unencumbered freehold. Arguably, CGT event F5 (lessor receives payment for changing lease) does not apply as a surrender of a lease involves more than a mere variation or waiver of the terms of the lease. Under a surrender of a lease, the lease itself is extinguished, whereas in a variation or waiver of a term the lease, as varied, continues.a Another instance where the Commissioner considers that CGT event H2 will occur is where an insurance agent receives an amount for selling part of an insurance register to another agent or the insurance company, by entering into a contractual variation of the agency agreement with the insurance company. TR 2000/1 expresses the view that the selling agent would make a capital gain to the extent that the amount received is greater than the incidental costs of that event (s 104-155, event H2). TR 2000/1 views the contractual variation as an act, transaction or event that occurs in relation to a CGT asset (the agency agreement). A capital loss is regarded as being made where the incidental costs exceed the amount received. The ruling notes that a payment received for a variation to a contract comes within ITAA97 s 104-155, irrespective of whether the agency agreement being varied was entered into before or after 20 September 1985.

a.

TR 1999/18 was withdrawn on 26 March 2003. The notice of withdrawal indicated that because of changes to ss 104-10(5)(b) and 104-25(5)(b), which recognised a lessor’s rights under a lease as assets for CGT purposes, the views in TR 1999/18 were being reconsidered.

6.52 Any capital gain or loss that you make from CGT event H2 is disregarded if the act, transaction or event that triggers the CGT event is the borrowing of money from another entity.

You borrow money on the security of land that you own. The granting of security in relation to the land would arguably trigger CGT event H2. The borrowed moneys would be the capital proceeds. Under ITAA97 s 104-155(5), however, any capital gain or loss made from this CGT event would be disregarded.

[page 316] 6.53 A capital gain or loss from CGT event H2 is also disregarded if the act, transaction or event requires you to do something that is itself another CGT event. Nor does CGT event H2 happen where: a company issues or allots equity interests or non-equity shares in the company; a trustee of a unit trust issues units in the trust; a company grants an option to acquire equity interests, non-equity shares or debentures in the company; a trustee of a unit trust grants an option to acquire units or debentures in the trust; or a company or a trust that is a member of a demerged group issues new ownership interests under a demerger. CGT provisions relating to demergers are discussed in Chapter 13.

1.

How would the CGT provisions in the ITAA97 apply if the facts in Hepples occurred today? 2. What would the position in Hepples be today if the restrictive covenant came into operation during the currency of the service contract? Reading the extracts from TR 95/3 in Study help dealing with the application of CGT to restrictive covenants may help you.

In FCT v McNeil (2005) 144 FCR 514; 60 ATR 275, the Full Federal Court considered whether CGT event H2 applied to an issue of put options by St George Bank Ltd (St George) as part of an off-market buy-back of shares.

FCT v McNeil Facts: Mrs McNeil owned 5450 shares in St George. In January 2001, St George announced that for every 20 ordinary shares held on 12 January 2001 it would issue one ‘sell back right’ to St George Custodial Pty Ltd (Custodial) as trustee for relevant shareholders on 19 February 2001. The sell back rights were in the form of put options. Each sell back right enabled the holder to require St George to buy back one share at $16.50. The number of shares subject to the announcement represented approximately 5% of the then-issued capital of St George. As a result of the arrangement, Custodial came to hold 272 sell back rights on trust for Mrs McNeil. If a shareholder wished to sell their shares back to St George or to sell their sell back rights on the market, the shareholder was required to give a notice to Custodial to this effect before the rights were issued on 19 February 2001. Where a shareholder did not so direct Custodial, the rights were issued to Custodial which was then obliged to sell them to the sole broker for the buy-back. The sole [page 317] broker was then required to sell or exercise the rights and to account to Custodial, as trustee for each shareholder in question.a The sell back rights traded on the ASX from 19 February 2001 until 13 March 2001. The market value of St George shares on 19 February varied between $14.45 and $14.64 per share. The sell back rights, therefore, had a value equal to the difference between the market value of St George shares and the amount of $16.50 at which a holder of the sell back rights could require St George to buy back shares. Using this logic, the parties agreed that the market value of one sell back right at the issue date was $1.89. Mrs McNeil did not give notice to Custodial that she wished either to sell her shares back to St George or to sell her rights on the market. Accordingly, Mrs McNeil’s rights were issued to Custodial, sold to the broker who then sold them on the market. Following the sale by the broker of the rights held on trust for Mrs McNeil, Custodial paid $576.64 being the proceeds of the sale into her bank account with St George. Part of the $576.64, namely $62.64, represented the increase in the realisable value of the sell back rights after their issue date. Mrs McNeil, in her return for the year ended 30 June 2001, declared $514 as ordinary income under ITAA97 s 6-5, representing the value, $1.89, of the sell back rights at the date of issue, multiplied by the number of rights. Mrs McNeil also declared $62 as a capital gain being the capital proceeds of $2.12 per right less the cost base of $1.89 per right multiplied by the number of rights. The Commissioner assessed Mrs McNeil on the basis of her return. Mrs McNeil objected to the inclusion of $514 in her assessable income under ITAA97 s 6-5 or as a capital gain. Mrs McNeil did not object to the accrual of the

capital gain of $62. The Commissioner disallowed the objection advising that the $514 was either ordinary income to Mrs McNeil under s 6-5 or was a capital gain on the basis that the grant of the rights triggered CGT event H2. Decision at first instance At first instance, McNeil v FCT (2004) 206 ALR 44, Conti J held that the grant of the put options was not ordinary income to Mrs McNeil and did not trigger CGT event H2. On appeal, a majority of the Full Federal Court also held that the grant of the put options was not ordinary income and did not trigger CGT event H2. Full Federal Court decision A majority (French and Dowsett JJ; Emmett J dissenting) of the Full Federal Court held that the grant of the put options was income under ordinary concepts to Mrs McNeil. The Full Federal Court unanimously held that the grant of the put options did not trigger CGT event H2. [page 318] French J held that neither the creation of the taxpayer’s entitlement to the sell back rights nor the payment of the proceeds of the sale of the rights could be said, at the time of the creation or payment, to have occurred in relation to a CGT asset then owned by the taxpayer. For the purposes of the scheme, it did not matter that Mrs McNeil held shares at the time of the grant of the rights (in April 2001) but what did matter was that Mrs McNeil held shares on 12 January 2001. Furthermore, in French J’s view, the act, transaction or event referred to in CGT event H2 could not itself be the money or consideration received for the purposes of identifying the capital proceeds of the event. Dowsett J considered whether an act, transaction or event had taken place ‘in relation to’ an asset. Dowsett J considered that this phrase might describe any event capable of affecting the capital value of a particular asset. Dowsett J questioned whether the issue of rights to Custodial was capable of affecting the value of the taxpayer’s shares. In Dowsett J’s view, the value of the taxpayer’s shares had already been affected by the decision of St George to implement the scheme. Dowsett J considered that it was unnecessary to decide this issue as there was no consideration for the grant of the rights. In response to the Commissioner’s argument that the rights themselves were the consideration for their grant, Dowsett J noted authorities to the effect that consideration normally involves an element of exchange. In Dowsett J’s view, no benefit flowed to Mrs McNeil from the grant of the rights. Rather, the grant of the rights was merely a mechanism to facilitate the realisation of Mrs McNeil’s pre-existing entitlements. In Dowsett J’s view, whatever the precise meaning of ‘consideration’, in the present context it could not describe something which was of no value. Emmett J held that the grant of the rights was not in relation to the taxpayer’s shares but, rather, was in relation to the taxpayer being a shareholder at the record date of 12 January 2001. In Emmett J’s view, CGT event H2 had to involve some juridical act by the taxpayer not merely the passive receipt by a taxpayer of a benefit from a third party. Capital proceeds were not money received by a taxpayer by reason of some act, transaction or event initiated by another person, whether or not that act, transaction or

event occurred in relation to an asset owned by the taxpayer. Here, the grant of the rights could not be a receipt for purposes of CGT event H2 as the grant itself was the only relevant act, transaction or event. The capital proceeds had to be something apart from the relevant act, transaction or event, since the section required that there was [page 319] something that the taxpayer received, or was entitled to receive, because of the relevant act, transaction or event. High Court decision The Commissioner appealed to the High Court where a majority (Gummow ACJ, Hayne, Heydon and Brennan JJ; Callinan J dissenting) held that the grant of the sell back rights was ordinary income to Mrs McNeil under the gain from property principle and, for that reason, it was unnecessary to consider whether the grant triggered CGT event H2. In his dissenting judgment, Callinan J held that the grant of the sell back rights was not ordinary income to Mrs McNeil and, agreeing with the judgment of Dowsett J in the Full Federal Court, did not trigger CGT event H2.

a.

1.

2.

Shareholders who were not Australian or New Zealand residents, and employees of St George who held shares under employee share schemes, were referred to as ‘excluded shareholders’. Excluded shareholders could not require the put options to be vested in them but were entitled to a proportionate share of the proceeds of the put options which were sold by the sole broker who then accounted for the proceeds to Custodial. Similarly, shareholders who elected for the put options to be vested in them, but who did not exercise them or sell them on the market, were also entitled to a proportionate share of the sale of the put options by the sole broker.

What CGT event (if any) occurred for St George Bank on the granting of the sell back rights? What would be the CGT consequences of the granting of the sell back rights for St George Bank? Return to this question later in this chapter and consider the possible operation of the market value substitution rule in ITAA97 s 116-30. What would be the position of a shareholder who exercised the sell back rights? What would be the position of a shareholder who transferred the sell back rights?

Following the High Court decision in FCT v McNeil (2007) 229 CLR

656; 2007 ATC 4223, Tax Laws Amendment (2008 Measures No 3) Act 2008 (Cth) inserted ITAA97 s 104-155(5)(ea), which means that CGT event H2 does not happen where a company grants put options in relation to shares in the company. These amendments are discussed in more detail at 13.115.

Change of residence and other events 6.54 Two CGT events can be triggered by a change in residence. Where a taxpayer is a foreign resident at the time of a CGT event, ITAA97 s 855-10 provides that a [page 320] capital gain or loss from the event is disregarded if the CGT event happens in relation to an asset that is not ‘taxable Australian property’, which is defined in s 855-15. Broadly, the effect of the definition is that taxable Australian property will be: (a) taxable Australian real property (real property and mining and quarrying rights situated in Australia); (b) indirect Australian real property interests (10% or greater interests held in Australian real property through, for example, one or more interposed companies — in the 2013–14 Federal Budget, the previous government proposed changes to the provisions relating to indirect interests in real property. Some of these proposals were enacted by the Abbott Government. The changes are discussed in more detail in Chapter 18); (c) assets which do not fall within either (a) or (b) and which the taxpayer uses in carrying on business in Australia through a permanent establishment (a branch would normally be an example of a permanent establishment — Tax and Superannuation Laws Amendment (2014 Measures No 4) Act 2014 (Cth) amended the definition of ‘permanent establishment’ for these purposes. The definition of ‘permanent establishment’ for these purposes is discussed in Chapter 18);

(d) an option to acquire any of the assets referred to in (a)–(c); and (e) an asset in respect of which the taxpayer has chosen under ITAA97 s 104-165(3) (discussed below) to disregard a capital gain or loss that would otherwise arise on the taxpayer ceasing to be an Australian resident. By contrast, Australia applies CGT to residents irrespective of the location of the asset or the source of the payment. Hence, if CGT events did not arise on a change of residence, unrealised capital gains by former residents on assets that were not taxable Australian property would escape Australian CGT if they were disposed of after the change of residency. CGT event I1 applies when an individual or company stops being an Australian resident. Capital gains and/or losses can arise under CGT event I1 in respect of all the individual’s or company’s post-19 September 1985 assets other than those that are taxable Australian property falling within categories (a) or (c) and within category (d) because the asset is an option or a right in relation to either a category (a) or a category (c) asset. Note, therefore, that, subject to exceptions, CGT event I1 takes place in relation to category (b) taxable Australian property. Capital gains and losses are calculated on an asset-by-asset basis. A capital gain is made if the market value of the asset at the time of the event is more than its cost base. A capital loss is made if the market value of the asset is less than its reduced cost base. In the case of category (b) taxable Australian property or an option to acquire category (b) taxable Australian property, the cost base and the reduced cost base of the relevant asset are deemed to be its market value just after the time of the event. An important exception to CGT event I1 is that, under s 104-165(2), an individual can choose to disregard making a capital gain or loss from all CGT assets covered by CGT event I1. The price for making this election, however, is that each of those assets is taken to be taxable Australian property until a CGT event happens to it that involves you ceasing to own the asset or you subsequently resume Australian

[page 321] residency: see s 104-165(3). As the assets continue to be taxable Australian property, they will be subject to Australian CGT if a CGT event takes place in relation to them. Under s 768-915, a capital gain or loss from CGT event I1 is disregarded where a temporary resident becomes a foreign resident.23 Similarly, CGT event I2 takes place when a trust stops being a resident trust. Under s 104-170, the trustee is required to determine if it made a capital gain or loss for each post-19 September 1985 CGT asset it owned in that capacity at that time other than assets that are taxable Australian property falling within categories (a) or (c) and within category (d) because the asset is an option or a right in relation to either a category (a) or a category (c) asset. Capital gains and losses are calculated on an asset-by-asset basis. The trustee makes a capital gain if the market value of an asset is more than its cost base. A capital loss is made if the market value of the asset is less than its reduced cost base. Again, where the asset is category (b) taxable Australian property or an option to acquire category (b) taxable Australian property, the cost base and the reduced cost base of the relevant asset are deemed to be its market value just after the time of the event.

Other CGT events 6.55 Several CGT events are discussed in other chapters. The following table summarises these events and indicates where they are discussed: CGT event

General description

Principal discussion

CGT event E1

Creating a trust over a CGT asset

15.91

CGT event E2

Transferring CGT assets to a trust

15.92

CGT event E3

Converting a trust to a unit trust

15.93

CGT event E4

Capital payment for trust interest

15.100–15.104

CGT event E5

Beneficiary becoming entitled to trust asset

15.105–15.106

CGT event E6

Disposal to beneficiary to end income right

15.107–15.110

CGT event E7

Disposal to beneficiary to end capital interest 15.111–15.117

CGT event E8

Disposal by beneficiary of capital interest

15.118

CGT event E9

Agreement to hold property on trust when it 15.94 comes into existence

[page 322] CGT event

General description

Principal discussion

CGT event C3

End of company-issued option to acquire shares or debentures

12.135

CGT event G1

Capital payment for shares

13.118–13.121

CGT event G3

Liquidator declares shares worthless

13.122

CGT event J1

Companies cease to be members of same 12.139 wholly owned group following Subdiv 126-B roll-over

CGT event K6

Pre-CGT shares or interests and company/trust with post-CGT assets

13.123–13.128, 15.124

CGT event K7

Balancing adjustment event happens to depreciating asset used partly for nontaxable purpose

10.65

CGT events: Conclusion 6.56 The concept of CGT events is of critical importance in the CGT provisions of the ITAA97. A capital gain or loss can arise only if a CGT event takes place. The details of how a capital gain or loss is calculated are specific to each CGT event. These details are contained within each operative provision that explains when a particular CGT event occurs. In applying CGT events, the general rule is that you use the event that is most specific to your situation. Thus, in practice, in most cases, a useful first step in determining whether a CGT liability will arise in your circumstances is to read through the list of CGT events in s 104-5 and identify the event or events that might apply to you.

Entity making the gain or loss

6.57 In some circumstances, special rules apply to deem the entity making the gain or loss to be a different entity to the entity that would otherwise make it if general law principles were applied. In other cases, special rules clarify which entity makes a capital gain or loss in situations where that conclusion would otherwise be uncertain. It is appropriate to mention three rules in the first category here. These are rules that apply where a CGT asset is vested in either a Trustee in Bankruptcy (ITAA97 s 106-30), in a liquidator (s 106-35) or in another entity (here referred to as ‘the security holder’) for the purpose of enforcing, giving effect to or maintaining a security, charge or encumbrance over the asset (s 106-60). The effect of these rules is that the vesting of the asset in the trustee, the liquidator or the security holder is ignored for CGT purposes and the acts in relation to the CGT asset of the Trustee, the liquidator or the security holder are treated as if they were done by the bankrupt, the company or the entity granting the security. Other special rules relate to partnerships and trusts. These rules will be discussed in Chapter 15 and Chapter 16 respectively. [page 323]

Case study on CGT event A1 6.58 The most common CGT event will probably be CGT event A1, which occurs when a CGT asset is disposed of. Working through the following extended case study based on the disposal of a CGT asset should assist you in understanding some of the key concepts that need to be applied in CGT event A1 and in CGT generally. Suggested solutions to the issues in the case study are contained in Study help references for 6.76, 6.78, 6.83, 6.84, 6.88, 6.98, 6.118, 6.124, 6.160 and 6.166.

Steve and Sarah Steve is an Australian resident taxpayer. He purchased a block of land in Whyalla in South Australia on 1 January 1984 for $2000. On 1 March 1986, he purchased 600 shares in BHP Ltd for $20,000. On 1 June 1987, he purchased a further 400 shares in BHP Ltd for $10,000. On 1 August 1990, he purchased a home in Melbourne for $400,000. Steve lived in the Melbourne home from 1 August 1990 until 1 September 2000 except for a period of 10 months in 1995 when he was stationed in Russia by his employer. Steve allowed one of his colleagues to live in the Melbourne home rent-free during this period. On 1 July 1996, he purchased a butterfly collection for $800 and purchased a coin collection for $600. In 1992, Steve purchased a yacht for $80,000. On 1 January 2017, he retired from his position as a rocket scientist. At retirement, he entered into a restrictive covenant with his employer under which he agreed that he would not divulge to any other party any secret information that he had gained while employed as a rocket scientist. Steve was paid $60,000 for entering into the restrictive covenant. On 1 July 2017, following his retirement, he subdivided the land in Whyalla into two blocks. From 1 July 2017 to 1 September 2017, using his own labour, he built a house on one of the blocks. Steve valued his labour at $20,000 and paid $50,000 for materials used in constructing the home. Steve sold the block with the house constructed on it for $80,000 on 1 September 2017. Steve sold the other block on 1 September 2017 for $1500. He also sold 500 of his shares in BHP Ltd on 1 September 2017 for $7500. He sold, on 1 September 2017, a 50% interest in the yacht to his sister, Sarah, for $35,000. The market value of the yacht at the time was $75,000. At this time, Steve sold his butterfly collection for $300 but retained his coin collection, which had increased in value to $1000. [page 324] On 1 September 2017, he sold his home in Melbourne for $700,000 and, on 1 November 2017, acquired a home and 100 hectares of adjoining rainforest land near the New South Wales town of Bellingen. Unfortunately, Steve’s coin collection was lost in moving to Bellingen on 1 November 2017. Steve received an insurance payout of $1200 (being the agreed value of the coin collection) on 1 December 2017. Steve’s intention was to reside in the home near Bellingen and watch the trees grow. Unfortunately, the solitude was too much for Steve and he drowned himself in the Bellinger River early on the morning of 1 January 2018. His sister Sarah is the sole beneficiary under his will. Sarah finds that Steve had not completed his 2016–17 tax return as at the date of his death. Sarah seeks your advice on

CGT matters relevant to Steve’s estate. Do not consider events in this case study from Steve’s death onwards.

6.59 Recall the diagram in 6.7 ‘How to calculate a capital gain and a capital loss’. Note that the first step involved in calculating a capital gain or a capital loss involves identifying what CGT events happened in the income year. When faced with a set of facts like those in the Steve and Sarah case study, you would be likely to think that several of the facts could amount to CGT events. At least, you need to think about what the CGT consequences of the following events would be (note, events from Steve’s death onwards will not be discussed here but reference should be made to the discussion of CGT aspects of deceased estates in 15.132–15.135): the receipt of $60,000 when Steve entered into the restrictive covenant on 1 January 2017; the subdivision of the two blocks of land in Whyalla on 1 July 2017; the construction of the house on one of the blocks of land in Whyalla between 1 July 2017 and 1 September 2017; the sale of the house and land in Whyalla on 1 September 2017; the sale of the remaining block of land at Whyalla on 1 September 2017; the sale of 500 BHP Ltd shares on 1 September 2017; the sale of the 50% interest in the yacht on 1 September 2017; the sale of the butterfly collection on 1 September 2017; the sale of the Melbourne home on 1 September 2017; and the loss of the coin collection on 1 November 2017 (note that the insurance payout took place on 1 December 2017). 6.60 In 6.25, we briefly outlined the prerequisites for the operation of CGT event A1. We also briefly noted the effect of CGT event A1. At this point, reading the operative provision which sets out CGT event A1 is worthwhile, as this will help us in identifying the constituent elements of CGT event A1.

[page 325]

104-10 Disposal of a CGT asset: CGT event A1 (1) [Application] CGT event A1 happens if you dispose of a CGT asset. (2) You dispose of a CGT asset if a change of ownership occurs from you to another entity, whether because of some act or event or by operation of law. However, a change of ownership does not occur if you stop being the legal owner of the asset but continue to be its beneficial owner. Note: A change in the trustee of a trust does not constitute a change in the entity that is the trustee of the trust (see subsection 960-100(2)). This means that CGT event A1 will not happen merely because of a change in the trustee. (3) [Time of the event] The time of the event is: (a) when you enter into the contract for the disposal; or (b) if there is no contract when the change of ownership occurs. Example: In June 1999 you enter into a contract to sell land. The contract is settled in October 1999. You make a capital gain of $50,000. The gain is made in the 1998–99 income year (the year you entered into the contract) and not the 1999–2000 income year (the year that settlement takes place). Note 1: If the contract falls through before completion, this event does not happen because no change in ownership occurs. Note 2: If the asset was compulsorily acquired from you: see subsection (6). (4) [Capital gain and capital loss] You make a capital gain if the capital proceeds from the disposal are more than the asset’s cost base. You make a capital loss if those capital proceeds are less than the asset’s reduced cost base. Exceptions (5) [Capital gain or loss disregarded] A capital gain or capital loss you make is disregarded if: (a) you acquired the asset before 20 September 1985; or (b) for a lease that you granted: (i) it was granted before that day; or (ii) if it has been renewed or extended the start of the last renewal or extension occurred before that day. Note 1: You can make a gain if you dispose of shares in a company, or an interest in a trust, that you acquired before that day: see CGT event K6.

[page 326] Note 2: [This note has been omitted by the authors.] Note 3: A capital gain or loss made by a demerging entity from CGT event A1 happening as a result of a demerger is also disregarded: see section 125-155. Note 4: A capital gain or loss you make because of section 16AI of the Banking Act 1959 is disregarded: see section 253-10 of this Act. Section 16AI of the Banking Act 1959: (a) reduces your right to be paid an amount by an ADI in connection with an account to the extent of your entitlement under Division 2AA of Part II of that Act to be paid an amount by APRA; and (b) provides that, to the extent of the reduction, the right becomes a right of APRA. Note 5: A capital gain or loss you make because, under section 62ZZL of the Insurance Act 1973, you dispose of a CGT asset consisting of your rights against a general insurance company to APRA is disregarded: see section 322-30 of this Act. Compulsory acquisition (6) [Time of the event] If the asset was acquired from you by an entity under a power of compulsory acquisition conferred by an Australian law or a foreign law, the time of the event is the earliest of: (a) when you received compensation from the entity; or (b) when the entity became the asset’s owner; or (c) when the entity entered it under that power; or (d) when the entity took possession under that power. Note: You may be able to choose a roll-over if an asset is compulsorily acquired: see Subdivision 124-B.

Constituent elements in CGT event A1 6.61 Analysis of ITAA97 s 104-10 reveals the following six constituent elements in CGT event A1: 1. You must have acquired a CGT asset (other than a lease) on or after 19 September 1985. 2. If the CGT asset is a lease, the lease must have been granted, renewed or extended on or after 19 September 1985. 3. You must have disposed of the CGT asset to another entity. 4. If you enter into a contract for the disposal, then the date of entry into the contract is when the CGT event takes place. 5. If you do not enter into a contract for the disposal, then the CGT event takes place when the change of ownership occurs.

[page 327] 6.

Special rules for determining the time of the disposal apply when the asset was compulsorily acquired from you. To ascertain whether a capital gain or loss was made from a CGT event A1, we would then need to: determine whether an exemption applied; in the case of a capital gain, compare the capital proceeds with the cost base of the asset; and in the case of a capital loss, compare the capital proceeds with the reduced cost base of the asset. These, however, are later steps in the process. To determine whether any of the facts in Steve and Sarah’s case study give rise to CGT event A1, we must look at the constituent elements in CGT event A1 in more detail.

CGT assets 6.62 CGT event A1 involves the disposal of a CGT asset by a taxpayer to another entity. Therefore, to determine whether any CGT A1 events have happened in Steve and Sarah’s case study, we must understand what is meant by a CGT asset.

1. 2. 3.

What do you think of when you hear the word ‘asset’? List examples of things that you would regard as assets. If you were asked to define what an asset is, how would you define it?

6.63 The term ‘asset’ is used in financial accounting. The AASB Framework for the Preparation and Presentation of Financial Statements (the Framework) at para 49 defines an asset as ‘a resource

controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity’. Paragraph 89 of the Framework goes on to state that ‘[a]n asset is recognised in the balance sheet when it is probable that the future economic benefits will flow to the entity and the asset has a cost or value that can be measured reliably’. Note that an entity has only to control, as distinct from own, future economic benefits for them to be considered to be assets. Note that the benefits only need to be probable for the asset to be recognised. Note also that an asset can be recognised only if it possesses a cost or value that can be measured reliably. Sometimes, a somewhat similar approach to determining what an asset is can be taken in law. In the Full Federal Court decision in Hepples v FCT (1990) 22 FCR 1; 94 ALR 81 at 100; 21 ATR 42 at 60, Gummow J, citing Page v International Agency and Industrial Trust (Ltd) (1893) 62 LR Ch 610 at 612–3, noted that ‘[t]he term “assets” is frequently used to identify that which may be turned to account in order to discharge liabilities’. [page 328] 6.64 The approach to defining ‘CGT asset’ in the ITAA97 is very different from the financial accounting approach. The ITAA97 definition is based on property law concepts rather than on financial accounting concepts. Property law is concerned with rights that courts of law or equity recognise and with notions of ownership. It is not an essential characteristic of property that it produce future economic benefits or possess a cost or value that can be measured reliably. The basic definition of ‘CGT asset’ in the ITAA97 is as follows: 108-5 CGT assets (1) [Meaning of CGT asset] A CGT asset is: (a) any kind of property; or (b) a legal or equitable right that is not property. (2) [Specific CGT assets]

To avoid doubt, these are CGT assets: (a) part of, or an interest in, an asset referred to in subsection (1); (b) goodwill or an interest in it; (c) an interest in an asset of a partnership; (d) an interest in a partnership that is not covered by paragraph (c). Note 1: Examples of CGT assets are: land and buildings; shares in a company and units in a unit trust; options; debts owed to you; a right to enforce a contractual obligation; foreign currency. Note 2: An asset is not a CGT asset if the asset was last acquired before 26 June 1992 and was not an asset for the purposes of former Pt IIIA of the Income Tax Assessment Act 1936: see section 108-5 of the Income Tax (Transitional Provisions) Act 1997.

6.65 Now review your response to the questions at 6.62. Did you think of all of the examples of CGT assets that are listed in Note 1 to s 108-5(2)? Did you think of any examples of assets that are not listed in Note 1? Would all the examples of CGT assets listed in Note 1 be assets under the definition of ‘asset’ that you developed in response to the question? Do you think that your definition of ‘asset’ included anything that would not be an asset under the s 108-5 definition of ‘CGT asset’? Note that for something to be a CGT asset under the s 108-5 definition, it must either be property or must be a legal or equitable right that is not property. Hence, [page 329] to explain the s 108-5 definition of CGT asset we must explain what the legal meaning of ‘property’ is and must explain what is meant by the phrase ‘a legal or equitable right that is not property’. 6.66 If we ask ourselves ‘What is property?’, we commonly think of a series of specific objects such as land, cars, personal computers, boats and so on. If pressed, we would probably agree that we regard shares

that we own, or bank accounts or other investments, as property. This, in fact, is one of the legal meanings of property. In McCaughey v Commissioner of Stamp Duties (1945) 46 SR (NSW) 192 at 201, Jordan CJ distinguished between two senses in which the law uses the term ‘property’. In the first sense, ‘property’ was used to denote the objects of proprietary rights. Thus, the objects that we have just referred to would be examples of ‘property’ in this sense. Jordan CJ, however, noted that the law used the term ‘property’ in a second sense. In this sense, ‘property’ is used to denote the proprietary rights in relation to a specific object. It is by the assertion of proprietary rights that you can establish your ownership of an object in the eyes of the law. For example, if someone brings a court action claiming that your notebook computer is theirs, you have a right to defend that action by proving that you obtained good title to the computer when you acquired it. Similarly, if someone steals your notebook computer, you have a right to bring a court action against the thief for either damages or for the return of the computer. In other words, when property is viewed from a legal perspective, you really own something only when you can bring or defend actions in court to establish your ownership. In bringing or defending such actions you are relying on proprietary rights. 6.67 In some cases, the property that you have may be nothing more than one or more proprietary rights. That is, sometimes rights can be property even though they do not relate to a physical object. Proprietary rights that do not relate to a physical object are regarded as intangible property. Examples of intangible property include: shares; debts that someone owes you; and goodwill. Unfortunately, a precise definition of what is a proprietary right cannot be given. Meagher, Gummow and Lehane24 noted that four criteria are used by the courts to evaluate whether proprietary interests exist. These are: (a) the power to recover the property the subject of the interest or the income thereof (that is, a ‘proprietary right’) compared with the recovery of compensation from the defendant payable from no specific fund;

(b) the power to transfer the benefit of the interest to another; (c) the persistence of remedies in respect of the interest against third parties who thus assume the burden thereof; and (d) the extent to which the interest may be displaced in favour of some competing dealings by the grantor or others with interests in the subject matter (that is, priorities).

[page 330] Meagher, Gummow and Lehane go on to point out that it is, however, incorrect to assume that unless all these characteristics are present there cannot be property. One or more of the criteria may be more important than the others in establishing the existence of proprietary rights, depending on the context in which the question is asked. This comment may be validly applied to other attempts to state the general characteristics of the legal idea of property. Hence, care should be taken in applying these statements in other contexts. 6.68 There are some rights that a court of law or equity will recognise and enforce that are not considered to be proprietary rights. In his judgment in the Full Federal Court in Hepples v FCT (1990) 22 FCR 1 at 23; 94 ALR 81; 90 ATC 4497, Gummow J gave the following examples of such personal rights that he would not regard as proprietary rights: an equity to have a court rectify a contract of personal services; a right to maintain an action for unliquidated damages for personal injury; property which by virtue of statute cannot effectively be assigned; the benefit of a contractual obligation where the identity of the person in whose favour the obligation is to be discharged is a matter of importance to the party on whom the obligation rests; a right to damages for breach of a contract for personal services; and a right to an injunction to restrain breach of negative covenants in a contract for personal services.

6.69 More recently, the High Court, in FCT v Orica (1998) 194 CLR 500; 38 ATR 66; 98 ATC 4494, considered whether rights that Orica as principal debtor had under a debt defeasance agreement were property for the purposes of ITAA36 s 160A. All judges held that the rights were property and hence were assets under s 160A. The following comments in the judgments of Gummow J and in the joint judgment of Gaudron, McHugh, Kirby and Hayne JJ suggest that transferability may not be necessary before a right is regarded as being a proprietary as distinct from a personal right.

FCT v Orica Ltd Facts: The facts in the case are set out in the extract in 6.29. Gaudron, McHugh, Kirby and Hayne JJ Their Honours referred to the definition of ‘asset’ in ITAA36 s 160A as it stood prior to its amendment by Taxation Laws Amendment Act (No 4) 1992 (Cth) (at [90]–[91]): We have no doubt that the rights acquired by the taxpayer against MMBW under the Principal Assumption Agreement are an asset for the purposes of Pt III A. The contention, accepted by the majority of the Full Court, that the right [page 331] acquired by the taxpayer “was merely a personal right … which was incapable of being assumed by a third party” must be rejected. The conclusion that the taxpayer’s right against MMBW was only a right to compel MMBW to specifically perform its obligations appears to have been founded in the proposition, adopted by the primary judge, that “no conceivable assignee would have any interest in enforcing MMBW’s obligation which was to discharge [the taxpayer’s] obligation to the debenture holders”. It may be doubted that enquiring whether there is any person who would have a commercial interest in taking an assignment will determine whether something is an item of property capable of assignment. The question is whether the rights are capable of assignment, not whether anyone is interested in taking an assignment. Furthermore, in construing the term “any form of property” in s 160A, it is important to bear in mind the following statement by Kitto J in National Trustees Executors & Agency Co of Australasia Ltd v FCT [(1954) 91 CLR 540 at 583]:

It may be said categorically that alienability is not an indispensible attribute of a right of property according to the general sense which the word “property” bears in the law. Rights may be incapable of assignment, either because assignment is considered incompatible with their nature, as was the case originally with debts (subject to an exception in favour of the King) or because a statute so provides or considerations of public policy so require, as is the case with some salaries and pensions; yet they are all within the conception of “property” as the word is normally understood … In any event, we do not accept that there is “no conceivable assignee” who would have an interest in taking an assignment from the taxpayer of its rights against MMBW. The debenture holders are an obvious class of persons who would have a real and lively commercial interest in having MMBW perform its obligations. It follows that the rights which the taxpayer had against MMBW under the Principal Assumption Agreement are an asset for the purposes of Pt IIIA. Gummow J said (at [108]–[110]): As to the first, [Capital Gains Tax issue] I agree that the rights acquired by the taxpayer under the Principal Assumption Agreement constituted an asset within the meaning of [page 332] s 160A. The obligations of MMBW to the taxpayer, particularly under cl 3 of the Principal Assumption Agreement, were not debts due and owing by MMBW to the taxpayer. However, the benefit of the covenants by MMBW in cl 3 were choses in action within the meaning of “asset” in s 160A. The covenants obliged MMBW to pay third parties not the taxpayer. However, the payments would discharge liabilities of the taxpayer and, if they had not been made by MMBW, the taxpayer would have had an action against MMBW for substantial not nominal damages. In the submissions, perhaps too much significance was attached to the approval by Mason J in R v Toohey; Ex parte Meneling Station Pty Ltd [(1982) 158 CLR 327 at 342–3; 44 ALR 63] of the statement by Lord Wilberforce in National Provincial Bank Ltd v Ainsworth [[1965] AC 1175 at 1247–8]: Before a right or an interest can be admitted into the category of property, or of a right affecting property, it must be definable, identifiable by third parties, capable in its nature of assumption by third parties, and have some degree of permanence or stability. Mason J was concerned to analyse particular statutory rights, and Lord Wilberforce was dealing with the novel development of the “deserted wife’s equity”. Neither was dealing with rights created under the general law of contract. However, that is the case with the Principal Assumption Agreement. Mason J did observe that assignability is not in all circumstances an essential characteristic of a right of property. The passage in the earlier judgment of Kitto J in National Trustees Executors and Agency Co of Australasia Ltd v FCT, which Gaudron, McHugh, Kirby and Hayne JJ set out, further emphasises and develops that point.

6.70 Notice that, under the current definition of CGT asset, if personal rights of the kind mentioned by Gummow J in Hepples v FCT (1990) 22 FCR 1; 94 ALR 81; 90 ATC 4497 are not property, they will still be CGT assets. This is because ITAA97 s 108-5(1)(b) includes ‘a legal or equitable right that is not property’ within the definition of ‘CGT asset’. Thus, for CGT purposes, the somewhat difficult and uncertain question of what is property for CGT purposes is no longer particularly relevant. All legal and equitable rights, whether or not they are proprietary rights, will now fall under the definition of ‘CGT asset’ in s 108-5. To determine what is a CGT asset under the current definition, the important question is ‘What is a legal or equitable right?’ [page 333]

What do you think of when you hear the word ‘rights’? Compile a list of what you think your rights are.

6.71 In contemporary history, the phrase ‘human rights’ has been widely used. Breaches of human rights are used to justify trade sanctions, military action by the United Nations or North Atlantic Treaty Organisation (NATO), and extradition proceedings against former presidents of sovereign states. When we think of the phrase ‘human rights’, we are likely to think of the kind of ‘rights’ that are dealt with in the United Nations’ Universal Declaration of Human Rights. That is, we are likely to think of ‘rights’ like the right to work, the right to vote, and the rights not to be discriminated against on the ground of race, religion or gender. While it is common to think of these

as ‘rights’, it is doubtful that any of them will be regarded as ‘legal or equitable right(s)’ for the purposes of ITAA97 s 108-5. 6.72 Several court judgments in Australia make a distinction between ‘rights’ that a court of law or equity will enforce and ‘liberties’ or ‘freedoms’ that all citizens in a free society enjoy. Some insight into the distinction that is drawn here can be gained from the following comments by Barwick CJ in Forbes v NSW Trotting Club Ltd (1979) 143 CLR 242 at 260–1: To convert the doctrine that, because of the public interest, there should be no unreasonable restraint on employment into a doctrine that every man has a “right to work”, is, in my opinion, to depart radically from the tenets of the common law … If the expression “ability to work” is used, there is less likelihood of misconception. It is in the public interest that a man should be able to exercise his capacity for work. The law does not enforce a right to exercise that capacity: it does no more than remove the unreasonable impediment to its exercise.

Similarly, Gummow J in his judgment in the Full Federal Court decision in Hepples v FCT (1990) 22 FCR 1; 94 ALR 81; 21 ATR 42 at 60–1 said: One may speak of “the right to work” (Nagle v Feilden [1966] 2 QB 633 at 644–7) or “the right to know” (British Steel Corp v Granada Television Ltd [1981] AC 1096 at 1168). Constitutional or statutory guarantees may be couched in such terms and a breach of them may give rise to individual rights of action, as in Bivens v Six Unknown Named Agents of Federal Bureau of Narcotics 403 US 388 (1971) (which is qualified by United States v Stanley 97 L Ed 2d 550 (1987)). But such terms otherwise have significance in the legal system principally to assist identification of the objects or purposes sought to be served by particular detailed statutory provisions or particular causes of action under the general law.

In other words, unless such ‘human rights’ are the subject of constitutional or statutory guarantees which give rise to individual rights to take court action to enforce them, they will not be regarded as legal or equitable rights. The point can be made most clearly in the case of the liberty to work. While each person over a given minimum age has the liberty to work, he or she cannot bring court action to compel an employer to give him or her a job. [page 334]

6.73 There are other examples of things that are popularly referred to as ‘rights’ that are not legal or equitable rights. In his judgment in the Full Federal Court decision in Hepples at ATR 63, Gummow J made the following comments on the phrase ‘any other right’ within ITAA36 s 160A: … those rights must exist at the time at which one asks, in applying the provisions of Pt IIIA, whether there was an “asset”. So called “future property” not yet acquired or in existence would not then be “assets”, nor would purely contingent interests which had not yet vested (whether in interest or in possession): cf Commr of Stamp Duties (NSW) v Bryan (1989) 20 ATR 863; 89 ATC 4529 at 4532–3.

In these cases, the logic is that until a future event happens no right exists that a court of law or equity will recognise. The position in relation to what is known as a ‘mere expectancy’ is similar. For example, an ordinary shareholder in a company has no right to a dividend until the company makes a profit and declares a dividend. In the meantime, the shareholder may hope that the company will make a profit and declare a dividend but that hope is a mere expectancy. It is not a right that a court of law or equity will recognise.

Discuss whether any of the following will be CGT assets: an employer’s rights under a contract of employment with an employee; your rights under your grandmother’s will while your grandmother is still alive; your right to privacy; your right to an action for unliquidated damages for personal injury; secret formulas that you use in your business.

Note that under ITAA97 s 108-5(2)(a), part of a CGT asset or an interest in a CGT asset is deemed to be a CGT asset. Hence, if only part of a particular asset is disposed of, that part will amount to a disposal of a distinct CGT asset. 6.74

Goodwill is expressly deemed to be a CGT asset under s 108-

5(2)(b). The decision to deem goodwill to be an asset may have reflected doubt that goodwill was property or that goodwill was a matter of right. These doubts now appear to have been removed by the High Court decision in FCT v Murry (1998) 193 CLR 605; 155 ALR 67; 39 ATR 129, which unambiguously affirms that goodwill is property because it is the valuable right or privilege to use the other assets of the business to produce income. In other words, goodwill is property because it is derived from rights which courts will enforce. It should be noted that the decision in Murry also clearly affirms that purchased and internally generated goodwill are regarded as property for legal purposes. Hence, both purchased and internally generated goodwill represent CGT assets. [page 335]

FCT v Murry Facts: The taxpayer and her husband as partners conducted a business of owning and leasing a single taxi and two taxi licences. The second licence was acquired from the Queensland Department of Transport in November 1987 for $85,000. At the same time, the partnership also acquired shares in Suncoast Pty Ltd (a taxi company), which were valued at $15,000. The partnership leased the second taxi licence to a Mr Gower who used his own vehicle to take advantage of the licence. The partnership sold the licence and the shares in Suncoast Pty Ltd to a Mr and Mrs Wilkins in 1992. Mr Gower sold his vehicle to Mr and Mrs Wilkins at the same time. The partnership made a capital gain of $6130 on the shares and $72,071 on the licence. Mrs Murry’s share of the capital gain on the licence was $36,036. The issue before the High Court was whether Mrs Murry was entitled under ITAA36 s 160ZZR to a 50% reduction in the capital gain of $36,036 on the basis that this was a receipt for goodwill attached to the licence. ITAA36 s 160ZZR applied only where a taxpayer disposed of an interest in a business that included goodwill, or included an interest in the goodwill of the business. Held: The majority of the High Court held that the non-exclusive licence disposed of by the taxpayer was not a source of goodwill. Hence, the disposal of the licence did not involve a disposal of goodwill and the s 160ZZR partial exemption was not available.

Passages in the judgment of the majority in FCT v Murry suggest that an exclusive licence could be a source of goodwill. The major emphasis in the majority decision of the High Court in FCT v Murry is that goodwill is inseparable from the business to which it relates and cannot be transferred independently of that business. Gaudron, McHugh, Gummow and Hayne JJ Goodwill as inseparable from the business [22] The definitions of Lord Lindley, Lord Macnaghten and Judge Swan bring out the point that goodwill has three different aspects — property, sources and value which combine to give definition to the legal concept of goodwill. What unites these aspects is the conduct of a business. As Barwick CJ pointed out in Geraghty v Minter, “goodwill is not something which can be conveyed or held in gross: it is something which attaches to a business. It cannot be dealt with separately from the business with which it is associated”. [page 336] Goodwill as property [23] From the viewpoint of the proprietors of a business and subsequent purchasers, goodwill is an asset of the business because it is the valuable right or privilege to use the other assets of the business as a business to produce income. It is the right or privilege to make use of all that constitutes “the attractive force which brings in custom.” Goodwill is correctly identified as property, therefore, because it is the legal right or privilege to conduct a business in substantially the same manner and by substantially the same means that have attracted custom to it. It is a right or privilege that is inseparable from the conduct of the business … No sale of goodwill where asset sold separately from the business [31] … the sale of an asset of a business does not involve any sale of goodwill unless the sale of the asset is accompanied by or carries with it the right to conduct the business. The sale of hotel premises, for example, may involve the sale of goodwill although the contract does not refer to goodwill. Similarly, the mortgage of land used as a business may involve the mortgage of the goodwill of the business although the mortgage does not mention goodwill. But the reason that is so is that, by necessary implication, the sale or mortgage of such a site includes the sale or transfer of the business conducted on the site. Unless a business is transferred to the person to whom an asset of the business is transferred, the transfer of the asset does not transfer any part of the goodwill of the business. … No goodwill was disposed of by the sale of the taxi licence [67] A taxi licence is a valuable item of property because it has economic potential. It allows its holder to conduct a profitable business and it may be sold or leased for reward to a third party. But neither inherently nor when used to authorise the conduct of a taxi business does it constitute or contain goodwill. A licence is a prerequisite to the conduct of many professions, trades, businesses and callings. But it is not a source of the goodwill of a business simply because it is a pre-requisite of a

business or calling. Nor is the situation different when only a limited number of licences are issued for a particular industry. [68] For legal purposes, goodwill is the attractive force that brings in custom and adds to the value of the business. It may be site, personality, service, price or habit that obtains custom. But with the possible exception of a licence to [page 337] conduct a business exclusive of all competition, a licence that authorises the conduct of a business is not a source of goodwill. A taxi licence therefore is simply an item of property whose value is not dependent on the present existence of a business. It is not and does not contain any element of goodwill. [69] There was disposal of the licence and the shares but there was no disposal of goodwill or of an interest in goodwill within the meaning of s 160ZZR.

Applying the s 108-5 definition of ‘CGT asset’ to Steve and Sarah’s case study Apply the ITAA97 s 108-5 definition of ‘CGT asset’ to the Steve and Sarah case study (see 6.58). What CGT assets can you identify? Think about this question in relation to each of the events that we identified in 6.59: the receipt of $60,000 when Steve entered into the restrictive covenant on 1 January 2017 (likely CGT event D1); the subdivision and sale of the two blocks of land in Whyalla on 1 July 2017; the sale of the house constructed on one of the blocks of land at Whyalla on 1 September 2017; the sale of 500 BHP Ltd shares on 1 September 2017; the sale of the 50% interest in the yacht on 1 September 2017; the sale of the Melbourne home on 1 September 2017; the sale of the butterfly collection on 1 September 2017; the loss of the coin collection on 1 November 2017. Suggested solutions are contained in Study help.

Special rules for personal use assets 6.75 For CGT purposes, some assets are classified as personal use assets. Since these assets typically decline in value over time, the revenue would be the loser if normal CGT rules applied to them. Unsurprisingly, special rules apply to personal use assets. These rules apply generally when a CGT event happens in relation to a personal use asset. Thus, it

is relevant to look at them when examining the elements in CGT event A1. A personal use asset is defined in ITAA97 s 108-20(2) as a CGT asset (except a collectable) that is used or kept mainly for your, or your associate’s, personal use or enjoyment. What constitutes a collectable is explained in 6.77. Section 108-20(3) [page 338] makes it clear that a personal use asset does not include land, a stratum unit or a building or structure that is taken, because of Subdiv 108-D, to be separate from the land. The following are deemed to be personal use assets: options to acquire a personal use asset; a debt arising from a CGT event happening in relation to a personal use asset; a debt arising other than in the course of gaining or producing assessable income or from carrying on your business. 6.76

The special rules that apply to personal use assets are: any capital loss you make from a personal use asset is disregarded (s 108-20(1); a set of personal use assets is taken to be a single personal use asset and each disposal of an individual item in the set is taken to be a disposal of part of that asset (s 108-25); in working out the cost base of a personal use asset, you do not take into account the costs of ownership (s 108-30); a capital gain that you make from a personal use asset is disregarded if you acquired the asset for $10,000 or less (s 11810(3): see 6.128).

1.

What do you think the purpose of the ‘set rule’ in s 108-25 is? What might happen if this rule did not exist? 2. In Favaro v FCT 96 ATC 4975, Branson J had to determine whether or not foreign currency brought into Australia and exchanged for Australian dollars was a personal use asset. What considerations do you think would be relevant in making this determination? Applying the special rules for personal use assets in Steve and Sarah’s case study (see 6.58): Will any of the assets in the Steve and Sarah case study be ‘personal use assets’? How will the special rules that apply to personal use assets affect the Steve and Sarah case study? Suggested solutions can be found in Study help.

Special rules for collectables 6.77 Special rules also apply to collectables. A collectable is exhaustively defined in ITAA97 s 108-10(2) as: artwork, jewellery, an antique, or a coin or medallion; or a rare folio, manuscript or book; or a postage stamp or first-day cover; that is used or kept mainly for your (or your associate’s) personal use or enjoyment. [page 339] An interest in any of these (eg, part ownership) is also a collectable. So, too, is a debt arising from any of them or an option or right to acquire any of them. Note that, even though people may collect other things, such as CDs or DVDs, they will only be collectables if they fit into one of the categories mentioned in s 108-10(2). Note that TD 1999/40 states that

‘an antique is an object of artistic and historical significance, that is of an age exceeding 100 years’. The term ‘antique’ may have a wider meaning in general usage but the Tax Determination appears to reflect the more specialised usage of antique dealers. The word must also be interpreted in its context. Hence, it would appear to be confined to ‘antiques’ other than artwork, jewellery, coins or medallions. The special rules that apply to collectables are: capital losses on collectables can only be offset against capital gains on other collectables (s 108-10(1)); if capital losses on collectables cannot be fully offset against capital gains on other collectables in the current year, any excess capital loss can only be carried forward and offset against future capital gains on other collectables (s 108-10(4)); a set of collectables is taken to be a single collectable and a disposal of each individual item in the set is taken to be a disposal of part of the collectable (s 108-15); in working out the cost base of a collectable, you do not take into account costs of owning it (s 108-17); a capital gain or loss you make from a collectable is disregarded if you acquired the collectable for $500 or less (s 118-10); and where the collectable is an interest in certain CGT assets, a capital gain that you make from the interest is disregarded only if the market value of the asset, at the time you acquired the interest, was $500 or less (s 118-10(2)). The exemptions in s 118-10 are also discussed in 6.128.

6.78

Applying the special rules for collectables in the Steve and Sarah case study Will any of the assets in the Steve and Sarah case study (see 6.58) be ‘collectables’? How will the special rules that apply to collectables affect the Steve and Sarah case study? Suggested solutions can be found in Study help.

Acquisition of CGT assets 6.79

Another aspect of the first constituent element in CGT event A1

involves the acquisition of a CGT asset. Knowing when a CGT asset has been acquired is important for several reasons. First, in general, CGT event A1 will apply only to disposals of CGT assets that were acquired on or after 19 September 1985. Where the CGT asset is a lease, the rule is that any capital gain or loss from CGT event A1 will be disregarded if the lease was granted before 20 September 1985 or its last [page 340] renewal or extension was before that date. Second, in the case of pre-21 September 1999 assets, it is necessary to know precisely when a CGT asset was acquired in order to add indexation for inflation to its cost base. Third, where a CGT event takes place on or after 21 September 1999, a taxpayer who is otherwise eligible for a CGT discount will need to know when the asset was acquired to show that the CGT event took place more than 12 months after the date of acquisition. 6.80 In the ITAA97, the general CGT rules that apply when you acquire a CGT asset as a result of a CGT event A1 happening are set out in s 109-5. 109-5 General acquisition rules (1) [Acquisition] In general, you acquire a CGT asset when you become its owner. In this case, the time when you acquire the asset is when you become its owner. (2) [Specific rules] This table sets out specific rules for the circumstances in which, and the time at which, you acquire a CGT asset as a result of [CGT event A1] happening. Note: The full list of CGT events is in section 104-5. Acquisition rules (CGT events) Event number

In these circumstances:

You acquire the asset at this time:

A1 (case 1)

An entity disposes of a CGT asset to you (except where you compulsorily acquire it)

when the disposal contract is entered into or, if none, when the entity stops being the asset’s owner

A1 (case 2)

You compulsorily acquire a CGT

the earliest of:

asset from another entity

(a) when you paid compensation to the entity; or (b) when you became the asset’s owner; or (c) when you entered the asset under the power of compulsory acquisition; or (d) when you took possession of it under the power.

Note that other parts of ITAA97 s 109-5(2) set out specific rules as to when you acquire a CGT asset as a result of other CGT events happening. It is important to remember that, although CGT event A1 can take place only if you dispose of the ownership of a CGT asset to another entity, you can acquire a [page 341] CGT asset to which CGT event A1 subsequently applies even though you did not acquire ownership of the CGT asset from another entity. The following examples illustrate situations where this can happen.

1. 2. 3. 4.

You commission an artist to paint your portrait. You contract with a builder to have a house built on land that you own. Someone enters into a restrictive covenant with you which gives you contractual rights. A company issues shares in the company to you.

6.81 In some cases, it is possible for you to become the owner of a CGT asset without a CGT event happening in relation to the asset.

ITAA97 s 109-10 sets out rules that explain when you are taken to acquire a CGT asset in these cases. 109-10 When you acquire a CGT asset without a CGT event This table sets out some specific rules for the circumstances in which, and the time at which, you acquire a CGT asset otherwise than as a result of a CGT event happening. Acquisition rules (no CGT event) Item

In these circumstances

You acquire the asset at this time:

1

You (or your agent) construct or create a CGT asset and you own it when the construction is finished or the asset is created

when the construction or work that resulted in the creation started

2

A company issues or allots equity interests or non-equity shares in the company to you

when contract is entered into or, if none, when equity interests or non-equity shares issued or allotted

3

A trustee of a unit trust issues units in the trust to you

when contract is entered into or, if none, when units issued

The importance of applying the correct acquisition rule is illustrated by the decision of McKerracher J in the Federal Court in Healey v FCT [2012] FCA 269. [page 342] There, McKerracher J held that the relevant CGT event that applied on the transfer of an asset to a trust was CGT event E2 not CGT event A1. Under the acquisition rule that applies when the acquisition is by CGT event E2, the time of acquisition was the time of transfer to the trust. This meant that the trust had not owned the relevant asset (shares) for more than 12 months prior to disposing of it. This in turn meant that the beneficiary of the trust, who was presently entitled to the capital gain, was not entitled to the CGT discount in relation to the capital

gain. As the trust had entered into a contract to acquire the shares more than 12 months prior to disposing of them, the beneficiary would have been entitled to a CGT discount if the acquisition by the trust had been regarded as taking place under CGT event A1. 6.82 Answering the following questions should highlight circumstances in which the different rules relating to acquisitions apply. You will need to refer to the full text of ss 109-5(2) and 109-10 to answer all of these questions.

1.

2. 3. 4.

When is a CGT asset acquired under a hire-purchase agreement where possession of the asset passes to the hirer while the instalments are being paid but title does not pass until the final instalment is paid? Say you commission a well-known painter to paint your portrait. When do you acquire the portrait? If you enter into a contract to purchase land and the contract is subsequently completed, when do you acquire the land? Bill visits India in January 2015 and tastes freshly squeezed sugar cane juice for the first time. He thinks it is terrific and wonders if a business selling freshly squeezed sugar cane juice in Australia would succeed. On his return to Melbourne on 1 July 2015, he commissions a market survey that suggests that Australians would not buy sugar cane juice. Undaunted, Bill buys a sugar cane crushing machine and, on 1 January 2016, sets up a stall in Victoria Market selling freshly squeezed sugar cane juice. By 1 January 2017, Bill has established a chain of Fresh Sugar Cane Juice outlets throughout Melbourne and the suburbs. When did Bill acquire the goodwill of the Sugar Cane Juice business?

6.83 We will now ask you to try to apply the rules relating to the acquisition of CGT assets in Steve and Sarah’s case study. [page 343]

Application of CGT acquisition rules to Steve and Sarah’s case study

How will the CGT acquisition rules apply in Steve and Sarah’s case study (see 6.58)? Consider particularly the position in relation to the following assets/events: the Whyalla land; the BHP shares; the Melbourne home; the yacht; the right to payment of $60,000; the subdivision of the Whyalla land; the construction of the house on the Whyalla land. Suggested solutions can be found in Study help.

Separate CGT assets 6.84 For CGT purposes, some assets are deemed to be distinct and separate assets in circumstances where, under the general law, they would not be. Where individuals own a CGT asset as joint tenants, s 108-7 treats them as if they each owned a separate CGT asset constituted by an equal interest in the asset held as if they were tenants in common. In addition, ITAA97 Subdiv 108-D deems some assets to be separate assets in circumstances where the general law would regard them as being part of another asset. In summary, the more important25 of the rules in Subdiv 108-D that deem certain assets to be separate are: buildings or structures on post-CGT land are deemed to be separate assets from the land, where certain balancing adjustment provisions apply to the building or structure (s 108-55(1)); buildings or structures on pre-CGT land are deemed to be separate assets from the land, if the contract for construction of the building or structure was entered into post-CGT, or, if there is no contract, if construction commenced post-CGT (s 108-55(2)); depreciating assets that are part of a building or structure are taken to be separate CGT assets from the building or structure (s 108-60); post-CGT land is taken to be a separate asset from adjacent preCGT land where titles are amalgamated (s 108-65);

[page 344] improvements to land are taken to be separate assets from the land if the balancing adjustment provisions referred to in s 108-55 apply to the improvements (s 108-70(1)); an improvement to a pre-CGT asset, which is not related to any other improvement, is taken to be a separate CGT asset from the original asset where the cost base of the improvement when a CGT event happens (except one that happens because of your death) to the original asset is more than the improvement threshold26 and more than 5% of the capital proceeds from the event (s 108-70(2));27 and related improvements28 to a pre-CGT asset are taken to be a separate CGT asset if the total of their cost bases when a CGT event happens to the original asset is more than the improvement threshold and more than 5% of the capital proceeds from the event (s 108-70(3)). Applying the separate asset rules in Steve and Sarah’s case study How will the separate asset rules affect Steve and Sarah’s case (see 6.58)? Identify those assets that will be deemed to be separate because of the operation of these rules. Also identify the relevant rule in each case. Suggested solutions can be found in Study help.

Disposal of a CGT asset 6.85 The next constituent element in CGT event A1 is the disposal of a CGT asset to another entity. Probably the most common sense in which the word ‘disposal’ is used is when ownership of an asset passes from one owner to another. Thus, if you sell your house to another person, you would normally say that you have disposed of your house. This is the sense in which the word disposal is used in CGT event A1. You will recall that ITAA97 s 104-10(2) states that you dispose of an asset, for purposes of s 104-10(2), if a change of ownership occurs from you to another entity. The change can take place either because of some

act or event or because of operation of law. However, a CGT event A1 disposal does not take place where you stop being the legal owner of an asset but continue to be its beneficial owner. Nor does a CGT event A1 disposal take place merely because of a change of trustee.29 [page 345] A clear example of a change in ownership occurring because of the operation of law is when one of two joint owners of property dies. Under the general law, the surviving joint tenant is treated as acquiring the interest that the deceased joint tenant had in the property. That is, a change in ownership occurs from the deceased joint tenant to the surviving joint tenant. This result is confirmed by s 128-50(2), which states that when one joint tenant dies the survivor is taken to have acquired, on the day the deceased died, the deceased joint tenant’s interest in the asset. Further specific rules apply where there are two or more survivors. Thus, CGT event A1 will take place when a joint tenant dies. It should be noted, however, that under s 128-10, any capital gain or loss that arises from CGT event A1 happening on the death of a joint tenant will be disregarded. The CGT effects of death will be examined in more detail in Chapter 15. 6.86 For an asset to be disposed of for CGT event A1 purposes, it seems that the asset which one owner disposes of must be identical with the asset the other owner acquires. An example of the application of this rule can be found in the Full Federal Court decision in Naval, Military & Airforce Club of South Australia v FCT (1994) 51 FCR 154; 122 ALR 201; 28 ATR 161.

Naval, Military & Airforce Club of South Australia v FCT Facts: Under the City of Adelaide Development Control Act 1976 (SA), an owner of land

could transfer ‘transferable floor area’ from that land to land owned by another person. The effect of this ‘transfer’ was that the maximum permissible floor area for the purposes of developing the latter site would be increased. The club entered into an agreement with a superannuation fund under which the club, subject to the approval of Adelaide City Council, and subject to a further agreement being entered into between the parties and the council, ‘transferred’ 1355 square metres of ‘transferable floor space’ from its premises to the superannuation fund’s premises. The consideration received for the transfer was $338,750. Issue: One of the issues in the case was whether a ‘transfer’ of a transferable floor area was a disposal under ITAA36 s 160M(1). Held: A majority of the Full Federal Court (Jenkinson and French JJ; von Doussa J dissenting on this issue) held, inter alia, that a ‘transfer’ of what was described as ‘transferable floor area’ under the City of Adelaide Development Control Act was not a disposal under ITAA36 s 160M(1). Reasons for decision: Both Jenkinson and French JJ held that the rights that the superannuation fund acquired were proprietary rights and, hence, were assets for purposes of the CGT provisions of the ITAA36. However, both Jenkinson and French JJ held that the asset [page 346] acquired by the superannuation fund had never been owned by the club. This was because the asset that the superannuation fund acquired was having a greater floor space taken into account when development applications were made in relation to its premises. The asset that the club disposed of, by contrast, was the ability to have the transferred floor space taken into account in relation to development applications of its premises. That is, there was no change in the ownership of the rights because the rights acquired related to one site, whereas the rights disposed of related to another site. Both judges also held that the club did not acquire its rights to transferable floor area from the council. This meant that there was no disposal for the purposes of ITAA36 s 160M(1) (the ITAA36 equivalent to CGT event A1).

The judgments in Naval, Military & Airforce Club of South Australia are also relevant to CGT events C2, D1 and H2. Extracts from the judgments in Naval, Military & Airforce Club of South Australia relevant to these issues are contained in Study help.30 6.87 CGT event A1 happens when you enter into a contract for the disposal of the asset or, if there is no contract, when the change of ownership occurs. In FCT v Sara Lee Household and Body Care (Australia) Pty Ltd (2000) 201 CLR 520; 44 ATR 370 (Sara Lee), the High Court held that, where there are two or more contracts which

affect the rights and obligations of the parties to a disposal of assets, the contract under which the assets are disposed of, for the purposes of ITAA36 s 160U(3), was the contract which was properly to be seen as the source of the obligation to effect the disposal. In that case, the original contract for disposal of a business was subsequently amended, but not rescinded, by a subsequent agreement which varied the price and substituted another purchaser. Gleeson CJ, Gaudron, McHugh and Hayne JJ held that the earlier contract was the source of the obligation as that was when the contractual obligation to dispose of the business began. Furthermore, key aspects of the latter agreement, the changes to the sale price and to the identity of the purchaser, were expressly stated to be pursuant to the earlier agreement. [page 347] Gleeson CJ, Gaudron, McHugh and Hayne JJ in Sara Lee summarised (at [40]),31 with apparent approval, the following comments by the Full Federal Court in the case under appeal on the meaning of ‘under a contract’ in ITAA36 s 160U(3): The Full Court, before coming to the issue to be resolved, made the following observations as to the legislative scheme. There is no reason why the date of disposition and the date of acquisition referred to in s 160U are necessarily the same. The section refers to the time of acquisition or disposal. Other provisions make it clear that disposal and acquisition are not necessarily contemporaneous, and it is not difficult to think of cases where they may be different. In order for there to be a disposal under a contract for the purposes of s 160U(3) it is not necessary that the contract be unconditional or specifically enforceable. What is relevant is the time of the making of the contract, not the time when it became unconditional, or specifically enforceable. Nor is there any reason why an asset cannot be said to be disposed of under a contract even though the transferee of the asset was not a party to the contract. [Footnotes omitted]

Note that these comments were made in relation to ITAA36 s 160U(3), which stated: Where the asset was acquired under a contract, the time of acquisition or disposal shall be taken to have been the time of making of the contract.

By contrast, in a CGT event A1 (Case 1) situation, the time of acquisition is stated to be when the disposal contract is entered into.

The combined effect of ITAA97 ss 109-5(1) and 104-10(3)(a) (the timing under contract rule in the operative provision for CGT event A1) is that, in this situation, disposal and acquisition will take place at the same time. 6.88 Remember that CGT event A1 arises only when ownership of a CGT asset changes from you to another entity. Hence, although, as we saw in 6.63–6.74, the definition of CGT asset is now wide enough to include legal and equitable rights that are not property, CGT event A1 will be able to take place only in relation to CGT assets that are capable of being transferred. Thus, CGT event A1 cannot apply to legal or equitable personal rights that are not capable of being transferred to another person. It should be remembered that other CGT events, such as CGT events C1 and C2, could take place in relation to CGT assets that are not transferable. Having explained what a disposal is for purposes of CGT event A1, we should now be able to identify the CGT A1 events that take place in Steve and Sarah’s case study. [page 348]

Identifying CGT A1 events in Steve and Sarah’s case study List the CGT A1 events that you think arise in the Steve and Sarah case study: see 6.58. Suggested solutions can be found in Study help.

Capital proceeds 6.89 Once you have decided what CGT events apply in a particular situation, it can save time to check if an exemption is relevant. If so, then, depending on the type of exemption, it might not be necessary to calculate any capital gain or capital loss. Some exemptions, however, have the effect of reducing the amount that is recognised as a capital gain. In these instances, it is necessary to first calculate the amount of the capital gain before the exemption can be applied. For this reason,

we shall now examine further steps in calculating capital gains or capital losses before discussing exemptions at 6.125–6.148. The next step in calculating whether capital gains or losses have been made is to ascertain the capital proceeds for each CGT event. The general rules for determining the capital proceeds for a CGT event are set out in ITAA97 s 116-20(1). 116-20 General rules about capital proceeds (1) [Meaning of capital proceeds] The capital proceeds from a CGT event are the total of: (a) the money you have received, or are entitled to receive, in respect of the event happening; and (b) the market value of any other property you have received, or are entitled to receive, in respect of the event happening (worked out as at the time of the event). Note 1: The timing rules for each event are in Div 104. Note 2: In some situations you are treated as having received money or other property, or being entitled to receive it: see section 103-10. Note 3: If you dispose of shares in a buy-back, the capital proceeds are worked out under Division 16K of the Income Tax Assessment Act 1936.

A table in s 116-20(2) sets out what the capital proceeds are from CGT events F1, F2, H2 and K9. Notice that the capital proceeds, whether they be money or other property, must be something that you have received or are entitled to receive. In the context of the corresponding provision dealing with amounts that you have paid or property that you have given, O’Loughlin J in Dingwall v FCT (1995) 57 FCR 274; 130 ALR 297; 30 ATR 498 (discussed in 6.105), held that there must be either an actual payment or a [page 349] present obligation to pay. If the same approach were applied in the converse situation, it would appear that, for you to have received money or other property or to be entitled to receive money or other

property, there must be an actual receipt at the time of the CGT event or, at least, a present right to receive a certain sum at a future date. Two UK cases, Marren v Inglis [1979] 1 WLR 1131 and Marson v Marriage [1980] STC 177, have held that a right to receive payment, the quantum of which was as yet unascertainable, is a chose in action and, hence, an asset for CGT purposes in the United Kingdom. This meant that the vendor was required to bring the value of this asset to account (as capital proceeds) for UK CGT purposes when the agreement for sale was entered into. Where the vendor’s rights were subsequently satisfied by payment, a capital gain accrued to the vendor equal to the excess of the amount received on satisfaction of the right over its value as at the time of the agreement for sale. The CGT consequences of earn-out arrangements had been discussed in Draft Taxation Ruling TR 2007/D10, which took what was known as ‘the separate asset’ approach to earn-out arrangements. In 2010–11, the Rudd Government announced that it would introduce a ‘look through’ approach to earn-out arrangements. In 2015, the Abbott Government released Exposure Draft Tax and Superannuation Laws Amendment (2015 Measures No 4) Bill 2015: CGT Treatment of Earnout Rights, which took a ‘look through’ approach to earn-out arrangements. Subsequently, the Tax and Superannuation Measures (2015 Measures No 6) Act 2016 introduced s 112-36 (discussed at 6.118) and s 116120 and Subdiv 118-I, which adopted the ‘look through’ approach to earn-outs. The broad effect of these amendments is that where a business is sold under an ‘eligible’ earn-out arrangement the value of the earn-out right will not be taken into account for either the vendor or the purchaser until future financial benefits under the right are paid or received. Where, in addition to the earn-out right, a fixed amount is paid or payable in respect of the sale of the underlying business assets the vendor recognises any capital gain or loss attributable to the fixed amount at the time that the sale occurs. When the financial benefits under the earn-out right are paid or payable, the vendor then adjusts the capital proceeds of the sale and recalculates any capital gain or loss. Similarly, the purchaser’s cost base for the assets acquired will be any

fixed amount paid or payable at the time of acquisition which will then be adjusted when the financial benefits under the earn-out arrangement are actually paid or payable. Subdivision 118-I includes provisions which mean that any capital gain or loss you make under CGT event C2 (in relation to an earn-out right you receive) or under CGT D1 (when you create an earn-out right) is disregarded. Section 116-120 and Subdiv 118-I are discussed in more detail at 6.99 as ‘Modifications to the General Rules’. In Lend Lease Custodian Pty Ltd v DCT (2006) 65 ATR 455, Conti J held that rights of the vendor company to retain ownership of shares, and to dividends on the shares, pending completion of a forward purchase agreement in respect of shares in Westpac Banking Corporation were not ‘property other than money’ for the purposes of ITAA36 s 160ZD(1)(c) (the equivalent of ITAA97 s 116-20). [page 350] Taxation Ruling TR 2010/04 considers that a dividend declared or paid by a target company to a vendor shareholder will be capital proceeds of the vendor shareholder in respect of the transfer of the shares. This will be so if the vendor shareholder has bargained for the receipt of the dividend (whether or not in addition to other consideration) in return for giving up the shares. It also states that a dividend will be capital proceeds in respect of a disposal of shares in certain other circumstances set out in the ruling. 6.90 Note that ITAA97 s 103-10 sets out special rules relating to the receipt of money or other property. Under s 103-10(1), you are regarded as receiving money or other property if it has been applied for your benefit or as you direct. For example, if instead of actually receiving money for a CGT event you direct that a payment be made to discharge an existing debt that you owe, this rule would mean that, for CGT purposes, you would be regarded as receiving the money used to discharge the debt. Under s 103-10(2)(a), if you are entitled to have

money or other property applied for your benefit or as you direct you are regarded as being entitled to receive money or other property. 6.91 A special rule is also set out in s 103-10(2)(b) relating to entitlements to subsequent receipts and to instalment payments. You are treated as being entitled to receive money or other property where you will not receive it until a later time or where it is payable by instalments. In applying these rules, it is important to remember, however, that, consistently with the decision of O’Loughlin J in Dingwall v FCT (1995) 57 FCR 274; 130 ALR 297; 30 ATR 498, for this rule to apply to an entitlement to receive money or other property you would have to have a present right to receive money or other property at a future date. A right that is contingent on the occurrence of a future event would not appear to trigger the operation of s 103-10(2)(b). 6.92 The money or other property must be ‘in respect of’ the CGT event. The courts have often commented that the words ‘in respect of’ have the widest possible meaning of any expression intended to convey some connection between two things. A good example of the breadth of this expression can be found in the Full Federal Court decision in FCT v Guy (1996) 67 FCR 68; 137 ALR 193; 32 ATR 590. There, the Full Federal Court held that the forfeited deposit on a sale where the purchasers defaulted was in respect of the disposal of the taxpayer’s principal residence even though the disposal was effected by a subsequent contract. The Full Federal Court also held that damages recovered by the taxpayer were in respect of the disposal of the taxpayer’s principal residence. This was because the forfeiture of the deposit and the recovery of the damages both formed part of the process or continuum of events which constituted disposal of the residence. Note that the capital proceeds include the market value of any property other than money that you are entitled to receive in respect of the CGT event happening. This rule will not apply to all non-monetary consideration. It applies only to non-monetary consideration that is property. Modifications to the general rules, however, may apply where a taxpayer receives non-monetary consideration that is not property. These rules will now be discussed.

[page 351]

Modifications to the general rules 6.93 The general rules relating to ascertaining the capital proceeds are modified in several circumstances.32 The first modification substitutes the market value of a CGT asset that is the subject of a CGT event for the actual capital proceeds for that event. There is an extensive body of case law on the meaning of value and market value in the context of compensation for resumptions. The effect of those authorities was summarised by Gummow J in Airservices Australia v Canadian Airlines International Ltd (1999) 202 CLR 133; 43 ATR 246 at [452] as follows: “Market value” is determined by an inquiry into what a willing purchaser will pay and a not unwilling vendor will receive for the subject-matter being valued. [Marks v GIO Australia Holdings Ltd (1998) 73 ALJR 12 at 22; Kenny & Good Pty Ltd v MGICA (1992) Ltd (1999) 73 ALJR 901 at 912, 917–18.] The premise of the inquiry is that an efficient market exists or, at least, that an efficient market can be reasonably hypothesised from an existing inefficient market. Where there is no market for exchange of the subject-matter, it is necessary to consider other means of fixing value. [See Commissioner of Succession Duties (SA) v Executor Trustee & Agency Co of South Australia Ltd (1947) 74 CLR 358 at 361–2. In United States v Miller 317 US 369 at 374 (1943), the Supreme Court of the United States said: “Where, for any reason, property has no market, resort must be had to other data to ascertain its value; and, even in the ordinary case, assessment of market value involves the use of assumptions, which make it unlikely that the appraisal will reflect true value with nicety.”]33

The Commissioner has applied this approach to determining market value in the CGT context: see IT 2378 and IT 2588. Care should be taken, however, in applying valuation principles from compensation cases in a revenue law context. As Dixon J noted in Commissioner of Succession Duties (SA) v Executor Trustee & Agency Co of South Australia Ltd (1947) 74 CLR 358, the difference of purpose in valuing property in the two contexts is likely to mean that in borderline revenue cases a lower valuation is more likely to be adopted. ITAA97 s 960-405 states that the market value of an asset at a particular time is reduced by

the amount of input tax credit you would have been entitled to if you had acquired the asset at that time solely for a creditable purpose. This rule does not apply to an asset where the supply of the asset cannot be a taxable supply for GST purposes. Nor does the rule apply for the purposes of the value shifting provisions in ITAA97 Pt 3-95. The value shifting provisions are discussed at 13.129–13.152. 6.94 The situations where the first modification is made are as follows: Under ITAA97 s 116-30(1), if there are no capital proceeds from a CGT event you are regarded as receiving the market value of the CGT asset that is subject to the event. It is important to note, however, that market value substitution under [page 352] s 116-30(1) does not apply to CGT C2 events arising on the expiry of a CGT asset or the cancellation of a statutory licence nor does it apply to CGT event D1. Under s 116-30(2)(a), market value of the asset is also substituted for the actual capital proceeds received where all or some of those proceeds cannot be valued.34 Under s 116-30(2)(b)(i), market value is substituted where the capital proceeds are more or less than market value and you and the entity that acquired the CGT asset from you did not deal with each other at arm’s length35 in connection with the event. Thus, this particular substitution of market value for actual capital proceeds will occur only where you disposed of the CGT asset to another entity. Section 116-30(2)(b)(ii) also substitutes market value where the actual capital proceeds are more or less than the market value of the asset and the CGT event is CGT event C2. Presumably, a situation where no capital proceeds are received will be covered by s 116-30(1) and (3) rather than by s 116-30(2), both by applying the generalia specialibus non derogant

principle36 and on the basis that s 116-30(1) and (2), when read together, evidence a legislative intent that a zero amount does not represent capital proceeds but, rather, is a case where there are no capital proceeds. After 30 June 2006, market value substitution is not made in the s 116-30(2) situation where there is a partial roll-over because of s 124150, nor is it made where CGT event C2 occurs in relation to a share in a widely held company or a unit in a widely held unit trust where the capital proceeds from the event are different from the market value of the share or unit. In the latter situation, the capital proceeds will be the actual amount received or receivable because of the CGT event.37 Where the market value substitution rule applies to an asset that is the subject of CGT event C2, you calculate the market value of the asset as if the CGT event had [page 353] not occurred and was never proposed to occur. In the case of CGT events D1, D2, D3, E8, K1 and K6, a table in s 116-30(4) sets out the asset that is the subject of the CGT event for the purposes of deciding whether or not the market value substitution rule is applicable. 6.95 The second modification is what is known as the apportionment rule. Under ITAA97 s 116-40(1), capital proceeds that relate to more than one CGT event are apportioned between the two events to the extent that they are reasonably attributable to them. This rule could easily be relevant in sale of business transactions; for example, where it is conceivable that several assets could be sold at once for a consideration that is not expressly allocated between them. The apportionment rule can also apply where you receive payment in connection with a transaction that relates to a CGT event and also to something else. Here, s 116-40(2) states that the capital proceeds from the CGT event are so much of the payment as is reasonably attributable to the CGT event. A common instance where this rule could be

applicable would be where one payment is received for work done and materials (other than trading stock) supplied for a consideration that is not expressly allocated between the work and materials. The performance of services will not be a CGT event but the supply of materials will be. In Re Gerard Cassegrain & Co Pty Ltd and FCT [2010] AATA 12; BC201000017, the Administrative Appeals Tribunal (AAT) held (at [62]) that, in reasonably attributing under ITAA36 s 160ZD(4) an undissected sum between termination of proceedings and disposal of assets, the following four-step process should be adopted: 1. identify the assets that were disposed of for the undissected sum; 2. determine the amount for which each of those assets might reasonably have been disposed of; 3. determine the relationship between the amounts previously determined and the undissected sum; and 4. multiply each individual amount by the factor determined under step 3. On appeal, the Full Federal Court (Downes, Edmonds and Greenwood JJ) in Gerard Cassegrain & Co Pty Ltd v FCT [2011] FCAFC 12; BC201100362, held that the AAT had made no error of law, and made the following observations (at [12] and [14] respectively) relevant to the task of apportionment: The task faced by the Tribunal could never have been an exact one. Section 160ZD(4) [the ITAA36 equivalent to ITAA97 s 116-40] called for a reasonable attribution where consideration related in part only to the disposal of a particular asset. The exercise must involve “common sense” (the taxpayers) or “judgment and impression” (the Commissioner). The parties both filed experts’ reports which the Tribunal found to be of only limited assistance. None of the experts proceeded in accordance with the method which the Tribunal found to be preferable. They accordingly had to pick and choose from the opinions and assessments of the experts and make use of the material in accordance with the Tribunal’s preferred method. … Our first impression was that the Tribunal carried out a well thought out and satisfactory process to arrive at their result in difficult circumstances, where precision

[page 354]

is not possible and minds may differ. It was not apparent to us that their approach might be affected with error of law. Whether their opinion of the preferable method or their assessment of the facts would accord entirely with ours is not to the point. The Tribunal was exercising the administrative power of the Commonwealth in an area of discretionary decision-making and it is not relevant that others might have acted differently. That is not to say that we disagreed with the Tribunal on any matter. It is simply that our opinion is not relevant other than on a question of law.

6.96 The third modification is what is known as the non-receipt rule. ITAA97 s 116-45 states that the capital proceeds are reduced if you are unlikely to receive some or all of them. The reduction applies only if you took all reasonable steps to obtain payment of the unpaid amount. Where you are unlikely to receive some or all of the amount because of something that you (or your associate) did, the reduction will not apply. If the capital proceeds are reduced by an unpaid amount, but you subsequently receive part of the unpaid amount, the capital proceeds are increased by the part payment received. Where s 116-45 applies to reduce capital proceeds because an amount is unpaid, the unpaid amount is not treated as a CGT asset.

(This example is based on one contained in ITAA97 s 116-45.) You sell a painting to Arthur for $5000. You agree that the capital proceeds of $5000 can be paid by monthly instalments of $100. After you have received $2000 Arthur stops paying. After reasonable inquiries it becomes clear that you are not likely to receive the remaining $3000. Here, s 116-45(1) will reduce the capital proceeds to $2000. If it later transpires that you, in fact, receive a further $1000 from Arthur, the capital proceeds from the sale of the painting will be increased by the $1000 to $3000. Because the debt of $3000 was not regarded as a CGT asset that Arthur owed you, CGT event C2 does not occur when Arthur repays the $1000.

6.97 The fourth modification is known as the repaid rule. ITAA97 s 116-50 tells us that the capital proceeds are reduced by: (a) any part of them that you repay; or (b) any compensation you pay that can reasonably be regarded as a repayment of them.

However, this rule does not apply in relation to any part of the

capital proceeds that you can deduct. 6.98 A fifth modification arises where the entity acquiring the asset assumes a liability by way of security over the asset. In these circumstances, ITAA97 s 116-55 increases the capital proceeds by the amount of the liability that the acquirer assumes.38 [page 355]

(Based on an example contained in ITAA97 s 116-55.) Alex sells land to Tony. Tony pays Alex $50,000 and agrees to become liable for $100,000 outstanding under Alex’s mortgage. The capital proceeds of $50,000 (the amount that Alex is entitled to receive in respect of the CGT A1 event happening) are increased by $100,000 (the amount of the liability by way of security that Tony assumes).

1.

2.

Can you think of an example of a consideration that ‘cannot be valued’? Why substitute market value for actual consideration where consideration cannot be valued? Can you give an example of a situation where a refund of the capital proceeds would be deductible to the party refunding?

Applying the capital proceeds rules in Steve and Sarah’s case study (see 6.58) Calculate the capital proceeds for the CGT A1 events that you identified earlier. Suggested solutions can be found in Study help.

Special rules

6.99 At 6.89 we noted that amendments in 2016 inserted s 116-120 and Subdiv 118-I dealing with the CGT treatment of ‘earn-out’ arrangements. In broad terms, s 116-120 has the effect of excluding from the vendor’s capital proceeds for CGT event A1 the value of any ‘look through earn-out right’ relating to the CGT asset and the disposal of that asset. Section 116-120 goes on to provide that the vendor’s capital proceeds from the CGT event A1 are increased by any financial benefit the vendor receives under the earn-out right and are reduced by an financial benefit that the vendor provides under the earn-out right. A ‘look through earn-out right’ has the meaning given in s 118-565. Subsection 118-565(1)39 provides that:40 [page 356]

(1) A look-through earnout right is a right for which the following conditions are met: (a) the right is a right to future *financial benefits38 that are not reasonably ascertainable at the time the right is created; (b) the right is created under an *arrangement that involves the *disposal of a *CGT asset; (c) the disposal causes *CGT event A1 to happen; (d) just before the CGT event, the CGT asset was an *active asset39 of the entity who disposed of the asset; (e) all of the financial benefits that can be provided under the right are to be provided over a period ending no later than 5 years40 after the end of the income year in which the CGT event happens; (f) those financial benefits are contingent on the economic performance of: (i) the CGT asset; or (ii) a business for which it is reasonably expected that the CGT asset will be an active asset for the period to which those financial benefits relate; (g) the value of those financial benefits reasonably relates to that economic performance; (h) the parties to the arrangement deal with each other at *arm’s length in making the arrangement.

Subsection 118-565(4) goes on to state that a right to receive one or

more financial benefits for ending a right to which s 118-565(1) applies is a look through earn-out right provided the right is certain.4142 Note that the 2016 amendments dealing with earn-out rights only apply to ‘look through earn-out rights’ as defined in s 118-565. In situations where the earn-out right is not within that definition it appears that the approach taken in the UK cases of Marren v Inglis [1979] 1 WLR 1131 and Marson v Marriage [1980] STC 177 (discussed at 6.89) might apply.

Cost base of CGT assets 6.100 In calculating whether a capital gain or capital loss has been made from a CGT A1 event, the next step is to determine what the cost base of the CGT asset is. The ITAA97 exhaustively defines what can be included in the cost base of a [page 357] CGT asset. Section 110-25 explains that the cost base of a CGT asset consists of five elements. The relevant extracts from s 110-25 state as follows. 110-25 General rules about cost base (1) The cost base of a CGT asset consists of 5 elements. Note 1: You need to keep records of each element: see Division 121. Note 2: The cost base is reduced by net input tax credits: see section 103-30. Note 3: An amount that makes up all or part of an element of the cost base of an asset may be determined under section 230-505, if the amount is provided for acquiring a thing, and you start or cease to have a Division 230 financial arrangement as consideration for the acquisition of the thing. 5 elements of the cost base (2) The first element is the total of: (a) the money you paid, or are required to pay, in respect of acquiring it; and (b) the market value of any other property you gave, or are required to give, in respect of acquiring it (worked out as at the time of the acquisition). Note 1: There are special rules for working out when you are required to pay money or give other property: see section 103-15.

Note 2: This element is replaced with another amount in many situations: see Division 112. (3) The second element is the incidental costs you incurred. These costs can include giving property: see section 103-5. Note: There is one situation to do with options in which the incidental costs relating to the CGT event are modified: see section 112-85. (4) The third element is the costs of owning the CGT asset you incurred (but only if you acquired the asset after 20 August 1991). These costs include: (a) interest on money you borrowed to acquire the asset; and (b) costs of maintaining, repairing or insuring it; and (c) rates or land tax, if the asset is land; and (d) interest on money you borrowed to refinance the money you borrowed to acquire the asset; and (e) interest on money you borrowed to finance the capital expenditure you incurred to increase the asset’s value. [page 358] These costs can include giving property: see section 103-5. Note: This element does not apply to personal use assets or collectables: see sections 108-17 and 108-30. (5) The fourth element is capital expenditure you incurred: (a) the purpose or expected effect of which is to increase or preserve the asset’s value; or (b) that relates to installing or moving the asset. The expenditure can include giving property: see section 103-5. Note: There are 3 situations involving leases in which this element is modified: see section 112-80. (5A) Subsection (5) does not apply to capital expenditure incurred in relation to goodwill. (6) The fifth element is capital expenditure that you incurred to establish, preserve or defend your title to the asset, or a right over the asset. (The expenditure can include giving property: see section 103-5.) [Note: Former s 110-25(7)–(11) have been repealed.] Assume a CGT event for purposes of working out cost base at a particular time (12) If: (a) it is necessary to work out the cost base at a particular time; and (b) a CGT event does not happen in relation to the asset at or just after that time; assume, for the purposes only of working out the cost base at the particular time, that such an event does happen in relation to the asset at or just after that time. Note 1: For example, in order to apply subsection 110-37(1), it is necessary for there to be a CGT event. Note 2: The assumption that a CGT event happens does not have any consequence beyond that stated. For example, it does not mean that the asset is afterwards to be

treated as having been acquired at the particular time with a first element of cost base equal to all of its former cost base elements.

The five elements of the cost base of a CGT asset are added together in calculating its cost base. Often these expenditures will be incurred at different times. Note that, as will be discussed in more detail in 6.119–6.120, the cost base of a CGT asset acquired at or before 11.45 am on 21 September 1999 also includes indexation of the elements of the cost base (except the third). For the purposes of calculating the capital gain from a CGT event that happens after that time, indexation is available only to an individual, a complying superannuation fund or a trust if the entity in question chooses that the cost base of the asset will include indexation. If the entity makes this choice then the entity will not be entitled to a CGT discount [page 359] in respect of the capital gain that arises from that CGT event. Indexation is discussed at 6.119–6.120. At this point, however, it is important to note that if indexation is applicable, then each element of the cost base of a CGT asset will be indexed separately. Indexation of each element of the cost base dates from the time when each element was incurred. Where the relevant CGT event occurs after 21 September 1999, the cost base of the CGT asset is indexed only up to the quarter ending on 30 September 1999. 6.101 Where an asset is acquired after 13 May 1997, as a general rule, expenditure does not form part of any element of the asset’s cost base to the extent that you have deducted it or can deduct it under another part of the ITAA97: see s 110-45(1). The exceptions to this rule are set out in s 110-45(2) as: where the deduction has been reversed by an amount being included in your assessable income under another Part of the

ITAA97 (eg, by a depreciation balancing adjustment); or where the deduction is under Div 243 (dealing with limited recourse debt); or where the deduction would have been so reversed but for certain provisions, listed in a table in s 110-45(2), which provide balancing adjustment relief. ITAA97 s 110-45(1B), in effect, provides that expenditure does not form part of the second or third elements of cost base to the extent that you have deducted or can deduct it in any circumstances. Cost base is reduced under s 103-30 by any net GST input tax credit of the entity in relation to the cost base. GST input tax credits are discussed in Chapter 19. 6.102 In the case of assets acquired after 7.30 pm on 13 May 1997, the cost base is reduced by ITAA97 s 110-45(4) to the extent that you have deducted or can deduct capital expenditure incurred by another entity in respect of the CGT asset. For example, this provision would operate to reduce the cost base of a CGT asset by the amount of any Div 43 capital works allowances that you have obtained in respect of expenditure by the person who conducted the capital works. Note that s 110-45(1) is not applicable in this situation. Your Div 43 deductions are for expenditure that the person who conducted the capital works made. Hence, such expenditure would never be included in the cost base of a CGT asset that you purchase. The rationale behind s 110-45(4) would appear to be that the Div 43 expenditure by the constructor of the capital works would have been reflected in the price that you paid for the asset. Hence, to allow you Div 43 deductions and to allow you the effect of the Div 43 expenditure on the price you paid for the asset in your cost base, effectively, would be to allow you to deduct the same amount twice.43 [page 360] 6.103

Where an asset was acquired on or before 7.30 pm on 13 May

1997, amounts that were otherwise deductible were included in all but the second and third elements of the cost base. Both before and after 13 May 1997, expenditure does not form part of any element of your cost base to the extent that you have received a recoupment for it except to the extent to which the recoupment is included in your assessable income. See ITAA97 ss 110-40(3) and 11045(3).

First element of the cost base 6.104 The first element of the cost base of a CGT asset will often be the largest. In essence, the first element of the cost base of a CGT asset is the price that you paid to acquire the asset. However, not everything that contributes to the acquisition of an asset will be recognised as forming part of the first element of its cost base. The first element is confined to money paid or other property given. Here, it is important to recognise that your own services will not be property. You will recall that under the decision in Brent v FCT (1971) 125 CLR 418; 2 ATR 563; 71 ATC 4195, the taxpayer was assessed because she was regarded as performing services rather than as disposing of property. So, for example, if you built a house to rent out on land that you own you would not be able to include the value of your own labour in constructing the house in the cost base of the house: see CGT Determination TD 60 (21 May 1992). Before money (or other property) can be included in the first element of the cost base of a CGT asset, it must be money (or other property) that you ‘paid or are required to pay’ (or gave or are required to give) in respect of the acquisition of the asset. For both cash and accrual basis taxpayers, the rule, as set out in ITAA97 s 103-15, is that you will be regarded as being required to pay money at a particular time even if you do not have to pay it until a later time or if it is payable by instalments. Taxation Determination TD 2005/52 takes the view that a set-off of moneys owed between a buyer and seller is included in the cost base of the asset acquired by the purchaser to the extent that the purchaser’s previous liability is extinguished. 6.105

A liability to pay money that is contingent on the occurrence of

a future event will not form part of the first element of the cost base of a CGT asset. In Dingwall v FCT (1995) 57 FCR 274; 130 ALR 297; 30 ATR 498, O’Loughlin J held that uncalled capital and uncalled premiums did not form part of the ITAA36 equivalent to the first element of the cost base of shares owned by the taxpayer. His Honour said (at ATR 505): … there is a requirement for either an actual payment or, at least, a present obligation to pay a sum certain at a future date. It is not enough that an amount might become payable in the future upon the happening of some contingency.

6.106 For a payment to be included in the cost base of a CGT asset, it must be made ‘in respect of’ the acquisition of the asset. Although the phrase ‘in respect of’ has been said to have the widest possible meaning of any expression intended to convey some connection between two things, it must be read in its context. Thus, it is likely that expenditure that falls within the more specific elements of cost base, such as incidental costs and capital expenditure to establish, preserve or defend your title, will not be considered to be ‘in respect of’ the acquisition of the CGT asset. [page 361] This would be on the basis that, in the event of conflict, more specific provisions prevail over general provisions. Expenditure must be able to be properly regarded as being referable to the acquired asset before it can be regarded as being ‘in respect of’ the acquisition. Hence, in AAT Case 11431 (1996) 34 ATR 1080, it was held that interest on money borrowed to acquire land did not form part of the ITAA36 equivalent to the first element of the cost base of the land. The interest was regarded as being payable in consideration of the loan by the bank, and not in consideration of the acquisition of the land itself. The first element of the cost base of the land to the taxpayer would be the same whether or not the taxpayer borrowed to acquire the land.44 6.107

Although it is arguable, based on UK authorities and the

structure of ITAA97 Subdiv 110-A, that the first element of the cost base of a CGT asset is limited to expenditure incurred up to the time of acquisition of the asset, the Commissioner takes a broader view. The Commissioner’s view of what was included as ‘consideration in respect of the acquisition’ of an asset for the purposes of ITAA36 s 160ZH(4) (the ITAA36 equivalent to the first element of the cost base) is set out in para 101 of Taxation Ruling TR 95/35. TR 95/35 101. Broadly speaking, money, property, or money and property come within the cost base and are regarded as paid or given in respect of the acquisition of the asset in terms of paragraph 160ZH(4)(a), (b) or (c) if there is some direct and substantial link between the money or property and the acquisition of the asset. In determining whether there is a direct and substantial link, we believe it is appropriate to consider the following indicators: the necessity for the payment of money or the giving of property; the degree of temporal relationship between the payment of money or the giving of property and the acquisition of the asset; the purpose (objective and subjective) of the payment of money or the giving of property; the nature of the asset; the circumstances of the acquisition of the asset including: parties (eg, whether money paid or property given to a third party); terms of the contract or agreement; and arising from a wrong or by a lack of consent; [page 362] the extent of causation; whether money paid or property given is in proportion to the value of the asset; and whether the degree of connection is diminished if money is paid or property is given for multiple benefits rather than solely to acquire the asset (eg, for services).

Second element of the cost base 6.108 The second element of the cost base of a CGT asset comprises the incidental costs that you incurred to acquire the CGT asset or that

relate to the CGT event. These costs are exhaustively defined in ITAA97 s 110-35 as follows. 110-35 Incidental costs (1) There are a number of incidental costs you may have incurred. Except for the ninth, they are costs you may have incurred: (a) to acquire a CGT asset; or (b) that relate to a CGT event. (2) The first is remuneration for the services of a surveyor, valuer, auctioneer, accountant, broker, agent, consultant or legal adviser. However, remuneration for professional advice about the operation of this Act is not included unless it is provided by a recognised tax adviser. Note: Expenditure for professional advice about taxation incurred before 1 July 1989 does not form part of the cost base of a CGT asset: see section 110-35 of the Income Tax (Transitional Provisions) Act 1997. (3) The second is costs of transfer. (4) The third is stamp duty or other similar duty. (5) The fourth is: (a) if you acquired a CGT asset costs of advertising to find a seller; or (b) if a CGT event happened costs of advertising or marketing to find a buyer. (6) The fifth is costs relating to the making of any valuation or apportionment for the purposes of this Part or Part 3-3. (7) The sixth is search fees relating to a CGT asset. (8) The seventh is the cost of a conveyancing kit (or similar cost). (9) The eighth is borrowing expenses (such as loan application fees and mortgage discharge fees). [page 363] (10) The ninth is expenditure that: (a) is incurred by the head company of a consolidated group or MEC groupa to an entity that is not a member of the group; and (b) reasonably relates to a CGT asset held by the head company; and (c) is incurred because of a transaction between members of the group. (11) The tenth is termination or other similar fees incurred as a direct result of your ownership of a CGT asset ending.

a.

‘MEC Group’ is defined in ITAA97 s 719-5. MEC groups are discussed at 12.116.

Note that incidental costs, except for the ninth type, must either be incurred to acquire the asset or must relate to the CGT event. That is, incidental costs that you incur in relation to a CGT event A1 disposal will be included in the cost base of the CGT asset. Both before and after 13 May 1997, amounts can only be included as incidental costs if they are not deductible under another part of the ITAA97. Incidental costs can include a giving of property. Under s 103-5, the market value of any property other than money will be used in calculating the amount of the incidental cost.

Third element of the cost base 6.109 The third element of the cost base of a CGT asset comprises the costs of owning that you incurred where you acquired the asset after 20 August 1991. Examples include: interest on moneys borrowed to acquire, refinance or improve the asset; maintenance, repair and insurance costs; and rates or land tax. We have noted that interest on moneys borrowed to acquire an asset is not included in the first element of the cost base of the asset. This appears to be because the interest is not regarded as being in respect of the acquisition of the asset. For similar reasons, the other amounts that are included in the third element of the cost base of an asset would not be included in the first element. When CGT was first introduced in Australia, non-deductible costs of maintaining an asset were not included in the cost base of the asset for CGT purposes. The CGT provisions in the ITAA36 were amended to allow non-deductible maintenance costs to be included in the cost base of assets acquired after 20 August 1991. To be included in the third element of the cost base of a CGT asset, an expenditure cannot be deductible under another part of the ITAA97. Maintenance expenses such as interest, repairs and insurance will normally be regarded as costs of owning as

[page 364] they are costs of maintaining rather than of acquiring an asset. Hence, they would not normally be characterised as being of a capital nature and would not be denied s 8-1 deductibility on that basis. However, such expenses may be denied deductibility under s 8-1 or other deduction provisions if the relevant nexus to the gaining or producing of your assessable income is not established. For example, interest on money borrowed to finance the acquisition of vacant land or a second home from which you do not obtain rental income would not normally be deductible.

Fourth element of the cost base 6.110 Expenditure that you have incurred, the purpose or intended effect of which is to increase or preserve an asset’s value, or which relates to installing or moving the asset, is included in the fourth element of the cost base of a CGT asset. Following amendments in 2005, the expenditure no longer has to be reflected in the state or nature of the asset. Under ITAA97 s 110-25(5A), capital expenditure in relation to goodwill is not included in the fourth element of cost base. A taxpayer’s own labour in making improvements to a CGT asset will not form part of the fourth element of the cost base of the asset. In Oram v Johnson [1980] 2 All ER 1; [1980] 1 WLR 558, Walton J held that a taxpayer’s own labour was not an expenditure within the equivalent UK provision. This was because expenditure of a taxpayer’s own labour did not diminish the taxpayer’s assets. CGT Determination TD 60 (issued 21 May 1992) confirms that the value of a taxpayer’s own labour will not be included in the cost base of a CGT asset. Prior to 2005, for an expenditure to be included in the fourth element of the cost base of a CGT asset, it had to be reflected in the state or nature of the CGT asset at the time of the CGT event. Courts in the United Kingdom interpreted this requirement in the equivalent UK provision narrowly. For example, in Aberdeen Construction Group Ltd v IRC 1977 SC 265; (1977) 52 TC 281,45 the Scottish Court of Session

held that a waiver of loans by a parent company to a subsidiary was not reflected in the state or nature of the parent’s shares in the subsidiary when those shares were sold. The waiving of the loans may have increased the value of the shares but it did not change the nature of the shares. A similar approach was taken by Middleton J in National Mutual Life Association of Australasia Ltd v FCT 2008 ATC 20-077, who held that a capital contribution by a parent company to its wholly owned subsidiary was not reflected in the state or nature of the shares in the subsidiary although the contribution increased their value. The decision was reversed on appeal with a majority of the Full Federal Court (Finn and Sundberg JJ) holding that the value of a share was one of its attributes and hence an increase in the value of a share was reflected in the state or nature of the share: National Mutual Life Association of Australasia Ltd v FCT [2009] FCAFC 96. See also the Administrative Appeals Tribunal’s decision in Re Taxpayer and Federal Commissioner of Taxation (2004) 58 ATR 1172 to a similar effect as Middleton J’s decision. [page 365] If similar facts to those in Aberdeen Construction Group Ltd occurred in Australia after 1 July 2005, the issue now would appear to be whether the forgiveness of the debt amounted to an expenditure for purposes of the fourth element of the cost base. If similar facts to those in National Mutual Life Association of Australasia Ltd were to occur after 1 July 2005, it is likely that the capital contribution would have formed part of the cost base of the parent company’s shares in the subsidiary. 6.111 In Emmerson v Computer Time International Ltd (in liq) [1977] 2 All ER 545, the English Court of Appeal considered the issue of when expenditure enhances the value of an asset. Orr LJ commented (at 550) that: If a tenant, in breach of his covenants, allows premises to fall into disrepair, it is clear

that as a result they will be less valuable than immediately before; and if he repairs them their value will be restored, but I consider that it would be a misuse of language to say that in such circumstances their value will be enhanced.

Under this approach, a restoration of an asset to its original condition when first in the taxpayer’s ownership might not amount to enhancing its value. This approach may be contrasted with the approach taken in Taxation Determination TD 98/19. In TD 98/19, initial repairs to an asset are regarded as being included in the fourth element of the cost base of the asset on the ground that they enhance the value of the asset by restoring the efficiency of function of the asset. While TD 98/19 appears to suggest that restoring an asset will enhance its value, it should be remembered that TD 98/19 is dealing with initial repairs. An initial repair will really be giving an asset a function that it has never had while in the taxpayer’s ownership. In other words, an initial repair is giving the asset a function, and hence a value, that it has never had while in the taxpayer’s ownership. Hence, an initial repair is properly regarded as an expenditure that increases the value of a CGT asset. Prior to its amendment in 2005, ITAA97 s 110-25(5) referred to expenditure ‘to increase the asset’s value’. Note that s 110-25(5) now refers to expenditure ‘the purpose or intended effect of which is to increase or preserve the asset’s value’. Following the 2005 amendment, it may be that, in a case where premises have fallen into disrepair, expenditure to restore them to the condition that they were in when first acquired by the taxpayer would now form part of the fourth element of the cost base of the premises as ‘expenditure … to … preserve the asset’s value’. Expenditure of the type conducted by the taxpayer in Broken Hill Theatres Pty Ltd v FCT (1952) 85 CLR 423, where the taxpayer was denied a deduction under ITAA36 s 51(1) (the equivalent of ITAA97 s 8-1) for legal expenses incurred in successfully opposing an application by a potential rival to open a motion picture theatre in Broken Hill, would also be likely to be included as part of the fourth element. Arguably, in this situation the legal expenses would have the effect of preserving the value of the taxpayer’s own licence to operate a motion picture theatre in Broken Hill. Note that, although capital expenditure in relation to goodwill is not included in the fourth element of the cost base, this rule would not appear to prevent

expenditure of the type conducted in Broken Hill Theatres from being included in the cost base of the licence. The decision of the High Court in FCT v Murry (1998) 193 CLR 605; 155 ALR 67; 39 ATR 129 (discussed at 6.74) is authority that a non-exclusive licence is not a source of goodwill and does not contain any element of goodwill. [page 366]

Fifth element of the cost base 6.112 The fifth element of the cost base of an asset is expenditure that you have incurred to establish, preserve or defend your title to the asset, or right over the asset. In the UK decision Allison v Murray [1975] 1 WLR 1578; (1975) 51 TC 57, it was held that the UK equivalent to the fifth element of the cost base did not apply to expenses involved in an acquisition. Rather, the fifth element could apply to acts done only after the CGT asset had been acquired. For example, if a taxpayer’s title to an asset was challenged, legal costs involved in establishing the taxpayer’s title would be included in the fifth element of the cost base.

Modifications to the general rules 6.113 The general rules about cost base are modified in several circumstances.46 ITAA97 s 112-15 provides that, if a cost base modification replaces an element of the cost base of a CGT asset with an amount, then the CGT provisions apply as if you had paid the substituted amount. The fifth modification, set out in s 112–37, was introduced following the High Court decision in FCT v McNeil (2007) 229 CLR 656 and concerns the cost base of company issued put options. This modification is discussed in more detail in Chapter 13. The first modification is that, in some cases, the ITAA97 substitutes the market value of the asset for the consideration that you actually

paid for it. The more important situations where market value will be substituted include: where you acquired the asset from another entity but did not incur expenditure to acquire it, except where your acquisition resulted from either CGT event D1 or from another entity doing something that did not constitute a CGT event happening (s 11220(1)(a)); where you acquired the asset from another entity but some or all of the expenditure that you incurred to acquire it cannot be valued (s 112-20(1)(b)); and where you acquired the asset from another entity but did not deal at arm’s length with the other entity in connection with the acquisition (s 112-20(1)(c)). Where you did not deal at arm’s length with the other entity, and your acquisition of the CGT asset resulted from another entity doing something that did not constitute a CGT event happening, s 112-20(2) states that market value is substituted only if what you paid for the CGT asset was more than its market value. In other words, in this situation a lower than market consideration is not increased to market value by the operation of the market value substitution rule.47 6.114 There are several exceptions to the market value substitution rule. Most of these relate to the acquisition of company-issued shares or unit trust-issued units [page 367] or to rights to receive income from a trust. These provisions will be discussed in Chapter 12 and Chapter 15 respectively. Two other exceptions to the market value substitution rule will be noted here. First, ITAA97 s 112-20(3) states that the market value substitution rule does not apply where you did not pay or give anything for a decoration awarded for valour or brave conduct. This exception applies to the original recipient of the decoration and also to any person who receives

the decoration as a gift. Second, under s 112-20(3), the market value substitution rule does not apply where you did not pay or give anything for a contractual or other legal or equitable right resulting from CGT event D1 happening. 6.115 The next modification to the general rules about cost base concerns split, changed or merged assets. The situation where an asset is split into two assets is dealt with in ITAA97 s 112-25(1)(a). Here, s 112-25(2) and (3) tell us that: the splitting is not a CGT event; and each element of the cost base of the original asset at the time of the splitting is apportioned to each new asset. In a case where an asset changes in whole or part into a new asset of a different nature, s 112-25(2) and (3) explain that: the change is not a CGT event; and each element of the cost base of the original asset at the time of the change is apportioned to each new asset. Where two assets are merged into a single asset and you are the beneficial owner of the original assets and the new asset, s 112-25(4) states that: the merger is not a CGT event; and each element of the cost base of the new asset at the time of merger is the sum of the corresponding elements of each original asset. Where land is subdivided, a disposal of the subdivided block is regarded (by the Commissioner in TD 97/3) as a disposal of an asset in its own right. It is not regarded as a disposal of part of the original land parcel. The subdivision amounts to a splitting of the original land and s 112-25(1) and (3) determines the cost base of the subdivided blocks. 6.116 The third modification to the general cost base rules is the apportionment rules. The first apportionment rule, set out in ITAA97 s 112-30(1), deals with the situation where only part of the expenditure that you incur under a transaction relates to the acquisition of a particular CGT asset. Here, s 112-30(1) applies the rule that the first

element of your cost base is that part of the expenditure that is reasonably attributable to the acquisition of the asset. For example, this rule could apply where several assets are purchased at the same time but consideration is not expressly allocated between them. The rule would also apply where work is done and materials are supplied at the same time but consideration paid is not broken down between the work and materials. Where only part of an expenditure relates to another element of the cost base of an asset (eg, where legal expenses are charged for a purchase of a business transaction as a whole and not in relation to each specific asset in the business), s 112-30(1A) apportions a reasonably attributable part of the expenditure to that element. [page 368] A second type of apportionment occurs when a CGT event happens to only part of a CGT asset. Here, under s 112-30(3), the cost base of the part of the CGT asset to which the CGT event happened is worked out as follows:

The remainder of the cost base is attributed to the part of the CGT asset to which the CGT event did not happen. However, an amount forming part of the cost base of a CGT asset is not apportioned under s 112-30 if, on the facts, that amount is wholly attributable to either the part of the asset to which the CGT event happened, or to the remaining part of the asset. 6.117 The fourth type of modification to the general cost base rules is the assumption of liability rule. This modification applies where you assume liabilities to which an asset was subject at the time you acquired the asset. Under ITAA97 s 112-35, the first element of the cost base of an asset will include the amount of any liabilities that you assume.

6.118 A further modification dealing with earn-out rights was introduced in 2016. The modification was part of the ‘look through’ approach to earn-out rights discussed at 6.89. The modification introduced in 2016 is set out in s 112-36. Subsection (1)48 of s 112-36 provides: (1) If you *acquire a *CGT asset because an entity *disposes of the CGT asset to you, and that disposal causes *CGT event A1 (the first CGT event) to happen: (a) neither the *cost base nor the *reduced cost base of the CGT asset includes the value of any *look-through earnout right relating to the CGT asset and the acquisition; and (b) include in the first element of the CGT asset’s cost base and reduced cost base any *financial benefit that you provide under such a look-through earnout right; and (c) reduce the first element of the CGT asset’s cost base and reduced cost base by an amount equal to the amount of any financial benefit that you receive under such a look-through earnout right.

Note that s 112-36 only applies to ‘look through earn-out rights’. The definition of a look through earn-out right was discussed at 6.99. [page 369]

Application of the cost base rules in Steve and Sarah’s case study Previously you identified the CGT assets that exist in Steve and Sarah’s case study (see 6.58). Now work out the cost base of each of those assets. Suggested solutions can be found in Study help.

Indexation of the cost base 6.119 Where you acquired a pre-21 September 1999 CGT asset, to which a CGT event relates, 12 months or more before that event, the elements of the cost base of the asset may be indexed to inflation. Where the taxpayer is an individual, a trust or a complying superannuation fund indexation is available only in respect of CGT events occurring on or after 21 September 1999 if the taxpayer chooses

indexation instead of a CGT discount. Sometimes different rules apply to determine when indexation is applicable. These different rules apply in cases of acquisitions by trusts (discussed in Chapter 15), certain rollovers (see 6.160–6.163), and when a taxpayer dies (discussed in Chapter 15). Where indexation of the elements of the cost base is applicable, it is included in the cost base of a CGT asset. The third element (costs of owning) of the cost base of a CGT asset is not indexed. Where an element of the cost base of an asset is modified by a specific rule, such as the market value substitution rule, that element as modified by the rule is indexed for inflation. The reduced cost base of a CGT asset (see 6.121–6.124) is never indexed. 6.120 The general rules on how to index expenditure are set out in ITAA97 Subdiv 960-M. Note that, for CGT events occurring on or after 21 September 1999, the effect of s 960-275(2) is that indexation is frozen as at the quarter ending 30 September 1999. Further details on the process of indexation can be found in Study help.

Reduced cost base 6.121 A capital loss will arise under CGT event A1 where the capital proceeds are less than the reduced cost base of the asset. Thus, in order to calculate a capital loss in respect of a CGT event A1, you need to know what the reduced cost base of the relevant CGT asset is. In some cases, it is possible for an amount, all or part of which is deductible under another part of the ITAA97, to be included in the cost base of a CGT asset. For assets acquired prior to 13 May 1997, the best example is the cost of depreciable property.49 Prior to that time, where depreciable property was purchased in an arm’s [page 370] length transaction, its cost for depreciation purposes included the actual purchase price. So, too, did its cost base for CGT purposes. If the owner of the property depreciated it and then sold it, a depreciation balancing

adjustment might have taken place at the time of sale. If the sale was for less than the cost base of the asset, it would not be appropriate to allow the owner of the property a capital loss on its disposal. This is because part of the cost of the property had already been allowed to the owner as depreciation deductions. If a capital loss were to be allowed as well, then the owner would be getting both a capital loss and depreciation deductions for the one expenditure. In general, the CGT provisions try to prevent this result from occurring by saying that a capital loss is made only where the capital proceeds from a CGT event are less than the reduced cost base of the asset which the CGT event related to. Consequently, under s 110-55(4), the reduced cost base never includes an amount to the extent that you have deducted or can deduct it and s 110-55(5) excludes amounts that you could have deducted for a CGT asset if you had used it wholly for the purpose of producing assessable income. Where it is necessary to determine the reduced cost base at a particular time, and a CGT event does not happen at or just after that time, s 110-55(10) requires that you assume, for the purpose of determining the reduced cost base at that time, that such an event did happen in relation to the asset at or just after that time. The reduced cost base of a CGT asset has the same elements as the cost base with the exception of the third element (costs of owning). The third element of the reduced cost base is any amount included in your assessable income because of a balancing adjustment. The third element also includes amounts that would have been included in your assessable income as balancing adjustments but for balancing adjustment relief provisions. Each of these elements is reduced by any part of it that has been or is deductible under another part of the ITAA97. It is important to note that the reduced cost base is never indexed for inflation. This means that losses due to inflation are not recognised as capital losses in the ITAA97. 6.122 ITAA97 s 110-55(9) represents a further respect in which the reduced cost base may differ from the cost base. Section 110-55(9) is designed to ensure that a taxpayer, in most cases, is not allowed both a capital loss and a revenue loss in respect of the one transaction. Under the ITAA36, s 160ZK reduced the cost base by so much of the

constituent elements of the cost base as had been allowed or were allowable as deductions under another part of the ITAA36. The argument was put that this reduction might not operate where the deduction under the other part of the ITAA36 was a revenue loss. The basis of this argument was that, in these circumstances, the deduction was not for a part of the cost of the asset but was a deduction of the excess of the cost over the proceeds for the asset. The ITAA97 endeavours to overcome this argument (subject to some exceptions that will not be discussed here) by reducing the cost base by any amount that you have deducted or could have deducted as a result of a CGT event that happens in relation to a CGT asset. The reduction is not made for amounts that could never have formed part of the reduced cost base or are excluded from the reduced cost base as a result of another provision in s 110-55. Where a CGT event triggers a revenue loss, the argument is that s 110-55(9) reduces the cost base because the revenue loss is as a result of the CGT event. Note that [page 371] where the CGT provisions (eg, via the market value substitution rule or ITAA97 Div 149) have deemed the cost base of an asset for CGT purposes to be something other than its actual cost, it is possible that the revenue loss that results from a CGT event may be a different amount from the capital loss that would result but for s 110-55(9). Where the revenue loss is less than the capital loss would otherwise be, the effect of s 110-55(9) is that the taxpayer obtains a revenue loss and a capital loss equal to the excess of what would otherwise be the capital loss over the amount of the revenue loss. Note that no exact equivalent to s 110-55(9) exists in the cost base provisions in Subdiv 110-A.50 6.123 Because the reduced cost base largely has the same elements as the cost base, to appreciate what will be included in your reduced cost base, it is necessary to review briefly some of our previous discussion of cost base.

Where an asset is acquired after 7.30 pm on 13 May 1997, ITAA97 s 110-45(1) will mean that, as a general rule, expenditure will not form part of an asset’s cost base to the extent that you can deduct it or have deducted it under another part of the ITAA97. The exceptions to this rule, set out in s 110-45(2), were outlined in 6.101. In brief, these exceptions are where the deduction has been reversed by an amount being included in your assessable income under a provision outside ITAA97 Pts 3-1 and 3-3 or Div 243 (eg, by a depreciation balancing adjustment), or where the deduction would have been reversed but for the operation of certain balancing adjustment relief provisions. As noted in 6.102, in the case of assets acquired after 7.30 pm on 13 May 1997, the cost base is also reduced by s 110-45(4) to the extent that you have deducted or can deduct (eg, under Div 43) capital expenditure incurred by another entity in respect of the CGT asset. 6.124 Where an asset was acquired on or before 7.30 pm on 13 May 1997, the requirement that expenditure would not be otherwise deductible before it could be included in cost base applied only to incidental costs and to (what were then described as) non-capital costs of ownership. Both before and after 13 May 1997, under ITAA97 ss 110-40(3) and 110-45(3), expenditure does not form part of any element of your cost base to the extent that you have received a recoupment for it, except to the extent to which the recoupment is included in your assessable income. Both before and after 13 May 1997, expenditure which is prevented from being deducted by certain specific deduction provisions is not included in the reduced cost base. As such expenditure is denied deductibility, s 110-45 will not prevent it from being included in the cost base. Hence, this is another respect in which the reduced cost base can differ from the cost base. The effect is that any one of the specified expenditures which is denied deductibility can be included in the cost base (and hence reduce the likelihood of a capital gain being made) but is excluded from the reduced cost base. The effect of the exclusion from the reduced cost base is that the expenditure will not result in a capital

loss being made on the realisation of the relevant asset. The expenditures fitting into this category are: [page 372] those relating to certain offences that are denied deductibility under s 26-54; bribes to a foreign public official or to a public official; those in respect of providing entertainment; penalties denied deductibility under s 26-5; those that represent the excess of boat expenditure over boat income that are denied deductibility under s 26-47; those that represent political contributions and gifts that are denied deductibility under s 26-22; certain water infrastructure improvements that are denied deductibility under s 26-100; and National Disability Insurance Scheme expenditure that is denied deductibility under s 26-100. Application to Steve and Sarah’s case study Apply the reduced cost base rules to determine what the reduced cost base of each CGT asset in the Steve and Sarah case study (see 6.58) was at the time the relevant CGT A1 event affected that asset. Suggested solutions can be found in Study help.

Exemptions 6.125 After identifying the CGT events that a particular set of facts gives rise to, it is necessary to check whether any exemptions apply in determining whether a capital gain or loss has arisen from any of the events. We shall examine four categories of CGT exemptions. These are: 1. exempt assets;

2. exempt or loss-denying transactions; 3. anti-overlap provisions; and 4. the main residence exemption. In addition, capital gains and losses that would otherwise arise from certain CGT events are disregarded where you acquired the asset to which they relate on or before 19 September 1985.

Pre-CGT assets 6.126 Capital gains and losses that would otherwise arise from several CGT events are disregarded where they take place in relation to a CGT asset that you acquired on or before 19 September 1985. The CGT events where a capital gain or loss is disregarded where the event takes place in relation to a pre-CGT asset include: CGT event A1 (s 104-10(5)); CGT event B1 (s 104-15(4)); CGT event C1 (s 104-20(4)); [page 373] CGT event C2 (s 104-25(5)); CGT event C3 (s 104-30(5)); CGT event E1 (s 104-55(6)); CGT event E2 (s 104-60(6)); CGT event E3 (s 104-65(4)); CGT event E4 (s 104-70(7)); CGT event E5 (s 104-75(4), (6)); CGT event E6 (s 104-80(6)); CGT event E7 (s 104-85(4), (6)); CGT event E8 (ss 104-95(6), 104-100(6)); CGT event F2 (s 104-115(4)); CGT event F4 (s 104-125(5));

CGT event F5 (s 104-130(5)); CGT event G1 (s 104-135(5)); CGT event G3 (s 104-145(6)); CGT event I1 (s 104-160(5)); CGT event I2 (s 104-170(5)); CGT event J1 (s 104-175(7)); CGT event K3 (s 104-215(5)); CGT event K4 (s 104-220(4)); CGT event K7 (s 104-235(4)); and CGT event K8 (s 104-250(5)).

Exempt assets 6.127 Exempt assets are dealt with in ITAA97 ss 118-5–118-13. Under s 118-5, a capital gain or loss that you make from any of the following CGT assets is disregarded: (a) a car, motor cycle or similar vehicle; (b) a decoration awarded for valour or brave conduct (unless you paid money or gave other property for it).

A car is defined in s 995-1(1) as meaning a motor vehicle (except a motorcycle or similar vehicle) designed to carry a load of less than one tonne and fewer than nine passengers. A motor vehicle is defined in s 995-1 as any motor-powered vehicle. The definition of ‘motor vehicle’ expressly includes a four-wheel drive vehicle. A motorcycle is not defined. The policy behind excluding gains and losses on motor vehicles from the CGT net would appear to be that, in most cases, these assets depreciate rather than appreciate in value over time. Thus, the revenue would be the loser if capital gains and losses on motor vehicles were recognised for tax purposes. A decoration for valour or brave conduct is not defined. Military decorations such as the Victoria Cross or the Distinguished Flying Cross would clearly be included. Civilian decorations, for example, for bravery in fighting bushfires, should also

[page 374] be included. Note that the exemption does not apply if you gave money or other property for the decoration. This does not mean that the exemption is available only to the original recipient of the decoration. The exemption would be available to taxpayers who pay no consideration for the decoration. For example, it would apply to taxpayers who receive the decoration as a gift in a will. 6.128 Under s 118-10, a capital gain that you make from a collectable is disregarded if you acquired the collectable for $500 or less. If you acquire an interest (such as part ownership) in a collectable, s 118-10(2) states that the exemption applies only if the market value of the collectable, at the time you acquired the interest, was less than $500. The definition of a ‘collectable’ was discussed in 6.77.

Oliver purchases from Hannah a 50% interest in a rare coin. The market value of the coin at the time that Oliver purchased the 50% interest was $800. Although the market value of Oliver’s interest is less than $500, the exemption does not apply as the market value of the coin itself is more than $500.

A capital gain or loss that you make from a personal use asset is disregarded if you acquired the personal use asset for $10,000 or less. The definition of a ‘personal use asset’ is discussed at 6.75. Capital gains and losses in relation to assets used to produce nonassessable non-exempt income and in relation to shares in a pooled development fund are also disregarded: see ss 118-12 and 118-13. Under s 118-15, a capital gain or loss that you make from a registered emissions unit or an Australian carbon credit unit is disregarded.51

Exempt or loss denying transactions

6.129 A further category of exemptions concerns CGT events relating directly to certain transactions (principally compensation and gambling). Under ITAA97 s 118-37, a capital gain or capital loss you directly make from a CGT event relating to certain activities, receipts and entitlements including the following is disregarded: [page 375] compensation or damages you receive for any wrong or injury you suffer in your occupation; compensation or damages you receive for any wrong, injury or illness you or your relative suffers personally;52 gambling, a game or a competition with prizes; certain water entitlement payments and water infrastructure improvement payments; subject to certain conditions, a tobacco industry exit grant received under the Tobacco Growers Adjustment Assistance Programme 2006; a right or entitlement to a tax offset, a deduction, or a similar benefit under an Australian law, a foreign law or a law of part of a foreign country; a variation, transfer or revocation of an allocation (within the meaning of the National Rental Affordability Scheme Act 2008 (Cth)); and anything of economic value provided by a department of a state or territory or by a body established for public purposes under the law of a state or territory in relation to your participation in the National Rental Affordability Scheme. Furthermore, under s 118-37(2), capital gains are disregarded when they are made from reimbursements or payments of expenses including those under: a scheme established by an ‘Australian government agency, a local governing body or a foreign government agency under an

enactment or an instrument of a legislative character’; the General Practice Rural Incentives Program; the Sydney Aircraft Noise Insulation Project; the M4/M5 Cashback Scheme; or the Unlawful Termination Assistance Scheme or the Alternative Dispute Resolution Scheme. Capital gains (but not capital losses) made from compensation received under the firearms surrender arrangements are disregarded under s 118-37(3). Note that in many — but not all — cases, firearms would be classified as personal use assets, and where that is the case, a capital loss on them would not be possible. Section 118-37(4)–(9) means that capital gains and losses from certain compensation and other payments received in relation to certain wrongs, injuries, damages to person or property, or any other detriment suffered due to persecution, flight from persecution or participation in a resistance movement during the National Socialist (Nazi) period in Germany or during World War II is to be disregarded. 6.130 The Commissioner’s views on ITAA36 s 160ZB (the equivalent to ITAA97 s 118-37 on compensation receipts) are set out in Taxation Ruling TR 95/35. In reading the extract from TR 95/35, note there are some differences between ITAA97 s 118-37 and ITAA36 s 160ZB. [page 376]

TR 95/35 Exemption for personal wrong or injury 210. Section 160ZB provides a statutory exemption from Part IIIA for certain types of capital receipts which might otherwise be included in the assessable income of the recipient. 211. Subsection 160ZB(1) provides: A capital gain shall not be taken to have accrued to a taxpayer by reason of the taxpayer having obtained a sum by way of compensation or damages for any wrong or injury suffered by the taxpayer to his or her person or in his or her profession or vocation and no such wrong or injury, or proceeding

instituted or other act done or transaction entered into by the taxpayer in respect of such a wrong or injury, shall be taken to have resulted in the taxpayer having incurred a capital loss. 212. We accept that the phrase ‘by way of’ should be given a wide meaning (Goldsbrough Mort & Co Ltd v FCT 76 ATC 4343 at 4348; (1976) 6 ATR 580 at 586). It is not necessary that the amount received by a taxpayer be described as an amount of compensation. An amount received in an out of court settlement (eg, as a result of conciliation) where liability is not admitted by either party still represents a sum received ‘by way of compensation’ in terms of subsection 160ZB(1). 213. The subsection is also intended to be read widely in considering the types of compensation receipts which fall within its scope. Certainly the Explanatory Memorandum accompanying the original CGT legislation suggests a very wide interpretation of the phrases ‘to his or her person’ and ‘in his or her vocation’ by referring to ‘insurance monies under personal accident policies’, and referring specifically to compensation for defamation. 214. We consider that the terms ‘to his or her person’ and ‘in his or her vocation’ should be read as widely as possible to cover the full range of employment and professional type claims, and include claims for discrimination, harassment and victimisation (or any directly related claims) arising out of state and Commonwealth anti-discrimination legislation, and wrongful dismissal. … 217. Exemption under subsection 160ZB(1) is also available for an undissected lump sum compensation amount which is received by a taxpayer wholly in respect of the personal injury of the taxpayer. Refer to paragraph 207 of this Ruling. [page 377] Alternative view: application of section 160ZB(1) 218. It has been suggested that the exemption available under subsection 160ZB(1) does not extend to cover an amount of compensation received by the taxpayer in respect of an illness or disease. 219. ‘Injury’ is not defined in Part IIIA. Most of the case law in this area considers the meaning of the word ‘injury’ in the context of a person’s working environment. The term is generally defined in the legislative enactments and in a number of jurisdictions the definition includes ‘disease’. The key phrase in early workers’ compensation legislation was ‘personal injury by accident’. No reference was made to ‘disease’. However, in interpreting the meaning of ‘injury’ the courts included ‘disease’ (for example, Innes or Grant v G&G Kynoch [1919] AC 765; Martin v Manchester Corporation (1912) 106 LT 741; 28 TLR 344). 220. Subsection 160ZB(1) does not require that an injury result from an accident; it only requires the fact of injury. We consider that the exemption provided by that subsection extends to cover compensation received by a taxpayer for an illness of the taxpayer.

In Employee v FCT (2010) 80 ATR 999; [2010] AATA 912; BC201008583 and Case 7/2010 2010 ATC 1-026, the Administrative Appeals Tribunal held that a settlement payment received by a taxpayer in proceedings for discrimination and breach of contract against his former employer was a termination payment and not within ITAA97 s 118-37. As the settlement payment was a single undissected lump sum with no part of it being attributed to the various claims for relief made by the taxpayer, it could not be said that any part of the payment was ‘for, or in respect of, personal injury’. This was so even if the pain and suffering that the taxpayer claimed to have endured amounted to personal injury for purposes of s 118-37. 6.131 Note that capital gains and losses from gambling, a game or a competition with prizes are disregarded. This is consistent with the traditional English rule that windfall gains are excluded from the income tax base. The rule also reflects practical considerations. Despite the fond hopes of most gamblers, the reality is that, taken as a whole, more gamblers lose than win. If gains and losses from gambling were to be recognised for CGT purposes, then the revenue would be the loser. In some countries, such as the United States, gambling winnings are recognised but gambling losses are not. This approach might not have been thought to have been politically acceptable in Australia. Taxing windfall gains, such as money found in the street, might also be thought to be virtually unenforceable unless accompanied by massive increases in administrative costs.

Anti-overlap provisions 6.132 The next category of exemptions that we shall examine in detail is anti-overlap provisions. The need for anti-overlap provisions stems from the basic structure of the Australian CGT rules and, in part, from the historic failure of Australian case [page 378] law to recognise capital gains as ordinary income. As we have seen, in

general, for a capital gain to be recognised under the Australian CGT rules, all that needs to happen is for the capital proceeds of a CGT event to be greater than the costs which are regarded as being relevant to that CGT event. In the case of CGT event A1, the capital proceeds must be greater than the cost base of the asset to which the CGT event relates. It is important to note that none of the CGT events expressly requires that the CGT event relate to a capital asset or that the receipt that triggers the CGT event be a capital receipt. Thus, in the absence of anti-overlap provisions, it is conceivable that a capital gain that is recognised on a CGT event could, at the same time, be regarded as ordinary income. 6.133 An important anti-overlap provision is ITAA97 s 118-25(1), which states that a capital gain or loss that you make from a CGT asset is disregarded if, at the time of the CGT event, the asset is your trading stock.53 This rule greatly simplifies the operation of the CGT provisions. In effect, it means that so long as an asset is part of your trading stock there will be no CGT consequences if you dispose of it. The ITAA97 expressly recognises that you can start holding an asset, such as a capital asset, that you already own as trading stock: see Chapter 11. In this case, for trading stock purposes you can elect, under s 70-30(1), to be treated as having sold the asset for either its cost or its market value. If you elect to be treated as having sold the asset for its cost, s 118-25(2) states that any capital gain or loss is disregarded. Note that, under s 70-30(3), the cost is what the item’s cost would have been for the purposes of s 70-45 if the item had been your trading stock since you acquired it. It may be conceivable that an item’s cost as determined under s 70-45 might be greater or less than its cost base for CGT purposes. Hence, in the absence of s 118-25(2), a capital gain or loss could arise if you elected, under s 70-30(1), to dispose of the asset at cost at the time of change of use. If, under s 70-30(1), you elect to have been taken to have disposed of the asset for its market value at the time of change of use, then CGT event K4 will arise. Under s 104-220, a capital gain will arise where the market value of the asset exceeds its cost base. A capital loss will arise where the market value of the asset is less than its cost base. Note that these capital gains and losses are not disregarded under s 118-25(2).

Where you dispose of an asset that was formerly part of the trading stock of your business but which has ceased to be held as trading stock, you are taken to have disposed of the asset at its cost and to have reacquired it at its cost. The examples following s 70-110 are consistent with a view that, after the reacquisition, the asset will no longer be regarded as trading stock. If this is so, then the s 118-25(1) exemption would not apply to an asset that was formerly held as trading stock but which was, immediately prior to its disposal, held as another category of asset (such as a capital asset).54

[page 379] 6.134 Another important anti-overlap provision is ITAA97 s 118-24. As from 30 June 2001, a capital gain or loss is disregarded where it is made from a CGT event that is also a balancing adjustment event that happens to a depreciating asset that you hold. The exception applies where decline in value has been determined under Div 40 or Div 328 or would have been if the asset had been used.55 Between 21 September 1999 and 30 June 2001, the s 118-24 exception applied where the asset disposed of was your plant. The s 118-24 exemption as it applied between 21 September 1999 and 30 June 2001 is discussed in Study help. 6.135 The general anti-overlap provision is ITAA97 s 118-20. To understand why s 118-20 exists, it is first important to remember that, as discussed in Chapter 3, a disposal of certain assets other than trading stock can give rise to profits that are regarded as ordinary income. Thus, the s 118-25 exemption, which is confined to disposals of your trading stock, would not prevent the same profit being taxed as both ordinary income and as a capital gain. Second, it is important to remember that CGT is not confined to gains and losses that arise when assets are disposed of. As we have seen, several CGT events do not involve a disposal of an asset. In none of these events are the capital proceeds from the event expressly confined to amounts received on capital account. Hence, it is conceivable that, in the absence of s 11820, a receipt from a CGT event that did not involve the disposal of a CGT asset could be regarded as giving rise to both ordinary income and a capital gain. 6.136 You will recall from Chapter 2 that ITAA97 s 6-25(1) deals with the situations where the same amount: may be ordinary income and also be included in your assessable income by one or more statutory income provisions; or may be included in your assessable income by more than one

statutory income provision. Section 6-25(1) states that, in these situations, the amount is included only once in your assessable income in the current or later years. You will also recall that s 6-25(2) states that, in general, the provisions about statutory income prevail over the rules about ordinary income. You may ask why s 118-20 was necessary, given the presence of s 6-25(1) and (2). One part of the explanation may be that s 6-25(1) would prevent the one gain being included in assessable income as both ordinary income and a net capital gain but would not prevent a capital gain (as distinct from a net capital gain) being recognised on a CGT event which also was regarded as producing ordinary income. This is because s 6-25(1) prevents the same amount being included in assessable income twice, whereas a capital gain, as such, is not included in assessable income. For example, s 6-25(1) would not be able to prevent a capital gain from reducing the size of a capital loss. The other part of the explanation is that, in the absence of s 118-20, the rule in s 6-25(2) would recognise, in the case where one amount was regarded as being both ordinary income and a net capital gain, the net capital gain in preference to the ordinary income. This would be to the disadvantage of the revenue because of the indexation and discount provisions that apply only to CGT. 6.137 ITAA97 s 118-20 reduces the capital gain that you would otherwise make from a CGT event where an ITAA97 provision outside Pt 3-1 includes an amount in [page 380] your assessable income.56 The combined effect of s 118-20(1) and (1A) is that, before s 118-20 operates, the inclusion in your assessable income under the other provision either has to be ‘because of the CGT event’ or ‘in relation to a CGT asset’. The capital gain is reduced to zero where it does not exceed the amount included under the other provision. Where the capital gain exceeds the amount included under

the other provision, the capital gain is reduced by the amount included. Section 118-20 states as follows. 118-20 Reducing capital gains if amount otherwise assessable (1) [Reduction in capital gain] A capital gain you make from a CGT event is reduced if, because of the event, a provision of this Act (outside of this Part) includes an amount (for any income year) in: (a) your assessable income or exempt income; or (b) if you are a partner in a partnership, the assessable income or exempt income of the partnership. (1A) [Application] Subsection (1) applies to an amount that, under a provision of this Act (outside of this Part), is included in: (a) your assessable income or exempt income; or (b) if you are a partner in a partnership, the assessable income or exempt income of the partnership; in relation to a CGT asset as if it were so included because of the CGT event referred to in that subsection if the amount would also be taken into account in working out the amount of a capital gain you make. Note: An example is an amount assessable under Division 16E of Part III of the Income Tax Assessment Act 1936, which deals with accruals taxation of certain securities. (1B) [Non-application to certain dividends] The rule in subsection (1) does not apply to: (a) an amount that is taken to be a dividend under section 159GZZZP of the Income Tax Assessment Act 1936 (which relates to buy-backs of shares); or (b) an amount included in assessable income under subsection 207-20(1), 207-35(1) or 207-35(3) of this Act (which relate to franked distributions). [page 381] (2) [Gain does not exceed included amount] The gain is reduced to zero if it does not exceed: (a) the amount included; or (b) if you are a partner, your share (the partner’s share) of the amount included in the assessable income or exempt income of the partnership (calculated according to your entitlement to share in the partnership net income or loss). Example: Liz bought some land in 1990, as part of a profit-making scheme. In December 1998 she sells it. Her profit from the sale is $40,000 and is included in her assessable income under section 6-5 (about ordinary income). Suppose she made a capital gain from the sale of $30,000. It is reduced to zero because it

is [sic] does not exceed the amount included. (3) [Gain exceeds included amount] The gain is reduced by the amount included, or the amount of the partner’s share, if the gain exceeds that amount. Note: These rules are modified for complying superannuation funds that become noncomplying and for foreign superannuation funds that become Australian superannuation funds: see Division 295. (4) [Gain reduced where assessable amount treated as exempt] A capital gain you make from a CGT event is reduced by the extent that a provision of this Act (except sections 59-40 and 316-255) treats: (a) an amount of your ordinary income or statutory income from the event as being non-assessable non-exempt income; or (b) if you are a partner, your share of the ordinary income or statutory income of the partnership from the event (calculated according to your entitlement to share in the partnership net income or loss) as being non-assessable non-exempt income of the partnership. Note: An example of a provision of this kind is section 121EG (about offshore banking units) of the Income Tax Assessment Act 1936. (4A) [Gains of superannuation funds] A capital gain the trustee of a superannuation fund makes from a CGT event happening in relation to a CGT asset in an income year is reduced if the asset’s market value was taken into account in working out the fund’s income from previous years under section 295325 or 295-330. (4B) [Reduction of gain to zero] The gain is reduced to zero if it does not exceed the amount that would have been the capital gain from the CGT event if the capital proceeds from the event were the asset’s market value that was taken into account [page 382] in working out that net previous income. If the gain exceeds that amount, it is reduced by that amount. Exceptions (5) [Balancing adjustment] The gain is not reduced if an amount is included in your assessable income, or the assessable income of the partnership, for any income year because of a balancing adjustment. (6) [Foreign equity distributions on participation interests] The gain is not reduced if an amount is included in your non-assessable non-exempt income under section 768-5 (about foreign equity distributions on participation interests) because a company makes a foreign equity distribution that is: (a) debited against a share capital account of the company; or (c) debited against an asset revaluation reserve of the company; or

(d) directly or indirectly attributable to amounts transferred from such an account or reserve of the company.

The example below illustrates the operation of s 118-20.

Assume that a taxpayer is buying and selling shares in similar circumstances to the taxpayer in London Australia Investment Co Ltd v FCT (1977) 138 CLR 106; 7 ATR 757; 77 ATC 4398 (discussed at 3.56). Under that decision, the shares will not be trading stock but profits made on the sale of shares will be ordinary income. Assume that the facts are as follows:

Cost of shares Sale price

$1000 $1600

(Assume that the sale is within 12 months of the date of acquisition with the consequence that no CGT discount or indexation is applicable.)

Profit Prima facie capital gain

$600 (Assessable under s 6-5) $600

As an amount has been included in the taxpayer’s assessable income because of the CGT event, s 118-20 will apply to reduce the capital gain. Because the capital gain does not exceed the amount included under s 6-5 it will be reduced to zero by s 118-20(2).

[page 383] 6.138 Note that the capital gain is not reduced by s 118-20 where an amount is included in your assessable income because of a balancing adjustment. An example would be where an amount is included in your assessable income because of a balancing charge arising on a disposal of depreciated property. So long as cost has the same meaning for depreciation and CGT purposes, it is not necessary for s 118-20 to operate where a balancing adjustment arises on a sale of depreciated property. This is because there is no real overlap between CGT and

depreciation balancing adjustments. Under the former depreciation provisions, depreciation balancing adjustments were limited to depreciation previously allowed. This means that a depreciation balancing adjustment could never exceed the difference between the written down value of plant and its cost. On the other hand, a capital gain could only ever arise on a disposal of plant where the capital proceeds for the disposal were more than the cost of the plant. These points are illustrated in the following example.

Cost of plant $10,000 Cost base of plant $11,000 ($10,000 + 1000 indexation) Depreciation claimed $ 4,000 Written down value $ 6,000 Sale price $13,000 Balancing charge $ 4,000 (recapture of previous depreciation claimed) Capital gain $ 2,000 ($13,000 − $11,000)

What would have happened in Example 6.17 if the cost of the plant for depreciation purposes had been $12,000 and $6000 of depreciation had been claimed prior to the sale of the plant? Note that, as discussed in 6.134, a capital gain or loss for a CGT event that happens on or after 21 September 1999 and before 30 June 2001 was disregarded if the asset is your plant. As from June 2001, a capital gain or capital loss is disregarded under s 118-24 where it is made from a CGT event that is also a balancing adjustment event that happens to a depreciating asset you held.

6.139 Other anti-overlap provisions include those relating to capital gains and losses on certain assets and liabilities that are part of a ITAA97 Div 230 financial arrangement (s 118-27), and amounts included in assessable income under research and development provisions (s 118-35). [page 384]

The main residence exemption 6.140 One of the best-known CGT exemptions is the main residence exemption set out in ITAA97 Subdiv 118-B. The main residence exemption is the largest tax expenditure in the Federal Government’s Budget.57 The basic situation where the exemption applies is set out in s 118-110. 118-110 Basic case (1) [Conditions for main residence exemption] A capital gain or capital loss you make from a CGT event that happens in relation to a CGT asset that is a dwelling or your ownership interest in it is disregarded if: (a) you are an individual; and (b) the dwelling was your main residence throughout your ownership period; and (c) the interest did not pass to you as a beneficiary in, and you did not acquire it as a trustee of, the estate of a deceased person. Note 1: You may make a capital gain or capital loss even though you comply with this section if the dwelling was used for the purpose of producing assessable income: see section 118-190. Note 2: There is a separate rule for beneficiaries and trustees of deceased estates: see section 118-195. Note 3: There is a separate rule for a CGT event that is a compulsory acquisition (or similar arrangement) happening to adjacent land but not also to the dwelling itself: see section 118-245. (2) [Relevant CGT events] Only these CGT events are relevant: (a) CGT events A1, B1, C1, C2, E1, E2, F2, I1, I2, K3, K4 and K6 (except one involving the forfeiting of a deposit); and

a CGT event that involves the forfeiting of a deposit as part of an uninterrupted (b) sequence of transactions ending in one of the events specified in paragraph (a) subsequently happening. Note: The full list of CGT events is in section 104-5.

6.141 Several of the terms used in s 118-110 are subsequently defined. Section 118-115 defines a ‘dwelling’. Under this definition, a building or part of [page 385] a building will be a dwelling provided it consists wholly or mainly of residential accommodation. For example, a single home unit in a block of home units would be a dwelling provided the single home unit consists wholly or mainly of residential accommodation. Similarly, a residential flat above a shop might arguably be a dwelling under this definition. A caravan, houseboat or other mobile home is also defined as a dwelling. In Taxation Determination TD 92/158, the Australian Taxation Office stated that, for purposes of the ITAA36 definition, an underground structure and a yacht could qualify as dwellings but that a tent would be unlikely to qualify. Under the definition in s 118-115, any land immediately under a unit of accommodation that is a dwelling is itself regarded as being a dwelling. This rule was not expressly stated in the ITAA36 but may have been implicit in the rule that, except in limited circumstances, a dwelling does not include land adjacent to a dwelling: s 118-115(2).58 The expressions ‘land immediately under a unit of accommodation’ and ‘land adjacent to a dwelling’ are not technical legal terms. In the case of a home unit, the proprietor of the home unit does not own the land that is under the building as a whole. Rather, the proprietor owns ‘strata space’ and has certain rights under strata titles legislation in relation to the land that is under the building as a whole. Problems may arise in the case of a unit of accommodation above a shop. The shop and the residence may be one building owned by the same proprietor. The

residence, as part of the building, might be regarded as a dwelling on the basis that it consists wholly or mainly of residential accommodation. In this context, will the land on which the building as a whole is erected be regarded as ‘land immediately under the unit of accommodation’? A possible view is that if the part of the building that is the residential flat is regarded as a dwelling, then there is no land immediately under the dwelling but, rather, the part of the building that is the shop is immediately under the dwelling. The position would arguably be different if a building has residential accommodation at the rear of a shopfront. 6.142 Under s 118-120, up to two hectares of land that is adjacent to a dwelling is treated as if it were a dwelling, provided you use the land primarily for private or domestic purposes in association with the dwelling. Under s 118-120(5) and (6), a garage, storeroom or other structure associated with a dwelling that is a flat or home unit is treated as if it were a dwelling, provided you use the structure primarily for private or domestic purposes in association with the flat or home unit. Again, the case of a residential flat above a shop may create difficulties in the interpretation of s 118-120. Will a yard at the rear of a building that has a shop on the ground floor and a residence on the first floor be regarded as land adjacent to a dwelling under s 118-120(1)? Common sense would suggest that it should be if the yard is used primarily for private or domestic purposes in association with the residence. It clearly will be if the land on which the building is erected is itself (via s 118115(1)(c)) regarded as a dwelling. However, if the land on which the [page 386] building is erected is not regarded as a dwelling, then it may be difficult to see how the backyard can be regarded as being ‘adjacent’ to the firstfloor residence. 6.143 ‘Ownership period’ is defined in s 118-125 as being the period on or after 20 September 1985 when you had an ‘ownership interest’ in

the dwelling or the (post-CGT) land on which the dwelling was subsequently erected. 6.144 ‘Ownership interest’ is defined in s 118-130. This will include a legal or equitable interest in land or a right to occupy it. In the case of dwellings other than flats or home units, an ownership interest will include a legal or equitable interest or a licence or right to occupy the dwelling. In addition, in the case of flats and home units, an ownership interest extends to company title home units where ownership of shares in the company confers rights to occupy a particular unit. The effect of these definitions is that you do not need to have a freehold interest in land in order to have an ‘ownership interest’ as defined. Crown lessees, tenants and licensees in retirement villages and, for that matter, shorterterm tenants and licensees will all be regarded as having ownership interests. Taxation Determination TD 58 and Interpretative Decisions ATO ID 2003/467 and ATO ID 2003/163 state that the s 118-10 exemption does not apply to disposals of dwellings owned by companies or trusts except, in the case of trusts, where the beneficiary is absolutely entitled to the dwelling as against the trustee. The concept of absolute entitlement is discussed in Chapter 15. 6.145 In some circumstances, special rules extend the main residence exemption. Table 6.1 summarises these rules. Table 6.1: Rules extending the main residence exemption Heading

Summary of extension

Statutory reference (ITAA97)

Moving into a dwelling

Dwelling treated as your main residence from when you acquired it even though it does not actually become your main residence until a later date when it was first practical to move into it.

s 118-135

Changing main residences

Applies when you acquire an ownership interest in a new main residence but still have an ownership interest in your existing main residence. Both dwellings treated as your main residence for the period (up to a maximum of six months) between the acquisition of your ownership interest in your new main residence and the ending of your ownership interest in your existing main residence. To qualify for

s 118-140

extension, your existing main residence must have been your main residence for at least three months in the 12 months preceding the ending of your ownership interest in it. Your existing main residence must not have been used for the purpose of producing assessable income in any part of that 12 months.

[page 387] Heading

Summary of extension

Statutory reference (ITAA97)

Absences

You may continue to treat a dwelling that was your main residence as your main residence even after it ceases to be your main residence. No other dwelling can be treated as your main residence for the period in which you choose to apply s 118-145. If you use the part of the dwelling that was your main residence for the purpose of producing assessable income then you can only treat it as your main residence under s 118-145 for a maximum period of six years. Each time the dwelling again becomes your main residence and then ceases to be your main residence and is used for the purpose of producing assessable income you can choose to treat it as your main residence for a further six years.

s 118-145

Absence from compulsorily acquired or destroyed dwelling

Where a dwelling that is treated as your main residence because of the absences provision in s 118145 is either compulsorily acquired or is lost or destroyed (‘the key event’), and within one year you have an ownership interest in a substitute dwelling or substitute vacant land, then you may choose to treat the substitute dwelling or a dwelling built on the substitute land (within four years of the later of the key event or the time of acquisition of the substitute land) as your main residence from the later of the time of acquisition of the substitute property or one year before the key event. Where you use all or part of the substitute property for the purpose of producing assessable income, then the maximum period in which you can treat the dwelling as your main residence is six years or such part thereof as had not passed before the key event if you used the substitute

s 118-147

property for the purpose of producing assessable income just before the key event. Extension of exemption to compulsory acquisitions of adjacent land

As from 29 June 2011,a the main residence exemption is extended to compulsory acquisitions of land adjacent to your main residence where your main residence itself is not compulsorily acquired and the sum of the area of the adjacent land and the land immediately under your main residence is 2 hectares or less.

s 118-245

If you build, repair or renovate a dwelling

Applies where you build, repair, renovate or finish a dwelling that becomes your main residence as soon as practicable after the work is finished. You can choose to regard the dwelling as your main residence from the time period (not exceeding four years) from when you acquired an ownership interest in the land to when the dwelling actually became your main residence. The dwelling must continue to be your main residence for at least three months after the work is finished. The time limit is extended when someone else was occupying the dwelling when you acquired an ownership interest in the land.

s 118-150

[page 388] Heading

Summary of extension

Statutory reference (ITAA97)

In this case the maximum period of four years starts from the time when the dwelling ceased to be occupied by someone else. From 3 June 2010 onwards, the Commissioner has a discretion to extend the four-year period. If you make the election under s 118-150, no other dwelling can be your main residence for the period for which the s 118-150 extension applies. Destruction of dwelling and sale of land

Applies where your main residence is accidentally destroyed and a CGT event occurs in relation to the land on which the dwelling was erected. Does not apply where another dwelling is erected on the land. You can choose the dwelling as not having been destroyed and as being your main residence for the time between its destruction and the time when the CGT event happened in relation to the land.

s 118-160

a.

Subject to conditions, a taxpayer can also choose for this extension of the exemption to apply in relation to CGT events that happen in the period from the start of the 2004–05 income year and 29 June 2011.

The following problem highlights the operation of these extensions of the main residence exemption.

Oscar and Lucinda tire of living at their converted warehouse apartment in Sydney and decide to build a glass house on the banks of the Bellinger River in northern New South Wales. They acquire an old, disused church and land near Bellingen. At the time that they acquired this land, an unemployed former curate had been squatting in the church. It takes Oscar and Lucinda 14 months to have the curate ejected from the church. They then demolish the church and commence erecting their glass house. This proves to be a time-consuming process. Due to bushfires and floods, the construction of the glass house is not completed until five years from the date they purchased the church and land. In the meantime, Oscar and Lucinda live in a tent in a small corner of the land near Bellingen. During this period, Oscar and Lucinda’s main source of income is rent from their warehouse apartment in Sydney. After Oscar and Lucinda move into the glass house at Bellingen, they decide to sell the warehouse apartment in Sydney. Discuss how they can best utilise the main residence exemption in relation to either or both the warehouse apartment in Sydney or the property near Bellingen.

[page 389] 6.146 Other special rules limit the main residence exemption. Table 6.2 summarises the more significant of these rules. Table 6.2: Special rules limiting the main residence exemption Heading

Summary of limitation

Statutory reference (ITAA97)

Separate CGT event for adjacent land and other structures

The main residence exemption does not apply when a CGT event happens in relation to land or other structures to which the main residence exemption applies via s 118-120 unless that event also happens in relation to your ownership interest in the dwelling.

s 118-165

Spouse having different main residence

Where spouses (other than spouses living permanently and separately apart) have different main residences during a period they must make an election under s 118-170. They can either choose one of the dwellings as the main residence for both of them or each may nominate the different dwellings as his or her main residence. Special rules for splitting the exemption apply where spouses nominate separate dwellings as their main residence. If a spouse’s interest in the dwelling nominated does not exceed 50%, then the dwelling is regarded as the spouse’s main residence for the whole of the period. Where the spouse’s interest in the dwelling is greater than 50%, the dwelling is only regarded as the spouse’s main residence for half of the period.

s 118-170

Dwelling your main residence for part only of ownership period

Where a dwelling was your main residence for only part of your ownership period, you only get a partial exemption. You calculate your capital gain or loss on the dwelling using a pro-rating formula.

s 118-185

Use of dwelling for producing assessable income

Applies where your main residence is used, during all or part of your ownership period, for the purpose of gaining or producing assessable income provided that you would have been able to deduct some or all of any interest on money borrowed to acquire the dwelling. Section 118-185 will mean that only a partial exemption is allowed in these circumstances. Under s 118-190, any capital gain or loss that you make is increased by a reasonable amount having regard to the extent to which you would have been able to deduct the interest. Any use of the dwelling for the purpose of producing assessable income is ignored for any period of absence where you continued to treat it as your main residence under s 118-145. Also ignored is any use of the dwelling to produce assessable income where you have elected for the dwelling to be treated as your main residence under the absences provision in s 118-147 except to the extent that the dwelling was used for the purpose of producing assessable income before it actually ceased to be your main residence.

s 118-190

[page 390] Heading

Special rule for first use to produce assessable income

Summary of limitation

Statutory reference (ITAA97)

Applies where you get only a partial exemption for a CGT event because the dwelling was used after 7.30 pm (Australian Capital Territory time) on 20 August 1996 for the purpose of producing assessable income, provided you would have received a full exemption if the CGT had happened just before the first time you used the dwelling for the purpose of producing assessable income. If these conditions are met, you are regarded as acquiring the dwelling at its market value at the time that it was first used for the purpose of producing assessable income.

s 118-192

6.147 Special provisions deal with the application of the main residence exemption where dwellings are acquired from deceased estates. The application of CGT to deceased estates generally is discussed at 15.132–15.135.

Other CGT exemptions 6.148 Other CGT exemptions in the ITAA97 include: certain capital gains and losses made in relation to particular types of insurance policies (s 118-300); certain capital gains and losses made in relation to certain rights to payments from or rights to an asset of a superannuation fund or an approved deposit fund (s 118-305); certain capital gains or losses relating to investments in Australian companies and unit trusts and some foreign holding companies through venture capital limited partnerships, venture capital fund of funds, or directly by certain foreign residents (Subdiv 118-F); and certain capital gains or losses of foreign tax exempt pension funds on investments in venture capital equity in an Australian company or fixed trust (Subdiv 118-G);

capital gains and losses relating to the creation of a ‘look-through earn-out right’ (Subdiv 118-I).

Small business concessions 6.149 ITAA97 Subdiv 152-A makes four CGT concessions available to small businesses. Provided the basic conditions set out in s 152-10 and the special conditions for CGT event D1 are satisfied, a capital gain (other than a capital gain from CGT event K7) may be reduced or disregarded under Subdiv 152-A. Significant amendments were made to the small business concessions in 2007 (with effect from 1 July 2006). Further amendments were made by the Tax Laws Amendment (2009 Measures No 2) Act 2009 (Cth). Among other changes, these amendments allow a [page 391] taxpayer who owns a CGT asset that is used in a business by the taxpayer’s affiliate to access the small business concessions through the small business entity test.59 The following discussion concerns the rules that govern the small business concessions following these amendments. The current concessions are the: 15-year exemption in Subdiv 152-B; 50% reduction in Subdiv 152-C; retirement concession in Subdiv 152-D; and small business roll-over in Subdiv 152-E.

Basic conditions for the small business concessions 6.150 Before you can obtain any of these concessions when a CGT event, other than CGT event D1, happens to an asset that you own, ITAA97 s 152-10 states the basic conditions that must first be satisfied: 1. A CGT event must have happened in relation to your CGT asset

in the income year and (apart from Div 152) the event must have resulted in a capital gain. In addition, the small business entity or maximum net asset value test must be satisfied — that is, at least one of the following must apply: (a) you are a CGT small business entity for the income year; (b) you satisfy the maximum net asset value test; (c) you are a partner in a partnership that is a small business entity for the income year and the CGT asset is an interest in an asset of the partnership; (d) the conditions mentioned in s 152-10(1A) or (1B) are satisfied in relation to the CGT asset in the income year. 2. The CGT asset must satisfy the active asset test. 3. If the CGT asset is a share in a company or an interest in a trust (the object company or trust) either: (a) you are a CGT concession stakeholder in the object company or trust; or (b) CGT concession stakeholders in the object company or trust together have a small business participation percentage in you of at least 90%.60 The conditions mentioned in s 152-10(1A) and (1B) were inserted by Tax Laws Amendment (2009 Measures No 2) Act 2009 (Cth). The conditions in s 152-10(1B) relate to CGT assets of a partner in a partnership which is a small business entity where the CGT asset is not an interest in an asset of the [page 392] partnership. Section 152-10(1B) is not discussed in detail in this chapter. The conditions in s 152-10(1A) relate to the CGT asset of the taxpayer to which the CGT event happened. In relation to that asset: your affiliate or an entity connected with you must be a small business entity for the year of income; and

you must not carry on business in the income year (other than in partnership); and if you do carry on business in partnership, then the CGT asset must not be an interest in an asset of the partnership; and the small business entity must be the entity that carries on the business (for the purposes of the definition of small business entity) in relation to the CGT asset. The effect of s 152-10(1A) is, therefore, that the small business concessions are available to a taxpayer who does not carry on a business but who owns a CGT asset which is used in the business of an affiliate of the taxpayer or by an entity connected with the taxpayer that is a small business entity. CGT small business entity is defined in ITAA97 s 152-10(1AA). The effect of the definition is that you will be a CGT small business entity where you carry on business in the current year and: you carried on business in the previous income year and your aggregated turnover for that year was less than $2m; or your aggregated turnover for the current year is likely to be less than $2m (except where you carried on business for the prior two years and your aggregated turnover for each of those years was $2m or more); or your aggregated turnover for the current year, calculated as at the end of the current year, is less than $2m.61 Your aggregated turnover for an income year is defined in s 328115(1) as the sum of your annual turnover, the annual turnover of an entity connected with you at any time during the income year, and the annual turnover of an entity that is an affiliate of yours at any time during the income year.62 The following dealings are excluded in calculating your aggregated turnover: those between you and entities connected with either you or your affiliates; and those between entities connected with either you or your affiliates, and entities connected with either you or your affiliates.

[page 393] Under s 328-125(1), an entity is ‘connected with another entity’ if either entity directly or indirectly controls the other entity or if both entities are controlled by a third entity. Under s 328-130, an individual or a company is an ‘affiliate’ of a taxpayer if the individual or company acts, or could reasonably be expected to act, in accordance with the taxpayer’s directions or wishes, or in concert with the taxpayer, in relation to the affairs or business of the individual or company. Spouses and children under 18 years of an entity (the asset owner), who are not affiliates of the asset owner or of another entity (the business entity) under s 328-130, can be deemed to be affiliates of the asset owner or of the business entity under s 152-47. This deeming applies where an asset owner owns a CGT asset that is used (or held ready for use) in the course of carrying on business by another entity or is inherently connected with a business carried on by the business entity. The deeming under s 152-47 applies only where the business entity is not an affiliate of the taxpayer under s 328-130 and is not connected with the taxpayer under s 328-125. Where the s 152-47 deeming applies, a spouse of an individual and a child under the age of 18 years of an individual are taken to be affiliates of the individual for the purposes of determining whether the business entity is an affiliate of, or connected with, the asset owner, and for the purposes of Subdiv 152-A, and for the purposes of ss 328-110–328-125 to the extent to which they relate to Subdiv 152-A. The deemings in s 152-47 can, in turn, mean that the CGT asset, subject to passing the ‘active asset’ tests (discussed below), can be an active asset of the asset owner. The application of the deemings in s 152-47 can be complex, as illustrated by the following example taken from the Explanatory Memorandum to the Tax Laws Amendment (2009 Measures No 2) Bill 2009 (Cth). Example 2.3 from Explanatory Memorandum to Tax Laws Amendment (2009 Measures No 2) Bill 2009 (Cth) Philip owns 100 per cent of Horse Farm Pty Ltd. Horse Farm Pty Ltd owns land. Philip’s spouse, Crystal, owns Pig Farm Pty Ltd. Pig Farm Pty Ltd uses the land to carry on a

business. Philip owns 30 per cent and Crystal 70 per cent of Carrot Pty Ltd. Horse Farm Pty Ltd does not carry on a business.

[page 394] … Operation of new law If Pig Farm Pty Ltd is already an affiliate of Horse Farm Pty Ltd under section 328-130 of the ITAA 1997, the new affiliate rule would not apply. Proceeding on the basis that Pig Farm Pty Ltd is not already an affiliate of, nor is connected with, Horse Farm Pty Ltd, the amendments treat Crystal as Philip’s affiliate in determining whether Pig Farm Pty Ltd (the entity that uses the land in its business) is connected with Horse Farm Pty Ltd (the entity that owns the land). The new affiliate rule applies because one entity (Horse Farm Pty Ltd) owns a CGT asset that is used in the business of another entity (Pig Farm Pty Ltd). Pig Farm Pty Ltd is connected with Horse Farm Pty Ltd because Philip controls Horse Farm Pty Ltd and Philip and his affiliate, Crystal, control Pig Farm Pty Ltd. This makes the land that Horse Farm Pty Ltd owns an active asset (new subparagraph 152-40(1)(a)(iii)). The land would also have to meet the requirements of the active asset test in section 152-35 of the ITAA 1997. Therefore, Horse Farm Pty Ltd could access the small business CGT concessions if its maximum net asset value is not more than $6 million. Horse Farm Pty Ltd could also access the concessions if Pig Farm Pty Ltd’s aggregated turnover is less than $2 million. Because Crystal is treated as Philip’s affiliate in determining whether Pig Farm Pty Ltd is an affiliate of, or connected with, Horse Farm Pty Ltd, Crystal is also treated as Philip’s affiliate for testing whether Carrot Pty Ltd is connected with Horse Farm Pty Ltd. Carrot Pty Ltd is, therefore, connected with Horse Farm Pty Ltd because Philip controls Horse Farm Pty Ltd and Philip and his affiliate, Crystal, control Carrot Pty Ltd.

In seeking access to the small business CGT concessions via the maximum net asset value test, Horse Farm Pty Ltd would need to include the net assets of its affiliates and entities connected with it. In seeking access to the small business CGT concessions via the small business entity test, Pig Farm Pty Ltd’s aggregated turnover would include the annual turnovers of its affiliates and entities connected with it.

In applying the aggregated turnover test for the purposes of s 15210(1A) or (1B), s 152-48 treats an entity (the deemed entity) that is an affiliate of or connected with the taxpayer which owns the CGT asset as being an affiliate of or connected with the entity (the test entity) that uses the asset in its business whether or not the deemed entity is, in fact, an affiliate of or connected with the test entity. The following example, taken from the Explanatory Memorandum to Tax Laws Amendment (2009 Measures No 2) Bill 2009 (Cth), explains the effect of the s 152-48 [page 395] deeming when combined with the rules for determining affiliates and connected entities set out in s 152-47. Example 2.6 from Explanatory Memorandum to Tax Laws Amendment (2009 Measures No 2) Bill 2009 Peter owns Pony Farm Pty Ltd. Pony Farm Pty Ltd owns land. Peter’s spouse, Diana, owns Worm Farm Pty Ltd. Worm Farm Pty Ltd uses the land in its business. Neither Peter nor Diana carries on a business. Bush Pty Ltd is an affiliate of Pony Farm Pty Ltd. Pony Farm Pty Ltd wholly owns Flowers Pty Ltd so the two entities are connected. Cherry Pty Ltd is an affiliate of Worm Farm Pty Ltd. Worm Farm Pty Ltd wholly owns Earth Pty Ltd so the two entities are connected. Worm Farm Pty Ltd is not an affiliate of Pony Farm Pty Ltd under section 328-130 of the ITAA 1997.

For the purposes of the small business CGT provisions, Diana and Peter are affiliates because of the new affiliate rule (new section 152-47). Therefore, Diana and Peter are connected with Worm Farm Pty Ltd, Pony Farm Pty Ltd, Flowers Pty Ltd, and Earth Pty Ltd. This makes each of these companies connected with each other. Of particular significance is that Pony Farm Pty Ltd and Flowers Pty Ltd are connected with Worm Farm Pty Ltd. Pony Farm Pty Ltd sells its land and seeks to qualify for the small business CGT concessions via the small business entity test by satisfying the conditions in new s 15210(1A). In these circumstances, the ‘test entity’ in the special rule is Worm Farm Pty Ltd because it needs to be a small business entity for the purposes of new s 152-10(1A). The special rule takes Bush Pty Ltd to be an affiliate of Worm Farm Pty Ltd because Bush Pty Ltd, the deemed entity, is not otherwise an affiliate of, or connected with, Worm Farm Pty Ltd and Bush Pty Ltd is an affiliate of Pony Farm Pty Ltd (the asset owner). Therefore, Worm Farm Pty Ltd would [page 396] treat Bush Pty Ltd as its affiliate during an income year while it is an affiliate of Pony Farm Pty Ltd during the income year. Worm Farm Pty Ltd would calculate its aggregated turnover in Subdivision 328-C on this basis but this calculation of aggregated turnover only applies for accessing the small business CGT provisions.

The maximum net asset value test is satisfied if, just before the CGT event, the net value of your CGT assets, the net value of CGT assets of entities connected with you, and the net value of CGT assets of affiliates of yours or of entities connected with your affiliates do not exceed $6m:

s 152-15. The ‘net value of the CGT assets’ of an entity is defined in s 152-20. In broad terms, this will be the amount (whether positive or negative) obtained by subtracting from the sum of the market values of those assets the sum of: (a) the liabilities of the entity that are related to the assets;63 and (b) provisions made by the entity for: (i) annual leave; (ii) long service leave; (iii) unearned income; and (iv) tax liabilities. [page 397] Section 152-20(2) indicates that certain assets are to be disregarded in determining the net value of the CGT assets of an entity. The assets that are to be disregarded in this determination include: shares, units or other interests (other than debt) in a connected entity or with an affiliate; where the entity is an individual, assets (other than certain dwellings) being used solely for the personal use or enjoyment of the individual (or the individual’s affiliate); subject to exceptions set out in s 152-20(2A), the market value of a dwelling that is the individual’s main residence; certain rights in relation to superannuation funds or approved deposit funds; and a policy of life insurance on the individual.64 Where a dwelling, or an ownership interest in a dwelling, was used by the individual for the purpose of producing assessable income during all or part of the period in which it was owned by the individual, and the individual was entitled to deduct at least some of the interest payable in relation to the dwelling, then s 152-20(2A) states that such amount as is

reasonable (having regard to the extent that the interest was deductible) is included in the maximum net asset test. Under s 152-35, where you have owned an asset for 15 years or less, it satisfies the active asset test if it was an active asset of yours for a total of at least seven and a half years during the period beginning when the asset was acquired and ending at the earlier of the CGT event or the time of cessation of the business where the business ceased to be carried on in the 12 months before the CGT event (or such longer time as the Commissioner allows). Where you have owned the asset for more than 15 years, it satisfies the active asset test if it was an active asset of yours for at least half of that period.65 A CGT concession stakeholder is defined in s 152-60 as a ‘significant individual’ in the company or trust, or a spouse of a significant individual in the company or trust, provided the spouse’s small business participation percentage in the company or trust is greater than zero. A ‘significant individual’ in a company or trust is defined in s 152-55 as one with a small business participation percentage in the company or trust of at least 20%. Under the definitions in ss 152-65, 152-70 and 152-75, a small business participation percentage in a company or trust is the sum of the individual’s direct and indirect interests in the company or trust. The definitions [page 398] of ‘CGT concession stakeholder’ and ‘significant individual’ are discussed in more detail at 6.153 and 6.154 respectively. The same tests apply where the gain is triggered by CGT event D1 but the right that triggers the event must be inherently connected with a CGT asset of yours that satisfies the active asset test. Under s 152-20, the net value of the CGT assets of an entity66 will be the amount (whether positive, negative or nil) obtained by subtracting from the sum of the market values67 of those assets the sum of the liabilities of the entity that are related to those assets and provisions for annual leave, long service leave, unearned income, and tax liabilities.

Where the entity is an individual, assets that are used solely for the personal use and enjoyment of the entity or of the entity’s affiliate are disregarded.68 So, too, is the market value of a dwelling of an individual or ownership interests in a dwelling that is the individual’s main residence except to the extent that the individual used the dwelling to produce assessable income but was not entitled to deduct the interest. Under s 152-20(2)(a), shares, units and other interests (other than debt) in another entity that is connected with the first entity69 will also be disregarded in calculating the net value of the CGT assets of the entity but liabilities [page 399] relating to these disregarded interests are taken into account. An individual’s right to any allowance, annuity or capital amount payable from or right to an asset of a superannuation fund or an approved deposit fund is also disregarded. So, too, are life insurance policies. In determining the net value of CGT assets of your affiliate or of an entity connected with your affiliate, assets that are not used, or held ready for use, in carrying on a business by you or by an entity connected with you, are disregarded. You or the entity connected with you may carry on the business alone or jointly with others. 6.151 An active asset is defined in ITAA97 s 152-40. A CGT asset (whether the asset is tangible or intangible) will be an active asset at a particular time if you own it and: use it, or hold it ready for use, in the course of carrying on a business; or it is used, or held ready for use, in the course of carrying on a business by your affiliate or by another entity connected with you; if it is an intangible asset inherently connected with the business you carry on (the examples given in the legislation are goodwill or the benefit of a restrictive covenant). Section 152-40(3) provides that a share in an Australian resident

company or an interest in a resident trust estate for CGT purposes will also be an active asset if the total of: (i) the market values of the active assets of the company or trust; and (ii) the market value of any financial instruments of the company or trust that are inherently connected with a business that the company or trust carries on; and (iii) any cash of the company or trust that is inherently connected with such a business; is 80% or more of the market value of all of the assets of the company or trust.

Where a share in a company or an interest in a trust was an active asset at an earlier time, s 152-40(3A) states that it will be an active asset at a later time if it is reasonable to conclude that the share or interest was still an active asset at the later time. A share or interest will be an active asset even though it failed to meet the requirements set out above where the failure was of a temporary nature only. 6.152 Certain assets cannot be active assets. Under s 152-40(4), these include: shares in a widely held company and certain widely held trusts (other than those of the kind described in 6.153 and 6.154 that are held by a CGT concession stakeholder); other shares or interests in companies or trusts or in other entities that are connected with you (other than those of the kind discussed at 6.153 and 6.154); [page 400] shares in another company (other than those of the kind described in 6.153 and 6.154); financial instruments (eg, loans, debentures, bonds, futures contracts, etc); and subject to some exceptions,70 an asset that is mainly used in the business to derive interest, an annuity, rent, royalties or foreign exchange gains.

6.153 At 6.150, we noted that, where the CGT asset is a share in a company, either of two additional basic conditions were required to be satisfied. The first of these was that you were a CGT concession stakeholder in the object company or trust. We noted that a CGT concession stakeholder is defined in ITAA97 s 152-60 as a ‘significant individual’ in the company or trust or a spouse of a significant individual in the company or trust provided the spouse’s small business participation percentage in the company or trust is greater than zero. Under s 152-50, an entity satisfies the significant individual test if the entity has at least one significant individual just before the CGT event in respect of which the concession is claimed. An individual is a significant individual in a company or a trust, at a particular time, where the individual has a small business participation percentage in the company or trust of at least 20%. An entity’s small business participation percentage is defined in s 152-65 as the sum of the entity’s direct and indirect small business participation percentages in the other entity. Where the other entity is a company, the entity’s direct participation interest in the company is the smallest of the percentage entitlements that the entity has (because of holding legal or equitable interests in shares in the company) of the following: the voting power, dividend entitlements, or entitlements to capital distributions. Where the other entity is a wholly fixed trust, the entity’s direct participation percentage in the trust is the smaller of the entity’s percentage entitlement to distributions of income or capital. Where the other entity is not a wholly fixed trust (eg, a discretionary trust), the entity’s direct participation percentage is the smaller of the entity’s percentage entitlement to any income distributions or capital distributions actually made through the year. Under s 152-75, indirect interests in a company or trust are determined by the successive multiplication of interests held through interposed entities. 6.154 Note that a CGT concession stakeholder, as defined in ITAA97 s 152-60, must be an individual or the spouse of an individual. The legislation, however, in s 152-10(2)(b) provides for the situation where individuals hold interests in the object company or trust through an interposed company or trust. In this situation, provided an individual

had an indirect small business participation percentage in the object company or trust of 20% or greater, the CGT small business concessions would be available to the individual if the individual sold his or her interest in the interposed entity. For bona fide commercial reasons, however, the individual might [page 401] prefer the interposed entity to sell its interest in the object company or trust. Where the interposed company or trust sells its interest in the object company or trust, the CGT small business concessions will still be available (provided the other basic conditions are met) where individuals who have a small business percentage in the interposed company or trust of at least 90% are CGT concession stakeholders in the object company or trust. The following example illustrates the operation of this provision.

Jasmin and her husband William each owns 50% of the units in J&W Unit Trust. J&W Unit Trust, as trustee, in turn owns 100% of the shares in Jas&Will Pty Ltd. As J&W Unit Trust is not an individual, it cannot be a CGT concession stakeholder in relation to Jas&Will Pty Ltd. However, both Jasmin and William are CGT concession stakeholders in relation to Jas&Will Pty Ltd as they each have indirect small business percentages in Jas&Will of 50% × 100% = 50%. Between them Jasmin and William have a small business participation percentage in J&W Unit Trust of greater than 90%. Hence, s 152-10(2)(b) is satisfied.

Order in which you apply the small business concessions 6.155 ITAA97 ss 152-215, 152-330 and 152-430 between them state that none of the small business 50% reductions in Subdiv 152-C, the small business retirement exemption in Subdiv 152-D or the small

business roll-over in Subdiv 152-E, respectively, applies if the small business 15-year exemption in Subdiv 152-B applies. However, under the ITAA97, it may be that you are entitled to the small business retirement exemption in Subdiv 152-D, the small business roll-over in Subdiv 152-E and the small business 50% reduction in Subdiv 152-C. If this is the case, then you obtain the Subdiv 152-C concession first and then the Subdiv 152-D and Subdiv 152-E concessions. You choose the order in which you apply the Subdiv 152-D and Subdiv 152-E concessions. Note that the Subdivs 152-C, 152-D and 152-E concessions are applied after any applicable CGT discount percentage. (CGT discounts are discussed in 6.10 and 6.11.) In summary, the small business concessions are applied in the following order: the Subdiv 152-B 15-year exemption is applied first (note that, if the 15-year exemption applies, then none of the other concessions is applicable); if the Subdiv 152-B exemption does not apply, then: – any applicable CGT discount percentage (see the discussion in 6.10 and 6.11) is applied; then – the Subdiv 152-C small business 50% exemption is applied; then – if applicable, the Subdiv 152-D small business retirement exemption and the Subdiv 152-E small business roll-over are applied in the order in which you choose. [page 402]

Small business 15-year exemption 6.156 The small business 15-year exemption means that capital gains arising from a CGT event are disregarded in certain circumstances. Note that capital losses are not disregarded. In the case of individuals, the small business 15-year exemption in ITAA97 Subdiv 152-B applies

to capital gains arising from CGT events where the basic conditions (discussed in 6.150–6.155) in Subdiv 152-A are met and: you continuously owned the CGT asset for the 15-year period ending just before the CGT event;71 you are 55 or over at the time of the CGT event which happens in connection with your retirement; or you are permanently incapacitated at the time of the CGT event. Where the CGT asset is a share in a company or an interest in a trust, the exemption is only available if, for a total of 15 years in the period in which you owned the share or interest, the company or trust had a significant individual.72 There is no requirement, however, that the same person be the controlling individual for the whole period. In the case of an entity that is a company or trust, a capital gain from a CGT event is disregarded if the basic conditions in Subdiv 152-A are met and: the entity continuously owned the CGT asset for the 15-year period ending just before the CGT event;73 for a total of 15 years during the period of the entity’s ownership of the CGT asset, the entity had a significant individual (again the same person need not be the significant individual for the whole period);74 an individual who was a significant individual of the company or trust just before the CGT event either: – was 55 or over at the time of the CGT event which happened in connection with that individual’s retirement; or – was permanently incapacitated at the time of the CGT event. [page 403] Where the 15-year exemption means that a capital gain by a company or a trustee is disregarded, s 152-110(2) states that any income (such as a net capital gain) that the company or trust derives from the CGT event is neither assessable income nor exempt income. The disregarded

capital gain is then called the ‘exempt amount’. Under s 152-125, a subsequent payment by the company or trust within two years of the CGT event75 to an individual CGT concession stakeholder will not form part of the taxable income of the individual to the extent that the total payment to that individual does not exceed the exempt amount multiplied by the stakeholder’s participation percentage.76 Section 152125(3) states that the ITAA97 applies to the payment (to the extent that it does not exceed the exempt amount multiplied by the stakeholder’s participation percentage) made as if it were not a dividend and not a frankable distribution.

Small business 50% discount 6.157 Provided that you did not obtain the small business 15-year exemption, the capital gain remaining (after the application of the appropriate discount percentage) is reduced by 50% under ITAA97 s 152-205 where the basic conditions in Subdiv 152-A (discussed in 6.150–6.155) are satisfied. Note that the small business 50% discount is obtained after any general CGT discount that may be applicable to the taxpayer is obtained. Remember that an individual can choose to claim indexation instead of a CGT discount where a CGT event happens on or after 21 September 1999 to a CGT asset that the individual acquired before that date. If the individual makes this choice, then he or she can still obtain the small business 50% discount if the basic conditions in Subdiv 152-A are satisfied.

Small business retirement exemption 6.158 Provided you did not obtain the small business 15-year exemption in relation to a capital gain and the basic conditions for obtaining the small business CGT concessions are satisfied,77 you can, subject to satisfying certain further conditions, choose the small business retirement exemption under Subdiv 152-D in relation to a capital gain. If the choice is made, the CGT exempt amount of the capital gain from the CGT asset is disregarded. An individual who was under 55 just before making the choice must contribute an amount

equal to the asset’s ‘CGT exempt amount’ into either a complying superannuation fund, a complying approved deposit fund or a [page 404] retirement savings account. Except in a case where either CGT events J2, J5 and J6 (discussed at 6.160) apply, however, the contribution need only be made at the later of when you make the choice or when you receive the capital proceeds for the relevant CGT event.78 In the case of CGT events J2, J5 and J6, the contribution must be made at the time you make the choice. Each individual has a lifetime CGT retirement exemption limit of $500,000. Your CGT retirement exemption limit at any given time is $500,000 reduced by the amounts that you have previously chosen to be CGT exempt amounts under the small business retirement exemption. For a company or trust to be able to choose the small business retirement exemption, it must first satisfy the basic conditions in Subdiv 152-A, must have a significant individual and must satisfy further conditions set out in s 152-325, which requires payments to be made by the company or trust to CGT concession stakeholders. The payments may be made through one or more interposed entities to CGT concession stakeholders. Under s 152-310(2), the payment will be nonassessable non-exempt income to the CGT concession stakeholder to whom it is made and will not be deductible to the paying company or trust.

Small business roll-over 6.159 Provided you did not obtain the small business 15-year exemption (see ITAA97 s 152-430), then you can choose the small business roll-over under Subdiv 152E. You may choose not to apply the Subdiv 152-C small business 50% discount before the small business roll-over. Note that it is possible for both the small business roll-over and the Subdiv 152-D small business retirement exemption to apply to the same capital gain. For example, it would be possible to roll over

part of a capital gain (up to the CGT retirement exemption limit) into a complying superannuation fund and to use the balance of the capital gain to acquire a replacement asset. In these circumstances, you could choose to apply the CGT retirement exemption to the amount rolled over into the complying superannuation fund and to apply the small business roll-over to the amount that was used to acquire a replacement asset. Under s 152-410, you can choose a Subdiv 152-E roll-over for a capital gain if the basic conditions in Subdiv 152-A are satisfied for the gain. A choice for a roll-over may be made even if you have not yet acquired a replacement asset or incurred expenditure under the fourth element of cost base (about capital improvements to an asset). However, if a replacement asset is not acquired or the fourth element of expenditure is not made by the end of the replacement asset period (being a period starting one year before and ending two years after the last CGT event in the income year in which you obtain the roll-over), then CGT event J5 will happen. If the cost of the replacement asset or the amount of the fourth element expenditure (or the sum of these two) is less than the amount of capital gain disregarded under the roll-over, then CGT event J6 will happen. If there is a change in the replaced or improved asset [page 405] after the end of the two-year period, then CGT event J2 may happen. CGT events J5, J6 and J2 are discussed at 6.160. Where the roll-over applies, you can choose to disregard all or part of each capital gain to which Subdiv 152-E applies: see s 152-415. Note that, unlike the position with replacement asset roll-overs generally (see 6.164–6.165), the replacement asset is not deemed to have the same CGT cost base and other characteristics as the original asset had. This means that, in general, the cost base of the replacement asset should include the price actually paid for it. This can mean that, where the price paid for the replacement asset is equal to or greater than the price

for which the original asset was sold, the end effect of the small business roll-over will be that the difference between the cost and sale price of the original asset is never taxed. This is so, even though a capital gain can arise when a subsequent CGT event occurs in relation to the replacement asset. This is illustrated in the following example.

Harry purchases a business (B1) on 1 March 2014. He pays $200,000 for the goodwill of the business. Harry expands the business and sells it on 31 December 2014 for $300,000. He uses the proceeds of the sale of business B1 to purchase another business (B2) on 1 February 2015 also for $300,000. Harry does not succeed in business B2 and sells it on 31 January 2016 for $300,000. In the absence of the small business concessions, Harry would make a capital gain of $100,000 on the sale of business B1. As Harry has not held either asset for a period of one year he is not eligible for the 50% discount otherwise available to individuals. He is, however, eligible for the small business 50% discount. Hence, the capital gain on business B1 is reduced to $50,000. Harry can also elect for a small business roll-over in respect of the $50,000 gain. As he has acquired a replacement active business asset within two years after the CGT event, CGT event J5 will not apply. Nor will CGT event J6 apply as the purchase price of business B2 is greater than the capital gain disregarded under the roll-over. The small business roll-over will mean that the capital gain of $50,000 is disregarded but will not affect the cost base of the replacement asset being the goodwill of business B2. Hence, when Harry sells business B2, neither a capital gain nor a capital loss is produced. Note that the effect of the small business roll-over has been that the difference between the cost of the goodwill of business B1 (ie, $200,000) and the sale price of that goodwill (ie, $300,000) is not taxed to Harry either at the time of the sale of the goodwill of business B1 nor at the time of the sale of the replacement asset, namely the goodwill of business B2.

[page 406] Under s 152-420, provided the status of the replacement asset has not changed in a way that triggers CGT event J2 (discussed at 6.160), the legal personal representative of a deceased individual, or a beneficiary in the estate of a deceased individual to whom the replacement asset has

passed, is, in effect, treated as if he or she were the deceased individual for the purposes of the small business roll-over. 6.160 At 6.159, we noted that several CGT events are potentially applicable where you choose the small business roll-over. CGT event J5 will happen if you choose a small business roll-over (as discussed in 6.159) and at the end of the replacement asset period (being a period commencing one year before and ending two years after the last CGT event in the income year in which you chose the roll-over): (a) you have not acquired a replacement asset and79 have not incurred expenditure fitting into the fourth element of the cost base of a CGT asset; or (b) the replacement asset does not satisfy the following conditions: (i) it must be an active asset; and (ii) if it is a share in a company or an interest in a trust, then you or an entity connected with you must be CGT concession stakeholders in the company or trust, or (where an entity such as a trust or company is interposed between the individual CGT concession stakeholders and the object company or trust) individual CGT concession stakeholders in the company or trust must have a small business participation percentage in the interposed company or trust of at least 90%. When these trigger conditions occur, then CGT event J5 takes place at the end of the replacement asset period. The effect of CGT event J5 is that you make a capital gain equal to the amount of the capital gain that you disregarded under the small business roll-over. The operation of CGT event J5 is illustrated by the following example.

Fred purchases a business (B1) on 3 January 2013. He pays $200,000 for the goodwill of the business. Fred expands the business and sells it on 1 January 2014 for $300,000. By 4

January 2016, he has not applied the proceeds of the sale of B1 towards either the acquisition of a replacement asset or towards improving an existing asset. In the absence of the small business concessions, Fred would make a capital gain of $100,000 on the sale of business B1. As Fred has not held business B1 for a period of one year, he is not eligible for the 50% discount otherwise available to individuals. He is, however, eligible for the small business 50% discount. Hence, the capital gain [page 407] eligible for the small business 50% discount. Hence, the capital gain on business B1 is reduced to $50,000. Fred elected for the small business roll-over in relation to the remaining $50,000 of capital gain on the sale of business B1. As Fred did not acquire a replacement asset and did not incur fourth element expenditure within the replacement asset period, CGT event J5 will be triggered. This means that Fred will make a capital gain of $50,000 equal to the capital gain that was disregarded under the small business roll-over.

Even where you acquire a replacement asset or incur fourth element expenditure on an existing asset (which also is called a replacement asset) in a manner which will mean that CGT event J5 does not apply, it is still possible that CGT event J6 will be triggered. This will happen where, in relation to each replacement asset, the total amount incurred (the ‘amount incurred’) on the first element of the cost base, the incidental costs incurred, and the amount of fourth element expenditure incurred is less than the capital gain that you disregarded under the small business roll-over. Where these trigger conditions occur, CGT event J6 takes place at the end of the replacement asset period. The effect of CGT event J6 is that you make a capital gain equal to the difference between the capital gain that you disregarded under the small business rollover and the amount incurred. The operation of CGT event J6 is illustrated in the following example.

Wilma purchases a business (B1) on 1 January 2015. She pays $100,000 for the goodwill of the business. Wilma expands the business and sells it on 31 December 2015 for

$400,000. She uses the proceeds of the sale of business B1 to purchase another business (B2) on 1 February 2016 for $100,000. In the absence of the small business concessions, Wilma would make a capital gain of $300,000 on the sale of business B1. As Wilma has not held business B1 for a period of one year, she is not eligible for the 50% discount otherwise available to individuals. She is, however, eligible for the small business 50% discount. Hence, the capital gain on business B1 is reduced to $150,000. Wilma also elected for a small business roll-over in respect of the $150,000 gain. As she has acquired a replacement active business asset within two years after the CGT event, CGT event J5 will not apply. CGT event J6 will apply, however, as the purchase price of business B2 ($100,000) is less than the capital gain of $150,000 [page 408] disregarded under the roll-over. Under CGT event J6, Wilma will make a capital gain of $50,000 equal to the difference between the disregarded capital gain of $150,000 and the price of $100,000 paid for the replacement asset.

Similarly, even where you acquire a replacement asset or incur fourth element expenditure on an existing asset (which also is called a replacement asset) in a manner which will mean that CGT event J5 does not apply, it is still possible that CGT event J2 will be triggered where: the replacement asset stops being your active asset;80 or the replacement asset becomes your trading stock; or you make a testamentary gift of the replacement asset under the Cultural Bequests Program; or you start using the asset solely to produce your exempt income or non-assessable non-exempt income. Where the replacement asset is a share in a company or an interest in a trust, other changes can also trigger the operation of CGT event J2. One change is where a liquidator declares the shares to be worthless with the result that CGT event G3 happens. CGT event G3 is discussed in Chapter 13. The second change is where the company stops being an Australian resident with the result that CGT event I1 happens. CGT event I1 is discussed in Chapter 18. CGT event J2 is also triggered where you (or a connected entity) stop being a CGT concession stakeholder or (where the share in the company or the interest in the

trust is held by an interposed entity) the CGT concession stakeholder in the object company or trust ceases to have a small business participation percentage in the interposed entity of at least 90%. Where these trigger conditions occur, CGT event J2 happens when the change happens. You make a capital gain which varies according to whether you had one replacement asset or two or more. Where you had one replacement asset, then your capital gain is equal to the capital gain that you disregarded under the small business roll-over. Where you had two or more replacement assets and a change of a kind that triggers CGT event J2 occurs for all of the replacement assets then, again, the amount of your capital gain under CGT event J2 will be the amount of the capital gain that you disregarded under the small business roll-over. The position is more complex where you had two or more replacement assets and a change of the kind that triggers CGT event J2 occurs for some but not for all of the replacement assets. Here, the CGT event J2 capital gain will be equal to so much of the capital gain disregarded under the small business roll-over as exceeds the sum of: (i) the first [page 409] element of the cost base of each replacement asset where a relevant change did not occur; (ii) the incidental costs in relation to each replacement asset where a relevant change did not occur; and (iii) the amount of fourth element expenditure incurred in relation to each replacement asset where a change did not occur. Identifying exemptions or concessions that apply in Steve and Sarah’s case study Now see if you can identify what exemptions or concessions, if any, are applicable in the Steve and Sarah case study (see 6.58). Suggested solutions are in Study help.

Shares in early stage innovation companies 6.161

The Tax Laws Amendment (Tax Incentives for Innovation) Act

2016 inserted ITAA97 Subdiv 360-A, which provides for tax offsets and capital gains exemptions for investors in ‘early stage innovation companies’. The conditions for obtaining the tax offset are discussed at 13.164. In broad terms the capital gains tax effects of Subdiv 360-A are that: (a) shares in the early stage innovation company are deemed to be held on capital account; (b) capital losses on shares held for less than 12 months must be disregarded; (c) investors who have held shares between 12 months and 10 years may disregard capital gains on them and must disregard capital losses on them; (d) shares held for at least 10 years are thereafter deemed to have a cost of market value at the 10year anniversary of the investor’s ownerships. Subdiv 360-A also contains provisions setting out how various potentially relevant rollover provisions (such as the Div 122 scrip for scrip roll-over discussed in Chapter 13) affect investors in early stage innovation companies.

Roll-over provisions 6.162 Roll-over provisions have the effect of deferring recognition of a capital gain or loss that would otherwise arise when a CGT event happens. ITAA97 Pt 3-3 contains the CGT roll-over provisions. In general, when a CGT roll-over is applicable, any capital gain or loss from a relevant CGT event is disregarded. Usually, roll-over provisions mean that the taxpayer receiving a post-CGT asset is deemed to acquire it for its cost base to the transferor taxpayer. This means that, if the recipient taxpayer subsequently sells the rolled over asset to a third party, any capital gain or loss not recognised at the time of roll-over will be recognised at the time of the subsequent sale. In the case of some roll-over provisions, consideration that a transferor taxpayer receives for a rolled over asset is deemed to have the same CGT characteristics (pre- or post-CGT asset cost base) as the rolled over asset had. In some cases, a taxpayer can choose whether or not a roll-over provision will apply. In other cases, a roll-over is compulsory. Note that the small business roll-over under Subdiv 152-E was discussed in 6.159 and will not be discussed under this heading.

[page 410]

Categories of roll-over provisions 6.163 The ITAA97 breaks CGT roll-overs down into four different categories. These are: 1. Pt 3-3 Div 122 ‘Roll-over for the disposal of assets to, or the creation of assets in, a wholly-owned company’ (see Chapter 12): Subdiv 122-A ‘Disposal or creation of assets by an individual or trustee to a wholly owned company’; Subdiv 122-B ‘Disposal or creation of assets by partners to a wholly-owned company’; 2. Pt 3-3 Div 124 ‘Replacement-asset roll-overs’: Subdiv 124-A ‘General rules’; Subdiv 124-B ‘Asset compulsorily acquired, lost or destroyed’; Subdiv 124-C ‘Statutory licences’; Subdiv 124-D ‘Strata title conversion’; Subdiv 124-E ‘Exchange of shares or units’; Subdiv 124-F ‘Exchange of rights or options’; Subdiv 124-I ‘Change of incorporation’; Subdiv 124-J ‘Crown leases’; Subdiv 124-K ‘Depreciating assets’ (see Chapter 10); Subdiv 124-L ‘Prospecting and mining entitlements’; Subdiv 124-M ‘Scrip for scrip roll-over’ (see Chapter 13); Subdiv 124-N ‘Disposal of assets by a trust to a company’; Subdiv 124-P ‘Exchange of a membership interest in an MDO for a membership interest in another MDO’; Subdiv 124-Q ‘Exchange of stapled ownership interests for ownership interests in a unit trust’; Subdiv 124-R ‘Water entitlements’; Subdiv 124-S ‘Interest realignment arrangements’.

3. 4.

Pt 3-3 Div 125 ‘Demerger relief’ (see Chapter 13); Pt 3-3 Div 126 ‘Same-asset roll-overs’: Subdiv 126-A ‘Marriage or relationship breakdowns’; Subdiv 126-B ‘Companies in the same wholly-owned group’ (discussed in Chapter 12); Subdiv 126-C ‘Changes to trust deeds’; Subdiv 126-D ‘Small superannuation funds’; Subdiv 126-E ‘Entitlement to shares after demutualisation and scrip for scrip roll-over’; Subdiv 126-G ‘Transfer of assets between fixed trusts’. In addition, mention should be made of the following roll-overs which apply for CGT purposes and also for other purposes: Div 328-G ‘Roll-over on small business restructure’; [page 411] Div 615 ‘Roll-overs for business restructures’; and Div 620 ‘Assets of wound up corporation passing to corporation with not significantly different ownership’.

Replacement asset roll-overs 6.164 The general rules for replacement-asset roll-overs are set out in ITAA97 s 124-10. The general rules for roll-overs where your ownership of the original CGT asset ends and you acquire one or more new CGT assets are: any capital gain or loss you make from the original CGT asset is disregarded; if the original asset was a post-CGT asset, the first element in the cost base of each new CGT asset is the original asset’s cost base (at the time your ownership ended) divided by the number of new CGT assets; where the original asset was a post-CGT asset, the reduced cost

base of each new CGT asset is calculated in a similar way; and if the original asset was a pre-CGT asset, each new asset will be regarded as a pre-CGT asset, except where the asset is a share to which CGT event J4 applies. The following example, based on one formerly contained in the ITAA97, illustrates the operation of the general rules regarding replacement-asset roll-overs.

Your commercial fishing licence expires and you are granted a new one. At the time of the expiry of the licence, the cost base of the old licence was $5000. You pay a fee of $500 for the grant of the new licence. The new licence is not renewed when it expires. The ITAA97 Subdiv 124-C roll-over relating to statutory licences will be available in this situation. Any capital gain or (more likely) capital loss on the licence is disregarded. The first element of the cost base of the new licence will be $5000, being the cost base of the old licence + (in the case of Subdiv 124-C and Subdiv 124-D roll-overs only) $500, being the money paid to acquire the new licence. The first element of the reduced cost base of the new licence will be calculated in the same way. When the new licence expires, you make a capital loss of $5500. The effect of the rollover has been to defer the capital loss that would otherwise have arisen on the expiry of the old licence until the expiry and non-renewal of the new licence.

6.165 It is important to note that while these general rules apply in most cases, there are some exceptions to them. For example, s 12410(2) states the general rule that, in the case of a replacement-asset rollover, a capital gain or loss you make [page 412] from the original asset is disregarded. One exception to this general rule occurs in the case of the Subdiv 124-B roll-over where an asset is compulsorily acquired, lost or destroyed. In some cases, under this roll-

over a capital gain that would otherwise accrue is merely reduced rather than disregarded. The replacement-asset roll-over that is likely to have the most general application is the Subdiv 124-B roll-over where an asset is compulsorily acquired, lost or destroyed. The full text of Subdiv 124-B is set out in Study help. Read through the text of Subdiv 124-B and then complete the following activity.

1.

Write a checklist of requirements that must be satisfied before a taxpayer who receives cash compensation for disposing of an asset to a Commonwealth Government agency can obtain a Subdiv 124-B roll-over. 2. Identify the circumstances in which a capital gain that would otherwise arise is reduced (rather than disregarded) under Subdiv 124-B where the taxpayer receives cash compensation. 3. Explain how the effects of Subdiv 124-B differ where cash compensation is received for a pre-CGT asset as compared with the situation where an asset other than cash is received for a pre-CGT asset. A suggested solution can be found in Study help.

Same-asset roll-overs 6.166 As noted above, there are six same-asset roll-overs. The ITAA97 Subdiv 126-B roll-over will be discussed in Chapter 12. A table summarising the preconditions for, and the effects of, the rollovers available under Subdiv 126-A on marriage and relationship breakdowns, and the roll-over under Subdiv 126-D can be found in Study help. The table does not cover the situation dealt with in s 12615 where an asset is transferred from a company or trustee to a spouse or former spouse because of a court order of the type specified in s 12615. Identifying the roll-overs that apply in Steve and Sarah’s case study Now see if you can identify what roll-overs, if any, are applicable in the Steve and Sarah

case study (see 6.58). Suggested solutions are contained in Study help.

1. 2. 3. 4. 5. 6. 7. 8.

9. 10.

11. 12.

13. 14. 15.

16. 17.

Australian Government, Reform of Australian Taxation System: Draft White Paper, AGPS, Canberra, 1985, paras 2.14, 7.4 and 7.5. Reform of the Australian Taxation System: Draft White Paper, paras 7.2 and 7.6. Dr Ken Henry (Chair) et al, Australia’s Future Tax System: Report To The Treasurer, Canberra, December 2009, Part One, Overview, Recommendation 14. Dr Ken Henry (Chair) et al, Australia’s Future Tax System: Report To The Treasurer, Recommendation 17. Treasurer’s Press Release No 28, 2 May 2010, Attachment. Commonwealth of Australia, Tax Forum Discussion Paper: Tax Reform; Next Steps For Australia, Canberra, 2011, p 11. H J Ault (principal author), Comparative Income Tax: A Structural Analysis, Kluwer Law International, Den Haag, The Netherlands, 1997, pp 194–5. ITAA97 s 102-5(2) says that in calculating your net capital gain for an income year in which you became bankrupt (or were released from debts under a law relating to bankruptcy), any net capital loss that you made in an earlier income year is disregarded. This approach assumes that a CGT event has happened, that no exemption is applicable, and that the asset is neither a personal-use asset nor a collectable. Note that listed investment companies, and life insurance companies where a CGT event happens to a virtual pooled superannuation trust (PST) asset are entitled to indexation only if they choose that the cost base of the relevant asset includes indexation. Discount capital gains may also be made by life insurance companies in relation to CGT events in respect of a CGT asset that is a virtual PST asset: see ITAA97 s 115-10. Where the asset has been involved in an unbroken series of roll-overs, the date of acquisition is the date on which it was acquired by the entity that owned it before the first roll-over in the series (in the case of a same asset roll-over) or the date on which the acquirer acquired the original asset involved in the first roll-over in the series (in the case of a replacement asset roll-over). Except shares that carried a right to participate in a distribution of profits or capital to a limited extent. Review of Business Taxation, A Tax System Redesigned, Commonwealth of Australia, 1999, Recommendation 18.1(a). ATO Interpretative Decision ID 2010/116 takes the view that CGT event C1 happens when shares in a company are sold without the owner’s consent to a bona fide purchaser for value without notice. This is on the basis that the shares are lost by the owner. See also ATO ID 2010/124, which indicates that CGT event C1 happens when shares are mistakenly sold by a broker without the owner’s consent. There are exceptions to this rule in s 116-30(2A) and (2B). These exceptions are discussed at 6.94. In the subsequent Federal Court decision in Ashgrove Pty Ltd v FCT (1994) 28 ATR 512,

18. 19.

20. 21. 22.

23.

24. 25.

26. 27. 28. 29.

30.

Hill J expressed the view by way of obiter, that, notwithstanding the difficulties of construction of ITAA36 s 160M(6) demonstrated by the High Court decision in Hepples, there was no difficulty in applying the original s 160M(6) to the creation of a new asset, such as a profit à prendre, out of an existing asset. See, for example, C J Taylor, Capital Gains Tax: Business Assets and Entities, Law Book Co, Sydney, 1994, [7.50]. ITAA97 s 102-25(3) thus appears to mean that the conclusion reached by the Full Federal Court in Brooks v FCT (2000) 44 ATR 352, that if ITAA36 s 160ZZC had not applied where a deposit was forfeited, ITAA36 s 160M(6) would have applied when the deposit was received, will not be possible under the ITAA97. An exception arises where the grantee acquires the option under a trust restructure and holds the asset acquired on exercising the option as trading stock. Mention should also be made of ITAA97 s 132-15, which applies where a lessee acquires ownership of leased land from the lessor. In the subsequent High Court decision in FCT v Murry (1998) 193 CLR 605; 155 ALR 67; 39 ATR 129, McHugh J, in a joint judgment with Gaudron, Gummow and Hayne JJ, expressly rejected the view of the nature of goodwill that he had espoused in Hepples. ITAA97 Subdiv 768-R deals with temporary residents. The guide to Subdiv 768 in s 768900 explains that: Generally foreign income derived by temporary residents is nonassessable non-exempt income and capital gains and losses they make are also disregarded for CGT purposes. There are also some exceptions for employment-related income and capital gains on shares and rights acquired under employee share schemes. Temporary residents are also partly relieved of record-keeping obligations in relation to the controlled foreign company rules. Interest paid by temporary residents is not subject to withholding tax and may be non-assessable non-exempt income for a foreign resident. R P Meagher, W M C Gummow and J R F Lehane, Equity: Doctrines and Remedies, 3rd ed, Butterworths, Sydney, 1992, [403]–[406]. Mention should also be made of ITAA97 s 108-75, which deals with improvements relating to Crown leases, prospecting or mining entitlements, or statutory licences where certain roll-over provisions have been applicable. The improvement threshold for the 2017–18 income year is $$147,582. The improvement threshold is indexed annually. TD 2017/1 takes the view that intangible capital improvements (such as rezoning) to land will be separate assets under s 108-70(2) or (3) if the relevant thresholds are satisfied. ITAA97 s 108-80 explains when improvements will be regarded as being related. The note to ITAA97 s 104-10(2) explains: ‘A change in the trustee of a trust does not constitute a change in the entity that is the trustee of the trust (see subsection 960-100(2)). This means that CGT event A1 will not happen merely because of a change in the trustee’. For a similar approach in the context of the main residence exemption, see Re Estate of J R Cawthen and FCT (2008) 74 ATR 320; [2008] AATA 1168. There, R W Dunne, Senior Member, held that a deceased’s right to occupy a residence owned by a company in which he and his wife were equal shareholders was not exempt from CGT under ITAA97 s 118195(1). Following the death of the deceased, the company owning the residence had been liquidated and its assets were distributed in specie. The AAT held that on a subsequent sale of the residence the exemption for a pre-CGT main residence did not apply when the

residence was subsequently sold, as the deceased’s right to occupy was not identical with the 50% interest in the residence as owner held by the deceased’s estate. 31. See also the judgment of Callinan J in Sara Lee (at [98]), where his Honour said: I do not take the language of [ITAA36] to require that in all cases and for all purposes there must be a simultaneous or immediately consecutive disposition and acquisition of an asset. The Act is drawn up in such a way, as the sections to which I have referred indicate, as to deem an event or sequence of events a disposition and some other event or sequence of events an acquisition.

32.

33. 34.

35.

36. 37.

38. 39.

40. 41.

See also the decision of Finn J in McDonald v FCT (2000) 44 ATR 577, upheld on appeal to the Full Federal Court in McDonald v FCT (2001) 46 ATR 426. Certain modifications that are confined to particular circumstances or to certain CGT events will not be discussed. These are set out in ITAA97 ss 116-65, 116-70, 116-75, 11680, 116-85, 116-95, 116-100, 116-105 and 116-110. There is also a sixth modification, the misappropriation rule, set out in s 116-60, which is not discussed in detail in this chapter. Footnotes in the judgment have been placed in square brackets in the above quotation. In TD 1999/84, the ATO states that: (a) the expression ‘proceeds cannot be valued’ applies ‘if capital proceeds cannot be valued at all. Situations where capital proceeds cannot be valued are likely to be rare’. The market value substitution (MVS) rule in ITAA97 s 116-30(2)(a) does not apply ‘if valuing capital proceeds is merely difficult, costly or inconvenient’; and (b) ‘[a]s a matter of policy, it is inappropriate to apply the MVS rule … if it is at all possible to value the capital proceeds’; that is, the MVS rule should be used ‘only as a last resort’. In FCT v AXA Asia Pacific Holdings Ltd (2010) 189 FCR 204; [2010] FCAFC 134, the Full Federal Court reviewed the case law on the meaning of the phrase ‘dealing at arm’s length’ and affirmed that in the absence of real bargaining, unrelated parties can be found not to have dealt with each other ‘at arm’s length’. Conversely, in the presence of real bargaining, related parties can be found to have dealt with each other at arm’s length. The key requirement to emerge from the case law is the need for real bargaining between the parties in relation to the relevant transaction. General provisions do not derogate from specific provisions. ITAA97 s 116-30(5) provides that s 116-30 does not apply to not apply to CGT event A1 or C2 to the extent that the CGT event is constituted by ceasing to own: (a) the carried interest of a general partner in a venture capital limited partnership (VCLP), an early stage venture capital limited partnership (ESVCLP) or an Australian venture capital fund of funds (AFOF) or a limited partner in a venture capital management partnership (VCMP); or (b) an entitlement to receive a payment of such a carried interest. There is a sixth modification known as the ‘misappropriation rule’. This rule is set out in ITAA 97 s 116-60. The misappropriation rule is not discussed in detail in this chapter. Other subsections in s 116-120 are concerned with: remaking choices in relation to an earn-out right; the amendment of assessments by the Commissioner; and objections to assessments in relation to earn-out rights. ‘Financial benefit’ is defined in s 974-160. The definition is discussed at 12.25. The meaning of ‘active asset’ is discussed at 6.150.

42. Special rules setting out circumstances in which the five-year requirement will not be regarded as having been met are set out in s 118-565(2) and (3). 43. Other exclusions from CGT cost base in the ITAA97 are: (a) expenditures related to certain offences (s 110-38(1)); (b) expenditure that is a bribe to a foreign public official or a bribe to a public official (s 110-38(2)); (c) expenditure in respect of providing entertainment (s 110-38(3)); (d) deductions for penalties denied under s 26-5 (s 110-38(4)); (e) the excess of boat expenditure over boat income (s 110-38(5)); (f) certain expenditure where you chose a tax offset under s 388-55 (about landcare and water facility tax offsets) (s 110-45(5)); (g) eligible heritage conservation expenditure that you could have deducted under certain Divisions (s 110-45(6)); and (h) expenditure to the extent that the thin capitalisation rules prevent you from deducting it (s 110-54). 44. Interest incurred after 20 August 1991 on money borrowed to acquire a non-incomeproducing asset would now normally be included in the third element of the cost base of the asset. The third element of the cost base is discussed at 6.109. 45. The taxpayer’s appeal to the House of Lords was upheld on other grounds. 46. Two modifications not discussed in detail in this chapter are: (i) a modification that applies to the rights that you acquire as a result of a company in which you own shares issuing ‘put options’ to you; and (ii) a modification that relates to the cost base and reduced cost base of geothermal extraction rights. The modification dealing with put options is discussed at 13.115. 47. The same approach also applies to company-issued shares and to unit trust-issued units. See the discussion in Chapter 12 and Chapter 15 respectively. 48. Other subsections in s 112-36 deal with: the taxpayer remaking choices; the amendment of assessments; and objections to assessments in relation to earn-out rights. 49. Note that for CGT events occurring on or after 21 September 1999 and before 30 June 2001, capital gains and losses on plant are disregarded. As from 30 June 2001, the exception, in broad terms, relates to capital gains or losses made from a CGT event that is also a balancing adjustment event that happens to a depreciating asset that you held. The current s 118-24 is discussed at 6.132 and at 10.65. 50. ITAA97 s 110-55(7) is another respect in which reduced cost base differs from cost base. Section 110-55(7) is discussed in Chapter 13. 51. The terms, ‘registered emissions unit’, and ‘Australian carbon unit’ are all defined in ITAA97 Div 420. The guide to Div 420 summarises the effect of that Division as follows (s 420-5): The purpose of income tax accounting for registered emissions units is to produce the same tax treatment, irrespective of your purpose in acquiring or holding the registered emissions units. There are 4 key features: (1) You bring your gross expenditure and gross proceeds to account, not your net profits and losses on disposal of a registered emissions unit. (2) The gross expenditure is deductible. (3) The gross proceeds are assessable income. (4) You must bring to account any difference between the value of your registered emissions units held at the start and at the end of the income year. This is done in such a way that: (a) any increase in value is included in assessable income; and

(b) any decrease in value is a deduction. 52. Amendments introduced in 2015 in effect apply the exemptions in relation to compensation received to situations where the compensation is received by a trustee on behalf of a beneficiary of a trust or received by the beneficiary from the trustee. 53. The application of ITAA97 s 118-25(1) in the context of partnerships and of trusts is discussed in Chapter 14 and Chapter 15 respectively. 54. It should be noted, however, that an argument could be made, consistently with the High Court decision in FCT v Murphy (1961) 106 CLR 146; 8 AITR 388; 12 ATD 366, that once an item is trading stock, it is always trading stock. 55. ITAA97 Div 40 balancing adjustments and CGT event K7 are discussed at 10.65. 56. The application of ITAA97 s 118-20 in the context of partnerships will be discussed in Chapter 14. Section 118-20 does not apply to share buy-backs that produce deemed dividends, and does not apply to franking credit gross-ups under ss 207-20(1) and 20735(1) and (3). 57. A tax expenditure arises where the tax treatment of something is more favourable to taxpayers than would be the case under a benchmark income tax. Figures in the government’s 2016–2017 Mid-Year Economic and Fiscal Outlook indicated that the discount component in the main residence exemption was worth $30 billion while the exemption portion of the main residence exemption was worth $25 billion. 58. Taxation Determination TD 1999/73 states that if the relevant unit of accommodation is removed from land, and the land is then sold, the land does not come within para (c) of the definition of ‘dwelling’ in ITAA97 s 118-115(1). The view taken in TD 1999/73 is that land under a unit of accommodation is only within the main residence exemption if the unit of accommodation and the land are sold together as a dwelling. 59. The amendments also allow a partner to access the concessions via the small business entity test where the relevant asset is owned by the partner but used in the partnership. The application of the small business concessions in the context of partnerships is not discussed in detail in this chapter. Extracts from the Explanatory Memorandum to the Tax Laws Amendment (2009 Measures No 2) Bill 2009 (Cth) dealing with the effect of the amendments on partners are contained in Study help. 60. In FCT v Devuba Pty Ltd [2015] FCAFC 168, the Full Federal Court held that the existence of a dividend access share arrangement in a company did not prevent the 90% business participation percentage requirement being met as no dividend was paid under the dividend access share immediately before the sale of the shares and as there were a number of limitations on the declaration of dividends in relation to the dividend access share. 61. The drafting in s 152-10(1AA) cross-references to the definition of ‘small business entity’ in ITAA97 s 328-10 but modifies that definition by substituting a reference to $2 million for the reference to $10 million. Under ITAA97 s 328-110(6), a person who is a partner in a partnership in an income year is not, in his or her capacity as a partner, a small business entity for the income year. 62. ‘Annual turnover’ is defined in ITAA97 s 328-120 as ‘the total ordinary income that the entity derives in the income year in the ordinary course of business’. In Doutch v FCT [2016] FCAFC 166, the Full Federal Court held that ‘ordinary course of business’ bore its ordinary meaning and did not have a technical meaning. The Full Federal Court held that ‘fuel disbursement receipts’ received were ordinary income derived in the ordinary course of

63.

64.

65.

66.

67.

carrying on the taxpayer’s mining business. In Re the Taxpayer and the FCT [2010] AATA 455, the AAT held that liabilities (legal fees, accountancy fees and real estate agent’s commission) incurred by the taxpayer after the relevant CGT event (sale of a hotel business) but which were ‘inextricably connected’ with the event were to be taken into account in determining whether the maximum net asset test was passed. In FCT v Byrne Hotels Qld Pty Ltd [2011] FCAFC 127, a majority of the Full Federal Court held that a real estate agent commission incurred on the sale of a hotel business could be included as a ‘liability’ for the purposes of the ‘maximum net asset value test’ despite the fact that the taxpayer was invoiced for commission after CGT event A1 and despite the fact that it was effectively contingent on the sale of the business being completed. Special leave to appeal to the High Court was refused. By contrast, in Re Scanlon and FCT [2014] AATA 725, the AAT held that ETPs paid to a husband and wife taxpayers who were the owners of a private healthcare company could not to be taken into account as liabilities for the purposes of the maximum net asset value test. The AAT found that the ETP liability had not arisen ‘just before’ the relevant CGT event and did not ‘relate’ to any CGT assets of the business for the purposes of the maximum net asset value test. In White v FCT [2012] FCA 109, Gordon J in the Federal Court held that the maximum net asset value test was satisfied on the sale by a husband and wife of their combined 55% share in a company as only the value of the husband and wife’s shares in the company and not the value of its underlying assets had to be taken into account. This was because ITAA97 s 152-20(4) provided that assets were to be disregarded in the calculation if those assets were ‘used, or held ready for use, in carrying on of a business by an entity that is connected with you only because of your small business CGT affiliate’. The court held that the assets of the company should not be taken into account as the company would not have been connected (in the relevant sense) with either taxpayer but for the shares held by each taxpayer’s affiliate. Where one or more of the entity’s *C GT assets were assets for which the entity later provided, or was later provided with, one or more *financial benefits under one or more *look through earn-out rights that were in existence at the valuing time s 152-20(6) gives you the option to treat the market value of those CGT assets as being equal to one of the values identified in s 152-20(6), which provides for the use of different values in particular situations. Interpretative Decision ATO ID 2010/90 states that for the purpose of determining whether a share in a company that has ceased to carry on business satisfies the active asset test, the business referred to in ITAA97 s 152-35(2)(b)(ii) is the business previously carried on by the company. Note that the net value of the CGT assets of the taxpayer, and entities connected with the taxpayer, and affiliates of the taxpayer or entities connected with affiliates of the taxpayer, will all be calculated separately and then aggregated in determining whether the maximum net asset test is passed. Section 328-125 sets out the meaning of ‘connected with an entity’ while ‘affiliate’ is defined in s 328-130. In Re Miley and FCT Devi and FCT [2016] AATA 73, the Administrative Appeals Tribunal (AAT) held that the market value of shares sold by a taxpayer was lower than the price paid for them by an arm’s length purchaser. The taxpayer had held a one-third share in a private company and all the owners of the company sold their shares in one arm’s length transaction to an independent third party. The total sale price was $17.7m and the taxpayer’s one-third share of the sale price was $5.9m. If the market value of the shares

68.

69. 70.

71.

72. 73.

74. 75.

had been regarded as $5.9m then, after taking into account the market value of other assets that the taxpayer owned, he would fail the $6m maximum net asset value test. The AAT held that the market value that a hypothetical willing but not anxious buyer would pay for the taxpayer’s one-third interest in isolation would be less than one-third of the actual price that the arm’s length purchaser paid for total control of the company. This was because a purchase of the taxpayer’s one-third interest would not have given the purchaser total control of the company. The AAT held that the market value of the taxpayer’s interest was $5.9m discounted by 16.7% to reflect the lack of control. At the time of writing, the case was on appeal to the Federal Court. In Re Altnot Pty Ltd and FCT [2013] AATA 140, the Administrative Appeals Tribunal (AAT) held that although the wife of the controller of the relevant taxpayer company was a ‘small business affiliate’ of the controller, she was not a ‘small business affiliate’ of the taxpayer company. This meant that the wife’s assets could not be taken into account in deciding whether the maximum net asset value test was satisfied. However, the AAT also held that the husband’s 50% interest in a holiday home could not be excluded from the maximum net asset value test as an asset used solely for the personal use and enjoyment of the husband or the husband’s affiliate. This was because, although the property was ready for personal use at the time of the CGT event and for several months prior to that, it was not actually being used at that time but had been used as a rental property for a period of seven years before it became vacant. Or with an affiliate of the first entity. These are: where the asset is an intangible asset and you substantially developed, altered or improved the asset so that its market value was substantially enhanced; and where the main use for deriving rent was only temporary: ITAA97 s 152-40(4)(e). In determining the main use of an asset for these purposes, ITAA97 s 152-40(4A) requires you to disregard any personal use or enjoyment of the asset by you and to treat any use of the asset by your affiliate or by an entity connected with you as your use. If you choose a roll-over where a CGT asset is compulsorily acquired, lost or destroyed, then, for the purposes of calculating the 15-year ownership period, you are regarded as acquiring the replacement asset at the time when you acquired the original asset. Where an asset is transferred to you under the marriage breakdown roll-over then, for the purposes of calculating the 15-year ownership period, you are regarded as acquiring the asset when the transferor acquired it. Special rules are set out in ITAA97 s 152-120 in the case of a discretionary trust in an income year in which the trust made a trust loss. If the company or trust chose a roll-over where a CGT asset is compulsorily acquired, lost or destroyed, then, for the purposes of calculating the 15-year ownership period, you are regarded as acquiring the replacement asset at the time when you acquired the original asset. Where an asset is transferred to the company or trust under the marriage breakdown roll-over then, for the purposes of calculating the 15-year ownership period, the company or trust is regarded as acquiring the asset when the transferor acquired it. Special rules are set out in ITAA97 s 152-120 in the case of discretionary trust in an income year in which the trust made a trust loss. Where the relevant CGT event happened because the company or trust *disposed of the relevant CGT asset the relevant period is the later of: 2 years; or 6 months after the latest

76.

77. 78.

79.

80.

time a possible *financial benefit becomes or could become due under a *look-through earn-out right relating to that CGT asset and the disposal. A stakeholder’s participation percentage is defined in ITAA97 s 152-125(2). Except in the case of trusts that are not wholly fixed, it will be the stakeholder’s small business participation percentage. In the case of a trust that is not wholly fixed, it will be 100 divided by the number of CGT concession stakeholders in the trust just before the CGT event. The basic conditions are not required to be satisfied where either CGT event J5 or CGT event J6 happens. See ITAA97 s 152-305(4). Subsection 152-305(1A) deals with the situation where the capital proceeds are received in instalments. Subsection 152-305(1B) treats you as receiving capital proceeds in instalments where the CGT event happened because you disposed of a CGT asset and the capital proceeds are increased by financial benefits that you receive under a look through earn-out right. Despite the use of the conjunction ‘and’ in the legislation, it is submitted that the better view is that the requirements to acquire a replacement asset and to improve an existing asset are alternatives. ITAA97 s 104-185(8) in effect states that (where the replacement asset is a share in a company or an interest in a trust) the replacement asset for CGT event J2 purposes does not cease to be an active asset only because of changes in the market value of assets that were owned by the company or the trust when you acquired the share or interest or incurred the fourth element expenditure.

[page 413]

CHAPTER

7

Fringe Benefits Tax Learning objectives After studying this chapter, you should be able to: identify when fringe benefits tax (FBT) is payable by an employer; calculate the taxable value of a fringe benefit; explain how overlap between FBT and income tax is prevented.

Introduction Overview of taxation of fringe benefits 7.1 Fringe benefits tax is payable by employers at the flat rate of 47% with respect to the grossed-up taxable value of ‘fringe benefits’ provided to employees in respect of their employment. The following points set out the statutory scheme with respect to employment remuneration: Salary and wages are included in an employee’s assessable income under the Income Tax Assessment Act 1997 (Cth) (ITAA97) s 6-5 for the purposes of the income tax. Non-cash benefits that are ‘fringe benefits’ provided to an employee in respect of their employment, and hence that fall within the ambit of the fringe benefits tax legislation, are deemed to be non-assessable non-exempt income by the Income Tax Assessment Act 1936 (Cth) (ITAA36) s 23L.

With respect to employment benefits, ITAA97 s 15-2 fulfils a residual function, as it does not apply to amounts that are assessable as ordinary income under s 6-5 and nor, by virtue of ITAA36 s 23L, does it have any effect with respect to fringe benefits that fall within the Fringe Benefits Tax Assessment Act 1986 (Cth) (FBTAA). This chapter comprises the following sections: an introduction to the history and policy of taxation of fringe benefits in Australia; a consideration of the definition of ‘fringe benefit’ for the purposes of the FBTAA; discussion of the rules governing the quantification of an employer’s fringe benefits tax liability; a consideration of the rules governing the valuation of fringe benefits; [page 414] discussion of the nature of exempt fringe benefits; discussion of the rebate allowed for fringe benefits tax payable by some employers; and a discussion of the principles of salary packaging.

Historical background, tax policy and alternative mechanisms for taxing fringe benefits Australian approaches to taxing fringe benefits prior to FBT 7.2

Australian approaches to taxing fringe benefits prior to the

introduction of the FBTAA (effective as from 1 July 1986) were discussed in Chapter 3 and Chapter 5. One of the problems associated with the taxation of fringe benefits arose from the rule in Tennant v Smith [1892] AC 150: that to be ordinary income, a receipt had to be convertible into money. We saw in 3.5 that it is unclear from the case law whether the principle in Tennant v Smith is universally applicable or depends on the facts of a particular case. Nonetheless, the circumstances, identified at 2.10, where the rule clearly did apply, provided sufficient scope for tax planning using non-cash benefits to necessitate the introduction of specific statutory provisions. In 3.6 and Chapter 5, we noted that the former ITAA36 s 26(e) (now ITAA97 s 152) was introduced to overcome the rule in Tennant v Smith. However, as noted at 5.4: Prior to the decision in Smith v FCT (1987) 164 CLR 513, the courts interpreted ITAA36 s 26(e) as a provision that merely provided greater certainty. The High Court decision in Smith v FCT made it clear that s 26(e) could apply to receipts that were not ordinary income, but by that stage FBT had come into operation. Furthermore, other problems with s 26(e) remained. As the decisions in FCT v Cooke & Sherden (1980) 10 ATR 696 (discussed in 2.10) and in Payne v FCT 96 ATC 4407 (discussed in 3.4) illustrated, s 26(e) could only tax a benefit where the requisite relationship existed between the benefit and the employment or services. A further problem with s 26(e) was that it brought to tax the ‘value to the taxpayer’ of benefits received. The language used in s 26(e) implied that some consideration of the individual circumstances of each employee was necessary to determine the value of the benefit to him or her. Bowen CJ in Donaldson v FCT [1974] 1 NSWLR 627 developed an administratively more workable rule, namely, what a prudent person in the taxpayer’s position would give for the rights rather than not obtain them. Even under this semi-objective approach, the valuation of fringe benefits for the purposes of s 26(e) was likely to be costly from

both an administrative and a compliance perspective and could result in some benefits not being taxed at all. [page 415] As we saw in 3.6, after the introduction of FBT, difficulties in s 26(e) associated with the valuation of non-cash business benefits were addressed by the introduction of s 21A into the ITAA36.1

The 1985 Draft White Paper recommendations 7.3 At the time FBT was introduced into Australia, the Draft White Paper noted that difficulties associated with taxing non-cash benefits in the employee’s hands had led to ‘almost universal non-inclusion by employees of fringe benefits received in kind’. The Draft White Paper favoured imposing a FBT at a fixed rate on all employers (including employers exempted from paying income tax) on the total taxable values of non-cash benefits provided to employees or their relatives. This option was favoured over the alternative of taxing fringe benefits through the PAYE system using specific valuation rules for several reasons including: imposing tax at the employer level avoided problems associated with imposing tax liability on employees who could not readily convert a non-cash benefit into cash; taxation at the employer level would be simpler for employees; compliance costs for employers would be minimised as: – employers would not need to allocate the value of non-cash fringe benefits (particularly discounted goods and services) to individual employees; – employers would not be required to make Pay-As-You-Earn (PAYE) deductions in relation to non-cash fringe benefits for individual employees; administrative costs would be lower as only employers would

need to be audited and taxable values would be easier to check as they would not be allocated to individual employees. 7.4 FBT was introduced in relation to fringe benefits provided on or after 1 July 1986. FBT is assessed under and imposed by the FBTAA. The current FBT rate is 47%. FBT is payable by employers who self-assess on the basis of an annual return lodged on 21 May. The FBT year runs from 1 April to 31 March. With effect from 1 April 2000, employers have been obliged to pay FBT by instalments on the same dates as Pay-As-You-Go (PAYG) instalments for a 1 April–31 March year are due. These dates are: 21 July, 21 October and 21 January in the FBT year and 21 April in the following year.2 With effect from 1 April 2000, the goods and services tax (GST) [page 416] rate is also taken into account in the gross-up formula for GST creditable benefits. See the discussion in 7.17. Prior to the 1999–2000 income year, fringe benefits were not taken into account in determining such matters as the Medicare levy, Medicare levy surcharge, concessions for personal and spouse superannuation contributions, superannuation contributions surcharge and HECS debt repayments. From the 1999–2000 income year, measures have been introduced to curtail the use of salary packaging as a means of reducing an employee’s liability for these charges. Employers are now required to calculate their FBT liability by allocating individual fringe benefits amounts to particular employees and then aggregating those amounts. (The process of calculation of FBT liability is discussed in more detail at 7.17–7.23.) Where an employee’s individual fringe benefits amount for the year of income is more than $2000, the employee has a reportable fringe benefits amount. An employee’s reportable fringe benefits amount is calculated by grossing up the employee’s individual fringe benefits amount using the formula:

Note that, unlike the gross-up formula discussed in 7.17 that is applicable when determining the taxable value of a fringe benefit, this gross-up formula does not vary according to whether or not the benefit is GST creditable. Reportable fringe benefits amounts do not form part of an employee’s assessable income. However, they are taken into account in calculating the employee’s Medicare levy, Medicare levy surcharge, concessions for personal and spouse superannuation contributions, superannuation contributions surcharge and HECS debt repayments.

Australia’s Future Tax System recommendations on FBT 7.5 In 2009, the Henry Review3 noted that business saw the FBT regime as complex, administratively burdensome, and discriminatory against both lower marginal rate employees and expatriate employees. The discrimination against lower marginal rate employees is a consequence of FBT being levied at a rate equal to the top marginal rate plus Medicare levy. We shall see in 7.60, however, that this discrimination can be neutralised in some cases if employees make contributions to the cost of providing a fringe benefit. Discrimination against expatriate employees occurs where the employee’s home country uses a foreign tax credit system that does not recognise FBT as a creditable tax. The primary recommendation of the Henry Review on the taxation of fringe benefits was to overcome these problems by taxing ‘readily valued’ employee fringe benefits to individual employees under the PAYG system.4 The government did not accept this recommendation. [page 417]

7.6 In Study help, there is a discussion of the following issues regarding the taxation of fringe benefits: salary-packaging strategies that exist when fringe benefits are not effectively taxed; the alternative approaches to the taxation of fringe benefits that were considered in the Draft White Paper of 1985; and the reasons why the Draft White Paper advocated the introduction of FBT.

Application of the fringe benefits tax: An overview 7.7 Under FBTAA s 66, an employer is liable to pay tax in respect of its fringe benefits taxable amount for the year of tax. For the year of tax beginning on 1 April 2000 and later years,5 ‘fringe benefits taxable amount’ is defined in FBTAA s 5B(1A) as the sum of the s 5B(1B) and (1C) amounts. The application of FBTAA s 5B(1B) and (1C) is considered in 7.17–7.19. However, in brief, those subsections require an employer to: 1. ascertain whether fringe benefits have been provided to an employee of the employer (see 7.8–7.16); and 2. determine the taxable value of those fringe benefits provided to each particular employee (see 7.24–7.27); and 3. calculate the fringe benefits tax payable by the employer with respect to the total value of fringe benefits provided to all of its employees. This step entails consideration of whether the employer is tax exempt, eligible for a rebate for fringe benefits tax paid or a non-exempt, non-rebatable employer (see 7.61).

FBTAA definition of ‘fringe benefit’ 7.8

The term fringe benefit, ‘in relation to an employee, in relation to

the employer of the employee’, is defined in FBTAA s 136. The definition has two major parts. The first, positive, part describes what a fringe benefit is. The second, negative, part excludes certain benefits from the definition of fringe benefit. The first part of the definition states: fringe benefit, in relation to an employee, in relation to the employer of the employee, in relation to a year of tax, means a benefit: (a) provided at any time during the year of tax; or (b) provided in respect of the year of tax; [page 418] being a benefit provided to the employee or to an associate of the employee by: (c) the employer; or (d) an associate of the employer; or (e) a person … other than the employer or an associate of the employer [called an arranger] under an arrangement … between: (i) the employer and an associate of the employer; and (ii) the arranger and another person; or (ea) a person other than the employer or an associate of the employer, if the employer or an associate of the employer: (i) participates in or facilitates the provision or receipt of the benefit; or (ii) participates in or facilitates or promotes a scheme or plan involving the provision of the benefit; and the employer or associate knows, or ought reasonably to know, that the employer or associate is doing so; in respect of the employment of the employee …

The negative part of the definition means that specified benefits are excluded from being fringe benefits. Some of the more important excluded benefits are: salary or wages (see 7.55–7.58); exempt benefits (see 7.54); rights to acquire shares and the acquisition of shares or rights under employee share schemes (see ITAA97 Div 83A);

contributions (eg, by employers) to complying superannuation funds (see 7.61); contributions to foreign superannuation funds in respect of employees who are temporary residents; contributions to retirement savings accounts; an employment termination payment; capital receipts relating to legally enforceable contracts in restraint of trade; capital receipts relating to personal injury; any payments that the ITAA36 deems to be a dividend paid to a person; anything done that causes a private company to be taken to pay a shareholder or an associate a dividend under ITAA36 Pt III Div 7A; benefits constituted by present entitlements to income or capital in a trust that would be included in a beneficiary’s assessable income but for ITAA36 Sch 2F s 271-105 of the trust loss provisions. In order to understand the positive part of the definition of fringe benefit, we need to discuss the meaning of several terms and phrases used in the definition. These are: benefit; provide; [page 419] employer; employee; associate; arrangement; in respect of the employment. These are now discussed in turn.

‘Benefit’ 7.9 ‘Benefit’ is defined in FBTAA s 136 as including any right, privilege, service or facility, including one that is, or is to be provided, under: (a) an arrangement for or in relation to: (i) the performance of work [including professional work]* … with or without the provision of property; (ii) the provision of, or use of facilities for, entertainment, recreation or instruction; or (iii) the conferring of rights, benefits or privileges for which remuneration is payable in the form of a royalty, tribute, levy or similar exaction; (b) a contract of insurance; or (c) an arrangement for or in relation to the lending of money. *Italicisation indicates author’s simplification.

The employer’s motives in making the provision are irrelevant in determining whether or not there is a benefit. So, too, is the fact that the employee is unable to gain any private advantage from the benefit. Thus, in National Australia Bank Ltd v FCT (1993) 26 ATR 503, Ryan J held that permitting bank employees who worked night and weekend shifts to charge taxi fares to the bank’s cabcharge account was a benefit under the FBTAA s 136 definition. This was so despite a submission from the bank that its only motive in permitting the employees to use the cabcharge facility was to minimise the danger and inconvenience to employees when they were required to work at inconvenient hours. The provision of the facility was a benefit despite the fact that the employee could not exploit the benefit to their private advantage (but see now FBTAA s 58Z).

‘Provide’ 7.10 ‘Provide’ in relation to a benefit is defined in FBTAA s 136 as including ‘allow, confer, give, grant or perform’. In relation to property, ‘provide’ is defined as meaning to dispose of: (i) the beneficial interest where the property is a beneficial interest that does not include legal

ownership; (ii) in other cases, the legal ownership of the property. The disposal may be by ‘sale, gift, declaration of trust or otherwise’. [page 420] One of the issues in Westpac Banking Corporation v FCT (1996) 32 ATR 479 concerned whether a fringe benefit was provided when the bank’s usual loan establishment fees were waived in respect of loan applications by bank employees. The bank argued that the benefit was the waiver of the usual fees. The bank further argued that the benefit was not ‘provided’ as the bank did not perform any positive act but merely failed to charge an amount. Hill J, however, accepted the Commissioner’s contention that the benefit was the service provided by the bank to its staff member in assessing the loan application, considering it, reviewing security (if security is offered) inspecting the property, considering any other relevant matters and communicating the bank’s decision. Alternatively, there was a benefit in the bank committing itself to making the loan. Once the benefit was described in this manner, it was clear that it was conferred by the bank on the employees and hence ‘provided’ to them.6 FBTAA s 138 is aimed at preventing the double counting of a provision of a fringe benefit. Where an employee is employed by two employers who are associates and a fringe benefit is provided to the employee or an associate of the employee by the first employer, s 138(1) deems the benefit not to be a fringe benefit in relation to the second employer. Where a fringe benefit is provided to an employee (or an associate) by two or more employers and s 138(1) does not apply (eg, because the employers are not associates), then, under s 138(2), the benefit is taken to be a fringe benefit in relation to such of those employers as the Commissioner determines. The benefit will not be a fringe benefit in relation to any of the other employers. Under s 138(3), a benefit provided jointly to an employee and to one or more associates of the employee is deemed to have been provided to the employee only. In National Australia Bank Ltd v FCT (1993) 26 ATR 503, Ryan J

held that s 138(3) meant that a loan fringe benefit in the form of a lowinterest investment loan provided to a bank employee and his spouse was deemed to be provided to the employee only. Where a benefit in respect of the employment of an employee is provided jointly to two or more associates of the employee, but not to the employee, s 138(4) deems the benefit to have been provided to one of the associates as the Commissioner determines and not to any other of the associates.

‘Employer’ and ‘employee’ 7.11 Neither the definition of ‘employer’ nor the definition of ‘employee’ on its own is particularly helpful. The definition of ‘employer’ in FBTAA s 136 states that ‘employer’ means a current, future or former employer but does not include the Commonwealth or a Commonwealth authority that cannot be made liable to taxation by a law of the Commonwealth. A significant aspect of this definition is that an employer will include a state or a state authority. Similarly, ‘employee’ is defined in FBTAA s 136 as including a current employee, a former employee or a future employee. The unanimous decision of the Full Federal Court in FCT v Indooroopilly Children Services (Qld) Pty Ltd (2007) 158 FCR 325; 65 ATR 369 confirmed earlier single judge decisions of the Federal Court in deciding that a fringe benefit must be [page 421] capable of being allocated to a particular employee. Thus, there will not be a fringe benefit where an employer provides a benefit to a class of employees in circumstances where there is no fixed basis for allocating the benefit across members of that class of employees who can be identified at the time that the benefit was provided. The essential feature of the employer–employee relationship becomes apparent when the definitions of current employer/employee are examined. Note that the definitions of former employer/employee and future employer/employee in turn refer to the concept of current

employer/employee. Thus, the definitions of current employer/employee are pivotal. The definition of ‘current employer’ states that the phrase means ‘a person (including a government body) who pays, or is liable to pay, salary or wages’. In the case of a partnership, the definition includes each partner and, in the case of an unincorporated association, includes its manager or other principal officer. Similarly, the definition of ‘current employee’ states that the phrase means ‘a person who receives, or is entitled to receive, salary or wages’. The phrase ‘salary or wages’ is defined in FBTAA s 136 as meaning an amount required to be withheld under either Taxation Administration Act 1953 (Cth) (TAA) Sch 1 s 1235 (payments of salary, wages, commission, bonuses or allowances to employees), s 12-40 (payments of directors’ fees to directors), s 12-45 (payments of salary, wages, commissions, bonuses to members of an Australian legislature; persons who perform the duties, or an appointment, office or position under the Constitution or an Australian law; members of the defence force or of a police force; or members of a local governing body), s 12-115 (Commonwealth education or training payments) or s 12-120 (certain compensation, sickness or accident payments). The meaning of ‘salary or wages’ is discussed in 7.56–7.59. Note that the provision of remuneration wholly in the form of noncash benefits would not amount to salary or wages as defined in s 136. FBTAA s 137 has the effect, for purposes of determining whether an employer–employee relationship exists under the FBTAA, of deeming a wholly non-cash remuneration to be salary or wages where it would have been if it had been paid in cash.

‘Associate’ 7.12 The definition of ‘associate’ in FBTAA s 136 refers us to the definition in ITAA36 s 318. Under that definition, ‘associate’ in relation to a natural person means: a relative of the person; a partner (or a spouse or a child of a partner) of the person or a partnership in which the person is a partner;

a trustee of a trust where the person or his or her associate benefits under the trust; a company which is ‘sufficiently influenced’ by the person. According to the definition of ‘sufficiently influenced’ in s 318(6), a company will be sufficiently influenced by a person where it is accustomed, or under an obligation to act in accordance with the directions, instructions or wishes of the person and/or the person’s associates; a company where the persons and/or the person’s associates are in a position to control more than 50% of the votes at a general meeting of the company. [page 422] The definition also explains who an associate of a company is and who an associate of a trustee of a trust estate is. In Caelli Constructions (Vic) Pty Ltd v FCT (2005) 60 ATR 542; [2005] FCA 1467, it was held that employee benefit trusts that were created for the purpose of providing benefits to employees were associates of the employees, even though no employee was a beneficiary or a member of the relevant trust when the benefit was provided.

‘Arrangement’ 7.13 The definition of ‘arrangement’ in FBTAA s 136 is very broad and states: arrangement means: (a) any agreement, arrangement, understanding, promise or undertaking, whether express or implied, and whether or not enforceable, or intended to be enforceable, by legal proceedings; and (b) any scheme, plan, proposal, action, course of action or course of conduct, whether unilateral or otherwise.

‘In respect of the employment’ 7.14 The phrase ‘in respect of’ in relation to the employment of an employee is defined in FBTAA s 136 as including ‘by reason of, by virtue of, or for or in relation directly or indirectly to, that employment’. In J & G Knowles v FCT (2000) 44 ATR 22 at 28, the Full Federal Court (Heerey, Merkel and Finkelstein JJ) made the following comments on the phrase ‘in respect of the employment’ in the FBTAA s 136 definition of ‘fringe benefit’: The words “in respect of” have no fixed meaning. They are capable of having a very wide meaning denoting a relationship or connection between two things or subject matters. However, the words must, as with any other statutory expression, be given a meaning that depends on the context in which the words are found: State Government Insurance Office v Rees (1979) 144 CLR 549 at 553–4 and 560–1; Technical Products Pty Ltd v State Government Insurance Office (Qld) (1988) 167 CLR 45 at 47, 51 and 54; Long Service Leave Board v Irving (1997) 74 FCR 587 at 595 and FCT v Scully (2000) 42 ATR 718 at 724 and 725. The AAT was correct in stating that the phrase requires a “nexus, some discernible and rational link, between the benefit and employment”. That, however, does not take the matter far enough. For what is required is a sufficient link for the purposes of the particular legislation: see Scully at 723–5. It cannot be said that any causal relationship between the benefit and the employment is a sufficient link so as to result in a taxable transaction. For example, a discretionary trust with a corporate trustee might be established to purchase a family home for the benefit of its directors and their family. It does not follow that the rent free occupation of that home on the authority of the directors is a benefit provided “in respect of” their employment for the purposes of the FBTAA. While there is a causal relationship between the provision of the benefit and the employment it is not a sufficient or material relationship. The rent free occupancy arises because the trust was established for that purpose; a reason extraneous to the employment of the directors.

[page 423] The facts in J & G Knowles v FCT involved the making of loans by a company, which was a trustee of a unit trust, to its directors. The units in the trust were held on trust by the unit holders for discretionary trusts for each of the directors and their families respectively. The Administrative Appeals Tribunal (AAT) determined that there was a causal link between the making of the loans and the employment of the

directors in that it was because of their capacity as directors that they were able to draw cheques on the company’s account. The Full Federal Court held that the AAT had failed to consider whether there was a sufficient or material relationship between the loans and the directors’ employment. The Full Federal Court commented (at ATR 31) that the material put before the AAT pointed in two possible directions: The first was that the directors drew upon the assets of the unit trust because ultimately the trust was established, and its assets were to be held and applied, for their benefit and that of their families. The second is that it was agreed between the directors that, as an incident of their directorship, each of them were entitled to draw upon the appellant’s funds by way of loans for their personal benefit. In the first case it is unlikely that there would be a sufficient connection with the employment, while in the second the loans are likely to be an incident or product of it.

As on the evidence it was open to the AAT to draw the first conclusion if it had considered the question of materiality, the Full Federal Court remitted the case back to the AAT to decide this issue.7 In Starrim Pty Ltd v FCT (2000) 44 ATR 487, Lindgren J applied the decision in J & G Knowles v FCT in holding that certain loans to directors of a proprietary company were made in their capacity as ‘purchasers’ of a property that the company had acquired. The payment by the company of certain expenses (telephone bills, council rates, etc) for the directors could have amounted to an expense payment fringe benefit but could just as easily have been paid to the directors as ‘landowners’, ‘shareholders’ or ‘security providers’. Lindgren J remitted the case back to the AAT to decide this issue. 7.15 FBTAA s 148 is also relevant to determining whether the provision of a benefit is in respect of the employment of an employee. FBTAA s 148(1) states: 148 Provision of benefits (1) A reference in this Act to the provision of a benefit to a person in respect of the employment of an employee is a reference to the provision of such a benefit: (a) whether or not the benefit is also provided in respect of, by reason of, by virtue of, or for or in relation directly or indirectly to, any other matter or thing; (b) whether the employment will occur, is occurring, or has occurred; (c) whether or not the benefit is surplus to the needs or wants of the recipient;

[page 424] (d) whether or not the benefit is also provided to another person; (e) whether or not the benefit is, to any extent, offset by any inconvenience or disadvantage; (f) whether or not the benefit is provided or used, or required to be provided or used, in connection with that employment; (g) whether or not the provision of the benefit is, or is in the nature of, income; and (h) whether or not the benefit is provided as a reward for services rendered, or to be rendered, by the employee.

Concerns were expressed by some commentators that, given that an employee includes a future and a former employee, FBTAA s 148 could catch benefits that did not relate to any actual employment. For example, the suggestion was made that FBTAA s 148 would regard a wedding gift given by parents to an adult child who had some years earlier worked after school in the family business as a fringe benefit. This would have been on the basis that the child was a former employee. In particular, reliance would be placed on FBTAA s 148(1) (a), (b) and (h). Despite the breadth of the phrase ‘in respect of’ and the extension of its scope by FBTAA s 148(1), the Commissioner has stated in Miscellaneous Taxation Ruling MT 2016 that the benefit must, in the case of a future employee, be in relation to employment activities ultimately undertaken and, in the case of a former employee, be in relation to employment activities previously undertaken.

Discuss whether any of the following benefits extracted from MT 2016 would be fringe benefits under the combined effect of the relevant FBTAA s 136 definitions and FBTAA s 148: (a) the value of accommodation and meals provided in the family home where children of a primary producer work on the family farm; (b) similarly, the value of board provided free in the family home to a son who is apprenticed to his father as a motor mechanic;

birthday presents given to children who work in small businesses run by their (c) parents; (d) a wedding gift given by parents to an adult child who had some years earlier worked after school in the family business; (e) an interest-free or concessional loan given to such a child for the purpose of buying a matrimonial home; (f) the rental value of a farm homestead occupied by a family whose private company conducts the farming business in which they work and holds the title to the homestead.

[page 425] 7.16 The following extract from MT 2016 sets out the Commissioner’s views as to whether the above benefits are fringe benefits. MT 2016 contains a more detailed discussion of benefit (f) which has not been included. MT 2016 12. In each of the examples in paragraphs 7(a) to (f) above [set out in Questions 7.1, above], the facts as presented lead strongly to the conclusion that the benefits and gifts were given in an ordinary family setting and would have been a normal incidence of family relationships. It would not be concluded that they were to any extent provided in respect of either past or current employment of the recipient members. 13. That is not to be taken as implying that all benefits provided to children or other family members who are employed in a family business will be outside the scope of the tax. For example, the private use of a motor vehicle provided to a relative employed as a travelling salesman in a business conducted by a family company could ordinarily be expected to be treated as a fringe benefit provided in an employment context rather than a family one.

Despite the breadth of the phrase ‘in respect of the employment’, a benefit will not be a fringe benefit if it is paid to the person in a capacity other than as an employee. Note, however, that for purposes of the FBTAA, the effect of the definition of ‘current employee’ is that a company director will be regarded as an employee of a company. Thus, if, in all the circumstances, a benefit can fairly be construed as being

paid to a person in their capacity as a shareholder rather than as an employee the benefit will not be a fringe benefit: see MT 2019. Note that as part of the A New Australian Tax System (ANTS) proposals, the government announced that FBT would be extended to benefits in excess of $1000 per year provided by companies to shareholders or by trustees to beneficiaries in circumstances where the benefits are not otherwise taxed.8 This has not been implemented.

Quantifying an employer’s fringe benefits tax liability 7.17 Under FBTAA s 66, an employer is liable to pay tax in respect of its fringe benefits taxable amount for the year of tax. For the year of tax beginning on 1 April 2000 and later years,9 ‘fringe benefits taxable amount’ is defined in FBTAA s 5B(1A) as the sum of the s 5B(1B) and (1C) amounts. The FBTAA s 5B(1B) amount [page 426] is calculated by multiplying the Type 1 aggregate fringe benefits amount by the multiplier calculated as follows:

The GST rate is 10% and the FBT rate is 47% for the FBT year commencing 1 April 2017; hence in calculating the s 5B(1B) amount in the year of tax ending 31 March 2018, the employer’s Type 1 aggregate fringe benefits amount is multiplied by 2.0802 (calculations have been made to four decimal places). The FBTAA s 5B(1C) amount is calculated by multiplying the Type 2 aggregate fringe benefits amount by the multiplier calculated as follows:

In the FBT year of tax ending 1 April 2018, the FBT rate is 47%. This means that in calculating the s 5B(1C) amount in the FBT year of tax ending 31 March 2018, the employer’s Type 2 aggregate fringe benefits amount is multiplied by 1/0.53 = 1.8868 (to four decimal places). For a year beginning on 1 April 2000 or a later year, an employer’s ‘aggregate fringe benefits tax amount’ is calculated under FBTAA s 5C(2)–(4).10

Assume that in the 2017–18 FBT year, an employer provided only Type 2 fringe benefits with an aggregate fringe benefits amount of $100,000. The FBT payable by the employer would be: $100,000 × 1.8868 × 47% = $88,679.60 If the employer provided $100,000 of Type 1 fringe benefits, the FBT payable would be calculated as: $100,000 × 2.0802 × 47% = $97,769.40 What if the employer provided fringe benefits which produce a Type 1 fringe benefits aggregate amount of $100,000 and benefits which produce a Type 2 fringe benefits aggregate amount of $100,000? Assuming that the employer does not have an aggregate non-exempt amount (see FBTAA s 5B(1D) and (1E)), the employer’s fringe benefits taxable amount is calculated as follows (see FBTAA s 5B(1A)): ($100,000 × 2.0802) + ($100,000 × 1.8868) = $396,700.00 Fringe benefits tax payable on this amount would be: $396,700.00 × 47% = $186,449.00

[page 427] 7.18

The Type 1 aggregate fringe benefits amount represents the sum

of the taxable value of fringe benefits that are GST creditable benefits. To calculate the Type 1 aggregate fringe benefits amount, the employer first identifies in respect of each employee the fringe benefits that are GST creditable benefits.11 The employer then determines the individual fringe benefits amounts in relation to each of those benefits. The employer then adds those individual fringe benefits amounts together. The employer then identifies the excluded fringe benefits that are GST creditable benefits in respect of each of the employer’s employees. The taxable values of these benefits are then added together. The sum of the individual fringe benefits amounts is then added to the sum of the excluded fringe benefits amount. The Type 2 aggregate fringe benefits amount represents the sum of the taxable value of fringe benefits that are not GST creditable benefits. These benefits include: fringe benefits that are GST-free; benefits provided where the employer did not acquire the goods or services through a taxable supply (eg, where the employer manufactured goods); benefits provided by employers who have not registered for GST and whose turnover is below the relevant GST threshold; benefits provided by certain registered employers who are input taxed for GST purposes.12 To calculate the Type 2 aggregate fringe benefits amount, an employer first identifies, in respect of each employee, the fringe benefits that are not GST creditable benefits. The employer determines the individual fringe benefits amount in respect of each of these benefits and adds those amounts together. The employer then identifies the excluded fringe benefits in respect of each employee that are not GST creditable benefits. The taxable values of the excluded benefits are then added together. The sum of the individual fringe benefits amounts is then added to the sum of the excluded fringe benefits amount. In practice, the Type 2 aggregate fringe benefits amount should represent the total fringe benefits amount less the Type 1 aggregate fringe benefits amount. 7.19

An employee’s ‘individual fringe benefits amount’ is determined

under FBTAA s 5E. The general rule is that an employee’s individual fringe benefits amount is the sum of the employee’s share of the taxable value of each fringe benefit that relates to the year of income and is provided in respect of the employment. Where an employee’s individual fringe benefits amount exceeds $2000, the employee has a ‘reportable fringe benefits amount’. An employee’s reportable fringe benefits amount is calculated by grossing up the employee’s individual fringe benefits amount by the 1/(1 – FBT rate) formula discussed in 7.17. An employee’s reportable fringe benefits amount is disclosed on the employee’s group certificate and is taken into account for the Medicare levy, Medicare levy surcharge and certain other purposes, such as eligibility for government benefits. The value of excluded fringe benefits is not taken into account in determining an employee’s individual fringe benefits [page 428] amount. A list of excluded fringe benefits is set out in FBTAA s 5E(3). The excluded fringe benefits are: the provision of meal entertainment that is not provided under a salary packaging arrangement); car parking fringe benefits; a benefit, the value of which is wholly or partly attributable to entertainment facility leasing expenses that is not provided under a salary-packaging arrangement; remote area residential fuel benefits; amortised fringe benefits;13 reducible fringe benefits;14 travel to a major population centre for employees and family members located in remote areas; related freight costs of foodstuffs for employees in remote locations; and benefits provided to address security concerns relating to the

personal safety of an employee, where those concerns arise in relation to the employee’s employment. Normally, as an exempt benefit is not a fringe benefit, the value of exempt benefits is not taken into account in determining an employee’s individual fringe benefits amount or reportable fringe benefits amount. An exemption occurs in the case of benefits which are exempt under FBTAA s 57A or s 58: see the discussion of these exemptions in 7.55. Under FBTAA s 135Q, an employee is regarded as having a ‘quasi fringe benefits amount’ in respect of these benefits. This means that the value of benefits that are exempt under FBTAA s 57A or s 58 is taken into account in calculating an employee’s individual fringe benefits amount and reportable fringe benefits amount.

Employee’s share of the taxable value of a fringe benefit 7.20 Rules for determining an employee’s share of the taxable value of a fringe benefit are set out in FBTAA s 5F. The rules distinguish three situations: 1. individual benefit provided in respect of one employee; 2. individually taxed benefit shared by two or more employees; 3. benefits valued in aggregate.

Individual benefit provided in respect of one employee Where: the fringe benefit was provided in respect of the employment of the employee and not in respect of the employment of anyone else; and the taxable value of the fringe benefit was worked out for that particular fringe benefit and not as part of the total taxable value of fringe benefits in a class; the employee’s share is 100% of the taxable value. 7.21

[page 429]

Individually taxed benefit shared by two or more employees Where: the fringe benefit was provided in respect of the employment of the employee and in respect of the employment of another employee; and the taxable value of the fringe benefit was worked out for that particular fringe benefit and not as part of the total taxable value of fringe benefits in a class; the employee’s share is so much of the taxable value as is reasonably attributable to the provision of the fringe benefit in respect of the employee’s employment. Examples of this situation are contained in Study help. 7.22

Benefits valued in aggregate Where: the fringe benefit is one of a class of fringe benefits provided in respect of the employment of one or more employees; and the total taxable value of all the fringe benefits in the class is worked out by a single calculation; the employee’s share is so much of the taxable value as is reasonably attributable to the provision of the fringe benefit in respect of the employee’s employment. 7.23

Review the discussion in 7.3 of the reasons the Draft White Paper favoured imposing FBT on employers rather than taxing fringe benefits through the PAYE system. To what extent, if at all, does the current system of calculating individual fringe benefits amounts mean that those reasons have less validity? A suggested solution can be found in Study help.

As an employer’s FBT liability will depend on the sum of the taxable

values of fringe benefits provided to individual employees, we need to discuss what a fringe benefit is and how its taxable value is determined.

General principles applicable in valuing benefits Contributions by employee 7.24 To the extent that an employee pays an employer, other than by the provision of the employee’s own services, for a benefit (as defined) provided by the employer, there has, in fact, been no benefit to the employee. Hence, the FBT valuation rules reduce the taxable value of fringe benefits by any contributions made by the employee. ITAA36 s 51AJ specifically denies a taxpayer an income tax deduction for the taxpayer’s contribution to the private component of a fringe benefit. [page 430] Where the applicable fringe benefits tax rate for a particular fringe benefit exceeds the employee’s marginal rate of income tax, it may be prudent for the employee to make a personal contribution to the cost of fringe benefits out of after-tax income. As such a contribution reduces the taxable value of the fringe benefit, fringe benefits tax at the rate of 47% is avoided. Taxation Ruling TR 2001/2 at paras 22 and 97–105 indicates that, following the introduction of GST, the full amount of employee contributions is deducted in calculating the taxable value of the relevant fringe benefit. The employee’s contribution is not reduced to reflect any GST that the employer may be required to remit in respect of the supply of the fringe benefit. Taxation Ruling TR 2001/2 indicates at para 26 that, following the introduction of GST, in applying the otherwise deductible rule the

employer takes into account the GST-inclusive value15 where applicable.

The otherwise deductible rule 7.25 In many instances, an employer may provide an employee with a fringe benefit but the benefit is used by the employee in gaining or producing the employee’s assessable income. Instead of paying the employee in fringe benefits, it would have been possible for the employer to have paid cash salary which the employee could then have spent to acquire the good or service that he or she used in gaining or producing assessable income. If this had happened, then the salary would have been assessable income of the employee but the expenditure on the good or service, to the extent that it was incurred in gaining or producing the employee’s assessable income, would have been deductible for income tax purposes. Thus, no tax would have been paid with respect to the amount applied to the acquisition of the good or service. To produce an equivalent result where a benefit is provided directly by the employer, the FBT valuation rules for various types of benefits (eg, expense payment fringe benefits (FBTAA s 24)) reduce the taxable value of the fringe benefit in question by the deduction which the employee would have obtained if he or she had acquired the benefit by payment. As no benefit or advantage exists to the extent that the employee pays the employer for the benefit provided, in calculating the reduction in the taxable value of the benefit under the otherwise deductible rule, any payment by the employee is subtracted. The operation of the otherwise deductible rule in relation to each of the relevant categories of fringe benefit will be examined as part of the discussion of that category. In calculating the deduction that the employee would have otherwise obtained, the threshold requirements relating to self-education (discussed at 8.80) and substantiation (discussed at 9.70–9.74) are not relevant. The operation of the otherwise deductible rule was considered in

John Holland Group Pty Ltd v FCT [2015] FCAFC 82. In that case, the Full Federal Court held that the employer’s payment of transport costs for employee travel from Perth Airport to a remote work site fell within the rule. This conclusion was based on the conclusion [page 431] that the employee’s work commenced at Perth Airport, and therefore the cost of travel from that airport would have been deductible to the employee in accordance with Lunney v FCT (1958) 100 CLR 478: see John Holland Group at [8]–[12]. For the otherwise deductible rule to apply, it is usually necessary for the employee to provide the employer with a declaration in the approved form before the date on which the employer’s FBT return is due. The declaration is not required in relation to airline transport, expense payments, property or residual benefits where, if the employee had incurred the expenditure directly, it would have been exclusively incurred in gaining or producing salary or wages of the recipient in respect of the employment to which the benefit relates. In the case of recurring expense payments, property and residual fringe benefits, FBTAA s 152A allows an employee to make a single declaration in respect of a series of benefits. This option is available where the benefits are essentially the same except for differences in the proportion of their business use or in their values: see FBTAA s 152A(10). A new declaration is required in the case of these benefits every five years (FBTAA s 152A(6)) or where there has been a more than 10% decrease in the business use of the benefit (FBTAA s 152A(7)).

Review the reasons why the 1985 Draft White Paper favoured imposing FBT on employers as a final tax rather than as a withholding tax: see 7.3. To what extent, if at all, does the ‘otherwise deductible’ rule mean that these reasons have less validity? A suggested response can be found in Study help.

‘In-house’ fringe benefits 7.26 Commonly, the cost to an employer of providing an ‘in-house’ fringe benefit will be less than its retail market value or its value to the employee. In these circumstances, it may be that, even where the benefit is valued at market value for FBT purposes, an employer will prefer to pay an employee in fringe benefits rather than salary in order to lower its costs. Some tax theorists argue that the advantage the employer gains by paying in fringe benefits rather than salary is a product of cost rather than tax considerations and so that advantage should not be taxed.16 The FBTAA gives some recognition to this argument by making the taxable value of certain in-house benefits either a wholesale value or 75%17 or 37.5% (in the case of [page 432] airline transport fringe benefits in some circumstances) of their retail value. In the absence of these valuation rules, imposition of FBT at the top marginal rate would mean that employers would not wish to reward lower marginal rate employees with in-house fringe benefits. This would not be economically efficient as the imposition of FBT at this rate would inhibit employers from choosing the most cost-effective method of employee remuneration.18

Other concessions 7.27 FBTAA Pt III Div 14 is a collection of miscellaneous concessional provisions that reduce what would otherwise be the

taxable value of certain fringe benefits. These include benefits in relation to remote area fuel, remote area housing, remote area holiday transport, overseas employment holiday transport, relocation transport and temporary accommodation, employment interviews and selection tests, work-related medical examinations, living away from home food, entertainment, and the education of the children of overseas employees. A further provision in Div 14, FBTAA s 62, reduces the taxable value of an in-house fringe benefit or of an airline transport fringe benefit by an amount not exceeding $500 per year. The taxable value of benefits relating to certain remote area housing schemes is amortised over periods varying between seven and 15 years (depending on when the benefit was provided) under FBTAA Div 14A.

Rules for specific types of fringe benefit 7.28 The FBTAA has rules for classifying benefits into particular types. This is done largely so that specific valuation rules can be applied to specific types of benefit. You will note that the rules enable benefits to be classified as, for example, car benefits, or debt waiver benefits or loan benefits. Usually the classification of a benefit as falling into one or another of these categories will not of itself mean that the benefit is a ‘car fringe benefit’ or a ‘debt waiver fringe benefit’ or a ‘loan fringe benefit’ and so on. For any benefit to be a fringe benefit it must fall within the definition of ‘fringe benefit’ discussed in 7.8–7.16. Having established that a benefit is a particular type of benefit and having determined that it is a fringe benefit, you can then apply the specific valuation rules relevant to that particular type of fringe benefit. Taxation Ruling TR 2001/2 at para 21 indicates that, following the introduction of GST, the taxable value of fringe benefits will be calculated on a GST-inclusive basis where appropriate.

Car fringe benefits 7.29 The benefit described in FBTAA s 7(1) is a ‘car benefit’. That definition is as follows:

[page 433]

7 Car benefits (1) [Employment benefit] Where: (a) at any time on a day, in respect of the employment of an employee, a car held by a person (in this subsection referred to as the provider): (i) is applied to a private use by the employee or an associate of the employee; or (ii) is taken to be available for the private use of the employee or an associate of the employee; and (b) either of the following conditions is satisfied: (i) the provider is the employer, or an associate of the employer, of the employee; (ii) the car is so applied or available, as the case may be, under an arrangement between: (A) the provider or another person; and (B) the employer, or an associate of the employer, of the employee, that application or availability of the car shall be taken to constitute a benefit provided on that day by the provider to the employee or associate in respect of the employment of the employee.

Read the s 7(1) definition. FBTAA s 136 tells us that a ‘car benefit’ means a benefit referred to in s 7(1). In your own words, list the essential elements in the benefit referred to in s 7(1). A suggested solution can be found in Study help.

Under FBTAA s 136, a ‘car’ means a motor vehicle (including a fourwheel drive) such as a motor car, station wagon, panel van, utility or similar vehicle, designed to carry a load of less than one tonne, or any other vehicle designed to carry a load of less than one tonne or fewer than nine passengers. The definition specifically excludes a motorcycle

or similar vehicle. A motorcycle fringe benefit, therefore, falls under the ‘miscellaneous fringe benefit’ category. Note that the provision of a car for an employee or associate will be a car fringe benefit only if the car is either applied for the private use of the employee or is taken to be applied for the private use of the employee. In relation to a motor vehicle, in relation to an employee or an associate of an employee, ‘private use’ is defined by FBTAA s 136 as meaning any use of the motor vehicle by the employee or the associate that is not exclusively in the course of producing the employee’s assessable income. [page 434] 7.30 Where a car, held by an employer or an associate or under an arrangement with a third person, is garaged or kept at or near the residence of an employee or an associate of the employee, the car is taken to be available for the private use of the employee or associate at that time.19 Under FBTAA s 7(3), a car is also taken to be available for private use where it is held by an employer or an associate or by a third party under an arrangement and is not kept at the business premises of the employer, the associate or the third party and either: the employee is entitled to apply the car for private use;20 or the employee, when not performing the duties of his or her employment, has custody or control of the car; or an associate of the employee is entitled to use the car privately or has custody or control of the car. If the application or availability of a car is not a benefit under FBTAA s 7, then FBTAA s 8(1) will mean that it is an exempt benefit. This provision prevents a car which does not fall within the s 7(1) definition of car benefit from being taxed as any other kind of fringe benefit, such as a residual benefit. Under FBTAA s 8(2), a car benefit is exempt where: the car is a taxi, panel van, utility or truck designed to carry a

load of less than one tonne or any other vehicle designed to carry a load of less than one tonne or nine persons; and there was no private use of the car during the year of tax in which it was provided other than work-related travel (ie, travel to and from work or travel incidental to travel in the course of performing employment duties) or other private use that was minor, infrequent or irregular. The provision of an unregistered car wholly or principally directly in connection with the business operations of the employer or a related company is an exempt car benefit under FBTAA s 8(3).

Valuation rules for car fringe benefits 7.31 Employers may choose from two alternative methods for valuing car fringe benefits. These are the statutory formula method and the operating cost method. If an election is not made, the statutory formula method is used. Employers may switch between methods annually. Even if the employer elects for the operating cost method, FBTAA s 10(5) means that the statutory formula method will apply where it produces a lower taxable value. [page 435] The statutory formula is set out in FBTAA s 9. The formula is:

where: A is the ‘base value of the car’ when first held by the provider; B is the ‘statutory fraction’; C is the number of days the vehicle is privately used or is available for private use;

D is the number of days in the tax year; and E

is the recipient’s payment.

Where, at the earliest time that the car was held by the provider or an associate, the car was owned by the provider or the associate, the ‘base value of the car’ is its cost price to the provider or the associate.21 Where the car has been held for four years or more at the commencement of the FBT year, the base value is two-thirds of the cost price of the car to the provider or the associate. In non-ownership cases, the base value of the car is the leased car value of the car to the provider or the associate at the earliest time that the provider or the associate held the car plus the cost price of each non-business accessory fitted to the car after that time. Where the car has been held for four years or more at the commencement of the FBT year, the base value is twothirds of the lease value of the car to the provider or the associate. Taxation Ruling TR 2001/2 at paras 75–77 indicates that, following the introduction of GST, the cost price of a manufactured, purchased or leased car will normally be the GST-inclusive value. For all contracts entered into after 7.30 pm on 10 May 2011, a flat statutory rate of .2 applies for the FBT year commencing 1 April 2014. For contracts entered into prior to 7.30 pm on 10 May 2011, the statutory fraction depended on the distance travelled by the car in the FBT year — the further the car travelled, the lower the rate that applied. The new flat statutory fraction was introduced to overcome the incentive for employees to use their cars more than they would otherwise have done in order to take advantage of the decline in the statutory fraction afforded to cars as the distance travelled by the car in the FBT year increased. In broad terms, the ‘recipient’s payment’ is the amount of the recipient’s contribution towards the provision of the car and its running expenses. Declarations in the approved form or documentary evidence are required in relation to a recipient’s contribution to running expenses. [page 436]

From 1 April 2015, George W’s employer provides him with a new Toyota Camry as part of his salary package. The leased value of the car was $26,000. The lease costs are $700 per month. The other running costs for the car including registration and insurance are $350 per month. Assume that, during the FBT year ending 31 March 2016, the car travelled 20,000 km, 30% of which was on business. Under the statutory formula method the value of the car fringe benefit will be calculated as follows:

A is the base value of the car — in this case, $26,000. B is the statutory fraction — in this case, 0.20 (the transitional measures specified in Taxation Laws Amendment (2011 Measures No 5) Act 2011 (Cth) will not apply as the car is provided under a new arrangement entered into after 10 May 2011). C is the number of days the vehicle was available for private use — in this case, 365. D is the number of days in the FBT year — in this case, 366. E is the recipient’s contribution — in this case, $0. Hence the value of the car fringe benefit will be: ($26,000 × 0.20 × 366/366) − 0 = $5200 To calculate the taxable value of the fringe benefit, this value is then grossed up as follows: $5200 × 2.0802 = $10,817.04 (assuming the benefit is GST creditable) The FBT payable on the fringe benefit would be: $10,817.04 × 47% = $5084.01

7.32 When the operating cost basis is used, the taxable value of a car fringe benefit is determined using the formula set out in FBTAA s 10(2):

where: C is the operating cost during the holding period.

BP is the business use percentage applicable for the car for the holding period (the business use percentage is reduced to nil under FBTAA ss 10A and 10B if log [page 437] book records22 are not maintained). The effect of this aspect of the formula is not to impose FBT on the business percentage use of the vehicle. In effect, this amounts to applying the otherwise deductible rule in the calculation of value of a car fringe benefit using the operating costs method. R is the amount (if any) of the recipient’s payment. The operating cost of the car23 during the holding period is defined in FBTAA s 10(3). Where the car is owned by the provider, the costs include registration and insurance expenses, other car expenses (other than insured repair expenses),24 depreciation, deemed interest, and depreciation and deemed interest in relation to non-business accessories fitted to the car. Where the car is leased by the provider, the operating cost includes registration and insurance expenses, and other car expenses, but does not include depreciation or deemed interest,25 or depreciation or deemed interest on any non-business accessory fitted to the car. The operating expenses of a leased car include so much of the charges paid or payable under the lease agreement as are attributable to the holding period.26 Where the car is neither leased nor owned by the provider, the operating costs include the amount of depreciation and interest that would be deemed to have been incurred by the provider if the car had been purchased for a consideration equal to the leased car value at the time that the provider commenced holding the car. The deemed rate of depreciation is calculated by dividing the diminishing value percentage at the start of the year (currently 200%) by the effective life of the car determined by the Commissioner of

Taxation (currently eight years). Thus, the deemed depreciation rate is 25%. Taxation Ruling TR 2001/2 indicates that, following the introduction of GST, the operating costs will be taken into account at their GSTinclusive value. The ‘recipient’s payment’ is defined in FBTAA s 10(3)(c). In essence, it will again be the recipient’s contribution towards the cost of the car and its running expenses. [page 438]

Assume the facts in Example 7.2. The value of the car fringe benefit under the operating costs method would be: [C × (100% − BP)] − R C is the operating costs in the holding period — in this case: $1050 × 12 = $12,600 BP is the business percentage use for the holding period — in this case, 30%. R is the recipient’s contribution — in this case, $0. Therefore, the value of the fringe benefit under the operating cost method is: [$12,600 × (100% − 30%)] − 0 = $8820 To calculate the taxable value of the fringe benefit, it is then grossed up as follows: $8820 × 2.0802 = $18,347.36 The FBT payable would be calculated as: $18,347.36 × 47% = $8,623.26

Debt waiver fringe benefits 7.33 The waiver of an obligation to pay or repay an amount is taken by FBTAA s 14 to constitute a benefit provided by the person waiving the obligation (the provider) to the person whose obligation is waived (the recipient). Under FBTAA s 15, the taxable value of a debt waiver

fringe benefit is the amount of the payment or repayment which is waived.

Loan fringe benefits 7.34 The making of a loan by a provider to a recipient is taken by FBTAA s 16 to constitute a benefit provided by the provider to the recipient in respect of each year of tax where the recipient is, in the whole or a part of the year, under an obligation to repay the whole or any part of the loan. Note that a recipient can be under an obligation to repay the whole or part of a loan in a given year even though the recipient is not obliged to make any repayments of principal in that particular year. It seems that it is enough that the obligation to repay the loan at a future date be current in the year of tax. FBTAA s 136 defines a ‘loan’ as including: an advance of money; the provision of credit or any other form of financial obligation; the payment of an amount for, on account of, on behalf of, or at the request of a person where there is an express or implied obligation to repay the amount; a transaction which in substance effects a loan of money. [page 439] FBTAA s 16(2) deems any debt which is unpaid at the date that it is due for payment to be a loan made at that time by the creditor to the debtor. The rate of interest on the deemed loan is taken to be the rate of interest payable on the unpaid debt. Where no interest is payable on the unpaid debt, the rate of interest on the deemed loan is taken to be nil. Unpaid interest accruing for periods of six months or more on a deferred interest loan is taken by FBTAA s 16(3) to be an additional loan by the provider at a nil rate of interest. The scope of the loan fringe benefit provisions was considered in the

Full Federal Court decision in Westpac Banking Corporation v FCT (1996) 34 ATR 143.

Westpac Banking Corporation v FCT Facts: Westpac Banking Corporation provided loans to its employees at concessional interest rates. Establishment fees that the bank usually charged to the public were not normally charged to its employees. The bank argued that the forgoing of the establishment fees was part of the loan fringe benefit and was taxable only under FBTAA Pt III Div 4 relating to loan fringe benefits. This would mean that the taxable value of the fringe benefit would be limited to the difference between the interest rate charged and the benchmark interest rate. The Commissioner argued that services associated with the establishment of the loan were a residual fringe benefit. Held: Although a loan fringe benefit within FBTAA Pt III Div 4 could not at the same time be a residual benefit under FBTAA Pt III Div 12, that did not mean that Div 4 operated as an exclusive code for all benefits in any way related to loans. Division 4 did not deal with the provision of services antecedent to the making of a loan. Rather, such services were dealt with under Div 12 dealing with residual benefits. Lindgren J (with whom Lockhart and Sackville JJ agreed on this point) said (at 151): In my view Div 4 catches in respect of any year of tax only the making of a loan as defined where the recipient is under an obligation to repay the whole or a part of the loan during the whole or a part of that year. The Bank’s investigation, assessment and determination of an application, writing of the letter of approval and receipt of the signed acknowledgment do not, of course, themselves generate an obligation to repay.

[page 440] 7.35 In several instances, the making of a loan will be an exempt loan benefit under FBTAA s 17. The three categories of exemption are: 1. loans by providers who are in the business of making loans to the public provided the interest rate charged does not at any time fall below the arm’s length rate charged to members of the public; 2. loans made solely for the purpose of meeting employment-related

3.

expenses provided the loan is not substantially in excess of the expenses and the employee is required to account for the loan within six months and to repay any excess; and loans repayable within 12 months whose sole purpose is to enable the employee to pay a rental bond, or a security deposit in relation to electricity, gas or telephone services or a similar amount in relation to temporary accommodation.

7.36 Under FBTAA s 18, the taxable value of a loan fringe benefit is the amount by which the notional amount of interest in relation to the loan in respect of the year of tax exceeds the amount of interest that has accrued on the loan in the year of tax. For loans made after 1 July 1986, the notional amount of interest is the amount of interest that would have accrued on the loan if interest were calculated on the daily balances of the loan at the statutory interest rate in relation to the year of tax. The ‘statutory interest rate’ is defined in FBTAA s 136 as being the ‘benchmark interest rate’. As from 1 April 1994, the benchmark interest rate is the large bank housing lenders’ variable interest rate for owner-occupied housing last published by the Reserve Bank before the beginning of the FBT year. For the FBT year commencing 1 April 2017, the benchmark interest rate is 5.25%: see Taxation Determination TD 2017/3. The taxable value of a loan fringe benefit is reduced by the otherwise deductible rule where interest that would otherwise have been payable on the loan would have been deductible to the employee. The amount of the reduction is the amount of the deduction that the employee would have been entitled to (but for ITAA36 s 82A and the substantiation provisions) less any deduction that the employee has actually obtained.

Expense payment fringe benefit 7.37 An expense payment fringe benefit is taken to arise when a provider makes a payment to discharge, in whole or part, an obligation of the recipient to a third person in respect of expenditure incurred by the recipient, for example, if an employer pays an employee’s credit

card debt: FBTAA s 20(a). A reimbursement, in whole or part, by the provider of an expense incurred by the recipient is also taken to constitute a benefit provided by the provider to the recipient. FBTAA s 136 extends the ordinary usage meaning of ‘reimburse’ to include ‘any act having the effect or result, direct or indirect, of a reimbursement’. Taxation Ruling TR 2001/2 at para 82 indicates that, following the introduction of GST, the taxable value of an expense payment fringe benefit will include any GST payable. Often it is difficult to distinguish between an ‘allowance’, which will form part of ‘salary and wages’ and, hence, will not be a fringe benefit, and a ‘reimbursement’ under the extended meaning in FBTAA s 136, which will be a fringe benefit. In TR 92/15, the Commissioner expressed the distinction in these terms: [page 441]

TR 92/15 2. A payment is an allowance when a person is paid a definite predetermined amount to cover an estimated expense. It is paid regardless of whether the recipient incurs the expected expense. The recipient has the discretion whether or not to expend the allowance. 3. A payment is a reimbursement when the recipient is compensated exactly (meaning precisely, as opposed to approximately), whether wholly or partly, for an expense already incurred although not necessarily disbursed. In general, the provider considers the expense to be its own and the recipient incurs the expenditure on behalf of the provider. A requirement that the recipient vouch expenses lends weight to a presumption that a payment is a reimbursement rather than an allowance. A requirement that the recipient refunds unexpended amounts to the employer adds further weight to that presumption. 4. The meaning of the word ‘reimburse’ includes payments made in advance of expenditure as long as those payments possess the characteristics outlined in paragraph 3.

The difficulty of drawing the distinction between a reimbursement

and an allowance can be seen in the following case example: Roads & Traffic Authority of New South Wales v FCT (1993) 26 ATR 760.

Roads & Traffic Authority of New South Wales v FCT Facts: The Roads & Traffic Authority (RTA) paid a fare allowance to employees for travel between home and work. The allowance was based on the public transport fare for the shortest possible route between the employee’s home and place of work. The allowance was payable only if the employee travelled by a ‘conveyance’ but employees were not required to use public transport. No check was made as to whether employees did, in fact, use public transport or incur any transport expense at all. Issue: One of the issues in the case was whether the fare allowance was a fringe benefit on the basis that it was a reimbursement. Held: Hill J made the following comments at ATR 812 on the meaning of ‘reimbursement’ in the FBTAA: Notwithstanding the width of the definition of “reimburse” contained in s 136(1), I doubt if it could properly be said that a payment of an amount of money having no relationship at [page 442] all to the actual cost (for example, of private car transport) operated so as to have the effect or result, directly or indirectly, of reimbursing the whole or part of the expenditure of operating the vehicle. It seems to me that the concept of reimbursement requires that the payment in question be made by reference to actual cost, that is to say that there would need to be some correspondence between the payment and the expenditure incurred, even if the reimbursement were to be but partial reimbursement. Hill J went on to state that, in his view, the payments to employees who actually used public transport would be ‘reimbursements’ while the payments to other employees would not be. However, it was not necessary to decide this question as the payments were clearly ‘salary or wages’ and hence could not be fringe benefits. Hill J considered that the payments might be ‘allowances’ and noted that, in his view, a ‘reimbursement’ under the extended meaning in FBTAA s 136 and an ‘allowance’ are not necessarily mutually exclusive concepts. Even if they were mutually exclusive concepts, the payments were ‘salary or wages’ as they formed part of the salary or wages paid to employees in their capacity as employees under ITAA36 s 221A.

With respect, the suggestion by Hill J in Roads & Traffic Authority of New South Wales that an allowance and a reimbursement under the extended definition are not necessarily mutually exclusive concepts is not helpful. As no obligation was placed on the employees to account for the payments, it may be questioned whether, even in the case of employees who travelled by public transport, the basis on which the payments were made was to compensate exactly for transport expenses incurred by employees. Under this analysis, none of the payments would be reimbursements but they all, clearly, would be allowances. No question would have arisen as to whether the payments could have both characters. The Commissioner’s view is that a reimbursement cannot also be within the definition of salary and wages: see TD 93/229. 7.38 are:

Certain expense payment benefits are exempt benefits. These expense payment fringe benefits covered by a no-private use declaration in the approved form by the employer (FBTAA s 20A); expense payment fringe benefits provided in respect of accommodation for eligible family members where the accommodation is required because the employee is required to live away from his or her usual place of residence to perform his or her duties and where the employee gives the employer a declaration in the approved form (FBTAA s 21); [page 443]

expense payment benefits in the form of certain reimbursements of car expenses incurred by the employee in relation to a car owned or leased by the employee (FBTAA s 22). Different rules apply for determining the taxable value of expense payment fringe benefits depending on whether the expense payment benefit is ‘in-house’ or is ‘external’. In the case of an external benefit, the taxable value is the payment made by the provider reduced by the

recipient’s contribution (if any) or the amount of the reimbursement made by the provider: FBTAA s 23. The taxable value of an external expense payment fringe benefit may be reduced under the ‘otherwise deductible’ rule in FBTAA s 24 as discussed at 7.25. In the case of an ‘in-house’ expense payment fringe benefit, a distinction is made between ‘in-house property’ expense payment fringe benefits and ‘in-house residual’ expense payment fringe benefits. An inhouse property expense payment fringe benefit arises where the recipient’s expenditure was incurred in respect of a property fringe benefit and either: the employer or an associate of the employer provided the property and at the time of provision carried on a business that consisted of or included the provision of identical or similar property principally to outsiders; or the property was acquired by the provider (who was not the employer or an associate of the employer) from the employer or an associate of the employer and at the time of the provision the employer or an associate of the employer carried on a business that consisted of or included the provision of identical or substantially similar property principally to outsiders. According to FBTAA s 22A, the taxable value of an in-house property fringe benefit is the amount that would have been calculated under FBTAA s 42 (see 7.49) as the taxable value of the fringe benefit if the provision of the property were an in-house property fringe benefit and if the recipient’s contribution (if any) were reduced by the expense payment by the provider or by the amount reimbursed by the provider. An in-house residual expense payment fringe benefit arises where the recipient’s expenditure was incurred in respect of the provision of a ‘residual benefit’ by a residual benefit provider. A ‘residual benefit’ is defined in FBTAA s 45. Where the residual benefit provider is the employer or an associate of the employer, the employer or associate, at or about the time of the provision, must have carried on a business that consisted of the provision of identical or similar benefits principally to outsiders. Otherwise, the residual benefit provider must have purchased the benefit from the employer or an associate of the employer and, at

about that time, the employer or an associate of the employer must have carried on a business that consisted of the provision of identical or similar benefits principally to outsiders. The taxable value of an in-house residual fringe benefit is the amount that would have been calculated under FBTAA s 48 or s 49 (see 7.54) as the taxable value of the fringe benefit if the provision of the residual benefit were an in-house residual fringe benefit and if the recipient’s contribution (if any) were reduced by the expense payment by the provider or by the amount reimbursed by the provider. The taxable value of expense payment fringe benefits is reduced under the ‘otherwise deductible rule’. In broad terms, the amount of the reduction is the amount [page 444] of the deduction that the employee would have been entitled to (but for ITAA36 s 82A and the substantiation provisions) less any deduction that the employee has actually obtained.27

Housing fringe benefits 7.39 The existence of a lease or licence granted by the provider to the recipient to occupy or use a unit of accommodation at a time when the unit of accommodation is the recipient’s usual place of residence is taken to be a benefit provided by the provider to the recipient. After 1 April 1997, housing benefits provided by primary producers to employees employed in primary production were exempt under former FBTAA s 58ZA. As noted below, this exemption was broadened with the introduction of the remote area housing exemption (FBTAA s 58ZC) with effect from 1 April 2000. Accommodation provided by a government, religious body or non-profit company to an employee who cares for elderly or disadvantaged people and lives with them to perform his or her duties is an exempt fringe benefit under FBTAA s 58. The taxable value of a housing fringe benefit varies according to

whether the benefit is a ‘remote area housing fringe benefit’ or is a ‘nonremote area housing fringe benefit’. Taxation Ruling TR 2001/2 indicates that, following the introduction of GST, as a supply of residential premises by way of lease or licence will be input taxed, there will generally be no GST levied on the supply. The taxable value of a non-remote area housing fringe benefit, where the unit of accommodation is not located in a state or internal territory, is so much of the market value of the lease or licence as exceeds the rent paid by the recipient. Where the unit of accommodation is located in a non-remote area in a state or internal territory, the valuation rule differs according to the nature of the provider’s business. Where the unit of accommodation is a caravan or mobile home, or is in a hotel, motel, hostel or guest house and the provider carried on a business of providing similar accommodation to outsiders under similar leases or licences, only 75% of the market value of the lease or licence28 is taken into account in determining the taxable value of the housing fringe benefit. In other cases, the taxable value of a non-remote area housing fringe benefit is the statutory value of the lease or licence multiplied by the number of days in the tenancy period and divided by the number of days in the year. The statutory annual value of the lease or licence depends on whether the year of tax is a base year. If the year is a base year, then the statutory annual value is the market value of the lease or licence multiplied by the number of days in the year and divided by the number of days in the tenancy period. Where the year is not a base year, then the statutory annual value will generally be the statutory annual value of the lease or licence for [page 445] the previous year multiplied by the indexation factor29 in respect of the current year of tax in respect of the state or territory. The employer can elect that a year of tax be a base year provided that there was either no housing fringe benefit provided to the recipient in the immediately

preceding year or that a housing fringe benefit was provided to the recipient for each of the preceding nine years and that none of the preceding nine years was a base year. The effect of this rule is that every 10 years there will be a new base year. As from 1 April 2000, remote area housing will generally be FBT exempt under FBTAA s 58ZC.

Living away from home allowance fringe benefits 7.40 It is not unusual for an employee to have higher than normal living expenses when living away from home while working. For example, where kitchen and laundry facilities in the employee’s temporary accommodation are inadequate, there is a natural tendency for the employee to rely more on prepared meals and laundry services. Where it would be concluded that an allowance was paid to an employee: 1. in whole or part to compensate him or her for additional (nondeductible) expenses (or for additional (non-deductible) expenses and other disadvantages) associated with living away from home; and 2. the employee is required to live away from her or his usual place of residence in order to perform the duties of that employment; the allowance is a benefit under FBTAA s 30. If the benefit meets the other criteria of a fringe benefit, then it will be a living away from home allowance fringe benefit (LAFHA). Unlike other allowances, a LAFHA is not included in the employee’s assessable income. Rather, the employer pays FBT on the LAFHA. However, as described below, the calculation of the taxable value of this benefit incorporates a concessional element. The scope of this concession was curtailed by the Tax Laws Amendment (Measures No 4) Act 2012 (Cth) (see below). With respect to the first element, in Atwood Oceanics Australia Pty Ltd v FCT (1989) 20 ATR 742, Lee J in the Federal Court held that, although it would be concluded that a living away from home allowance paid to workers on an offshore oil rig was paid to

compensate them for other disadvantages suffered because the workers were required to live away from home to perform their duties, the allowance was not a LAFHA. This was because it could not be concluded that the allowance was paid to compensate the workers for additional expenses incurred and other disadvantages suffered. On the oil rig, the workers could not incur additional expenses as all their normal living requirements were met without charge by their employer. To similar effect, see Best v FCT (2005) 59 ATR 1151 and Crane v FCT (2005) 60 ATR 1170, where merchant seamen paid a ‘hardlying’ allowance in consideration for having to share a cabin while on their vessel were held to receive an assessable allowance rather than a LAFHA. [page 446] Following the decision in Atwood Oceanics Australia Pty Ltd, FBTAA s 30(2) was inserted in 1991. Section 30(2) applies where the employee’s usual place of employment is an oil rig or other petroleum or gas installation at sea. Where the employee is provided with residential accommodation at or near his or her place of employment and is paid an allowance that is expressed to be paid as a living away from home allowance, but that allowance does not fall within s 30(1), it will be a LAFHA under s 30(2) if it would be concluded that the whole or part of the allowance was in the nature of compensation for disadvantages that the employee suffers because he or she is required to live away from home. Thus, FBTAA s 30(2) will now catch allowances paid to compensate employees for non-monetary disadvantages associated with living on an oil rig even though the employees incur no additional expenses. For an allowance to fall within FBTAA s 30(1), the additional expenses that the LAFHA is regarded as compensating for must not be expenses that are deductible to the employee. Thus, in Roads & Traffic Authority of New South Wales v FCT (1993) 26 ATR 760, Hill J in the Federal Court held that a camping allowance paid to employees of the

authority would be concluded to be in the nature of compensation for additional expenses and other disadvantages associated with living away from home. Nonetheless, Hill J held that the allowance was not a LAFHA as the additional expenses, on food and other living expenses, would have been deductible to the employees. This was because the occasion of the outgoing (expenditure incurred while living away from home while working) stamped it as having a business or employmentrelated character. Under the approach taken by Hill J in Roads & Traffic Authority of New South Wales, it will be unusual for an allowance to amount to a LAFHA under FBTAA s 30(1) as the additional expenses will usually be deductible to the employee.30 With respect to the second element, that the employee be required to live away from his or her ‘normal residence’: ‘Normal residence’ is a phrase defined in FBTAA s 136. With respect to earlier wording of the provision expressed in terms of the employee’s ‘usual place of residence’, in Compass Group (Vic) Pty Ltd v FCT (2008) 71 ATR 720; [2008] AATA 845, the AAT decided that FBTAA s 30 could not apply where an employee chose to rent an apartment nearer to his workplace while maintaining his usual place of residence. The definition of the taxable value of a living away from home allowance may incorporate a concessional component. As a result of amendments made by the Tax Laws Amendment (Measures No 4) Act 2012 (Cth), the scope of this concession has been restricted to two categories of employees: [page 447] 1.

2.

those living away from their normal residence in Australia, provided that their normal residence remains available for their immediate use. Further, the concessional calculation of the taxable value of the LAFHA is limited to allowances paid with respect to the first 12 months that the employee is required to live away from their normal residence (see FBTAA s 31D); and employees employed on a fly-in/fly-out basis, or on a drive-

in/drive-out basis. There is no concessional calculation of taxable value of LAFHA for any other employee. According to FBTAA s 31, the taxable value of a LAFHA covered by FBTAA s 30(1) is the amount of the allowance reduced by any ‘exempt accommodation component’ and any ‘exempt food component’. The expressions ‘exempt accommodation component’ and ‘exempt food component’ are defined in FBTAA s 136. For oil and gas rig employees to whom FBTAA s 30(2) applies, the entire LAFHA is the value of the benefit. For other employees, FBTAA s 136 states that the exempt accommodation component will, subject to the provision of declarations in the approved form, be so much of the allowance as would be concluded to be in the nature of compensation for additional accommodation expenses as might reasonably be expected to be incurred for the accommodation of the employee and his or her family during the allowance period. Thus, to the extent that a LAFHA represents reasonable accommodation expenses, it will not be subject to FBT. To the extent that the accommodation component of a LAFHA exceeds what is reasonable, it is subject to FBT. The valuation rule reflects an assumption that, in the absence of work-related travel and a LAFHA, reasonable accommodation would be available for the employee at home. Hence, accommodation up to a reasonable level is not seen as a benefit while accommodation beyond that level is regarded as a benefit. According to the definition of ‘exempt food component’ in FBTAA s 136, the amount of the exempt food component varies according to how the LAFHA is calculated and according to the amount of the allowance. One set of rules applies where the food component of the LAFHA is calculated by allowing for the amount (the ‘deducted home consumption expenditure’) which might reasonably have been expected to have been incurred by the employee in respect of food and drink for the employee and his or her family at the employee’s usual place of residence. Here, if the deducted home consumption is equal to or more than the statutory food amounts in respect of eligible family members,

the exempt food amount is the food component of the LAFHA. That is, provided the food component of the LAFHA is calculated in this manner, the taxable value of the LAFHA will be reduced by the amount of the food component where the employer has allowed for normal food consumption expenditure when calculating the employee’s food component, and the amount of the reduction of the food component exceeds the statutory benchmark. Where the ‘deducted home consumption expenditure’ is less than the statutory food component, the exempt food component is the food component less the excess of the statutory food amount over the deducted home consumption expenses. Where the food component was not calculated by allowing for deducted home consumption expenditure, the exempt food component is the amount of the allowance less [page 448] the statutory food amount. In this, more usual, situation, the effect of the valuation rule is that the statutory food amount is subject to FBT while the excess of the allowance above that amount escapes FBT.

Airline transport fringe benefits 7.41 The provision of airline transport (subject to standby restrictions applicable to airline industry employees) and incidental onboard services to an employee constitutes a fringe benefit under the FBTAA. As a result of amendments enacted in the Tax and Superannuation Laws Amendment (2013 Measures No 1) Act 2013 (Cth), these benefits are treated in the same manner as other in-house residual fringe benefits.

Board fringe benefits 7.42

The provision of a ‘board meal’ (defined in FBTAA s 136) by a

provider to a recipient constitutes a benefit under FBTAA s 35. To be a board meal, a meal must be provided to the recipient on a ‘meal entitlement day’, which is defined in FBTAA s 136 as a day on which the recipient is entitled (under an industrial award or an employment arrangement) to be provided with residential accommodation and on which the employee is entitled to receive two meals. Having regard to the definition of ‘board meal’, a board meal will generally be a meal that is cooked, or otherwise prepared, provided to an employee by an employer, or by a related company, and provided at eligible premises of the employer. The premises must not be open to the public. Meals prepared at premises for use wholly or principally for the cooking or preparation of meals solely for a particular employee or associate are excluded. Special provisions relate to meals provided to employees who work in, or whose work is associated with, an eligible dining facility. According to FBTAA s 36, the taxable value of a board fringe benefit is $2 per meal ($1 per meal where the employee is under 12 years of age) reduced by the employee’s contribution and by the otherwise deductible rule.

Meal entertainment fringe benefits 7.43 The meal entertainment fringe benefit provisions apply only at the employer’s election: FBTAA s 37AA. The provision of meal entertainment by an employer (the provider) to another person (the recipient) constitutes a benefit provided by the provider to the recipient. The ‘provision of meal entertainment’ is defined in FBTAA s 37AD as the provision of: entertainment by way of food or drink; or accommodation or travel in connection with or for the purpose of facilitating entertainment by way of food or drink; or the payment or reimbursement of expenses incurred in providing either of the above forms of entertainment. These forms of entertainment amount to meal entertainment whether or not: business discussions or business transactions occur;

[page 449] they are connected with the working of overtime or the performance of the duties of any office or employment; they are for the purposes of promotion or advertising; or they are at or in connection with a seminar. For the Commissioner’s views on the meaning of ‘meal entertainment’, see Taxation Ruling TR 97/17. For example, a sandwich lunch provided by an employer will not be ‘meal entertainment’, but a dinner held at a luxury resort during an annual residential seminar will be: Amway of Australia v FCT (2004) 57 ATR 339; [2004] FCA 273. If the employer elects for the meal entertainment fringe benefit provisions to apply, FBTAA s 37AF provides that no other fringe benefit applies in relation to the provision of the meal entertainment. Note that, as is the case with all benefits, a meal entertainment benefit will be subject to FBT only if it is a fringe benefit. Thus, meal entertainment benefits will be fringe benefits only if they are provided to employees or to associates of employees. A meal entertainment benefit that is provided to a non-employee, such as a client, will not be a fringe benefit, but the employer will be denied an income tax deduction in respect of the cost of providing the benefit. 7.44 An employer can elect to adopt one of two methods for valuing meal entertainment fringe benefits. However, this election is not available with respect to salary-packaged meal entertainment expenditure (with effect from 1 April 2016): FBTAA s 37AC. These methods are the 50/50 split method (FBTAA s 37BA) and the 12-week register period (FBTAA s 37C). The default method is the 50/50 split method. Under the 50/50 split method, the total taxable value of the meal entertainment fringe benefits for the FBT year is 50% of the expenses incurred by the employer in providing meal entertainment fringe benefits in the FBT year. Under the 12-week register period, the total taxable value of the meal entertainment fringe benefits for the FBT year is the total meal entertainment expenditure for the FBT year multiplied by the ‘register percentage’. The register percentage is

determined by dividing the total value of meal entertainment fringe benefits in a 12-week period by the total value of meal entertainment benefits in that period. Thus, the numerator in the fraction will generally be confined to meal entertainment benefits provided to employees while the denominator will include meal entertainment provided to non-employees such as clients. Taxation Ruling TR 2001/2 indicates that, following the introduction of the GST, as both methods are based on actual meal expenditure, the taxable value will be the GST-inclusive value of the expenditure where applicable. Entertainment provided by a tax-exempt employer for the benefit of an employee or associate of the employee will be a benefit under FBTAA s 38. Under FBTAA s 39, the taxable value of a tax-exempt employer entertainment fringe benefit will be so much of the employer’s expenditure on entertainment as is attributable to the entertainment of employees or their associates.

Car parking fringe benefits 7.45 The provision of certain parking facilities on or after 1 July 1993 to an employee is taken, under FBTAA s 39A, to be a benefit provided by the employer or [page 450] an associate in respect of the employment of the employee. The conditions that must be met before a car parking benefit arises are: on a particular day, the car must be parked at the business premises or associated premises of the provider for a period or periods exceeding four daylight hours (defined in FBTAA s 136 as the hours between 7 am and 7 pm); a commercial parking station must be located within a 1 km radius of the premises where the car is parked and the lowest fee charged to the public at that station for all day parking must be

more than the car parking threshold.31 In FCT v Qantas Airways Ltd [2014] FCAFC 168, the Full Federal Court considered the definition of ‘commercial parking station’. The Full Federal Court held that the reference to ‘public’ in the definition should be given its ordinary meaning. This decision means that airport parking stations are ‘commercial parking stations’, notwithstanding the fact that, as a matter of practice, or because of contractual stipulation (in the case of Canberra Airport), those parking stations were used by travellers, persons meeting travellers and/or persons sending off departing travellers. Accordingly, Qantas employees provided with parking on Qantas premises were held to receive a parking fringe benefit; any of the following conditions applies: – a car benefit relating to the car is provided by the employer or an associate on that day in respect of the employment of the employee; – the car is owned by, or leased to, an employee or an associate at any time during the period or periods; or – the car is made available to the employee or an associate of the employee at any time during the period or periods by another person who is not the employer or an associate of the employer and where the car was not made available under an arrangement to which the employer or an associate was a party; the provision of parking facilities for the period is in respect of the employment of the employee; the employee has a primary place of employment on that day and during the period or periods the car is parked at, or in the vicinity of, that place. In Virgin Blue Airlines Pty Ltd v FCT [2010] FCAFC 137; BC201008947, the Full Federal Court held unanimously that a car park that was 941 metres from the employee’s place of employment, but which was approximately 1.9 km away by the most direct travel route, was not near to or ‘in the vicinity’ of the primary place of employment; and

the provision of car parking facilities is not excluded from s 39A by the regulations. [page 451] 7.46 There are five choices of method for valuing car parking fringe benefits: 1. The default method for valuing car parking fringe benefits is set out in FBTAA s 39C. The method is simply the lowest fee charged for all-day parking by an operator of a commercial parking station within a 1 km radius of the employer’s premises, reduced by the amount of the recipient’s contribution. 2. The second valuation method allows the employer to elect for the car parking fringe benefit to be valued under FBTAA s 39D rather than under s 39C. Under FBTAA s 39D, the taxable value of a car parking fringe benefit will be the amount that the recipient could reasonably be expected to have paid to the provider for the car parking benefit in an arm’s length transaction, less the recipient’s contribution. The employer’s election that s 39D apply must be accompanied by an arm’s length valuer’s report about the valuation of the fringe benefit. The arm’s length value of the fringe benefit in the employer’s FBT return must be based on the valuer’s report. 3. Under the third valuation method, the employer may elect that the taxable value of car parking fringe benefits be determined under the ‘average cost’ method set out in FBTAA s 39DA. Under this approach, the taxable value of the car parking fringe benefit will be the average cost of the benefit less any recipient’s contribution. The average cost is the average of the lowest fee charged by a commercial operator within a 1 km radius of the employer’s premises on the first day of the FBT year, and the lowest fee charged by a commercial operator within a 1 km radius of the employer’s premises on the last day of the FBT year. Taxation Ruling TR 2001/2 at para 91 indicates that, following the

4.

5.

introduction of GST, the lowest fee charged will include GST. The fourth valuation method is the statutory formula method set out in FBTAA s 39FA. Employers can elect that this method will apply where the employer provides car spaces to employees. This method begins with the ‘daily rate amount’, which is the amount that would have been the taxable value of the benefit under either the default commercial parking station, arm’s length or average cost methods. The taxable value of the car parking benefit is then calculated using the following formula:

The final method is the 12-week record-keeping method set out in FBTAA s 39GA. Under this method, the employer determines the total value of car parking benefits by keeping a register for a representative 12-week period. The register calculates the value of car parking benefits provided under either the default commercial parking station, the arm’s length, or the average cost methods. The taxable value of the car parking fringe benefits provided in the year is then calculated using the formula:

[page 452]

Property fringe benefits 7.47 Under FBTAA s 40, the provision32 of property33 to another person constitutes a benefit provided by the provider to the recipient at that time. When a person does anything that results in the creation of property in another person, FBTAA s 154 deems the first person to have

provided the property to the other person when the property came into existence. A property benefit will be an exempt benefit where it is provided to a current employee in respect of his or her employment and is provided to or consumed by the employee on a working day and on business premises of the employer or a related company: FBTAA s 41. Note that this exemption does not apply where such benefits are provided under a salary sacrifice arrangement (such as a meal voucher ‘purchased’ with sacrificed salary): FBTAA s 41(2). Other exempt property benefits are noted at 7.55. The taxable value of a property fringe benefit varies depending on whether the benefit is an in-house or an external property fringe benefit. Taxation Ruling TR 2001/2 indicates at para 94 that, following the introduction of GST, whether or not the taxable value of a property fringe benefit is GST inclusive will depend on whether or not GST is payable on the supply. Under the FBTAA s 136 definition, an in-house property fringe benefit is a property fringe benefit in respect of tangible property and either: the provider was the employer or an associate and at or about the provision time the provider carried on a business that consisted of, or included the provision of, identical or similar property principally to outsiders; or the provider was not the employer or an associate but the provider acquired the property from the employer or associate (the seller) and at or about the time of the provision the seller carried on a business that consisted of, or included the provision of, identical or similar property principally to outsiders. An external property fringe benefit is a property fringe benefit that is not an in-house property fringe benefit. 7.48 The taxable value of an in-house property fringe benefit is determined under FBTAA s 42. The valuation rules vary according to two factors: whether the benefit is provided under a salary-packaging arrangement (defined in FBTAA s 136). In these cases, the taxable

value of the benefit is its notional value; and [page 453] whether the recipient’s property was manufactured, produced, processed or treated by the provider. Where the benefit falls within the second category (and is not provided under a salary-packaging arrangement), and the provider sold identical property in the ordinary course of business to manufacturers, wholesalers or retailers in arm’s length transactions, then the taxable value of the fringe benefit is the lowest price obtained in such transactions. Where the sales to manufacturers, wholesalers or retailers are not at arm’s length, the taxable value is the lowest price at which identical property could have been sold under an arm’s length transaction. Where the provider did not sell identical property to manufacturers, wholesalers or retailers, but did sell identical property in arm’s length transactions to members of the public in the ordinary course of business, the taxable value of the fringe benefit is 75% of the lowest price at which that property was sold to a member of the public. Where the sales to the public are not at arm’s length, the taxable value is 75% of the notional value (arm’s length value) of the recipient’s property at the time the property was provided. Where the provider did not manufacture, produce, process or treat the recipient’s property but acquired it, the taxable value of the fringe benefit is the lesser of the arm’s length price in respect of the acquisition (which will be the cost price if the transaction was at arm’s length) or the notional value (the amount at which the property could reasonably be expected to be acquired in an arm’s length transaction). In any other case, the taxable value of the fringe benefit is 75% of the notional value of the fringe benefit. In all of the above cases, the taxable value of the in-house fringe benefit is reduced by the amount of the recipient’s contribution. 7.49

Under FBTAA s 43, the taxable value of an external property

fringe benefit is: the cost to the provider in cases where the employer or an associate was the provider and the recipient purchased the property under an arm’s length transaction; the expenditure incurred by the employer or an associate where the provider was not the employer or an associate but the employer or an associate incurred expenditure to the provider under an arm’s length transaction; or in any other case the ‘notional value’ (reasonable arm’s length price to the recipient (see FBTAA s 136)) of the recipient’s property. In all of the above cases, the taxable value of the external property fringe benefit is reduced by the recipient’s contribution (if any). FBTAA s 44 reduces the taxable value of property fringe benefits via the otherwise deductible rule. Where the recipient employee would have been entitled to a once-only deduction for purchasing the property, the taxable value of the property fringe benefit is reduced by the amount of the once-only deduction less the recipient’s contribution (if any).

Residual fringe benefits 7.50 Anything that is within the FBTAA s 136 definition of ‘benefit’ (discussed in 7.9) that is not one of the specific benefits identified in FBTAA Subdiv A of Pt III [page 454] Divs 2–11 will be a residual benefit. In other words, residual benefits are any benefits that are not car benefits, debt waiver benefits, loan benefits, expense payment benefits, housing benefits, living away from home benefits, airline transport benefits, board benefits, meal entertainment benefits, tax-exempt body entertainment benefits, car parking benefits or property benefits: see FBTAA s 45.

Certain residual benefits are exempt benefits. These are: provision of transport between home and work for employees of operators of transport for members of the public (FBTAA s 47(1)); recreational or child-care facilities located on the business premises of the employer or of a related company (FBTAA s 47(2)); use of business property on the employer’s premises (FBTAA s 47(3)); accommodation for eligible family members provided because the employee is required to live away from home to perform his or her duties (FBTAA s 47(5)); provision or use of a motor vehicle where private use consists wholly of work-related travel or is minor, infrequent and irregular (FBTAA s 47(6)); provision or use of an unregistered motor vehicle wholly or principally used directly in connection with business operations of the employer or a related company (FBTAA s 47(6A)); certain transport between the employee’s usual place of employment and usual place of residence where the employee’s usual place of employment is an oil rig or other installation at sea and/or is in a state or internal territory but is not adjacent to an eligible urban area (FBTAA s 47(7)); and employer contributions to obtain priority of access to child-care benefits (FBTAA s 47(8)). 7.51 Taxation Ruling TR 2001/2 indicates at para 95 that, following the introduction of GST, the taxable value of a residual benefit will be GST inclusive or GST exclusive depending on whether or not GST is payable on the supply. The taxable value of a residual fringe benefit depends on which of the following classifications the benefit fits into: in-house non-period residual fringe benefits (FBTAA s 48); in-house period residual fringe benefits (FBTAA s 49); external non-period fringe benefits (FBTAA s 50);

external period fringe benefits (FBTAA s 51).

Categories of residual fringe benefits 7.52 An in-house non-period residual fringe benefit is an in-house fringe benefit that is not provided in a period. An in-house fringe benefit arises either: where the employer, or an associate, provides the benefit at or about the time when the employer, or an associate, carried on a business that consisted of or included the provision of identical benefits principally to outsiders; or where the provider purchased the benefit from the employer, or from an associate of the employer (‘the seller’) and at or about the time of provision the provider and the seller carried on a business that consisted of or included the provision of identical or similar property principally to outsiders. [page 455] A benefit provided under a contract of investment insurance is specifically deemed not to be an in-house residual fringe benefit. An in-house period residual fringe benefit means an in-house fringe benefit that is provided during a period. That is, where the benefit is provided during the course of a period, as where an employee is allowed to use property over a period of time: see FBTAA s 149(1). An external non-period residual fringe benefit means a non-period residual fringe benefit other than an in-house residual fringe benefit. An external period residual fringe benefit means a period residual fringe benefit other than an in-house residual fringe benefit.

Determining the taxable value of a residual fringe benefit 7.53 The taxable value of an in-house non-period residual fringe benefit is 75% of the lowest price at which an identical benefit was sold to a member of the public by the provider in arm’s length transactions

in the ordinary course of business. In any other case, the taxable value of an in-house non-period residual fringe benefit is 75% of the notional value of the benefit at the comparison time34 (in this case, the time when the benefit was provided). The taxable value of an in-house period residual fringe benefit is 75% of the lowest amount paid or payable by any member of the public in an arm’s length transaction in respect of a current identical benefit in relation to an identical overall benefit obtained. In any other case, the taxable value of an in-house period residual fringe benefit is equal to 75% of the notional value of the recipient’s current benefit. The taxable value of an external non-period residual fringe benefit is the amount the employer or provider paid for the benefit in an arm’s length transaction. Where the employer is not the provider but incurred expenditure to the provider under an arm’s length transaction to provide the benefit, the taxable value of the benefit is the amount of that expenditure. In any other case, the taxable value of an external non-period residual fringe benefit is the notional value of the benefit at the comparison time (here it is the time when the benefit was provided). The taxable value of an external period residual fringe benefit provided by the employer or an associate purchased under an arm’s length transaction is the amount payable by the employer or provider in respect of the recipient’s current benefit. Where the employer is not the provider but incurred expenditure to the provider under an arm’s length transaction in respect of the provision of the recipient’s current benefit, the taxable value is the amount of that expenditure. In any other case, the taxable value of an external period residual fringe benefit is the notional value of the recipient’s current benefit. [page 456] Under amendments introduced by the Tax Laws Amendments (2012 Measures No 6) Act 2013 (Cth), the concessional treatment is denied where the in-house benefit is accessed by way of a salary-packaging arrangement.

In all cases, the taxable value of a residual fringe benefit is reduced by the amount of the recipient’s contribution. FBTAA s 52 applies the otherwise deductible rule to reduce the taxable value of residual fringe benefits by the amount of a once-off deduction that the employee would have obtained less the amount of contribution by the recipient. Further, in accordance with FBTAA s 62, the sum of the taxable value of in-house fringe benefits and airline transport fringe benefits is reduced by $1000, but not to below zero.

Exempt fringe benefits 7.54 Several exempt fringe benefits have already been noted in our discussion of the specific categories of fringe benefits. In addition to those exemptions, which are contained in FBTAA Pt III Divs 2–12, a series of miscellaneous exempt benefits is set out in Pt III Div 13. Note that under the definition in FBTAA s 136, an exempt benefit will be excluded from being a fringe benefit. The exempt benefits in FBTAA Pt III Div 13 are: any car expense payment benefit, car property benefit and car residual benefit when attributable to a period when a car fringe benefit was provided (s 53); the provision of food or drink, not being a meal, at eligible premises of the employer when a board fringe benefit is provided to the employee (s 54); benefits provided by certain international organisations (s 55); benefits that would be exempt from tax because of diplomatic and consular immunity (s 56); benefits provided by a religious institution to a religious practitioner (or to a spouse or child of a religious practitioner) provided principally in respect of pastoral duties or in respect of any other duties or activities directly related to the practice, study, teaching or propagation of religious beliefs (s 57);

benefits provided by a public benevolent institution in respect of the employment of its employees: s 57A(1). As from 1 April 2001, this exemption has been capped at a grossed-up value of $30,000 of benefits for each employee (s 5B(1E)); as from 1 April 2003, benefits provided in respect of the employment of an employee of a government body where the duties of the employee are exclusively performed in, or in connection with either: – a public hospital; or – a hospital carried on by a non-profit society or a non-profit association: s 57A(2), (3) and (4). As from 1 April 2003, these exemptions are capped at a grossed-up value of $17,000 of benefits for each employee (s 5B(1E)); certain benefits provided to live-in residential care workers (s 58); [page 457] certain benefits provided in respect of employment interview and selection tests (s 58A); certain benefits provided in respect of the removal and storage of an employee’s household effects as a result of an employee being required to live away from home to perform duties, to return home to perform duties, or to change his or her usual place of residence to perform duties (s 58B); certain expense payments and residual benefits in connection with the sale or purchase of a dwelling which took place solely because the employee was required to change his or her usual place of residence to perform employment duties (s 58C); benefits provided in respect of the connection or re-connection of the employee’s (or family’s) telephone service, and/or gas or electricity supply arising because the employee is required to live away from home to perform duties, to return home to perform duties, or to change his or her usual place of residence to perform

duties (s 58D); exempt or residual benefits in connection with the leasing of household goods where benefits provided to the employee in relation to the lease or licence of accommodation are exempt benefits under either s 21 or s 47(5) (s 58E); certain benefits provided in respect of relocation transport (s 58F); expense payment benefits, other than eligible car parking expense payment benefits, in respect of the provision of motor vehicle parking facilities and residual benefits consisting of motor vehicle parking facilities (s 58G(1)); eligible car parking expense payment benefits and car parking benefits provided by scientific institutions, religious institutions, charitable institutions, public educational institutions or by government bodies to an employee employed in, or in connection with, a public educational institution (s 58G(2) and (3)); certain car parking benefits provided by small businesses entities (not public companies and with an ordinary and statutory income for the previous year of less than $10 m) (s 58GA); benefits relating to the provision of newspapers and periodicals for employees where the newspaper or periodical was for purposes that included gaining or producing the employee’s salary or wages (s 58H); certain benefits provided in relation to compensable work-related trauma (either under a workers compensation law or such benefit as is reasonable in the circumstances) (s 58J); benefits consisting of the provision of health care in an in-house health care facility (s 58K); certain benefits associated with travel from an overseas employment location to obtain medical treatment (s 58L); certain benefits associated with travel by the employee (or a close relative) either to visit a close relative (or the employee as the case may be) during a serious illness or to attend the funeral of a close relative (or the employee as the case may be) (s 58LA);

[page 458] benefits associated with work-related medical examinations, work-related medical screening, work-related preventative health care, work-related counselling and work-related migrant training (s 58M); certain benefits relating to the provision of emergency health care on the premises of the employer (or an associated company) or at or adjacent to the place where the employees perform their duties (s 58N); minor benefits (other than airline transport fringe benefits, inhouse fringe benefits and certain tax-exempt body entertainment fringe benefits) with a notional taxable value of less than $300 (s 58P(1)); associated benefits in relation to minor benefits (s 58P(2)); employer contributions to certain approved worker entitlement funds (s 58PA); part of the benefit received under a long service leave award (s 58Q); the first $200 received by an employee under safety awards (s 58R); certain benefits provided under the Australian Traineeship System (s 58S); certain benefits provided to live-in workers employed by religious institutions or by religious practitioners who render domestic or personal services for religious practitioners or their relatives (s 58T); certain benefits provided to live-in carers for elderly or disadvantaged persons (s 58U); food and drink provided to non-live-in domestic employees of natural persons or religious institutions (s 58V); deposits under the Small Superannuation Accounts Act 1995 (Cth) (s 58W);

the provision of certain work-related items (mobile phones, protective clothing, computer software, notebook computers, etc) (s 58X); subscriptions for trade or professional journals, entitlements to use corporate credit cards, and entitlements to use airport lounge membership (s 58Y); single taxi trips beginning or ending at the employee’s place of work. Taxi trips as a result of sickness of, or injury to, an employee between the employee’s place of work, place of residence or other appropriate place (such as a hospital) (s 58Z); from 1 April 2000, remote area housing benefits are exempt benefits. The conditions for the exemption are set out in s 58ZC; benefits provided in respect of participation by an employee in an approved secondary student exchange program (s 58ZB); meals provided on working days to an employee by a primary producer where the employment is principally in a remote area (s 58ZD).

Reconciliation with income tax 7.55 As FBT is a separate tax from income tax and is imposed on the employer rather than on the employee, ITAA97 s 6-25(1) (noted in 2.14) will not prevent the one benefit being taxed under both the FBTAA and either the ITAA97 or the ITAA36. To prevent the same benefit being taxed both under the FBTAA and under either of the two assessment Acts (ITAA), provisions in the Acts try to ensure [page 459] that fringe benefits that are subject to fringe benefits tax and amounts included in assessable income under the ITAAs are mutually exclusive. Under ITAA36 s 23L, discussed in 2.23, fringe benefits under the FBTAA are non-assessable non-exempt income: s 23L(1)(a). Thus,

amounts attributable to fringe benefits which otherwise would be assessable under ITAA97 ss 6-5 and/or 15-2 will not be assessable income. Further, s 23L(1)(b) states that benefits (other than benefits under ITAA97 s 15-75) that would be fringe benefits under the FBTAA, but for the fact that they are exempt benefits, are exempt income. Although non-cash business benefits under ITAA36 s 21A are not subject to FBT, s 23L exempts such amounts where the total amount of those benefits in the year of income does not exceed $300. 7.56 Within the FBTAA itself, the definition of fringe benefit in FBTAA s 136 prevents any overlap between the FBTAA and the ITAA by excluding certain amounts that are taxable under the ITAA from being fringe benefits as defined. The most important exclusion is salary or wages (including amounts that would be salary or wages but for the fact that they are exempt income). Other exclusions were noted in 7.8. ‘Salary or wages’ is defined in FBTAA s 136 as meaning ‘a payment from which an amount must be withheld’ under certain provisions in TAA Sch 1. These are TAA Sch 1 s 12-35 (certain payments to employees); s 12-40 (certain payments to company directors); s 12-45 (certain payments to certain office holders); s 12-115 (certain Commonwealth education or training payments); and s 12-120 (certain compensation, sickness or accident payments). Prior to its amendment in 1999, the FBTAA s 136 definition of ‘salary or wages’ referred to salary or wages within former ITAA36 s 221A. The payments in relation to which amounts are required to be withheld under the TAA basically parallel the payments that are deemed to be salary or wages under the ITAA36 s 221A definition. The ITAA36 s 221A definition has been considered in several FBT cases, which will now be discussed. 7.57 The opening part of the s 221A definition unhelpfully stated that ‘salary or wages’ includes ‘salary, wages …’. In Roads & Traffic Authority of New South Wales v FCT (1993) 26 ATR 760 at 820, Hill J made the following comments on the definition of ‘salary or wages’ in ITAA36 s 221A: The language of the definition of “salary or wages” in s 221A(1) is deliberately wide.

The legislative purpose was to include in the definition, and so that tax could be deducted by the employer and ultimately remitted to the Commissioner as an anticipatory payment of the employee’s tax liability, all amounts paid as a reward for services rendered by the employee: FCT v J Walter Thompson (Australia) Pty Ltd (1944) 7 ATD 401 at 405–6; 69 CLR 227 at 233–4. The description of the payment, for example as a fee, will not be determinative. Nor, as the J Walter Thompson case reminds us, will it be determinative that, for the purposes of legislation such as the Truck Act 1896 (UK), the word “wages” was limited to payments made to manual workers as the context of that legislation is substantially different to the present. Thus Latham CJ said (at ATD 406; CLR 234), speaking of the comparable definition in the Pay-roll Tax Assessment Act 1941 (Cth): In my opinion … the word “wages” should be held to include any remuneration paid or payable to an employee as a reward for his services as an employee.

[page 460] That wide approach was later to be adopted by the majority of the Full High Court in Murdoch v Commr of Pay-roll Tax (Vic) (1980) 143 CLR 629, where it was held that distributions by the trustees of a will of a percentage of the profits among employees, in such proportions as the trustees thought fit, were wages paid by the trustee, being the employer, to its employees as such and hence assessable to payroll tax. This was, as the joint judgment of Mason, Murphy and Wilson JJ said (at 645), because the payments in question were “rightly described as remuneration paid to employees because they were employees”.

By applying this approach, Hill J in Roads & Traffic Authority of New South Wales held that a payment of a transport allowance (based on the public transport fare by the shortest possible route) to employees who actually travelled by public transport was clearly salary or wages. This was so, even if the payment amounted to a reimbursement and even if the payment was not an allowance. Note that Hill J’s comments in the passage quoted appear to refer primarily to the reference to ‘salary, wages …’ in the ITAA36 s 221A definition. A further application of this approach is illustrated in Dean v FCT (1997) 37 ATR 52 in the following case example.

Dean v FCT Facts: A parent company paid retention payments to two employees of a subsidiary company to induce them to remain in the subsidiary company’s employment for 12 months after its sale. The payments were refundable on a pro rata basis if the employee did not complete 12 months’ service with the subsidiary following the sale. Issues: Were the payments ‘salary or wages’ within ITAA36 s 221A or were they fringe benefits and hence exempt income under ITAA36 s 23L? Held: Merkel J quoted from the judgment of Hill J in Roads & Traffic Authority of New South Wales in concluding that the retention payments were salary or wages. Merkel J stated that under the ITAA36 s 221A definition, it did not matter if the payments were not made wholly in respect of the employees’ employment so long as they were made ‘principally’ in respect of the employees’ employment. Nor did it matter that the payment was made by the parent company which was not the employees’ common law employer. There was nothing in the definition of salary or wages in ITAA36 s 221A which confined the concept to payments by the common law employer of the employees.a It was enough that the payments were made to the employees in their capacity as employees and in respect of their services as employees. Thus, the payments were not fringe benefits and were, therefore, not exempt income under ITAA36 s 23L.

a.

On this point, see also the decision of Hill J in Newcastle Club Ltd v FCT (1994) 53 FCR 1; 29 ATR 216. [page 461]

Note, however, that TAA s 12-35 also imposes a withholding obligation on a payer of commission, bonuses and allowances. The meaning of a bonus was considered by Merkel J in Dean. There Merkel J stated that, if he were wrong in his conclusion that the payments were salary or wages as being in respect of the service of the employees, the payments, nevertheless, would amount to a ‘bonus’. The essential characteristic of a bonus was a payment over and above what was due and payable for the services of the employee. While a bonus would normally be a voluntary payment, in some circumstances it could be payable as a contractual obligation. However, where the payment was made as a contractual obligation, it was more likely that the payment

was ‘salary or wages’ as a payment for an employee’s services. If this were the case, then the payment was not likely to be a bonus. The meaning of an ‘allowance’ was discussed in 7.37. As allowances are subject to withholding payments under TAA Sch 1 s 12-35 and, hence, cannot be a fringe benefit, generally they will be assessable income either under ITAA97 Sch 1 s 6-5 or under s 15-2. Although a LAFHA is an allowance, TAA Sch 1 s 12-1(2) states that there is no withholding obligation with respect to such payments. This is because a LAFHA is taxed as a fringe benefit. See the discussion of LAFHAs in 7.40–7.41. 7.58 Although a payment need not be made by an employer to amount to ‘salary or wages’, it must be made to an eligible person (employees and certain other persons)35 in his or her capacity as an employee for it to amount to salary or wages. The point is illustrated by the Full Federal Court decision in FCT v De Luxe Red and Yellow Cabs Co-operative (Trading) Society Ltd (1998) 38 ATR 609. There, the Full Federal Court held that the relationship between a taxi cooperative and drivers of its managed fleet was one of bailment. This meant that payments by the cooperative to drivers were not in respect of their employment and were not under contracts that were principally for their labour. Hence, for PAYE and Superannuation Guarantee Charge purposes, the payments were not ‘salary or wages’.

Rebate for tax-exempt employers 7.59 When FBT was made deductible in 1994, a rebate of FBT was introduced to compensate certain tax-exempt employers for whom FBT deductibility had no value as they neither paid income tax nor obtained deductions. The rebate is available under FBTAA s 65J. The tax-exempt employers who are entitled to the rebate are set out in s 65J(1). From 1 April 2000 onwards, the rebate is not available to public benevolent institutions and is not available to public hospitals or hospitals carried on by non-profit societies or by non-profit associations. The rebate is calculated using the following formula:

[page 462] The aggregate non-rebatable amount is determined in accordance with the method statement set out in FBTAA s 65J(2B). For the FBT year commencing 1 April 2001 and all subsequent FBT years, the amount calculated is reduced by $30,000 for each employee. In effect, this means that the rebatable amount for the employer is reduced to $30,000 for each employee as from 1 April 2001.

Principles of salary packaging 7.60 The central principle of salary packaging is for an employer to determine the total sum of an employee’s remuneration package and, from that starting point, to maximise the after-tax value of the employee’s remuneration package. This is achieved by providing a mix of assessable income and fringe benefits which both fits the employee’s lifestyle and also produces the least tax cost. In determining the extent to which a remuneration package ought to include fringe benefits, the package should include fringe benefits up to the point that the employer’s cost of providing fringe benefits equals the cost to the employee of obtaining the same benefit from after-tax income. In this regard, the employer’s cost includes not only the cost of obtaining the particular benefits, but also fringe benefits tax and the cost of administering the provision of those fringe benefits. Two factors are critical to determining the fringe benefits tax liability of the employer: 1. The tax status of the employer — tax exempt, rebatable or fully taxed? 2. The tax status of the benefit provided — exempt, concessionally

taxed or fully taxed? Exempt benefits, benefits excluded from the definition of fringe benefits and benefits (such as car fringe benefits or in-house fringe benefits) whose taxable value may be less than the cost of providing or acquiring the benefit, play an important role in salary packaging. For example, where an exempt benefit is substituted for part of an employee’s salary, greater after-tax benefits can be obtained for the employer or the employee as no FBT needs to be added in calculating whether the package has an equivalent cost or benefit to the previous salary arrangement. This is shown in Example 7.4.

Alpha and Omega Inc is a religious institution. Prior to entering into salary-packaging arrangements, it paid Delphic, one of its religious practitioners, a salary of $50,000 pa. Alpha and Omega Inc and Delphic then enter into a salary-packaging arrangement under which Alpha and Omega Inc provides Delphic with a motor vehicle so that she can perform her pastoral duties more effectively. The leased car value of the car is $26,000. The lease costs are $700 per month. The other running costs of the car, also borne by Alpha and Omega Inc, are $350 per month. Assume that the car is used [page 463] for pastoral duties 30% of the time. Notwithstanding this partial use, the provision of the car will be an exempt fringe benefit under FBTAA s 57. If Alpha and Omega Inc simply wants to maintain its costs at the same level, it will reduce Delphic’s salary by the cost to Alpha and Omega Inc of providing the benefit. Thus, it will reduce Delphic’s salary by $8400 (lease costs) plus $4200 (running costs). However, as Alpha and Omega Inc should obtain a GST input credit for the GST paid in acquiring the car and paying its running costs, the true cost of providing the car to Alpha and Omega Inc would be the actual costs of $12,600 less GST of $1145 (ie, $12,600 × 1/11). Assuming that Delphic would otherwise lease the car and would obtain a deduction for 30% of the lease and operating costs, in the absence of salary packaging the after-tax income of Delphic would be as follows (using 2015–16 tax rates but ignoring rebates and levies other than Medicare):

Salary Less deductions

$50,000.00 $3780.00

($12,600 × 30%)

Taxable income

$46,220.00

Tax payable Medicare levy After-tax income

$6568.50 $924.40 $42,507.10

Under the salary-packaging arrangement for the car, the after-tax benefit position of Delphic would be:

Salary Taxable income Tax payable Medicare levy Value of car benefit

$38,545.00 $38,545.00 $4074.13 $770.90 $11,295.90

After-tax benefits

$44,995.87

($12,600 less value of deduction that arises under non salary-packaged remuneration [ie, $12,600 × 30% deduction × 32.5% tax and Medicare = $1304.10])

7.61 Contributions to complying superannuation funds also play an important role in much salary packaging. Where an employee pays nondeductible contributions to a complying superannuation fund out of the employee’s after-tax salary, there is no tax borne in the fund on the contributions made. However, it is necessary to remember [page 464] that the employee was taxed at his or her marginal rate on the income from which the contributions were sourced. You will recall, however,

that contributions to a complying superannuation fund by an employer are excluded from the definition of fringe benefit. Where the employer is not tax exempt, it will be entitled to an income tax deduction for the contributions made and the fund will be taxed at the rate of 15% on the deductible contributions received. A prospective salary sacrifice arrangement may also wholly or partially fulfil an employer’s superannuation guarantee charge obligations. As contributions to complying superannuation funds are excluded from the definition of ‘fringe benefit’, such contributions will not form part of the employee’s reportable fringe benefits amount disclosed on the employee’s group certificate. This, in turn, means that such contributions will not be taken into account in determining the employee’s Medicare levy surcharge (if any). You will also recall that eligible termination payments fall within the definition of salary and wages and hence are excluded from being fringe benefits. The taxation of employment termination payments was discussed in Chapter 5.

Scientia College is a company limited by guarantee and is a wholly owned subsidiary of the newly established Euphoria University in the new Australian state of Euphoria. Euphoria University was established in January 1999 under the Euphoria University Act 1999 of the Euphoria Parliament. Since its inception, Euphoria College has required its Head of College to live in premises provided by the college. At the time of her appointment, the current Head of College resided in her own home at Leichhardt. Since her appointment on 1 January 2014, the Head of College has maintained her home at Leichhardt although she does live in college. A local real estate agent estimates that the market value of the premises provided to the Head of College is $300 per week. The Head of College is also required to eat 70% of her meals at the college dining hall. The Head of College is not charged for meals consumed at the college dining hall. The marginal cost of a meal to the college is $3. Under her employment contract, the Head of College is entitled to the full private use of a new motor vehicle. From 1 October 2014, she obtains a car with a retail sales price of $40,000. The cost of leasing the car is $1500 per month. Running costs for the car are $450 per month. In the FBT year ending 31 March 2017, the car travelled 15,000 km, 25% of which was related to the Head of College’s employment duties.

Part of the duties of the Head of College include travelling to South-East Asian countries to promote the college. The college pays all airfares associated with these promotional tours by the Head of [page 465] College. The college also provides her with an accommodation allowance for the promotional tours and issues her with a credit card in the name of the college. The Head of College is authorised to use this credit card to entertain university and school principals while on her promotional tours in South-East Asia. The Head of College is also a full-time academic with the Commerce Faculty of the University of Euphoria and her income from this source is $75,000 pa. Discuss the liability of Scientia College for FBT for the year ending 31 March 2016. Scientia College is keen to maximise legally any advantages of salary packaging which continue to be open to it. Advise Scientia College of what steps, if any, it can take to maximise the advantages, if any, of salary packaging which are available to it and its employees. In your advice state any additional information you would require from Scientia College before giving a definitive answer. In what respects, if any, would your answer differ if Scientia College was conducted by a religious institution on land leased from the University of Euphoria and if the Head of College and the resident tutors were all religious practitioners? A suggested solution is found in Study help.

1. 2.

3.

4. 5. 6.

Australian Government, Reform of the Australian Taxation System: Draft White Paper, AGPS, Canberra, 1985, para 8.3. Issues relating to the collection, administration and enforcement of FBT and the compliance obligations imposed on employers by the FBT legislation are not discussed in detail in this chapter. In particular, it should be noted that under FBTAA Pt XIA, employers, subject to satisfying certain requirements, are not required to comply with the ordinary FBT recordkeeping requirements, and may have their FBT liability for a year determined by reference to their aggregate fringe benefits amount from an earlier ‘base year’ in which they kept records. Dr Ken Henry (Chair) et al, Australia’s Future Tax System: Report to the Treasurer, Commonwealth Attorney-General’s Department, Canberra, December 2009. Publications associated with the review may be found at . Australia’s Future Tax System: Report to the Treasurer, note 3 above, Part 2, vol 1, p 47. For earlier years, the definition is contained in FBTAA s 5B(1). The decision of Hill J in Westpac Banking Corporation v FCT (1996) 32 ATR 479 was upheld on appeal to the Full Federal Court in Westpac Banking Corporation v FCT (1996) 34 ATR 143.

7.

8. 9. 10. 11. 12. 13. 14. 15. 16. 17.

18.

19. 20.

21.

22.

23.

When the case was remitted back to the AAT ((2000) 45 ATR 1101), it held that the loans were provided for the directors and their families as ultimate owners of the business. There was no agreement or intention that the loans were provided as an incident of their directorships. The Treasury, Tax Reform: Not a New Tax, a New Tax System: The Howard Government’s Plan for a New Tax System, Commonwealth of Australia, 1998, pp 49–50. For earlier years, the definition is contained in FBTAA s 5B(1). For earlier years, the employer’s aggregate fringe benefits amount is calculated under FBTAA s 5C(1). GST creditable benefits are defined in FBTAA s 149. This list has been derived from the Explanatory Memorandum to A New Tax System (Fringe Benefits Tax) Bill 2000 (Cth), para 1.23. The taxable value of fringe benefits relating to Remote Area Home Ownership Schemes is amortised under FBTAA s 65CA. These are reducible benefits relating to Remote Area Home Repurchase Schemes dealt with under FBTAA s 65CC. Presumably the reference is to the GST-inclusive value of what the employee would have obtained by incurring the expense. This point, however, is not made clear in the ruling. See, for example, A Katz and G Mankiw, ‘How Should Fringe Benefits Be Taxed’ (1985) National Tax Journal 37. The following sections in the FBTAA apply the 75% taxable value rule to in-house fringe benefits: s 22A (in-house expense payment fringe benefits); s 26 (in-house non-remote housing fringe benefits); s 42 (in-house property fringe benefits); s 48 (in-house non-period residual fringe benefits). For more detailed argument on this point, see C J Taylor and C W Butcher, ‘Towards A Neutral Fringe Benefits Tax: Australia Tries Again’, paper presented at Fifth Australasian Tax Teachers’ Association Conference, Christchurch, New Zealand, January 1993, pp 433–8 and Table 14, p 447. This deeming does not apply where the car is used by an ambulance, fire or police service, is fitted with a flashing warning light and siren and is visibly marked: see FBTAA s 7(2A). Where the employee or associate is prohibited from applying the car for private use but the prohibition is not consistently enforced, FBTAA s 7(4) will deem the person to be entitled to use the car or to apply the car to private use notwithstanding the prohibition. Where the car is acquired in a non-arm’s length transaction for less than its arm’s length cost, then under FBTAA s 13 the cost price of the car is increased to what would have been the cost in an arm’s length transaction. Log books must be maintained for 12 weeks in the first year of the holding period and retained for five years thereafter. The requirements for maintaining log book records and odometer readings are similar to those that apply for substantiation purposes. See the discussion in 9.68–9.69. New log books are required every five years. In estimating the business percentage, employers must make a ‘reasonable estimate’ of the number of business kilometres travelled in the year. Regard must be had to all relevant matters including log book records, odometer readings and other records. Where costs are incurred in non-arm’s length transactions for less than an arm’s length price, FBTAA s 13 increases the cost to an arm’s length cost.

24. See the definition of ‘insured car expense’ in FBTAA s 10(3A). 25. Detailed rules for calculating deemed depreciation and interest in these circumstances are set out in FBTAA s 11. 26. Where the lessor was entitled to privileges or exemptions in relation to sales tax or customs duty, the operating costs include so much of the charges paid or payable under the lease agreement as would have been attributable to the holding period if the lessor had not been entitled to the privileges or exemptions. 27. The amount of the notional deduction varies according to whether the expense payment benefit is ‘in-house’ or ‘external’. The detailed rules are set out in FBTAA s 24. Substantiation rules are also set out in FBTAA s 24. These are particularly relevant to fuel and oil for a motor vehicle, extended travel expense payment benefits and car expense payment benefits. 28. Note that this rule applies only where the fringe benefit would have been an in-house residual fringe benefit if it had not been a housing fringe benefit: see FBTAA s 26(1)(b). 29. The indexation factor is calculated by using the rent index for the state or territory published by the Australian Statistician. The method for calculating the rent index is set out in FBTAA s 28. See Taxation Determination TD 2016/1. 30. Compare the decision in FCT v Toms (1989) 20 ATR 466, where a self-employed forestry worker was denied a deduction for the cost of maintaining a caravan over 1000 km from his home and for the additional costs (such as food) associated with living in camp. In distinguishing FCT v Toms, Hill J in Roads & Traffic Authority of New South Wales v FCT placed emphasis on the fact that Toms was self-employed and chose to live over 1000 km from his place of work. See also the discussion of private and domestic expenses in 8.69–8.80. 31. The car parking threshold for the FBT year commencing 1 April 2017 is $8.66: see Taxation Determination TD 2017/14. 32. FBTAA s 155 deals with the situation where property is supplied under a hire-purchase or similar agreement where the use of the property passes to the recipient for a period after which title will or may pass to the recipient. Here, the property is regarded as having been provided when the recipient obtained use of the property. If the recipient does not obtain title to the property when the use period terminates, an amended assessment is made and the property is not regarded as being provided at all. 33. ‘Property’ is defined in FBTAA s 136 as including tangible and intangible property. The definition of ‘intangible property’ includes real property, choses in action and other kinds of intangible property but excludes rights under a contract of insurance or leases or licences in relation to intangible property. 34. The ‘comparison time’ will be the commencement of the ‘billing period’ where FBTAA s 46(2) applies to the benefit. In other cases, the comparison time will be, in the case of a period residual fringe benefit, the time where the recipient’s overall benefit commenced to be provided, and in other cases the time when the benefit is provided. 35. The other persons are: holders of Commonwealth, state or territory appointments or offices; persons in the service of the Commonwealth, a state or a territory (eg, defence force personnel, police officers); members of an Australian parliament; and members of local governing bodies.

[page 467]

CHAPTER

8

General Deductions Learning objectives After studying this chapter, you should be able to: work out your taxable income; link the elements of ITAA97 s 8-1 to the limbs of ITAA36 s 51(1); identify and follow the research trail for ITAA97 s 8-1; identify and apply the ‘unlegislated tests’; recognise and apply the legal bases for apportionment of expenditure; distinguish between objective and subjective purpose; determine when an outgoing is incurred; identify the principal tests for distinguishing outlays on revenue and capital account; apply the principles and tests of deductibility to given fact situations.

Introduction 8.1 In Chapter 2, the ‘tax equation’ was identified in Income Tax Assessment Act 1997 (Cth) (ITAA97) Div 4 thus: 4-10 (3) Work out your income tax for the financial year as follows:

4-15 (1) Work out your taxable income for the year like this:

The central or core provisions relating to assessable income are ITAA97 s 6-5 for ordinary income, s 6-10 relating to statutory income, s 6-20 dealing with exempt income and s 6-23 relating to non-assessable non-exempt income. The core provisions concerned with deductions are ITAA97 s 8-1, which covers general deductions, and s 8-5, which deals with specific deductions. For deductions to be allowable under either the general or a specific provision, an outgoing or expense must be linked to the production of assessable income in the particular manner required by the deduction provision. This link or nexus is the subject of detailed examination. [page 468] The core deduction section, s 8-1, provides as follows: 8-1 General deductions (1) You can deduct from your assessable income any loss or outgoing to the extent that: (a) it is incurred in gaining or producing your assessable income; or (b) it is necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income. (2) However, you cannot deduct a loss or outgoing under this section to the extent that: (a) it is a loss or outgoing of capital or of a capital nature; or (b) it is a loss or outgoing of a private or domestic nature; or (c) it is incurred in relation to gaining or producing your exempt income or your non-assessable non-exempt income; or (d) a provision of this Act prevents you from deducting it. (3) A loss or outgoing that you can deduct under this section is called a general deduction.

There are a number of parallels between the core assessing and deducting provisions in the ITAA97. Section 6-5 assesses the great bulk of amounts most readily recognised as ‘ordinary income’ — such as salaries and wages, business proceeds, property income like rent and interest. Section 8-1 provides for deductibility of a huge range of outgoings connected with the generation of ordinary or statutory income. Common business expenses from A–Z stand to be considered under s 8-1: from advertising, bank fees and cleaning through to wages. The provision also covers employee-related expenses, such as tools of trade, technical or professional journals and travel, as well as the expenses of deriving property income, such as interest on loans to acquire investments. Of course, to be deductible, these outgoings need to satisfy the requirements of the deduction provision as well as other conditions imposed by the Acts, but s 8-1 accommodates a large and diverse range of outgoings (thus enabling ‘negative gearing’). 8.2 The rationale for a general deduction provision was stated by Kirby J in Steele v DCT (1999) 197 CLR 459; 41 ATR 139 at 156; 99 ATC 4242: It is sometimes hazardous to specify the purpose of provisions of the ITAA 1936, because of the complex terms in which this legislation is often expressed. But [former ITAA36] s 51(1) is a central provision of the Australian system of taxation. It is relatively simple and conceptual in its expression. Its overall purpose seems clear enough. It represents, in a sense, an accommodation between the taxpayer’s legitimate claim to allowable deductions where and to the extent to which, the losses and outgoings in question were incurred in gaining or producing the assessable income upon which tax may be levied. Behind this part of the subsection lies an acknowledgment by the Parliament that it is just that such “losses and outgoings” should be deducted from the income brought

[page 469] to tax. In part, this idea rests upon a notion that the income of a taxpayer may then, or in the foreseeable future, be diminished by the losses and outgoings concerned. In part, it represents a quid pro quo afforded by the Parliament to the taxpayer. It says, in effect: if you incur “losses and outgoings … in gaining or producing the assessable income” upon which we can levy tax, we (the community) will allow you (the taxpayer) deductions to that extent. We will do so out of recognition that without the expenditures which constitute such “losses and outgoings” the taxpayer’s assessable income might well be lessened and could even be non-existent.

In essence, this rationale is centred on the reduction caused by losses or outgoings in a taxpayer’s ability to pay, or reduction in income if the losses or outgoings are viewed as outside the scope of consumption under the Haig-Simons income definition: see 2.7. Equity therefore requires some recognition of these expenses. This perspective also helps explain some of the negative limbs contained in s 8-1(2). For instance, losses or outgoings of capital or a capital nature: see 8.61. Typically, such outgoings add to a taxpayer’s business structure and so, at least initially, do not reflect a reduction in the taxpayer’s assets. Further, Kirby J’s discussion also emphasises, from an economic efficiency perspective, the role of deductions in avoiding disincentives to taxpayers undertaking income-producing activities. This may help explain the existence of s 8-1(2)(b), which precludes deductibility for losses or outgoings of a private or domestic nature: see 8.70.

1. 2. 3.

8.3

What do you think would be the outcome if the Australian system of taxation did not contain a general deduction provision such as ITAA97 s 8-1? What would be the practical result if ordinary taxpayers were taxable on their net cash flow (or if all losses and outgoings were allowable deductions)? Instead of a tax system that brings to account assessable income from which amounts may be deducted, might it not have been simpler to tax net profit?

Specific deductions are identified in ITAA97 s 8-5:

8-5 Specific deductions (1) You can also deduct from your assessable income an amount that a provision of this Act (outside this Division) allows you to deduct. (2) Some provisions of this Act prevent you from deducting an amount that you could otherwise deduct, or limit the amount you can deduct. (3) An amount that you can deduct under a provision of this Act (outside this Division) is called a specific deduction.

[page 470] Section 8-5 provides a contrast to s 8-1 and parallels s 6-10. Section 6-10 identifies statutory income but is not an assessing provision at all. Section 8-5 identifies and describes as specific deductions other deductible amounts but it does not allow any deductions. Section 8-5 also acknowledges that some provisions may qualify or deny amounts prima facie satisfying s 8-1, but it does not deny or qualify anything itself. Specific allowing and qualifying provisions are located in ITAA97 Div 25 and specific denying provisions in Div 26. Other specific matters, such as depreciation and trading stock, are addressed in ITAA97 Divs 40 and 70 respectively. If an amount is potentially deductible under both the general and a specific deduction provision, s 8-10 provides as follows: 8-10 No double deductions If 2 or more provisions of this Act allow you deductions in respect of the same amount (whether for the same income year or different income years), you can deduct only under the provision that is most appropriate.

Typically, it might be expected that the most specific provision would be the ‘most appropriate’. However, an alternative view, given the nature of deductions as reflecting a decrease in the taxpayer’s ability to pay and as aimed at avoiding disincentivising income-producing activities, is that the provision which provides the largest deduction is the most appropriate.1

The general deduction provision Development of the general deduction provisions 8.4 ITAA97 s 8-1 is the descendant of a long line of general deduction provisions and there is considerable continuity in language. As a result, key words and phrases have been the subject of judicial

examination for over 100 years. Section 12 of the first colonial income tax Act, the South Australian Income Tax Act 1884, provided: 12 All losses, outgoings and expenses actually incurred by the taxpayer in the production of the income shall be deducted from the gross amount of the income of the taxpayer …

[page 471] There is an unmistakable similarity between this first deduction provision and the present s 8-1(1)(a). The first Commonwealth income tax legislation, the Income Tax Assessment Act 1915 (Cth), provided in s 18(1) as follows:2 18 (1) In calculating the taxable income of a taxpayer the total income derived by the taxpayer from all sources in Australia shall be taken as a basis and from it there shall be deducted — (a) all losses and outgoings, not being in the nature of losses and outgoings of capital, including commission, discount, travelling expenses, interest and expenses actually incurred in Australia in gaining or producing the gross income.

In the Income Tax Assessment Act 1922 (Cth), the words of s 18(1) (a), above, were reordered in s 23(1)(a) as follows: (a) all losses and outgoings (including commission, discount, travelling expenses, interest and expenses, and not being in the nature of losses and outgoings of capital) actually incurred in gaining or producing the assessable income.

Section 25 of the 1922 Act also contained the following proviso:3 25 A deduction shall not, in any case, be made in respect of any of the following matters … (e) money not wholly and exclusively laid out or expended for the production of assessable income.

It will be observed that these two provisions (ss 18(1)(a) and 23(1)(a)) contain an exclusion for capital expenditure that corresponds to ITAA97 s 8-1(2)(a). It will [page 472] also be noticed that none of these predecessor sections makes reference to expenses ‘incurred in carrying on a business for the purpose of gaining or producing your assessable income’ as in ITAA97 s 8-1(1)(b). This has led to the general deduction provisions that preceded the Income Tax Assessment Act 1936 (Cth) (ITAA36) being described as single limb provisions. This is an important observation because, following the enactment of the ITAA36, the general deduction provision — s 51(1) — introduced an additional limb, the second or business limb: 51 Losses and outgoings (1) All losses and outgoings to the extent to which they are incurred in gaining or producing the assessable income, [first limb] or are necessarily incurred in carrying on a business for the purpose of gaining or producing such income, shall be allowable deductions [second or business limb] except to the extent to which they are losses or outgoings of capital, or of a capital, private or domestic nature, or are incurred in relation to the gaining or producing of exempt income [third or negating limb].

The result has been an analysis of the general deduction provision and the development of a jurisprudence in terms of the limbs. Until the ITAA97, the limb analysis was a convention or convenience. There was no separation of the limbs in ITAA36 s 51(1). They are part of an integrated provision. With ITAA97 s 8-1, the division of limbs has been formalised in the creation of subsections and paragraphs.

Research trail 8.5 It is important to remember that ITAA97 s 8-1 is the general deduction provision and that an item of expenditure should first be

considered within its ambit. In addition, there are a number of specific provisions which deny deductibility notwithstanding the item may satisfy the requirements of s 8-1. This is made clear by s 8-1(2)(d). For example, s 26-45 denies a deduction for subscriptions to recreational clubs. Some specific provisions impose tests additional to or different from s 8-1; for example, ITAA97 Div 32 in relation to entertainment. Another category of provisions provides a modified arrangement permitting or qualifying deductions for an item denied under s 8-1; for example, ITAA97 Div 40 in relation to depreciation of plant and other depreciating assets. Over and above these provisions hover the general anti-avoidance provisions which are charged with protecting the revenue from schemes and arrangements which have as their dominant objective the avoidance of tax. Other specific provisions operate in tandem with s 8-1. For example, s 25-55 allows a deduction for membership of trade, professional or business associations but subject to a maximum of $42. The provision advises that the payment may also be deductible under s 8-1 and, if it is, it is not limited to $42 under that section. [page 473] There are more complicated arrangements between s 8-1 and the specific provisions. For instance, s 25-35 sets out its conditions for the deductibility of bad debts and, under s 8-10, would seem to be the appropriate provision to deduct these particular amounts. However, if a loss is outside the ambit of s 25-35, it will be appropriate to consider the matter under s 8-1.

Figure 8.1:

The research trail for deductions

Deductibility criteria 8.6 Paragraphs (a) and (b) of ITAA97 s 8-1(1) correspond to the positive limbs of the former ITAA36 s 51(1) and the limbs have been the subject of a good deal of judicial examination. It has been said by the High Court on many occasions that the two positive limbs are not mutually exclusive but operate as alternatives.4 The reference in the second limb to ‘business’ means that wage and salary earners are excluded from its operation.5 This ought not to be a disadvantage because the High Court has also said on many occasions that, in actual working, the second limb adds little to the first and the words of the first limb have a very wide operation and will cover almost all the ground occupied by the second limb.6 However, the words of the second limb (ITAA97 s 8-1(1)(b)) ‘in carrying on a business for the purpose of gaining or producing’ lay down a test that is different [page 474]

from that implied by the words (‘incurred in gaining or producing your assessable income’) in the first limb: ITAA97 s 8-1(1)(b). In John Fairfax & Sons Pty Ltd v FCT (1959) 101 CLR 30; 7 AITR 346, Fullagar J thought that primarily, at least, the first limb was concerned with expenditure voluntarily incurred whereas the second or business limb accommodated some abnormal or unavoidable expenditure for the business generally. In an earlier decision, FCT v Snowden & Willson Pty Ltd (1958) 99 CLR 431; 7 AITR 308, Fullagar J considered that legal expenses incurred by the taxpayer in defending itself before a Royal Commission against allegations of unfair and dishonest trading activities were ‘exactly the type of expenditure that is covered by the second category of [the former ITAA36] s 51(1)’: at AITR 317. However, his Honour conceded the expenditure might well satisfy the first limb also. The fact that many business expenses would satisfy both of the positive limbs of s 51(1) (ITAA97 s 8-1(1)(a) and (b)) will not be surprising. One would expect that, in the case of a business, overlap between the positive limbs would be the norm simply because the two positive limbs are not mutually exclusive. However, a distinction between the positive limbs based on the degree of volition or normality of the expenditure is not reflected in the leading authorities. For example, in Charles Moore & Co (WA) Pty Ltd v FCT (1956) 95 CLR 344; 6 AITR 379, a deduction for the loss of around £3000 in an armed robbery was allowed under the first limb of the former s 51(1). Such an outgoing seems both abnormal and involuntary. There is clearly a different test required of the two positive limbs. The words ‘in gaining or producing the assessable income’ mean ‘in the course of gaining or producing such income’: Ronpibon Tin at AITR 245. It follows that to succeed under the first positive limb (or s 8-1(1) (a)) there must be a connection or nexus between the loss and outgoing and activities regularly carried on for the production of income: FCT v DP Smith (1981) 147 CLR 578; 11 ATR 538 at 541. The second limb (or s 8-1(1)(b)) sets down a different test requiring a connection between the loss or outgoing and the carrying on of a business. So s 8-1(1)(b) would clearly cover a situation where a business

has not yet produced any income or had operated at a loss and failed to produce assessable income: Ronpibon Tin at AITR 244–5.7 Nevertheless, the breadth of s 8-1(1)(a) is likely to render any such difference relatively immaterial, as it is also clear that the first positive limb can permit deductions where the relevant activities have not yet produced assessable income or fail to produce assessable income: Steele v DCT (1999) 197 CLR 459; 41 ATR 139 per Gleeson CJ, Gaudron and Gummow JJ at ATR 151. See 8.24. [page 475]

Nexus requirement 8.7

The first limb of ITAA36 s 51(1) provided:

All losses and outgoings to the extent to which they are incurred in gaining or producing the assessable income … shall be allowable deductions. …

ITAA97 s 8-1(1)(a) provides: You can deduct from your assessable income any loss or outgoing to the extent that: (a) it is incurred in gaining or producing your assessable income; …

The required connection between a loss or outgoing and the generation of assessable income has been described as the first limb nexus. The word ‘nexus’ simply refers to a link or particular type of connection.8 When tax scholars speak of the ‘expenditure–income nexus’ they mean to convey a relationship between the two terms that reflects both the statutory wording and a long history of judicial consideration. A range of judicial tests have been proposed over the years to help elucidate this nexus. Recent authorities have warned against substituting those judicial tests for the words of s 8-1(1) and have

suggested that a test that better reflects the statutory wording is to ask the question ‘is the occasion of the outgoing found in whatever is productive of actual or expected income’: CT v Day (2008) 236 CLR 163; 70 ATR 14 at [29]–[30] per Gummow, Hayne, Heydon and Kiefel JJ.9 The nexus may then be restated as requiring a connection between the expenditure and the operations or activities directed to the production of income. See also Amalgamated Zinc (de Bavay’s) Ltd v FCT (1935) 54 CLR 295; 3 ATD 288 per Dixon J at ATD 298; Robert G Nall Ltd v FCT (1937) 1 AITR 169 per Dixon J at 176; DP Smith at ATR 541. As emphasised in Day, this makes it imperative to determine ‘what it is that is productive of assessable income’.10 That is, the scope and nature of the operations or activities. [page 476] The connection required by the nexus is not satisfied by demonstrating a mere causal connection. For instance, simply that the expenditure is a prerequisite to the earning of income or that without incurring the particular outgoing the taxpayer could not begin to earn income: Lunney v FCT (1958) 100 CLR 478; 7 AITR 166; Lodge v FCT (1972) 128 CLR 171; 3 ATR 254; 72 ATC 4174. Arguments fashioned along the lines that ‘one must eat to live to work to earn income and so therefore the cost of food is deductible’ simply do not satisfy the nexus. The connection is too remote. Nevertheless, as the cases on the ‘unlegislated tests’ (see 8.9–8.14) demonstrate, it is relevant that expenses are incurred in order to support or further income-producing activities (for instance, directors’ fees so as to enable a company to be carried on and for consideration to be given to the company’s investments in Ronpibon Tin,11 or payments to induce a co-managing director to resign so as to improve a company’s efficiency and so support the business operations in W Nevill & Co Ltd v FCT (1937) 56 CLR 290; 1 AITR 67 at 76 per Dixon J), or that expenses follow on as a consequence of income-producing activities

(like the legal fees and settlement payments in Herald and Weekly Times Ltd v FCT (1932) 48 CLR 113; 2 ATD 169). That is, causal connections, both between the expenditure and the effect of that expenditure on the income-producing activities and from the incomeproducing activities to the need for the expenditure, are relevant. However, the unlegislated test cases also emphasise that expenditure that is too independent of or too remote from the income-producing activities will not qualify for a deduction, even if a causal connection exists. This may, for instance, result from temporal remoteness (see 8.21–8.24), public policy grounds (see the discussion of fines at 8.13) or the dual purpose nature of the expense (see the discussion of living expenses at 8.12–8.14). So, to refer to the link between expenditure and income as a nexus requirement is to try to convey the special type of connection that is required at law in order to come within s 8-1. 8.8

The second positive limb of ITAA36 s 51(1) provided:

All losses and outgoings to the extent to which they are … necessarily incurred in carrying on a business for the purpose of gaining or producing such income, shall be allowable deductions …

In its rewritten form, the business limb appears in ITAA97 s 8-1(1) (b): You can deduct from your assessable income any loss or outgoing to the extent that: (a) … (b) it is necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income.

[page 477] ‘Business’ is defined to include any profession, trade, employment vocation or calling, but does not include occupation as an employee: ITAA97 s 995-1. The mere holding of property from which income is

derived does not amount to a business either. Although many outlays would satisfy both heads, the words ‘in carrying on a business for the purpose of gaining or producing’ lay down a test that is different from that implied by the first positive limb: Ronpibon Tin NL v FCT (1949) 78 CLR 47; 4 AITR 236; 8 ATD 431. The test requires a nexus between the loss or outgoing and the carrying on of a business. It is not necessary that actual income arises as a direct result. While the first limb (ITAA97 s 8-1(1)(a)) is concerned with expenditure incurred in the actual course of producing assessable income, the second limb is concerned with expenditure made for the purpose of the business generally. However, it has been said on many occasions that the two limbs are complementary, that in actual workings the second limb can add but little to the first, and that the words of the first limb have a very wide operation and will cover almost all the ground occupied by the second limb. That expenditure must be incurred in ‘carrying on’ a business requires some ongoing or continuity of business. Expenditure that is ‘too soon’ or ‘too late’ will fall outside the provision. It is the business that must be carried on with the purpose of producing assessable income and the reference to ‘purpose’ is not a reference to the taxpayer’s purpose. The word ‘necessarily’ has not been interpreted strictly but rather means ‘clearly appropriate or adapted for’: Ronpibon Tin. In FCT v Snowden & Willson (1958) 99 CLR 431; 7 AITR 308 at 312, Dixon CJ said that the word meant ‘dictated by the business ends to which it is directed, those ends forming part of or being truly incidental to the business’. In Spriggs v FCT; Riddell v FCT (2009) 239 CLR 1; [2009] HCA 22, the High Court endorsed an alternative way of asking the question: is the loss or outgoing ‘reasonably capable of being seen as desirable or appropriate from the point of view of the pursuit of the business ends of the business’.12 It should be noted that what is appropriate is the taxpayer’s prerogative. It is not for the court or the Commissioner to tell a taxpayer how to run a business.

Examine the following items typically found in a company’s Profit and Loss Account. Which of them would be allowable deductions under ITAA97 s 8-1? (You should consider: 1. Is there a loss or outgoing? 2. Is it incurred? 3. Does it satisfy the positive parts of s 8-1? 4. Is it capital or private?) accrued wages; advertising; [page 478] bad debts provision; depreciation; discounts allowed; donations to political parties; hire-purchase payments; interest; insurance of plant and equipment; lease payments; morning and afternoon tea; printing and stationery; provision for long service leave; rates; repairs; staff training; taxation expense. A suggested solution can be found in Study help.

Unlegislated tests 8.9 Several unlegislated tests have developed that seek to articulate the nature of the connection required by the first limb nexus. Principal among these are the ‘incidental and relevant’ test and the ‘essential character’ test. These tests are by no means mutually exclusive. There are also a number of felicitous phrases such as ‘perceived connection’ or

‘term or condition of employment’ that are sometimes alleged to be tests but on closer examination do not carry the same authority. The tests are described as ‘unlegislated’ because they derive from court decisions, not from the legislation itself. The principal requirement is that a loss or outgoing satisfy the words of the provision and the courts have warned many times of the dangers of substituting alternative words and phrases. Therefore, the unlegislated tests should not be seen as substitutes for criteria expressed in the statute but, rather, as attempts to articulate judicial understanding of the criteria. The tests themselves can be traced to particular decisions and perhaps the real value of the exercise is discovering how the court that first used the particular expression explained the operation of the section.

‘Incidental and relevant’ 8.10 To qualify as a deduction allowable under ITAA97 s 8-1, a loss or outgoing must be ‘incidental and relevant’ to the production of assessable income. This test developed in relation to the 1922 Act and, in particular, from the decisions in Herald and Weekly Times Ltd v FCT (1932) 48 CLR 113; 2 ATD 169; Amalgamated Zinc [page 479] (de Bavay’s) Ltd v FCT (1935) 54 CLR 295; 3 ATD 288; and W Nevill & Co Ltd v FCT (1937) 56 CLR 290; 1 AITR 67.13 These three decisions are discussed below. As was outlined above, the general deduction provision in this legislation was in the form of a single limb. In the course of analysing these authorities relating to this test, it is instructive to note the range of expenditure, much of it business-related, that qualified under a single limb.

Herald and Weekly Times Ltd v FCT Facts: The taxpayer published an evening newspaper and incurred legal fees of £3131 in connection with defending and settling an action for libel. A deduction was claimed under s 23(1)(a) of the 1922 Act but the Commissioner disallowed the claim on the grounds that it was not ‘wholly and exclusively laid out or expended’ to produce assessable income as was required by s 25(e) of the Act. In the Supreme Court of Victoria ((1932) 2 ATD 69), Mann J accepted that the expenditure could be described as ‘incidental’ if that expression can be properly applied to an expenditure which represents one of the inevitable or almost inevitable consequences of publishing an evening newspaper (at ATD 70) but that s 25(e) disallowed the amount. The taxpayer appealed to the High Court. Held: A majority of the High Court (Gavan Duffy CJ, Rich, Dixon and McTiernan JJ; Starke and Evatt JJ dissenting) held that the expenditure was wholly and exclusively laid out for the production of income and deductible under s 23(1)(a). Gavan Duffy CJ and Dixon J said (at ATD 170–1): To establish a right to such a deduction, it is necessary for the taxpayer to show that the expenditure is a loss or outgoing (not being in the nature of a loss or outgoing of capital) actually incurred in gaining or producing the assessable income, so that it falls within s 23(1)(a) of the Income Tax Assessment Act, 1922– 29 and to negative the application of s 25(e) which forbids the deduction of money not wholly and exclusively laid out or expended for the production of assessable income … [page 480] [In the Supreme Court Mann J] described the payments as incurred as one of the consequences of gaining or producing the assessable income and in that sense as being incidental to the carrying on of the business. But he regarded the expenditure as in no sense productive expenditure, directly or indirectly. He said it was an unavoidable loss arising as one of the consequences of carrying on the business of newspaper production, a loss which is not in any sense productive of anything, by preserving the business, the business connection, or the assets from depletion. None of the libels or supposed libels was published with any other object in view than the sale of the newspaper. The liability to damages was incurred or the claim was encountered because of the very act of publishing the newspaper. The thing which produced the assessable income was the thing which exposed the taxpayer to the liability or claim discharged by the expenditure. It is true that when the sums were paid the taxpayer was actuated in paying them, not by any desire to produce income, but, in the case of damages or compensation, by the necessity of satisfying a claim or liability to which it had become subject, and, in the case of law costs, by the desirability or urgency of defeating or diminishing such a claim. But this expenditure flows as a necessary or natural consequence from the inclusion of

the alleged defamatory matter in the newspaper and its publication. Expenditure in which the taxpayer is repeatedly or recurrently involved in an enterprise or exertion undertaken in order to gain assessable income cannot be excluded by s 25(e) simply because the obligation to make it is an unintended consequence which the taxpayer desired to avoid. No point was made of the fact that the publication took place in a former year and properly so. The continuity of the enterprise requires that the expenditure should be attributed to the year in which it was actually defrayed. Rich J said (at ATD 173): The evidence in the case and the findings of Mann J [in the Supreme Court] led to the conclusion that the expenditure in question is practically inevitable in the publication of an evening newspaper, but he considered it was not productive expenditure. Matter set up in a newspaper is published for the purpose of increasing its circulation and attracting advertisements. Income is gained and produced and liability is sometimes incurred. Publication is at once the source of income and the cause of liability. Payments subsequently [page 481] made by way of compensation in respect of this liability or for costs to escape such liability relate back to publication. As publication is the common source of income and liability the necessary connection between the carrying on of the business of the newspaper and the liability which causes the expenditure is complete. In dissent, Starke J considered the expenditure was made not for the production of income but was in fact a depletion of income incurred to pay compensation for civil wrongs. Evatt J expressed a similar view; the liability arose out of a court judgment (or threatened judgment) against the taxpayer, not in the course of gaining income. Thus, while both Starke and Evatt JJ affirmed the decision of Mann J, they did so on the basis that the expenditure did not satisfy s 23(1)(a), not because s 25(e) denied the deduction otherwise allowable, as was Mann J’s conclusion. The use of the description ‘incidental’ by Mann J in the Supreme Court and by the majority in the High Court was taken to mean that the payment was one of the consequences of publishing the newspaper and was in that sense incurred in carrying on a business even though it was not directly productive of income. It is also necessary that the expenditure be ‘relevant’ to the production of income, as is illustrated in Amalgamated Zinc.

Amalgamated Zinc (de Bavay’s) Ltd v FCT Facts: The company carried on business mining in Broken Hill. Mining ceased in 1924 and by 1929 stocks and plant and machinery were sold. Subsequently, the only income was derived from investments. However, the company remained liable to make compensation payments to former workers who had contracted tuberculosis. The company’s liability was pursuant to a special statutory scheme and arose simply because of the earlier mining activities. For the years ended 1932 and 1933 the company claimed a deduction for such payments against its investment income. The Commissioner disallowed the claim on the grounds that the payments were made after the taxpayer had ceased its mining activities. Held: The High Court unanimously held that the payments were not deductible under s 23(1)(a). Several members of the court made reference to the requirement that the expenditure be ‘incidental’ to the generation of income. Dixon J also made reference to ‘relevance’. The following extracts contain statements widely cited [page 482] as defining the interpretation and scope of the former single limb general deduction provision. Latham CJ said (at ATD 293): The phrase “losses and outgoings actually incurred in gaining or producing the assessable income” may, in relation to outgoings, be read as meaning that the outgoing must be an expenditure which has an effect in gaining or producing income, eg, the purchase price of goods that are subsequently sold. But it is difficult to see how a loss, as distinct from an outgoing, can ever gain or produce income. On the contrary a loss, as distinct from an outgoing, simply or merely reduces income or capital, as the case may be. In order to make the section intelligible it must, in my opinion, be read as meaning “losses and outgoings actually incurred in the course of gaining or producing the assessable income”. [Emphasis added] In this case, however, the outgoings in question have no relation whatever to the assessable income of the years in question. It is true that, in cases of continuing businesses, it has been conceded … that expenditure may be allowed as a deduction though it produces and is possibly designed to produce results in the way of income in a future year and not in the year in relation to which income is being assessed; Ward & Co v Commr of Taxes [1923] AC 154. So it has been held that expenditure which has a direct relation to income of a past year can be deducted in a later assessment year when it is of such a character that, in a continuing business, it must be met from time to time as part of the process of gaining income; Herald and Weekly Times Ltd v FCT (1932) 48 CLR 113; 2 ATD 169. But even this benevolent interpretation cannot assist the taxpayer in a case like this, where there has been a complete cessation of the income producing operations out of which the necessity to make the outgoing arose. Dixon J said (at ATD 297–8):

A very wide application should be given to the expression “incurred in gaining or producing the assessable income”. But the words refer to the assessable income from which the deduction is to be made. In a continuing business, items of expenditure are commonly treated as belonging to the accounting period in which they are met. It is not the practice to institute an inquiry into the exact time at which it is hoped that expenditure made within the accounting period will have an effect upon the production of assessable income, and refuse to allow it as a deduction if that time is found to lie beyond the period. And, in the case of expenditure [page 483] for which the taxpayer contracted a liability during an earlier accounting period than that in which it has matured, it is not the practice to consider whether its effect on the production of income of a still continuing undertaking has already been exhausted. The terms of s 23(1)(a) have never been understood as requiring such a thing; Ward & Co v Commr of Taxation … Herald and Weekly Times Ltd v FCT … The expression “in gaining or producing” has the force of “in the course of gaining or producing” and looks rather to the scope of operations or activities and the relevance thereto of the expenditure than to purpose itself. Purpose itself may be the criterion expressed by the word “for” which occurs in the correlative prohibition contained in s 25(e). This provision, however, does not prefix the definite article to the words “assessable income” and, therefore, is satisfied if the purpose is the production of income considered independently of division into periods of account. The practice which prevails in the case of continuing businesses is, therefore, not inconsistent with the interpretation of s 23(1)(a) which makes it refer to the assessable income from which the deduction is to be made … In the present case, the actual expenditure was met in the current year. But it was completely dissociated from the gaining or production of the assessable income of that year. The payment, in effect, did no more than keep down an annual charge arising out of a business which had closed. It is a charge of uncertain duration and of uncertain amount … What is important is the entire lack of connection between the assessable income and the expenditure … It was a payment independent of the production of income. [Emphasis added]

8.11 Several principles emerge from these decisions. First, to say that a loss or outgoing is ‘incidental and relevant’ to the gaining or production of assessable income is to say that it has a necessary connection with income generation. That is the essence of the nexus requirement. Second, it is unnecessary to trace or link or match an expenditure with an item of income. In Toohey’s Ltd v CT (NSW)

(1922) 22 SR (NSW) 432 at 440, Ferguson J likened attempts to connect individual outgoings and incomings to the futility of connecting lumps of coal with bursts of steam. Losses and outgoings refer to the assessable income generally. Precisely how long a time period may elapse between the income-producing activity, the income and the outlay before its relevance is questioned is at the heart of the decision in Amalgamated Zinc and is the subject of further consideration.14 [page 484] Third, the expression ‘in gaining or producing’ means ‘in the course of gaining or producing’. In Latham CJ’s opinion, this interpretation is necessary to make sense of the word ‘loss’ because, in itself, a loss is not productive of anything. Dixon J did not address the question of losses separately and simply read the provision as meaning losses and outgoings actually incurred in the course of gaining or producing assessable income. In W Nevill & Co Ltd v FCT (1937) 56 CLR 290; 1 AITR 67, Dixon J relied on the above discussion in Amalgamated Zinc to use, for the first time, the words ‘incidental and relevant’ to describe a requirement of expenditure that satisfied the general deduction provision of the 1922 Act. The case involved a claim for payments made to a joint managing director to induce him to resign from the taxpayer company. The object of the arrangement was to effect a salary saving and enhance the efficiency of the company by abolishing the system of joint control.15 Dixon J stated the requirement as follows (at AITR 75): Under [s 23(1)(a) of the 1922 Act] it is necessary that the expenditure should have been incurred in the gaining or producing of the assessable income, that is the assessable income of the given financial year or accounting period. This means that it must have been incurred in the course of gaining or producing the assessable income. It does not require that the purpose of the expenditure shall be the gaining or production of the income of that year. The condition the provision expresses is satisfied if the expenditure was made in the given year or accounting period, and is incidental and relevant to the operations or activities regularly carried on for the production of income. [Emphasis added]

These decisions related to the single limb general deduction

provisions that preceded the former ITAA36 s 51(1). In Ronpibon Tin NL v FCT (1949) 78 CLR 47; 4 AITR 236; 8 ATD 431, the High Court analysed the reformulated general deduction provision in terms of its three limbs. The judgment of Latham CJ in Amalgamated Zinc was affirmed. To be an allowable deduction under the first positive limb of s 51(1), the court said the loss or outgoing must be ‘incidental and relevant to that end’. The court added: … to come within the initial part of the subsection it is both sufficient and necessary that the occasion of the loss or outgoing should be found in whatever is productive of the assessable income or, if none is produced, would be expected to produce assessable income.

Collectively, these judgments indicate that an expenditure will be incidental when it is incurred in order to support or further incomeproducing activities, or when it is a consequence of operations but not directly productive of income. That is, the expenditure is incurred as one of the consequences of gaining or producing the assessable income. On the other hand, relevance looks to the dependency of the expenditure and the production of assessable income. A payment that is [page 485] independent of the production of assessable income is irrelevant. Arguably, expenses of a private (or domestic) nature are irrelevant. It may be contended that expenditures are irrelevant if, like fines and penalties for breaches of the law, they fall upon taxpayers as aberrant citizens. More generally, expenditures are irrelevant if, for whatever reason, they are outside the scope of income-producing activities.

‘Essential character’ 8.12 The value of the ‘incidental and relevant’ test is that it has been explained in language that articulates the nature of the required nexus between an outlay and assessable income but it is doubtful if, by itself, it sets the boundaries of deductibility. It merely states an attribute without which an outgoing will not be deductible.16

The ‘essential character’ test provided some embellishment of relevance as it is understood in the ‘incidental and relevant’ test. This test derives from the decisions in Charles Moore & Co (WA) Pty Ltd v FCT (1956) 95 CLR 344; 6 AITR 379; 11 ATD 147 and Lunney v FCT (1958) 100 CLR 478; 7 AITR 166; 11 ATD 404. The Charles Moore case concerned the armed robbery of company employees on the way to bank the previous day’s takings. It had been accepted by the courts before Charles Moore’s case that involuntary outgoings and unforeseen or unavoidable losses were allowable deductions when they were the kind of mischance or misfortune that was a natural or recognised incident of a trade or business: CT (NSW) v Ash (1937) 61 CLR 263; 5 ATD 76. In the circumstances of Charles Moore’s case, the High Court said that was so ‘even if armed robbery of employees carrying money through the streets had become an anachronism which we no longer knew’. In regard to the words ‘incidental and relevant’, the court said (at ATD 149): Phrases like … “incidental and relevant” when used in relation to the allowability of losses as deductions do not refer to the frequency, expectedness or likelihood of their occurrence or the antecedent risk of their being incurred but to their nature or character. What matters is their connection with operations which more directly gain or produce the assessable income.

A more important refinement of the ‘incidental and relevant’ test was made in Lunney’s case. The case is also notable because it addressed the question of deductibility of travel to work, an issue often before the courts.17 [page 486]

Lunney v FCT Facts: Two appeals were heard concurrently in relation to claims by Lunney, an

employee, and Hayley, a professional dentist. Each sought to deduct the cost of travel from his residence to the place of employment or business. Held: A majority of the High Court (Dixon CJ, Williams, Kitto and Taylor JJ; McTiernan J dissenting) held the expenditure was not deductible. Dixon CJ considered that the weight of authority compelled the conclusion but was of the view that, if the matter were to be worked out again on bare reason, he would have misgivings about such a conclusion. McTiernan J considered that without incurring the fares to work the taxpayers could not earn their assessable income and it was an unduly narrow construction of the first positive limb of the former ITAA36 s 51(1) to confine it to expenditure made in the bare physical and temporal limit of a workplace. After examining Amalgamated Zinc, W Nevill & Co and Ronpibon Tin, Williams, Kitto and Taylor JJ stated as follows (at AITR 178–9): Examination of these cases, however, readily shows that the expression “incidental and relevant” was not used in an attempt to formulate an exclusive and exhaustive test for ascertaining the extent of the operation of the section; the words were merely used in stating an attribute without which an item of expenditure cannot be regarded as deductible under the section … In the context in which they have been used [the words ‘incidental and relevant’] have been intended as a reference, not necessarily to the purpose for which an item of expenditure has been incurred, but, rather, to the essential character of the expenditure itself … The question whether the fares which were paid by the appellants are deductible under s 51(1) should not and, indeed, cannot be solved simply by a process of reasoning which asserts that because the expenditure on fares from a taxpayer’s residence to his place of employment or place of business is necessary if his assessable income is to be derived, such expenditure must be regarded as “incidental and relevant” to the derivation of such income. No doubt both the propositions involved in this contention may, in a limited sense, be conceded but it by no means follows that, in the words of the section, such expenditure is “incurred in gaining or producing the assessable income” or “necessarily incurred in carrying on a business for the purpose of gaining or producing such income”. It is, of course, beyond question [page 487] that unless an employee attends his place of employment he will not derive assessable income and, in one sense, he makes the journey to his place of employment in order that he may earn his income. But to say that expenditure on fares is a prerequisite to the earning of a taxpayer’s income is not to say that such expenditure is incurred in or in the course of gaining or producing his income. Whether or not it should be so characterized depends upon considerations which are concerned more with the essential character of the expenditure itself than with the fact that unless it is incurred an employee or a person pursuing a professional practice will not even begin to engage in those activities from which their respective incomes are derived. Their Honours considered several UK cases rejecting the deductibility of cost of travel to work and noted:

Indeed they go further and refuse assent to the proposition that such expenditure is, in any relevant sense, incurred for the purpose of earning assessable income and unanimously accept the view that it is properly characterised as a personal or living expense.

8.13 Being ‘incidental and relevant’ is a necessary attribute of a loss or outgoing, in order for it to be deductible. The words are not meant to formulate an exclusive and exhaustive test of deductibility. Rather, they are meant to refer to the essential character of the outlay. To be deductible, the expenditure should possess an essential character of a business expense.18 Cases adopting the ‘essential character’ test provide further authority for the proposition that it is not enough to show that an outlay is a prerequisite to the generation of income. This means that it will be insufficient to show that the purpose of the expenditure was incidental to income-producing activities; it must also be relevant to the derivation of assessable income and relevance will be assessed by reference to the outlay having an essentially business (as opposed to living) character.19 In Lunney’s case, the fares were not business expenses. They were, essentially, living expenses, and it did not matter that it was a practical necessity that the expenditure be made before income could be produced. The manner in which the ‘incidental and relevant’ and ‘essential character’ tests operate in tandem is illustrated in a number of more recent High Court decisions. [page 488] For example, in FCT v DP Smith (1981) 147 CLR 578; 11 ATR 538; 81 ATC 4114, the court said (at ATC 4117): What is incidental and relevant in the sense mentioned falls to be determined not by reference to the certainty or likelihood of the outgoing resulting in the generation of income but to its nature and character and generally to its connection with the operations which more directly gain or produce the assessable income.

In Fletcher v FCT (1991) 173 CLR 1; 22 ATR 613; 91 ATC 4950, the High Court said (at ATC 4957): The question whether an outlay was, for the purposes of s 51(1), wholly or partly “incurred in gaining or producing the assessable income” is a question of characterization. The relationship between the outgoing and the assessable income must be such as to impart to the outgoing the character of an outgoing of the relevant kind. It has been pointed out on many occasions in the cases that an outgoing will not properly be characterized as having been incurred in gaining or producing assessable income unless it was “incidental and relevant to that end”.

Both these decisions suggest that determining the essential character of an outgoing is part of the process of establishing relevance. In turn, this suggests that the ‘essential character’ test is neither a new nor even a separate test; it is just another way of stating an attribute that an expenditure must possess to satisfy the general deduction provision. For example, in Herald and Weekly Times Ltd v FCT (1932) 48 CLR 113; 2 ATD 169, a case instrumental in the development of the ‘incidental and relevant’ test, the court said (at ATD 172) of a penalty imposed for breach of the law that ‘[i]ts nature severs it from the expenses of trading’ (emphasis added). Referring to the same issue in the later case of FCT v Snowden & Willson Pty Ltd (1958) 99 CLR 431; 7 AITR 308; 11 ATD 463, Dixon CJ said (at AITR 312): ‘There the character of the expenditure and the reasons why the law imposes a fine or penalty separate the expenditure from the conduct of the business’ (emphasis added). As a result, as these cases suggest, expenditure that falls on the taxpayer in some capacity other than as an income earner, or in the course of activities other than those directed to the production of income, will be irrelevant because it does not have the essential character of a business expense even though the outgoing may arise in a time frame contemporaneous with income production. Thus, it might be said that characterisation is a process of determining whether an expenditure is incidental to income-producing activities and has a relevance that stamps it as an allowable deduction. Penalties for breach of the law occasioned by income-producing activities do not have an essential income-earning character or, at any rate, are not deductible because they are contrary to public policy.20 In determining the essential character of an outgoing, regard may be

had to the nature of the receipt calculated to be received, but it will not be determinative. Rather, the character of the receipt requires consideration of the purpose for which a taxpayer entered into a particular contract or incurred certain expenditure.21 In DP Smith’s case, the High Court said (at ATC 4115): [page 489] If it is correct to include the moneys received under the policy [of insurance] in the assessable income of the taxpayer then that consideration is relevant to, but not necessarily determinative of, the question whether the premium is deductible under s 51(1).

What is important in characterising expenditure is its relevance to the income-producing process, not necessarily the outcome. There will be occasions where it is genuinely hoped that no income will result from an expenditure, for example, in the case of insurance premiums. Accordingly, expenditure to monitor investments or to insure assets of a business or to insure against an adversity are to be characterised by their relevance to income-earning activities generally rather than by reference to a receipt that may be generated.22 Dicta in Herald and Weekly Times Ltd and Snowden & Willson Pty Ltd support the view that what was articulated as the ‘essential character’ test in Charles Moore & Co (WA) Pty Ltd v FCT (1956) 95 CLR 344; 6 AITR 379; 11 ATD 147 and Lunney v FCT (1958) 100 CLR 478; 7 AITR 166; 11 ATD 404 is little more than an attempt to assess relevance. If this appraisal is correct, the ‘essential character’ test does not qualify the ‘incidental and relevant’ test so much as bring it into sharper focus. So, in terms of Lunney’s distinction between ‘living’ and ‘business’ expenses, a ‘living’ expense is irrelevant to income production. This is so even though, in one sense, it might be connected because it is a prerequisite to the earning of income and is outlaid within the same time frame as the earning of income. In FCT v Day (2008) 236 CLR 163; [2008] HCA 53, a majority of the High Court allowed a customs officer deductions for legal expenses incurred in defending himself against charges brought under the Public

Service Act 1922. Gummow, Hayne, Heydon and Kiefel JJ said (at [29]): Expressions used in the cases, such as “incidental and relevant”, as referable to a business, should not be thought to add more to the meaning of provisions such as s 81(1)(a) of the ITAA, or to narrow its operation. They should be taken to describe an attribute of an expenditure in a particular case, rather than being an exhaustive test for ascertaining the limits of the operation of the provision [Lunney v FCT (1958) 100 CLR 478 at 497 per Williams, Kitto and Taylor JJ]. Reference in some cases to the expenditure having an “essential character” must likewise be treated with some care. As Gaudron and Gummow JJ observed in Payne, the use of the term may avoid the evaluation which the section requires [(2001) 202 CLR 93 at 110–11]. It is perhaps better understood as a statement of conclusion than of reasoning.

8.14 The essential character test presents two difficulties when its analytical usefulness is examined. First, as a workable non-statutory test, some criteria are required to evaluate that character. It is true that when the test is used in situations such as in Lunney’s case, and the distinction is between ‘business’ and ‘living’ expenses, there is some division even if the line of demarcation is unstated. However, where a business/living distinction is not the issue, the test is limited. Although the test was adopted in Charles Moore’s case, it was used there to refine the ‘incidental and relevant’ test. The court said that it was not the ‘frequency, expectedness, or likelihood’ that mattered so much as the ‘nature or character’ of the outgoing. In the court’s view, the central issue was the ‘connection with the operations which more [page 490] directly gain or produce assessable income’. The same point was made in DP Smith’s case but in neither Charles Moore nor DP Smith was the division between business/living expenses the critical issue. In both of these cases, the Commissioner contended that the expenditure was capital. As a result, although it would be accepted that an essential character as a business expense will stamp the character of an outgoing, what it is that distinguishes ‘non-business’ expenses remains elusive. A second problem with the test is the question of whether characterisation refers to an attribute of an expenditure itself or the

object of an expenditure. For example, can it be said that expenditure on food, clothing or travel always will have an essential character that disallows a deduction because the outlays are essentially ‘living’ expenses? Such a blanket denial would be both unwelcome and inconsistent with case law. However, two (majority) High Court decisions in relation to deductibility for expenses for home offices carry a suggestion that a home has an essentially private character that is not changed by the use to which some part of it might be put: Handley v FCT (1981) 148 CLR 182; 11 ATR 644; 81 ATC 4165; FCT v Forsyth (1981) 148 CLR 203; 11 ATR 657; 81 ATC 4157.

Handley’s and Forsyth’s cases Facts: The two cases concerned barristers who, in one case, purchased a house with a room that could be used as a study (Handley), and, in another case, paid a family trust for the use as a study of a room in the family’s residence (Forsyth). The taxpayers claimed a deduction for an apportioned cost of interest on the mortgage and the rental charge by the trust, respectively. Held: A majority of the High Court disallowed the claims (Mason, Murphy and Wilson JJ; Stephen and Aickin JJ dissenting) on the grounds that they had an essential character of a private or domestic nature. Wilson J delivered the leading judgment in both cases. In Forsyth at ATR 664, his Honour held: In my opinion, an important question is the relationship of the study and ancillary space to the house as a whole. There would appear to be a complete integration, with no suggestion of any physical exclusivity. The study is indistinguishable from other rooms in the living area of the house and is so placed as to the taxpayer’s bedroom that he finds it convenient to keep his clothes in the study and use it as a dressing room … The taxpayer maintains chambers in the city. There is no compulsion for him to work at home … Like many professional people, he finds it convenient to do so. The professional activity he engages in at home is mostly research and reading, presumably not requiring the services of a secretary. Resort to the house by clients and/or solicitors for the purpose of professional conferences are apparently so infrequent as to be immaterial. [page 491] His Honour went on to conclude that the outgoings were neither ‘incidental nor relevant’

to the gaining or producing of assessable income. Even if prima facie the rent was an outgoing that satisfied the positive part of the provision, it was denied as a loss or outgoing of a domestic nature and that nature was unchanged by the use made of the study: The agreement itself coupled with the physical arrangements of the house and all the circumstances supply the necessary relation between the outgoing and the household to establish its domestic character. The argument was dismissed that the rental payment to the trust in Forsyth’s case was genuinely for the use of the study and associated facilities in the course of gaining assessable income: It seems to me that to adopt a test in these terms is quite clearly to abandon the “essential character” test in favour of a “use” criterion preferred by the New Zealand Court of Appeal. In dissent, Stephen J (Aickin J agreeing) rejected a blanket characterisation of a home as private in nature. Whether a loss or outgoing is of a nature or character sufficiently incidental and relevant to the derivation of assessable income depends on a variety of factors and, particularly in relation to a home office, the advantage sought can be evaluated only by examining the use made of part of a house.

The decision in Handley’s and Forsyth’s cases highlights a weakness of the ‘essential character’ test. If a particular category of expenses is to be labelled ‘essentially private’, the test is too extreme because it prevents examination of particular circumstances. It will mean that ‘essentially private’ expenditure on food, clothing and travel cannot be deductible. Such a conclusion is inconsistent with authorities and the Commissioner’s practice. Alternatively, the test could be viewed as a medium for breaking up broad, generic categories. So, for example, although there are many instances where food costs are essentially living expenses, there are occasions (such as in the case of a food critic) where they are ‘business’ expenses. Similarly, there will be times where clothing is worn for reasons other than essentially observing social proprieties.23 Paradoxically, these exceptions stem from examining the expenditure’s relevance.

Condition of employment; perceived connection ‘tests’ 8.15 It is likely that when these or similar descriptions are used, it is done in the course of assessing relevance of an outgoing. In FCT v Hatchett (1971)

[page 492] 125 CLR 494; 2 ATR 557, Menzies J remarked in relation to the deductibility of self-education expenses that there must be a ‘perceived connection’ between the outgoing and the earning of assessable income. However, there is no High Court decision that describes either of these phrases as tests; in fact, several courts have criticised the suggestion.24 That is not to say that an expenditure undertaken as a condition of employment cannot satisfy the nexus requirement. On the contrary, demonstration that an expenditure — such as continuing professional education by an accountant — is an implied term of employment goes a long way to demonstrating that it is incidental and relevant to income generation. However, it does not follow that, in order to satisfy the nexus requirement of s 8-1, it is necessary to examine the terms of an appointment for express or implied terms that require the particular expenditure. There are other cases concerned with the deductibility of selfeducation expenses that have adopted expressions suggesting a ‘condition of employment test’ but it is likely the expression has been employed as a surrogate for other tests rather than as a refinement of them. For example, in FCT v Kropp (1976) 6 ATR 655 at 659, Waddell J adopted the expression to describe the nexus requirement. In Martin v FCT (1984) 15 ATR 808, the Full Federal Court said it did not believe the expression was intended to be a substitute for tests developed in the older authorities: see also FCT v Klan (1985) 16 ATR 176; 85 ATC 4060. In FCT v Anstis (2010) 241 CLR 443; [2010] HCA 40; BC201008389, there was no relevant employment, but the High Court, in dismissing the Commissioner’s appeal, allowed self-education deductions incurred in satisfying conditions for receipt of the Youth Allowance.25 The court said (at [34]): ‘Those outgoings were deductible by reason of their being incurred in the course of her retention of a statutory right to payment’. The test applied was the standard question of whether the occasion of the outgoings was to be found in the activities or operations productive of assessable income. The activities

or operations productive of assessable income involved satisfaction by Anstis of an ‘activity test’ under the Social Security Act 1991 (Cth), so that she could keep her statutory right to Youth Allowance. Where an employee incurs an outgoing pursuant to an express or implied term or condition of employment, it may satisfy the first positive limb of ITAA97 s 8-1(1)(a)26 and, where there is no such employment requirement, the onus is on the taxpayer to adduce alternative evidence of the nexus. The absence of such a requirement does not necessarily lead to a conclusion that the outlay is not deductible and in this sense it is not a test of deductibility. Outlays incurred voluntarily or in carrying out [page 493] activities beyond those required by law or pursuant to an employment contract will be deductible when otherwise they satisfy the expenditure– income nexus. Thus, the ‘incidental and relevant’ and ‘essential character’ tests are not qualified or refined by a purported ‘conditions of employment’ or ‘perceived connection’ test.

Construction issues 8.16 One issue relating to the construction and interpretation of ITAA36 s 51 is whether an expenditure can be incurred in gaining or producing assessable income or be necessarily incurred in carrying on business for the purpose of gaining or producing such income, thus falling within one or more of the positive limbs of the section, and yet be excluded from deductibility because it was within one of the negative limbs.

1.

2.

3.

Is it logically possible that a loss or outgoing can fail to satisfy ITAA97 s 8-1(1)(a) (ie, not be incurred in gaining or producing assessable income) yet satisfy ITAA97 s 81(1)(b) (ie, be necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income)? Is it possible that a loss or outgoing may satisfy ITAA97 s 8-1(1) (a) or (b), yet be: (i) capital, or of a capital nature; (ii) private or domestic nature? Suggest examples. Why is it impossible for expenditure incurred deriving exempt income to satisfy the positive parts of the provision?

In Ronpibon Tin NL v FCT (1949) 78 CLR 47; 4 AITR 236; 8 ATD 431, the High Court observed that, as exempt income is by definition not assessable income, a loss or outgoing incurred in gaining or producing assessable income could not at the same time be incurred in gaining or producing exempt income. Thus, rather than being a true exception, the exclusion of losses or outgoings incurred in gaining or producing exempt income was to emphasise, by making what the High Court termed ‘an express contrast’, the mutual exclusivity of expenditure directed towards producing assessable income and expenditure directed towards producing exempt income. While the position in relation to the exclusion of expenditure directed towards gaining exempt income has usually been regarded as being settled by the comments of the High Court in Ronpibon Tin, the question of whether the exclusions of capital expenditure and of expenditure of a capital, private or domestic nature are true exceptions or contradistinctions has generated considerable discussion. These issues are discussed in Study help. [page 494]

Operational issues 8.17 From an operational perspective, it is not critical how the general deduction provision is construed since, ultimately, the question

is whether the relevant loss or outgoing is an allowable deduction. To that end, the limbs of the former ITAA36 s 51(1) and the paragraphs and subsections of ITAA97 s 8-1 offer alternative approaches to resolving questions of deductibility. If an item of expenditure is of a capital or private nature, it is not deductible. It is unnecessary to agonise over whether the item falls within the positive part of the provision. Similarly, there may be occasions where it is not immediately clear whether an outgoing is incurred in gaining or producing assessable income (ITAA97 s 8-1(1)(a)) but it may be evident that it is incurred in carrying on a business for that purpose (ITAA97 s 8-1(1)(b)). Consider the following three illustrations.

The business limb 8.18 In Ferguson v FCT (1979) 3 ATR 873; 79 ATC 4261, the taxpayer was a naval officer who intended upon retirement to raise beef cattle. Several years before retirement he entered into a leasing arrangement under which he bred cattle, retained the female calves and sold the bulls. In this way, he hoped to build up a herd and ultimately engage in full-scale cattle production. The question before the Federal Court was whether the costs connected with leasing, breeding and agistment of the cattle were deductible under former ITAA36 s 51(1). One way of resolving the question was to determine whether the taxpayer was carrying on a business for the purpose of gaining or producing assessable income as opposed to a hobby or pastime, or whether the activities and the expenditure occurred ‘too soon’ in the sense of being too remote or in the nature of preliminary or set-up costs and capital in nature. The court concluded, on the facts, that the taxpayer’s activities amounted to carrying on a business and, as a result, the expenditure was deductible. This case illustrates how the former business limb of ITAA97 s 8-1(1)(b) might be put to practical use. It provides an alternative to attempts to decide the issue under the first limb of ITAA97 s 8-1(1)(a).

The capital exclusion 8.19

From an operational point of view, a loss or outgoing of capital

is not deductible. It may be hypothesised that such an outlay satisfies the positive part of the provision in order to focus on the critical issue: Is the amount on revenue or capital account? In John Fairfax & Sons Pty Ltd v FCT (1959) 101 CLR 30; 7 AITR 346; 11 ATD 510, the Full High Court considered the deductibility of certain legal expenses incurred in an allotment of shares as a defensive measure against a takeover threat. The critical question was whether the outgoing was of a capital nature. Dixon CJ said (at ATD 512): The question whether the expenditure in respect of which a deduction is here sought is of a capital nature appears to me to be of more general importance, although of less difficulty, than the question of whether it qualifies under the earlier part of [former ITAA36] s 51(1) … I shall say nothing more about the latter question than that it depends much less on principle … and much more on the view taken of the specific facts.

[page 495] The court concluded the outgoing was capital in nature and it is clear that Dixon CJ adopted what he saw as an easier course of action by deciding whether the amount was capital rather than whether it fell within the positive part of s 51(1). Again, this case illustrates the facility of the negating limb.

The private/domestic exclusion 8.20 In FCT v Hatchett (1971) 125 CLR 494; 2 ATR 557; 71 ATC 4184, a schoolteacher claimed a deduction for certain expenses associated with gaining a higher certificate, successful completion of which led to higher income. He also claimed university fees for a course undertaken at the encouragement of his employer who partially reimbursed the fees. The taxpayer succeeded in gaining a deduction only for the higher certificate expenses. The university fees failed the test of deductibility. Of them, Menzies J said at ATC 4188: ‘The payment of university fees was, I think, expenditure of a private nature notwithstanding the assistance given by the department’. Menzies J concluded that the expenses failed the positive part of the provision and were of a private nature but, to deny deductibility, it

would be enough to conclude they were private. In this sense, his Honour has demonstrated the operational function of the negating limb of the former ITAA36 s 51(1) as a possible expedient to resolving questions of deductibility.27 Thus, there have been occasions when recourse to the limbs of s 51(1) assisted in resolving questions of deductibility that may not have been so easily or evidently determined by reference to the positive part of the provision. There is some attraction in the view that, in the course of characterising expenditure, the focus should be the critical issue in dispute — whether it be if there is a business or whether the outgoing is of a capital or private nature. It may even be hypothesised that the amount does satisfy the positive part of the provision in order to focus on the critical issue. A conclusion that there is a business or that the outgoing is capital or private in nature resolves the issue categorically. The possible application of paras (c) and (d) of ITAA97 s 8-1(2) is consistent with this approach.

Relaxing the temporal nexus 8.21 Difficult questions of deductibility arise when the operations that generate a current obligation to pay have ceased or been abandoned or sold, or where an endeavour is terminated before income materialises. What is at issue is conveniently described as the ‘temporal nexus’.28 How remote or proximate in terms of time must the operations-outlay-income be before doubts arise concerning whether the [page 496] liability is incurred ‘in gaining or producing the [or your] assessable income’? Several subsequent cases show a relaxation of the strict view evident in Amalgamated Zinc (de Bavay’s) Ltd v FCT (1935) 54 CLR 295; 3 ATD 288, discussed above.29 The classic older authority on the temporal nexus is Amalgamated Zinc (see 8.10) and what was critical in that case was that ‘there had

been a complete cessation of the income-producing operations out of which the necessity to make the outgoing arose’. The business of mining had ceased completely. This decision might seem harsh by today’s standards and, as the next two cases are examined, consider whether an argument couched in the following terms would have succeeded: suppose that, because the company faced commitments relating to mining activities, it set aside investments specifically to provide funds to meet the future obligations and that the compensation payments were a necessary outgoing of a diversified operation. 8.22 An important case in the relaxation of the temporal nexus was AGC (Advances) Ltd v FCT (1975) 132 CLR 175; 5 ATR 243; 75 ATC 4057. In that case, the taxpayer (operating initially under another name) carried on a financing business until December 1968 when its operations were suspended and it entered into a scheme of compromise with creditors. In April 1970, Australian Guarantee Corp acquired the shares in the company and it resumed operations under the new name. A number of debts outstanding before December 1968 were subsequently written off and a deduction was claimed under the former ITAA36 s 51(1). Barwick CJ said: In the application of [s 51(1)], it has not been possible to utilize the definite article as to require the expenditure in question to have produced or assisted to produce the assessable income of the particular year of the expenditure. Nor can it be construed to require that the loss be similarly related to the assessable income of the particular year …

Mason J said: It is inconceivable that Parliament intended to confine deductions to losses and outgoings incurred in connection with the production of income in the year in question and to exclude losses and outgoings incurred in connection with the production of income in preceding or succeeding years.

In Barwick CJ’s view, the decision in Amalgamated Zinc required only that, where there was a break in business activity, the resumed business must be substantially the same. In addition, Amalgamated Zinc said nothing about losses (as opposed to outgoings) and a business loss may be deductible even though it occurs in a year when a taxpayer is not actively carrying on a business.

Mason J relied on the fact that the earlier decision was in relation to a general deduction provision that did not contain a ‘business limb’ and if the matter was to be decided anew, outlays directed to the production of income should not be divided into accounting periods. [page 497] In Placer Pacific Management Pty Ltd v FCT (1995) 31 ATR 353; 95 ATC 4459, the taxpayer carried on a number of business activities, including the manufacture of conveyor belts. A dispute arose in 1978 between the taxpayer and a particular customer and, although the conveyor belt division was later sold, the taxpayer continued to be liable for claims arising out of that particular contract. Subsequently, the taxpayer paid damages in 1981 of $325,000 plus legal fees of $58,000 which it sought to deduct under the former ITAA36 s 51(1). The Full Federal Court allowed the taxpayer’s appeal, holding that the decision in AGC (Advances) established a proposition: … that provided the occasion of a business outgoing is to be found in the business operations directed towards the gaining or production of assessable income generally, the fact that the outgoing was incurred in a year later than the year in which the income was [derived] and the fact that in the meantime business in the ordinary sense may have ceased will not determine the issue of deductibility. There is no relevant distinction to be drawn between losses and outgoings. Provided the occasion for the loss or outgoing is to be found in the business operations directed to gaining or producing assessable income, the loss or outgoing will be deductible unless it is capital or of a capital nature.

The more liberal application of the temporal nexus evident in AGC (Advances) and Placer Pacific Management was applied by the Full Federal Court in FCT v Brown (1999) 43 ATR 1; 99 ATC 4600; [1999] FCA 721. In that case, the Browns borrowed money to acquire a delicatessen in partnership. The shop was later sold but funds were insufficient to pay out the loan. The issue before the court was whether the interest on the continuing loan after the sale of the delicatessen was an allowable deduction. The court dismissed the Commissioner’s appeal. However, in doing so, the court did indicate that the nexus between the interest payments and the delicatessen business might be

broken in the future by factors such as the extended time between the cessation of the delicatessen business and the payment of interest or by the nature of a future refinancing. A similar issue to Brown arose in FCT v Jones [2002] FCA 204; 2002 ATC 4135. In that case, a husband and wife carried on a transport business in partnership and arranged loans to finance purchases of equipment. Following the husband’s death, the taxpayer struggled to clear outstanding debts and eventually refinanced the loan. The Full Federal Court held that the taxpayer had no free choice between continuing the loan or repaying it. In addition, the court held that refinancing the loan did not break the nexus between the interest expense and the business: ‘It is well established that when an original borrowing is refinanced, the new financing takes on the same character as the original borrowing. The character of the loan is not changed. See Commissioner of Taxation v Roberts (1992) 37 FCR 246 …’. 8.23 The decisions in Amalgamated Zinc and Brown concerned postclosure expenses. In Placer Pacific Management, a part of the business had ceased. In AGC (Advances), there was a hiatus in activity. The situation when payment preceded the derivation of income was examined in FCT v Brand (1995) 31 ATR 326; 95 ATC 4633 and Steele v DCT (1999) 197 CLR 459; 41 ATR 139; 99 ATC 4242. In Brand’s case, the taxpayer invested in a proposed prawn-farming venture with companies NQIT, which was to provide ponds and facilities and farm the prawns, [page 498] and GRS, which was to manage the operation. The taxpayer paid $15,000 for a seven-year licence for use of the facilities to be constructed by NQIT but before the ponds were ready, NQIT was wound up and the taxpayer received no return on his investment. Nicholson J in the Federal Court (95 ATC 4262) upheld the taxpayer’s appeal against the Commissioner’s denial of a deduction for the

invested funds and the Full Federal Court dismissed the Commissioner’s appeal. The Commissioner’s argument that to be deductible an outgoing must be contemporaneous with an income-producing activity was dismissed. The court also rejected a contention that a line of authority disallowing deductions because they were ‘too soon’ did not lay down a further test of deductibility. A conclusion that expenditure was ‘too soon’ in the circumstances of a particular case was to say only that the statutory test was not satisfied.

Steele v DCT 8.24 One of the issues in Steele’s case was the remoteness of income. The taxpayer, who had interests in the hospitality industry, was seeking new opportunities and, in 1980, acquired land considered suitable for motel and residential development. Until the land was sold in 1988, the taxpayer pursued several development options unsuccessfully and the land was used only for agisting horses. Over the period, $29,000 was derived. The issue centred on the deductibility of interest amounting to $900,000. The Administrative Appeals Tribunal held that the interest, to the extent that it exceeded the agistment income, was directed to creating a profit-making structure and the Full Federal Court held the interest was on capital account. A majority of the High Court held that the Federal Court had erred in finding that the interest was on capital account. In the usual case, interest is revenue in nature and its character is not changed because the funds are used to buy a capital asset. In relation to the nexus question, the majority said the reference in s 51(1) to ‘the assessable income’ was to be construed as an abstract phrase referring not only to income derived in any particular year but also to assessable income that the outgoing would be expected to produce. Although the fact that an asset has not yet become, and may never become, an income-producing asset may be relevant to a decision concerning deductibility under the first limb of the former s 51(1), where the purpose of the taxpayer in borrowing the money is immediately satisfied by the use of the borrowed funds to acquire the

capital asset for income-producing purposes, the necessary connection exists. In summary it can be said: first, that the weight of authority on the construction of ITAA36 s 51(1) is clearly in favour of reading the phrase ‘the assessable income’ as referring to ‘assessable income generally’. Second, that while some of the judgments that imposed a contemporaneity requirement were based on the presence of the definite article (‘the’) in the first limb of 51(1) and its progenitors, others were not; and that in recent years, the Full Federal Court has distanced itself from notions of contemporaneity in the construction of s 51(1). The end result of this analysis is that the courts, even without resort to ITAA97 s 1-3, are unlikely to conclude that any change in meaning was intended by the substitution, in the ITAA97, of the phrase ‘your assessable income’ for the phrases ‘the assessable income’ and ‘such [page 499] income’ used in the ITAA36. If anything, the ITAA97 more clearly expresses what the courts had held to be the law under the ITAA36. In addition, comments made by the High Court in Steele’s case have identified the contemporaneity requirement as a consideration rather than a legal requirement. The majority said (at ATR 151): There are cases where the necessary connection between the incurring of an outgoing and the gaining or production of assessable income has been denied upon the ground that the outgoing was “entirely preliminary” to the gaining or production of assessable income or was “too soon” before the commencement of the business or income producing activity.

The majority continued: The temporal relationship between the incurring of an outgoing and the actual or projected receipt of income may be one of a number of facts relevant to a judgment as to whether the necessary connection might, in a given case, exist, but contemporaneity is not legally essential and whether it is factually important may depend upon the circumstances of the particular case.

In a separate but concurring judgment, Callinan J said (at ATR 167), after quoting the above comments by the majority: In FCT v Riverside Road Lodge Pty Ltd the Full Court of the Federal Court discussed

Texas Co (Australasia) Ltd … and … Total Holdings (Australia) Pty Ltd. They then referred to Maddalena and Lodge and a text by Professor RW Parsons which they said established that there should be an element of contemporaneity between the expenditure and the commencement of the business or income producing activity. I doubt whether they do establish such a proposition. If they do, they cannot now be taken as correct in view of the decision of the majority here.

The provision analysed 8.25 As indicated above, ITAA97 s 8-1 is the descendant of the original general deduction provisions that have been a feature of Australian taxation legislation since the 19th century. As a result, the meaning of key words and phrases common to the provisions — and the former s 51(1) in particular — have been established during a century of judicial consideration. This section of the chapter seeks to distil the essence of the courts’ deliberations in relation to: losses and outgoings; ‘to the extent to which’; ‘incurred’/‘necessarily incurred’; ‘in gaining or producing’; ‘in carrying on a business’; the/such/your assessable income; carrying on a business; purpose; capital or of a capital nature; private or domestic nature; exempt income. [page 500]

Before commencing this section, re-read ITAA97 s 8-1 carefully: see 8.1. Can you summarise the provision in your own words? Make a list of what you intuitively think the above words and phrases mean.

Losses and outgoings 8.26 Most expenses deductible under ITAA97 s 8-1 would be described as outgoings. Business expenses such as advertising, interest, rent, wages and employment expenses are understood as disbursements, outlays or outgoings. What is meant by a loss is not so clearly understood. The sale of an item for an amount less than its cost or the discharge of a liability for more than its face value is one understanding. An involuntary loss through a fire or theft is another. Both these conceptions of a loss are accepted in law. There is authority to distinguish a loss and an outgoing. In the UK decision Allen (HM Inspector of Taxes) v Farquharson Bros & Co (1932) 17 TC 59 at 64, Findlay J distinguished the terms as follows. An outgoing is:30 … something or other which the trader pays out; I think some sort of volition is indicated. He chooses to pay some disbursement; it is an expense; it is something which comes out of his pocket. A loss is something different. That is not a thing he expends or disburses. That is a thing which, so to speak, comes upon him ab extra.

On this basis, outgoings may be thought of as relating to voluntary actions on the part of the taxpayer — albeit payments made under contractual obligation. Losses could be understood to cover the situations in Charles Moore & Co (WA) Pty Ltd v FCT (1956) 95 CLR 344; 6 AITR 379; 11 ATD 147 (theft of the sales receipts in the course of banking them) or Guinea Airways v FCT (1950) 83 CLR 584; 5 AITR 58; 9 ATD 197 (destruction of a stock of spare parts through enemy bombing during World War II). It would be unnecessary to consider the question of a taxpayer’s subjective purpose or motive (to the extent that it is relevant anyway) in matters involving losses. It might be speculated that, in relation to losses, the question of whether the amount was on capital account or revenue account was the central

issue in dispute (as was the case, for example, in the Guinea Airways case and was contended by the Commissioner in Charles Moore).31 Another occasion when a distinction was drawn between a loss and an outgoing was Barwick CJ’s judgment in AGC (Advances) Ltd v FCT (1975) 132 [page 501] CLR 174; 5 ATR 243; 75 ATC 4057.32 The case concerned the deductibility of certain debts that had arisen some time in the past. It might have been fitting to describe the irrecoverability of the advances as involuntary losses, but Barwick CJ’s focus was different. A strict application of the decision in Amalgamated Zinc (see 8.10) might have disallowed a deduction but the Chief Justice noted that Amalgamated Zinc disallowed an outgoing, but said nothing about losses and, in the circumstances of AGC (Advances), the amounts in question were deductible losses of circulating capital.33 8.27 Although outgoings are usually thought of as a gross concept, there is authority to support a view that a loss may be a net amount: FCT v Commercial Banking Co of Sydney (1927) 27 SR (NSW) 231; Colonial Mutual Life Assurance Society Ltd v FCT (1946) 73 CLR 604; 3 AITR 450.34 That a net loss is deductible should not be surprising because it is clear that a net amount may enter assessable income as ordinary income: London Australia Investment Co Ltd v FCT (1977) 138 CLR 106; 7 ATR 757; 77 ATC 4398. It might be argued, therefore, that if it is appropriate to assess a net profit in a particular transaction, the same transaction if unsuccessful should generate a deductible net loss. That, at least, would be the outcome if there was conceptual symmetry between income and deductions.35 To be deductible as either a loss or an outgoing, an amount must satisfy the required nexus with assessable income. Normally, this will mean that a deduction incurred by one entity on another’s behalf will not satisfy s 8-1. Ordinarily, expenditure by shareholders in a company

or a beneficiary under a trust will not be sufficiently related to the income derived by the company or trust: North Australian Pastoral Co v FCT (1946) 71 CLR 623; 3 AITR 314. Two qualifications attach to this general rule. The first is where there is a nexus between the shareholder’s outgoing and the generation or the prospect of generating income. For example, in FCT v Total Holdings (Aust) Pty Ltd (1979) 9 ATR 885; 79 ATC 4279, the Federal Court agreed that a taxpayer was entitled to a deduction for interest on a loan on-lent to a subsidiary interest free because it generated ‘present or prospective income’. This decision, together with the Federal Court decision in FCT v EA Marr & Sons (Sales) Ltd (1984) 15 ATR 879; 84 ATC 4580, blurs the separate entity notion in [page 502] group company situations. The income tax consolidation rules (see 12.112) may apply in a company group setting in any event. Second, where a parent controls a subsidiary’s affairs, and is in a position to channel its resources in preferred directions, the subsidiary may generate profits which the parent can direct to itself as dividends and so satisfy s 8-1: see EA Marr & Sons. However, an employee in receipt of a salary will not be entitled to a deduction for expenditure voluntarily incurred on an employer’s behalf. The prospect of dividends and bonuses is too remote and the nexus requirement is not satisfied: North Australian Pastoral Co. A loss or outgoing of capital is denied deductibility by s 8-1(2)(a). Losses attributable to gambling have been almost invariably denied either because the prospective gain is not income (and hence the nexus is not satisfied) or because the activities do not amount to a business: Brajkovich v FCT (1989) 20 ATR 1570; 89 ATC 5227.36

‘To the extent that’ (or ‘to the extent to which’) 8.28

Losses and outgoings are allowable deductions ‘to the extent

that’ they are incurred in the course of activities directed to the gaining or producing assessable income. The phrase ‘to the extent that’ of itself suggests apportionment of a composite expenditure and the High Court decision in Ronpibon Tin NL v FCT (1949) 78 CLR 47; 4 AITR 236; 8 ATD 431 provides such authority, if it is needed. It will be noted that as ITAA97 s 8-1 has been drafted, these words qualify all the paragraphs of s 8-1(1) and (2).37 The effect of the words ‘to the extent that’ is to allow for apportionment of an outlay that in part satisfies and in part fails to satisfy the positive parts of s 8-1 or, under s 8-1(2), is in part of a capital, private or domestic nature, or is in part directed to the production of exempt income.38 The leading decision on the former ITAA36 s 51(1), in general, and in relation to apportionment, in particular, is Ronpibon Tin. That decision marked the first occasion the Full Court of the High Court addressed the reconstituted general deduction provision that preceded the current s 8-1.39 [page 503]

Ronpibon Tin NL & Tongkah Compound NL v FCT Facts: The companies carried on the business of tin mining in Siam and Malaya, the income from which was, until the mines were overrun by enemy forces in 1942, exempt under the former ITAA36 s 23(q). They also derived assessable income from investments. In the past, the Commissioner had allowed as deductions from this income 2.5% of a range of administrative expenses. Following the loss of the mines, the companies continued to incur expenses in the nature of management fees, directors’ fees, audit and administrative fees as well as allotments made to dependants in Australia of the manager (and his assistants) who were interned in Siam. The taxpayers sought to offset all deductions against the investment income. Held: The amounts relating to mining matters were affairs of capital, not deductible under the first limb of s 51(1). There was no guarantee the mines would produce income

again and the maintenance of an infrastructure was capital. Other outgoings (in relation to a ‘buffer stock scheme’) related to exempt income. The percentage of administrative costs that were deductible was remitted for the trial judge’s determination. (Ultimately an amount of £400 of a total £1206, or 33%, was allowed.) In comparing s 51(1) to its single-limb predecessor in general, and to the issue of apportionment in particular, the Full Court made three observations: 1. Section 51(1) adopted ‘a principle that will allow for dissection and even apportionment of losses and outgoings’. 2. Section 51(1) ‘introduces an alternative ground or head of deduction; it allows the deduction of all losses and outgoings to the extent to which they are necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income’. 3. The third matter to be mentioned is the express exception with which s 51(1) concludes. To except losses and outgoings of capital is both necessary and logical. But to except losses and outgoings to the extent to which they are incurred in relation to the gaining or production of exempt income seems to except something from the primary description which could not fall within it, for exempt income can never be assessable income. They are mutually exclusive categories. The explanation, doubtless, is the desire to declare expressly that so much of the losses and outgoings as might be referable to exempt income should not be deductible from the assessable income. [page 504] With respect to dissection and apportionment the court said (at AITR 247): The charges for management and directors’ fees are entire sums which probably cannot be dissected. But the provision contemplated in s 51(1), as has already been said, contemplates apportionment. The question what expenditure is incurred in gaining or producing assessable income is reduced to a question of fact when once the legal standard or criterion is ascertained and understood. This is particularly true when the problem is to apportion outgoings which have a double aspect, outgoings that are in part attributable to the gaining of assessable income and in part to some other end or activity. It is perhaps desirable to remark that there are at least two items of expenditure that require apportionment. One kind consists in undivided items of expenditure in respect of things or services of which distinct and severable parts are devoted to gaining or producing assessable income and distinct and severable parts to some other cause. In such cases, it may be possible to divide the expenditure in accordance with the applications which have been made of the things or services. The other kind of apportionable items consists in those involving a single outlay or charge which serves both objects indifferently. Of this directors’ fees may be an example. With the latter kind, there must be some fair and reasonable assessment of the extent of the relation of the outlay to assessable income. It is an indiscriminate sum apportionable, but hardly

capable of arithmetical or ratable division because it is common to both objects.

8.29 Two elements of a framework are evident in this extract from Ronpibon Tin: 1. First, a dissection of expenditure where a composite outgoing has distinct and severable components devoted to assessable and nonassessable income derivation or are, in part, capital or private (domestic) outgoings. As the court observed, entire sums such as management and directors’ fees of the type under consideration in Ronpibon Tin probably cannot be dissected. However, it is easy to imagine circumstances where composite amounts can be dissected; for example, an itemised invoice or where discrete amounts of trading stock are applied to business and private purposes. Routine accounting data such as time sheets and jobcost sheets also provide plausible bases for dissection. Dissection does not provide conceptual difficulties. It is not a test but it might be useful to inquire whether a different pattern of expenditure could have been arranged to isolate the nondeductible component. If so, that will [page 505]

2.

provide the arithmetic for dissection. There will be occasions where dissection is impractical because an outlay serves two or more objects indifferently. The second element, therefore, is apportionment on a fair and reasonable but necessarily arbitrary basis in circumstances where a single outlay serves two or more objects indifferently. For example, in Kidston Goldmines v FCT 91 ATC 4538 at 4546, the Federal Court considered it appropriate to apportion interest paid on borrowed funds by a taxpayer deriving formerly exempt income from goldmining and assessable interest income:

The interest outlaid is, in a real sense, a cost of short term investments, just as it is a cost of the activity of extracting ore from the ground and selling gold.

Note that it was not possible in Kidston Goldmines to point to distinct uses (goldmining and earning of interest income) for severable portions of the borrowed funds. Instead, Kidston Goldmines Ltd’s cash balance varied markedly over time due to the timing of gold sale receipts, production expenses and interest payments. At times when Kidston Goldmines Ltd had surplus cash, it would invest this in the short-term money market to derive interest income. Accordingly, the borrowed funds were, from time to time, used to carry out goldmining or to invest in the short-term money market, but not in severable portions.

Suggest a method of dividing interest into deductible and non-deductible elements where a loan is used partly for producing assessable income and partly for producing exempt income.

Apportionment is, therefore, an alternative to dissection when division is conceptually possible but impracticable in any scientific manner. The stronger the evidence in support of apportionment, the closer it approaches dissection. Thus, for example, an itemised telephone account may be dissected into business and nonbusiness phone lines. However, a composite electricity account for premises used partly for business and partly for private purposes must be apportioned on, say, a floor area or room basis. Onto this framework, evident in Ronpibon, must be grafted a third category to accommodate limiting cases falling outside the bounds of dissection or apportionment because there is no legal basis for apportionment. Whether there is a legal basis for apportionment is discussed below but this category will cater for expenditure that is perhaps tainted by a non-deductible object but which remains entirely

deductible because, by its very nature, it is incapable of apportionment either conceptually or by reference to legal criteria. By way of corollary, this element will accommodate expenditure that is not deductible, notwithstanding some aspect of income connection, because the income is too remote. Of the former category, advertising by a retailer provides a good example. The expenditure is typically entirely deductible despite the fact that, in addition to the generation of sales revenue, it enhances the capital [page 506] asset, goodwill. Legal expenses of the type considered in Magna Alloys & Research Pty Ltd v FCT (1980) 11 ATR 276; 80 ATC 4542 are to be similarly treated; that is, as wholly deductible when they satisfy the general deduction provision or entirely non-deductible if they do not. There is no basis for apportionment. As Brennan J observed (at ATR 288): The character of the expenditure is not lost because the expenditure was apt to serve both the business purpose and the purpose of defending the directors, nor is its character lost because the principal or dominant reason for incurring the expenditure was to defend the directors.

On the other hand, this category must cover outgoings of the type considered by the High Court in Handley v FCT (1981) 148 CLR 182; 11 ATR 644 and FCT v Forsyth (1981) 148 CLR 203; 11 ATR 657: see 8.14. Once a conclusion is reached that an outgoing is irrelevant to the production of assessable income, or is of a private nature, there is no basis for apportionment either by way of compromise or by way of notional allowance. The decision by the Full Federal Court in FCT v Markey 89 ATC 4600 provides an illustration of payments not apportionable. The taxpayer sought to deduct an actuarially calculated proportion of superannuation contributions that he claimed related to invalidity payments. The court held that superannuation is a pension, not a payment in lieu of income, and distinguished the decision in FCT v DP Smith (1981) 147 CLR 578; 11 ATR 538; 81 ATC 4114. No part

of the scheme provided indemnity in respect of loss of income. No portion was deductible. There is no taxation by economic equivalence. It should also be appreciated that apportionment is not about regulating a taxpayer’s business practices or spending habits. Again, the authority for this statement is Ronpibon Tin. The court said (at AITR 247): It is important not to confuse the question of how much of the actual expenditure of the taxpayer is attributable to the gaining of assessable income with the question of how much would a prudent investor have expended in gaining the assessable income. The actual expenditure in gaining the assessable income, if and when ascertained, must be accepted. The problem is to ascertain it by apportionment. It is not for the Court or the Commissioner to say how much a taxpayer ought to spend in obtaining his income, but only how much he has spent: see per Ferguson J in Toohey’s Ltd v CT (NSW) (1922) 22 SR (NSW) 432 at 440; per Williams J in Tweddle v FCT (1942) 180 CLR 1; 2 AITR 360 at 364.

Establishing a legal basis for apportionment 8.30 When the issue of apportionment arises, two questions must be addressed. First, on what basis is the disallowable element to be identified? Second, how is the disallowable element to be apportioned arithmetically? The answer to the first question is found in legal principles. The second issue is a question of fact. Where expenditure can be dissected into deductible and non-deductible amounts, the legal basis for apportionment is explicit. Generally, the basis will be the different objects of the expenditure; that is, the purposes of the outlay. From the leading authorities dealing with apportionment issues, two legal bases can be identified — a legal rights basis and a purpose basis. Initially, the cases focused on the legal rights acquired but they ought to be viewed collectively as directed towards [page 507] characterising and disallowing some part of an outgoing that does not satisfy the tests of deductibility. Initially, the cases focused on the legal rights acquired. That is, if it could be demonstrated that the consideration was for trading stock, or for a right of occupancy of

property, and no other advantages accrued for which some part of the consideration could be attributed, there was no basis for apportionment. The difficulty with a legal rights basis was that, clearly, there would be instances where an outlay was unsuccessful in securing legal rights. Failure to secure legal rights could not realistically be a basis for disallowing expenditure and it was necessary to examine the purpose of the expenditure. What is understood by the purposive basis should be made clear at the outset. In the normal case, characterising an item of expenditure involves identifying the object of the expenditure — what will be described as the objective purpose. Seldom will the taxpayer’s motive be an issue. As the court said in Ronpibon Tin, ‘[i]t is not for the Court or the Commissioner to say how much a taxpayer ought to spend’, and the reason why taxpayers do what they do is their own business. This matter will be described as the subjective purpose or motive. These terms were defined in Magna Alloys & Research Pty Ltd v FCT (1980) 11 ATR 276; 80 ATC 4542 as follows: motive — the reason why a taxpayer decides to incur expenditure; subjective purpose — the object which the taxpayer intends to achieve; objective purpose — the object which the incurring of the expenditure is apt to achieve. Care should be exercised in discussions of ‘purpose’ to make it clear whether reference is to the direct object of the expenditure or the indirect object of the taxpayer.

Legal rights cases 8.31 The prominent legal rights cases include Cecil Bros Pty Ltd v FCT (1964) 111 CLR 430; 9 AITR 246; Europa Oil (NZ) Ltd [No 2] v CIR (NZ) [1976] 1 All ER 503; (1976) 5 ATR 744; 76 ATC 6001; FCT v South Australian Battery Makers Pty Ltd (1978) 140 CLR 645; 8 ATR 879; 78 ATC 4412 (SABM); and FCT v Isherwood & Dreyfus Pty Ltd (1979) 9 ATR 473; 79 ATC 4031. Overall, these cases stand for the non-apportionment of expenditure because of conclusions that bona fide legal rights were acquired and, that being the case, there was no

basis to insist that a lesser amount might have been expended or the transaction might have been arranged differently. By ‘legal rights’ is meant that the expenditure produces stock in trade or title to property or a right of occupancy or some other enforceable right. Stated simply, this basis focuses strictly on the legal form of the arrangement. For example, rent paid pursuant to a valid contract in exchange for the legal right of occupancy of premises would give rise to an allowable deduction. 8.32 These cases suggest that a provision such as ITAA97 s 8-1 does not authorise the apportionment and disallowance of expenditure whenever it is found that some economic advantage accrues to a taxpayer as a result of an outlay. Rather, for apportionment to be warranted, it must be established that, as part of the arrangement, some advantage was gained other than the production of assessable income and that some part of the expenditure can be quantified as consideration for [page 508] that additional advantage. This will require a rigorous and objective examination of the contractual arrangement. With that test in mind, consider the Federal Court decision in FCT v Phillips (1978) 8 ATR 783; 78 ATC 4361.

FCT v Phillips Facts: The taxpayer was a partner in an accounting firm. As a guard against potential litigation, the firm established a service trust. The firm’s assets were sold to the trust and secretarial and general staff who were formerly employed by the firm were employed by the trust. Interests in the trust were held by the partners in proportion to their partnership interests and family members were the ultimate beneficiaries. The accounting firm thereafter paid a commercially realistic service fee to the trust for the use of assets and the

provision of non-professional services and the service trust recorded a profit. The partnership claimed a deduction for the service fee. The Commissioner disallowed the deduction under the former s 51(1). The taxpayer relied on the decisions in Cecil Bros and Europa Oil [No 2] and argued that the only enforceable right acquired was the right to services provided. Held: The Full Federal Court held the amount was deductible under s 51(1). Bowen CJ and Deane J allowed the deduction because there was no additional collateral advantage that could be said to be the object of the expenditure. Fisher J said the services were essential to the operation of the partnership and the charges were commercially realistic. Bowen CJ and Deane J said (at ATR 785): It is not to the point that the reasonable commercial profits which the trust derived as a result of its contractual arrangements with the partnership could reasonably have been expected to have accrued to the partnership if the re-arrangement had not been effected or that those profits would, in due course, be credited or distributed either to a partner or to individuals, trusts or companies with which one or more of the partners were associated … There was not, in the present matter, any associated collateral advantage (in terms of either legal entitlement or commercial anticipation) outside the ordinary internal administration of the trust which could properly be seen as a purpose for the making of the payments or the incurring of the liabilities. It is therefore, in the view we take, unnecessary for the taxpayer to rely on the approach which found favour with the majority of their lordships in Europa Oil (NZ) Ltd [No 2] … The decision [page 509] in the present case is governed by the decision by the High Court of Australia in Cecil Bros … Fisher J said (at ATR 791): A crucially important circumstance in the present matter is the unchallenged finding of the trial judge that the charges paid by the firm were realistic and not in excess of commercial rates. The services were essential to the conduct of the firm’s business and the fact that the charges paid were commercially realistic raises at least the presumption that they were a real and genuine cost of earning the firm’s income and the cost of that alone. It strongly supports the view that the expenditure was exclusively for business purposes … Doubtless the converse would apply, namely, if the expenditure was grossly excessive, it would raise the presumption that it was not wholly payable for the services and equipment provided but was for some other purpose. Such is not the case here.

The decision in Phillips’s case is clearly framed in terms of the objective purpose of the expenditure. Although the arrangement

generated benefits to the partners’ families, it could not be said that that outcome was a purpose of making the payments. Doubtless, that result was part of the taxpayers’ intention or motive. However, the role of motive must be approached cautiously. For example, a taxpayer’s decision to lease rather than buy an item of equipment may be motivated in part by the expectation of a tax deduction for the rental payment, but that does not change the objective purpose of the expenditure. It cannot be said that a tax deduction is the object of the expenditure. In Phillips’s case, the taxpayer acquired legal rights and paid a commercially realistic price in consideration for those rights. However, Phillips’s case is significant in that it delivers a warning that commercial reality will be an important part of the vigorous and objective examination of the contractual arrangement. While commercially realistic expenditure supports a view that bona fide legal rights are acquired, excessive expenditure raises a presumption that additional objectives are sought. What might have been a commercially realistic rental payment in South Australian Battery Makers is unknown but it is interesting that the parties accepted the Commissioner’s apportionment in the event that the court held some part of the payment was capital in nature.

Purpose as a basis of apportionment 8.33 There are two weaknesses in a strict legal rights approach. As Stephen and Aickin JJ pointed out in the South Australian Battery Makers case, an examination of the rights acquired would be an essential step in characterising expenditure. As their Honours cautioned, one could not conclude non-deductibility of an outgoing only [page 510] because no legal rights could be demonstrated. Expenditure which is directed to securing some right could not be denied deductibility only for the reason that it was unsuccessful and, therefore, acquired no enforceable rights. Similarly, if no legal rights are acquired because

what is sought is a practical, though intangible business advantage, it too must be examined to see whether in whole or part it satisfies s 8-1. An examination of the object or purpose of the expenditure is required. An examination of purpose would also seem appropriate to remedy a second weakness of a strict view of legal rights, namely, what if the expenditure, although ‘relevant’ to the production of assessable income, is ‘grossly excessive’? Would that be a basis on which to deny or apportion deductibility? If so, on what principle is a distinction to be made between ‘grossly’ and ‘mildly’ excessive expenditure? Why should the discreet taxpayer succeed where a more cavalier schemer fails? Gibbs ACJ’s opinion expressed in South Australian Battery Makers was that the decision in Europa Oil [No 2] could not have meant that the character of an expenditure be determined solely by reference to legal rights. However, the Chief Justice could not point to additional advantages accruing to the taxpayer company. The same considerations are evident in Phillips’s case, which is generally viewed as having grafted to the former s 51(1) a ‘commercial reality’ test. Arguably, the quantum of the outgoing is not itself determinative but, rather, is another consideration in the process of characterising expenditure. That is, inferences about the purpose of the expenditure may be drawn when a demonstrable quid pro quo is not evident. 8.34 The word ‘purpose’ appears only in s 8-1(1)(b) and its role there is in connection with the carrying on of a business for the purpose of gaining income. Assessable income generation must be the purpose of the business. ‘Purpose’ is not part of the statutory requirements of the losses and outgoings. When one speaks of ‘purpose’ in terms of s 8-1, its role is implicit in the characterisation process. The decision in Magna Alloys & Research Pty Ltd v FCT (1980) 11 ATR 276; 80 ATC 4542 was important in identifying the role of purpose and is significant in that, although a dual motive was clearly evident in making the expenditure, there was no basis for apportionment.

Magna Alloys & Research Pty Ltd v FCT Facts: The taxpayer employed a number of agents on an incentive basis to sell its products. It was alleged the agents offered incentives and commissions to existing and prospective customers, including employees of government departments. Following an investigation, three of the company’s directors and four agents were charged with criminal offences. The company incurred legal expenses of $285,762 in the course of defending the accused and sought to deduct the costs under ITAA36 s 51(1). Held: The Full Federal Court allowed the taxpayer’s appeal. The fact that defending the personnel was driven by the directors’ self-interest [page 511] did not prevent the expenses being necessarily incurred in carrying on a business. In relation to ‘purpose’, Deane and Fisher JJ said (at ATC 4560): [T]he identification of the dominant motive of the directors in deciding to incur the expenditure was not the essential question which arose for determination. There is no necessary dichotomy between what can properly be regarded as incidental and relevant to the business ends of a business and that which advances the personal interests of those who are employed or otherwise involved in that business. In many cases, the legitimate ends of a business carried on by a company will encompass what is in the personal interests of the directors and employees of that company … It is not essential, for the purposes of s 51(1) … that such outgoings be shown to have been incurred with a dominant motive characterized by lack of self-interest or generosity before they can be said to have been necessarily incurred in carrying on the particular business. … In particular, the fact that the needs of some directors and agents provided the occasion of an outgoing and that the resulting benefit to directors or agents constituted the dominant motive of the taxpayer for incurring it does not, of itself, preclude the outgoing from being necessarily incurred in carrying on the taxpayer’s business for the purposes of s 51(1). In relation to the roles of purpose and motive, Brennan J said (at ATC 4544 and 4548): Purpose may be either a subjective purpose — the taxpayer’s purpose — where it means the object which the taxpayer intends to achieve by incurring the expenditure; or it may be an objective purpose, meaning the object which the incurring the expenditure is apt to achieve. Both motive and subjective purpose are states of mind and they are to be distinguished from objective purpose, which is an attribute of a transaction. An objective purpose is attributable to a transaction by reference to all the known circumstances; whereas subjective purpose and motive,

being states of mind, are susceptible of proof not by inference alone but also by direct evidence, for a state of mind may be proved by the testimony of him whose state of mind is relevant to a fact in issue. [W]hen the question is whether expenditure is incurred in gaining or producing assessable income, the connection between the advantage to the taxpayer which the incurring of the relevant expenditure is calculated to effect and the taxpayer’s income-earning undertaking or business must be [page 512] considered. If the advantage can be sufficiently identified by reference to a contract, and the taxpayer’s undertaking is known, the connection between the incurring of the expenditure and the undertaking is manifest, and it would be otiose to refer to the purpose of incurring the relevant expenditure. But purpose is relevant to describe an element of connection between expenditure and a taxpayer’s undertaking or business in cases where a taxpayer incurs expenditure or agrees to incur expenditure without any antecedent obligation to do so or where the occasion of the expenditure (unlike the purchase of trading stock) is not manifestly to be found in whatever is productive of assessable income …

8.35 Brennan and Deane JJ (together with Sheppard J) were also members of the Full Federal Court that heard the appeal in Ure v FCT (1981) 11 ATR 484; 81 ATC 4100. In that case, the taxpayer borrowed funds at around 10% and on-lent them to his family trust at 1%. He then sought to deduct the interest incurred under s 51(1). Brennan J said (at ATR 489): The purpose for which money is laid out is an issue of fact, turning upon the objective circumstances which human experience would judge to be relevant to the issue (cf Magna Alloys & Research Pty Ltd …). In the present case, there is an air of unreality about the proposition that the borrowed moneys were laid out wholly for the purpose of earning a return of 1 per cent pa. Rather it is right to say that the purpose for which the borrowed moneys were laid out included all of the purposes earlier mentioned, only one of which was to earn a return of 1 per cent pa. If the borrowed moneys had been laid out solely for the purpose of gaining assessable income, the interest would be wholly deductible; but as they were laid out in part for that purpose, and in part for other purposes, the interest charges must be apportioned.

Deane and Sheppard JJ addressed the question of the appropriate weighting to be given to a taxpayer’s indirect objects. In their Honours’ view, there was no rigid principle that could be stated but where there was an equivalence between the outgoing and income, or where some

contractual quid pro quo is demonstrated, indirect objects and motives are irrelevant. On the other hand, there will be cases where the outgoing is not explained by these factors and it will be necessary to examine indirect objectives and motives, and they may be decisive. For example, in FCT v Ilbery (1981) 12 ATR 563; 81 ATC 4661, certain share transactions could be explained only by reference to a dominant purpose of securing a tax advantage. Toohey J said (at ATR 571): The taxpayer never tried to conceal that his object in paying five years’ interest in one year was to secure the tax advantages thought to flow from that course. To the extent then that purpose is relevant to throw light upon the character of a payment, no purpose can be discussed here other than that of gaining a tax advantage.

In Ure’s case, the excess of the interest over the 1% income was apportioned and disallowed as a deduction and the basis for the apportionment was the mixed [page 513] purposes for which the expenditure was incurred. Although the disparity between the outlay and the income alerts attention, it is an examination of the purpose of the outlay that is critical and the conclusion that there is a dual purpose that provides the basis for apportionment. In the language of Phillips’s case, if there is discovered to be some additional collateral advantage that can be seen as an object of the expenditure, the outlay may be apportioned. Apportioning the consideration attributable to that collateral advantage is a question of fact.

Brenda and Eddy are planning their retirement and decide to purchase a unit that could possibly be used as a residence after retirement on the coast. They plan to ‘negatively gear’ the property and borrow $150,000 at 7.5% interest and rent the unit to tenants. Net rental is $7500; interest $11,000; other costs $2000. Is there a basis for apportioning some of the expenditure?

A suggested solution can be found in Study help.

8.36 The decision by the Full High Court in Fletcher v FCT (1991) 173 CLR 1; 22 ATR 613; 91 ATC 4950 refined the views expressed in Magna Alloys in relation to the roles of motive and purpose.

Fletcher v FCT Facts: The taxpayer (and three others in partnership) entered into an annuity arrangement. A number of documents were exchanged but no cash payments were made. The annuity arrangement was calculated to return neutral cash flows with high tax deductions initially and high assessable income, especially in the last five years. A feature of the scheme was that there was an opportunity to terminate it in the last five years. In the relevant year, the partnership derived assessable income of $170,000 and claimed deductions of $360,000. A number of matters were argued before the case reached the High Court but before the Full Court the Commissioner’s contention was that the interest deduction should be apportioned and disallowed under s 51(1) to the extent that it exceeded the partnership income. Held: The matter was remitted to the Administrative Appeals Tribunal to determine whether, as a matter of fact, the scheme would run its full 15 years or whether it would be terminated before the last five. In the former case, the assessable income would exceed deductions and the interest would be an allowable deduction under s 51(1). [page 514] In the latter case, an explanation must be sought for the excess of deductions, of some $2.7m, over assessable income and, to the extent that the explanation lay in substantial tax advantages, the outlays were not incurred in gaining assessable income. (Ultimately, the matter was decided in the Commissioner’s favour.) Mason CJ, Brennan, Deane, Dawson, Toohey, Gaudron and McHugh JJ said (at ATR 622–3): [I]t is commonly possible to characterize an outgoing as being wholly of the kind referred to in the first limb of s 51(1) without any need to refer to the taxpayer’s subjective thought process. This is ordinarily so in a case where the outgoing gives rise to the receipt of a larger amount of assessable income. In such a case, the characterization of a particular outgoing as wholly of a kind referred to in s 51(1)

will ordinarily not be affected by considerations of the taxpayer’s subjective motivation … The position may, however, well be different in a case where no relevant assessable income can be identified or where the relevant assessable income is less than the amount of the outgoing. Even in a case where some assessable income is derived as a result of the outgoing, the disproportion between the detriment of the outgoing and the benefit of the income may give rise to a need to resolve the problem of characterization of the outgoing for the purposes of the subsection by a weighing up of the various aspects of the whole set of circumstances, including direct and indirect objects which the taxpayer sought in making the outgoing, see eg Robert G Nall Ltd v FCT (1937) 57 CLR 695; 1 AITR 169. Where that is so, it is a “commonsense” or “practical” weighing of all the factors which must provide the ultimate answer … If, upon consideration of all those factors, it appears that, notwithstanding the disproportion between outgoing and income, the whole outgoing is properly to be characterized as genuinely and not colourably incurred in gaining or producing assessable income, the entire will fall within the first limb of s 51(1) unless it is somehow excluded by the exception of “outgoings of capital, or of a capital, private or domestic nature” or “incurred in relation to the gaining or production of exempt income”. If, however, that consideration reveals that the disproportion between outgoing and relevant assessable income is essentially to be explained by reference to the independent pursuit of some other objective and that part only of the outgoing can be characterized by reference to the actual or expected production of assessable income, apportionment of the outgoing between the pursuit of assessable income and the pursuit of that other objective will be necessary.

[page 515] Reduced to its essential elements, if income exceeds outgoings, the taxpayer’s motives are largely irrelevant. If there is no assessable income or outgoings exceed income, a practical and common sense weighing up of all factors is warranted, including the taxpayer’s motive. As was anticipated in Phillips’s case, a disparity between outlay and income may trigger a more rigorous examination of a contract or arrangement. As was suggested in Ure’s case, the absence of a commercial quid pro quo will raise questions about the purpose of the expenditure. Where bona fide legal rights are acquired, the objective purpose of the expenditure is determined and it remains true to say that in those circumstances it is not for the court or the Commissioner to tell

taxpayers how to manage their affairs. Where there is a dual purpose, or a purpose other than income production, expenditure is to be apportioned and there will be circumstances where purpose may mean subjective purpose or motive.

Smith (of Smith & Jones Pty Ltd) arranges to employ his neighbour’s daughter at award rates in the following scenarios: 1. He thinks she is a good worker. 2. He knows she has been in trouble but wants to ‘give her another chance’. 3. He has a full complement of staff but knows the family needs money. What if he paid over-award rates? What if the employee was his own daughter, not his neighbour’s? A suggested solution can be found in Study help.

The arithmetic of apportionment 8.37 Apportionment is a question of fact and, putting aside dissection, its inherent difficulty is that it is ‘hardly capable of arithmetic or ratable division’: Ronpibon Tin NL v FCT (1949) 78 CLR 47; 4 AITR 236 at 247; 8 ATD 431 (see 8.28). In Kidston Goldmines v FCT 91 ATC 4538, the Federal Court left it to the parties to make an appropriate apportionment of interest paid on funds borrowed by a taxpayer deriving formerly exempt income from goldmining and assessable investment income. Where there is a disallowable component, the courts looked in Robert G Nall Ltd v FCT (1937) 57 CLR 695; 1 AITR 169 to a quid pro quo and both Ure and Fletcher are consistent with that approach. In Reliance Finance Corp Pty Ltd v FCT (1987) 18 ATR 224; 87 ATC 4146, interest paid on borrowing by a moneylender and on-lent interest free was apportioned in the same ratio of income-producing to nonincome-producing assets. The decision in FCT v South Australian Battery Makers Pty Ltd (1978) 140 CLR 645; 8 ATR 879; 78 ATC

4412 illustrates an approach that might be adopted in respect of capital expenditure. In that case, the South Australian Housing Trust was intent on recouping the cost of the property. The option price to purchase [page 516] the property was determined in accordance with an amortisation factor applied to the rent. In Ronpibon Tin, the apportioned amount was more arbitrary. Simple cases of apportioning partly private expenditure are illustrated by FCT v Collings (1976) 6 ATR 476; 76 ATC 4254, where travel expenses in relation to a motor vehicle were apportioned on a mileage basis. Records or reasonable estimates of usage seem sensible bases to apportion partly private, partly ‘business’ use of items such as telephones or motor vehicles. The amount of time an item is used or effort is directed to income-producing activities could be an appropriate basis, but in Case R13 84 ATC 168 the Board of Review regarded it as inappropriate to apportion fares in proportion to a fiveday conference out of a 40-day overseas stay and allowed one-half of the cost. However, a time basis would seem appropriate in respect of accommodation (if dissection is not appropriate). In Case V133 88 ATC 847, the AAT considered the correct manner of apportioning expenses associated with a rental property used partly for private purposes was the ratio of nights for letting to 365.

Indicate whether there is a legal basis for apportionment under IAA97 s 8-1 and, if so, how it might be effected: 1. Jeckle Bros Pty Ltd acquires trading stock from an unrelated wholesale company for $250,000. The Commissioner considers equivalent stock could be purchased from another supplier for $200,000. 2. Janet borrows $100,000 at 12.5% interest from her bank and on-lends it at 2% to a private company.

3.

Jimoin owns a beach cottage, which is used for four months for private purposes and let to tenants for four months. For the rest of the year, the cottage is vacant but available to let. Mortgage interest is $6000. A suggested solution can be found in Study help.

‘Incurred’/‘necessarily incurred’ 8.38 A loss or outgoing is deductible to the extent that it is incurred in gaining or producing assessable income or necessarily incurred in carrying on business for that purpose. The verb ‘to incur’ is the activating word in ITAA97 s 8-1; a loss or outgoing is deductible when it is incurred. In this sense, incurred is the counterpart to derived in the context of ITAA97 s 6-5; income is assessable when it is derived. However, it needs to be appreciated at the outset that incurred does not correspond to derived.40 The distinction between cash and accrual basis taxpayers that was established in relation to income assessment does not translate to issues [page 517] of deductibility. This is because the jurisprudential development of ‘incurred’ has developed independently of ‘derived’. It would make administrative sense if a taxpayer returning assessable income on a cash basis claimed deductions under s 8-1 as they were dispersed. There is no doubt that an amount paid has been incurred but it will also become evident that incurred does not only mean paid. An amount will be incurred when there is a presently existing pecuniary liability and such a liability may arise before actual payment.41 It should also be appreciated at the outset that a taxpayer returning on an accrual basis does not always incur a loss or outgoing for the purposes of s 8-1 when the amount is recognised as an expense for financial accounting reporting purposes. These matters are discussed in greater depth below.

Meaning of ‘incurred’ 8.39

Incurred is about the timing of a deduction. An enduring

statement of the general rule governing its meaning comes from Dixon J’s statement in New Zealand Flax Investments Ltd v FCT (1938) 61 CLR 179; 1 AITR 366 at 378: To come within [s 51(1)] there must be a loss or outgoing actually incurred. “Incurred” does not mean only defrayed, discharged, or borne, but rather it includes encountered, run into, or fallen upon. It is unsafe to include exhaustive definitions of a conception intended to have such a various and multifarious application. But it does not include a loss which is no more than impending, threatened or expected.

It is clear that an amount that is paid (defrayed, discharged or borne) is incurred but so, too, is an amount that is encountered or run into — provided the encounter is more than threatened or expected. In FCT v James Flood Pty Ltd (1953) 88 CLR 492; 5 AITR 579, the High Court used the words ‘definitively committed’ to describe an amount encountered. The court added (at 584–5): [The words] do not admit of the deduction unless, in the course of gaining or producing the assessable income or carrying on the business, the taxpayer has completely subjected himself to them. It may be going too far to say that he must have come under an immediate obligation enforceable at law whether payable presently or at a future time. It is probably going too far to say that the obligation must be indefeasible.

From these two short extracts, it is possible to say that to incur a loss or outgoing a taxpayer must be definitively committed but the obligation need not be indefeasible. This means there is an obligation to which the taxpayer is completely subjected. To say that a liability is defeasible means that ultimately it may be avoided or brought to an end. If such an obligation is divested in a later year, the amount may be assessable income.42 In general, an amount is incurred when there is a presently existing obligation as opposed to an obligation or liability that is merely contingent. [page 518] In James Flood’s case, the court added that the meaning of ‘incurred’ was: … not a matter depending upon proper commercial and accountancy practice rather than jurisprudence. Commercial and accountancy practice may assist in ascertaining the true nature and incidence of an item … but it cannot be substituted for the test.

The leading authorities, the relevance of accounting principles and the acceptance of provisions and estimates are discussed below.

Leading authorities 8.40 General deduction provisions containing language often identical to that of ITAA97 s 8-1 have been a feature of Australia’s taxation Acts for more than a century. Key words such as ‘incurred’ have acquired a considerable body of judicial analysis. In W Nevill & Co Ltd v FCT (1937) 56 CLR 290; 1 AITR 67, the High Court said of ‘incurred’ (at AITR 73): [T]he word used is “incurred” not “made” or “paid”. The language lends colour to the suggestion that, if a liability to pay money as an outgoing comes into existence, [the requirements are satisfied] even though the liability has not been actually discharged …

The court added that it is the incurring of the outgoing that must have occurred, not a payment. Subsequent cases have refined the understanding of exactly when a liability might be said to be incurred. Three central cases are FCT v James Flood Pty Ltd (1953) 88 CLR 492; 5 AITR 579; Nilsen Development Laboratories Pty Ltd v FCT (1981) 144 CLR 616; 11 ATR 505; 81 ATC 4031; and RACV Insurance Ltd v FCT [1975] VR 1; (1974) 4 ATR 610; 74 ATC 4169.

FCT v James Flood Facts: The taxpayer carried on business as a motor-body builder and general engineer. In its accounts for the year ended 30 June 1947 was an amount of £1888 described as ‘holiday and sick pay’. This amount included £578 that had been accrued through an account styled ‘Provision for Holiday Pay’, but not paid. The Commissioner disallowed this amount as a deduction from the assessable income on the grounds that it was not incurred. The taxpayer argued that its employees were entitled to receive holiday pay after 12 months of continuous service so that, as employees worked, the company become progressively liable to make payments. If an employee did not complete a period of 12 months there was no entitlement to holiday pay. Certain events could also preclude an entitlement from arising, such as if an employee was involved in unauthorised industrial action.

[page 519] Held: The Full High Court (Dixon CJ, Webb, Fullagar, Kitto and Taylor JJ) disallowed the claim for the amount that had been set aside via the provision account: Nothing that was decided in W Nevill & Co Ltd was intended to imply that a liability to pay an ascertained sum is never incurred until the sum becomes due and payable. The question in that case was whether a sum which a company had agreed to pay one of two joint managing directors to induce him to retire was an outgoing on account of capital or was deductible. A portion of the sum was to be met by monthly payments over a period extending beyond the year of income and secured by promissory notes. It was decided that the outgoing was not on account of capital and was deductible but so much of it as was payable outside the year of income belonged to the ensuing accounting period. Probably on this minor point, to which the parties do not appear to have attached importance, the judges were influenced to some extent by some of the considerations affecting their decision on the major question and looked upon the monthly payments not so much as deferred instalments of an accrued liability in a lump sum but as an attempt to spread over a period of trading an outgoing parallel with the salary that had been saved. But whatever be the rationale of the decision of the point, clearly enough it is not based on a view that no outgoing could be incurred until actual payment was made. It is one thing, however, to say that it is not necessary, for the purposes of [former ITAA36 s 51(1)] that an actual disbursement should have taken place. It is another thing to say that in the present case the taxpayer had incurred a loss or outgoing in the year of income in respect of the pay of its men during the annual leave to be taken in the ensuing accounting period by employees whose service had not as yet qualified them for annual leave. In respect of those employees there was no debitum in praesenti solvendum in futuro. There was not an accrued obligation, whether absolute or defeasible. There was at best an inchoate liability in process of accrual but subject to a variety of contingencies. It may be true that regarding the labour employed as a whole, the accrual of an amount of the order claimed had, by 30 June 1947, become predictable with certainty. But that is not the test. If it be regarded nevertheless as an evidentiary consideration having some weight then it cannot be divorced from the further consideration that the source of the accruing [page 520] liability, the award, imposes it as an obligation to pay wages for a period of time in the future during which the employee must be given leave. That means that it is imposed in the form of a liability associated with the operations of the taxpayer for the ensuing year. In short the deduction claimed of £578 does not represent an expenditure associated with the production of income before 30 June 1947 for which a liability had been completely incurred before that date.

The statement by the court that ‘there was at best an inchoate liability in process of accrual but subject to a variety of contingencies’ suggests that one reason for rejecting the taxpayer’s claim was that the obligation was a contingent liability rather than a presently existing liability. It was possible that employees would fail to complete the necessary 12-month qualifying period or for other reasons fail to qualify for holiday pay.43 In this sense, it might be argued that the company had not really incurred a liability; it merely faced a future liability when the entitlements became due and payable. However, to focus on this type of contingency obscures whether the taxpayer is definitively committed. The gravamen of Flood’s case might be better stated more generally that where a liability arises on the happening of certain events (the performance of duties, the taking of annual leave), an amount is not incurred until the happening of those events.44 It is clear from Flood’s case that the accounting imperative of ‘matching’ costs with revenue did not determine that matter for tax purposes. That is not to say that the accounting treatment of wages and salaries is fundamentally at odds with jurisprudence. For example, an accrued wages expense would be an allowable deduction under s 8-1 because the work has been performed and an obligation to make payment has arisen. 8.41 A material difference in facts in Nilsen Development Laboratories Pty Ltd v FCT (1981) 144 CLR 616; 11 ATR 505; 81 ATC 4031 was that the employees were entitled to pro-rata payment for accrued leave. The question before the High Court was whether in those circumstances the provisions raised in the accounts were incurred. [page 521]

Nilsen Development Laboratories Pty Ltd v FCT Facts: The taxpayer claimed deductions for accrued annual and long service leave entitlements. Some of the entitlements were satisfied in that employees had completed the relevant employment period and were due for long service leave, or payments in lieu of long service leave. Other employees were entitled to annual leave (or payments in lieu) or to pro-rata payments for long service leave under the relevant Metal Trades Award. Prior to 1974, the company raised provisions in its accounts for the accrued leave but made no claim for tax purposes. For the year ended 30 June 1974, however, the company made a claim for the leave, even though none was in fact taken in that year. Held: The Full High Court (Barwick CJ, Gibbs, Stephen, Mason, Murphy, Aickin and Wilson JJ) held that no loss or outgoing was incurred in terms of the former ITAA36 s 51(1). Even though the leave payments were inevitable and indefeasible, the taxpayer was not under a present obligation to make the payments until such time as the employees took the leave or payments in lieu of the leave. In relation to earlier authority, Barwick CJ made the following points: The decision in James Flood did not resolve the question arising in the present case. In James Flood, the court could have reached its conclusion directly on the ground that only actual payment satisfied s 51(1), but that was not the reason given, or else was not stated unequivocally. Rather, Dixon J’s language in New Zealand Flax Investments needed to be applied. To the statement there that ‘incurred … does not include a loss or expenditure which is no more than pending, threatened or expected’, the following should be added: ‘no matter how certain it is in the year of income that loss or expenditure will occur in the future’. In Barwick CJ’s view, a pecuniary liability will undoubtedly arise when, but not before, the employee enters a period of leave. The Chief Justice said (at ATC 4035): It was suggested in argument that a liability to make such a payment was accruing during the time the employee was serving the period qualifying him for leave. But, in my opinion, it is not a precise or proper use of language to so describe the circumstance that an employee is becoming progressively qualified by length of service to be able to require that he be given leave of one sort or another. In my opinion, no liability is “accruing” in a proper sense of the word during the time [page 522] that the employee is serving his qualifying period nor has it accrued when he has served that qualifying period. All that then can really be said is that it has become certain that, in due course when further events occur, that is to say, the time for the taking of leave is fixed and the period of leave is entered upon, a liability to pay money will arise. It is quite wrong, in my opinion, in this connection to treat any liability as either

accruing or having accrued at any time prior to the time when the employee enters upon the leave, whether it be annual or long service. Of course, it may very well be that in the keeping of commercial accounts it would be proper to make provision against the annual gross profits of some sum related to the amount of the liability which must in due course arise because of the service by the employee during the year of accounting; and to do so before arriving at the profits or gains of the period during which the qualification of the employee is taking place. But the prudence and commercial propriety of such a course has little bearing on the question whether there is present in the year of income a loss or outgoing within the meaning of s 51(1). These considerations, in my opinion, are the foundation for the view that no deduction under s 51(1) in respect of leave, whether annual or long service, of any amount can properly be claimed by an employer bound by an award or industrial agreement substantially in the terms of the awards presently under consideration, until the employee enters upon the appropriate leave. Then, and only then, and for the first time, there is an accrued liability to pay money and then, and only then, there is, in my opinion, an outgoing which is deductible under the provisions of s 51(1). For these reasons, I would dismiss the taxpayer’s appeals. Gibbs J said (at ATC 4037): The principle to be applied in deciding whether a loss or outgoing was “incurred” is clear. It is not necessary that there should have been any actual disbursement: New Zealand Flax Investments Ltd … Emu Bay Railway Co Ltd … FCT v James Flood Pty Ltd … and see King v Commissioner of Inland Revenue [1974] 2 NZLR 190, at pp 194–195. Indeed, it was suggested in FCT v James Flood Pty Ltd that it is not necessary that there should be an immediate obligation enforceable at law whether payable presently or at a future time, or that the obligation should be indefeasible. It is not now necessary to [page 523] consider whether those suggestions should be accepted as correct. But what is clearly necessary is that there should be a presently existing liability. In FCT v James Flood Pty Ltd, this was expressed by saying that the provisions of s 51(1) cover “outgoings to which the taxpayer is definitively committed in the year of income although there has been no actual disbursement”, and that those provisions “do not admit of the deduction of charges unless … the taxpayer has completely subjected himself to them”. In other words, s 51(1) does not cover “a loss or expenditure which is no more than impending, threatened or expected”: New Zealand Flax Investments Ltd … If these principles are applied to the present case, the question is whether the taxpayer was under a present liability to make a payment to its employees in respect of leave. The answer is that it was not. The employees were entitled to leave, but they were not entitled to payment.

Gibbs J’s judgment (as does Mason J’s) makes a distinction between a liability to provide leave and a liability to pay on the happening of events. Barwick CJ emphasised that the relevant liability was a pecuniary liability and although it may be paid in a later year, it may yet be a presently existing liability. In the Chief Justice’s view, what was critical was that the obligation was, in the words of New Zealand Flax, ‘pending, threatening or expected’, no matter how certain it was that a loss or outgoing would occur in the future.a

a.

The practical impact of Flood’s case and Nilsen Development Laboratories was foreclosed by the enactment in 1978 (before the High Court appeal was decided) of ITAA36 s 51(3) (ITAA97 s 26-10), which defers a deduction for leave until payment is made. In relation to holiday pay, see also FCT v Foxwood (Tolga) Pty Ltd (1981) 147 CLR 278; 11 ATR 859; 81 ATC 4261; Ransburg Australia Pty Ltd v FCT (1980) 10 ATR 663; 80 ATC 4114.

8.42 In Coles Myer Finance Ltd v FCT (1993) 176 CLR 640; 25 ATR 95; 93 ATC 4214, the High Court said of the decision in Flood’s case (at ATC 4220): Flood therefore stands as authority for the proposition that a liability must presently be existing in order to be “incurred” within the meaning of s 51(1).

And on the decision in Nilsen Development Laboratories (at ATC 4220–1): … the amounts provided in the taxpayer’s accounts to meet employees’ long-service leave entitlements were not outgoings “incurred” within the meaning of s 51(1) because there was no liability to make payment until the employees either took leave or ceased employment.

In FCT v Citylink Melbourne Ltd (2006) 228 CLR 1; 228 ALR 301; 2006 ATC 4404; [2006] HCA 35, this line of reasoning was reiterated by the High Court.

[page 524] In that case, a majority dismissed the Commissioner’s appeal against a decision of the Full Federal Court allowing deductions for concession fees payable to the state of Victoria for the construction and operation of a road system. Under the agreement, Citylink could defer payment of the amounts until 2034 but claimed a deduction for the accrued liabilities. Delivering the majority judgment, Crennan J said (at [134]): The conclusion will be reached here that the concession fees were incurred in the years of income. On a semi-annual basis, the respondent was subjected to a contractual liability to pay the concession fees. The liability arose as and when each concession fee became due. That is when the outgoing was encountered or run into. These facts exemplify a situation where a liability is “incurred” in the year of income but not “discharged” in that same year. The circumstances are distinguishable from those in Nilsen Development Laboratories Pty Ltd v Federal Commissioner of Taxation … Here the liability comes into existence in the year of income. The deferral of the time for its discharge cannot alter this conclusion, nor can the length of time of the deferral.

The argument was also rejected that the concession fees were instalments of a lump sum capital fee to acquire an asset. Rather, the payments were periodic licence fees for use of an asset that was ultimately required to be returned to the state of Victoria. This aspect of the High Court’s conclusion may be contrasted with the Full Federal Court’s decision in FCT v Star City Pty Ltd (2009) 72 ATR 431; [2009] FCAFC 19. In that case, an amount of $120m described as a prepayment of rent in respect of a 99-year lease of a New South Wales casino was held to be capital designed to secure exclusive rights to operate a casino. 8.43 The question of whether a taxpayer was definitively committed arose in a different context in Ogilvy & Mather v FCT (1990) 21 ATR 841; 90 ATC 4836. The taxpayer was an advertising agency. The usual sequence of events was for the taxpayer to make appropriate bookings and, when an advertisement appeared in a media outlet, the media billed the taxpayer and the taxpayer invoiced the client. However, under Media Council rules, the taxpayer was responsible for all

advertisements it organised. As a result, when a booking entered the non-cancellation period (of between three and 70 days before the advertisement appeared), the taxpayer became liable for the cost. In effect, the taxpayer sought to claim the cost of the advertisements once the non-cancellation period was entered. In the Federal Court, Sweeney and Ryan JJ held that, at the beginning of the non-cancellation period, the obligation was no more than ‘threatened’ or ‘impending’. It was not ‘encountered’ until the advertisement in fact appeared in the media. Their Honours said (at ATC 4846): [T]he agent’s obligation to pay those charges did not attach at the commencement of the non-cancellation period. At that time, in our view, the agent had not completely subjected itself to the liability in the sense that “payment was a matter of commercial certainty and was not subject to any contingency which would be regarded as such in the world of ordinary business affairs” (Commercial Union Assurance Co of Australia Ltd v FCT (1977) 32 FLR 32; 7 ATR 435; 77 ATC 4186). Here payment depended on more than the mere effluxion of time from the commencement of the non-cancellation period.

Their Honours’ statement that ‘payment depended on more than the mere effluxion of time from the commencement of the non-cancellation period’ underscores the fact [page 525] that the liability ‘came home’ to the advertising agency when the advertisements appeared in the media. The critical event in triggering the liability was the publication of the advertisement. The commercial reality was that the agency would be billed then and, although it was bound by Media Council rules to accept responsibility for the cost at an earlier point in time, that only served to make the liability impending and certain, it was not yet incurred. 8.44 If the happening of critical events is what brings home an obligation, then the decision in RACV Insurance Ltd v FCT [1975] VR 1; (1974) 4 ATR 610; 74 ATC 4169 may be reconciled with the authority discussed above. However, the case is interesting in two respects. First, in Coles Myer Finance, McHugh J said that although the decision in RACV was ‘eminently sensible’, it ‘strained the rules’ set

down in Flood’s case and Nilsen Development Laboratories. Second, the decision allowed a deduction for provisions raised in the company’s accounts.

RACV Insurance Ltd v FCT Facts: The taxpayer carried on the business of motor vehicle and compulsory ‘third-party’ insurance. Under relevant state legislation, it was liable in respect of third-party personal injury whether or not a notice of claim had been received from an insured party. The taxpayer claimed a deduction for estimates of ‘unreported claims’ arising out of accidents that had occurred and for which it was liable to indemnify. The taxpayer argued that the event that gave rise to the liability was the accident. The Commissioner contended that no pecuniary liability was incurred until the matter was determined by settlement or court order. Held: In the Supreme Court of Victoria, Menhennitt J upheld the taxpayer’s appeal. A loss or outgoing was incurred as soon as the liability to indemnify the driver arose and that the estimates made in respect of such liabilities were reasonable. His Honour held (at VR 8): When there has to be considered the question whether an insurance company has incurred a loss or outgoing in a particular year that question comes to be considered in relation to the nature of the business being carried on. The essence of insurance business is that, in respect of each class of risk insured against, the insurance company aims to satisfy its liabilities to the policy holders who actually experience the risk primarily out of the total of the premiums paid by all the policy holders, most of whom normally do not experience the risk. In relation to liability insurance the insurance company is bound to indemnify its insured against his liability to a third person. Once events have occurred out of which a liability to indemnify an insured arises, it appears to me that within the meaning of s 51(1) of the Income Tax Assessment Act [page 526] a loss or outgoing has been incurred. Events have occurred which have subjected it to a liability to indemnify its insured against his liability to a third person and the extent of that liability is capable of reasonable estimate. Where there is no real question of the liability of the insured to the third party and the only question is one of estimating damages, the fact that the quantum of the loss or outgoing is a matter of estimate and that the amount may have to be adjusted in the light of later events does not stand in the way of it being a loss or outgoing (see New

Zealand Flax Investments Ltd v Federal Commissioner of Taxation (1938) 61 CLR 179 at 199 and Texas Co (Aust) Ltd v Federal Commissioner of Taxation (1940) 63 CLR 382 at 465-6; [1940] ALR 126), and in a case where the liability of the insured to the third party is in issue but the amount which is likely to be payable can be reasonably estimated, it is still I think true to say that within the meaning of s 51(1) a loss or outgoing has been incurred by the insurance company. In Ballarat Brewing Co Ltd v Federal Commissioner of Taxation [1951] ALR 603 at 606; 82 CLR 364 at 369, Fullagar J said: It is common ground that the account must, almost of necessity, proceed upon an “accrual” or “earnings” basis. It is the appropriate figure for book debts that is in question. This is in essence a matter of estimation, and (apart from express provision in the Act) it would be proper to make an allowance for bad and doubtful debts. In Sun Insurance Office v Clark [1912] AC 443 at 454; [1911–13] All ER Rep 495 at 498, Lord Loreburn said: There is no rule of law as to the proper way of making an estimate. There is no way of estimating which is right or wrong in itself. It is a question of fact and figures whether the way of making the estimate in any case is the best way for that case.

8.45 The decision in RACV Insurance is supported by Commercial Union Assurance Co of Australia Ltd v FCT (1977) 7 ATR 435; 77 ATC 4186. It was established in RACV Insurance that the company’s accounting for unreported claims was consistent with industry practice. The facts in Commercial Union Assurance were similar to RACV Insurance with the exception that it was a condition that the insured notify Commercial Union Assurance of an accident before a legal obligation arose to indemnify. There was no such condition in RACV Insurance. As a result, the Commissioner argued that, unless the policy conditions were satisfied and appropriate advice was given, the insurer could not be completely subjected [page 527] to the liability. It would follow that a liability could not be incurred in the case of unreported accidents. Newton J in Commercial Union Assurance found that, on the

evidence, claims were almost invariably paid such that ‘[p]ayment was a matter of commercial certainty, and was not subject to any contingency which would be regarded as such in the world of ordinary business affairs’: at ATC 4193. His Honour said that since it was certain that the condition regarding notice would never be relied upon, the liability was incurred with the happening of the event insured against. The principles in RACV Insurance and Commercial Union Assurance were extended beyond motor vehicle insurance in ANZ Banking Group Ltd v FCT (1994) 27 ATR 559; 94 ATC 4026. In that case, the taxpayer was a ‘self-insurer’ for the purpose of workers compensation legislation. The company also made a claim for deductions in respect of accidents that had occurred but which were unreported at the end of the year. The Commissioner argued that the principles in RACV Insurance and Commercial Union Assurance were limited to insurance companies and did not extend to the ‘self-insured’ and that, at any rate, the estimates could not be made reliably. The Full Federal Court held unanimously that the provisions raised were incurred. Whether or not an amount was incurred turned on jurisprudential analysis and the principles were not confined to insurance companies. The amount was also reasonably capable of estimation and was accepted as such in that the company’s accounts had been audited and the amounts were not qualified. In FCT v Mercantile Mutual Insurance (Workers Compensation) Ltd (1999) 42 ATR 8; 99 ATC 4404, the Federal Court held that the estimated amount to satisfy outstanding future claims (together with a ‘prudential margin’) was an allowable deduction. The amount deductible in that case was the nominal (as opposed to the present) value of the provision. Legislative amendment overrules this decision in requiring that, for insurance businesses, the amounts be calculated on a present-value basis: ITAA97 Div 321.

Accounting provisions and estimates 8.46 The jurisprudential analysis considered above (and also in relation to the question ‘when is income derived?’) has clearly rejected accounting principles as determining when an outgoing is incurred. In

FCT v James Flood Pty Ltd (1953) 88 CLR 492; 5 AITR 579 at 585, the court said: Commercial and accountancy practice may assist in ascertaining the true nature and incidence of an item as a step towards determining whether it answers the tests laid down by [the general deduction provision], but it cannot be substituted for the test.

Provisions raised in respect of holiday pay, exchange rate fluctuations or warranties45 are not incurred. However, where a liability has been incurred, the fact that it cannot be quantified exactly has been no barrier to deductibility. The essential question is whether it is reasonably capable of estimation. [page 528] In Texas Co (Australasia) Ltd v FCT (1940) 63 CLR 382; 2 AITR 4, Latham CJ and Dixon J specifically accepted the deductibility in earlier years of estimated liabilities that had increased in the relevant year as a result of unfavourable movements in the exchange rate. The fact that the estimates had to be adjusted in subsequent years did not affect deductibility (or assessability) provided the amounts were on revenue account. In Ballarat Brewing Co Ltd v FCT (1951) 82 CLR 364; 5 AITR 151, Fullagar J accepted estimates and allowances as essential elements in determining ‘a substantially correct reflex of the taxpayer’s true income’. In Commonwealth Aluminium Corp Ltd v FCT (1977) 7 ATR 376 at 386; 77 ATC 4151, Newton J said: In my opinion the authorities also establish that [for the purposes of ITAA36 s 51(1)] a taxpayer can completely subject itself to a liability, notwithstanding that the quantum of the liability cannot be precisely ascertained, provided that it is capable of reasonable estimation … In this context, I think the quantum of a liability is “capable of reasonable estimation”, if it is capable of approximate calculation based on probabilities …

The making of such an estimate is a question of fact: Ballarat Brewing Co Ltd. At first instance in the ANZ Banking Group case, Sweeney J considered that the best estimate that could be made in the circumstances may yet fall short of a reasonable estimate. This suggests there is some benchmark of reasonableness. It may even be that a liability that can be estimated only very approximately is too remote

and is at best a contingent liability. This is a matter that has yet to be decided but, on appeal in the ANZ Banking Group case, Hill J (with whom Northrop and Lockhart JJ agreed) considered the estimates in that case were bona fide, the method of calculation not dissimilar to that employed in RACV Insurance and not the subject of any reservation by the taxpayer’s auditors. It follows that amounts brought to account in a taxpayer’s books may provide evidence that, as a matter of commercial practice and acceptance, a liability has definitively arisen and is incurred for the purposes of a general deduction provision such as ITAA97 s 8-1. If this is confirmed on jurisprudential analysis, the amount is an allowable deduction. It does not matter that the amount is an estimate, provided it is reasonably capable of estimation. 8.47 In FCT v Citibank (1993) 26 ATR 423; 93 ATC 4691, Hill J discussed the relevance of accounting evidence in the context of finance leases and the acceptability for tax purposes of accounts prepared in accordance with former Accounting Standards AAS 17 and ASRB 1008, and s 269(8A) of the Companies Code. His Honour expressed the following views in relation to the general deduction provision: Commercial and accountancy practice may assist in determining whether an item satisfies tests laid down by the Acts but cannot be substituted for those tests: Flood’s case; Nilsen Development Laboratories. Where claims are incurred but not reported, accounting and business practice will be relevant in determining the appropriate treatment under the Act: RACV Insurance; Commercial Union Assurance Co. Whether a liability is reasonably capable of estimation will be susceptible to business and accounting evidence: Commonwealth Aluminium Corp. [page 529]

In Hooker Rex Pty Ltd v FCT (1988) 19 ATR 1241; 88 ATC 4392, accounting evidence reinforced a conclusion regarding the proper treatment of a contingent liability where there was a reasonable probability of it becoming absolute. Accounting evidence may have particular significance in determining the timing of a deduction; that is, not whether it has been incurred but whether it is incurred in the year of income: New Zealand Flax Investments Ltd v FCT (1938) 61 CLR 179; 1 AITR 366; FCT v Australian Guarantee Corp (1984) 15 ATR 982; 84 ATC 4642; Coles Myer Finance Ltd v FCT (1993) 176 CLR 640; 25 ATR 95; 93 ATC 4214.

The ‘matching’ convention 8.48 It is clear from the decisions in FCT v James Flood Pty Ltd (1953) 88 CLR 492; 5 AITR 579 and Nilsen Development Laboratories Pty Ltd v FCT (1981) 144 CLR 616; 11 ATR 505; 81 ATC 4031 that the accounting convention of ‘matching’ expenditure and income was rejected as a universal basis for resolving questions of when an outgoing is incurred. However, in very many cases, accounting and jurisprudential analysis will produce identical outcomes, and debit items in a profit and loss account will be deductible losses and outgoings (subject to specific statutory qualifications). That there is much common ground is only to be expected. Where the outcomes differ — as, for example, in Flood’s case — the jurisprudential analysis will prevail. There have been several cases where the courts have drawn attention to the fact that the accounting and legal outcomes correspond. In RACV Insurance Ltd v FCT [1975] VR 1; (1974) 4 ATR 610; 74 ATC 4169, Menhennitt J said (at VR 13–14): In Federal Commissioner of Taxation v James Flood Pty Ltd (1953) 88 CLR 492 at 506; [1953] ALR 903 at 907, the High Court said that although the question whether a loss or an outgoing had been incurred is not a matter depending upon proper commercial or accountancy practice rather than jurisprudence, commercial and accountancy practice may assist in ascertaining the true nature and incidence of the item as a step towards determining whether it answers the test laid down by s 51(1), but it cannot be substituted for the test. In Commissioner of Taxation (NSW) v Manufacturers Mutual Insurance Ltd, … the Court, in the passage I have cited, had regard to the practical business point

of view and, in the passage cited by Fullagar J [in Ballarat Brewing Co Ltd], said that any statement of the company’s affairs professing to show the result of the year’s operations, which neglected to take into account the liability in respect of pending claims, would be grossly inaccurate and misleading. What was said in [Flood and Ballarat Brewing Co] makes it proper, I think, to have regard to the long-established practice of insurance companies of including among losses in each year’s accounts the estimates of liabilities in respect of claims arising out of events which occur in that year in order to ascertain the true nature and incidence of the items as a step towards determining whether they are losses or outgoings incurred within the meaning of s 51(1). That long-established practice reinforces the conclusion that the true nature and incidence of these estimates is that they are losses and outgoings incurred within the meaning of that section. Further, the provision in s 51(1) that a loss or outgoing is an allowable deduction to the extent to which it is incurred in gaining or producing assessable income appears to me to be a statutory recognition and application of the accountancy principle

[page 530] which all the accountants who gave evidence referred to as the matching principle. [Evidence was given] that this principle is almost universally accepted among Western accountants. The principle as stated by [accountants who gave evidence] is that you endeavour as far as possible in preparing or drawing up accounts to bring to account in the same year in which you bring in revenue from a particular transaction the expenditure or anticipated losses directly related to that revenue. He further said that applying that principle he believes that it is proper and necessary to bring to account by way of debit to the profit and loss account in the year in which you bring a certain premium income resulting from contracts of the kind of compulsory third party insurance estimates of the amounts likely to have to be paid out on account of claims which have been notified and also the best estimate that can be made of claims that have not yet been notified so that they will be matching the claim against the revenue. In my view not only is this in accordance with accepted accountancy principles but it is also what s 51(1) of the Income Tax Assessment Act contemplates.

8.49 In Coles Myer Finance Ltd v FCT (1993) 176 CLR 640; 25 ATR 95; 93 ATC 4214, the High Court indorsed this view. In a joint judgment, Mason CJ, Brennan, Dawson, Toohey and Gaudron JJ said (at ATC 4222): Under s 51(1) a loss or outgoing is a deduction only to the extent to which it is incurred in gaining or producing the assessable income. That provision has been described as “a statutory recognition and application of the accountancy principle which all the accountants who gave evidence referred to as the matching principle” to use the words of Menhennitt J in RACV Insurance …

In the Coles Myer Finance case, the taxpayer carried on business as

financier to the Coles Myer group of companies. In the course of this activity, bills of exchange and promissory notes were sold at a discount. In other words, CMF raised money by selling bills and notes for less than their face value and was subsequently required to pay the face value of the bills and notes upon maturity. In the year ended 30 June 1984, instruments discounted by $4.7m were accepted by CMF. The issue before the High Court was whether this amount was incurred when the bills were issued (in 1984) or when they were redeemed (in 1985). The court held that a presently existing liability arose on issue and acceptance of the bills and notes (in 1984).46 The joint judgment reiterated the conclusions of Flood’s case and Nilsen Development Laboratories, and added (at ATC 4221): But it is not enough to establish the existence of a loss or outgoing actually incurred. It must be a loss or outgoing of a revenue character and it must be properly referable to the year of income in question.

Then, after the reference to RACV Insurance cited above, the court said (at ATC 4222): Apportionment of the cost over the two years of income therefore accords with both the accounting principle and the statutory prescription.

The result of the decision was that a liability incurred in one year (1984) was deductible (on a straight-line basis) over two years. [page 531]

In Coles Myer Finance Ltd v FCT (1993) 93 ATC 4214 at 4229, McHugh J expressed the following view: Although the results in (RACV Insurance and Commercial Union Insurance) appear to be eminently sensible, they are reached only by a strained application of the rules laid down in James Flood and Nilsen Development Laboratories. That a sensible result can only be achieved by a strained application of those decisions must throw doubt upon the validity of the principles that decided them.

1. 2.

Identify the rules laid down in James Flood and Nilsen Development Laboratories. In your opinion, in what way does the decision in RACV Insurance strain those rules?

8.50 There is no Australian authority requiring the amortisation of prepayments and it is clear that an amount that is paid is incurred and, subject to ITAA36 ss 82KZL–82KZO, is an allowable deduction. There is a significant departure from the accounting requirement of matching in this respect. Some outgoings that are prepayments would fail tests of deductibility because they are capital in nature. Others, designed to secure a tax advantage, such as prepaid interest (FCT v Ilbery (1981) 12 ATR 561; 81 ATC 4661; FCT v Gwynvill Properties Pty Ltd (1986) 17 ATR 844; 86 ATC 4652) and prepaid rent (FCT v Creer (1986) 17 ATR 548; 86 ATC 4318) failed to satisfy tests under the former ITAA36 s 51(1). Where commercially realistic benefits accrued (FCT v Lau (1984) 6 FCR 202; 16 ATR 55; 84 ATC 4929; FCT v Raymor (NSW) Pty Ltd (1990) 24 FCR 90; 21 ATR 458; 90 ATC 4461;47 FCT v Brand (1995) 31 ATR 326; 95 ATC 4633), the prepayments were deductible and, prima facie, prepaid outgoings would be ‘defrayed, discharged or borne’. The decision in Coles Myer Finance introduced a secondary test as to when an item of expenditure is incurred. The Commissioner has indicated in Taxation Ruling TR 93/21 that, where the term of a debt instrument is 12 months or less but extends over two years, the discount will be apportioned on a straight-line basis: Coles Myer Finance. If the term exceeds 12 months, ITAA36 Pt III Div 16E applies (in effect to amortise the discount over the relevant period). However, in FCT v Energy Resources of Australia Ltd (1996) 185 CLR 66; 33 ATR 52; 96 ATC 4536, the High Court held that, where the proceeds of debt are used to discharge existing liabilities, discounts were incurred in the year of issue and no temporal apportionment of the type applied in Coles Myer Finance was required. [page 532] These cases confirm that there is no necessary symmetry between the

requirements of accounting principles and jurisprudential analysis. In RACV Insurance Ltd v FCT [1975] VR 1 at 13–14; (1974) 4 ATR 610; 74 ATC 4169, Menhennitt J considered that accounting evidence provided support for a conclusion he had already reached on a jurisprudential analysis. In Hooker Rex Pty Ltd v FCT (1988) 19 ATR 1241; 88 ATC 4392, Sweeney and Gummow JJ drew attention to the increasing reliance placed on ‘the concepts of business and the principles and practices of commercial accountancy’ in regard to both income and expenditure issues. In FCT v Australian Guarantee Corp (1984) 15 ATR 982; 84 ATC 4642, Toohey J considered an amount claimed as interest on deferred interest debentures was an outgoing incurred on the basis that: ‘It was calculated in accordance with sound accounting practice, designed to give a true picture of the taxpayer’s operations, and it was an approach not precluded by the language of the Act’. As indicated above, the joint judgment in Coles Myer Finance considered the apportionment ‘accords with both accounting principle and practice and the statutory prescription’. 8.51 ITAA97 Div 230 (see 4.1 and 5.55) contains extensive rules as to recognition and timing of gains and losses from financial arrangements (TOFA rules). Such arrangements include debt instruments like loans, bonds and debentures; risk-shifting derivatives such as swaps; and equity interests. The intent of the provisions was to better align tax treatment with the economic substance and commercial treatment of financial arrangements and the TOFA rules may therefore affect the timing and recognition of deductions discussed in this chapter.

Necessarily incurred 8.52 ‘Necessarily’ does not take on its literal meaning of essential, imperative or unavoidable, but rather has a more liberal meaning of ‘clearly appropriate’. In Ronpibon Tin NL v FCT (1949) 78 CLR 47; 4 AITR 236; 8 ATD 431 at 435, the High Court said: The word “necessary” no doubt limits the operation of the alternative, but probably it is intended to mean no more than “clearly appropriate or adapted for”.

In FCT v Snowden & Willson Pty Ltd (1958) 99 CLR 431; 7 AITR

308; 11 ATD 463, Fullagar J cited the following from Hannan’s Treatise (at AITR 317):48 The meaning of “necessary” in that context is probably not limited to compulsion in a legal sense … and may extend to business expenditure arising out of the exigencies created by difficult or unusual circumstances.

His Honour added: I would respectfully adopt that passage, omitting the word “probably” and substituting the word “does” for the word “may” … [necessarily] means for practical purposes that, within the limits of reasonable human conduct, the man who is carrying on the business must be the judge of what is “necessary”.

[page 533] In Magna Alloys & Research Pty Ltd v FCT (1980) 11 ATR 276; 80 ATC 4542, Deane and Fisher JJ noted (at ATC 4557):49 For practical purposes and within the limits of reasonable human conduct, it is for the man who is carrying on the business to be the judge of what outgoings are necessarily incurred … It is no part of the function of the Act or those who administer it to dictate to taxpayers in what business they shall engage or how to run the business profitably or economically.

Thus it would seem that, to qualify for deduction, an outgoing need only be appropriate or adapted to the ends of the business being carried on. Expenditure cannot be denied because a cheaper alternative is available, for example. However, it is clear from Magna Alloys that ‘necessarily’ presupposes an objective purpose test and that outgoings incurred for purposes other than business can be disallowed or apportioned.50

Summary 8.53 The cases discussed above lead to the following conclusions about when an outgoing or liability is incurred, and to what extent: An outgoing that is paid is incurred. An outgoing that is not paid is incurred when the taxpayer is completely subjected and there is a presently existing liability. An outgoing will not be incurred when it is no more than contingent, threatened or expected, no

matter how certain it may be that the loss or expenditure will occur in the future. An estimate of a pecuniary liability is acceptable where the liability is reasonably capable of estimation. Where a deduction has been allowed for such an estimated liability and in a future period the actual amount needed to defray the liability is greater than the earlier estimate, the difference is deductible. Alternatively, if the payment is less than the estimate, the difference is assessable income.

‘In gaining or producing’; ‘in carrying on a business’ 8.54 The clauses ‘in gaining or producing your assessable income’ and ‘in carrying on a business for the purpose of gaining or producing your assessable income’ are at the heart of the losses and outgoings and deductibility. They clearly require a connection between expenditure and income or business. This has been described as the nexus requirement and it will be satisfied when the occasion of the outlay is found in whatever is productive of actual or expected income. In the past, the language has been interpreted to import a contemporaneity requirement. Professor Parsons said that ‘an expense to be deductible must be contemporaneous with the process by which [page 534] income is derived’.51 This description clearly carries with it a temporal dimension that suggests expenditure incurred before an activity commences, or after an activity ceases, does not satisfy the temporal nexus. There is no ground for rejecting this; an amount incurred before (or after) income-producing activities commence is not incurred in gaining or producing assessable income. However, there is evidence in a number of more recent court decisions of a relaxation of the temporal requirement.52 In Steele v DCT (1999) 197 CLR 459; 41 ATR 139; 99

ATC 4242, Gleeson CJ, Gaudron and Gummow JJ (Callinan J agreeing) said (at ATR 151): The temporal relationship between the incurring of an outgoing and the actual or projected receipt of income may be one of a number of facts relevant to a judgment as to whether the necessary connection might, in a given case, exist, but contemporaneity is not legally essential and whether it is factually important may depend upon the circumstances of the particular case.

There is no suggestion that the temporal nexus has been rejected, only that other factors may show that the occasion of an outlay is found in whatever is productive of actual or expected income when, as in Steele’s case, an activity is abandoned before income is realised or, as in FCT v Brown (1999) 41 ATR 1; 99 ATC 4600, an obligation that is grounded in a former business continues after cessation of the business. These considerations should be kept in mind as the following issues and authorities are examined. It is long established that the words ‘in gaining or producing’ are to be read as ‘in the course of gaining or producing’: Amalgamated Zinc (de Bavay’s) Ltd v FCT (1935) 54 CLR 295; 3 ATD 288. Of the phrase ‘carrying on a business’, Menzies J said in John Fairfax & Sons Pty Ltd v FCT (1959) 101 CLR 30; 7 AITR 346 at 363: The element that I think it necessary to emphasize here is that the outlay must have been incurred in the carrying on of a business, that is, it must be part of the cost of trading operations.

There is evidence that the word in (as in ‘in gaining or producing’ or ‘in carrying on a business’) has been interpreted strictly. A literal interpretation of the word provides a basis for delineating outlays preparatory to or beyond the scope of income-producing activities even though they may be essential prerequisites to the derivation of income. For example, in Lodge v FCT (1972) 128 CLR 171; 3 ATR 254; 72 ATC 4174, Mason J drew specific attention to the word ‘in’ as he dismissed a claim for child-minding expenses incurred to permit a solicitor to earn income because the outlay was not incurred in or in the course of income earning. Expenditure made to reduce future expenses will be in the course of business and it is not to the point that, in itself, the outlay did not produce income. In W Nevill & Co v FCT (1937) 56 CLR 290; 1 AITR

67, the Full High Court allowed a claim for a sum paid to secure the retirement of a former managing director. The object of the exercise was to reduce future salary payments and enhance efficiency. [page 535] However, payments made contemporaneously with the carrying on of business will not be so incurred when they fall upon the taxpayer in a capacity other than as an income earner. For example, contrast the decision in W Nevill & Co with Ash v FCT (1938) 61 CLR 263; 1 AITR 447. In the latter case, the taxpayer sought to deduct an instalment made under an agreement to make good misappropriations made by a former partner. The High Court pointed out the obligation was outside the scope of the taxpayer’s business and fell upon him through the principles of agency. It was not a recurrent expenditure incidental to the carrying on of business. 8.55 There is a clear distinction to be drawn between expenditures necessarily incurred if income is to be earned but which are nevertheless not incurred in the course of deriving that income. It is not enough to show that it is proper, reasonable or necessary to incur the outlays when they would be incurred whether or not income was derived: FCT v Green (1950) 81 CLR 313; 4 AITR 471. Expenses are not incidental and relevant to income production simply because they are necessary: Lunney v FCT (1958) 100 CLR 478; 7 AITR 166 (costs of travel to work). Similarly, expenses to free a taxpayer to work do not satisfy a literal interpretation of ‘in’: Lodge v FCT (1972) 128 CLR 171; 3 ATR 254; 72 ATC 4174; Martin v FCT (1984) 15 ATR 808; FCT v Klan (1985) 16 ATR 176; 85 ATC 4060. Expenses connected with changing employment or seeking employment are not ‘in’ the course of gaining assessable income: FCT v Maddalena (1971) 2 ATR 541; 71 ATC 4161. In that case, the taxpayer failed because the expenses incurred by him as a professional footballer in negotiating a contract with a club were held to be incurred in getting work, not performing work.53

Where outgoings arise within the same time frame as business activities, they will yet be non-deductible when their nature severs them from expenses incurred in trading. For example, in Madad Pty Ltd v FCT (1984) 15 ATR 1118; 84 ATC 4739, the Full Federal Court held that a penalty imposed for a breach of the Trade Practices Act 1974 was a personal deterrent and its nature severed it from a trading expense. It was not incurred in carrying on a business. It was not part of the cost of trading operations. The costs of establishing, expanding or diversifying a business are incurred at a point too soon to be seen as incurred in carrying on a business: Softwood Pulp & Paper Ltd v FCT (1976) 7 ATR 101; Griffin Coal Mining Co v FCT (1990) 21 ATR 819; see 8.57–8.58. Such expenses will usually be of a capital nature in that they are structure related: see 8.61. Expenditure incurred in closing down a business similarly falls outside the temporal requirement: Peyton v FCT (1963) 109 CLR 315; 9 AITR 912. Deductions will often be available under other provisions, especially under ITAA97 Div 40, for such expenses. [page 536]

The/such/your assessable income 8.56 The first limb of ITAA36 s 51(1) provided a deduction for losses and outgoings incurred in gaining or producing ‘the assessable income’ and the second limb referred to carrying on a business for the purpose of gaining ‘such income’. Both these descriptions have been substituted in ITAA97 s 8-1 with ‘your assessable income’. Neither the definite article ‘the’ nor the adjective ‘such’ has been interpreted literally in the sense that expenditure needs to be linked up with income and ‘your assessable income’ assumes the same legacy. The descriptions refer to income generally. It is sufficient for a deduction that income arises in the year of income or is reasonably expected to arise in a future year of income or, in the case of a continuing business,

may have arisen in an earlier year of income: Amalgamated Zinc (de Bavay’s) Ltd v FCT (1935) 54 CLR 295; 3 ATD 288. In Ronpibon Tin NL v FCT (1949) 78 CLR 47; 4 AITR 236; 8 ATD 431, the Full Court of the High Court said (at ATD 435): The words “such income” mean “income of that description or kind” and perhaps they should be understood to refer not to the assessable income of the accounting period but to assessable income generally.54

In the case of an employee, what matters is whether the outgoing is incidental and relevant to operations regularly carried on for the production of income. There is no requirement that the purpose of the expenditure shall be the gaining of the income of that year. In FCT v DP Smith (1981) 147 CLR 578; 11 ATR 538; 81 ATC 4114, an employee medical practitioner successfully claimed a deduction for contributions for disability insurance. It will be appreciated that, although such insurance is prudent, seldom would it be taken out with an enthusiastic hope of a payout. Subsequent receipts would be income by ordinary concepts, being a substitute for income, but the best case scenario would be no receipt at all. However, the High Court held that such an insurance premium was an outgoing incurred in the course of operations directed to the production of income. It is not necessary that income in fact arises.55 The issue is not the connection with particular items of income. The payments were incidental and relevant to Smith’s usual salary. Thus, if no income is produced in a given year of income, an outgoing will still be deductible if it was expected to produce income or is part of operations that more directly produce income. In the case of a business taxpayer seeking a deduction under s 8-1(1)(b), the requisite connection is between the loss or outgoing and the carrying on of a business. In the case of employee taxpayers, expenditure is deductible if it might produce future assessable income or simply if it is sufficiently connected to the taxpayer’s income-earning activities. [page 537]

Carrying on a business 8.57 ITAA97 s 8-1(1)(b) (and the second limb of the former ITAA36 s 51(1)) permits a deduction for losses and outgoings necessarily incurred in the course of carrying on a business. Business is defined to include ‘any profession, trade, employment, vocation or calling, but does not include occupation as an employee’.56 Whether or not a business is carried on is a question of fact and degree and whether a person is in the business of trading is a question of fact.57 In the course of determining whether or not a business exists, reference will be made to establishing a profit motive or the commercial viability of the undertaking but a profit motive does not mean that profits must be generated in a particular year. Short-term losses or a failed venture do not deny the existence of a business. In Tweddle v FCT (1942) 180 CLR 1; 2 AITR 360, Williams J said (at AITR 364): I am satisfied that the appellant is seeking to establish himself at Winlaton as a recognized breeder of high class stud stock and that while he is prepared to take losses to achieve this ambition, he has a genuine belief that he will be able eventually to make the business pay.

Thus, the taxpayer in Ferguson v FCT (1979) 9 ATR 873; 79 ATC 4261 was successful in establishing that a business of primary production existed because of his long-term plans for commercial viability, whereas, in McInnes v FCT (1977) 7 ATR 373; 77 ATC 4167, the taxpayer was unsuccessful because the activity lacked an existing or prospective commercial character. Purpose in relation to carrying on a business is principally the objective purpose and it may be inferred from examining other attributes of a business, such as the scale of operations. In London Australia Investment Co Ltd v FCT (1977) 138 CLR 106; 7 ATR 757; 77 ATC 4398, Jacobs J said (at ATR 772): I do not think that a conclusion on scale by itself provides the answer; but it is very important evidence tending to show a business of acquiring and disposing of shares and it was some evidence from which a purpose of thereby making a profit might be inferred.

Although every business must begin with an initial transaction, repetition and continuity are key elements of a business and point to a profit intention. A single transaction may amount to a business and, in respect of an isolated transaction, this is especially so if a separate

transaction is carried out as an incident of the taxpayer’s normal trading activities. An isolated transaction entered into with the intention of a profit will stamp the proceeds as income in nature. The degree of activity which is requisite to the carrying on of a business varies according to the circumstances of the particular business being considered. Little [page 538] activity is sufficient for a business that does not require much activity and, in many businesses, long periods of inactivity may occur.58

Preliminary expenditure 8.58 Preliminary expenses connected with the establishment or acquisition of a business are not deductible under ITAA97 s 8-1 because either they are not incurred in carrying on a business or they relate to the creation of a profit-yielding structure and are capital in nature: see 8.61. In the case of a company, the issuing of capital and attending to other formalities does not amount to carrying on a business and neither, typically, does investigation of processes, the carrying out of feasibility studies or construction of premises. Of course, it is ultimately the particular scope of the taxpayer’s business activities that will determine whether an expense is too preliminary to be sufficiently connected with those activities and feasibility-type costs have, for instance, been deductible in circumstances where the taxpayer’s business was a business of petroleum exploration.59 The leading decision concerning preliminary expenses is Softwood Pulp & Paper Ltd v FCT (1976) 7 ATR 101; 76 ATC 4439. In that case, the taxpayer sought to deduct the costs of investigating setting up a paper mill in South Australia. The proposal was abandoned when the company failed to secure financial backing. Menhennitt J said (at ATR 113): The project had not reached anything like the stage of doing anything in the course of

gaining or producing assessable income. All that had happened was that certain tests had been made to ascertain whether or not the project would be feasible.

His Honour went on to say that ‘no one was committed, at all, to go on with the project’. Of relevance, the capitalisation of Softwood Pulp & Paper Ltd was significantly less than the sum that would have been required to proceed with the project. Demonstrating commitment is an important element in these cases and it may be that commitment is sufficient to make a non-contemporaneous expense relevant to income production.60 In Esso Australia Resources Ltd v FCT (1998) 39 ATR 394; 98 ATC 4768, the Federal Court said (at ATC 4782): In our view it can now be taken as well established that … in determining whether there is a sufficient nexus between expenditure claimed to be deductible under s 51(1)

[page 539] and the prospect of income being earned by a taxpayer’s business as a consequence of the expenditure the element of commitment is an important criterion …

In Inglis v FCT (1980) 40 FLR 191; 10 ATR 493; 80 ATC 4001, the taxpayers claimed deductions in relation to a farming property on which they had ceased to conduct their business but had intended to return to at some time in the future. The Federal Court held that, having regard to the uncertainties of the future, the property was not used in or committed to the production of income.61 In Steele v DCT (1999) 197 CLR 459; 41 ATR 139; 99 ATC 4242, a majority of the High Court indicated that the utility of the concept of commitment may vary from case to case. But it remarked that, although the taxpayer was not financially committed to any particular development, no use of the property was envisaged other than one that would produce income. One of the issues before the High Court in Steele’s case was the remoteness of income. The taxpayer who had interests in the hospitality industry was seeking new opportunities and in 1980 acquired land considered suitable for hotel and residential development. Until the land was sold in 1988, the taxpayer pursued several development options unsuccessfully and the land was used only

for agisting horses. Over the period, $29,000 was derived. The issue centred on the deductibility of interest amounting to $900,000. The Administrative Appeals Tribunal held that the interest, to the extent that it exceeded the agistment income, was directed to creating a profit-making structure; the Full Federal Court held that the interest was on capital account, and so was not deductible, but raised doubts over the AAT’s finding that there was a lack of commitment. A majority of the High Court held that the Federal Court had erred in finding that the interest was on capital account. In the usual case, interest is revenue in nature and its character is not changed because the funds are used to buy a capital asset. In the cases dealing with preliminary expenses, the stage of development reached by a business is an important consideration but the business need not have reached its optimal or desirable level of activity before the preliminaries can be said to be completed. Where an existing business incurs expenditure as part of the cost of forming a new source of income, the amount will not be deductible whether or not it is characterised as capital in nature. Experimental work conducted towards the establishment of new products also fails tests of deductibility.62 [page 540]

Cessation of business 8.59 Expenses relating to the closing down of a business are not incurred in carrying on a business. In Peyton v FCT (1963) 109 CLR 315; 9 AITR 112, Kitto, Taylor and Owen JJ said (at AITR 117): [The taxpayer] incurred the loss or outgoing, therefore, not in gaining or producing the assessable income but in parting with the means by which he had been gaining or producing it; not in carrying on the business for the purpose of gaining or producing such income, but in disposing of the business and ceasing thereby to gain or produce such income.

Non-deductibility extends to payments made after the taxpayer has ceased income-producing activities or, in the case of a company, is in

the process of liquidation.63 However, expenses paid by receivers and managers that had arisen from leases entered into by the taxpayer the default of which led to the appointment of receivers will satisfy the requisite nexus.64 There is a distinction to be drawn between expenses that arise after a business has ceased and those that might be incurred or paid after the cessation of business but which are grounded in the business operation that has since ceased (and which are sufficiently connected: see 8.21–8.24).65 As a result, where there has been a complete cessation of the activities by which assessable income was generated, losses and outgoings incurred in a subsequent year of income will not be deductible. Where there has been a break in a particular income-earning activity which is subsequently resumed, losses and outgoings relating to the earlier years of income will be deductible. In the case of temporary suspensions of business, holding and other relevant costs will continue to be deductible where there is a reasonable prospect of resuming activity but not where the evidence supports a conclusion that the business has ceased.66

Purpose 8.60 The word ‘purpose’ appears only once in ITAA97 s 8-1. Section 8-1(1)(b), which corresponds to the second or business limb of the former ITAA36 s 51(1), provides a deduction for losses and outgoings necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income. It is clear that ‘carrying on a business’ must have the purpose of assessable income production. The loss or outgoing is linked to assessable income via the business. [page 541] Once it becomes established that a business exists and its object is income production (as opposed to a hobby or non-profit organisation), ‘purpose’ is not part of the statutory tests of deductibility. However, it

is clear that, in the process of characterisation and in the application of the unlegislated tests of deductibility, it is implicit that the (objective) purpose of the expenditure should be the generation of assessable income. Where expenditure is incurred with the object of securing outcomes other than the production of income, the courts have adopted ‘purpose’ as a basis of apportionment. In addition, the courts have been prepared to examine the (subjective) purpose of the taxpayer in cases where, for example, expenditure exceeds income: see 8.33–8.36.

Capital or of a capital nature 8.61 Section 8-1(2)(a) (and the negating limb of the former ITAA36 s 51(1)) prevents a deduction for a loss or outgoing that is capital or of a capital nature. Problems of distinguishing between transactions on revenue account and those on capital, from the point of view of expenditure, correspond to those identified in Chapter 3 in respect of income, and there are many instances where the courts have been pessimistic about the hope of discovering enduring distinctions. One English judge suggested that the spin of a coin would decide the matter almost as satisfactorily as an attempt to find reasons.67 Some early UK attempts to formulate tests for distinguishing income and capital include the ‘once and for all’ test in Vallambrosa Rubber Co Ltd v Farmer (1910) 5 TC 529. There, Lord Dunedin made the tentative distinction that ‘capital expenditure is a thing that is going to be spent once and for all, and income expenditure is a thing that is going to recur every year’. In that case, the taxpayer made a claim for the cost of pest control and weeding a rubber plantation but the revenue authorities reduced the deduction to the proportion of trees on the estate that at the time were producing rubber. On the basis of Lord Dunedin’s ‘once and for all’ test, the court held that the amount was on revenue account. A second test was formulated in British Insulated & Helsby Cables v Atherton (1926) 10 TC 155. In that case, expenditure to establish a pension fund for staff was held to be on capital account because it

provided an ‘enduring benefit’. The ‘once and for all’ test was qualified by Viscount Cave as follows: Where an expenditure is made, not only once and for all, but with a view to bringing into existence an asset or advantage for the enduring benefit of a trade … there is very good reason … for treating such expenditure as properly attributable not to revenue but to capital.

In a later decision, Tucker v Granada Motorway Services Ltd [1979] 2 All ER 801, the House of Lords held that a payment made to amend onerous conditions in a 40-year lease was capital. Lord Wilberforce embellished Viscount Cave’s statement as follows (at 812): [page 542] … a benefit [is one] which endures, in the way that fixed capital endures; not a benefit that endures in the sense that for a good number of years it relieves you of a revenue payment … It is not always an actual asset, but it endures in the way that getting rid of a lease or getting rid of onerous capital assets [endures].

In Australia, however, the test for distinguishing revenue and capital derives from Dixon J’s judgment in Sun Newspapers Ltd and Associated Newspapers Ltd v FCT (1938) 61 CLR 337; 1 AITR 403; 5 ATD 87. Of the views expressed in the earlier UK decisions, Dixon J said in Hallstroms Pty Ltd v FCT (1946) 72 CLR 634; 3 AITR 436 at 442; 8 ATD 190: For myself, however, I am not prepared to concede that the distinction between an expenditure on account of revenue and an outgoing of a capital nature is so indefinite and uncertain as to remove the matter from the operation of reason and place it exclusively within that of chance or that the discrimen is so unascertainable that it must be placed in the category of an unformulated question of fact. The truth is that, in excluding as deductions losses and outgoings of capital or of a capital nature, the income tax law took for its purposes a very general conception of accountancy, perhaps of economics, and left the particular application to be worked out, a thing which it thus became the business of the courts of law to do.

What conceptual framework grounded in accountancy or economics would disallow a deduction for capital expenditure, and for what reason?

The process–structure test 8.62 In Australia, the leading test for distinguishing income and capital is a ‘process–structure test’, or, as sometimes described, a ‘business entity test’. The test derives from Sun Newspapers Ltd and Associated Newspapers Ltd v FCT (1938) 61 CLR 337; 1 AITR 403; 5 ATD 87, and its focus is whether the expenditure relates to the structure, or the profit-yielding subject of a business entity, or to the process of operating that structure.

Sun Newspapers Ltd and Associated Newspapers Ltd v FCT Facts: Sun Newspapers (Sun) was publisher of a number of journals. Associated Newspapers (Associated), which held nearly all the shares in Sun, entered into an agreement to pay a rival publisher £86,500 if it agreed not to publish The Star within 300 miles of Sydney for three years and to pass over control of plant and equipment for three years. The Star was a rival newspaper that was proposed to be sold for 1 penny, a significantly lower price than the 1.5 pennies charged by Sun for its newspapers. The payment did not result in [page 543] Sun or Associated acquiring an interest in The Star. As a result of the arrangements, the rival went out of business. The payment was claimed as a deduction allowable to either Sun or Associated. Held: The High Court found no part of the outgoing was allowable as it was an outgoing of capital. In a widely quoted judgment, Dixon J said (at AITR 410–13): The distinction between expenditure and outgoings on revenue account and on capital account corresponds with the distinction between the business entity structure or organisation set up or established for the earning of profit and the process by which the organisation operates to obtain regular returns by way of regular outlay, the difference between the outlay and returns representing profit or

loss. The business structure or entity or organisation may assume any of an almost infinite variety of shapes and it may be difficult to comprehend under one description all the forms in which it may be manifested. In a trade or pursuit where little or no plant is required, it may be represented by no more than the intangible elements constituting what is commonly called goodwill … On the other hand it may consist in a great aggregate of buildings, machinery and plant all assembled and systematised … But in spite of the entirely different forms, material and immaterial, in which it may be expressed, such sources of income contain or consist in what has been called “a profit yielding subject”, the phrase of Lord Blackburn in United Collieries Ltd v IRC (1930) 12 TC 1248. … There are, I think, three matters to be considered, (1) the character of the advantage sought, and in this its lasting qualities may play a part; (2) the manner in which it is to be used, relied upon or enjoyed and in this and under the former head recurrence may play its part; and (3) the means adopted to obtain it; that is by providing a periodical reward or outlay to cover its use or enjoyment for periods commensurate with the payment or by making a final provision or payment so as to provide future use or enjoyment.

8.63 The test was reiterated in Hallstroms Pty Ltd v FCT (1946) 72 CLR 634; 3 AITR 436; 8 ATD 190 as a contrast between: the acquisition of the means of production and their use; the establishment or extension of a business organisation and the carrying on of the business; [page 544] the implements employed in work and the regular performance of the work in which they are employed; and the enterprise itself and the sustained effort of those engaged in it. So, Lord Wilberforce’s conclusion in Tucker v Granada Motorway Services Ltd [1979] 2 All ER 801, that money spent on the acquisition or improvement of an asset or the elimination of a commercial disadvantage, is easily absorbed into the broader confines of the test in Sun Newspapers. In addition, the Sun Newspapers test provides parameters that are more considered than the simple ‘once and for all test’ in the Vallambrosa Rubber case. For example, recurrence is not a

test under Dixon J’s criteria; it is a consideration, the weight of which depends on the nature of the expenditure. Similarly, the character of the advantage sought is a consideration relevant to the test rather than, as in British Insulated & Helsby Cables v Atherton (1926) 10 TC 155, a test in its own right.68 Dixon J’s criteria in Sun Newspapers provide a test (and considerations relevant to the test) to determine whether an outgoing is such that it enhances or establishes the profit-yielding subject and, therefore, is of a capital nature. It would seem to hold that expenditure, intended to enhance profit-yielding structure, but failing to do so, would be a loss of a capital nature. Expenditure merely to restore the profit-yielding subject to what it may have been would seem to have revenue characteristics, while expenditure, either periodic or once only, to operate or work the profit-yielding structure, would be of a revenue nature. However, in the case of expenditure to protect the profityielding structure, Australian case law has generally held the outgoings to be of a capital nature: see John Fairfax & Sons Ltd v FCT (1959) 101 CLR 30; 7 AITR 346; Broken Hill Theatres Pty Ltd v FCT (1952) 85 CLR 423; 5 AITR 296; and FCT v Snowden & Willson Pty Ltd (1958) 99 CLR 431; 7 AITR 308. 8.64 In Sun Newspapers, the following conclusions were made (at AITR 413): (1) The expenditure was of a large sum incurred to remove finally the competition feared from the Star … (2) It could be regarded as recurrent only in the sense that the risk of a competitor arising must always be theoretically present, and that the reality or imminence of the risk depends upon circumstances which can never clearly be foreseen. (3) The chief object of the expenditure was to preserve from immediate impairment and dislocation the existing business organisation of the taxpayers. (4) The impairment or dislocation feared involved a lowering of selling price, a loss of circulation, a change in advertising rates, and a reorganisation of selling and production arrangements, all of a lasting character; that is, the changes would involve structural changes in the business and be of an indefinite duration and their effects would continue until they disappeared under influences brought by the future, the exact nature of which could not be foreseen.

[page 545]

(5) The transaction involved the acquisition for cash consideration of the right to enjoy for three years all the property, tangible and intangible, of an existing undertaking, that is the acquisition of a going concern for a period, a thing recognised as a capital asset. The advantage in terms of profit was not to be obtained by the use of the undertaking but by putting it out of use; but in itself it remained a capital asset.

In the circumstances, the transactions were regarded as strengthening and preserving the business organisation or entity, the profit-yielding subject, and affecting the capital structure.

Circulating and fixed capital 8.65 The accounting distinction between fixed and working or circulating capital provides a workable but imperfect basis for applying the income/capital distinction. The accounting literature defines a current asset as: … cash, or other assets of the entity that would in the ordinary course of the operations of that entity be consumed or converted into cash within twelve months of the end of the last financial year of the entity.

Fixed (or non-current) assets are all assets other than current assets and working capital is current assets minus current liabilities.69 The courts have referred to the circulating/fixed asset distinction a number of times and nominated several items that fall within the ambit of each term but there is no definitive statement of its relevance and application to the broader distinction between income and capital. Fixed capital is that from which a return on operations is expected. The return from operations is in the form of working or circulating capital: BP Australia Ltd v FCT (1965) 112 CLR 386; 9 AITR 615; AGC (Advances) Ltd v FCT (1975) 132 CLR 175; 75 ATC 4057. Losses of circulating capital, such as debts, and expenditure to acquire items of circulating capital, such as trading stock, are on revenue account. The acquisition of a fixed asset is on capital account but where the commercial advantage does not take the form of a tangible benefit, the distinction itself is of little assistance, although, based on broader accounting criteria, a conclusion that an expenditure provides future economic benefits (and so should be capitalised) is compatible with the process–structure test and may provide evidence of the appropriate treatment for tax purposes.

The income/capital dichotomy applied 8.66 Suggestions are offered in BP Australia Ltd v FCT (1965) 112 CLR 386; 9 AITR 615 (per Lord Pearce at AITR 622) and Heather v PE Consulting Group Ltd [1972] 13 WLR 833 (per Lord Denning at 837) that when less obvious or more difficult cases arise concerning the capital/revenue outgoing distinction, the approach should be as follows: search through the decided cases and see whether the particular problem has come up before, and, if so, be guided by it. If not, then go by the nearest instance you can find. It is the borderline cases that sharpen the distinction and they are discussed under the headings that follow. [page 546]

Immunity from competition 8.67 Costs incurred to create, preserve or defend a monopoly position have been regarded as capital outgoings in Australia, the United Kingdom and other common law jurisdictions. On occasions when expenditure of this type has been an allowable deduction, the courts have found that the reduction of competition was short term: BP Australia Ltd v FCT (1965) 112 CLR 386; 9 AITR 615. Where costs are incurred in defending against a routine business hazard, they will be on revenue account. However, costs to eliminate a potential business rival are capital in nature: Broken Hill Theatres Pty Ltd v FCT (1952) 85 CLR 423; 5 AITR 296; Sunraysia Broadcasters Pty Ltd v FCT (1991) 91 ATC 4530.

Acquisition of a capital asset 8.68 The cost of acquiring a capital asset is itself on capital account but differing views have been expressed when consideration is other than a lump sum. For example, in Cliffs International Inc v FCT (1979) 142 CLR 140; 9 ATR 507; 79 ATC 4059, the High Court split 3:2 in holding that certain ‘deferred payments’ were in the nature of a royalty

and on revenue account. AusNet Transmission Group Pty Ltd v FCT [2015] HCA 25; 2015 ATC 20521 demonstrates the potential difficulty in determining whether payments are for the acquisition of a capital asset or for the use of an intangible asset. In 1997, AusNet Transmission Group (ATG) acquired electricity transmission assets from a state-owned entity as part of Victoria’s privatisation of its electricity supply industry. The assets included tangible transmission equipment, intangible assets such as customer contracts and a licence that provided the holder with the right to transmit electricity. Under the licence conditions and the applicable legislation, the state was able to impose additional special licence fees. The special licence fees comprised additional specified amounts totalling $177.5m payable at set times over a three-year period. It was a mechanism to recoup excess monopoly profits obtainable by the licence holder as a result of an overly generous cap on electricity transmission prices under a Tariff Order that expired in December 2000. Under the asset sale agreement for the electricity transmission assets, ATG agreed that it would assume responsibility for the special licence fees. ATG argued that the special licence fees were periodic payments for use of the licence. The Commissioner asserted that the special licence fees formed part of the consideration for acquiring the transmission assets. A majority of the High Court found that the special licence fees were paid for the acquisition of the transmission assets and were therefore capital. However, Nettle J, in a dissenting judgment, characterised the special licence fees as being for the maintenance and use of the licence, by way of analogy to rental payments. Returning to the reasoning in the majority judgments, one of the ways in which AusNet can be distinguished from Cliffs International is that while the consideration provided for the shares in Cliffs International included an obligation to make ‘royalty’ payments, the obligation to pay any particular amount was contingent on mining occurring and on the extent of that mining. In AusNet, the obligation to pay specific licence fees was entered into under the asset sale agreement and while the obligation may have been

[page 547] defeasible (in the sense that it might come to an end if ATG transferred the licence), it was not contingent on any action on the part of ATG, such as the extent of use of the licence. The cost of acquiring rights, for example, to quarry gravel or cut standing timber are also capital: Stow Bardolph Gravel Co Ltd Pty v Poole [1954] 3 All ER 637. Payments made to extract gravel or cut timber where the payments are in relation to the quantity removed are royalties and part of assessable income: McCauley v FCT (1944) 69 CLR 235; 3 AITR 67. Such royalty (or rental) payments made in relation to the extent of extraction of resources (or the occupation of land for mining from time to time) are also likely to be revenue outgoings: Cape Flattery Silica Mines Pty Ltd v FCT (1997) 36 ATR 360; 97 ATC 4552. The interest on a loan to acquire a capital asset that is to be used for income-producing purposes is on revenue account: Steele v DCT (1999) 197 CLR 459; 41 ATR 139; 99 ATC 4242.

Outgoings to defend title to an asset 8.69 There are some differences evident in the treatment of such expenditure between the Australian and UK courts: see John Fairfax & Sons Ltd v FCT (1959) 101 CLR 30; 7 AITR 346 at 353. At issue is the nature of the perceived threat. It would seem that, where a business entity is in peril or under substantial threat, costs of defence or protection will be on capital account. However, where the outlays are more in the nature of exploiting a position or a defence against a business hazard that is something less than perilous, the amounts are on revenue account: see FCT v Rothmans of Pall Mall (Australia) Ltd (1992) 37 FCR 582; 23 ATR 620; FCT v Snowden & Wilson Pty Ltd (1958) 99 CLR 431; 7 AITR 308. Costs of the physical protection of assets, such as in relation to security, monitoring or insurance, are on revenue account: Australian National Hotels Ltd v FCT (1988) 19 FCR 234; 19 ATR 1575; 88 ATC 4627. They are operating expenses in that they arise in the course of

prudent business management. They are recurrent expenditures that in themselves provide no enduring advantage. The loss or physical destruction of assets is on capital account: Guinea Airways Ltd v FCT (1949) 83 CLR 584; 4 AITR 299.

Private or domestic nature 8.70 Losses and outgoings are not deductible under ITAA97 s 8-1 to the extent to which they are losses and outgoings of a private or domestic nature. Whether such outgoings can meet the requirements of the positive parts of the provision may be doubted, but the High Court has said that there is no necessary antipathy between a loss or outgoing satisfying the positive parts of the provision and being of a private nature: John v FCT (1989) 166 CLR 417; 20 ATR 1; 89 ATC 4101. From the point of view of operational expediency, the suggestion in Steele v DCT (1999) 197 CLR 459; 41 ATR 139; 99 ATC 4242 is adopted that it be accepted by hypothesis that s 8-1(1)(a) or (b) is satisfied and the exclusion in s 8-1(2)(b) be considered. There is a view that ‘private’ is distinguishable from ‘domestic nature’. By ordinary concepts, domestic expenditures would be seen as a subset of private expenditures. [page 548] On that view, it follows that ‘domestic’ is inserted by way of emphasis in the same way that the words ‘or of a capital [nature]’ follow ‘capital’ in s 8-1(2)(a). This would suggest that the word ‘or’ is conjunctive (rather than disjunctive) and that whatever is said of private expenditure is true a fortiori of domestic outgoings. The alternative view (that domestic can be distinguished from private) is evident in Handley v FCT (1981) 148 CLR 182; 11 ATR 644; 81 ATC 4165; FCT v Forsyth (1981) 148 CLR 203; 11 ATR 657; 81 ATC 4157.70

Relevance and character

8.71 Unlegislated tests of deductibility under the general deduction provision require that losses and outgoings should be ‘incidental and relevant’ (Amalgamated Zinc (de Bavay’s) Ltd v FCT (1935) 54 CLR 295; 3 ATD 288; W Nevill & Co v FCT (1937) 56 CLR 290; 1 AITR 67; Ronpibon Tin NL v FCT (1949) 78 CLR 47; 4 AITR 236; 8 ATD 431) or possess an ‘essential character’ that establishes an incomeearning nexus (Charles Moore & Co (WA) Pty Ltd v FCT (1956) 95 CLR 344; 6 AITR 379; Lunney v FCT (1958) 100 CLR 478; 7 AITR 166). In respect of private or domestic expenses, emphasis has been placed on the ‘essential character’ test. However, it should be noted that the High Court in Lunney employed an analysis of the outgoing’s essential character in order to establish its relevance to the derivation of assessable income.

Which (if any) of the following expenses would be ‘incidental and relevant’ and have an essential character that stamps them as ‘business’ as opposed to ‘living’ expenses: an alarm clock used by a night-shift worker; a suit worn by a chartered accountant; overalls worn by a mechanic; additional food and vitamins consumed by a professional footballer; hairdressing costs by a model; spectacles worn by a solicitor; [page 549] sunglasses worn by a police motorcyclist; goggles worn by a welder; sunscreen worn by a physical education teacher; moisturising cream used by a flight attendant? Which of these expenses should be deductible? A suggested solution can be found in Study help.

One of the weaknesses of the ‘essential character’ test is that, if applied indiscriminately, expenditures on food, clothing, shelter, etc, will be denied deductibility categorically because such expenditures are typically private in nature. In truth, however, many such expenses are potentially dual purpose expenses in that they are incurred both for income-producing and personal purposes. One of the difficulties with administering the private or domestic exclusion becomes evident when this weakness is appreciated because if it is admitted that food and clothing are not always inherently private, a very good filter becomes necessary to eliminate such expenditure that satisfies the positive part of the provision but is not disqualified by the exclusion. Unfortunately, a very good test is unavailable. 8.72 One basis for distinguishing private from non-private derives from Lunney v FCT (1958) 100 CLR 478; 7 AITR 166, and lies in a distinction between ‘business’ and ‘living’ expenses. The advantage of this classification is that it shifts the focus away from categories of expenditure (food, travel, etc) towards the necessary link or nexus between the outlay and income production (‘business’ expenses). Williams, Kitto and Taylor JJ illustrated the distinction in the context of travel expenses thus (at AITR 181):71 A distinction must be drawn between living expenses and business expenses. In order to decide into which category to put the cost of travelling, you must look to see what is the base from which the trade, profession or occupation is carried on. In the case of a tradesman, the base of his trading operations is his shop. In the case of a barrister, it is his chambers. Once he gets to his chambers, the cost of travelling to the various courts is incurred wholly and exclusively for the purpose of his profession. But it is different with the cost of travelling from his home to his chambers and back. That is incurred because he lives at a distance from his base. It is incurred for the purposes of his living there and not for the purposes of his profession, or at any rate not wholly and exclusively; and this is so whether he has a choice in the matter or not. It is a living expense as distinct from a business expense.

Their Honours concluded that travel costs from home to work were irrelevant to the production of income. They added: [page 550]

And even if it were possible — and we think it is not — to say that its essential purpose is to enable a taxpayer to derive his assessable income there would still be no warrant for saying, in the language of s 51(1), that it was “incurred in gaining or producing the assessable income” or “necessarily incurred in carrying on a business for the purpose of gaining or producing such income”.

The expenditure in question failed to satisfy the positive parts of ITAA36 s 51(1) but it seems that to characterise it as a living expense is enough to disqualify it as private or domestic. As Menzies J observed in FCT v Hatchett (1971) 125 CLR 494; 2 ATR 557 at 560; 71 ATC 4184: ‘It must be a rare case when an outgoing incurred in gaining assessable income is also an outgoing of a private nature’.

Specific categories 8.73 The exclusion (or apportionment) of private and domestic expenditure is one of the more difficult administrative areas of tax because so many private outgoings are incidental to income derivation but have an essential character that denies them the necessary relevance. In many marginal cases, the characterisations are influenced by unarticulated policy reasons, or else can be seen as arbitrary and not without doubt. In a large number of cases, the ATO’s rulings provide the only practical guide. The following items of expenditure have been considered by the courts under the private and domestic exclusion.

Food 8.74 Generally, expenditure on food is of a private or domestic nature: see FCT v Cooper (1991) 21 ATR 1616; 91 ATC 4396. However, clearly, the purchase of food as trading stock is an allowable deduction and, as the specific provisions relating to entertainment expenses in ITAA97 Div 32 (see Chapter 9) suggest, there will be occasions where the consumption of food falls within ITAA97 s 8-1 (although it may be the subject of fringe benefits tax: see Chapter 7). There are also some occupations where food consumption forms an integral part of the income-producing activities, for example, a food critic. Other instances are illustrated by the decision in Cunliffe v FCT (1983) 14 ATR 364; 83 ATC 4380. In that case, a restaurateur

undertook an extensive overseas trip to study food-preparation techniques and sample exotic dishes. The Commissioner allowed onethird of the claim. The Supreme Court was not persuaded to alter the apportionment while conceding that the expenses ‘… having regard to the taxpayer’s business, may be considered as losses or outgoings incurred in gaining or producing assessable income’: at ATR 370.

Clothing 8.75 Like food, clothing is a necessity of life rather than an item relevant to income derivation but a clear distinction arises between conventional and occupational clothing: see Taxation Ruling TR 97/12 and occupation-specific rulings. For example, clothing is ‘incidental and relevant’ when it is worn to protect a person from an occupational hazard rather than a routine environmental hazard. Such clothing is likely to be ‘necessarily and peculiar’ as was illustrated in (1983) 26 CTBR (NS) Case 136 — claiming for a dark suit on the basis that ‘only funeral [page 551] directors and eccentrics’ wear black suits in tropical Queensland. It is unlikely that eccentrics would succeed, however. Uniforms will generally be deductible (subject to ITAA97 Div 34), as will protective clothing. Where an occupation requires an additional wardrobe, the cost can be deductible: FCT v Edwards (1994) 28 ATR 87; 94 ATC 4255; see also Mansfield v FCT (1995) 31 ATR 367; 96 ATC 4001. The distinction between occupational and environmental hazards has diminished in recent years. Although sunglasses and hats would be regarded as (non-deductible) conventional clothing, a motorcycle police officer was allowed a deduction for sunglasses because they have an additional safety feature over and above protection from the natural environment. Anti-glare glasses worn by a VDU operator have been allowed (being an occupational hazard) and the Commissioner has ruled (TR 95/19) that anti-glare glasses worn by pilots are deductible. In

Morris v FCT (2002) 50 ATR 104; 2002 ATC 4404, a test case was taken by a number of taxpayers (including a farm manager, surveyor, builder, physical education teacher) whose employment or business meant they were exposed to the elements. Expenditure on sunglasses, hats and sunscreen was allowed. The Federal Court said it was irrelevant that the items were designed for protection from the natural as opposed to occupational environment. The health dangers of overexposure to sunlight established a sufficient connection between the expenditure and outdoor employment. Evidence of increased productivity strengthened the claims.

Health and medical expenditure 8.76 The deductibility of health-related expenses has not been examined by the superior courts but the clear inference from related cases is that they are private or domestic in nature or perhaps (by way of analogy) capital. In Australia, medical costs have been granted concessional deductibility and have historically been subject to a tax rebate, albeit that the net medical expenses offset is to be phased out by 2019–20.

Child-minding costs 8.77 The costs of childcare incurred by working parents have been held not to be deductible either because they failed to satisfy the positive parts of ITAA97 s 8-1 or were excluded as private or domestic: Lodge v FCT (1972) 3 ATR 254; 72 ATC 4174; Martin v FCT (1984) 15 ATR 808; 84 ATC 4513.

Home-office expenses 8.78 The authorities have made a distinction between a ‘home office’ (or place where work is done) and a ‘place of business’ that is accepted by the Commissioner: see Taxation Ruling TR 93/30. Where part of a home is set aside as a ‘place of business’, related costs (such as apportionment of rent, rates or mortgage interest) are deductible.72 Where work is performed in a home study as a matter of convenience, related costs are not deductible.

[page 552] There is a distinction made also between a house per se and its contents such that depreciation on a desk (and other depreciable assets) is an allowable deduction when the equipment is used in connection with income-earning activities. So, too, is an apportionment of the cost of lighting and heating. The disallowance of costs in connection with a house (in the case of a home study) derives from the High Court decisions in Handley v FCT (1981) 148 CLR 182; 11 ATR 644; 81 ATC 4165 and FCT v Forsyth (1981) 148 CLR 203; 11 ATR 657; 81 ATC 4157: see 8.14.

Travel 8.79 The costs of travel from home to a place of employment or business are not deductible under ITAA97 s 8-1: Lunney v FCT (1958) 100 CLR 478; 7 AITR 166. This conclusion rests either on accepting that such travel fails to satisfy the positive parts of the general deduction provision (it is not incurred in gaining or producing income) or that it is a private, ‘lifestyle’ choice to live away from a place of employment. This situation may be qualified where a home is a ‘base of operations’. Thus, travel to work is not deductible, or private, but once work has commenced, travel may be an essential element in incomeproducing activities. As result, where a home is a ‘base of operations’, work commences sooner and to leave the base on income-related matters would be travel in the course of gaining or producing assessable income. In cases where the travel has purposes other than merely conveying a taxpayer to work, it may lose its private and domestic nature.73 In FCT v Vogt (1975) 5 ATR 274; 75 ATC 4073, a musician successfully claimed the cost of transporting a bulky instrument. In FCT v Ballesty (1977) 7 ATR 411; 77 ATC 4181, a professional footballer who travelled to various sporting venues was allowed a deduction. In FCT v Collings (1976) 6 ATR 411; 76 ATC 4254, a computer consultant was required to be on call 24 hours daily and to attend the office in the event of a computer malfunction. Her travel outside normal hours was

held to be incurred in gaining her assessable income. Similarly, in FCT v Wiener (1978) 8 ATR 335; 78 ATC 4006, a teacher involved in a pilot scheme was required to attend a number of different schools on the same day. The question in that case was whether motor vehicle expenses to the first school and from the last were deductible. The court considered the taxpayer’s occupation could be classified as an itinerant one and her home was one of her two workplaces. However, just because phone calls are received at home from an agency requesting a taxpayer to work is not enough to make a taxpayer’s home a place of work: FCT v Genys (1987) 19 ATR 356; 87 ATC 4875. Travelling expenses incurred in the course of a taxpayer’s business or employment will be deductible. In John Holland Group Pty Ltd v FCT (2015) 232 FCR 59; [2015] FCAFC 82, the Full Federal Court found, for the purposes of the FBT ‘otherwise deductible rule’,74 that air travel expenses on flights from Perth to Geraldton for fly-in fly-out employees working on the Midwest rail upgrade project would have been deductible under ITAA97 s 8-1 for the employees. Key to this conclusion was the finding that the employment duties (and remuneration for performance of those [page 553] duties) of the employees commenced on arrival at Perth airport and that they were subject to the directions of John Holland, such that the employees were travelling on work and not to work. By contrast, in Re WTPG and Commissioner of Taxation [2016] AATA 971; 2016 ATC 1-086, a taxpayer with a disability was unable to claim a deduction for the travel costs of his wife, who accompanied him as his carer, on the basis that the care was a necessary precursor to his employment duties, rather than being provided in the course of his employment duties.75 Although acknowledged as inexact, an analogy was made with childminding costs. In Garrett v FCT (1982) 12 ATR 684; 82 ATC 4060, a medical practitioner who practised in a number of centres including his property where he conducted a farming business was allowed a

deduction for the costs of using an aircraft to commute between the different locations. In FCT v Payne (2001) 202 CLR 93; 2001 ATC 4027, a majority of the High Court disallowed travel costs incurred by a taxpayer between his farm in country New South Wales and his place of employment as a pilot in Sydney. In the view of Gleeson CJ, Kirby and Hayne JJ, the relevant principle was one ‘which excludes outgoings which, although incurred for the purpose of deriving assessable income, are not incurred in the course of doing so’: at ATC 4031. The taxpayer’s travel occurred in the intervals between the two income-producing activities and not while he was engaged in either activity. The decision in Fullerton v FCT (1991) 22 ATR 757; 91 ATC 4983 illustrates non-deductible travel expenditure incurred to relocate from one place of employment to another. In that case, Pincus J disallowed an appeal claiming the costs incurred in transferring from Bundaberg to Maryborough notwithstanding the taxpayer’s continued employment depended on the transfer. Following the decision in Payne’s case, ITAA97 s 25-100 was introduced. The section does not override s 8-1. Instead, it allows a deduction for non-capital expenditure incurred by an individual for travel between unrelated workplaces where the purpose of the travel is to engage in income-producing activities at the second workplace, except where the taxpayer resides at one of the workplaces: see 9.32. Travel expenses, both local and international, which are relevant to other aspects of income generation, such as self-education, also stand to be considered under s 8-1 except to the extent that they are private: FCT v Finn (1961) 106 CLR 60; 8 AITR 406; FCT v Kropp (1976) 6 ATR 655; 76 ATC 4406; FCT v Man (1985) 16 ATR 176; 85 ATC 4060; Griffin v FCT (1986) 18 ATR 23; 86 ATC 4838.

Self-education expenses 8.80 Self-education expenses are subject to the same general tests of deductibility under ITAA97 s 8-1, subject to ITAA36 s 82A. On the authority of FCT v Finn (1961) 106 CLR 60; 8 AITR 406 and FCT v Hatchett (1971) 125 CLR 494; 2 ATR 557; 71 ATC 4184, such

outgoings are not of a capital nature. In Finn, Windeyer J said (at CLR 70): [page 554] Outgoings incurred for the genuine purpose of acquiring or maintaining knowledge and skill in a vocation do not become an outgoing “of a private nature” simply because the taxpayer got pleasure and satisfaction in increasing his knowledge and attainments.

The High Court reiterated this view in FCT v Anstis (2010) 241 CLR 443; [2010] HCA 40; BC201008389. In that case, education expenses incurred in pursuing study as a condition for receipt of the Youth Allowance were held to be deductible.76 However, as Hatchett’s case demonstrates, there are occasions when education expenses may be private (in part). The costs of study undertaken before commencing employment are not deductible because the relevant nexus with assessable income cannot be shown. However, study undertaken concurrently with employment will be deductible where there is the necessary connection with that income, or prospective income or where the study simply keeps the taxpayer up to date in technical or professional developments. Deductible costs will include journals and books and attendance at seminars and similar continuing educational courses. Tuition fees (other than those imposed under HECS or HELP, ITAA97 s 26-20) are also deductible. Travel to an institution or from a place of employment to an institution are also deductible: see Taxation Rulings TR 92/8 (partially withdrawn) and TR 98/9. 8.81 Deductibility under s 8-1 is qualified by ITAA36 s 82A. In effect, s 82A provides that where a deduction is allowable under ITAA97 s 8-1 in respect of self-education expenses, the first $250 is not deductible. In this respect, ‘expenses of self-education’ means a course of study provided by a school, university, college or other place of education for the purpose of gaining qualifications for use in employment or profession. In TR 98/9, ‘other place of education’ is taken to be a place, the primary function of which is that of education.

The ruling also expresses the view that short-term refresher and continuing education programs are not courses of education and, therefore, eligible for self-education expenses for the purpose of s 82A. In the calculation of the $250 threshold, there is no requirement that the expenses be deductible under s 8-1, only that they be ‘expenses of self-education’. So, for example, child-minding expenses of the type considered in Jayatilake v FCT (1991) 22 ATR 125; 91 ATC 4516 are self-education expenses. However, only the excess over $250 that satisfies s 8-1 will be an allowable deduction.

Exempt income 8.82 ITAA97 s 8-1(2)(c) denies a deduction for losses and outgoings connected with the derivation of exempt income. Section 6-15(2) provides that, if an amount is exempt income, it is not assessable income. In regard to this exclusion, the High Court said in Ronpibon Tin NL v FCT (1949) 78 CLR 47; 4 AITR 236 at 245: To except losses and outgoings of capital is both necessary and logical. But to except losses and outgoings to the extent to which they are incurred in relation to the gaining or production of exempt income seems to except something from the primary description which could not fall within it. For exempt income can never be assessable

[page 555] income. They are mutually exclusive categories. The explanation doubtless is the desire to declare expressly that so much of the losses and outgoings as might be referable to exempt income should not be deductible from the assessable income. Although it may not be strictly logical to express the declaration in the form of an exception, the declaration serves the not unimportant purpose of making an express contrast.

Conclusion 8.83 ITAA97 s 8-1 is the current version of a long line of general deduction provisions and many of its key words and phrases have been the subject of more than 100 years of judicial consideration. It is described as a ‘general deduction’ provision because of the large

quantity of items that come within its ambit. Section 8-1(2)(d) recognises, however, that other provisions of the Acts operate to qualify or deny amounts that, prima facie, satisfy s 8-1 or to allow amounts failing or excluded from s 8-1. These are described as ‘specific deductions’: ITAA97 s 8-5. In the event that an amount potentially falls within both the general and a specific deduction provision, only one deduction is allowable, and that is under the more appropriate provision: s 8-10. Subsequent chapters include discussion on specific provisions that: allow outright deductions in the year of expense; deny deductibility of amounts that would otherwise be deductible; limit the amount that is deductible; impose additional requirements for deductibility; allow deductions for capital expenditure over a period. If it is possible to reduce to two basic propositions more than a century of judicial consideration of general deduction provisions, the following statements from Amalgamated Zinc (de Bavay’s) Ltd v FCT (1935) 54 CLR 295; 3 ATD 288 (see 8.10) are difficult to better: 1. ITAA97 s 8-1 does not require that the purpose of the expenditure shall be the gaining of the income in that year, so long as it was made in the given year and is incidental and relevant to the operations or activities regularly carried on for the production of income. 2. What is incidental and relevant in the sense mentioned falls to be determined, not by reference to the certainty or likelihood of the outgoing resulting in the generation of income, but to its nature and character and, generally, to its connection with the operations which more directly gain or produce the assessable income.

Tom Tucker carries on business as a fast-food outlet at the Central Cricket Ground. The business is a sole proprietorship. On an annual basis, Tom tenders to the trustees of the

ground for the right to operate during official fixtures. He leases a caravan converted into a mobile kitchen and employs several staff on a casual basis. [page 556] Frozen food is purchased from Food Wholesalers Pty Ltd under an arrangement whereby unopened packets may be returned. Unsold food from opened packets is used in two ways. First, staff may consume what they wish, on the premises, at the conclusion of the final day’s trading. Second, any residual foodstuff is consumed by Tom and his family. Tom’s wife, Tammy, derived interest income of $518. There are no children. Tom presents you with the following information relating to the 2016–17 cricket season:

Sales receipts

$215,000

Sub-lease fees

2,500

Note 1

Refunds

(450)

Note 2

217,050 Gross purchases

95,000

Note 3

750

Note 4

Licence fee

6,500

Note 5

Vendor’s licences

1,200

Note 6

Lease payments

10,800

Note 7

Tender costs

Cooking materials Wages Provision for settlement Trading profit

3,700 32,000

Note 8

10,000 159,950 $57,100

Note 9

Notes: 1. Tom sublets the caravan for five months during the football season for $500/month. This private arrangement is against the terms of his lease agreement. See further Note 7. 2. On New Year’s Day, several customers complained that food consumed had made them ill and demanded that their money be refunded. Tom refunds $450.

3.

Tom suspects a bag of frozen chips was contaminated and is negotiating a refund from Food Wholesalers. The matter is unresolved at 30 June 2017. Tom is more concerned with a threat from one ill customer to sue him for damages. See Note 9. Tom’s opening and closing stock is nil. Gross purchases are accounted for in the following way: [page 557]

Purchases

$95,000

Sales

78,500

Returns [to suppliers]

10,200

Staff consumption Tom’s consumption

1,800 4,500 $95,000

4.

Tender costs include accounting fees, typing and other costs of complying with the trustees’ requirements. 5. The licence fee is an annual levy payable to the trustees for the right of entry to the cricket ground and to occupy a site. It is levied on all commercial users of the ground. 6. Various licensing requirements of local government. 7. Lease payments are $900 per month. An amount of $9900 has been paid to 30 June with one payment overdue. 8. Award payments amount to $29,000 but Tom always pays his staff a bonus of around 10%. 9. Tom’s solicitor has informed him that defending an action or settling out of court could cost between $5000 and $15,000. See further Note 2. Advise on the s 8-1 deductibility of the above items. Indicate whether the amounts are losses or outgoings incurred, whether they satisfy the expenditure income nexus, whether they are apportionable, and whether they are on revenue or capital account. Calculate Tom’s taxable income applying the formula in ITAA97 s 4-15. A suggested solution can be found in Study help.

1. 2.

See, for example, Taxation Ruling TR 2017/1 at [8]. The nomination of specific items (commission, discount, etc) raised a question of what exactly was qualified by the words ‘incurred in Australia’. In Alliance Assurance Co Ltd v FCT (1921) 29 CLR 424, the Full High Court held that the key phrase, ‘losses and

3.

4.

5.

6. 7.

8.

9.

10. 11. 12.

13.

14. 15.

16.

outgoings’, was not qualified by the words ‘incurred in Australia in gaining or producing the gross income’. These words refer to ‘expenses’ only or, at most, to the words ‘commission, discount, travelling expenses, interest and expenses’. The 1922 Act is especially relevant to cases instrumental in the development of the ‘incidental and relevant’ test (see 8.10), such as Amalgamated Zinc (de Bavay’s) Ltd v FCT (1935) 54 CLR 295; 3 ATD 288, and s 25(e) is important in Herald and Weekly Times v FCT (1932) 48 CLR 113; 2 ATD 169. Ronpibon Tin NL v FCT (1949) 78 CLR 47; 4 AITR 236 at 244; FCT v Snowden & Willson Pty Ltd (1958) 99 CLR 431; 7 AITR 308 at 317; John Fairfax Pty Ltd v FCT (1959) 101 CLR 30 at 40; 7 AITR 346. ITAA97 s 995-1 defines ‘business’ as including any profession, trade, employment, vocation or calling, but does not include occupation as an employee. It follows that an employee is limited to the first positive limb, s 8-1(1)(a). Ronpibon Tin NL v FCT (1949) 78 CLR 47; 4 AITR 236 at 244. The former s 23 of the 1922 Act did not contain a business limb but several High Court decisions in relation to that provision effectively read into the law a business limb: see Herald and Weekly Times Ltd v FCT (1932) 48 CLR 113; 2 ATD 169; W Nevill & Co Ltd v FCT (1937) 56 CLR 290; 1 AITR 67. LexisNexis Butterworths, Concise Australian Legal Dictionary, 4th ed, Sydney, defines ‘nexus’ as ‘a link or connection, especially a causal connection or a relation of interdependence’. Quoting FCT v Payne (2001) 202 CLR 93; 2001 ATC 4027 at [11] per Gleeson CJ, Kirby and Hayne JJ. The test has been subsequently reiterated by the High Court, including in Spriggs v FCT; Riddell v FCT (2009) 239 CLR 1; [2009] HCA 22 at [55] per French CJ, Gummow, Heydon, Crennan, Kiefel and Bell JJ and FCT v Anstis (2010) 241 CLR 443; 76 ATR 735 at [28]–[30] per French CJ, Gummow, Kiefel and Bell JJ. CT v Day (2008) 236 CLR 163; 70 ATR 14 at [31] per Gummow, Hayne, Heydon and Kiefel JJ. Note that only part of the directors’ fees was deductible: see 8.28. Per French CJ, Gummow, Heydon, Crennan, Kiefel and Bell JJ at [75], quoting Magna Alloys & Research Pty Ltd v FCT (1980) 11 ATR 276; 80 ATC 4542 per Deane and Fisher JJ. In fact the description ‘incidental to the earning of the assessable income’ appeared in the taxpayer’s notice of objection in the Herald and Weekly Times case and drew its inspiration from Lord Loreburn’s comment, ‘I think only such losses may be deducted as are connected with [the trade or business] in the sense that they are really incidental to the trade itself’: Strong & Co v Woodfield [1906] AC 448; 5 TC 215 (emphasis added). The phrase ‘incidental and relevant’ to income-producing operations seems to have been used first by Dixon J in W Nevill & Co at AITR 75. See 8.21. The High Court unanimously allowed the taxpayer’s appeal. It is significant that a claim for a deduction that was directed to reducing future costs (and increasing efficiency) was allowable under the former s 23 of the 1922 Act, which was a single limb provision; that is, there was no second or business limb. This is evident in Robert G Nall Ltd v FCT (1937) 57 CLR 695; 1 AITR 167, a case

17. 18.

19. 20. 21. 22. 23. 24.

25.

26. 27.

28.

29.

30. 31. 32.

concerned with the exclusion under s 23(1)(e) of the 1922 Act of expenditure not ‘wholly and exclusively laid out or expended for the production of assessable income’. Dixon J (at AITR 176) indicated that, when considering the question of the purpose of the payment, it was necessary to examine the attributes of the transaction. This suggests that there may be characteristics of an outlay that stamp it as relevant or irrelevant. See FCT v Payne (2001) 202 CLR 93; 2001 ATC 4027; see also 8.79. In this context, ‘business expenses’ are to be contrasted with ‘living expenses’ such that the reference to business is not confined to taxpayers carrying on a business as opposed to employee taxpayers: Lunney v FCT (1958) 100 CLR 478; 7 AITR 166 at 179–81; 11 ATD 404 per Williams, Kitto and Taylor JJ. See Lodge v FCT (1972) 128 CLR 171; 3 ATR 254; 72 ATC 4174; FCT v Klan (1985) 16 ATR 176; 85 ATC 4060. See Madad Pty Ltd v FCT (1984) 15 ATR 631; 84 ATC 4115; Mayne Nickless Ltd v FCT (1984) 15 ATR 752; 84 ATC 4458; see also ITAA97 s 26-5. Carapark Holdings Ltd v FCT (1967) 115 CLR 653; 10 AITR 378; 14 ATD 402. Australian National Hotels Ltd v FCT (1988) 19 FCR 234; 19 ATR 1575; 88 ATC 4627. See Cunliffe v FCT (1983) 14 ATR 364; 83 ATC 4380; FCT v Edwards (1994) 28 ATR 87; 94 ATC 4255; Mansfield v FCT (1995) 31 ATR 367; 96 ATC 4001 and 8.75. In FCT v Klan (1985) 16 ATR 176; 85 ATC 4060, Ormiston J considered a ‘perceived connection’ insufficient to provide a deduction, together with other descriptions such as ‘real connection’ in FCT v Smith (1978) 8 ATR 518; 78 ATC 4157 and ‘clear connection’ in FCT v Lascelles-Smith (1978) 8 ATR 524; 78 ATC 4162. From 2011–12, ITAA97 s 26-19 denies deductions for expenses incurred in connection with rebatable government assistance (including Newstart and Youth Allowance), thus overcoming the decision in Anstis. It almost goes without saying that it may not satisfy the first positive limb. See, for instance, FCT v Cooper (1991) 21 ATR 1616; 91 ATC 4396. A similar approach was adopted by a majority of the Federal Court in FCT v Cooper (1991) 29 FCR 177; 21 ATR 1616; 91 ATC 4396. In that case, supplementary food consumed by a professional footballer was held to be of a private nature and not deductible. It was also held the expenditure failed the first limb. Mason J adopted a similar reasoning process in relation to child-minding expenses in Lodge v FCT (1972) 128 CLR 171; 3 ATR 254; 72 ATC 4174. In relation to the elapsing of time between the incurring of a loss or outgoing and the gaining of income, the description ‘temporal hiatus’ was used by Lee and Linger JJ in FCT v Brand (1995) 31 ATR 326; 95 ATC 4633. See AGC (Advances) Ltd v FCT (1975) 132 CLR 175; 5 ATR 243; 75 ATC 4057; Placer Pacific Management Pty Ltd v FCT (1995) 31 ATR 353; 95 ATC 4459; FCT v Brand (1995) 31 ATR 326; 95 ATC 4633; Steele v DCT (1999) 197 CLR 459; 41 ATR 139; 99 ATC 4242. Similar views were expressed in the New Zealand decision CT (NZ) v Webber (1956) 6 AITR 291 at 295 and 299. On the other hand, in Ash v FCT (1938) 1 AITR 447, a loss arising from the misappropriation of partnership funds was on capital account. The decision is discussed at 8.21–8.22.

33. The distinction in this context is now qualified since in Placer Pacific Management Pty Ltd v FCT (1995) 31 ATR 253; 95 ATC 4459, the Federal Court did not read the decision in AGC (Advances) as making a material distinction between losses and outgoings. 34. In the Colonial Mutual Life Assurance case, the High Court said: ‘… the sounder view is that profits and losses on the realization of investments of the funds of an insurance company should be taken into account in the determination of profits and gains of the business’. See also Kitto J’s remarks in National Bank of Australasia Ltd v FCT (1969) 118 CLR 529; 1 ATR 53; 69 ATC 4042. 35. That is not to imply a symmetry of the type that would make the recovery of a formerly deductible amount ipso facto income. Such a rule was unanimously rejected by the High Court in FCT v Rowe (1997) 187 CLR 266; 35 ATR 432; 97 ATC 4317. 36. See also Evans v FCT (1989) 20 ATR 922; 89 ATC 4540; Babka v FCT (1989) 20 ATR 1215; 89 ATC 4963. 37. Note that the business limb of the former ITAA s 51(1) had been read as if the words ‘to the extent to which’ qualified its operation as well as the first limb: Ronpibon Tin; see also FCT v Snowden & Willson (1958) 99 CLR 431; 7 AITR 308, per Dixon CJ at AITR 311. 38. There was no equivalent to para (d) of s 8-1(2) in the former ITAA36 s 51(1). The denial in para (d) of losses and outgoings to the extent that a provision of the Act prevents its deduction suggests the possibility of apportionment as between s 8-1 and other provisions of the Act. 39. Earlier decisions by the Full Court in relation to s 51(1) considered questions of ‘incurred’ (Emu Bay Railway Co Ltd v FCT (1944) 71 CLR 596; 3 AITR 126) and capital expenditure (Hallstroms Pty Ltd v FCT (1946) 72 CLR 634; 3 AITR 436). 40. The verbs derive and incur have in common the question of timing — that is, when is income derived or when is an outgoing incurred? The legal principles governing the two words have developed independently on a case-by-case basis. 41. For a useful summary, see, for example, FCT v Malouf (2009) 174 FCR 581; 75 ATR 335 at [43]; Taxation Rulings TR 97/7 and IT 2613. For a cash basis taxpayer, the Commissioner will accept returns on a cash received–cash paid basis provided the deduction has not been claimed at an earlier time; for example, when the liability arose. If deductions are claimed as presently existing liabilities arise, that method should continue to be used. 42. See, for example, Warner Music Australia Pty Ltd v FCT (1996) 34 ATR 171; 96 ATC 5046, where liability to sales tax was allowed as a deduction but contested as improperly imposed. The appeal was successful and the liability cancelled, and the taxpayer was assessable on the gain. 43. Relevant factors mentioned in Flood’s case (at AITR 583) were death, termination of employment, strike activity, absenteeism or sale of the business. 44. For a recent example, see Academy Cleaning & Security Pty Ltd v DCT [2017] FCA 875, in which Rares J found that Academy had no obligation to pay the remaining 85% of the purchase price for certain carbon emission unit rights unless and until a third party had completed several carbon sequestration projects and the rights in relation to those projects would provide carbon credit rights to Academy under (then unenacted) Australian laws. Accordingly, the outstanding amount of the purchase price had not been incurred: at [80]– [85]. 45. In CIR (NZ) v Mitsubishi Motors New Zealand Ltd [1996] 1 AC 315; 95 ATC 711, the

46.

47.

48. 49.

50.

51.

52. 53.

54.

55. 56.

57.

58.

Privy Council allowed a deduction under the NZ legislation for estimated costs of warranties. The matter has not been before the Australian courts and the Commissioner’s position (Taxation Ruling IT 2648) is that the outgoing is not incurred until a claim materialises. ITAA97 Div 230 (see 8.51) would likely now apply. Where Div 230 does not apply, discounted and deferred interest securities that are ‘qualifying securities’ are now assessable/deductible on an accrual (present value) basis under ITAA36 Pt III Div 16E. In the Raymor case, a liability to pay for the advance purchase of trading stock (at a discount) was incurred when the contracts were entered into. Subsequent payment was not strictly a prepayment because it discharged a presently existing obligation. J P Hannan, A Treatise on the Principles of Income Taxation, Law Book Co, Sydney, 1946, p 291. The passage from Magna Alloys was paraphrased with approval by the High Court in Spriggs v FCT; Riddell v FCT (2009) 239 CLR 1; [2009] HCA 22 at [75]: ‘the loss or outgoing will be “necessarily incurred” if it is “reasonably capable of being seen as desirable or appropriate from the point of view of the pursuit of the business ends of the business”’. See, for example, Academy Cleaning & Security Pty Ltd v DCT [2017] FCA 875 at [105]– [112] (tax purpose rather than a purpose of burnishing environmental credentials for business purposes). R W Parsons, Income Taxation in Australia, Law Book Co, Sydney, 1985, [5]–[37]. It might be noted Parsons anticipated that the absence of contemporaneity is no more than an indication that the expenditure is not relevant and that other factors may establish relevance to a non-contemporaneous expense. See 8.21. In Spriggs v FCT; Riddell v FCT (2009) 239 CLR 1; [2009] HCA 22, fees paid by two professional footballers to agents who negotiated new playing contracts were deductible under s 8-1(a) or (b). The High Court held (at [69]) that the players were ‘engaged in the business of commercially exploiting their sporting prowess and associated celebrity’ and they were not exclusively employees of their clubs. See also comments by Dixon CJ in John Fairfax Pty Ltd v FCT (1959) 101 CLR 30; 7 AITR 346; Mason J in AGC (Advances) Ltd v FCT (1975) 132 CLR 175; 5 ATR 243; 75 ATC 4057; and the Full High Court in FCT v DP Smith (1981) 147 CLR 578; 11 ATR 538; 81 ATC 4114. See also FCT v Finn (1961) 106 CLR 60; 8 AITR 406; Australian National Hotels Ltd v FCT (1988) 19 FCR 234; 19 ATR 1575; 88 ATC 4627. See the definition in ITAA36 s 6(1). The definition is cumulative rather than exhaustive (FCT v St Hubert’s Island Pty Ltd (1978) 138 CLR 210; 2 ATR 452; 78 ATC 4104) and includes a range of professionals who would not ordinarily be regarded as ‘businessmen’. However, the exclusion of employees from the definition means s 8-1(1)(b) is unavailable to them. Blockey v FCT (1923) 31 CLR 503; Martin v FCT (1952) 90 CLR 470; 5 AITR 548; Ferguson v FCT (1979) 9 ATR 873; 79 ATC 4261; Evans v FCT (1989) 20 ATR 922; 89 ATC 4540; John v FCT (1989) 166 CLR 417; 20 ATR 1; 89 ATC 4101. See Inglis v FCT (1980) 40 FLR 191; 10 ATR 493; 80 ATC 4001; Thomas v FCT (1972) 3

59.

60.

61.

62.

63. 64.

65. 66.

67. 68.

69. 70.

ATR 165; 72 ATC 4094. In Inglis, Brennan J quoted Lord Sumner’s observation in South Behar Railway Co v IRC [1925] AC 476 at 488: ‘Business is not confined to being busy; in many businesses long levels of inactivity may occur’. See FCT v Ampol Exploration Ltd (1986) 13 FCR 545; 18 ATR 102; 86 ATC 4859 (seismic surveys and analysis). A majority of the Federal Court held that the taxpayer carried on the business of exploration to which the outgoings in question were incidental and relevant. See also Taxation Ruling TR 2017/1; Southern Estates Pty Ltd v FCT (1967) 10 AITR 525; Thomas v FCT (1972) 3 ATR 165; 72 ATC 4094. In regard to primary production, compare the decisions in Hanlon v FCT (1981) 12 ATR 540; 81 ATC 4617 and FCT v Osborne (1990) 21 ATR 888; 90 ATC 4889. In the Federal Court in Steele v DCT (1997) 35 ATR 285; 97 ATC 4239 at 4243, the majority said: ‘[T]here is much to be said for the proposition that the tribunal’s own findings of fact … suggest it was not open to the tribunal to find in this case a relevant lack of commitment’. See also Temelli v FCT (1997) 97 ATC 4716 at 4721, where Merkel J dismissed a claim for interest deductibility because: ‘In my view the taxpayers did not have the requisite degree of commitment to the relevant income-producing activity’. See Cannop Coal Co Ltd v IRC (1918) 12 TC 31; Ferguson v FCT (1979) 9 ATR 873; 79 ATC 4261. In Griffin Coal Mining Co Ltd v FCT (1990) 21 ATR 819; 90 ATC 4870, a majority of the Federal Court found the costs of diversifying business activities did not satisfy the positive limbs of s 51(1) and that it was unnecessary to consider whether they were of a capital nature. At first instance ((1989) 20 ATR 1038), Lee J held the outgoings both failed the positive limbs and were of a capital nature: see also Goodman Fielder Wattie Ltd v FCT (1991) 22 ATR 26; 91 ATC 4438. See Freeman v FCT (1983) 13 ATR 729; 83 ATC 4456; Kratzmann v FCT (1970) 1 ATR 127; 70 ATC 4043. See FCT v EA Marr & Sons (Sales) Ltd (1984) 15 ATR 879; 84 ATC 5580. The Federal Court distinguished Amalgamated Zinc (de Bavay’s) Ltd v FCT (1935) 54 CLR 295; 3 ATD 288 and highlighted that the expenses were incurred and found in the taxpayer’s leasing activities. This distinction and approach was adopted in Placer Pacific Management Pty Ltd v FCT (1995) 31 ATR 353; 95 ATC 4459. See, for example, Placer Pacific Management Pty Ltd v FCT (1995) 31 ATR 353; 95 ATC 4459; FCT v Brown (1999) 43 ATR 1; 99 ATC 4600. See Associated Minerals Consolidated Ltd v FCT (1994) 29 ATR 147; FCT v Chapman (1989) 20 ATR 438; Queensland Meat Export Co Ltd v DCT (1939) 1 AITR 490; Inglis v FCT (1980) 40 FLR 191; 10 ATR 493; 80 ATC 4001. IRC v British Salmson Aero Engines Ltd (1938) 22 TC 29 per Green MR at 43. See also Lord Denning’s comments in Heather v PE Consulting Group Ltd [1972] 3 WLR 833. The character of the advantage sought is the dominant consideration: GP International Pipecoaters Pty Ltd v FCT (1990) 170 CLR 124; (1990) 21 ATR 1 at ATR 7; FCT v Citylink Melbourne Ltd (2006) 228 CLR 1; 228 ALR 301; 2006 ATC 4404; [2006] HCA 35 at [148] per Crennan J. For greater detail on current and non-current assets, see Australian Accounting Standard AASB 101. In FCT v Hatchett (1971) 125 CLR 494; 2 ATR 557; 71 ATC 4184, Menzies J said (at ATR 560): ‘It must be a rare case when an outgoing incurred in gaining assessable income

71.

72.

73. 74. 75. 76.

is also an outgoing of a private nature’. There is no suggestion in Hatchett that private and domestic outgoings are to be distinguished. In Forsyth’s case, Wilson J said of Menzies J’s dictum (at ATR 664): ‘With respect, I can readily accept his Honour’s statement. But it will be noted that it is confined to outgoings of a private nature. It is certainly not true of outgoings of a capital nature … Nor, in my opinion, should it necessarily be true of outgoings of a domestic nature’. This extract is quoted from Lord Denning’s judgment in Newsom v Robertson [1953] 1 Ch 7. The reference to expenditure ‘wholly and exclusively’ for the purpose of a trade or profession comes from the relevant UK legislation and was not part of the statutory requirements of ITAA36 s 51(1) under which Lunney’s case was decided. Note that the concurrent use of a house for the production of income and as a principal residence in terms of the capital gains tax provisions (see Chapter 6) can reduce the exemption. In addition to the cases discussed in this section, see also Draft Taxation Ruling TR 2017/D6. So as to reduce the taxable value of the fringe benefits. Note that ITAA97 s 26-30 also applied to preclude the deduction. The decision in Anstis’s case is reversed by ITAA97 s 26-19. Losses and outgoings incurred in connection with ‘rebatable benefits’ (government payments such as the Youth Allowance) are specifically denied deductibility.

[page 559]

CHAPTER

9

Specific Deductions Learning objectives After studying this chapter, you should be able to: list the major, specific provisions of the Acts qualifying and denying deductibility; distinguish a deductible repair from a capital improvement; identify the conditions that must be satisfied to claim a deduction for a bad debt; calculate losses that may be carried forward and recouped in future years; distinguish deductible and non-deductible expenditure for entertainment; identify the circumstances that attract provisions such as ITAA97 ss 26-30 and 26-35 and ITAA36 ss 82KH–82KL; determine what prepayments are deductible and what are amortised; apply the requirements of the substantiation provisions.

Introduction 9.1 The structure of the Income Tax Assessment Act 1936 (Cth) (ITAA36) and Income Tax Assessment Act 1997 (Cth) (ITAA97), so far

as deductions are concerned, is similar to the assessing provisions in that the principal components of the Acts, assessable income and allowable deductions, are each made up of two groups: assessable income is ordinary income and statutory income; deductions comprise general deductions and specific deductions. As the research trail in 8.5 illustrates, one goes first to the general deduction provision (ITAA97 s 8-1) to determine deductibility. A specific deduction might then qualify the item’s treatment. It might deny a deduction outright, alter the timing of a deduction or provide additional requirements that need to be satisfied. Alternatively, an amount that fails the general deduction provision might be specifically allowed, albeit in a qualified manner. Other amounts are allowable on a concessional basis in that they are unrelated to income production. Even if an amount is addressed by a specific provision, it may be appropriate to reconsider the matter under s 8-1. Sometimes this is made explicit. For example, ITAA97 s 25-55 (dealing with subscriptions to professional associations up to the amount of $42) carries the note: ‘Alternatively you can deduct the amount under s 8-1 (which is about general deductions) if you satisfy the requirements of that section’. On other occasions, it derives from case law. For example, in relation to the ITAA36, the decision in [page 560] AGC (Advances) Ltd v FCT (1975) 132 CLR 175; 5 ATR 243; 75 ATC 4057 held that certain irrecoverable amounts that failed to satisfy the specific provision (ITAA36 s 63 — bad debts) were deductible under the general provision (ITAA36 s 51(1)). It will be appreciated that both general and specific deductions will be allowable when the necessary link is established with assessable income or the specific requirements are satisfied. A general or specific deduction can relate to either ordinary or statutory income. This is clear from ITAA97 s 8-5, which provides as follows.

8-5 Specific deductions (1) You can also deduct from your assessable income an amount that a provision of this Act (outside this Division) allows you to deduct. (2) Some provisions of this Act prevent you from deducting an amount that you could otherwise deduct, or limit the amount you can deduct. (3) An amount that you can deduct under a provision of this Act (outside this Division) is called a specific deduction.

In the event that an amount is potentially deductible under more than one provision, ITAA97 s 8-10 provides as follows. 8-10 No double deductions If 2 or more provisions of this Act allow you deductions in respect of the same amount (whether for the same income year or different income years), you can deduct only under the provision that is most appropriate.

ITAA97 s 8-10 replaces former ITAA36 s 82, which was directed to the same issue but declared that the amount was allowable only under the provision that ‘in the opinion of the Commissioner is most appropriate’. It will be noted that in ITAA97 s 8-10, the Commissioner’s discretion has been removed and the most appropriate provision applies. So, for example, a repair to a motor vehicle used for income-producing purposes would be deductible under the general provision ITAA97 s 8-1 as well as the specific ITAA97 s 25-10 and the latter section seems more appropriate. The specific deduction provisions have been extensively but not completely rewritten with the result that the ITAA97 operates in tandem with the ITAA36. This chapter is organised as follows, reflecting the general functions of specific deduction provisions in the ITAA97: ITAA97 Div 25 (specific provisions confirming and (possibly) extending the operation of the general deduction provision, s 8-1); [page 561]

ITAA97 Div 26 (specific provisions confirming the nondeductibility of amounts or denying certain amounts in whole or part); deductions of specific amounts (ITAA97 Divs 27, 28, 30, 32, 34, 35, 36 and 900); the remaining ITAA36 framework; and ITAA97 Div 84 (personal services income).

On the assumption that the following amounts are not deductible under ITAA97 s 8-1 or specific deduction provisions: 1. Should they be deductible in the course of determining a correct assessment of a taxpayer’s true income? 2. Should they be deductible on some concessional basis or is a cash subsidy a preferred option? (a) Costs of travel to work. (b) Costs of child minding for a working parent. (c) Knee reconstruction costs for a footballer. (d) Education expenses. (e) Income tax. What would be the net result of an income tax regime that allowed a deduction for all of the above items (as well as other worthy items you might care to add)?

Specific deductions addressed in this and subsequent chapters are not underpinned by a common rationale. Sometimes the amounts will fail under s 8-1, for example, capital allowances such as depreciation, but it is considered desirable from an economic viewpoint to allow deductibility. In Div 25, items such as s 25-10 (repairs) and s 26-35 (bad debts) could satisfy s 8-1 and are qualified to varying degrees. In Div 26, a number of provisions (such as s 25-5 — fines and penalties) are enacted to ‘remove doubt’ about their non-deductibility. On the other hand, throughout the legislation there are many specific provisions designed to provide deductions as concessions to selected

industries (such as films, primary production, afforestation and mining) or to benefit entities and institutions. Division 30, for example, provides tax deductions for contributions to a range of health, education and welfare institutions. Concessional deductions of these types are described as tax expenditures. Their motivation is the channelling of resources into the specified areas either to further some broad political agenda or in response to pressure by special-interest groups. The alternative to tax expenditures is a cash subsidy. Direct payments to employers under employment or apprenticeship schemes and welfare payments to the economically disadvantaged provide familiar examples but, in general, governments have preferred the administrative convenience of concessions through tax deductions even though such assistance is often inaccurately delivered. [page 562]

ITAA97 Div 25: Specific allowing and qualifying provisions (Note: All references are to the ITAA97 except where indicated.) 9.2 The focus of Div 25 ‘Some amounts you can deduct’ is to allow specific deductions either outright or in some qualified manner. Few of the deductions allowable under this Division can be described as tax expenditures. Broadly, they fall into two groups. First, Div 25 confirms the deductibility of certain types of expenditure that would satisfy s 8-1 in any event. For example, s 25-10 permits a deduction for repairs. A deduction is also allowed for bad debts (s 2535) but the timing of the deduction is dictated. Whereas a bad debt per se would fall within s 8-1, a standard accounting balance day adjustment of raising a ‘provision for bad debts’ would not. Second, it extends deductibility to amounts that would or, in some circumstances, could fail under s 8-1. For example, consider expenses of borrowing (s 25-25) or losses through theft or embezzlement by an employee (s 25-

45). If they satisfy s 8-1, Div 25 confirms their deductibility; but if they are of a capital nature, and so fail s 8-1, their deductibility is nonetheless assured. Expenses in connection with the preparation of tax returns and allied accounting and compliance matters (s 25-5) in the circumstances may be deductible under s 8-1 to some classes of taxpayers, but s 25-5 offers a universal deduction for tax-related expenditure. The principal sections in Div 25 are as follows: 25-5

Tax-related expenses

25-10

Repairs

25-15

Amount paid for lease obligation to repair

25-20

Lease document expenses

25-25

Borrowing expenses

25-30

Expenses of discharging a mortgage

25-35

Bad debts

25-40

Loss from profit-making undertaking or plan

25-45

Loss by theft etc

25-50

Payments of pensions, gratuities or retiring allowances

25-55

Payments to associations

25-60

Parliament election expenses

25-70

Deductions for election expenses does not extend to entertainment

25-75

Rates and land taxes on premises used to produce mutual receipts

25-95

Deduction for work in progress amounts

25-100

Travel between workplaces

25-110

Capital expenditure to terminate lease etc

[page 563]

1. 2.

3.

Would a loss through embezzlement by an employee be an allowable deduction under ITAA97 s 8-1? What about embezzlement by a partner in a business partnership? On the assumption that the costs of seeking or changing employment are not deductible under s 8-1, why should the costs of seeking election to parliament be deductible? What items would your own political agenda add to ITAA97 Div 25?

Section 25-5: Tax-related expenses (former ITAA36 s 69) 9.3 A range of tax-related expenses is deductible under s 25-5(1), some of which would satisfy and some fail s 8-1. The deduction is allowable for expenditure, other than capital expenditure, that is incurred in: managing tax affairs; complying with Commonwealth tax laws relating to tax affairs; or interest imposed under ITAA36 s 170AA for the late payment or underpayment of tax. Section 25-5(2)(a) and (b) excludes from deductibility payments of tax itself, including amounts within the extended definition of ‘tax’ in s 995-1 (such as penalties, withholding tax, additional tax, etc). Section 25-5(c) excludes interest on loans to pay tax or instalments of tax (or penalties, etc) and para (d) excludes matters relating to breach of a law. Section 25-5(2)(e) disallows fees or commissions incurred for advice about the operation of Commonwealth tax laws unless the advice is provided by a ‘recognised tax adviser’. This term is defined in s 995-1 and means a registered tax agent, or a barrister or solicitor. Section 255(3) disallows amounts expressly denied under other provisions of the Act. Finally, s 25-5(4) disallows capital expenditure, but an amount is not capital expenditure merely because managing tax affairs relates to matters of a capital nature.

Managing tax affairs 9.4 The management of tax affairs concerns affairs relating to tax assessed under relevant Income Tax Acts and covers fees and

commissions paid for the preparation of tax returns, objections, tax audits and appeals. Other accounting matters not directly relating to tax affairs, such as audits, etc, relating to corporations law or sales tax may be deductible under s 8-1: see Jazareed Pty Ltd v FCT (1989) 20 ATR 683. The use of property, such as a computer, to complete a tax return and retain relevant documentation, can also be deductible under other provisions of the Act, such as the depreciation provisions: see s 25-5(5).

Capital expenditure 9.5 Expenditure of a capital nature is not deductible generally under s 8-1 or, in relation to tax affairs, under s 25-5(4). The cost of advice regarding a business [page 564] reorganisation, feasibility study or other structure-related activity is not allowable: see 8.57. However, one’s tax affairs include liabilities under the capital gains tax provisions and it follows, as s 25-5(4) allows, that an amount is not capital just because it relates to matters of a capital nature.

Assessable recoupments 9.6 A recoupment of expenditure deductible under s 25-5 is assessable under s 2030 item 1.3: see 5.23.

Section 25-10: Repairs (former ITAA36 s 53) 9.7 The relationship between ss 8-1 and 25-10 (and their predecessors) has not been the subject of discussion in any reported cases. There are good reasons for thinking that a repair would satisfy the tests of deductibility under the general deduction provision, s 8-1. On this view, s 25-10 confirms the deductibility of repairs. However, in the absence of court decisions to the contrary, it is arguable that there may be occasions when the scope of s 25-10 is wider than s 8-1.1

Section 25-10 provides a deduction for expenditure by a taxpayer for repairs, not being expenditure of a capital nature, to income-producing assets. To come within the provision, the expenditure must be incurred2 by the taxpayer3 in respect of premises or part of premises, plant, machinery, implements, utensils, rolling stock or articles. The relevant assets need not be owned by the taxpayer. It is enough that they are held, occupied or used for the purpose of producing assessable income or in carrying on a business for that purpose. Repairs carried out during a temporary cessation of business, during which time it is intended to resume business, will satisfy the provision.4 Where the assets are held only partly for the gaining of assessable [page 565] income or only partly in carrying on a business, the deduction is limited to so much as is reasonable in the circumstances.

Suppose the Brown family owns a beach house that is used for private purposes for four months of the year, rented to holidaymakers for four months, and available for rent during the winter months but seldom occupied. Costs of painting amount to $1000. 1. What is it about some (or all) of the $1000 that makes it potentially a tax deduction? 2. How much is ‘reasonable in the circumstances’ as a deduction under ITAA97 s 25-10? A suggested solution can be found in Study help.

The deductibility of expenditure for repairs and maintenance is well grounded in taxation law and commercial principles. The words ‘repair and maintenance’ derive their meaning from ordinary concepts. Deductibility of such expenditure follows from a view that, if the proceeds from committing property to the gaining of assessable income are taxable, the cost of maintaining the property in good working order

or remedying defects caused by such use ought to be allowable deductions.

Meaning of repair 9.8 The term ‘repair’ has not been defined in the Acts and takes its ordinary judicial meaning. Whether or not work done on premises or plant is aptly described as a repair is a question of fact and degree: W Thomas & Co Pty Ltd v FCT (1965) 115 CLR 58; 9 AITR 710 at 719 per Windeyer J. In Lurcott v Wakely & Wheeler [1911] 1 KB 905 at 924, Buckley LJ said: “Repair” and “renew” are not words expressive of a clear contrast. Repair always involves renewal; renewal of a part; of a subordinate part … repair is restoration by renewal or replacement of subsidiary parts of a whole. Renewal, as distinguished from repair, is reconstruction of the entirety, meaning of the entirety not necessarily the whole but substantially the whole subject matter under discussion. [Emphasis added]

The last two sentences have been quoted approvingly by the High Court in several instances. In W Thomas & Co, Windeyer J said (at AITR 719): Repair involves a restoration of a thing to a condition it formerly had without changing its character. But in the case of a thing considered from the point of view of its use as distinct from its appearance, it is restoration of efficiency in function rather than exact repetition of form or material that is significant.

In Morcom v Campbell-Johnson [1955] 3 All ER 264 at 266, Denning LJ said: It seems to me that the test, so far as one can give any test in these matters, is this: If the work which is done is the provision of something new for the benefit of the occupier, that is, properly speaking, an improvement; but if it is only the replacement of something already there which has become dilapidated or worn out, then, albeit that

[page 566] it is a replacement by its modern equivalent, it comes within the category of repairs and not improvements.

In BP Oil Refinery (Bulwer Island) Ltd v FCT (1992) 23 ATR 65 at 73, Jenkinson J said: In my opinion work will not be considered repair unless it includes some restoration of

something lost or damaged, whether function or substance or some other quality or characteristic.

These observations have in common a view that the critical element of a repair is restoration of function, not the use of exact materials or the reproduction of exact form. They also have in common a distinction between repair and improvement. Expenditure that goes beyond restoration by renewal or replacement of subsidiary parts will not be a deductible repair: Lindsay v FCT (1961) 106 CLR 377; 8 AITR 458. Expenditure that is of a capital nature is specifically excluded by s 2510(3) even if it could be regarded as a repair within the meaning of s 25-10(1).5 A minor improvement to efficiency is no barrier to deductibility because all repairs improve the condition of an item relative to its condition before the repair: W Thomas & Co. To characterise an expenditure as a non-deductible improvement or as capital in nature, there must be a significant degree of functional enhancement or advantage. In Lindsay’s case, the Full High Court said (at AITR 460): Substantially the whole of the slipway was abolished, the new work was executed in concrete, and the new slipway was substantially longer. Each of these and other factors referred to by Kitto J [at first instance (1960) 8 AITR 99] may not, singly, be thought to be decisive of the question before us and they would, of course, carry less weight, if as the appellant contended, what was done should properly be regarded as work done to restore part of the entirety.

The use of more modern materials will not generate a non-deductible improvement ipso facto. To convert a ‘repair’ into an improvement there should be considerable advantages, not only in degree but also in kind.6

Entirety and subsidiary parts 9.9 One aid to resolution of repair/improvement issues referred to in the authorities above is whether what was done could be seen as affecting an entirety or a subsidiary part of an entirety. [page 567]

A repair involves the renewal or replacement of a subsidiary part of the whole (or entirety). As a result, the focus becomes whether the item affected was an entirety or a subsidiary part of the entirety with the aim of resolving the broader issue: was the expenditure a repair or improvement? This method is illustrated in Kitto J’s judgment at first instance in Lindsay v FCT (1960) 106 CLR 377; 8 AITR 99.

Lindsay v FCT Facts: The taxpayer carried on a shipping business, including ship repairs. A considerable amount was expended on reconstructing one of two slipways and the taxpayer sought to deduct the amount as a repair. Concrete was used to replace the previous timber structure as suitable timber was unavailable but evidence was presented that the cost of concrete was not materially different from the cost of timber and there was no advantage in terms of durability. The taxpayer argued the slipway should be regarded as a part of the premises on which the ship-repairing business was carried out or that, alternatively, it was part of the whole slip that included machinery, winches and allied equipment. Held: The taxpayer’s appeal was dismissed. The slipway was an entirety in itself. The expenditure constituted the renewal of an entirety. Kitto J rejected the argument that either the whole of the premises or the whole of the slip should be regarded as the entirety. His Honour said (at AITR 103): I am unable to accept this argument in either of its forms. The only justification that was suggested for treating the whole premises, or the whole No 1 slip, as the relevant entirety, was that the entirety to be considered is “the income earning unit”. In order to determine whether an item of expenditure is to be held on general principles to be chargeable to income or capital account, it is of course necessary to distinguish between “the business entity, structure or organization established for the earning of profit and the process by which such an organization operates to obtain regular returns by means of regular outlay”; and it is true that “the business structure or entity or organization … may consist in a great aggregation of buildings, machinery and plant all assembled and systematized as the material means by which an organised body of men produce and distribute commodities and perform services” (Sun Newspapers Ltd and Associated Newspapers Ltd v FCT (1938) 61 CLR 337 at 359, 360; 1 AITR 403 at 410). But where the question is whether the expenditure has been for repairs, and for the purpose of deciding that question one asks what is the entirety which is relevant to consider, one is [page 568]

looking not for a profit-earning structure or entity, as such, but for a physical thing which satisfies a particular notion. Kitto J concluded that the No 1 slipway was the relevant entirety and not a subsidiary part of anything else. It was separately identifiable as a principal item of capital equipment. The question of whether what was done to it was a repair or a renewal had to be resolved in the context of the slipway not a larger aggregation of assets.

There is an important distinction in Kitto J’s judgment between the test for distinguishing income and capital for the purpose of the general deduction provision (s 8-1) and distinguishing repairs and capital improvements for the purpose of a specific provision addressing repairs (s 25-10). What is to be regarded as an entirety for the purposes of repairs is not determined by examining a profit-earning structure. While the criteria stated by Dixon J in Sun Newspapers Ltd and Associated Newspapers Ltd v FCT (1938) 61 CLR 337; 1 AITR 403 for distinguishing structure-related and process-related expenditure remained the appropriate test, it did not follow that an aggregation of assets that could be described as the structure for s 8-1 purposes was appropriate to identify an entirety for the purpose of s 25-10. With respect, this must be the case. Consider the outcome if the argument is reversed. One could not, for example, claim that an item of machinery was not capital simply because it was only one item in a bigger structural unit. What is part of the profit-earning structure and so capital in nature does not determine what is an entirety. On the question of the deductibility of repairs, the question is whether what is done is the replacement of subsidiary parts of an entirety. One way to identify an entirety could be to examine whether the item under consideration is capable of performing a separate function. There is no judicial support for this approach but it is compatible with the view that an entirety is not ‘the income-earning unit’. Rather, one asks what is the entirety that is relevant to consider and looks for a physical thing that satisfies that notion. So, for example, a particular building could be an entirety whereas the roof is a subsidiary part. The approach is less useful in more complicated cases. In some cases, it will be right to regard a building or premises as an entirety and, in other cases, some part of the building or premises.7

[page 569]

Initial repairs 9.10 Initial repair refers to the cost of remedying defects existing in an asset at the time of acquisition.

Why should an initial repair not be an allowable deduction for taxation purposes? Would your response be different if the defects were not discovered until six months after the date of purchase? (For example, a rusted roof of a workshop is discovered after a heavy storm.) How is expenditure for initial repairs treated under generally accepted accounting principles?

The accounting standards governing expenditure such as initial repairs and other ‘incidental costs’ of acquisition require capitalisation. Under Statement of Accounting Concepts 4 (SAC 4), an expense is the consumption of or loss of future economic benefits. Routine repairs and maintenance costs are expenses. The cost of an asset, including incidental costs of acquisition and installation are aggregated up to the point that the asset can perform the function for which it was acquired. Similarly, improvements that increase the functional capacity (future economic benefits) of an asset are capitalised.8 A jurisprudential equivalent of this ‘suitability doctrine’ might be stated as follows: When an item purchased for use as an asset in the course of producing assessable income is not in good order or suitable for use in the way intended, the cost of making it suitable is part of the cost of its acquisition, not a cost of its maintenance: Law Shipping Co Ltd v IRC 1924 SC 74; (1923) 12 TC 621; FCT v Western Suburbs Cinemas Ltd (1952) 86 CLR 102; 5 AITR 300; CIR (Cook Islands) v A B Donald Ltd (1965) 9 AITR 501; W Thomas & Co Pty Ltd v FCT (1965) 115 CLR 58; 9 AITR 710.

However, to express a proposition in such broad terms is to obscure some differing judicial approaches. In the leading cases, it is possible to discern three rationales for the non-deductibility of initial repairs: 1. A state of disrepair will usually be reflected in the price paid for an asset. It follows that the cost of an initial repair is properly classified as part of the acquisition cost. [page 570] 2.

An initial repair is an improvement in the sense that it adds a functional capacity to an asset that it did not possess when it first came into the taxpayer’s ownership. 3. Initial repairs are not maintenance costs in that they do not remedy defects that arose from the use of the asset by the present taxpayer. The defects relate to use by the previous owner. The leading UK decision on initial repairs is Law Shipping Co Ltd v IRC [1924] SC 74; (1923) 12 TC 621.

Law Shipping Co Ltd v IRC Facts: The taxpayer purchased a ship at a cost of £97,000. The ship was badly in need of repairs and a periodic Lloyd’s survey was overdue. The taxpayer obtained permission to complete a voyage. The Lloyd’s survey was undertaken and repairs costing £51,558 were necessary. The taxpayer sought to deduct the amount. Held: The court held that an amount of £12,000 of repairs was attributable to the one journey undertaken while the taxpayer was the owner and the amount of £39,558 related to defects that had accumulated prior to the acquisition and were part of the capital cost of acquiring the ship.a Lord Clyde said (at TC 625–6): Repairs may be executed as the occasion for them occurs; or, if they are such as brook delay, they may be postponed to a convenient season: but, in either case, they truly constitute a constantly recurring incident of that continuous employment of the ship which makes them necessary. They are therefore an

admissible deduction in computing profits, and, as is admitted in the case, if the ship had not been sold, the purchasers’ predecessors would have been entitled to deduct the whole of the £51,558 in returning their profits for Income Tax. Accumulated arrears for repairs are, in short, none the less repairs necessary to earn profits, although they have been allowed to accumulate. In the present case, however, the accumulation of repairs represented by the expenditure of £51,558 required to overtake them, was an accumulation which extended partly over a period during which the ship was employed not in the purchasers’ trade, but in that of the purchasers’ predecessors. And the question relates to the computation of the purchasers’ profits only. [page 571] The purchasers started their trade with a ship already in need of extensive repairs. The need was not so clement as to make it impossible to employ her (as she stood at the time of the purchase) in the voyage she was then about to commence. So much is clear from the fact that she was allowed exemption from survey for the purposes of that voyage. But, while some portion of the repairs executed after her return was no doubt attributable to her employment in the purchasers’ trade between the date of their purchase and the return of the ship and while such portion was therefore necessary to the earning of profits by them in that and subsequent voyages it seems plain that a large portion of them was attributable solely to her employment by the purchasers’ predecessors, in whose profits the purchasers had no interest whatever. Statements by Lord Clyde and Lord Cullen make it clear that the ship’s state of disrepair was reflected in its price. Lord Clyde said (at TC 626): It is obvious that a ship on which repairs have been allowed to accumulate is a less valuable capital asset with which to start business than a ship which has been regularly kept in repair. And it is a fair inference that the sellers would have demanded and obtained a higher price than they actually did, but for the immediate necessity of repairs to which the ship was subject when they put her in the market. Lord Cullen agreed (at TC 628): I am of opinion that it has been properly treated by the Commissioner as capital expenditure. It is, in substance, the equivalent of an addition to the price. If the ship had not been in need of the repairs in question when bought, [the taxpayer] would, presumably, have had to pay a correspondingly larger price.

a.

It should be noted that the deductibility of repairs in the Law Shipping Co case was to be decided under Sch D of the UK legislation. This Schedule brought to charge as

taxable income ‘annual profits or gains’ from trade. The question before the court, therefore, was whether the amount expended was deductible in computing the taxpayer’s annual profits. This scheme of taxation contrasts with that of Australia with its specific deduction provisions. It is significant, however, that in the Law Shipping Co case, the court was prepared to divide the total amount into deductible and non-deductible components without any specific statutory direction. Law Shipping Co was followed in Australia in W Thomas & Co Pty Ltd v FCT (1965) 115 CLR 58; 9 AITR 710. In that case, the taxpayer was a flour miller and grain merchant that acquired a building to use as a store. An amount of £6097 was expended on repairs to the roof, walls and floor, painting and the installation [page 572] of amenities. The taxpayer capitalised the cost of installing the amenities and claimed £5082 as repairs. The claim was disallowed. Windeyer J said (at AITR 719): Expenditure upon repairs is properly attributed to revenue account when the repairs are for the maintenance of an income-producing capital asset. Maintenance involves the periodic repair of defects that are the result of normal wear and tear in operation. It is an expense of a revenue nature when it is to repair defects arising from the operations of the person who incurs it. But if when a thing is bought for use as a capital asset in the buyer’s business it is not in good order and suitable for use in the way intended, the cost of putting it in order suitable for use is part of the cost of its acquisition, not a cost of its maintenance.

Windeyer J cited Law Shipping Co as authority for the proposition but his Honour did not comment on the correspondence between the purchase consideration and the state of disrepair of an asset. Obviously, there will be instances where initial expenditure is not in the nature of initial repairs but would be aptly described as an improvement. For example, in W Thomas & Co, one element of the expenditure was directed to the installation of a lunch room and other amenities and this

amount was capitalised and no deduction was claimed. However, Windeyer J chose to quote a passage from Woodhouse J’s judgment in the New Zealand decision of Collector of Inland Revenue, Cook Islands v A B Donald Ltd (1965) 9 AITR 501 at 506, which, like Law Shipping Co, was a case concerning initial repairs to a ship: To the extent that such initial defects are restored, the result is an improvement in the quality of the asset purchased, and, in my opinion, there has been an outlay of capital. To treat this outlay as a revenue loss is no more justified, in my opinion, than to treat the value of the improvement as an income gain … Defects may arise gradually over an extended period or develop from unexpected or sudden causes, but in so far as they have matured at the time of purchase by the new owner, they affect the quality of the asset he has acquired. Any subsequent need to remove them must be regarded as a legacy inherited by him as part of his bargain. It follows, therefore, that I take the view that the restoration of defects in an asset cannot be classed as a revenue charge unless the defects have arisen out of the taxpayer’s application of that asset in his search for income and unless the work is limited to those defects and does not become enlarged into such a reconstruction that a permanent improvement in quality has been affected.

The clear thrust of Woodhouse J’s judgment is that initial repairs amount to an improvement in the sense that the expenditure adds a functional capacity that the asset did not possess when it first came into the taxpayer’s possession. 9.11 The doctrine of suitability for use is not without its difficulties in an Australian context. An article may be suitable for use even though it is in need of some repair. It may also be prudent to anticipate future maintenance requirements. In W Thomas & Co, Windeyer J said (at AITR 721) that preventative expenditure provided one instance of the difficulty of limiting deductible expenditure to defects resulting from the taxpayer’s operations. His Honour quipped, ‘a stitch in time is as much a repair as the nine it saves’. Thus, a taxpayer may acquire, at an arm’s length price, a second-hand item in good working condition but anticipate some defect arising and take some preventative measure. The expenditure would seem to be an ‘initial repair’. On the other hand, it is clear from the decision in W Thomas & Co that the fact that the purchaser may be unaware of the defects at the time of purchase is immaterial. [page 573]

It is equally immaterial that the remedial work is done progressively as parts of the item are put into producing income. Deductibility is limited to expenditure made necessary by the taxpayer’s own operations. Windeyer J said (at AITR 720): Applying the principles to the present case it seems to me that the expenditure of £5,082 upon repairs … was of a capital nature. It seems to me immaterial that when the taxpayer acquired the building it did not know of some of its defects … That means only that the cost of obtaining an asset suitable for its purpose was greater than had been expected. It is equally immaterial that some parts of the work of repair were done progressively as parts of the building were taken into actual use. Expenditure of a capital nature does not cease to be so because made for work the doing of which was spread over a period of weeks or months and paid for as it was done.9

The position reflected in UK authorities is different. Although the leading authority on initial repairs is Law Shipping Co, the more recent decision in Odeon Associated Theatres Ltd v Jones (Inspector of Taxes) [1972] 1 All ER 681 adopted a more accommodating view that where assets are in operating condition and the purchase price reflects that state, and there is no necessity to carry out repairs immediately, expenditure to remedy defects that accrued before the date of acquisition are deductible. In Odeon Associated Theatres, the taxpayer acquired a number of theatres immediately after World War II. War-time regulations had prohibited all but essential maintenance and the theatres were in poor condition. However, this did not have any effect on the purchase price or attendances. Repairs were effected over the next 10 years. The court allowed the deductions and distinguished Law Shipping Co on three grounds: 1. the ship was not suitable for use whereas the theatres were income-earning assets at the time of purchase; 2. the purchase price was not lower as a result of the disrepair; and 3. if the theatre had remained in the former owner’s hands, the repairs would have been deductible. Such a decision flies in the face of a view that initial repairs are not maintenance costs in that they do not remedy defects that arose from the use of the asset by the present taxpayer. The defects relate to use by the previous owner. It is evident in Lord Clyde’s judgment in Law

Shipping Co, extracted above at 9.10, that had the ship in that case not been sold, the repairs would have been deductible to the former owners — but that did not change their character as initial repairs to the new owners. However, the decision in Odeon Associated Theatres may be rationalised on the ground that no additional functional capacity was added and so the expenditure was not really an initial repair. At the same time, it must be conceded that the circumstances would be exceptional where the state of disrepair does not affect [page 574] the price a purchaser is prepared to pay for an asset and perhaps the situation in post-war Britain could be so described. The distinction in Odeon Associated Theatres has not been considered by Australian authorities. W Thomas & Co is the leading authority here.

Terminal repairs 9.12 The description ‘terminal repairs’ describes expenditure ordinarily in the nature of a repair but made when an asset ceases to be used for income-producing purposes. The asset could subsequently be used for private purposes or sold.10 The authorities referred to above have consistently referred to repairs as involving restoration. For example, in W Thomas & Co, Windeyer J said: ‘Repair involves a restoration of a thing to a condition it formerly had without changing its character’. An argument fashioned along the lines that the expenditure would be deductible if the disrepair was caused during the time that income was produced would be consistent with the authorities. The argument would be strengthened if the repair was made in the same year that income was produced. However, the argument is not weakened simply because, for example, a rental agreement terminates on 30 June and repairs necessitated by the rental activity are not incurred until July or August. Indeed, there is a view that s 25-10 may have a wider temporal scope than the general

deduction provision in that it allows a deduction for premises or plant ‘held or used’ for income-producing purposes, whereas s 8-1 requires that the expense be incurred ‘in’ gaining or producing assessable income.11 The alternative view adopts an analysis derived from the decision in Fletcher v FCT (1991) 173 CLR 1; 22 ATR 613; 91 ATC 4950 in relation to the general deduction provision and the role of the taxpayer’s motive or subjective purpose. In that case, the High Court drew a distinction between cases where assessable income exceeded relevant expenditure and those where there was a shortfall.12 In the former instance, characterisation of the outlay was largely unaffected by the taxpayer’s objective. However, in the latter instance it was appropriate to weigh up the whole set of circumstances including direct and indirect objectives and advantages which the taxpayer sought in making the expenditure. Thus, the argument would run, where the taxpayer’s objective in making a terminal repair is to secure a sale of a capital asset or to enhance the sale price, the expenditure is on capital account.

Notional repairs 9.13 FCT v Western Suburbs Cinemas Ltd (1952) 86 CLR 102; 5 AITR 300 is authority for the non-deductibility of notional repairs. Faced with a choice between [page 575] spending £600 to patch up a ceiling or £3000 to replace the entirety, the taxpayer chose the latter course but sought to deduct the lesser amount. Kitto J dismissed the claim as follows (at AITR 304): The answer to the first proposition is that when a taxpayer has two courses open to him, one involving an expenditure which will be an allowable deduction for income tax and the other involving an expenditure which will not be an allowable deduction, and for his own reasons chooses the second course, he cannot have his income tax assessed as if he exercised his choice in the opposite way. [Former ITAA36] Section 53 is concerned with

expenditure which was in fact incurred, not with expenditure which could have been incurred but was not.

Capital expenditure 9.14 Section 25-10(3) specifically disallows a deduction for amounts of a capital nature. Initial repairs are of a capital nature for one or a combination of several reasons. If an item of expenditure amounts to the replacement of an entirety, it is of a capital nature. Whether the object of the expenditure is an entirety or a subsidiary part is a question of fact and degree. If an item of expenditure does not constitute the replacement of an entirety, it may yet fail deductibility if it goes beyond mere restoration and amounts to an improvement. As with all such distinctions, where to draw the line is seldom clear cut. Some helpful comments come from Denning LJ in Morcom v Campbell-Johnson [1955] 3 All ER 264 at 266: If the work which is done is the provision of something new … that is, properly speaking, an improvement; but if it is only the replacement of something already there which has become dilapidated or worn out, then, albeit that it is a replacement by its modern equivalent, it comes within the category of repairs and not improvements.

This view sits comfortably with Windeyer J’s opinion expressed in W Thomas & Co at AITR 719: ‘Repair involves restoration of a thing to a condition it formerly had without changing its character … it is restoration of efficiency in function …’. It would seem a useful test to ask whether something different is brought into existence or whether there is a new or enhanced functional capacity. Where newer or different materials are used or where, through the passage of time, the original is a subjective image, it may be helpful to assess whether any advantage has accrued. Thus, in Western Suburbs Cinemas, Kitto J said (at AITR 302): In this case the work done consisted of the replacement of the entire ceiling, a major and important part of the structure of the theatre, with a new and better ceiling. The operation seems to me different, not only in degree, but in kind, from the type of repairs which are properly allowed for in the working expenses of a theatre business. It did much more than meet a need for restoration; it provided a ceiling having considerable advantages over the old one, including the advantage that it reduced the likelihood of repair bills in the future.

It seems clear that the advantage of reduced future repair bills will

not, of itself, convert a repair to an improvement. Support for this view is evident in Kitto J’s language. In addition, in Lindsay v FCT (1961) 106 CLR 377; 8 AITR 458, the Full High Court in a joint judgment said (at AITR 460): Substantially the whole of the slipway was abolished, the new work was executed in concrete, and the new slipway was substantially longer. Each of these and other factors

[page 576] referred to by Kitto J [at first instance] may not, singly, be thought to be decisive of the question before us and they would, of course, carry less weight, if as the appellant contended, what was done should properly be regarded as work done to restore part of the entirety.

This should not imply the number of advantages is unimportant. Rather, as their Honours said earlier (at 459), ‘[i]t is, therefore, necessary, in cases such as the present, that the work in respect of which the expenditure was incurred should be seen in its true perspective’. Undoubtedly, a large number of advantages would affect the perspective. One dominant advantage may be sufficient to establish that perspective. However, it is restoration of function that is the critical element and the authorities point to ‘considerable advantages’. Restoration of function should be contrasted with the creation of a new functional capacity.

Apportionment 9.15 Amendments to ITAA36 s 53 in 1984 provided a discretionary power to the Commissioner in cases where repairs related to assets used for private and income-producing purposes, to permit a deduction for so much as was reasonable. There was no similar discretion in relation to expenditure that might be in part revenue and in part capital. The general deduction provision, ITAA97 s 8-1, provides for apportionment of both capital and private outgoings. The present s 25-10(2) provides for apportionment on a reasonable basis of repairs to an asset used partly for income-producing purposes and partly for private purposes. Apportionment is a question of fact and

what is reasonable will depend on the circumstances. So, for example, it would seem reasonable that repairs to a motor vehicle used partly for private and partly for business purposes should be apportioned on the basis of the ‘business percentage’ of use where the log book method of substantiation is used. Repairs to a roof of premises serving as a shopcum-residence might reasonably be apportioned on an area basis. In other situations, the time period attributable to the different activities might serve as a reasonable basis. The reformulation of the specific repair provision (ITAA36 s 53 and, subsequently, ITAA97 s 25-10) made no reference to part revenue, part capital expenditure and simply denies a deduction for expenditure of a capital nature. It may be argued, however, that specific statutory language is unnecessary for apportionment.

1.

In W Thomas & Co Pty Ltd v FCT (1965) 1 15 CLR 58; 9 AITR 710, Windeyer J said: ‘The words “repair” and “improvement” may for some purposes connote contrasting concepts; but obviously repairing a thing improves the condition it was in immediately before repair’. Does this mean that all repairs are on capital account? [page 577]

2.

Consider whether the following expenditures are deductible repairs: (a) wooden piles on a wharf being encased in concrete to prevent further deterioration caused by marine organisms; (b) installing a reconditioned engine in a truck used for income-producing purposes; (c) the renovation in 2012 of a Victorian-era hotel; (d) replacement of a culvert with a bridge on an access road to a rental property. The bridge measured about 8 metres of a 200-metre-long access road; (e) replacement of worn vinyl with carpet in a medical practitioner’s waiting room; (f) resealing a bitumen car park in a shopping centre. A suggested solution can be found in Study help.

Section 25-15: Amount paid for lease obligation to repair (former ITAA36 s 53AA) 9.16 Where a lessee is obliged under the terms of a lease to make repairs to leased premises used for income-producing purposes but fails to do so and, as a result, is required to pay the lessor, a deduction is allowable under s 25-15. The amount received by the lessor is assessable under s 15-25.

Section 25-20: Lease document expenses (former ITAA36 s 68) 9.17 Outgoings by a tenant of business premises relating to the preparation, registration or stamping of a lease or an assignment of a lease are allowable deductions to the extent that the premises are used for business purposes. If the premises are used only partly for business or income-earning purposes, then the deduction abates accordingly. Expenses of this nature may well be capital in nature and not deductible under s 8-1.

Section 25-25: Borrowing expenses (former ITAA36 s 67) 9.18 Where money is borrowed in connection with the derivation of assessable income, the initial cost of borrowing is an allowable deduction. Borrowing expenses do not include interest. Interest is the price paid once the money has been borrowed. It is the cost of the use of the funds. Interest is deductible under s 8-1 as a cost of securing funds that are applied to the production of assessable income: FCT v Munro (1926) 38 CLR 153. Borrowing expenses are the costs of raising or securing a loan, and include loan application fees in the case of a bank loan; procuration fees, commission, etc, paid in connection with other debt arrangements; guarantee fees for an overdraft; and legal costs or brokerage arising on the issue of instruments such as debentures. They are

[page 578] the cost of borrowing, as opposed to interest on the loan. There may be occasions when such fees would be deductible under s 8-1 (see, for example, McGuiness v FCT (1991) 23 ATR 75; 92 ATC 4006) but, in other circumstances, may be in the nature of capital and disallowed under s 8-1. In effect, s 25-25 provides for the amortisation of the borrowing expenses over the period of the loan. Where the particular loan is used only partly for the requisite purpose then only a portion of the borrowing expenses is allowable. The allowable deduction is calculated by apportioning the expenses over the period of the loan, or five years if that is longer. Amounts less than $100 are deductible in the year incurred: s 25-25(6). The five-year limit or period of the loan extends over 1825 days (5 × 365) from the date of incurrence. The amount deductible in each year is calculated by multiplying the undeducted expenditure by the ratio of the number of days of the loan in the loan year and the number of days remaining in the loan period.

A loan used for income-producing purposes is arranged on 1 September 2017. The term of the loan is five years (1825 days). Borrowing expenses are $500. Year 1

500 × 303/1825

= $83

Year 2

500 − 83 = 417 417 × 365/1522

= 100

417 − 100 = 317 317 × 365/1157

= 100

317 − 100 = 217 217 × 365/792

= 100

217 − 100 = 117 1 17 × 365/427

= 100

117 − 100

= 17

Year 3 Year 4 Year 5 Year 6

If the loan was repaid in full on 31 March in Year 4, the deduction would be $217. Note that the same result follows from amortising the amount of $500 over five years and apportioning on a monthly basis: Year 1, 100 × 10/12 = $83; Years 2–5, $100; Year 6, $17.

The Commissioner released Interpretative Decision ATO ID 2005/42, which examined the deductibility of interest and borrowing expenses incurred by a non-resident taxpayer on a loan used to exercise share options. In ATO ID 2005/42, the Commissioner concluded that a nonresident is not entitled to deductions under ITAA97 s 25-25 for interest and borrowing expenses on a loan used to exercise [page 579] options acquired under an employee share scheme. The Commissioner justified his conclusion on the basis that there is an ‘insufficient nexus’ between the interest and borrowing expenses and the discount given in relation to the rights that are acquired by the non-resident taxpayer. According to the Commissioner’s ruling, the discount that is included in the taxpayer’s assessable income in the year the options were exercised was merely incidental to the acquisition of the shares. Since the discount was incidental, there is an insufficient nexus between the incurred business and interest expenses and the gaining of income (the discount associated with the exercise of the options).

Section 25-30: Expenses of discharging a mortgage (former ITAA36 s 67A) 9.19 Where property is mortgaged as security for a loan used for income-producing purposes, the cost of discharging the mortgage is a deduction under s 25-30. It does not matter that the mortgaged property is not a business asset. It is the use to which the loan is put that is important. Where the loan is partly for income-producing purposes and partly private, the deduction is apportioned appropriately.

Section 25-35: Bad debts (former ITAA36 s 63) 9.20 A deduction is allowable for a debt (or part of a debt) written off as a bad debt in the year of income if the amount has been included in assessable income or, in the case of a taxpayer in the business of lending money, the debt is a loan made in the ordinary course of business. In the former case, a taxpayer on an accrual basis would return service or sales revenue as assessable income derived at the point of sale (or rendering of service) when an enforceable debt arises. The writing off of a bad trade debt can have no tax effect for the taxpayer on the cash basis as the income to which the debt relates has never been returned as assessable income. The deduction for a bad debt, therefore, reverses the assessment process. By definition, a taxpayer in the business of lending money, who may deduct irrecoverable loans, would not be on the cash basis. Four elements must be satisfied in order to claim a deduction: 1. there must be a debt; 2. the debt must be bad (or partly bad); 3. the debt must be written off as bad during the year of income; and 4. the debt must have been formerly brought to account as assessable income.

There must be a debt 9.21 In order to satisfy the requirement of a debt in existence, the write-off must occur before the debt is released or extinguished at law. The cases of Point v FCT (1970) 119 CLR 453; 1 ATR 577; 70 ATC 4021 and G E Crane Sales Pty Ltd v FCT (1971) 126 CLR 177; 2 ATR 692; 71 ATC 4268 give rise to a peculiarity in that where a debt is extinguished in law it ceases to exist and cannot be written off. In Point’s case, the taxpayer entered into a scheme of arrangement in May 1964 that formally released a debtor from the obligation to repay but made no entry in its own

[page 580] books to write off the debt until the subsequent year of income. The High Court held that whatever debt existed at 30 June 1964 had ceased to exist. In G E Crane Sales, the taxpayer voluntarily assigned its debts under a scheme of arrangement. Menzies J said that, within the meaning of former ITAA36 s 63, debts meant: … moneys which the taxpayer is presently entitled to receive … existing debts … What has ceased to be a bad debt does not fall within the description of “debts which are bad debts”.

The debt must be bad (or partly bad) 9.22 For the debt to be bad, it must be considered irrecoverable having regard to ordinary business criteria. Whether a debt is bad is a question of fact. The taxpayer must have made a concerted effort to recover or be able to justify his or her actions in terms of prudent business practice. It does not matter that the taxpayer may continue to pursue the recovery so long as, at the time of the write-off, there was a reasonable expectation that the debt would not be recovered. Obvious cases of a bad debt arise where the debtor has died or been declared bankrupt, a company has been liquidated or assets cannot be traced: see Taxation Ruling TR 92/18.

The debt must be written off as bad during the year of income 9.23 The third requirement is that deductions are allowable only if the debts are literally ‘written off’ in the year of income. While no particular form of entry is required, a relevant book entry must be made during the year of income. It is not sufficient to make a post-balance date entry, back-dated to the year of income.13 As a result, the standard accounting treatment of raising a provision does not satisfy this requirement.

Profit & loss account

Bad debts provisions account

Debit A

Debit B

Debtor’s account

Credit A

Credit B

A: A provision is raised based on the likelihood of collecting trade debtors. B: B debt becomes ‘bad’ and is written off. B is the only entry to give rise to a deduction.

[page 581]

The debt must have been formerly brought to account as assessable income 9.24 Except in the case of moneylenders, taxpayers must have previously brought to account as income the amount claimed as a debt. Thus, the effect of s 25-35 is to square up when formerly assessable income is not receivable. Under s 25-35(1)(b), finance companies and other taxpayers that are in the business of lending money may obtain a deduction for a loss of capital being an irrecoverable loan made in the ordinary course of conducting a moneylending business. It is not essential that the taxpayer be a registered moneylender if it can be demonstrated that the lending operations amount to the carrying on of a business of moneylending. A moneylender that acquires a debt from another moneylender may claim a deduction in the event the debt becomes bad for an amount up to the cost paid for the debt, not its face value: s 25-35(2), (3) and (4). Section 25-35(3) places a limit on the amount deductible where a debt is purchased. A debt may be purchased under a factoring arrangement whereby a business sells its trade debts to secure finance or to relieve itself of the administrative burden of debt collection. Such sales will be at a discount. For example, if a factoring company acquires

a debt with a face value of $100 for an amount of $90 and the debt proves uncollectable, s 25-35(3) limits the deduction to $90. In the event that a bad debt is not deductible under s 25-35, it may yet satisfy s 8-1. This will be an option where a loan is on revenue account but the lender does not come within s 25-35(1)(b): see FCT v Marshall & Brougham Pty Ltd (1987) 17 FCR 541; 18 ATR 859; 87 ATC 4522, where a taxpayer claimed a deduction under former ITAA36 s 51(1) for an investment in the short-term money market. See also AGC (Advances) Ltd v FCT (1975) 132 CLR 175; 5 ATR 243; 75 ATC 4057. Bad debts written off that are subsequently recovered are assessable: s 20-30 item 1.1. In the case of companies, special rules apply to deductions for bad debts and for the treatment of debts forgiven by related companies. The situations covered by special rules are listed in s 25-35(5).

1. 2.

What is the difference between: (a) a bad debt; (b) a doubtful debt; and (c) a provision for bad debts? Jack proposes to sell to Jill a business consisting of the following assets. It is estimated that 10% of debtors will be uncollectable. Inventory (market value) Debtors

$10,000 8,000

Plant (market value)

25,000

Goodwill

20,000 $63,000

Which (if any) of the following options would you recommend? [page 582] (a) Jack should sell the assets for $63,000 and Jill claim a deduction for bad debts. (b) Jack should claim a deduction for $800 bad debts and sell the assets for $62,200.

(c) Jack should sell the assets other than debtors for $55,000. A suggested solution can be found in Study help.

Section 25-40: Loss from profit-making undertaking or plan (former ITAA36 s 52) 9.25 A deduction is allowable under s 25-40 for a loss from a profitmaking undertaking or plan if, had the undertaking been successful, the profit would have been assessable under s 15-15: see 5.8. The deduction is not allowable if the loss arises in respect of the sale of property acquired on or after 20 September 1985. The capital gains tax (CGT) provisions now cover such a loss. For the loss to be deductible, the taxpayer must have notified the Commissioner (in writing) that the property had been purchased with the relevant intention or, in the absence of such advice, the Commissioner must otherwise be satisfied of that intention.

Section 25-45: Loss by theft, etc (former ITAA36 s 71) 9.26 A deduction is allowable at the time of discovery for losses by way of theft, embezzlement, defalcation, misappropriation, etc by an employee or agent. The money must have previously been brought to account as assessable income and the deduction does not apply to individuals employed for private purposes, such as domestic help. The restrictions placed on the application of s 25-45 mean it does not apply to theft, etc, by partners or to directors of a company nor to embezzlement of moneys borrowed or paid-up capital. However, such losses that are found to be normal incidents of a business may be deductible under s 8-1: see Charles Moore & Co (WA) Pty Ltd v FCT (1956) 95 CLR 344; 6 AITR 379; 11 ATD 147. Recoveries of amounts deductible under s 25-45 are assessable under s 20-30 item 1.5. The Full Federal Court in FCT v La Rosa (2003) 129 FCR 494; 2003 ATC 4510 was asked to consider the deductibility of a theft of a large sum of money which arose out of the context of illegal activities. In La Rosa, the taxpayer sought a deduction for the theft of $220,000 which

occurred while the taxpayer was engaged in alleged illegal activity. The Full Court of the Federal Court held that the taxpayer was entitled to a tax deduction for the theft of the sum of money on the basis that the theft occurred in the course of the taxpayer’s alleged illegal activities. However, in Case 15/2004 (2004) 58 ATR 1059; 2004 ATC 301, the Administrative Appeals Tribunal (AAT) concluded that s 25-45 was not applicable on the basis that the taxpayer did not conduct a business of share trading. Hence, if a loss occurs within an entirely private purpose, no loss can be deducted under s 25-45. [page 583] In FCT v Lean [2009] FCA 490; BC200903915, the Federal Court was asked to consider whether misappropriation of funds deposited by an investor and share trader into a broker’s account could be a deductible loss under s 25-45. The Commissioner disallowed the misappropriation of the taxpayer’s funds, $3,287,749, as a deductible loss on the basis that it was either not a loss incurred in carrying on a business or profit-making undertaking or, alternatively, was a loss of a capital nature. At first instance, the AAT rejected the Commissioner’s submissions and set aside the Commissioner’s determination. The Commissioner appealed. On appeal to the Federal Court, the court set aside the tribunal’s decision and held in favour of the Commissioner. According to the Federal Court, to qualify for deductibility under s 25-45, the loss must have the following characteristics: 1. it must be in respect of money; 2. it must have been discovered in the income year in which the deduction is sought; and 3. it must have been brought about by theft. The court was of the view (at [49]) that: … once money received as income is deployed by the taxpayer, personally or by way of an agent, for expenditure or investment, the characterisation as income is no longer appropriate and the loss cannot be said to have been incurred in respect of the money

included in assessable income. At that point the more appropriate characterisation of the money in respect of which the loss has been incurred is as capital of the taxpayer.

Hence, according to the Federal Court, once the taxpayer in Lean instructed his stockbroker to transfer the proceeds of the share sale to the fund manager for the purpose of investment, the characterisation of the money as income is inappropriate and the loss could not be described as ‘in respect of money that was included in [the taxpayer’s] assessable income’: at [49].

Section 25-50: Payments of pensions, gratuities or retiring allowances (former ITAA36 s 78(11)) 9.27 Pensions, gratuities and retirement allowances made to employees, former employees or their dependants are allowable deductions to the extent that they are made in good faith in consideration of past services and are not otherwise deductible under other provisions of the Act. To be ‘in good faith’ means that the payment must be made with the genuine intention of rewarding past services. The reference to ‘past services’ also requires demonstration of bona fides, especially where a former employee is re-employed with an associate of the former employer. Although a company director is not an employee, payments made to those who might be described as ‘working directors’ may satisfy s 2550. The phrase ‘to the extent that’ clearly invites apportionment of the type considered under s 8-1. In dealing with predecessor legislation (ITAA36 s 78(11)), the Commissioner indicated he would consider factors such as the terms and length of service, remuneration and benefits, such as those arising under employer-sponsored superannuation schemes: Taxation Ruling IT 2152. [page 584] Under s 25-55, a limit is placed on certain deductions (including s 2550) that produce a tax loss. The deduction cannot increase a loss.

Accordingly, it may be preferable to consider the deduction under s 8-1. At any rate, s 25-50(3) denies a deduction if the outgoing is deductible under another section of the Act. Under the general deduction provision, outgoings need to satisfy the nexus or business test and retirement payments have received mixed success. For example, in Union Trustee Co of Australia Ltd v FCT (1935) 53 CLR 263 and Telecasters North Queensland Ltd v FCT (1989) 20 ATR 637; 89 ATC 4501, payments motivated by gratitude or primarily to reward the retiree were not deductible. The nexus with assessable income was not established for the purpose of s 8-1: former ITAA36 s 51(1). On the other hand, in Maryborough Newspaper Co Ltd v FCT (1929) 43 CLR 450, a payment designed to remove an editor was allowable because it was designed to increase circulation. The object of s 25-50 is to provide a deduction in circumstances illustrated by the first two cases.

Section 25-55: Payments to associations (former ITAA36 s 73) 9.28 Payments for membership of trade, professional or business associations up to a maximum of $42 are allowable under s 25-55. However, the amount should be considered under s 8-1 where no limit applies and where deductible amounts do not affect the $42 amount under s 25-55.

Section 25-60: Parliament election expenses (former ITAA36 s 74) 9.29 Ordinarily, the costs of seeking employment are not deductible. The connection with assessable income is too remote: FCT v Maddalena (1971) 2 ATR 541; 71 ATC 4161. Section 25-60 provides a deduction to aspiring politicians contesting Commonwealth, state or territory elections. The term ‘elections’ was interpreted to exclude expenditure directed to pre-selection: FCT v Wilcox (1982) 13 ATR 395; 82 ATC 4411. Expenditure on entertainment is not allowable: s 25-70.

Reimbursements of election expenditure are assessable under s 20-30 item 1.6.

Section 25-75: Rates and land taxes on premises used to produce mutual receipts (former ITAA36 s 72) 9.30 Council, water, sewerage rates, etc, and land tax relating to premises used for producing assessable income are deductible under s 81. Such charges on land used for mutual receipts are deductible under s 25-75. By virtue of s 25-75(4), the amounts are not deductible under s 8-1. Recoupments are assessable under s 20-30 item 1.7.

Section 25-95: Deduction for work in progress amount 9.31 Payments made for work (as opposed to goods) that has been partly performed is a ‘work in progress amount’ and is deductible under s 25-95. The recipient is assessable under s 15-50; see 5.20. Unlike partially manufactured goods, professional work in progress is not regarded as trading stock (Henderson v FCT [page 585] (1970) 119 CLR 612; 1 ATR 596; 70 ATC 4016) with the result that payments fall outside Div 70: see Chapter 11.

Section 25-100: Travel between workplaces 9.32 Section 25-100 was introduced into the ITAA97 in 2004 following the High Court’s decision in FCT v Payne (2001) 202 CLR 93; 2001 ATC 4027. In Payne, the High Court held that expenses incurred by a taxpayer while travelling between two unrelated places of work were not deductible under s 8-1. The High Court in Payne based its decision on the fact that the taxpayer’s expenses were incurred in transit between the two workplaces but were not incurred in the course of work-related activity. The High Court’s interpretation of travel

expenses between workplaces was at odds with previous income tax and court rulings. Hence, s 25-100 was introduced to override the High Court’s ruling in Payne. Under s 25-100, a deduction is allowable where an individual incurs transport expenditure in travelling directly between workplaces, the purpose of which is to derive assessable income and the individual does not reside at either workplace. The Explanatory Memorandum to the Tax Laws Amendment (2004 Measures No 1) Bill 2004 (Cth), which inserted s 25-100, provides examples of transport expenses that would be an allowable deduction and includes transport expenses incurred by the taxpayer in travel between two places of employment, two places of business, and a place of employment and a place of business.

Section 25-110: Capital expenditure to terminate a lease etc 9.33 Section 25-110 was introduced into the ITAA97 in 2006 following recommendations made by the Review of Business Taxation (the Ralph Review), which identified a series of expenditures that were known as ‘black hole’ expenditures. Black hole expenditures consisted of business expenses that could be incurred by taxpayers but which fall outside the various deduction provisions under income tax law. Under s 25-110, businesses are allowed a deduction for capital expenditure incurred to terminate a lease or licence if the expenditure is incurred in carrying on or ceasing a business. The expenses are to be deducted straight line over five years. The amendment contained in s 25-110 overcomes a previous ‘black hole’ because lease surrender payments made by a lessee to a lessor were not deductible or eligible to be written off under income tax law. Deductibility under s 25-110 is now allowed for lease payments (including instalment payments) provided the payment(s) results in the lease being surrendered. If a payment is made to terminate a lease or licence but does not result in actual termination of the lease or licence, a deduction will not be allowable under Div 25. Instead, the payments are to be quarantined until such time that the lease or licence is actually terminated.

ITAA97 Div 26: Specific denying provisions (Note: All references are to the ITAA97 except where indicated.) 9.34 Specific denying deductions derive from predecessor legislation that was, at best, mixed in its objective. Several provisions were introduced to ‘remove [page 586] doubt’ about expenditure which had been the subject of cases that ultimately held the expenditure in question to be non-deductible. Others may be genuine denying provisions enacted for reasons of public policy. A third category would seem to be enacted by way of emphasis. The object of Div 26 is to confirm or emphasise the non-deductibility of certain amounts and to restrict deductions otherwise allowable under s 8-1. Deductions may be restricted for public policy reasons, as in the case of subscriptions to clubs or the provision of leisure facilities (ss 26-45 and 26-50) and fines and penalties for breach of the law (s 26-5) or to anticipate potential abuses such as excessive salary payments to relatives (s 26-35) or an effective taxpayer-funded subsidy to relatives’ travel costs: s 26-30. Division 26 also confirms the non-deductibility of ‘provisions for annual or long service leave’14 but allows a deduction when payment is made for accrued leave entitlements. The principal sections in Div 26 cover the following matters: 26-5

Penalties

26-10

Leave payments

26-20

Assistance to students

26-30

Relative’s travel expenses

26-35

Reducing deductions for amounts paid to related entities

26-45

Recreational club expenses

1. 2.

26-50

Expenses for a leisure facility

26-54

Expenditure relating to illegal activities

26-55

Limit on deductions

What principle of public policy denies a deduction for: (a) HECS fees; and (b) recreational club expenses? Should first-class air travel for company executives be an allowable deduction?

Section 26-5: Penalties (former ITAA36 s 51(4)) 9.35 A deduction is denied by s 26-5 for penalties imposed under an Australian or foreign law or an amount ordered by a court on a conviction of an entity against [page 587] either such law. Penalties of this nature were not deductible under former ITAA36 s 51(1): ITAA97 s 8-1. The decisions in Mayne Nickless Ltd v FCT [1984] VR 863; (1984) 15 ATR 752; 84 ATC 4458 and Madad Pty Ltd v FCT (1984) 15 ATR 1118; 84 ATC 4739 illustrate the non-deductibility of fines and penalties imposed for breaches of laws committed at a time when income-producing activities are in process. Just because expenditure is incurred within the time frame of income-producing activities does not mean it satisfies deductibility criteria. A taxi-driver’s speeding fine may arise while in the process of earning income but it cannot be said that it is incurred in the course of operations directed to the production of assessable income. The obligation falls on the driver as an individual rather than a taxpayer. At any rate, it would be contrary to public

policy to allow errant taxpayers to mitigate their penalties through tax deductibility. A literal reading of s 26-5 indicates that penalties imposed as disciplinary measures by voluntary and sporting associations, etc, are outside the ambit of the provision. Note too that the provision makes no reference to the non-deductibility of legal expenses. These will continue to be deductible when they satisfy s 8-1: see Magna Alloys & Research Pty Ltd v FCT (1980) 49 FLR 183; 11 ATR 276; 80 ATC 4542.

Section 26-10: Leave payments (former ITAA36 s 51(3)) 9.36 Section 26-10 defers a deduction for long service leave, annual leave, sick leave or other leave until either: an amount is paid in the year of income to the relevant party; or an accrued leave transfer payment is made in the year of income. An ‘accrued leave transfer payment’ is defined in s 26-10(2) to mean a payment by a former employer to a future employer to assume responsibility for accrued leave. Such payments are assessable to the future employer under s 15-5. The effect of s 26-10(1)(a) is to disallow a deduction when a provision for leave entitlements is raised. Provisions for annual leave or provision for long service leave are in accordance with accounting principles, but the High Court has held that the amounts are not incurred for the purpose of former ITAA36 s 51(1): s 8-1. Given that the amounts are not allowable under s 8-1, s 26-10 (like s 26-5) is not really a denying provision at all. However, unlike s 26-5, s 26-10 allows a deduction and that is for when leave entitlements are paid. In Nilsen Development Laboratories Pty Ltd v FCT (1981) 144 CLR 616; 11 ATR 505; 81 ATC 4031, the High Court relied on its earlier decision in FCT v James Flood Pty Ltd (1953) 88 CLR 492; 5 AITR 579; 10 ATD 240 to disallow deductibility of provisions for employees’ holiday and long service leave provisions. In James Flood, the claims were disallowed because the employees’ rights were subject to a number of contingencies: for example, they might not complete the requisite

qualifying period to secure entitlement. In Nilsen Development Laboratories, the emphasis shifted slightly and the court pointed to the fact that the events to which the provisions related (the leave entitlements) had not yet occurred. That is, it was not that the payments were contingent but rather that, however contingent, the [page 588] events and the obligations attaching to them simply had not yet eventuated. The accounting imperatives of ‘matching’ did not govern the legal meaning of ‘incurred’. In general, accounting provisions are not incurred.

Section 26-20: Assistance to students (former ITAA36 s 51(6)) 9.37 Section 26-20 disallows contributions or payments to reduce a debt arising under the Higher Education Support Act 2003 (Cth), unless the payment is made in providing a fringe benefit.15 The deductibility of education fees depends on satisfying the general deduction provision, s 8-1. When the nexus with assessable income is shown, the costs are deductible: FCT v Finn (1961) 106 CLR 60; 8 AITR 406; 12 ATD 348. This would be comparatively easy where the taxpayers are income earners seeking to enhance their career prospects or simply keeping abreast of developments in their chosen profession or trade. For students not employed, or for those in unrelated employment, the nexus is too remote. So, for that latter group, the non-deductibility of the HECS levy was to be expected. Clearly, those in the former group would be disadvantaged by s 26-20 but, at any rate, from a fiscal perspective it would be counter-productive to impose a charge for education and make it tax deductible.

Section 26-30: Relative’s travel expenses (former ITAA36 s 51AG)

9.38 In the event that travel costs are tax deductible under s 8-1 for a relative accompanying a taxpayer on a trip, they are denied under s 2630 except where certain conditions are satisfied. Where, in the course of employment or carrying on a business, a taxpayer is required to travel and is accompanied by a relative, the cost of the relative’s travel is not deductible unless: 26-30 (2) … (a) your relative, while accompanying [the taxpayer], performed substantial duties as [the taxpayer’s] employer’s employee, or as your employee; and (b) it is reasonable to conclude that [the taxpayer’s] relative would still have accompanied [the taxpayer] even if he or she had not had a personal relationship with [the taxpayer].

[page 589] The rule in s 26-30 does not apply where the expenditure is a fringe benefit: that is, the cost of a relative’s travel is deductible and also the subject of fringe benefits tax: s 26-30(3). A relative is defined in s 995-1(1) to mean the following (including the spouse and de facto spouse of each party): relative of a person means: (a) the person’s spouse; or (b) the parent, grandparent, brother, sister, uncle, aunt, nephew, niece, lineal descendant or adopted child of that person, or of that person’s spouse; or (c) the spouse of a person referred to in paragraph (b). …

Section 26-35: Reducing deductions for amounts paid to related entities (former ITAA36 s 65) 9.39 Payments made or obligations incurred to pay amounts to related entities that are otherwise deductible under the Act (such as

wages to an employee relative) are limited by s 26-35 to an amount considered by the Commissioner to be reasonable. A ‘related entity’ includes the relatives indicated above in 9.38 as well as a partnership in which a relative is a partner. Section 26-35 is an anti-avoidance provision designed to reduce deductions for payments to associated persons where the amount of the payment is seen to be commercially unrealistic. The provision does not allow a deduction; it provides for a limit on amounts otherwise deductible. Whether or not a payment is unreasonable will depend on what is done by the relative to merit the payment and what is a reasonable commercial reward for the effort. It does not mean that only minimum or award payments may be made to relatives.

Section 26-45: Recreational club expenses (former ITAA36 s 51AB) 9.40 A deduction for membership of a recreational club that might otherwise satisfy s 8-1 is denied by s 26-45. A ‘recreational club’ is defined in s 26-45(2) to mean a company that was established or is carried on mainly to provide facilities to members for drinking, dining, recreation or entertainment. Section 26-45 does not provide a deduction for anything. It operates to deny a deduction that may otherwise be available under the Act. So, if it is established that the particular club is carried on mainly for purposes other than those specified in s 26-45(2), the denial does not apply but it is still necessary that the loss or outgoing come within s 8-1 and the necessary expenditure–income nexus must be established. The denial in s 26-45(1) does not apply to payments that are fringe benefits. [page 590]

Section 26-50: Expenses for a leisure facility (former ITAA36 s 51AB)

9.41 A similar denial to s 26-45 operates in relation to the cost of obtaining or maintaining leisure facilities or boats. A leisure facility is defined to mean land, a building or part of a building that is used for holidays or recreation. Clearly, the term includes facilities such as swimming pools, tennis courts, bowling and putting greens, gymnasiums and holiday lodges. A ‘boat’ is not defined but is probably recognisable. Section 26-50(3) and (4) sets out a number of exclusions. The denial does not apply if, at all times during the year of income: the leisure facility (or boat) is held for sale or use in the ordinary course of business; the leisure facility (or boat) is used mainly for hire, rent, fees or charges in the ordinary course of business; the leisure facility (but not the boat) is for employees’ use or the care of employees’ children. Part-year use of a leisure facility or boat for one of the excepted purposes permits a deduction that is reasonable. The denial of deductibility does not apply to fringe benefits. Section 26-50(7) is an anti-avoidance provision designed to prevent what are in the Commissioner’s opinion schemes to circumvent the section.

Section 26-54: Expenditure relating to illegal activities 9.42 In 2005, s 26-54 was introduced into the ITAA97. The section deals with the deductibility of expenses which are incurred in relation to the commission of an illegal activity. The section provides that in the case of expenditure which is directly related to, or in furtherance of, the commission of an indictable offence (ie, an offence that is punishable by a term of imprisonment for at least 12 months) and the taxpayer has been convicted of that offence, the loss or outgoing cannot be deducted. Further, s 26-54(2) provides that the Commissioner has up to four years after the taxpayer has been convicted of an indictable offence to issue an amended assessment. This allows the Commissioner time to amend a taxpayer’s assessment in the event that the taxpayer has made a claim for a deduction and is subsequently convicted of an indictable offence.

Section 26-54 was introduced to overcome the ruling by the Full Federal Court in FCT v La Rosa (2003) 129 FCR 494; 2003 ATC 4510. In La Rosa, the Full Federal Court held that a tax deduction claimed by the taxpayer for the amount of $220,000 for theft was an allowable deduction, notwithstanding that the taxpayer had been engaged in an illegal activity. On an application for special leave to appeal to the High Court, the High Court refused the Commissioner’s application to appeal the Full Federal Court’s decision.

Section 26-55: Limit on deductions (former ITAA36 s 79C) 9.43 Section 26-55 operates to limit the amount deductible under several provisions. The section prevents a tax loss arising or increasing due to deductions allowable under a number of headings, the main ones being: Div 30, dealing with gifts; s 25-50, dealing with pensions. [page 591]

(i)

(ii)

$ 10,000

10,000

Allowable deductions

(8,500)

(12,000)

Div 30 gift

(2,000)

(2,000)

Nil

(2,000)

Assessable income

Taxable income

In case (i) only, $1500 of the gift is deductible. It cannot produce a loss. In case (ii), the gift is not deductible. It cannot increase a loss.

Deductions of particular amounts

(Note: All references are to the ITAA97 except where indicated.) 9.44 Qualifications allowing or denying amounts in terms of s 8-1 are not confined to Divs 25 and 26, and even within those Divisions some of the classifications may seem arbitrary. Besides Div 25, specific allowing and qualifying provisions are included in Div 30 ‘Gifts or contributions’ and Div 36 ‘Tax losses of earlier income years’. In addition, like Div 26, specific denying provisions are included in Div 32 ‘Entertainment expenses’. Elements of both Divs 25 and 26 are evident in Div 34 ‘Non-compulsory uniforms’, while Divs 28 and 900 provide additional requirements of deductibility in the form of substantiation for expenditure that otherwise satisfies the general or specific deduction provisions. This category addresses the following matters: Div 30

Gifts or contributions

Div 32

Entertainment expenses

Div 34

Non-compulsory uniforms

Div 35

Deferral of losses from non-commercial business activities

Div 36

Tax losses of earlier income years

Div 28

Car expenses and substantiation

Div 900

Substantiation rules

Div 27

Effect of input tax credits etc on deductions

Division 30: Gifts or contributions (former ITAA36 s 78) 9.45 Division 30 provides a deduction for gifts of money or property (including trading stock) of $2 or more that are made to one of the bodies listed in the index in s 30-315. There may be occasions where donations (perhaps especially) of trading stock are in the nature of promotional activities that are deductible under s 8-1. More generally, donations to charitable and deserving causes are classic instances of tax expenditures. Tax expenditures in the form of concessional deductions are [page 592]

alternatives to government spending. In effect, the ITAA97 is used as a spending tool to hand out money to approved institutions and activities. Tax expenditures are not confined to Div 30. They apply where some preferential tax treatment is given to income or expenditure. The deduction for gifts of $2 or more to approved bodies is provided under s 32-15. That provision sets out: who the recipient of the gift can be; the type of gift or contribution that you can make; how much you can deduct; and any special conditions that apply. In general, a non-testamentary gift of $2 or more in value may be: money; property that was purchased during the 12 months before the making of the gift (the value is the lesser of the market value on the day the gift is made or the amount you paid for it); or trading stock that is disposed of outside the ordinary course of business (the value is the market value on the day the gift is made).16 In the case of donations to a political party, these general conditions apply except that gifts of trading stock are not allowable deductions. In addition, donations by companies are not allowable. The maximum deduction in any one year is $100. The political party must be registered under the Commonwealth Electoral Act 1918 (Cth). Special conditions may attach to deductibility depending on the fund, authority or institution and these are set out in Subdiv 32-B. As a general condition, the relevant body must be in Australia. Subdivision 30-B contains a list of recipients of deductible gifts:17 1.

Health

10. International affairs

2.

Education

11. Sports and recreation

3.

Research

12. Philanthropic trusts

4.

Welfare and rights

13. Cultural organisations

5.

Defence

14. Fire and emergency services

6.

The environment

15. Australian disaster relief funds declaration by Minister

7.

Industry, trade and design

16. Australian disaster relief funds declaration under state and territory law

8.

Scholarship

17. Other recipients

9.

The family

[page 593] Within each of these groups, general and specific entities are nominated. For example, under ‘Health’ is listed a public hospital and non-profit hospitals run by associations or societies. Specific bodies include the Royal Australasian College of Surgeons. Under ‘Education — General’ is a public university (but not schools); under ‘Education — Specific’, the Australian Academy of Science. Under ‘Welfare and rights — General’ is a ‘public benevolent institution’; and under ‘Welfare and rights — Specific’, Amnesty International and the Royal Society for the Prevention of Cruelty to Animals (RSPCA). The government has announced its intention to redefine charities for the purpose of deductible gifts. It has also announced that from 1 July 2004 it will provide a tax deduction for cash donations over $250 to deductible gift recipients where there are only minor benefits associated with the gift. ‘Minor’ will mean a benefit received of not more than the lesser of 10% of the donation or $100. For example, if a fundraising dinner cost $1000, but the market value of the dinner was $100, participants will be entitled to a $900 tax deduction.

Defining gifts: What is a gift? 9.46 In 2005, the Commissioner released TR 2005/13 ‘Tax Deductible Gifts — What is a Gift?’ According to para 1 of the Commissioner’s ruling, the intention of issuing the ruling was to explain what a gift is for the purposes of the gift deduction provisions under ITAA97 Div 30. The term ‘gift’ is not currently defined in the ITAA97. Instead, courts have defined gifts according to certain characteristics, which include:

there is a transfer of the beneficial interest in the property; the transfer is made voluntarily; the transfer arises by way of benefaction; and no material benefit or advantage is received by the giver by way of return. The courts have attempted to use the above characteristics in a global context when assessing the issue of gifts. The courts examine the whole set of circumstances surrounding the transfer of the gift from the transferor to the transferee. Hence, to qualify as a gift, the property must be voluntarily transferred, with no strings attached and with no material advantage accruing to the donor. There must be a genuine transfer of the beneficial interest in the property to the transferee which involves an unconditional and immediate transfer of control of the property. In Case T57 86 ATC 432, a deduction to a qualifying children’s home was held not to be deductible because the donor, the manager of the home, gained a material benefit from the home — his family was housed and fed by the home as part of the manager’s conditions. In FCT v McPhail (1968) 10 AITR 552; 15 ATD 16, a payment by a parent to a school building fund in return for reduced tuition fees was not a gift. See also Klopper v DCT (1997) 34 ATR 650; 96 ATC 2020. In addition, ITAA36 s 78A operates to deny a deduction where the donor receives a benefit other than the tax deduction. Consider the decision in Leary v FCT (1980) 11 ATR 145; 80 ATC 4438. [page 594]

Leary v FCT Facts: The taxpayer entered a scheme whereby he paid $10,000 to a benevolent

institution. The promoter received a fee of 98.8%, and a loan of $8500 repayable in 40 years was made available to the taxpayer. The institution received $120. The present value of the loan was virtually nil and the taxpayer acquired the lender’s rights for $17. As a result, the taxpayer expended $10,000, received $8500 as a loan (less $17) and sought to claim a deduction of $10,000. The promoter received $1397, that is: $10,000 ‒ 8500 ‒ 120 + 17 Held: A claim for the deduction of $10,000 was disallowed. The Federal Court held that the word ‘gift’ took its meaning from ordinary concepts that implied the absence of material advantage to the donor and some element of benefaction. Bowen CJ said (at ATR 148–9): It seems that a transfer of property, to qualify as a gift under [former ITAA36 s 78] need not be made out of motives of benevolence … but the essential idea of a gift is the transfer of property by way of benefaction … In [former ITAA36 s 78] the notion of benefaction appears to be an essential idea, particularly having regard to the nature of the funds, authorities and institutions listed in the 45 sub-paragraphs. The purpose of [former ITAA36 s 78] seems clear enough. It is to offer an allowable deduction for income tax purposes in order to encourage benefaction to the bodies specified, which clearly are considered to be bodies which it is in the public interest to assist. … In determining whether a benefaction is conferred upon the prescribed body, it may be relevant to look at the matter both from the point of view of the donor and the donee. The donor may have erected a structure which is such that he can take back a benefit of the gift as in Bray v FCT (1978) 52 ALJR 484; 8 ATR 569 … Or the donee may to the knowledge of the taxpayer have so arranged its affairs so that it can never beneficially retain the gift … What I am suggesting is that if the taxpayer is aware or suspects that his gift will not benefit the prescribed body the element of benefaction essential to the notion of “gift” … may be missing.

Benefaction need not be the sole motivation of a gift and a deduction is not denied because a taxpayer is partly motivated by the tax deduction available: FCT [page 595] v Copplestone (1981) 12 ATR 358; 81 ATC 4550. Further, the transferor must not receive a material benefit or advantage in return for transferring the gift to the transferee. Only benefits which are material will disqualify the transfer from being recognised as a gift. Whether a

transferor has received a material benefit or otherwise is a question of fact to be determined by the courts having regard to all of the circumstances surrounding the transfer. In 2010, the Commonwealth Parliament passed amending legislation in the form of the Tax Laws Amendment (Political Contributions and Gifts) Act 2010 (Cth), which removed tax deductibility for donations made to political parties. The abolition of tax deductibility of donations to political parties includes donations to independent members and independent candidates. This Act received the Royal Assent on 15 March 2010.

Public benevolent institutions 9.47 Under Table 4 ‘Welfare and rights’ (see s 30-45), reference is made to a ‘public benevolent institution’. The meaning of the term was considered by the High Court in Maughan v FCT (1942) 2 AITR 365. McTiernan J said (at 367–8): The term “public benevolent institution” is not a term of art. Its meaning may be governed by the context in which it is found. There is nothing to indicate that the expression in [former ITAA36 s 78] has any other meaning than its ordinary meaning … [T]he common understanding of the words “benevolent institution” when used together is a body organised for the relief of poverty or distress … The institution is not incapable of being properly described as a public benevolent institution because it is not owned or controlled by the Government. It would be contrary to a considerable volume of judicial authority to say that such is the only test whether an institution is public.

A state fire brigade board is not a public benevolent institution but an enterprise charging a fee for services performed: AAT Case 6086 (1990) 21 ATR 3549; Case X64 90 ATC 487. The levying of a fee is not a critical consideration; however, in Commr of Pay-Roll Tax (Vic) v Cairnmillar Institute (1992) 23 ATR 314; 92 ATC 4307, an institute that provided clinical and counselling facilities for psychological, spiritual and social disorders was held to be a public benevolent institution even though it charged for services and was not confined to serving those in poverty or distress.

Environmental organisations 9.48 Gifts to environmental organisations (Table 6 in s 30-55) are deductible only if the organisation is entered on the register of

environmental organisations kept under Subdiv 30-E: s 30-15. To be entered, criteria in ss 30-260–30-275 must be satisfied. Matters covered include non-distribution of profits to members, statement of objects and dissolution clauses that require assets to be transferred to another organisation on the register.

Sports and recreation 9.49 Table 10 ‘Sports and recreation’ (see s 30-90) includes the Australian Sports Foundation, Girl Guides Australia, Scout Association of Australia, Bradman Memorial Fund and Amy Gillett Foundation; however, payments to a football or other sporting club will not become tax deductible simply by channelling them through [page 596] the Australian Sports Foundation. In these circumstances, it will not normally be possible to say that there was no material advantage accruing to the donor or that the payments were outside ordinary contractual obligations: see Klopper v DCT (1997) 34 ATR 650; 96 ATC 2020.

Philanthropic trusts 9.50 Table 11 ‘Philanthropic trusts’ (see s 30-95) includes the Playford Memorial Trust, Sir Robert Menzies Memorial Foundation, Winston Churchill Memorial Trust, Foundation for Young Australians and Visy Cares.

Cultural organisations 9.51 Table 12 ‘Cultural organisations’ (see s 30-100) includes a public fund that, when the gift is made, is on the register of cultural organisations kept under Subdiv 30-F. The register of cultural organisations includes a public library, public museum and public art gallery. Included under Table 12 are culturally specific organisations,

such as the Australiana Fund, Australian Business Arts Foundation Ltd and Ranfurly Library Service Incorporated.

Testamentary gifts 9.52 In general, testamentary gifts are not tax deductible. There are circumstances where testamentary gifts of property (other than land or buildings) will qualify under the Cultural Bequests Program and be tax deductible. To be eligible, among other things the gift must be made to the Australiana Fund, a public library or art gallery and must be accepted for inclusion in a collection maintained or being established at the institution.

Valuation requirements 9.53 Subdivision 30-C covers valuation requirements. Gifts of property require at least two written valuations by approved valuers stating the market value of the property at the date of gifting not more than 90 days before the date of gift. Where a gift of property is made on a conditional basis, the allowable deduction is reduced to an amount reasonable in the circumstances.

Division 32: Entertainment expenses (former ITAA36 s 51AE) 9.54 Deductions for the cost of entertainment that might satisfy s 8-1 are denied under Div 32, except in limited circumstances. Three provisions set out the basic machinery: 32-5 No deduction for entertainment expenses To the extent that you incur a loss or outgoing in respect of providing entertainment, you cannot deduct it under section 8-1. However, there are exceptions, which are set out in Subdivision 32-B. [page 597] 32-10 Meaning of entertainment (1) Entertainment means:

(a) entertainment by way of food, drink or recreation; or (b) accommodation or travel to do with providing entertainment by way of food, drink or recreation. (2) You are taken to provide entertainment even if business discussions or transactions occur.

32-15 No deduction for property used for providing entertainment To the extent that you use property in providing entertainment, your use of the property is taken not to be for the purpose of producing assessable income if section 32-5 would stop you deducting a loss or outgoing if you incurred it in the income year in providing the entertainment.

The object of these provisions is to deny a deduction otherwise allowable under the Act. Thus, in order for s 32-5 to apply, the loss or outgoing must satisfy s 8-1. If property the subject of depreciation is used for entertainment purposes, s 32-15 deems it not to be held for income-producing purposes and, as a result, the depreciation deduction is denied.18 The definition of ‘entertainment’ is circular: ‘entertainment means entertainment (by way of food, drink or recreation)’. Section 32-10 provides as examples of entertainment: business lunches; and social functions. It also includes examples of what is not entertainment: meals on business travel overnight; theatre attendance by a critic; a restaurant meal of a food critic. Clearly, that the food eaten in these examples is consumed in the course of income-producing activities is not a critical element. Presumably, employees at a business lunch are entertained, whereas the food critic is not. Both ss 32-5 and 32-15 use the words ‘to the extent’ and, therefore, clearly invite apportionment both between expenditure that is entertainment and that which is

[page 598] not and between that which is entertainment and that which is excepted under ss 32-20 and 32-25. Division 32 is directed at business lunches, cocktail parties and socials, leisure pursuits such as cruises, joy flights and tours, holidays and travel, tickets to theatrical and sporting events and entertainment allowances. The use of property is also entertainment where the usefulness of the property is consumed or expires (such as the use of a sponsor’s box at a sporting event). While the cost to an employer of a staff Christmas party is not deductible, the Commissioner has indicated that inexpensive gifts of food on occasions such as Christmas will be allowable: Miscellaneous Taxation Ruling MT 2042. Morning and afternoon teas are also not regarded as being entertainment, nor are light lunches provided to employees during the working day: Taxation Ruling IT 2675. The more elaborate the food and its presentation, the more likely it is to be entertainment but even the consumption of alcohol need not be entertainment when it is incidental to some work-related activity as opposed to a social occasion: TR 97/17. For example, where an employee travelling in the course of employment duties consumes alcohol with a meal, the cost will be an allowable deduction.

Exceptions 9.55 Two groups of exceptions are available. Under s 32-20, entertainment provided as a fringe benefit is excepted.19 The second group is excepted by virtue of s 32-30 and five tables of items covered are set out in ss 32-30–32-50. Definitions relevant to these exceptions are provided in Subdiv 32-C. The principal exceptions are as follows.

Employer expenses: s 32-30 9.56 Section 32-5 does not deny a deduction for the cost of food and drink to employees in an in-house dining facility. This is defined as a canteen or dining room (not open to the public) on property occupied

by the employer and operated mainly for providing food and drink to employees: s 32-30 item 1.1. The exception does not extend to food and drink provided at a social function. In the case of non-employees who use an in-house dining facility, an employer has a choice: either the cost is deductible, in which case an amount of $30 is assessable for each meal provided (s 32-70(1)); or the employer can elect not to claim the costs of the meals (s 3270(2)). The exception covers the cost of food and drink provided to an employee under an industrial instrument relating to overtime and to property such as in-house recreation facilities operated wholly or principally on working days by employees. A recreation facility excludes accommodation and dining and drinking facilities: s 32-30 item 1.5. [page 599] An entertainment allowance paid to an employee is excepted provided it is included in the employee’s assessable income. However, allowances paid to an employee’s spouse or relative are not excepted: s 32-30 item 1.8.

Seminar expenses: s 32-35 9.57 Excepted costs include the cost of providing food, drink, accommodation or travel reasonably incidental to attending a seminar of at least four hours’ duration: s 32-35 item 2.1. A seminar includes a conference, convention, training session, etc and the four-hour requirement does not include time for meals, rest or recreation. Seminars solely for the training of staff (employees, including partners and directors) and/or to enable staff to discuss policy and management issues will qualify as an eligible seminar provided they are conducted on premises operated by an unrelated party in the business of organising seminars or making property available for seminars: s 32-65. The exception under s 32-35 does not apply if the seminar has a

dominant purpose of promoting or advertising the business or the goods or services it provides. It does not apply either if it could be concluded that the dominant purpose of the seminar is the provision of entertainment.

Entertainment industry expenses: s 32-40 9.58 The cost of providing entertainment in the ordinary course of business, such as in the tourism, travel and hospitality industry, is excepted under s 32-40. In addition, costs are deductible for providing meals to employees on working days by a restaurant or other dining facility operated from property occupied for the purpose of providing a dining facility: s 32-30 item 1.3. Again, the exception does not cover social occasions.

Promotion and advertising expenses: s 32-45 9.59 Where pursuant to a contract for the supply of goods and services a taxpayer provides entertainment, the cost of the entertainment is excepted under s 32-40. For example, the exception covers incentives granted to customers by way of prizes that are in the nature of entertainment, such as discounted theatre tickets and free or discounted food. The exception extends to entertainment incurred in the course of advertising goods provided it is available to ordinary members of the public rather than to select groups such as clients or suppliers. This covers, for example, firework displays and promotions at sporting arenas and shopping malls.

Other expenses: s 32-50 9.60 Other excepted expenses are for the cost of food and drink to do with working overtime where an allowance is paid under an industrial instrument. Thus, an allowance is deductible to the employer, assessable to the employee and the employee may claim costs incurred. The exception also covers costs of providing free entertainment to members of the public who are sick, disabled, poor or disadvantaged.

[page 600]

1.

Wilson Partners are a firm of accountants planning to conduct a one-day seminar for partners and staff. The object is to review the firm’s strategic plan and marketing strategy. It is proposed to invite the spouses of partners and managers to hear the keynote address by a visiting American expert. It is proposed the firm will provide breakfast and a working lunch. The day will conclude with a formal dinner to which spouses will be invited and the ‘employee of the year’ will be announced. The venue is yet to be decided but will be either the firm’s boardroom or a small convention centre at a nearby hotel. (a) Advise the firm on the tax matters to be considered in selecting the venue and who should attend. (b) Which of the following amounts would be tax deductible (depending on the chosen venue)?

venue hire (if relevant) visual aids breakfast and lunch formal dinner

(a) in the boardroom (b) at the convention centre

(a) at a nearby restaurant (b) at the convention centre fee, accommodation and meals for the American expert. 2.

The Big Red Wine Cellar is a retail liquor outlet. Two or three times a year the proprietor arranges free of charge a tasting of vintage wines to which selected customers are invited. Cheese and biscuits are also provided. Advise the proprietor. A suggested solution can be found in Study help.

Division 34: Non-compulsory uniforms (former ITAA36 s 51AL) 9.61 An employee is denied a deduction for the cost of a noncompulsory uniform unless two conditions are satisfied: first, the

amount must satisfy s 8-1; second, the design of the uniform has been registered by the Industry Secretary. An employee is defined for purposes of fringe benefits tax (see 7.14) and, in general, includes a person who receives payment in the form of salary and wages in return for work or services rendered. A uniform is clothing that identifies the employee as being associated with a particular employer. It is non-compulsory unless there is a deliberate policy by the employer requiring all similar employees to wear a particular uniform. The denial does not extend to clothing described as ‘protective clothing’ nor to ‘occupation-specific clothing’ such as a nurse’s uniform. [page 601]

Division 36: Tax losses of earlier income years (former ITAA36 s 79E) 9.62 Income tax is an annual levy. Section 3-5 provides that income tax is payable for each year by each individual and company and by some other entities. Under s 4-10(2), tax liability is calculated by reference to taxable income for the income year. This partitioning of a taxpayer’s life into 12-monthly periods is a practical if artificial division. Seldom is it feasible to wait until the completion of the taxpayer’s economic life to assess taxes. Under s 4-15, taxable income is assessable income minus deductions. In any one year, it is possible that deductions exceed assessable income. In order to link the loss year to future years, the Act provides for the recognition of a ‘tax loss’ and machinery in Div 36 permits a taxpayer to carry forward tax losses and offset them against the assessable income of subsequent years. Such losses may be carried forward indefinitely or until they are recouped. A number of special rules affecting tax loss deductibility are addressed in 9.67. In a recent AAT decision in Cachia v FCT (No 2) 2005 ATC 2297, the tribunal found against a taxpayer claiming prior year losses. In

reaching its decision, the tribunal stated that, under s 4-15, there exists a requirement that in order to calculate taxable income for a particular year, any deductions must be taken away from the income year. Further, the tribunal stated that, under s 4-15, a taxpayer cannot take away a previous year’s deductions from an income year except for prior year losses.

Tax loss defined 9.63 In order for a tax loss to arise, deductions must exceed total income, not just assessable income. A loss is defined and calculated as provided in s 36-10: 36-10 How to calculate a tax loss for an income year (1) Add up the amounts you can deduct for an income year (except tax losses for earlier income years). (2) Subtract your total assessable income. (3) If you derived exempt income, also subtract your net exempt income (worked out under section 36-20). (4) Any amount remaining is your tax loss for the income year, which is called a loss year.

That is: Tax loss: D > AY + NEY where: D = deductions (exclusive of any past year loss deduction) AY = assessable income NEY = net exempt income. [page 602] Natural persons, trustees and companies may deduct past losses carried forward if certain conditions are satisfied. Partnerships do not carry forward losses. The losses are distributed to the partners according to their profit-sharing ratio: ITAA36 s 92. Individual partners

are entitled to deduct their share of the partnership loss, or carry forward any overall tax loss, as the case may be. Broadly, a loss is identified with the year in which it is incurred. Losses incurred after the income year 1989–90 may be carried forward indefinitely. Losses may not be carried back, although that is not quite true for long-term contractors: see ITAA36 s 170(9). Thus, where there is no exempt income: Tax loss = D ‒ AY If there is net exempt income: Where D = AY + NEY, the loss is nil. Where D > AY + NEY, the loss is the difference.

Tax losses transferred within a group 9.64 In two recent decisions by the Federal Court, the issue of transfer and timing of tax losses arose for consideration. In Keycorp Ltd v FCT 2007 ATC 4176; [2007] FCA 41, the Federal Court was asked to determine whether a transfer of part of a tax loss, which was incurred by the taxpayer in part of an income year involving subsidiary companies within a group, was allowable under ITAA97 Div 170. Allsop J concluded (at [85]–[86]): Ultimately, I think the matter is capable of being rendered to one issue: Is Division and, in particular, s 170-10 directed in any circumstances to the transfer of a tax that is referable to part of an income year and as such able to be described as “part tax loss for an income year?” The view that I have come to is that the answer to question is “no”.

170 loss of a this

Tax loss transfer agreements 9.65 Having decided the matter against the taxpayer in Keycorp, the Federal Court was asked to determine the issue of a loss transfer agreement involving subsidiaries within a related group. In BHP Billiton Direct Reduced Iron Pty Ltd v Duffus, DCT 2007 ATC 5071; [2007] FCA 1528, the Federal Court was asked to decide whether the Commissioner’s refusal to extend the time for making an agreement relating to a loss transfer agreement under s 170-50(2)(d) was valid. The taxpayer requested an extension of time to transfer a loss of

$89,848,357 from BHP Billiton Direct Reduced Iron Pty Ltd to a related entity, BHP Development Finance Pty Ltd. The Federal Court disagreed with the Commissioner’s ruling under review. French J set out (at [122]) a number of factors which are relevant for the Commissioner to take into account when exercising his discretion under s 170-50(2)(d): (i)

The length of the delay in making the agreement. If the delay is short that would be a factor which, depending upon its explanation, will weigh against any adverse impact on good administration.

[page 603] (ii) The explanation for the delay. If a delay has occurred by reason of error or inadvertence on the part of the taxpayer rather than an unwarranted assumption that time would be extended, that may be a factor weighing in favour of the exercise of the discretion to extend time. The Commissioner would, at the same time, be entitled to take the view that corporate taxpayers should have in place systems to ensure that error and inadvertence do not occur and that, absent such systems, error or inadvertence may not warrant the grant of the extension sought. (iii) The delay being the product of an understanding or arrangement with the Commissioner to defer making the transfer agreement until the tax position of the relevant companies for the income year in question has crystallised. While such understandings or arrangements would not give rise to an “administrative estoppel” it would be a mandatory relevant consideration to ensure that the primary purpose of the loss transfers facility is not defeated by the Commissioner’s own actions. (iv) Related to the above, whether the group has kept the Commissioner informed of its intention to seek to effect a transfer of losses upon crystallisation of the tax position of relevant companies in the group. (v) As was set out at [20] of Taxation Ruling TR 98/12, where an agreement is made out of time as the result of an adjustment to the tax position of the company group by the Commissioner, that may be a factor weighing in favour of the exercise of the discretion. However, where the adjustment and the consequential delay is the result of fraud or evasion on the part of a company in the group, then that is a factor which would weigh against the exercise of the discretion. The refusal to extend time in such a case would be based on the entirely legitimate consideration that time should not readily be extended for a delay flowing from an unsuccessful attempt to defeat the broader policy objectives of the ITAA 1997. (vi) Whether the delay would have any adverse impact on the administration of the Act

if the extension of time were allowed.

Net exempt income 9.66 The tax loss provisions were enacted on the assumption that tax losses should not receive a double benefit. While the tax loss can be carried forward, no loss in fact arises unless deductions exceed all income, that is, assessable income plus net exempt income. Simply stated, net exempt income is exempt income less the costs of deriving it. The term is defined in s 36-20 as follows: for a resident, net exempt income is all exempt income (except ‘excluded exempt income’)20 less non-capital losses and outgoings incurred deriving the income, less any foreign taxes on the exempt income; for a non-resident, net exempt income is, broadly, all Australiansource net exempt income21 less non-capital losses and outgoings incurred deriving the income, less any taxes on the exempt income. [page 604]

Deducting tax losses 9.67 In the course of recouping tax losses, the loss is first offset against any net exempt income and then recouped against the excess of assessable income over deductions: s 36-15. That is: No net exempt income in year of recoupment: [AY − D] − Tax loss Net exempt income in year of recoupment: [AY − D] − [NEY − Tax loss] Tax losses are recouped in the order they arise. Any tax loss not recouped in one year is carried forward to be offset successively against net exempt income and then the excess of assessable income over deductions.

Non-deductible amounts: s 26-55 9.68 Certain specific amounts that are allowable as deductions in normal circumstances are prevented by s 26-55 from creating or increasing a tax loss: see 9.43. The principal relevant provisions are: s 25-50 — pensions, gratuities and retiring allowances; Div 30 — gifts to approved bodies and institutions (however, deductions can be spread over a period of up to five years); s 290-150 — superannuation contributions. Section 26-55 does not apply to these items if they are deductible under some other provision but for the operation of s 8-10. Consider the following example.

Tom has been a retailer for a number of years. Trading has been poor but is beginning to improve. He also derives income from the Australian Army Reserve (exempt under s 51-5 item 1.4). He makes a gift to Community Aid Abroad (CAA), deductible under Div 30. He presents the following information: Yr 1

Yr 2

Yr 3

Yr 4

Current

Trading income (loss)

($10,000)

($20,000)

$5,000

($15,000)

$50,000

Cash gift CAA

$1,000

$1,000

$1,000

$1,000

$1,000

Army income

$2,000

$2,000

$2,000

$2,000

$2,000

What is Tom’s tax position at the end of each year? Yr 1: There is an excess of deductions over assessable income from trading activities and a tax loss is imminent. Section 26-55 prevents a deduction for CAA. The army income is exempt. The tax loss is $10,000 − $2000 = $8000. [page 605]

Yr 2: As above; tax loss is $20,000 − $2000 = $18,000. Carry forward loss $26,000. Yr 3: Assessable income exceeds deductions by $5000; s 26-55 does not apply, the CAA amount of $1000 is deductible. Prior losses must be offset first against net exempt income [$26,000 − $2000 = $24,000] and can be recouped in part: $24,000 − $4000 = $20,000 carry forward loss. Yr 4: As in Yrs 1 and 2. Loss is $15,000 − $2000 = $13,000 + $20,000 = $33,000 carry forward loss. Current: Taxable income is $18,000. All losses are recouped.

Matters affecting tax losses 9.69

The following matters will affect tax losses: Division 35 operates from 2000–01 to prevent losses from ‘noncommercial business activities’ carried out by individuals (alone or in partnership) being offset against income from other sources unless certain tests are satisfied or the Commissioner exercises a discretion. Such losses must be carried forward to be offset against income in subsequent years from the particular activity. To be deductible, one of the following tests must be satisfied (ss 35-30– 35-45): – assessable income from the activity is at least $20,000 pa; – the reduced cost bases of real property used in the activity must be at least $500,000; – the value of other assets (excluding motor vehicles) is at least $100,000 (being the written down value of depreciated assets, trading stock and other property); – the activity generated taxable income in three of the last five years (including the present year). The Commissioner has a discretion to allow the loss in special circumstances — such as natural disasters — or where the activity has commenced and there is an expectation that it will be commercially viable: s 35-55. The object of Div 35 is business activities and it does not apply to non-business pursuits such as investment and rental activity. It

does not apply to primary production business or a professional arts business where assessable income from other sources is less than $40,000: s 35-10(4). Bankruptcy: Where a taxpayer has been declared bankrupt or is later released from bankruptcy because creditors have accepted a composition, s 36-35 prevents the taxpayer from claiming a deduction for the tax loss incurred prior to bankruptcy or release of debts. Special rules relate to the deductibility of prior year losses for companies: see Divs 165, 166 and 175, discussed in Chapter 12. The rules relate to private and public companies but place a heavier obligation on private companies to [page 606] demonstrate that they comply with the rules. The rules are designed to halt trafficking in loss companies and to ensure that substantially the same group of shareholders that owned the company when the loss was sustained benefit from its recoupment. In effect, to recoup a prior year loss, companies must satisfy one of two continuity tests: – that, at all times during the year of loss and year of recoupment, there must be more than 50% continuity in ownership; or – that, at all times during the year of loss and year of recoupment, the company must carry on the same business. Capital losses within the meaning of the CGT provisions are not covered by the rules discussed above. While a prior year revenue loss may be recouped against a capital gain (being part of assessable income), a capital loss must be carried forward and offset against future capital gains. The rules relating to prior year losses discussed above do not apply to foreign losses. Resident Australian taxpayers who derive

losses from dealings outside Australia are covered by ITAA36 ss 79D and 160AFD. In effect, losses are quarantined according to the class of income and can be recouped only against subsequent income from the same class. In the May 2009 Federal Budget, the then Treasurer announced amendments which were designed to tighten the application of the noncommercial losses rules in relation to individuals with an adjusted taxable income of over $250,000. The Tax Laws Amendment (2009 Measures No 5) Act 2009 (Cth) introduced a new income test under ITAA97 Div 35, which is designed to prevent high-income individual taxpayers from offsetting deductions from non-commercial business activities against their salary or other income. The income requirement is met when an individual has an adjusted taxable income of less than $250,000 in the relevant income year. Hence, under the amendment, losses from non-commercial business activities must be quarantined unless the income requirement is met and at least one of the following objective tests is met: assessable income from the activity is at least $20,000 pa; the reduced cost bases of real property used in the activity must be at least $500,000; the value of other assets (excluding motor vehicles) is at least $100,000 (being the written down value of depreciated assets, trading stock and other property); the activity generated taxable income in three of the last five years (including the present year). The income requirement of adjusted taxable income of less than $250,000 is met when, in any given income year, the sum of an individual’s taxable income, reportable fringe benefits, reportable superannuation contributions and total net investment losses is less than $250,000.

Divisions 28 and 900: Car, work and business expenses, and substantiation 9.70

The primary sources of deductions for both business and

employee taxpayers is the general deduction provision, s 8-1. Specific deductions addressed in Divs 25 [page 607] and 26 have been discussed above. Superimposed on this machinery is an additional layer of requirements. Three classes of expenditure are deductible only if, in addition to the criteria under the appropriate provision, they can be substantiated, meaning that documentary evidence can be produced to support the claim. The classes of expenditure are: car expenses; work expenses; business travel expenses. The rules relate to individuals and partnerships but not to companies and trusts. The additional rules are set out as follows: car expenses (Div 28 and Subdiv 900-C); work expenses (Subdiv 900-B); business travel expenses (Subdiv 900-D). Car expenses differ from the other two categories in that Div 28 provides two options for determining the amount of deductible car expenses that do not require the documentary evidence of the substantiation provisions. However, two further options do require substantiation pursuant to Subdiv 900-C.

Division 28: Car expenses 9.71 A car expense is a loss or outgoing (including depreciation) to do with a car. It does not include travel outside Australia or taxi fares and the like: s 28-13. To be deductible, car expenses must first satisfy ss 8-1 and 25-10, in respect of repairs, and the depreciation provisions. Division 28 offers taxpayers a choice of four methods of calculating the value of the deductible amount. Two of the methods apply statutory

rules that do not require substantiation and two require record-keeping of varying detail. The four options are set out in Table 9.1. Table 9.1: Calculating deductible car expenses Method Rules Substantiation requirements

1.

1.

Cents/km (Subdiv 28-C)

5000 km maximum

None required

2.

12% of cost (Subdiv 28-D)

5000 km minimum

Substantiation of car expenses not required

3.

One-third of expenses (Subdiv 28-E)

5000 km minimum

Substantiation of car expenses

4.

Log book (Subdiv 28-F)

no limit

Substantiation of car expenses and log book

The taxpayer may make a reasonable estimate of business-related car travel, subject to a maximum of 5000 km and multiply by the appropriate kilometre [page 608]

2.

3.

rate: s 28-25. If travel exceeds 5000 km, the deduction is limited to 5000 multiplied by the appropriate rate. No documentary evidence is required (although the basis of estimate should be supportable). The kilometre rates depend on engine capacity and are published annually in TaxPack. The deductible amount is calculated as 12% of the original cost of the car: s 28-45. For this option to be available, business-related travel must exceed 5000 km. No log book or documentary evidence in relation to fuel etc, need be maintained. Method 3 provides for a deduction of one-third of car expenses. Written evidence in the nature of a receipt or invoice is required for fuel, servicing, depreciation etc, but it is unnecessary to maintain a log book. However, a taxpayer may keep a log book record of odometer readings from which estimates can be made of

fuel and oil consumption. 4. The log book method requires the maintenance of odometer records for a representative period of 12 weeks in the first year and thereafter every five years. As with Method 3, fuel and oil usage may be estimated from these records but other expenses require documentary evidence. Subject to the distance travelled, any one method may be used for a particular car in a given year and it is possible to switch methods in different years.

Subdivision 900-C: Work expenses 9.72 A work expense is a loss or outgoing incurred in producing salary and wages: s 900-30. ‘Salary and wages’ is defined in ITAA36 s 221A. A work expense specifically includes a travel allowance expense and a meal allowance expense being accommodation, food and meal expenses where a travel allowance or meal allowance is paid. It also includes depreciation of property used to derive salary and wages. Notwithstanding satisfaction of relevant deduction provisions, such expenses are deductible only if written evidence can be produced. There are a number of exceptions to the requirement that written evidence be retained. For example: if the total of work expenses (including ‘laundry expenses’) is not more than $300: s 900-35. Note the amount of $300 is a limit, not a threshold — if expenses are $350, the full amount must be substantiated, not $50; if ‘laundry expenses’ do not exceed $150 (s 900-40); if the expense is a ‘transport expense’ pursuant to an allowance paid under an industrial award (s 900-45); if the expense is a ‘travel allowance expense’ for travel within Australia, provided the Commissioner considers total travel expenses are reasonable (s 900-50) (travel outside Australia is covered by a similar rule, subject to certain requirements (s 90055)); if the expense is a ‘meal allowance expense’ paid as a result of

overtime or paid under an industrial award (s 900-60). [page 609]

Subdivision 900-D: Business travel expenses 9.73 A business travel expense is a travel expense incurred in gaining assessable income other than salary and wages: s 900-95. Travel allowance expenses are treated as work expenses. Business travel expenses are deductible only if they can be substantiated by written evidence as required by Subdiv 900-E. Principal among the requirements is a ‘travel record’ that records activities undertaken during the course of travel and how they relate to the earning of income. Accounts, invoices etc, relating to costs must also be retained.

Subdivision 900-E: Record-keeping requirements 9.74 The record-keeping requirements needed to substantiate expenditure are set out in Subdiv 900-E. For example, under s 900-115, a taxpayer must obtain from the supplier of goods or services a document (such as a receipt or invoice) showing: the supplier’s name; the amount paid; the date of the document; and the date when the expense was incurred and details of the expense. If the expense is not more than $10 (and the aggregate of all such expenses is less than $200), the taxpayer may simply record the expense instead of obtaining the above documents. In addition to documents relating to particular expenses, a travel diary must be kept for work-related and business travel. The diary or similar journal must show the nature of the activity, its location and the date, time and duration. Substantiation documents must be kept for five years after the

lodgment of a tax return. There is only limited scope for relief from the substantiation requirements: Subdiv 900-H. The production of alternative evidence could suffice. There may also be relief where the taxpayer had a ‘reasonable expectation’ that compliance was unnecessary or where documents are lost or destroyed.

Division 27: Effect of input tax credits, etc on deductions 9.75 Division 27 is concerned with the effect of input tax credits on general and specific deductions. Section 27-5 disallows a deduction for a loss or outgoing incurred to the extent that it includes an ‘input tax credit’. An input tax credit arises when an entity carrying on a business acquires goods and services. Except in the case of a limited range of input-taxed supplies, the business will offset the input credits against any GST on goods and services sold to its own customers. For example, a shoe store acquiring trading stock for $1100 (including GST) is entitled to a deduction for $1000; $100 is an input tax credit. However, an employee acquiring a pair of (deductible) safety boots from the store for $110 (including GST) is entitled to a deduction for $110. [page 610]

The remaining ITAA36 framework 9.76 Several provisions of the ITAA36 have yet to be rewritten and continue to operate as part of the ITAA36 framework. These include: ss 82KZL–82KZO (prepaid expenses); ss 82KH–82KL (losses and outgoings incurred under certain tax avoidance schemes); ss 51AF and 51AGA (motor vehicle and car parking expenses); and s 51AH (reimbursements), s 51AJ (private contributions to fringe benefits) and s 51AK (non-cash business benefits).

ITAA36 ss 82KZL–82KZO: Prepaid expenses 9.77 Subject to ITAA36 s 82KZM, a deduction is allowable when it is incurred for the purposes of ITAA97 s 8-1. A loss or outgoing will be incurred when it is paid, and a payment includes a prepayment. There has been no High Court decision that requires the amortisation of an allowable deduction over the lifetime of the benefits derived. However, statutory rules operate to amortise prepaid expenditure over the eligible service period. For the prepayment rules to apply, the expenditure must satisfy ITAA97 s 8-1. There are three classes of ‘excluded expenditure’ (ITAA36 s 82KZL(1)): 1. amounts less than $1000; 2. expenditure required by law or a court order; 3. payments under a contract of service (eg, wages and salary). The rules operate at two levels: 1. From 1 July 2001 to 30 June 2007, small business taxpayers who have adopted the simplified tax system (STS) accounting method (see 4.34) and non-business individuals. After 1 July 2001, prepaid expenditure incurred by a small business taxpayer (average annual turnover less than $1m) and non-business expenditure incurred by individual taxpayers will be deductible when incurred, provided the services are performed within 12 months. Prior to 1 July 2001, a 13-month rule applied. Otherwise, the amount is deductible over the period during which the services are performed, (the ‘eligible service period’) or a maximum of 10 years.

1.

On 1 February 2017, Kath (an employee obfuscator) pays $1450 to the Certified Obfuscators Association for a two-semester continuing professional education course. The amount is deductible (s 8-1) in the year of payment.

[page 611] 2.

On 1 December 2013, Kim, a small business taxpayer, pays $5000 for three years rent of business equipment. As the eligible service period exceeds 12 months, the payment is amortised as follows: 2013–14

213/1096 × 5000

=

972

2014–15

365/1096 × 5000

=

1665

2015–16

365/1096 × 5000

=

1665

2016–17

153/1096 × 5000

=

698 $5000

2.

Other businesses.

9.78 For business taxpayers who are not in the STS system (and nonindividuals that do not carry on business), ITAA36 ss 82KZMA– 82KZMD apply. Expenditure (other than ‘excluded expenditure’) made for services not wholly provided in the ‘expenditure year’ is amortised over the period of the services (the ‘eligible service period’) as in Example 9.5, illustration 2, above. The essential difference between the two groups is that a 12-month rule applies to the former. Prepaid expenditure under what are called ‘tax shelter’ arrangements is also apportioned, being spread evenly over the relevant years of the service period: ITAA36 s 82KZMF. A feature of such arrangements is that a taxpayer’s allowable deductions for the ‘expenditure year’ under the arrangement exceed the year’s assessable income from the arrangement and the taxpayer does not have day-to-day control over the operation (eg, prepaid management fees).

ITAA36 ss 82KH–82KL: Losses and outgoings incurred under certain tax avoidance schemes 9.79 In addition to the blanket anti-avoidance provision of ITAA36 Pt IVA, the Act contains many specific anti-avoidance provisions designed to overcome particular abuses of the legislation: for instance, ITAA97 s 26-35 gives the Commissioner a discretion to ensure

deductions claimed for remuneration paid to a relative are reasonable, and ITAA97 s 70-15 prevents the misuse of trading stock provisions. In particular, machinery in ITAA36 ss 82KH–82KL (Subdiv D of Pt III Div 3) is aimed at preventing abuse of general and specific deduction provisions by use of inflated invoice values, dealings not at arm’s length, prepayment schemes to obtain a deduction while delaying the time of assessment by the recipient, etc. ITAA36 Pt III Div 3 Subdiv D is arranged as follows: Section 82KH provides complex pivotal definitions designed to particularise the provisions where limits are placed on deductions under conditions set out in following provisions within the Subdivision. [page 612] Section 82KJ denies ‘inflated prepayment scheme’ deductions where an associate receives a benefit as a result of the scheme. Section 82KJ denies a deduction for all time if the inflated prepayment scheme is established to the Commissioner’s satisfaction, even if later the associated recipient is assessable on the amount of the denied deduction claimed earlier by the payer. It should be noted that ordinary arm’s length prepayments are deductible under ITAA97 s 8-1 subject to the limitations of ITAA36 s 82KZM (above at 9.77). Section 82KK denies a deduction where a claim is made for an expense incurred to an associate and the associate has no equivalent assessable income. The deduction is postponed until the two are synchronised. For example, a resident company may incur an interest expense to a non-resident, which is simply accrued rather than paid. The accrued amount is not deductible until the actual remittance. Section 82KL is similar to s 82KJ in many respects, and denies a deduction if the sum of the additional benefit and the potential

tax saving is greater than the eligible expenditure: s 82KH(1F).

ITAA36 ss 51AF and 51AGA: Car parking expenses 9.80 Where an employer provides a motor vehicle for exclusive use by an employee (or relatives), expenses incurred by the employee in connection with the car are specifically denied by ITAA36 s 51AF. Under s 51AGA, a deduction is denied to an employee for the cost of parking a vehicle used for travel from home to work in the vicinity of a primary place of employment for more than four hours between 7 am and 7 pm.

ITAA36 ss 51AH, 51AJ and 51AK: Non-cash business benefits 9.81 ITAA36 ss 51AH and 51AJ respectively disallow a deduction to employees for expenditure reimbursed by an employer and for the private component of any contribution towards a fringe benefit. ITAA36 s 51AK operates where, in order to induce a taxpayer to make an outlay, an additional non-business benefit is provided. The effect of s 51AK is to reduce the amount allowable as a deduction by the value of the benefit.

ITAA97 Pt 2-42 Divs 84–87: Personal services income 9.82 ITAA97 Pt 2-42 Divs 84–87 could be described both as specific anti-avoidance measures and specific denying provisions. The provisions operate from 1 July 2000 and were enacted on the recommendation of the Review of Business Taxation (Ralph Review). The broad thrust of the measures is as follows: Division 85 limits the entitlements of individuals to deductions relating to their personal services income.

[page 613] Division 86 sets out the tax consequences of the diversion of individuals’ personal services income through entities such as companies and trusts (income alienation). Between them, these Divisions reflect two views of the Ralph Review. First, that a degree of inequity arose in that taxpayers operating through interposed entities could claim deductions not available to employees. Second, the practice of alienating income was growing and posed a threat to the tax base. The effect of Divs 85 and 86 is that failure to satisfy certain tests will mean limiting deductions and attributing to the individual the income derived by the interposed entity. Division 87 excludes a personal services business from the operation of the personal services income regime. In essence, personal services income (PSI) is income derived mainly from personal effort or individual skill — as opposed to the supply of goods or use of property. Whether a personal services business (PSB) exists depends on the entity satisfying tests set out in Div 87. The following ATO flowchart shows how to establish whether PSI is income from a PSB.

Figure 9.1:

PSB flowchart

[page 614] The flowchart illustrates the following features: If the income is not PSI, the rules in Divs 85 and 86 do not apply: see 9.83. If the income is PSI, the rules do not apply if the results test is satisfied: see 9.84. If the results test is failed, the PSI legislation applies unless: – no more than 80% of the income comes from one client; and – any one of the three following tests is satisfied (see 9.85): unrelated clients test

where the income arises from at least two unrelated clients; employment test where at least 20% of the principal work is performed by an employee (or engaged) entity; or business premises test where the activity is conducted from exclusive business premises.

Personal services income (PSI) 9.83

ITAA97 84-5 defines PSI as follows.

84-5 Meaning of personal services income (1) Your ordinary income or statutory income, or the ordinary income or statutory income of any other entity, is your personal services income if the income is mainly a reward for your personal efforts or skills (or would mainly be such a reward if it was your income). Example 1: NewIT Pty Ltd provided computer-programming services but Ron does all the work involved in providing those services. Ron uses the clients’ equipment and software to do the work. NewIT’s ordinary income from providing the services is Ron’s personal services income because it is a reward for his personal efforts or skills. Example 2: Trux Pty Ltd owns one semi-trailer, and Tom is the only person who drives it. Trux’s ordinary income from transporting goods is not Tom’s personal services income because it is produced mainly by use of the semi-trailer, and not mainly as a reward for Tom’s personal efforts or skills. Example 3: Jim works as an accountant for a large accounting firm that employs many accountants. None of the firm’s ordinary income or statutory income is Jim’s personal services income because it is produced mainly by the firm’s business structure, and not mainly as a reward for Jim’s personal efforts or skills.

Income from the supply of goods is clearly outside the ambit of PSI, as is income from the use of assets. In the context of some cases concerned with the derivation of income, PSI would include income of a medical practitioner in Dr Carden’s [page 615]

circumstances (see CT (SA) v Executor Trustee and Agency Co of South Australia Ltd (1938) 63 CLR 108; 1 AITR 416; 5 ATD 98 (Carden’s Case); see 4.6) but not that of a large firm of accountants (as in Henderson v FCT (1970) 119 CLR 612; 1 ATR 596; 70 ATC 4016: see 4.9). The use of the word ‘mainly’ in s 84-5 suggests no more than half of the income must be a reward for personal skill with the other half arising from the use of equipment, the efforts of other workers or other property: see Taxation Ruling TR 2001/07. A conclusion that the income is not PSI of an individual or entity means it is outside the PSI regime.

The results test 9.84 If an individual or a personal services entity carries on a personal services business (PSB), it is outside the PSI rules. That conclusion may follow from a consideration of the factors outlined above or from the application of tests set out in ITAA97 Div 87: see TR 2001/08. The principal test is the results test: ITAA97 s 87-18. An individual or an entity satisfies the results test if, in relation to at least 75% of the PSI: the income is from ‘producing a result’; the individual is required to supply plant, equipment or tools of trade needed to complete the work; liability for the cost of rectifying any defect rests with the individual. The results test applies considerations that historically have been used to distinguish employees and contractors for the purpose of the Pay-AsYou-Go (PAYG) (or Pay-As-You-Earn (PAYE)) withholding tax system. The distinction turns on the common law ‘master–servant’ relationship. Where an entity contracts to perform services, and is in control of the way they are performed, there is a results outcome, as opposed to acting as directed in the manner of a servant. Taxpayers can self-assess whether they satisfy the results test.

The 80% rule and other tests 9.85 Failure to satisfy the results test will mean that, to avoid the PSI rules, the entity must satisfy the 80% rule and one of three additional tests. The threshold requirement is that less than 80% of the individual’s (or entity’s) PSI is from one entity (ie, customer or client and associates). If 80% or more of such income comes from one client, the PSI regime applies unless a PSB determination is obtained from the ATO: see 9.86. Satisfaction of the 80% rule is a threshold requirement, and, in addition, one of the following three tests must be satisfied: 1. Unrelated clients test: This requires that the income is derived from at least two entities that are unrelated to each other or to the taxpayer and that the services are provided as a result of direct offers or invitations to the public; for example, through advertising or tendering. 2. Employment test: An individual satisfies the employment test through the engagement of at least one entity (other than nonindividual associates) that [page 616]

3.

performs at least 20% of the market value of the individual’s principal work. A personal services entity must satisfy the same 20% test and the engaged entity must comprise neither individuals whose PSI is included in the entity’s income nor non-individuals who are associates of the entity. The test is satisfied through the engagement of an apprentice for at least half the year. ‘Principal work’ does not mean incidental administrative or clerical work: TR 2001/8. Business premises test: This requires the maintenance and use throughout the year of business premises that are used to derive the PSI, that are exclusively available to the individual or entity, that are physically separate from any private premises used by the

taxpayer (or associates) and that are physically separate from the premises of the entity for which services are performed. An ‘associate’ is defined in ITAA36 s 318 to include relatives (and their spouses), a partnership in which the person is a partner, trusts in which the person is a beneficiary and companies in which the person (or an associate) holds controlling interests. Commonwealth Government agencies and authorities are not treated as associates for the purposes of the PSI legislation. The 80% threshold and the unrelated clients test are modified in the case of an individual or entity acting as an agent who bears entrepreneurial risk. Essentially, agents (not employees) of principals who earn at least 75% of their fees from performance-based contracts and actively seek customers for the principal will be treated as carrying on a PSB: ITAA97 s 87-40.

PSB determinations 9.86 Failure to satisfy the 80% test is not fatal if the ATO grants a determination that a PSB is being conducted. The Commissioner has a discretion (ITAA97 Subdiv 87-B) to make a determination if satisfied that: for an individual it could reasonably be expected that the results test, the employment test or the business premises test could be satisfied or, but for ‘unusual circumstances’, could reasonably have been expected to satisfy one of the PSB tests; and the individual’s PSI was (or could reasonably have been expected to be) from the individual conducting activities that satisfied one of those tests. Applications must be in the prescribed format and it is possible to object to unfavourable determinations. The Commissioner considers that ‘unusual circumstances’ are temporary exceptions to the norm, which will be resumed in the short term: TR 2001/8. In Metaskills Pty Ltd v FCT 2002 ATC 2274, ‘unusual circumstances’ arose through a combination of factors (pressure of work, introduction of the GST) that would not separately constitute ‘unusual circumstances’.

Attribution of PSI: Div 86 9.87 Where the PSI rules apply, two consequences follow. First, under ITAA97 Div 86, PSI income of an entity is attributed to the individual. Second, under ITAA97 Div 85, deductions available to an individual are limited to those allowable if the income had been received as wages and salary: see 9.89. [page 617] The object of Div 86 is to attribute to the individual ordinary and statutory income that is PSI of an entity such as a partnership, company or trust. This is designed to prevent individuals from reducing tax by splitting or diverting income to lower-taxed individuals: ITAA97 ss 8610 and 86-15. Attribution does not apply to the extent that the entity pays wages or salary to the individual as an employee.22 The amount of attributable income is determined under ITAA97 s 8620 via the following method statement: Step 1:

Step 2: Step 3: Step 4: Step 5: Step 6:

Work out any deductions (other than ‘entity maintenance deductions’ or salary and wages paid to you) to which the entity is entitled that are deductions relating to your PSI. Work out any ‘entity maintenance deductions’ to which the entity is entitled. Work out the entity’s assessable income disregarding any income it receives that is your PSI. Subtract the amount under Step 3 from the amount under Step 2. If the amount under Step 4 is greater than zero, the amount of the reduction is the sum of the amounts under Steps 1 and 4. If the amount under Step 4 is not greater than zero, the amount of the reduction is the amount under Step 1.

See the facts at 9.83, ITAA97 s 84-5(1) Example 1. Assume the following: $120,000 of NewIT’s income is Ron’s PSI.

NewIT has deductions of $50,000 (including superannuation contributions) relating to Ron’s PSI: Step 1. NewIT has entity maintenance deductions of $8000: Step 2. NewIT has investment income of $20,000 (ie, income other than Ron’s or anybody else’s PSI): Step 3. Step 4: Less than zero — ($12,000). Step 5: Does not apply. Step 6: The amount of the reduction is $50,000. The amount included in Ron’s assessable income is: $120,000 ‒ 50,000 = $70,000

[page 618]

Assume alternatively that NewIT’s Step 3 income is only $2000. Step 4: $6000. Step 5: $56,000. Step 6: Does not apply. The amount included in Ron’s assessable income is: $120,000 ‒ 56,000 = $64,000

9.88 Deductions allowable to the personal services entity are set out in ITAA97 Subdiv 86-B. The general rule is that deductions are not allowable to the extent that they relate to the individual’s PSI — except if the individual could have deducted the amounts (or the entity qualifies as a PSB). Deductions allowable to the entity include ‘entity maintenance deductions’: ITAA97 s 86-65. These include bank fees, tax-related expenses (deductible under s 25-5) and registration and lodgment fees imposed by law. Expenses relating to cars used 100% for incomerelated purposes are deductible. Where a car has private usage and FBT

is payable, deductions are allowable for only one car except where there are two or more employees who work independently of each other, in which case, there can be one car each. Superannuation contributions are deductible; however, where there are two or more individuals, deductions are limited to amounts required by the superannuation scheme for an individual performing less than 20% of the entity’s principal work.

Deductions denied: Div 85 9.89 Where an individual earns PSI as a non-employee (other than as a PSB), deductions allowable are limited by ITAA97 Div 85 to those allowable if the individual was an employee. Specific denials include: rent, mortgage interest, rates and land tax relating to an individual’s or an associate’s residence (s 85-15); payments to associates to the extent that they relate to earning your PSI — except to the extent that the associate performs part of the principal work. The same rule relates to contributions to a superannuation fund: ss 85-20 and 85-25. Non-deductible payments are not income of the associate. Deductible superannuation contributions cannot exceed requirements under the superannuation guarantee scheme. On the other hand, s 85-10(2)(a)–(h) specifies a range of expenditures that are excepted from the broad denial: gaining work (such as advertising or tendering costs); insurance for loss of income or earning capacity; public liability or professional indemnity insurance; engaging an entity that is not an associate to perform work; [page 619] engaging an associate to perform principal work; superannuation contributions for yourself;

workers compensation insurance; meeting obligations under the goods and services tax (GST) legislation.

Limited recourse debt: ITAA97 Div 243 9.90 The purpose of the limited recourse debt provisions under ITAA97 Div 243 is to impose an obligation on an entity such as a debtor to pay an amount to another entity (usually the creditor) where the rights of the creditor as against the debtor in the case of default are limited wholly or predominantly to any of the following: rights including (the right to money payable) to the debt property or use of the debt property; goods produced, supplied, carried, transmitted or delivered, or services provided, by means of the debt property; the loss or disposal of the whole or a part of the debt property or of the debtor’s interest in the debt property; rights in respect of a mortgage or other security over the debt property or other property; rights that arise out of any arrangement relating to the financial obligations of an end user of the financial property towards the debtor. Under ITAA97 s 243-20, a conclusion may also be reached that it is reasonable to conclude that the rights of the creditor as against the debtor in the event of default of payment of the debt are capable of being treated as a limited recourse debt based on the following factors: the assets of the debtor (other than indemnities or guarantees that are provided in relation to the debt); any arrangement to which the debtor is a party; whether all of the assets of the debtor would be available for the purpose of the discharge of the debt; whether the debtor and creditor are dealing at arm’s length in relation to the debt.

In the High Court decision FCT v BHP Billiton Ltd (2011) 277 ALR 224; [2011] HCA 17, the High Court dismissed appeals by the Commissioner of Taxation against the decision of the Full Federal Court. The Commissioner had assessed BHP Billiton Ltd under Div 243 on the basis of a number of projects that the company had engaged in which had led to capital allowance deductions being claimed by BHP Billiton Direct Reduced Iron for the years 1996–2002 and by BHP Billiton for the years 2003–06. In 2007, the Commissioner issued new assessments to reduce the tax losses to the other companies in the group. BHP Billiton objected to the Commissioner’s assessment, which was subsequently disallowed. BHP Billiton appealed to the Federal Court, which held that Div 243 did not apply to the arrangement. The Commissioner appealed to the Full Court, which dismissed the Commissioner’s appeal. The Commissioner appealed to the High Court. The High Court held that a [page 620] debt owed by a BHP Billiton subsidiary, BHP Billiton Direct Reduced Iron Pty Ltd, to another subsidiary, BHP Billiton Finance Limited, was not a limited recourse debt within the meaning of Div 243. The High Court rejected the Commissioner’s argument that Div 243 was not concerned with current contractual limitations or rights with economic equivalence but was concerned with a practical capacity to bring restrictions or limitations on legal rights. The High Court’s conclusion meant that the parent entity, BHP Billiton Ltd, was not liable to an increase in assessable income as assessed by the Commissioner. In 2013, the Commonwealth Government introduced amendments to Div 243 following announcements on budget night in May 2012. The amendments were contained in the Tax Laws Amendment (2012 Measures No 6) Act 2013 (Cth). The amendment introduced changes to the definition of ‘limited recourse debt’ under Div 243. Under the amendment, the definition of ‘limited recourse debt’ was clarified to include a debt arrangement where it is reasonable to conclude that the

debtor has not been fully at risk with respect to the debt. This is because the creditor’s recourse for any debt default is limited to the financed property or property provided to secure the debt. The amendment was seen as necessary in light of the High Court decision in BHP Billiton (see above), which had held that the previous definition contained in Div 243 only included debt arrangements where the recourse is contractually limited or is capable of being legally limited.

Forgiveness of commercial debt: ITAA97 Div 245 9.91 The object of these provisions is the anomaly that arises when commercial debts are forgiven. In such a case, the creditor who forgives a debt receives a deduction (either on revenue account or as a capital loss) whereas (generally) the debtor derives no assessable amount. However, instead of denying the particular amount outright, the provisions restrict unrelated deductions that may otherwise be allowable to the debtor. Specifically, the ‘net forgiven amount’ is applied (in order) to reduce the debtor’s ‘reducible amounts’, being four classes as follows: deductible revenue losses deductible under ITAA97 s 36-15 (or foreign losses deductible under ITAA36 s 160AFD); deductible net capital losses; a range of deductible expenditure specified in ITAA97 s 245-140, principal among them being the cost of depreciable plant and capital allowance expenditure; the cost base of CGT assets (excluding goodwill, personal use assets and a principal residence). The ‘net forgiven amount’ must be applied successively against the four classes, but within a particular class, the debtor may choose the amounts. In the event that all amounts within the four classes are annihilated, any remaining forgiven amount lapses.

[page 621]

Commercial debt 9.92 A debt is defined for the purposes of ITAA97 Div 245 as a legally enforceable obligation on one person to pay an amount to another. It does not include debts that constitute fringe benefits. It is a ‘commercial debt’ if the interest would have been deductible to the debtor. If interest is not charged, the debt is still a ‘commercial debt’ if, had interest been charged, it would have been deductible to the debtor.

Debt forgiveness 9.93 A debt is forgiven when it is released, waived or otherwise extinguished, statute-barred, there is a debt-for-equity swap or other ‘in-substance’ arrangements occur: ITAA97 s 245-35. Specifically excluded is debt forgiveness under bankruptcy, under the terms of a will or for reasons of natural love and affection: ITAA97 s 245-40.

Net forgiven amount 9.94 The net forgiven amount is the nominal value of the debt (ie, its market value on the assumption that the debtor could pay all debts) less any consideration (in money or property) paid in respect of the forgiveness. The amount is also net of any amount that has (or will be) included in the debtor’s assessable income, any deduction that has (or will be) reduced or the amount by which the cost base of any asset of the debtor is reduced. Where the debtor and creditor are companies under common ownership, they may enter into an agreement for the debtor to forgo any deduction and the forgiven amount is accordingly reduced: ITAA97 s 245-90.

The following financial information relates to a suburban retail business, Harry’s Hardware, conducted by Harry as a sole proprietor. Profit & Loss Account 30 June 2017

Gross profit Operating expenses: Accounting fees Bad debts Bank fees Cleaning Commissions Depreciation Entertainment Fines Freight Fringe benefits tax

$169,450 $1,488 1,500 100 355 590 1,750 390 55 1,535 375 [page 622]

Hiring fees Interest Legal fees Membership subscriptions Motor vehicle expenses Payroll tax Rent Repairs Salaries and wages Staff training

375 3,355 200 175 4,944 320 22,000 300 57,130 435

Staff amenities Travelling expenses: WA Overseas Write-down of investments Operating profit Other income (debt forgiven) Net profit (before tax)

879

184 8,355 10,000

116,790 $52,660 10,000 $62,660

Required: Consider the information in items (i)–(xv) below and indicate the relevant provision of the Act and how the items are treated for tax purposes. Other information: (i) Accounting fees apply to a recognised tax adviser and comprise the following:

preparation of 2015–16 tax return advice on formation of a partnership estimated cost of this year’s tax return

$680 208 600 $1,488

(ii) Bad debts: on the advice of his accountant, Harry raised for the first time a provision for bad debts. No amounts have been debited to the account but Harry has grave concerns for an amount of $1200 owed by a business in voluntary administration. (iii) Depreciation is calculated according to provisions of the ITAA97. [page 623] (iv) Entertainment relates to refreshments provided at a gathering arranged to demonstrate Harry’s wares and attended by invited sales representatives. (v) Interest: $355 relates to interest on overdue accounts payable; $3000 relates to an overdraft facility. (vi) Legal fees relate to defending an application by a competitor to establish an outlet in the same shopping centre as Harry. The prospective competitor withdrew for financial reasons and the matter lapsed. (vii) Subscriptions relate to Harry’s membership of the Retail Club Inc. He uses the club as a venue to cultivate business contacts.

(viii) Motor vehicle expenses consist of fuel, oil and insurance ($2024 in total). The balance relates to depreciation on a Holden Cruze wagon acquired by the business (new) on 15 September 2015 (cost: $28,000). Harry uses the vehicle in the course of the business, collecting trading stock, delivering sales and to drive daily from the shop to his residence but rarely uses it at weekends. He maintains a logbook that shows travel is 80% business related. (Assume the depreciation rate for cars is 18.75%.) (ix) Rent includes an amount of $3000 paid for storage space that was ultimately not required. That lease was terminated on payment by Harry of $5000 (also included in the amount of $22,000) in May 2016 although the lease had another 12 months to run. As tenant, Harry had no right to sublet. The balance was paid to the shopping centre manager and included a prepayment for July and August 2016.

Storage space Termination of lease Shopping centre Prepayment

$3,000 5,000 12,000 2,000 $22,000

(x) Repairs relate to replacement of a broken window. It was necessary to repaint the window sill so Harry arranged for the whole wall to be repainted although it was still in reasonable condition. (xi) Of the amount paid for wages and salaries, $2000 was paid to Harry’s 14-year-old daughter (Helen) for ‘filing duties’ she performed during two hours each Saturday morning. An appropriate award rate is $6.50/hr. [page 624] (xii) Harry and spouse (Henrietta, who is employed by the business as purchasing officer) travelled to South-East Asia to discuss contracts with regular suppliers. The trip was for eight days, including two days travel. The intervening weekend was spent at a tourist resort. Cost of airfares amounted to $2350, accommodation (apart from the tourist resort) $4350. The balance related to the tourist resort. (xiii) Staff amenities relates to the provision of morning and afternoon teas provided to staff: cost $575. On the last Friday of every month, the staff gather at 5 pm to discuss in-house business. Soft drinks and sandwiches are provided: cost $304. (xiv) The write-down of share investments is consistent with the accounting policy of valuing investments at market value. (xv) The credit for ‘debt forgiven’ relates to a bequest from Harry’s late father who had lent the business $10,000, interest-free, in July 2017. The debt was forgiven under the terms of his will. A suggested solution can be found in Study help.

1.

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8. 9.

See further the discussion in R W Parsons, Income Taxation in Australia, Law Book Co, Sydney, 1985, [6-156]ff. For example, s 25-10 may have a wider temporal scope in that it allows a deduction for premises or plant ‘held or used’ for income-producing purposes whereas s 8-1 requires that the expense be incurred in gaining or producing assessable income. Although expenditure incurred before such holding or use would be denied under the ‘initial repairs’ principle, expenditure incurred after use (or holding) has ceased might well be deductible: see 9.10. The expenditure must be incurred in the year of income. It is not enough that the need for repairs has arisen, nor is there a deduction for notional repairs: see 9.13. The meaning of ‘incurred’ in the context of s 8-1 is discussed in 8.39ff. A taxpayer is a person deriving income or gains of a capital nature. In Peyton v FCT (1963) 9 AITR 112, a hotelier who paid a sum to cover repairs to a hotel as a condition for the landlord’s consent to assign the lease failed in a claim to deduct the amount. In Usher’s Wiltshire Brewery Ltd v Bruce (1914) 6 TC 399, a deduction was allowable to a lessor who, for reasons of commercial expediency, carried out repairs although the lease agreement provided the lessee should effect repairs. Queensland Meat Export Co Ltd v DCT (Qld) (1939) 1 AITR 490. It will be noted that several of the words and phrases in former ITAA36 s 53 correspond to former ITAA36 s 51(1) but there is no authority on the relationship between the two provisions. If an amount falls potentially within the ambit of both sections, the deduction is allowable under the more appropriate: s 8-10. FCT v Western Suburbs Cinemas Ltd (1952) 5 AITR 300 per Kitto J. The test of what is capital for the purposes of former ITAA36 s 53 or ITAA97 s 25-10 is derived from Sun Newspapers Ltd v FCT (1938) 61 CLR 337; 1 AITR 403: see 9.9 and 9.14. In Morcom v Campbell-Johnson [1955] 3 All ER 264, the replacement of a drainage system with the modern equivalent producing minor advantages was considered a repair: see also W Thomas & Co Pty Ltd v FCT (1965) 115 CLR 58; 9 AITR 710. In Wates v Rowland [1952] 1 All ER 470, a wooden floor replaced by tiles constituted a repair; see also FCT v Western Suburbs Cinemas Ltd (1952) 5 AITR 300 per Kitto J. In BP Oil Refinery (Bulwer Island) Ltd v FCT (1992) 23 ATR 65; 92 ATC 4031, encasing wooden wharf piles in concrete to prevent them from further damage from marine organisms constituted a nondeductible improvement. See Phillips v Whieldon Sanitary Potteries Ltd (1952) 33 TC 213; Lindsay’s case (see 9.9) and Thomas’s case (see 9.8). See also O’Grady v Bullcroft Main Collieries Ltd (1932) 17 TC 93 (expenditure to replace a factory chimney generating a 125% increase in capacity was capital expenditure to renew an entirety); Samuel Jones & Co (Devondale Ltd) v CIR (1951) 32 TC 513 (repairs to a chimney were deductible, the factory being the entirety); Rhodesia Railways Ltd v Resident Commissioner & Treasurer, Bechuanaland Protectorate [1933] AC 362 (repairs to 33 miles of railway line and another 40 miles of sleepers were repairs to subsidiary parts of a 394-mile track). See also AASB 1015 Accounting for the Acquisition of Assets; AASB 1021 Depreciation; AASB 1019 Inventories. There is in this passage an implied relationship between the purchase price and the state of

10.

11. 12.

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19. 20.

21. 22.

disrepair, subject to the principle of caveat emptor. However, Windeyer J conceded (at AITR 720–1) that ‘it is perhaps possible that some part of the expenditure might perhaps on a more close analysis than the evidence permits be shown to contain elements that would, if they could be separated, be a justified charge to revenue account’. Several Board of Review decisions have held that repairs to formerly rented premises were not allowable deductions because the income-producing activities had ceased: (1961) 10 CTBR (NS) Case 24; (1962) 10 CTBR Case 56. Parsons, Income Taxation in Australia, note 1 above, [6-156]ff. There is authority supporting a view that the taxpayer’s motive is at least a factor, and may be one of the controlling factors in characterising expenditure for the purpose of ITAA36 s 51(1) (ITAA97 s 8-1): W Nevill & Co Ltd v FCT (1937) 56 CLR 290; 1 AITR 67; Magna Alloys & Research Pty Ltd v FCT (1980) 49 FLR 183; 11 ATR 276; 80 ATC 4542. This requirement presents real difficulties for taxpayers who do not maintain written books of account or whose books of account are prepared periodically or irregularly by their accountants. Although occasionally the Administrative Appeals Tribunal has interpreted the ‘write-off’ requirement generously (see Case T91 86 ATC 1136), the literal requirement of the provision makes it prudent to examine debtors and make a record before 30 June. The non-deductibility of such amounts under ITAA97 s 8-1 (ITAA36 s 51(1)) was established in FCT v James Flood Pty Ltd (1953) 88 CLR 492; 5 AITR 579 and Nilsen Development Laboratories Ltd v FCT (1981) 144 CLR 616; 11 ATR 505. These decisions held that such provisions were not ‘incurred’ for the purpose of ITAA36 s 51(1). No outgoing was incurred until the leave was taken and there arose a presently existing pecuniary obligation to pay the relevant amount. Section 26-10 confirms the decision in Nilsen Development Laboratories. A payment made by an employer to discharge an obligation under HECS is an ‘expense payment fringe benefit’ pursuant to s 20 of the Fringe Benefits Tax Assessment Act 1986 (Cth). Under ITAA97 s 26-20(2), the amount paid is an allowable deduction to the employer but subject to fringe benefits tax. A tax payment made under HECS by a student or parent is simply not deductible. This would correspond to the amount brought to assessment under ITAA97 s 70-90 as a disposal outside the ordinary course of business: see 11.27. A full list of bodies to which deductible gifts or donations may be made is published by the Australian Taxation Office (ATO) on its website at . It will be evident that there are different schemes in operation. Section 32-5 is a denying provision in that the amount must first satisfy s 8-1. Section 32-15 does not deny deductions relating to property. It provides that property cannot satisfy tests of deductibility under the relevant provisions (such as depreciation or repairs). See Chapter 7 for a discussion of the options, etc for valuing the taxable value of entertainment provided as a fringe benefit. ‘Excluded exempt income’ is defined in s 36-20(3). It includes income exempted under ITAA36 ss 23AH, 23AI, 23AJ, 23AK (covering branch profits and controlled foreign companies) and 23L (which exempts fringe benefits). Also excluded is ‘excluded net exempt income’ as well as exempt income subject to withholding tax and ITAA36 s 26AG film proceeds. Note the PAYG withholding requirements apply to salary and wages so the payment must

be made by the 14th day after the PAYG period. PAYG also applies to attributed PSI income.

[page 625]

CHAPTER

10

Capital Allowances Learning objectives After studying this chapter, you should be able to: explain what a capital allowance is; identify a depreciating asset for ITAA97 Div 40 purposes; calculate the decline in value of a depreciating asset; explain what a balancing adjustment is; list three distinctive features of capital works allowances; identify when ITAA97 Div 43 deductions are available.

Introduction 10.1 You will recall from Chapter 8 that losses or outgoings of a capital nature are not deductible under s 8-1 of the Income Tax Assessment Act 1997 (Cth) (ITAA97). From an economic point of view, in most cases, outright deductibility of losses or outgoings of a capital nature should not be allowed as such expenditure will generally be directed at producing lasting advantages. For this reason, an expenditure of a capital nature will not normally reduce the taxpayer’s stock of wealth in the year the expenditure is incurred. Allowing an outright deduction for a capital expenditure in the year of expense would understate the profits made by the taxpayer in the year of

expense and would overstate profits in later years. Over time, however, the value of advantages obtained by capital expenditures may decline. This decline may be due to wear and tear (in the case of physical assets), to expiration of rights, or (increasingly) to technical obsolescence. The decline in value of capital advantages over time is properly seen as a cost of the income produced by using those advantages. If the profits of a business are to be determined accurately on a year-to-year basis, it is necessary to make some allowance for this decline in the value of capital assets. The capital allowance regime is the mechanism used in the ITAA97 for recognising this decline in value by allowing deductions of certain capital costs over a period of time.

Scope of the capital allowances regime 10.2 Prior to the introduction of the uniform capital allowance regime on 1 July 2001, the ITAA97 contained 37 separate capital allowance regimes. The more generally applicable of these were Div 42, which allowed depreciation of ‘plant or articles’; Div 43, which provided for capital allowance deductions in respect of [page 626] certain buildings and other capital improvements; and Div 373, which provided for capital allowances in respect of certain expenditures on intellectual property. Many of the other capital allowance provisions related to specific industries such as mining, primary production or telecommunications. Beginning with the provisions in the Income Tax Assessment Act 1936 (Cth) (ITAA36) permitting depreciation of plant or articles (ITAA36 s 54ff), other capital allowance regimes had developed over time as the need for particular types of capital allowances was recognised. The need for specific regimes was due in part to the relatively narrow scope of the depreciation regime in the ITAA36. As mentioned above, depreciation was only allowable in relation to ‘plant

or articles’. If an asset, such as a building, was not technically plant or articles then it was not depreciable under ITAA36 s 54. Thus, when the legislature chose to provide for capital allowances in respect of buildings, it did so through a separate regime which ultimately became ITAA97 Div 43. In addition, the existence of a multiplicity of separate capital allowance regimes could be explained by the tendency to use capital allowances as a tax incentive. Thus, governments which wanted to encourage investment in equipment or in particular industries provided for special rates of depreciation or outright deductions for particular capital expenditures. Even in the case of the depreciation provisions in ITAA36 s 54 (later ITAA97 Div 42), rates of depreciation varied considerably over time according to the policy objectives of the government of the day. Tax rates of depreciation did not necessarily match those determined by reference to the effective useful life of the asset. The end result of this gradual process of accretion was the existence of 37 separate regimes which fundamentally did the same thing — they allowed deductions for particular expenditures to be spread over a period of time — but did so using rules and rates of depreciation that were distinctive to each. Furthermore, as the regimes were based on statutory rates and a rigid statutory pigeonholing, they differed significantly from the approach to depreciation taken in financial accounting, based as it is on the concept of useful life and on a broad concept of depreciable asset. 10.3 The New Business Tax System (Capital Allowances) Act 2001 (Cth) introduced a new ITAA97 Div 40, which contains a uniform capital allowance regime. Division 40 applies to most types of depreciating assets. As discussed in more detail below, Div 40 does not apply to depreciating assets that are: associated with certain international telecommunications submarine cable systems (IRUs) (an IRU is an indefeasible right to use a telecommunications cable system); cars, where deductions for the cars have been substantiated using certain methods; or

capital works under ITAA97 Div 43. Under transitional rules, amounts taken into account under nowrepealed capital allowance regimes (such as ITAA97 Div 42 dealing with depreciation) are regarded as having been taken into account under the uniform capital allowance regime. The core provisions for calculating capital allowance deductions for most depreciating assets are contained in ITAA97 Subdiv 40-B. This first section of this chapter explains how capital allowance deductions are determined under Subdiv 40-B. [page 627] In the process of this explanation we shall refer to two other Subdivisions. These are Subdiv 40-C, which explains the meaning of the key concept of ‘cost’ for the purposes of the capital allowance provisions, and Subdiv 40-D, which explains the operation of balancing adjustments. The chapter then discusses Subdiv 40-E, which contains special provisions dealing with low-value and software development pools. Our discussion then turns to Subdiv 40-I, which deals with capital allowances that are available for certain ‘black hole’ expenditures. We then discuss how the simplified tax system (STS) treats depreciating assets. This will involve us in a brief consideration of Subdiv 328-D. The final section of this chapter will discuss capital works allowances under ITAA97 Div 43. 10.4 This chapter does not discuss three Subdivisions in ITAA97 Div 40. These are Subdiv 40-F (dealing with primary production depreciating assets), Subdiv 40-G (dealing with capital expenditure of primary producers and certain other landholders) and Subdiv 40H (which allows immediate deductions for certain capital expenditure on exploration and prospecting; rehabilitation of mining or quarrying sites; paying petroleum resource rent tax; and environmental protection activities).

Key features of the ITAA97 Div 40 regime 10.5 The key features of the capital allowance regime in ITAA97 Div 40 are: the decline in value of a depreciating asset for an income year is an allowable deduction; subject to some exceptions, discussed in detail below, a depreciating asset is defined as an asset that has a limited effective life and can reasonably be expected to decline in value over time as it is used; the rate of capital allowance is determined by reference to the useful life of the asset either by using the taxpayer’s own estimate or by using rates published by the Commissioner; either the prime cost (straight line) or diminishing value method of depreciation may be used; the following ‘balancing adjustments’ are made when a depreciating asset is disposed of: – the excess of the termination value (generally the sale proceeds) of the asset over its adjustable value (generally cost less decline in value) is included in assessable income as a balancing adjustment inclusion; – where the excess of the termination value of the asset over its cost is attributable to a private use of the asset, it will give rise to a capital gain but not a balancing adjustment inclusion; – the excess of the adjustable value of the asset over its termination value is a balancing adjustment deduction; and – where the excess of the cost of the asset over its termination value is attributable to a private use of the asset, it will give rise to a capital loss but not to a balancing adjustment deduction.

[page 628] The basic capital allowance provision in ITAA97 Div 40 is s 4025(1), which states: You can deduct an amount equal to the decline in value for an income year … of a depreciating asset that you held for any time during the year.

In general,1 where part of the asset’s decline in value is attributable to your use of it, or having it installed ready for use, for a purpose other than a taxable purpose you reduce your deduction under s 40-25(2). The reduction is by the part of the asset’s decline in value that is attributable to the use or installation for a purpose other than a taxable purpose.2 We shall now discuss the meaning of some of the key concepts found in s 40-25(1).

The meaning of ‘depreciating asset’ 10.6 Note that capital allowance deductions under ITAA97 Div 40 are allowed in respect of the decline in value of depreciating assets. A ‘depreciating asset’ is defined in s 40-30, the first two subsections of which state as follows: 40-30 What a depreciating asset is (1) A depreciating asset is an asset that has a limited effective life and can reasonably be expected to decline in value over the time it is used, except: (a) land; or (b) an item of trading stock; or (c) an intangible asset, unless it is mentioned in subsection (2). (2) These intangible assets are depreciating assets if they are not trading stock: (a) mining, quarrying or prospecting rights; (b) mining, quarrying or prospecting information; (c) items of intellectual property; (d) in-house software; (e) IRUs;

[page 629] (f) spectrum licences; (g) datacasting transmitter licences; (h) telecommunications site access rights.

Note that, although land is not a depreciating asset, improvements to land or fixtures on land can be. Section 40-30(3) states that Div 40 ‘applies to an improvement to land, or a fixture on land, whether the improvement or fixture is removable or not, as if it were an asset separate from the land’. We shall see in 10.8–10.13, however, that, generally, expenditure improvements to land or fixtures on land, which would otherwise be classified as being on capital works (for the purposes of Div 43), will only be within Div 40 if the improvements or fixtures are plant. The definition in s 40-30 has much in common with the definition of ‘depreciable asset’ in AASB 1021 Depreciation (now superseded by AASB 116 Property, Plant and Equipment), which stated at para 14.1 ‘depreciable asset means an non-current asset having a limited useful life’ and ‘depreciable amount means the historical cost of a depreciable asset … [less] the net amount expected to be recovered on the disposal of the asset at the end of its useful life’. One feature common to the tax and accounting definitions is the requirement that an asset decline in value. For tax purposes, if an asset cannot reasonably be expected to decline in value, then it will not be a depreciating asset. For accounting purposes, an asset that does not decline in value will have a zero reportable amount. Both the tax and accounting notions of a depreciating asset are underpinned by the concept of the ‘useful life’ of an asset. 10.7 Section 40-45 is also relevant in determining the assets to which Div 40 applies. Section 40-45(1) states that Div 40 does not apply to plant used or installed ready for use exclusively for the purpose of carrying on research and development activities unless you have elected that the research and development provisions do not apply to the plant. The meaning of ‘plant’ is discussed in 10.9–10.13.

The boundary between ITAA97 Divs 40 and 43 10.8 Under ITAA97 s 40-45(2), Div 40 does not apply to capital works for which you can deduct amounts under Div 43 (discussed in 10.94–10.110) or for which you could have deducted amounts under Div 43 but for the expenditure being incurred, or but for the capital works being started, before the date at which the relevant Div 43 deduction commenced or had you used the capital works for a relevant purpose. In broad terms, Div 43 provides for capital allowance deductions for building and other capital works that are used for producing assessable income. The availability of and the rate of Div 43 deductions depend on when the building or other capital works commenced. We shall see that the effect of s 43-70 is that Div 43 only applies where other capital allowance regimes and certain other specific deduction provisions do not. In particular, the effect of s 43-70(2)(e) is that expenditure on ‘plant’ will not qualify for Div 43 capital allowances. Note that depreciable property is not required to be plant for capital allowance deductions to be available in respect of it under [page 630] Div 40. However, if property is plant, then the effect of s 43-70(2)(e) is that capital allowances in respect of expenditure on it are available under Div 40 but are not available under Div 43. A taxpayer will usually prefer a Div 40 capital allowance to a Div 43 capital allowance as the former is based on the useful life of the asset. Thus, for an understanding of the relationship between Divs 40 and 43, it is necessary to be familiar with the meaning of ‘plant’.

The meaning of ‘plant’ 10.9 Plant is defined in ITAA97 s 45-40 as including, among other things, ‘articles, machinery, tools and rolling stock’.

Many judicial discussions of the meaning of ‘plant’ in the depreciation provisions begin by citing the following definition given by Lindley LJ in Yarmouth v France (1887) 19 QBD 647 at 658 in a nontax context: … in its ordinary sense, it includes whatever apparatus is used by a business man for carrying on his business, — not his stock-in-trade which he buys or makes for sale; but all goods and chattels, fixed or moveable, live or dead, which he keeps for permanent employment in his business.

In Yarmouth v France, the English Court of Appeal held that horses which were used by a wharfinger in his business were plant for the purposes of the Employer’s Liability Act 1880 (UK). The courts have several times commented that definitions like that in Yarmouth v France need to be read in the context of the legislation that they were interpreting. While ‘plant’ is an ordinary English word, its meaning may be influenced by the statutory context in which it is used. In Quarries Ltd v FCT (1961) 106 CLR 310; 12 ATD 356; 8 AITR 383, Taylor J (at CLR 315) made the following comments on the definition in Yarmouth v France and on other definitions in English cases: … valuable as such cases may be as a general guide when considering the question of what may and what may not be regarded as plant in any particular case, they demonstrate the impossibility of formulating any precise rule by the application of which the problem may always be readily solved.

10.10 It is also relevant to bear in mind that the ways in which business generally is organised and conducted change over time. As Mahoney J noted in Macquarie Worsteds Pty Ltd v FCT (1974) 3 ALR 122 at 126; 4 ATR 334; 74 ATC 4121: … the mode of carrying on a business then common was of a kind sufficiently uncomplicated to enable a distinction to be made between those things which were stock in trade or the mere setting of the business on the one hand, and those things which were plant on the other hand, by the use of the term “apparatus”. However, now the nature of business operations often requires that the setting of the business be more specialized than a setting which merely excludes wind and weather, and be a setting in which particular conditions or facilities are available, and the term “apparatus”, or its contrast with “setting” and “stock in trade”, does not provide a test by the application of which an inevitable answer is produced, in such a case as the present.

Technological developments may also mean that definitions in older cases have to be reinterpreted in the light of the flexibility and capacity of more-modern technologies.

[page 631] 10.11 In many cases, there will be little doubt that a particular item of property is plant. For purposes of determining whether Div 40 or Div 43 applies to expenditure, the question narrows to whether a particular expenditure on capital works (as defined in Div 43) is an expenditure on plant. If it is, then the relevant capital allowance Division that applies to the expenditure is Div 40 rather than Div 43. The key issue in answering this question is whether a building or structure is plant as distinct from merely being a convenient setting in which business operations are carried on. In summary, it can be said that, in deciding whether buildings or structures are ‘plant’, the courts tend to find that something which has an active function in the taxpayer’s operations is plant, whereas something that has a passive function is not. The following cases, Wangaratta Woollen Mills Ltd v FCT (1969) 119 CLR 1; 1 ATR 329; 69 ATC 4095 and Imperial Chemical Industries of Australia and New Zealand Ltd v FCT (1970) 120 CLR 396; 1 ATR 450; 70 ATC 4024 (Imperial Chemical Industries case), illustrate the divergent results that have followed from an application of this approach.

Wangaratta Woollen Mills Ltd v FCT Facts: The taxpayer was a dyer and spinner of wool and synthetic yarns. Held: In the High Court, McTiernan J held that the taxpayer’s dye-house was plant. This was on the basis that the dye-house was in the ‘nature of a tool’ in the trade and did ‘play a part’ itself in the manufacturing process. The dye-house was much more than a convenient setting for the taxpayer’s operations. McTiernan J (at CLR 10) noted the unique features of the dye-house in deciding that it played a part in the manufacturing process: I am of the opinion that the plaintiff’s dye-house is “in the nature of a tool” in the trade and does “play a part” itself in the manufacturing process. It is much more than a convenient setting for the plaintiff’s operations. It is an essential part in the efficient and economic operation of the plaintiff’s business. The complex

ventilation system including the cavity wall does more than merely clear the atmosphere. Its structure is an active tool in preventing spoiling of material, and in enabling the operatives to carry out their tasks. It would be completely unnecessary in almost every other industry and quite useless to any buyer except a dyer. The protective coatings and tiling are essential in preserving the whole “tool”. It is as unreal to dissect the paint or tile from its foundation as it is to separate the paint from a workman’s tool of trade. The drains do not just remove waste liquids, they remove volatile liquids which would disrupt the process as much as vapours escaping from the vats. If boiling liquids were left uncovered in the building, in vats or drains, the whole process would quickly become [page 632] unworkable. I think, therefore, that the dye-house should be regarded as a single unit of plant and not a collection of bricks, mortar, paint, timber, etc, each of which is to be separately examined. It is not merely a special factory; it is a complex whole in which every piece is essential for the efficient operation of the whole. I would, however, except from the description of “plant” what might be referred to as the external “cladding” of the dye-house, that is the external walls including the single walls at the east and west ends and the roof as distinct from the ceiling, but not the controlled louvres or the cowlings in the roof. The cladding really does nothing more than exclude the elements, and whilst I am not convinced of the validity of this distinction nevertheless it is clearly supported by prior decisions on this sort of question.

Imperial Chemical Industries of Australia and New Zealand Ltd v FCT Facts: The taxpayer owned two buildings in which were a removable sound-absorbing ceiling and certain electrical installations. Facts: In the High Court, Kitto J held that the ceiling and installations were not plant or articles. The floor space in the buildings was divided by moveable partitions many of which did not reach the ceiling. The removable sound-absorbing ceiling had been installed to overcome excessive noise that would otherwise result. Kitto J held (at ATC 4026): Obviously the ceilings and every part of them, the removable panels no less than the supporting framework, are fixtures and form part of the buildings. The mode of affixation is slight but adequate, and its purpose is to provide the building with

ceilings as essential parts of the structure. The purpose, in other words, is to make the building a complete building. The ceilings are there for the sake of the building, not the building for the sake of the ceilings. In my opinion, while they are in position they are plainly not “articles”. The appellant’s main contention concerning them is that they are “plant”. But they are no more than parts of the shelter, so to speak, in which the appellant chooses to carry on its activities. They play no part in those activities. Their sound-absorbing qualities do, no doubt, make working in the building more comfortable, and consequently, I presume, more efficient, and to that extent they are better ceilings than sound-reflecting ceilings would be. But every part of a building makes some contribution to [page 633] the comfort and efficiency of those who work in it. To take it notionally to bits and describe as “plant”, any bit that has a function which is useful in connexion with the business carried on there, seems to me indefensible. The truth is that the ceilings with which we are concerned do nothing for the appellant’s business that they would not do for the business of any other occupier. They are in like case with the walls, floors, windows and doors, not to mention the roof; that is to say they are useful for anyone who wants to work in the building, and more useful than less well thought out units of the same kind would be, but still only part of a general setting for work, not part of the apparatus of any income-producing process. In my opinion they are not “plant”. The electrical wiring with its enclosing conduits, and the trunking, are also parts of the general equipment of the building, fixtures beyond question, and having no relevance to the activities of the appellant beyond the relevance they would have to any occupier’s activities … The construction of the building as a building of the general type to which it belongs would be incomplete without them, and their function does not go beyond making the building a suitable general setting for a wide range of possible activities.

1.

2.

Would the moveable partitions in the Imperial Chemical Industries case be plant? Would the moveable partitions have been ‘articles’? What would have been the result in the Imperial Chemical Industries case if the partitions and the ceilings had formed one modular moveable unit? In Div 43, the definition of ‘capital works’ includes ‘structural improvements, or extensions, alterations or improvements to structural improvements’. Would the moveable partitions be ‘capital works’ for purposes of Div 43? If they were not capital

3.

4.

works, do we need to know whether or not they are plant to obtain Div 40 deductions in respect of expenditure on them? Should the external cladding of the dye-house in Wangaratta Woollen Mills have been regarded as plant? Under the current law, assuming that the external cladding was a structural improvement, why is it important to determine whether or not it was plant? Would any of the following be ‘plant’? (i) a drive-through car wash; [page 634] (ii) a cool room in a liquor shop; (iii) a lift well; (iv) a soundproof TV studio.

10.12 Note that the definition of ‘plant’ in s 45-40 includes ‘articles, machinery, tools and rolling stock’. In interpreting the meaning of ‘plant’ for the purpose of the depreciation provisions in the ITAA36, the courts did not require that articles or machinery perform a function that was especially related to the taxpayer’s operations before they regarded them as depreciable. Rather, the courts concerned themselves with the question of whether the articles or machinery were used for the purpose of gaining or producing assessable income. On the basis of this reasoning, something that is an ‘article’ would be ‘plant’ within the s 45-40 definition whether or not it performed a function that was especially related to the taxpayer’s operations.3 Similarly, the term ‘machinery’, when used in the ITAA36 definition of ‘plant’, has been held to have a meaning and effect additional to the meaning of ‘plant’ outside that definition: Carpentaria Transport Pty Ltd v FCT (1990) 21 ATR 513; 90 ATC 4590. It would appear to follow from this that ‘machinery’ will be ‘plant’ within the s 45-40 definition whether or not it performs a function that is especially related to the taxpayer’s operations. 10.13 In many cases, ‘articles, machinery, tools and rolling stock’ will not be buildings or structural improvements and hence will not be ‘capital works’ for purposes of Div 43. If they are not capital works

then, in determining whether Div 40 deductions are available in respect of expenditure on them, we do not need to consider whether or not they are plant. However, where an article becomes a fixture, it may be a building or structural improvement and hence capital works for purposes of Div 43. Note, from the Imperial Chemical Industries case above, that if an article becomes a fixture and, thus part of the land at general law, it will no longer be considered to be an article. In these circumstances, Div 43 will apply to expenditure on it unless it satisfies the test of being ‘plant’ in the sense of performing a function that is especially related to the taxpayer’s operations. If the fixture is ‘plant’ in this sense, then Div 40 deductions will be available in relation to expenditure on it. The position appears to be different in the case of machinery. Because the ITAA36 definition of ‘plant’ included ‘machinery’, it was held in Carpentaria Transport that certain machinery (motorised roller doors) was depreciable under the ITAA36 whether or not it formed an integral part of a building or was a part of the setting in which business was carried on. Even though machinery played only a passive role in a taxpayer’s business operations, it was still depreciable. The reasoning seems to be that machinery which has become an integral part of a building does not thereby [page 635] cease to be machinery and hence ‘plant’ under the statutory definition. Machinery that becomes an integral part of a building will be likely to be capital works for Div 43 purposes. However, since the machinery retains its status as machinery, it will be ‘plant’ under the s 45-40 definition and hence will fall within Div 40 rather than Div 43. 10.14 An often overlooked area for determining capital allowances concerns the use of plant ‘exclusively’ for the purposes of carrying on research and development activities by, or on behalf of, the company. For assets acquired or constructed prior to 29 January 2001, ITAA97

Div 40 will continue to apply, due to the operation of the transitional provisions provided under the New Business Tax System (Capital Allowances — Transitional and Consequential) Act 2001 (Cth). The deductibility for the capital allowance for plant acquired prior to 29 January 2001 used in research and development activities (but not exclusively) arises from the operation of ITAA97 Div 40. Importantly, the deduction which accounts for the decline in value of the plant will be calculated on a notional basis as provided under Div 40.

Other exclusions from ITAA97 Div 40 10.15 Division 40 also does not apply to the following: IRUs to the extent that expenditure was incurred before 11.45 am on 21 September 1999; IRUs over an international telecommunications submarine cable system that had been used for telecommunications purposes at or before 11.45 am on 21 September 1999. Section 40-55 indicates that you cannot obtain Div 40 deductions for the decline in value of a car if you use either the ‘cents per kilometre’ or the ‘12% original value’ method to substantiate your car expense deduction claims. Division 40 deductions can be claimed, however, where you use either the ‘one-third of actual expenses’ or the ‘log book’ method of substantiation. The various methods for substantiating car expenses are discussed in Chapter 9. Where you use a mixture of a method for which Div 40 deductions are allowed and a method for which Div 40 deductions are not allowed, special rules apply when a balancing adjustment event takes place in relation to the car. These rules are discussed in 10.63. Special provisions in the legislation deal with the following situations: composite items (s 40-30(4)); renewals or extensions of depreciating assets that are rights (s 4030(5)); and interests held in depreciating assets (s 40-30(6)).

Consider whether any of the following will be depreciable assets under the s 40-30 definition: brand names; buildings in respect of which Div 43 deductions are available; tangible assets in respect of which Div 43 deductions are not available; [page 636] trademarks; patents; goodwill; land; trading stock. A suggested response can be found in Study help.

The meaning of ‘hold a depreciating asset’ 10.16 For you to be entitled to a capital allowance, you must ‘hold’ a depreciating asset during the year of income. A table set out in ITAA97 s 40-40 is used to determine who holds a particular depreciating asset. You can be regarded as holding an asset under only one item in the table. The key principle underpinning the concept of holding a depreciating asset is one of economic ownership.4 Economic ownership is the ability to access the economic benefits of an asset while preventing other entities from doing the same.5 It is possible for there to be several economic owners of a depreciating asset at any particular time. However, in some cases, the nature of a particular entity’s economic ownership is such that other entities are prevented from being economic owners of the asset. Where this is the case, the table in s 40-40 specifically identifies the entity which is not regarded as the holder.

Often economic ownership of an asset and legal ownership of the asset will coincide. However, there are circumstances where the economic owner of a depreciating asset will not hold legal title to it. 10.17 There are three general rules about holding depreciating assets set out in the table in s 40-40. The first general rule is contained in item 5 in the table in s 40-40. Item 5 states: Item 5

Identifying the holder of a depreciating asset This kind of depreciating asset Is held by this entity A right that an entity legally owns but which The economic owner and not another entity (the economic owner) exercises the legal owner or has a right to exercise immediately, where the economic owner has a right to become its legal owner and it is reasonable to expect that: (a) the economic owner will become its legal owner; or (b) it will be disposed of at the direction and for the benefit of the economic owner

[page 637] The second general rule is set out in item 6 in the table in s 40-40. Item 6 states: Item 6

Identifying the holder of a depreciating asset This kind of depreciating asset Is held by this entity A depreciating asset that an entity (the former holder) would, apart from this item, hold under this table (including by another application of this item) where a second entity (also the economic owner): (a) possesses the asset, or has a right as against the former holder to possess the asset immediately; and (b) has a right as against the former holder the exercise of which would make the economic owner the holder under any item of this table;

The economic owner and not the former owner

and it is reasonable to expect that the economic owner will become its holder by exercising the right, or that the asset will be disposed of at the direction and for the benefit of the economic owner

The third general rule is set out in item 10 in the table in s 40-40. Item 10 states: Item 10

Identifying the holder of a depreciating asset This kind of depreciating asset Is held by this entity Any depreciating asset

The owner, or the legal owner if there is both a legal and equitable owner

Consistently with general principles of statutory interpretation, the more specific provisions in items 5 and 6 of the table, where applicable, would prevail over the more general provision in item 10. Working through the following activity should assist you in appreciating who will be the holder of a depreciating asset in particular circumstances.

Read the above extracts of items 5, 6 and 10 in the table in ITAA97 s 40-40. Who do you think will be the holder of the depreciating asset in the following circumstances? where a tangible asset is mortgaged to Big Bank Ltd under an arrangement in which legal title to the asset passes to the bank subject to the mortgagor’s equity of redemption; where the legal owner of an intangible depreciating asset (eg, a patent) grants a call option over the asset to another person; [page 638] where a tangible asset is held subject to a bare trust in favour of a single sui juris beneficiary; where a tangible asset is in the process of being acquired under a hire-purchase agreement; where a tangible asset is held subject to a unit trust for several beneficiaries where the trustee has active duties to perform.

Suggested solutions can be found in Study help.

10.18 Three of the items in the table in s 40-40 are relevant to determining who is the holder of fixtures and other improvements to land. Items 2 and 3 deal with the situation where land is subject to what the legislation describes as a ‘quasi-ownership right’. A ‘quasi-ownership right’ is defined in ITAA97 s 995-1 as a lease over land, an easement (such as a right of way) in connection with the land, or any other right, power or privilege over the land or in connection with the land. Someone, such as a sub-lessee, who acquires a right from the holder of a quasi-ownership right, also holds a quasiownership right. Item 2 deals with the situation where a depreciating asset is fixed to land that is subject to a quasi-ownership right in the situation where the owner of the quasiownership right (eg, a lease) has the right to remove the fixture. Under the general law, a chattel that is affixed to land becomes part of the land and is legally owned by the landlord rather than by the tenant. However, tenants have a right to remove their fixtures during the term of the lease and for a reasonable time afterwards. Item 2 in the table states that while the tenant has the right to remove depreciating fixtures the tenant (or other holder of a quasiownership right) will be a holder of the fixture. Note, however, that item 2 does not state that the owner of the land is not the holder of the depreciating fixture. It would be possible for the legal owner of the land to be the holder of the fixture under item 10 of the table. However, the legal owner of the land will only be able to claim a capital allowance in relation to the fixture for the cost of the asset to him or her. In many cases, it is likely that the fixture would not have cost the legal owner of the land anything. This would mean that the legal owner of the land would not be able to claim capital allowances in relation to the fixture. If the fixture were classified as a structural improvement, it would therefore be capital works for purposes of Div 43. If so, then, as discussed in 10.8–10.13, Div 40 deductions would be available only in respect of expenditure on the fixture if it were the legal owner of the land’s plant. Where the fixture has a cost to both the tenant and the

legal owner of the land, then, under the jointly held depreciating asset provisions mentioned below, both the tenant and the legal owner of the land would be able to claim capital allowances for the decline in the value of the asset to each of them. Item 3 deals with the situation where an improvement is made to land that is subject to a quasi-ownership right (such as a lease), where the owner of the quasi-ownership right has no right to remove the asset. Item 3 applies whether or not the improvement [page 639] is a fixture. Here, item 3 states that the tenant (or other holder of a quasi-ownership right) is a holder of the asset during the term of the lease (or other quasi-ownership right). Where the improvement is a fixture, the legal owner of the land would again have become the legal owner of the fixture. In this situation, the legal owner of the land would be a holder of the fixture under item 10 of the table. Whether the legal owner of the land would be able to claim capital allowances in relation to the fixture would again depend on whether or not the fixture cost the legal owner of the land anything. If the fixture were classified as a structural improvement, it would therefore be capital works for purposes of Div 43. If so, then, as discussed in 10.8–10.13, Div 40 deductions would be available only in respect of expenditure on the fixture if it were the legal owner of the land’s plant. 10.19 Item 4 deals with the situation where a depreciating asset (eg, an advertising sign) is leased from the owner (or another holder) of the asset and is affixed to land. Item 4 only deals with the situation where the lessor has a right to recover the asset. In this situation, the lessor is regarded as holding the asset while the right to recover the asset exists. Again, as the asset will be a fixture, the legal owner of the land to which it is affixed will also be a holder of the asset under item 10 in the table in s 40-40. Whether the legal owner of the land would be able to claim capital allowances in relation to the fixture would again depend on whether or not the fixture cost the legal owner of the land anything. If

the fixture were classified as a structural improvement, it would therefore be capital works for purposes of Div 43. If so, then, as discussed in 10.8–10.13, Div 40 deductions would be only available in respect of expenditure on the fixture if it were the legal owner of the land’s plant. 10.20 Notwithstanding the exclusions in items 5 and 6 of the table in s 40-40, there can, as shown in 10.17, be more than one holder of a depreciating asset. There are three situations where the joint holding will commonly be significant. These are: cases of joint ownership; cases where there are multiple interests in the same land or depreciating asset, and more than one holder of an interest contributes to the cost of the asset (eg, where two or more lessees contribute to the cost of acquiring a depreciating asset and affix it to the leased land); and cases where both lessee and lessor contribute to the cost of a depreciating asset (eg, as shown in 10.17, where a lessee, in circumstances other than those discussed in 10.18, attaches a depreciating asset to land so that it becomes a fixture).6 In cases where a depreciating asset is held by one or more entities, s 40-35 states that Div 40 applies as if your interest in the depreciating asset were the underlying asset itself. This will mean that, even though more than one entity may be entitled to Div 40 deductions in relation to the same asset, no double deductions should arise, as each entity will obtain deductions only in relation to the decline in value of its interest in the depreciating asset. The Explanatory Memorandum (EM) to the New Business Tax System (Capital Allowances — Transitional and Consequential) Bill 2001 (Cth) states, at para 1.60, that the term ‘interest in’ the underlying asset [page 640] is intended to be interpreted broadly, and is not limited to rights which

create a proprietary interest in the underlying asset. The reference is intended to be to an entity’s holding or economic ownership of the underlying asset. The EM goes on to say, at para 1.61, that the effective life of the interest is the same as the effective life of the underlying asset. Changes in each holder’s interest in the underlying asset do not affect the other holders as each holder’s interest is dealt with as if it were a separate asset. Thus, where one of several co-owners of a depreciating asset sells his or her interest to a third party, no balancing adjustment event occurs for the other co-owners. Balancing adjustments are discussed in 10.54–10.66. Note, however, that this rule does not apply in the case of partnerships as, for Div 40 purposes, partnership assets are regarded as being held by the partnership and not by the individual partners. The position in relation to depreciating partnership assets is discussed in detail in 14.44–14.47. Other items in the table in s 40-40 deal with more specific situations and clarify who will be the holder of the depreciating asset in those situations. These items deal with leased luxury cars (item 1), partnership assets (item 7 — discussed in detail in 14.44), and certain mining and quarrying information (items 8 and 9). Barclays Mercantile Business Finance Ltd v Mawson (Inspector of Taxes) [2005] 1 All ER 97 provides a case example involving the purchase of a gas pipeline.

Barclays Mercantile Business Finance Ltd v Mawson (Inspector of Taxes) Facts: In this decision, the House of Lords was asked to determine the taxpayer’s entitlement to a capital allowance for the purchase of a gas pipeline under the Irish Sea. Barclays Mercantile Business Finance Ltd (BMBF) purchased the gas pipeline for £91m. The purchase was funded from its parent entity, Barclays Bank, and Barclays Bank provided the cash collateralised guarantee to its related entity BMBF. At all relevant times, BMBF retained ownership of the gas pipeline. BMBF sought a capital allowance deduction for its ownership of the gas pipeline. Inland Revenue disputed the availability of the

capital allowance on the basis that the transaction was circular and lacked commercial reality. Held: At first instance, Park J held the transaction lacked commerciality and considered that BMBF was not entitled to a capital allowance deduction for its purchase of the gas pipeline. On appeal, the Court of Appeal allowed the appeal and set aside the judgment of Park J: [2002] EWCA Civ 1853. The Court of Appeal concluded that BMBF was entitled to a capital allowance following its purchase of the gas pipeline which was, for all intents and purposes, a depreciable asset capable of attracting a capital allowance. [page 641] On appeal to the House of Lords, the House of Lords agreed with the finding of the Court of Appeal: [2005] 1 All ER 97. The House of Lords held (at [42] per Nicholls, Steyn, Hoffmann, Hope and Walker LJJ): No one disputes that BMBF had acquired ownership of the pipeline or that it generated income for BMBF in the course of its trade in the form of rent chargeable to corporation tax. In return it paid £91 million. The circularity of payments which so impressed Park J and the Special Commissioners arose because BMBF, in the ordinary course of its business, borrowed the money to buy the pipeline from Barclays Bank and Barclays happened to be the bank which provided the cash collateralised guarantee to BMBF for the payment of the rent. But these were happenstances. None of these transactions, whether circular or not, were necessary elements in creating the entitlement to the capital allowances.

How decline in value is calculated 10.21 Generally, a depreciating asset is regarded as starting to decline in value from ‘when you first use it, or have it installed ready for use, for any purpose’: see ITAA97 s 40-60(1) and (2). This is referred to as the asset’s ‘start time’. Note that the use does not have to be for a taxable purpose. 10.22 In most cases, a taxpayer can choose to calculate the decline in value of a depreciating asset under either the diminishing value method or the prime cost method: see ITAA97 s 40-65(1). The choice must, under s 40-130(1)(a), be made by the time the taxpayer’s tax return for the first income year in which the asset’s decline in value is being calculated. Once made, the method chosen for a particular asset cannot

be revoked: see s 40-130(2). It is possible, however, for the one taxpayer to use different methods for different depreciating assets that he or she owns. 10.23 The choice between the prime cost and diminishing value methods is not available in some situations. Where you acquire a depreciating asset from an associate, where the associate has deducted or can deduct ITAA97 Div 40 capital allowances in respect of the asset, then, under s 40-65(2), you must use the same method as the associate used. Where you acquire the depreciating asset from a former holder who was using the depreciating asset at the time you acquired it, and who continues to use it while you hold it, then you are required to use the same method as the former holder used:7 see s 40-65(3). Furthermore, s 40-70(2) prohibits the use of the diminishing value method for calculating the decline in value of in-house software, an item of intellectual property, a spectrum licence or a datacasting transmission licence. [page 642] 10.24 Under ITAA97 s 40-80(2), a depreciating asset’s decline in value will be its cost, if that cost does not exceed $300, you use the asset predominantly for the purpose of producing assessable income other than from carrying on a business, the asset is not part of a set of assets whose total cost exceeds $300, and the total cost of the asset, and any other substantially identical asset that you start to hold in the income year, does not exceed $300. Under ITAA97 s 40-80(1), the decline in value of certain depreciating assets used in exploration or prospecting for minerals or quarry materials available by mining operations can also be the asset’s cost. 10.25 Special provisions, set out in ITAA97 Subdiv 40-E, apply for determining the decline in value of a low-cost asset held in a pool. These provisions are discussed in 10.71–10.76.

The prime cost method 10.26 ITAA97 s 40-75 explains how to calculate the decline in value of a depreciating asset under the prime cost method. 40-75 (1) You work out the decline in value of a depreciating asset for an income year using the prime cost method in this way: where:

where: days held has the same meaning as in subsection 40-70(1). …

In the income year in which the asset’s start time occurs, s 40-75(7) states that the decline in value cannot be more than the asset’s cost. In subsequent years, the decline in value cannot exceed the ‘opening adjustable value’ of the asset for that year and any amount included in the second element of its cost for that year. 10.27 The prime cost method is thus very simple. Your deduction in any given year of income is the asset’s cost multiplied by the days you held the asset over the number of days in the income year multiplied by one over the effective life of the asset. In cases where you held the asset for the whole of the year, your deduction will simply be the cost of the plant multiplied by one over the effective life of the plant. Note that the expression ‘days held’ has the same meaning as it has in ITAA97 s 4070(1). Under s 40-70(1), ‘days held’ means the number of days you held the asset in the income year ignoring any days when you did not use the asset or have it installed ready for use for any purpose. Note that the use does not have to be for a taxable purpose. In 10.5, we noted how capital allowance deductions are reduced where the asset is held for a purpose other than a taxable purpose. Thus, to calculate the decline in value of an asset using the prime cost method, we need to know: what the cost of the asset is; and what the effective life of the asset is.

[page 643] Remember that, for years after the start year, the decline in value cannot exceed the opening adjusted value of the asset for that year plus any amount included in the second element of the cost of the asset in that year. In simple terms, this will equal the cost less the asset’s decline in value up to that point. The meaning of ‘opening adjustable value’ is discussed in 10.43–10.44. 10.28 How the cost of an asset for capital allowance purposes is determined is discussed in 10.33–10.42. The method for determining the effective life of plant is discussed in 10.45–10.50. In certain circumstances (referred to in the legislation as ‘the change year’), adjustments are made to the asset’s cost and to the asset’s effective life in calculating the asset’s decline in value under the prime cost method. The following example illustrates the use of the prime cost method to calculate an asset’s decline in value. Note that the effects of the goods and services tax (GST) have not been taken into account.

On 1 July 2015, Rory buys a machine for $20,000 for use in his sail-making business. The machine is used in the business from the day it is purchased and for the whole of the 2015–16 year of income. Rory estimates that the useful life of the machine will be eight years. He wishes to depreciate the machine using the prime cost method. The decline in value of the asset in the 2015–16 year of income will be calculated as follows: $20,000 (cost) × 365 (days owned)/365 × 100%/8 = $2500 If the machine continues to be used in Rory’s business, then capital allowance deductions will be allowed at this rate for each following year that Rory owns the machine until, after eight years, the total of the capital allowance deductions equals $20,000. For the remaining years that Rory owns the machine, he will not be entitled to any further capital allowance deductions as, for reasons explained below, the decline in value of the machine in subsequent years will be zero. Note that in Year 1, the decline in value of $2500 will be less than the asset’s cost of $20,000. In the eighth year of Rory’s ownership the opening adjusted value of the machine will be $2500 (ie, $20,000 − $17,500). As the decline in value for the eighth

year of Rory’s ownership (as calculated under the formula) does not exceed the opening adjusted value of the machine the decline in value of the machine in that year will be $2500. In subsequent years, although the decline in value as calculated under the formula will be $2500, the opening adjusted value of the machine will be zero. This will mean that the decline in value for subsequent years will be zero.

[page 644]

The diminishing value method for pre-9 May 2006 assets 10.29 ITAA97 s 40-70 explains how to calculate the decline in value of an asset using the diminishing value method for pre-9 May 2006 assets. 40-70 (1) You work out the decline in value of a depreciating asset for an income year using the diminishing value method in this way:

where: base value is: (a) for the income year in which the asset’s start time occurs its cost; or (b) for a later year the sum of its opening adjustable value for that year and any amount included in the second element of its cost for that year. days held is the number of days you held the asset in the income year from its start time, ignoring any days in that year when you did not use the asset, or have it installed ready for use, for any purpose.

10.30 The diminishing value method cannot be used to calculate the decline in value of in-house software, an item of intellectual property, a spectrum licence or a datacasting transmitter licence. The decline in value of a depreciating asset for an income year cannot exceed the base value of the asset in the s 40-70(1) formula. 10.31 While slightly more complex than the prime cost method, the diminishing value method is also simple. Your deduction in any given year of income is the base value of the asset multiplied by the days you

owned the asset in the income year over the number of days in the income year multiplied by 150% over the asset’s effective life. In cases where you owned the asset for the whole of the year, your deduction will simply be the base value of the asset multiplied by 150% over the asset’s effective life. As noted in 10.27, ‘days held’ means the number of days you held the asset in the income year ignoring any days when you did not use the asset or have it installed ready for use for any purpose. Note that the use does not have to be for a taxable purpose. In 10.5 and 10.27, we noted how capital allowance deductions are reduced where the asset is held for a purpose other than a taxable purpose. Thus, to calculate the decline in value of an asset using the diminishing value method, we need to know: what the base value of the asset is; and what the effective life of the asset is. How the base value of the asset for capital allowance purposes is determined is discussed in 10.43. The method for determining the effective life of plant is discussed in 10.45–10.50. In certain circumstances (referred to in the legislation as ‘the change year’), adjustments are made to the asset’s cost and to the asset’s effective life in calculating the asset’s decline in value under the prime cost method. [page 645]

The diminishing value method for post-9 May 2006 assets 10.32 On 9 May 2006, the then Treasurer, the Hon Peter Costello, announced that incentives for investing in plant and equipment would be enhanced. The Treasurer announced that the diminishing value rate used for calculating the decline in value of a depreciating asset should be raised from 150% to 200%. The new rate of 200% should apply to determine the decline in value of project pools: see Treasurer’s Press Release No 041 of 9 May 2006. Under s 40-72 (diminishing value method for post-9 May 2006 assets), the approved formula with the

higher rate (200%) applies a higher rate for determining the decline in value of a depreciating asset. ITAA97 s 40-72 explains how to calculate the decline in value of an asset using the diminishing value method for post-9 May 2006 assets. 40-72 (1) You work out the decline in value of a depreciating asset for an income year using the diminishing value method in this way if you started to hold the asset on or after 10 May 2006:

where: base value has the same meaning as in subsection 40-70(1). days held has the same meaning as in subsection 40-70(1).

The following example illustrates the use of the diminishing value method to calculate an asset’s decline in value. Note that the effects of GST have not been taken into account and the asset in Example 10.1 above is post-9 May 2006.

Assume the facts in Example 10.1 with the variation that Rory wishes to calculate the decline in value of the machine using the diminishing value method. The decline in value of the machine for the 2016–17 year of income will be calculated as follows: [$20,000 (base value, in this case = cost) × 365 (days owned)/365] × 200%/8 = $5000 Assuming that Rory continues to own and use the machine, the decline in value in Year 2 of ownership will be calculated as: [$15,000 (base value) × 365 (days owned)/365] × 200%/8 = $3750 In Year 3 of Rory’s ownership, the decline in value would be: [$11,250 (base value) × 365 (days owned)/365] × 200%/8 = $2812.50 [page 646]

In Year 4 of Rory’s ownership, the decline in value would be: [$8,437.5 (base value) × 365 (days owned)/365] × 200%/8 = $2109.38 In Year 5 of Rory’s ownership, the decline in value would be: [$6,328.13 (base value) × 365 (days owned)/365] × 200%/8 = $1582.04 In Year 6 of Rory’s ownership, the decline in value would be: [$4746.09 (base value) × 365 (days owned)/365] × 200%/8 = $1186.52 In Year 7 of Rory’s ownership, the decline in value would be: [$3559.57 (base value) × 365 (days owned)/365] × 200%/8 = $889.89 In Year 8 of Rory’s ownership, the decline in value would be: [$2669.68 (base value) × 365 (days owned)/365] × 200%/8 = $667.42 Assume that Rory scrapped the machine at the beginning of the next year of income. Rory would be entitled to a balancing deduction of $2002.26 equal to the adjusted value of the machine, $2002.26, over the market value of the machine at the time it was scrapped, namely $0.

Refer to Example 10.1 and Example 10.2. Assuming the facts in those examples, complete the following chart showing the decline in value under the prime cost method and the diminishing value method in each year of Rory’s ownership. What differences do you note between the two methods? Think about the factors that would influence you in choosing one method over the other. Year 1

Year 2

Year 3

Year 4

Year 5

Year 6

Year 7

Year 8

Prime cost decline in value Diminishing value decline in value

[page 647]

Key concepts used in calculating decline

in value The meaning of ‘cost’ 10.33 ITAA97 Subdiv 40-C explains how to determine the cost of a depreciating asset for the purposes of the capital allowance provisions. Usually the cost is determined at the time when you began to hold the depreciating asset. There are two elements to the cost of a depreciating asset. The table set out in s 40-180, reproduced in Table 10.1 below, explains how the first element of the cost of a depreciating asset is determined in certain specified situations. Table 10.1: Item

First element of the cost of a depreciating asset In this case: The cost is:

1

A depreciating asset you hold is split into 2 or more assets

For each of the assets into which it is split, the amount worked out under section 40-205

2

A depreciating asset or assets that you hold is or are merged into another depreciating asset

For the other asset, the amount worked out under section 40-210

3

A balancing adjustment event happens The termination value of the asset to a depreciating asset you hold at the time of the event because you stop using it for any purpose expecting never to use it again, and you continue to hold it

4

A balancing adjustment event happens to a depreciating asset you hold but have not used because you expect never to use it, and you continue to hold it

The termination value of the asset at the time of the event

5

A partnership asset that was held, just before it became a partnership asset, by one or more partners (whether or not any other entity was a joint holder) or a partnership asset to which subsection 40-295(2) applies

The market value of the asset when the partnership started to hold it or when the change referred to in subsection 40-295(2) occurred

6

There is roll-over relief under section 40- The adjustable value of the asset to 340 for a balancing adjustment event the transferor just before the happening to a depreciating asset balancing adjustment event occurred

7

You are the legal owner of a

The market value of the asset when

depreciating asset that is hired under a you started to hold it hire purchase agreement and you start holding it because the entity to whom it is hired does not become the legal owner

[page 648] Table 10.1: Item

First element of the cost of a depreciating asset (cont’d) In this case: The cost is:

8

You started to hold the asset under an arrangement and: (a) there is at least one other party to the arrangement with whom you did not deal at arm’s length; and (b) apart from this item, the first element of the asset’s cost would exceed its market value

The market value of the asset when you started to hold it

9

You started to hold the asset under an arrangement that was private or domestic in nature to you (for example, a gift)

The market value of the asset when you started to hold it

10

[Item 10 not extracted]

[Not extracted]

11

To which Division 58 (which deals with assets previously owned by an exempt entity) applies

The amount applicable under subsections 58-70(3) and (5)

12

A balancing adjustment event happens to a depreciating asset because a person dies and the asset devolves to you as the person’s legal personal representative

The asset’s adjustable value on the day the person died, or if the asset is allocated to a low-value pool, so much of the closing pool balance for the income year in which the person died as is reasonably attributable to the asset

13

You started to hold a depreciating asset because it passed to you as the beneficiary or a joint tenant

The market value of the asset when you started to hold it reduced by any capital gain that was disregarded under section 128-10 or subsection 128-15(3), whether by the deceased or by the legal personal representative

14

A balancing adjustment event happens

What would, apart from subsection

to a depreciating asset you hold because of subsection 40-295(1B)

40-285(3), be the asset’s adjustable value on the day the balancing adjustment event occurs

Read through the table in ITAA97 s 40-180, and then think about the following questions: 1. What is the cost to the hirer (eg, a finance company) of a depreciating asset that is hired under a hire-purchase agreement where the entity to whom it is hired does not become its legal owner? In your view, at what time would this provision most likely be triggered? 2. Where you did not deal at arm’s length with at least one of the other parties to the arrangement under which you started to [page 649] hold a depreciating asset, what other conditions must be satisfied before the market value of the asset at that time will be its cost? 3. Identify any ways in which you may come to hold a depreciating asset that are not dealt with in the table. Suggested solutions can be found in Study help.

Where the table in s 40-180 does not apply, the first element of the cost of a depreciating asset is determined under s 40-185. Here, the first element of the cost of the depreciating asset will be the greater of: 40-185 (1) … (a) the sum of the amounts that would have been included in your assessable income because you started to hold the asset or received the benefit, or because you gave something to start holding the asset or receive the benefit, if you ignored the value of anything you gave that reduced the amount actually included; or (b) the sum of the applicable amounts set out in this table in relation to holding the asset or receiving the benefit. Amount you are taken to have paid to hold a depreciating asset or to receive a benefit Item 1

In this case: You pay an amount

The amount is: The amount

2

You incur or increase a liability to pay an amount

The amount of the liability or increase when you incurred or increased it

3

All or part of a liability to pay an amount owed to you by another entity is terminated

The amount of the liability or part when it is terminated

4

You provide a non-cash benefit

The market value of the non-cash benefit when it is provided

5

You incur or increase a liability to provide a non-cash benefit

The market value of the non-cash benefit or the increase when you incurred or increased the liability

6

All or part of a liability to provide a non-cash benefit (except the depreciating asset) owed to you by another entity is terminated

The market value of the non-cash benefit when the liability is terminated

[page 650] Working through the following activity should assist you in appreciating the operation of s 40-185 in calculating the cost of a depreciable asset. A suggested solution is contained in Study help.

Antonio borrows $500,000 from Shylock. Antonio purchases a 50% interest in a boat that Bassanio uses in his fishing business. Assume that Antonio and Bassanio thereafter conduct independent fishing businesses in which the boat is used as an asset. Antonio pays Bassanio $500,000 in cash (using the money borrowed from Shylock), forgives a debt of $100,000 that Bassanio owes him in relation to a previous fishing venture, and undertakes to provide Bassanio with 20% of Antonio’s fishing catch for the next six months. Three months later, Bassanio accepts an offer from Antonio to release Antonio from his obligation to provide Bassanio with 20% of Antonio’s fishing catch for the remaining three months in exchange for a new set of scales for use in Bassanio’s business. What will be the cost of the interest in the fishing boat to Antonio? What will be the cost of the new set of scales to Bassanio?

10.34 You should note when trying to work out the cost of a depreciating asset that, in some cases, the ITAA97 or ITAA36 may deem you to have paid amounts under notional transactions. These deemed amounts will be included in the cost of a depreciating asset to you. The relevant amounts are: the price of a notional purchase made when trading stock is converted to a depreciating asset under ITAA97 s 70-110 (discussed in 11.30); the cost of an asset under a hire-purchase arrangement under ITAA97 s 240-45; and a lessor’s deemed purchase price when a luxury car lease is terminated under ITAA36 Sch 2E s 42A-105(3). Note also that ITAA97 s 40-185(1)(a) interacts with the non-cash business benefit rules in ITAA36 s 21A: see 3.6. For example, say you receive an item of depreciable property that is a non-cash business benefit to you. Here, the cost of the item will be the amount included in your assessable income under ITAA36 s 21A less any contribution that you made to receive the depreciable property. 10.35 Except where the cost of a depreciating asset is modified to be its market value, its cost is reduced under ITAA97 Subdiv 27-B where ITAA97 Div 40 deductions are available, and the holder of the asset is entitled to a GST input tax credit or a decreasing adjustment in respect of its acquisition or importation or for an amount included in the second element of its cost. The reduction is equal to the amount of the GST input tax credit or the decreasing adjustment (as the case may be). Conversely, where the entity is entitled to an increasing GST adjustment [page 651] for a depreciating asset, the cost of the asset is increased by the amount of the increasing adjustment. GST input tax credits, decreasing adjustments and increasing adjustments are discussed in Chapter 19.

10.36 Case law on the general law meaning of cost in other related contexts raises the issue of whether a particular outlay relates to a particular asset. For example, in FCT v Broken Hill Proprietary Co Ltd (1969) 120 CLR 240, Kitto J held that expenditure associated with demolishing existing structures did not form part of the cost of new structures for the purposes of the general mining provisions of the ITAA36. Kitto J’s reasoning was that the demolition expenses were not specific to the new structures, but brought about general advantages to the land on which the new structures were ultimately erected. However, Kitto J did regard excavation expenses as part of the cost of the new structures as the only purpose served by the excavations was peculiar to the new structures.8 By contrast, in BP Refinery (Kwinana) Ltd v FCT (1960) 12 ATD 204; 8 AITR 113, Kitto J held that expenses associated with removing temporary accommodation for construction workers formed part of the cost of plant constructed by the workers. It is arguable that the approach taken by Kitto J in Broken Hill Proprietary Co means that items like customs duty and expenses of obtaining delivery form part of the cost of an asset under the general law meaning of cost. This is on the basis that such expenses are specific to the asset in question.9

1. 2. 3.

Would costs of removing an old machine from a building be included in the first element of the cost of a replacement machine? Would costs associated with reinforcing a platform on which a new machine is to rest be included in the cost of the new machine? Would items like customs duty and expenses of obtaining delivery form part of the cost of a depreciable asset?

10.37 The second element of the cost of a depreciating asset is determined under ITAA97 s 40-190 and will be the amount paid for each economic benefit that has contributed to bringing the asset to its present condition and location since you started to hold the asset.

[page 652]

Reconsider the questions in Questions 10.2, above. Would any amount that did not, in your view, fall into the first element of cost fall into the second element of cost?

Note that, under s 40-315, non-deductible expenses that are reasonably attributable to a balancing adjustment event form part of the termination value of the depreciating asset and will not form part of the cost of the asset.10 There are several additional rules relevant to determining the cost of a depreciating asset. We shall now examine some of the more significant of these rules. 10.38 ITAA97 s 40-195 applies an apportionment rule where you pay an amount for two or more things that include at least one depreciating asset. The rule also applies where you pay an amount for two or more things and that amount includes a contribution to bringing a depreciating asset to its present condition or location. The language of s 40-195 suggests that ‘thing’ is intended to include the performance of an act (such as delivery) as well as referring to a chattel or to a chose in action. Where the apportionment rule applies, you take into account as part of the cost of the depreciable asset only so much of your payment as is reasonably attributable to the asset. 10.39 ITAA97 s 40-215 is directed at preventing a taxpayer from obtaining capital allowances under Div 40 while obtaining deductions under another Division of the ITAA97 (other than Div 328) or under the ITAA36. It does this by reducing each element of the cost of a depreciating asset by any portion that has been or will be deducted, or has been or will be taken into account, in calculating a deductible amount, other than under Div 40.

A related provision is s 40-220, which indicates that the cost of a depreciating asset is reduced by any portion of it that consists of an amount that is not of a capital nature. A simple example of the operation of s 40-220 would occur where a depreciable asset was repaired. The repairs would be deductible under s 25-10. Prima facie, the amount spent on the repairs would be included in the second element of the cost of the depreciated asset (as an amount paid for each economic benefit that has contributed to bringing the asset to its present condition and location). However, you will recall that s 25-10(3) states that you cannot deduct capital expenditure under s 25-10. Thus, any amount deducted under s 25-10 must necessarily not be of a capital nature. This would mean that s 40-220 would reduce the cost of the depreciated asset by the amount of the s 25-10 repairs deduction. 10.40 Special provisions also apply where depreciating assets are split or merged. Under ITAA97 s 40-205, the cost of each separate asset into which a depreciating asset is split is a reasonable proportion of the sum of the following amounts: [page 653] (a) the adjustable value of the original asset just before it was split; and (b) the amount that you are taken to have paid under section 40-185 for any economic benefit involved in splitting the original asset.

The ‘adjustable value’ of a depreciating asset is discussed in 10.43–10.44. Generally, the adjustable value of a depreciating asset will, at a given point, be its cost less the decline in its value to that point. The amount paid under s 40-185 for any economic benefits involved in splitting the original asset will generally refer to costs associated with splitting the asset. Note also that, consistently with the broad interpretation given to the term ‘interest’ in Div 40, the granting or assignment of an interest in an item of intellectual property is treated by s 40-115(3) as if the grantor had stopped holding the part of the item subject to the grant. Hence, a balancing adjustment event (see the discussion of balancing adjustment

events at 10.54–10.58) will take place in relation to the part of the item represented by the interest granted. The cost of the interest granted in relation to the item and the cost of the retained part of the item will, under s 40-205, be a reasonable proportion of the cost of the original item. The EM to the New Business Tax System (Capital Allowances — Transitional and Consequential) Bill 2001 (Cth) at para 12.113, in commenting on ss 40-115(3) and 40-205, indicates that the granting of a licence over an item of intellectual property will be treated as a part disposal of that item of intellectual property. 10.41 Similarly, where depreciable assets are merged, ITAA97 s 40210 states that the first element of the cost of the merged asset is a reasonable proportion of the sum of: (a) the adjustable value or adjustable values of the original asset or assets just before the merger; and (b) the amount you are taken to have paid under section 40-185 for any economic benefit involved in merging the original asset or assets.

The amount paid under ITAA97 s 40-185 for any economic benefit involved in merging the assets will generally refer to costs associated with merging the assets. 10.42 Other adjustments to cost are relevant where the depreciating asset is a car. Sometimes, cars may be acquired at a discount because the purchaser (or an associate) sells another asset at less than its market value to the vendor of the car (or an associate). In these circumstances, ITAA97 s 40-225 will increase the first element of the cost of the car provided you (or another entity — usually, but not necessarily, an associate) have deducted or can deduct an amount for the other asset, and the sum of the cost of the car and the discount portion exceeds the car limit set out in s 40-230. Under s 40-230, the first element of the cost of certain cars is reduced to the car limit for the financial year in which you started to hold it if its cost exceeds that limit. The car limit for the 2016–17 financial year is $57,581. The limit is indexed annually. Where a car is purchased second-hand, Taxation Ruling

[page 654] TR 93/24 states that the limit applies to the purchaser’s first use of the car whether or not the previous owner had depreciated the car. The car discount provisions and the car limit provisions apply only to cars designed mainly for carrying passengers. Neither provision applies to a car: (a) fitted out for transporting disabled people in wheelchairs for profit; or (b) whose first element of cost exceeds [the car limit] only because of modifications made to enable an individual with a disability to use it for a taxable purpose.

Alain wishes to trade in his old sports car for a new one for use in his business of selling motor lubricants. He approaches Stirling, a car dealer, who shows him the latest model of his current car. Its retail price is $70,000. Another dealer has offered Alain $40,000 for his current car. Alain’s current car cost him $50,000 and its adjustable value for capital allowance purposes is $35,000. After negotiations, Stirling agrees to sell Alain the new car for $55,000 and offers a trade-in of $25,000 on his old car. If ITAA97 s 40-225 did not apply, the position would be:

Balancing deduction on old car

$10,000

(ie, $35,000 adjusted value for capital allowance purposes minus $25,000 tradein) Cost of new car for capital allowance purposes

$55,000

If s 40-225 applies and assuming the transaction with Stirling is at arm’s length, the position will be: Balancing deduction on old car

$10,000

Cost of new car under s 40-225

$70,000

Cost of new car reduced to car limit under s 40-230

$57,581

Although Alain and Stirling are not related parties, it may be that they are not dealing at arm’s length in relation to the sale on the basis that there has not been real bargaining between them. In that case, item 6 in the table in s 40-305 would mean that the market value of the old car, $40,000, was its termination value. This would mean that there would be a balancing inclusion of $10,000 in Alain’s assessable income on the sale of the old car. The cost of the new car would be determined as shown in the above example. Balancing adjustments and the calculation of termination value are discussed at 10.54–10.69. The implications of s 40-320 for Alain when he subsequently sells the new car are discussed at 10.63.

[page 655]

The meaning of ‘base value’, ‘adjustable value’ and ‘opening adjustable value’ 10.43 In 10.32, we noted that, to calculate an asset’s decline in value using the diminishing value method, we needed to know what the base value of the asset was. Under ITAA97 s 40-70(1), the base value of an asset will be: (a) for the income year in which the asset’s start time occurs its cost; or (b) for a later year the sum of its opening adjustable value for that year and any amount included in the second element of its cost for that year.

Under s 40-60(2), the start time of a depreciating asset is when you first use it, or have it installed ready for use for any purpose. 10.44 The concepts of ‘opening adjustable value’ and ‘adjustable value’ cannot be understood in isolation from each other. ITAA97 s 4085 explains what the two concepts refer to: 40-85 Meaning of adjustable value and opening adjustable value of a depreciating asset

(1) The adjustable value of a depreciating asset at a particular time is: (a) if you have not yet used it or had it installed ready for use for any purpose its cost; or (b) for a time in the income year in which you first use it, or have it installed ready for use, for any purpose its cost less its decline in value up to that time; or (c) for a time in a later income year the sum of its opening adjustable value for that year and any amount included in the second element of its cost for that year up to that time, less its decline in value for that year up to that time. (2) The opening adjustable value of a depreciating asset for an income year is its adjustable value to you at the end of the previous income year.

In simple terms, the adjustable value of a depreciating asset at a particular time will normally be the cost of the asset less its decline in value to that time. Note that in calculating adjustable value, it does not matter that the asset might not have been used wholly for a taxable purpose. The fact that the asset has not been used wholly for a taxable purpose will mean that the capital allowances claimed in respect of the asset will be reduced under ITAA97 s 40-25(2). Differences between the capital allowances claimed and the decline in value of the asset can have significant consequences when the depreciable asset is sold. [page 656] The opening adjustable value is reduced or increased because of the availability of GST input tax credits, decreasing adjustments and increasing adjustments in a similar manner for the way cost is adjusted for these GST consequences. See the discussion at 10.35.

The concept of effective life 10.45 Under both the prime cost and the diminishing value methods, to calculate the decline in value of an asset you need to know what the ‘effective life’ of the asset is. Thus, the concept of effective life is central to the capital allowance provisions. You are required by ITAA97 s 40-95 to choose either to use an

effective life determined by the Commissioner under s 40-100 or to determine the effective life of the asset yourself under s 40-105. Generally,11 the choice must be made so that it is regarded as being in force at the time when you entered into the contract to acquire the asset or when you started constructing it. This rule does not apply where you did not start using the asset (or have it installed ready for use) within five years of the time when you acquired it or started constructing it. In these circumstances, the choice is required to be regarded as being in force at the time when you start using the asset or have it installed ready for use. The actual time for making the relevant choice in each case is the day on which you lodge your income tax return for the year to which the choice relates or within such further time as the Commissioner allows: see s 40-130. Once made, your choice applies to the income year to which it relates and to all later income years. This rule, however, does not apply where you choose to recalculate the effective life of a depreciating asset under s 40-110. 10.46 In making a determination of the effective life of a depreciable asset under ITAA97 s 40-100, the Commissioner is required to estimate the period for which it can be used by any entity for a taxable purpose or for the purpose of producing exempt income. In making this determination, the Commissioner is required to: (a) assume that the asset will be subject to wear and tear at a [reasonable rate]; (b) assume that the asset will be maintained in reasonably good order and condition; and (c) have regard to the period within which the asset is likely to be scrapped, sold for no more than scrap value or abandoned.

The fact that the likelihood that an asset will be scrapped can be taken into account in determining its useful life means that the useful life of the plant can be shortened due to technical or commercial obsolescence. The Commissioner’s determination of the effective life of an asset may specify conditions for particular depreciating assets. The determination may also specify a day from which it takes effect. In certain circumstances, set out in s 40-100(3), the determination may operate retrospectively.

[page 657] 10.47 If you choose to determine the effective life of an asset yourself under ITAA97 s 40-105, you do so by estimating the period for which it can be used by any entity for a taxable purpose or for a purpose of producing exempt income. In making this determination, you are required to make the same assumptions and have regard to the same factors as the Commissioner makes and has regard to under s 40-100. The period is determined as from the time when you started using the asset or had it installed ready for use for any purpose. Where you acquire a depreciating asset from an associate who has deducted capital allowances, s 40-95(4) requires you to use the same effective life (in the case of the diminishing value method) or unelapsed effective life (in the case of the prime cost method) as the associate was using. 10.48 The effective lives of the following intangible depreciating assets are set out in a table in ITAA97 s 40-95(7), reproduced below in Table 10.2. Item

Table 10.2: Effective life of certain intangible depreciating assets For this asset: The effective life is:

1

Standard patent

20 years

2

Innovation patent

8 years

3

Petty patent

6 years

4

Registered design

15 years

5

Copyright (except copyright in a film)

The shorter of: (a) 25 years from when you acquire the copyright; or (b) the period until the copyright ends

6

A licence (except one relating to a copyright or in-house software)

The term of the licence

7

A licence relating to a copyright (except copyright in a film)

The shorter of: (a) 25 years from when you become the licensee; or (b) the period until the licence ends

8

In-house software

4 years

9

Spectrum licence

The term of the licence

10

Datacasting transmitting licence

15 years

14

Telecommunications site access right

The term of the right

10.49 You may choose to recalculate the effective life of a depreciating asset under ITAA97 s 40-110. The recalculation may be made if the effective life that you have been using is no longer accurate because of changed circumstances relating to the nature of the use of the asset. Examples in the legislation indicate that circumstances such as changes in demand, more rigorous than anticipated use, legislative change, and technological changes could all justify a recalculation of the effective life [page 658] of a depreciating asset. In certain circumstances, set out in s 40-110(2) and (3), a recalculation of a depreciating asset’s effective life is required where the cost of the asset increases by more than 10%. Recalculations of effective life are made under the self-assessment method set out in s 40-105. Note that the provisions relating to recalculation of effective life do not apply to intangible depreciating assets mentioned in the table in s 40-95(7). Note that no use is made of broad-banded or accelerated depreciation rates in Div 40. Capped effective lives apply in some cases. This should mean that, in most cases, capital allowances permitted under Div 40 should correspond with depreciation allowed for financial accounting purposes. 10.50 Taxation Ruling TR 2008/4 ‘Income Tax: Effective Life of Depreciating Assets’ issued by the Commissioner in 2008 came into effect on 1 July 2008, replacing the previous TR 2007/3 which was withdrawn on 1 July 2008. In TR 2008/4, the Commissioner’s determination concerning the effective life of depreciating assets has been amended by the new ruling. In TR 2008/4, the Schedule provides a consolidated version of the amended effective life for depreciating

assets. On 24 June 2009, the Commissioner issued TR 2009/4, which replaced TR 2008/4. TR 2008/4 was withdrawn on 1 July 2009. In TR 2009/4 ‘Income Tax: Effective Life of Depreciating Assets’, the Commissioner has prepared a Schedule which contains a consolidated list of depreciable assets and effective lives for use from 1 July 2009.

The meaning of ‘taxable purpose’ 10.51 Your capital allowance deduction under ITAA97 s 40-25 is reduced under s 40-25(2) by the part of the asset’s decline in value that is attributable to your use of the asset or having it installed ready for use for a purpose other than a taxable purpose. The definition of ‘installed ready for use’ in ITAA97 s 995-1(1) states that it means ‘installed ready for use and held in reserve’. A ‘taxable purpose’ is defined in s 40-25(7) as: (a) (b) (c) (d)

the purpose of producing assessable income; or the purpose of exploration or prospecting; or the purpose of mining site rehabilitation; or environmental protection activities.

The phrase ‘purpose of producing assessable income’ is in turn defined in ITAA97 s 995-1(1) as follows: purpose of producing assessable income: something is done for the purpose of producing assessable income if it is done: (a) for the purpose of gaining or producing assessable income; or (b) in carrying on a business for the purpose of gaining or producing assessable income.

[page 659] It appears that there is no requirement that the use of the unit of plant be an active use (as distinct from a passive use) in gaining or

producing assessable income. It has been held in other contexts that ‘[a] person who owns land may be said to use it for his own purposes notwithstanding that he permits someone else to occupy it, even under a lease’: Ryde Municipal Council v Macquarie University (1978) 139 CLR 633 at 638. See also (in the context of investment allowance claims) Tourapark Pty Ltd v FCT (1982) 149 CLR 176. Allowing a passive use to satisfy the test for capital allowances means that assets can be depreciable even though they do not perform an active function in the taxpayer’s business. 10.52 In relation to the ITAA36 provisions relating to depreciation, the Commissioner expressed the view in Taxation Determination TD 95/52 that plant is only ‘held in reserve’ when it is held for future use in an existing business. Administrative Appeals Tribunal (AAT) cases in relation to the ITAA36 depreciation provisions have held that the required connection with income production is not satisfied where the business has not commenced at the time that depreciation is claimed.12

Compare the connection with income production that is implicit in ITAA97 s 40-25(2) and (7) with the connection required for purposes of s 8-1. In view of the High Court decision in Steele v DCT (1999) 197 CLR 459; 41 ATR 139; 99 ATC 4242, discussed in 8.24, should the Commissioner’s view in TD 95/52 be reconsidered?

10.53 As noted above, where the decline in value of a depreciating asset is attributable to your use of the asset or having it installed for a purpose other than a taxable purpose, your capital allowance is reduced under ITAA97 s 40-25(2). The following example illustrates the operation of the reduction under s 40-25(2).

Trevor buys a computer on 1 July 2015 to use in a consulting business that he conducts from home. The purchase price of the computer is $6000 and Trevor estimates that its useful life will be three years. Trevor decides to depreciate the computer using the prime cost method. Under the prime cost method, Trevor will be entitled to a capital allowance of $2000 per year. On 1 January 2016, Trevor commences employment with a company that provides him with access to a computer at work. Trevor’s employer does not object to him using the computer in his workplace in his consulting business. [page 660] Because of this, Trevor decides that he will no longer need the computer that he has at home in his consulting business. Trevor decides to retain his home computer but uses it only for private purposes between 1 January 2016 and 30 June 2016. For the year ending 30 June 2016, Trevor’s capital allowances will be reduced under ITAA97 s 40-25(2). In these circumstances, Trevor has used the computer for a taxable purpose for only half of the year, and it would be reasonable to reduce Trevor’s deductions by 50%. Thus, Trevor’s deductions are reduced from $2000 to $1000. Jocelyn purchases a television on 1 July 2015 for use in her business as a freelance TV critic (which she conducts from home) and for private purposes. The purchase price of the TV is $1000 and Jocelyn estimates that it has a useful life of five years. Jocelyn also estimates that she uses the TV 60% for business purposes and 40% for private purposes. Jocelyn decides to depreciate the TV using the prime cost method. In the absence of s 40-25(2), Jocelyn would be entitled to a capital allowance of $200. Under s 40-25(2), however, her deduction will be reduced by the part of the asset’s decline in value that was attributable to its use for a purpose other than a taxable purpose. In these circumstances, it would be reasonable to reduce Jocelyn’s deduction by 40%. This would mean that her capital allowance deduction for the year would be $120.

Balancing adjustments 10.54 It should be obvious that any method of allowing deductions for the decline in value of a depreciating asset is at best an estimate of that decline in value over time. This estimate will not necessarily coincide with the actual decline in value of the asset. Sometimes an asset may have actually declined in value over a shorter period than the

useful life that was taken into account in calculating capital allowance deductions. Conversely, the depreciating asset may have declined in value over a longer period than the estimated effective life for capital allowance purposes. Under ITAA97 Div 40, certain events — most commonly when you stop holding the depreciating asset — are adopted as the occasion for reconciling the capital allowance deductions previously allowed with the actual decline in value of the depreciating asset. This reconciliation is achieved through what are known as ‘balancing adjustments’. In general, if the capital allowance deductions have been greater than the actual decline in value of the depreciating asset, including an amount in assessable income recaptures the excessive deductions. If the capital allowance deductions have been less than the actual decline in value of the depreciating asset, then an additional deduction is allowed. 10.55 Under ITAA97 s 40-285(1), an amount is included in your assessable income where a ‘balancing adjustment event’ occurs for a depreciating asset and the decline in value of the asset was calculated under Subdiv 40-B (or would have been if you [page 661] had used the asset) and the asset’s ‘termination value’ is more than its adjustable value just before the event occurred. The amount included is the excess of the depreciating asset’s termination value over its adjustable value. The inclusion in your assessable income takes place in the year in which the balancing adjustment event occurred. 10.56 You are allowed a deduction under s 40-285(2) where a ‘balancing adjustment event’ occurs for a depreciating asset and the decline in value of the asset was calculated under Subdiv 40-B (or would have been if you had used the asset) and the asset’s ‘termination value’ is less than its adjustable value just before the balancing adjustment event occurred. The amount of the deduction is the excess of the depreciable asset’s termination value over its adjustable value.

10.57 Generally, after a balancing adjustment has been made in relation to a depreciating asset, s 40-285(3) will mean that the adjustable value of the depreciating asset will be zero if you continue to hold the asset after the balancing adjustment event.13 10.58 A ‘balancing adjustment event’ must occur in relation to a depreciating asset before a balancing adjustment can be made. Some circumstances where a balancing adjustment event will occur are set out in ITAA97 s 40-295(1). (1) A balancing adjustment event occurs for a depreciating asset if: (a) you stop holding the asset; or (b) you stop using it, or having it installed ready for use, for any purpose and you expect never to use it, or have it installed ready for use, again; or (c) you have not used it and: (i) if you have had it installed ready for use you stop having it so installed; and (ii) you decide never to use it. Note: A balancing adjustment event occurs under paragraph 40-295(1)(a) when you start holding a depreciating asset as trading stock.

You may recall from the definition of depreciating asset in s 40-30, discussed in 10.6, that an item of trading stock cannot be a depreciating asset. Hence, when a depreciating asset becomes trading stock, although you continue to hold an asset, you no longer hold a depreciating asset. This means that a balancing adjustment event occurs under s 40-295(1) (a) when you start to hold a depreciating asset as trading stock. [page 662]

1.

Identify which, if any, of the following are balancing adjustment events as defined in ITAA97 s 40-295: (a) a depreciating asset is destroyed by fire;

(b) you start using a computer wholly for private purposes when you previously used the computer wholly for business purposes; (c) you start holding an asset that was previously part of your trading stock for the purpose of gaining your assessable income; (d) you start holding an asset for the purpose of gaining your exempt income when you previously held the asset for the purpose of gaining your assessable income; (e) you, as lessee of a car that you used for business purposes, acquire legal ownership of the car at the expiration of the lease. 2. Identify a situation where the balancing adjustment event described in s 40-295(1)(b) could occur. Suggested responses can be found in Study help.

A balancing adjustment event also occurs under s 40-295(2) where changes occur in the holding of, or in the interests of, entities in a depreciating asset due to the formation or dissolution of a partnership or due to changes in the composition of a partnership. Section 40295(2) is discussed in more detail in 14.45–14.46. Note that s 40-295(3) states that merely splitting a depreciable asset into two depreciating assets or merging a depreciating asset with another does not of itself amount to a balancing adjustment event. For there to be a balancing adjustment event in these circumstances, there would have to be a change in the holding, use or interests in the asset as set out in s 40-295(1) and (2). 10.59 In order to calculate a balancing adjustment in relation to a depreciating asset, you need to know what the asset’s ‘termination value’ was just before the balancing adjustment event. The table in ITAA97 s 40-300, reproduced below in Table 10.3, sets out what the termination value of a depreciating asset will be in certain specified circumstances. If more than one item in the table applies to the balancing adjustment event, then the relevant termination value will be the one set out in the last applicable item in the table. If no item in the table applies in the circumstances of the balancing adjustment event, then the depreciating asset’s termination value will be the amount that you are taken to have received for the asset under ITAA97 s 40-305 (examined in more detail below).

[page 663]

Item

Table 10.3: Termination values (s 40-300) For this balancing adjustment event: The termination value is:

1

You stop using a depreciating asset, or having it installed ready for use, for any purpose and you expect never to use it again even though you still hold it

The market value of the asset when you stopped using it or having it installed ready for use

2

You decide never to use a depreciating asset that you have not used even though you still hold it

The market value of the asset when you make the decision

3

You stop using in-house software for Zero any purpose and you expect never to use it again even though you still hold it

4

You decide never to use in-house software that you have not used even though you still hold it

Zero

5

One or more partners stop holding a depreciating asset when it becomes a partnership asset or a balancing adjustment event referred to in subsection 40-295(2) occurs

The market value of the asset when the partnership started to hold it or when the balancing adjustment event occurred

6

You stop holding a depreciating asset under an arrangement and: (a) there is at least one other party to the arrangement with whom you did not deal at arm’s length; and (b) apart from this item, the termination value would be less than its market value

The market value of the asset just before you stopped holding it

7

You stop holding a depreciating asset under an arrangement that was private or domestic in nature to you (for example, a gift)

The market value of the asset just before you stopped holding it

8

A depreciating asset is lost or destroyed

The amount or value received or receivable under an insurance policy or otherwise for the loss or destruction

9

You stop holding a depreciating asset because you die and the asset starts being held by the legal personal representative

The asset’s adjustable value on the day you died or, if the asset is allocated to a low-value pool, so much of the closing pool balance for the income year in which you died as is reasonably

attributable to the asset 10

You stop holding a depreciating asset The market value of the asset on the day because it passes directly to a you die beneficiary or joint tenant when you die

[page 664]

Item

Table 10.3: Termination values (s 40-300) — (cont’d) For this balancing adjustment event: The termination value is:

11

[Item 11 not extracted]

[Not extracted]

13

The balancing adjustment event occurs under subsection 40-295(1A)

Zero

14

The balancing adjustment event occurs under subsection 40-295(1B)

What would, apart from subsection 40285(3), be the asset’s adjustable value on the day the balancing adjustment event occurs

1.

Note that under several items in the table, the termination value of the depreciating asset will be the market value of the asset at a particular time. Assuming that the depreciating asset has, in fact, declined in value, what will be the effect of this market value substitution where the actual decline has been greater than the decline calculated for ITAA97 Div 40 purposes? What will be the effect of market value substitution where the decline calculated for Div 40 purposes is greater than the actual decline in value? 2. Identify the items in the table where the termination value of a depreciating asset is its market value. Having regard to your response to Question 1, why do you think the termination value is the market value of the asset in these circumstances? 3. Note that, in the case of Item 9 in the table, the termination value of the depreciating asset will be the adjustable value of the asset when you die. What will the effect of this be? Why do you think the termination value is the adjustable value in these circumstances? Suggested responses can be found in Study help.

10.60

As mentioned above, where none of the items in the table in

ITAA97 s 40-300 apply, then the termination value of a depreciating asset is determined under s 40-305. Under s 40-305, the termination value will be the greater of: (a) any amounts you have deducted or can deduct or that have or will be taken into account in calculating an amount you can deduct because of the balancing adjustment event; and (b) the sum of the relevant amounts set out in the table in s 40-305 below. [page 665] Table 10.4: Termination values (s 40-305) Amount you are taken to have received under a balancing adjustment Item

In this case:

The amount is:

1

You receive an amount

The amount

2

You terminate all or part of a liability to pay an amount

The amount of the liability or part when you terminate it

3

You are granted a right to receive an amount or an amount to which you are entitled is increased

The amount of the right or increase when it is granted or increased

4

You receive a non-cash benefit

The market value of the non-cash benefit when it is received

5

You terminate all or part of a liability to provide a non-cash benefit

The market value of the non-cash benefit or reduction in the non-cash benefit when the liability or part is terminated

6

You are granted a right to receive a non-cash benefit or you become entitled to an increased non-cash benefit

The market value of the non-cash benefit, or the increase, when it is granted or increased

Note 1: Item 1 includes not only amounts actually received but also amounts taken to have been received. Examples include the price of the notional sale made when a depreciating asset is converted to trading stock under section 70-30, the consideration for an asset held under a hire purchase arrangement under section 240-25 and a lessee’s deemed consideration when a luxury car lease ends under subsection 242-90(3). Note 2: Section 230-505 provides special rules for working out the amount of consideration for an asset if the asset is a Division 230 financial arrangement or a Division 230 financial arrangement is involved in that consideration.

It is clear that the reference in s 40-305(1)(a) ‘to an amount you can

deduct because of the balancing adjustment event’ is to deductions obtainable under s 8-1, for example, when a depreciating asset is given to a customer as a goodwill gesture.14 It cannot be a reference to amounts deducted under Div 40. The balancing deduction provisions would not operate properly if the reference to deductions in s 40-305(1) (a) to ‘an amount you can deduct’ included a balancing deduction. Note that, under s 40-315, any non-deductible expenses reduce the termination value of a depreciating asset that you have that are reasonably attributable to the balancing adjustment event. This rule does not apply to balancing adjustment events occurring in the circumstances referred to in items 6 or 11 in the table in s 40-300 (Table 10.3 above). Under Subdiv 27-B, the termination value of a balancing event that is a GST taxable supply is reduced by an amount equal to the GST payable on the supply except where the termination value is modified to be the market value of the asset. [page 666] The termination value is also reduced if the entity that held the asset has an increasing adjustment that relates directly or indirectly to the taxable supply in the year the balancing adjustment occurred. The termination value is increased where the entity has a decreasing adjustment that relates to the taxable supply in the year. 10.61 Where a receipt is only partially in respect of a balancing adjustment event occurring in relation to a depreciating asset, ITAA97 s 40-310 indicates that you take into account, as the termination of the depreciating asset, only the part of the receipt that is reasonably attributable to the asset. The following examples illustrate the calculation of the termination value of depreciating assets in a variety of circumstances.

Arthur sells a depreciating asset to Simon for $50,000 in an arm’s length transaction. The adjustable value of the asset at the time of the sale was $40,000. The cost of the asset to Arthur was $60,000. Arthur had used the asset wholly for a taxable purpose. No item in the table in ITAA97 s 40-300 (Table 10.3) is applicable. Under s 40-305, the termination value of the asset will be the greater of the deductions allowed or allowable to Arthur and the amount received from Simon ($50,000). No deductions will be allowable to Arthur in this situation. Hence, in this situation, the termination value of the depreciating asset will be $50,000. A balancing adjustment of $10,000 will be included in Arthur’s assessable income.

Arthur sells a depreciating asset to Preston for $70,000 in an arm’s length transaction. The adjustable value of the asset at the time of the sale was $40,000. The cost of the asset to Arthur was $60,000. Arthur had used the asset wholly for a taxable purpose. No item in the table in ITAA97 s 40-300 (Table 10.3) is applicable. Under s 40-305, the termination value of the asset will be the greater of the deductions allowed or allowable (nil) to Arthur and the amount received from Preston ($70,000). Hence, in this situation, the termination value of the depreciating asset will be $70,000. Note that, in this situation, the difference between cost ($60,000) and adjusted value ($40,000) represents recaptured allowances. Although the excess of the termination value of $70,000 over the cost of $60,000, in effect, represents a capital gain, it will be included in the balancing adjustment and will be taxed as statutory income. Importantly, the CGT discount will not apply to the ‘capital gain’ element in the termination value.

[page 667]

Assume the facts in Example 10.5 with the variation that the sale to Simon is a non-arm’s length transaction and the market value of the depreciating asset at the time of the sale was $65,000. In this situation, item 6 in the table in ITAA97 s 40-300 (Table 10.3) applies and the termination value of the asset will be its market value, namely $65,000. A balancing adjustment of $25,000 will be included in Arthur’s assessable income.

William sells a depreciating asset to Harold for $30,000 in cash and for shares in Hastings Ltd worth $40,000. The cost of the depreciating asset was $100,000 and the adjustable value of the depreciating asset is $80,000. In these circumstances, none of the items in the table in ITAA97 s 40-300 (Table 10.3) will be applicable. The termination value under s 40-305 will be the greater of the amount received and the deductions allowed and allowable. In calculating the amount received, s 40-305(2) will mean that the market value of the shares in Hastings Ltd will be taken into account. Hence, the total amount received will be $70,000 (being $30,000 in cash and $40,000 being the value of the shares). This is greater than the total deductions (nil) allowed or allowable to William. William will be allowed a s 40-285(2) deduction of $10,000.

Dorothea sells a depreciating asset to Adam for $30,000 in cash. The cost of the depreciating asset was $100,000 and the adjustable value of the asset at the time of the sale was $80,000. The termination value of the asset will be the greater of the cash received and the deductions allowable to Dorothea (nil). Hence, in this situation, the termination value will be $30,000. This will mean that Dorothea will be allowed a s 40-285(2) balancing deduction of $50,000.

10.62 You will recall from 10.57 that a balancing adjustment event occurs when a depreciating asset becomes trading stock. You will also

recall that the note to the table in ITAA97 s 40-305(1) (Table 10.4 above) pointed out that item 1 in the [page 668] table includes amounts taken to have been received as well as amounts actually received. When you continue to own a depreciating asset, but commence holding it as trading stock, s 70-30 treats you as if you had sold the depreciating asset and then repurchased it for the same amount. You can choose whether the sale is deemed to be at what would have been the cost of the item for trading stock purposes or its market value just before it became trading stock. Assuming that the plant has depreciated, a taxpayer will normally prefer the deemed sale to be at market value especially if this value is at or below the written-down value of the plant. This will mean that no balancing charge is included in the taxpayer’s assessable income or, if the market value is below written-down value, that the taxpayer obtains a balancing deduction. Choice of market value will also minimise the cost of the item for trading stock purposes. This will mean that any s 70-35(2) inclusion in assessable income is minimised. The s 70-35(2) inclusion is discussed in 11.2. See also the discussion of s 70-30 at 11.30. 10.63 Recall from the discussion at 10.42 that under ITAA97 s 40230, the cost of certain cars is reduced to the car limit for the financial year in which you started to hold the car. When a balancing adjustment event occurs in relation to a car, the cost of which has been reduced under s 40-230, only the same proportion of termination value is recognised for balancing adjustment purposes. Section 40-325 does this by multiplying the termination value by the following fraction:

where: CL is the car limit for the car for the financial year in which you first

used it for any purpose. The adjustment in termination value is illustrated in the following example.

On 1 July 2012, Amelia buys a luxury car for use in her business. The purchase price of the car is $90,000. Assume that Amelia did not incur any expenses which could be included in the second element of the cost of the car to her. The car depreciation limit for 2016–17 is $57,581. Assume that Amelia sells the car on 1 January 2017 for $85,000. The termination value of the car will be calculated as follows: $85,000 × $57,581/$90,000 = $54,382.06

We also noted in 10.41 that s 40-225 will increase the cost of a car which is acquired at a discount because the purchaser sells another asset to the vendor of the car. In these circumstances, s 40-320 will increase the termination value of the car to the vendor by the discount portion. [page 669]

Assume the facts in Example 10.3. When Alain subsequently sold the new car, its termination value would be increased under ITAA97 s 40-320 by the discount portion, that is, $15,000. Say, for example, Alain sells the car after one year and after claiming capital allowances of $7126.13. The adjustable value of the car at that time will be $49,882.87. Assume that the sale price of the car is $63,000. Here, the language of s 40-320 suggests that we should first calculate the termination value of the car (taking into account the apportioning of the termination value under s 40-325) and then increase the termination value by the amount of the discount. Hence, the result of the adjustments will be as follows: Calculation of termination value before s 40-320 increase: $63,000 × $57,581/$70,000 = $51,822.90

We then add the amount of the discount of $15,000 thus producing a termination value of $66,822.90. This will produce a balancing inclusion for Alain of $3822.90.

10.64 In 10.15, we noted that a car, in relation to which you choose the ‘cents per kilometre’ or the ‘12% of original value’ method for calculating your car expense deductions, is not a depreciating asset for purposes of ITAA97 Div 40. Nor do balancing adjustments apply when you dispose of the car. Division 40 capital allowances can be claimed, however, in relation to a car where you use the ‘one-third of actual expenses’ or the ‘log book’ method of substantiation. Where you have used one of these methods, a balancing adjustment will arise under s 40285 when you dispose of the car. However, where you use a mixture of either the ‘cents per kilometre’ method or the ‘12% of original value’ method with either the ‘one-third of actual expenses’ or the ‘log book’ method, then the amount that you must include in your assessable income when you subsequently dispose of the car is calculated using a method set out in s 40-370(2). 10.65 The position where you sell a depreciating asset that you have used only partially for a taxable purpose is complex and merits further explanation. Where a depreciating asset has not been used wholly for a taxable purpose, your capital allowance deductions will have been reduced under ITAA97 s 40-25(2). Where a balancing adjustment event occurs in relation to a depreciating asset, and where your deductions have been reduced under s 40-25(2), the balancing adjustments that would otherwise be made under s 40-285 are reduced. The reduction is calculated using the formula set out in s 40-290(2):

[page 670]

Assuming that there has been no roll-over relief for the asset under s 40-340 (roll-over relief under s 40-340 is discussed in 10.67–10.69), the ‘sum of reductions’ will be the reductions in your capital allowances previously made under s 40-25. Assuming that there has been a s 40340 roll-over, and that provisions relating to splitting and merging of depreciated assets do not apply (provisions relating to splitting and merging of depreciating assets are discussed in 10.40), ‘total decline’ will be the decline in value of the depreciating asset since you started to hold it. The calculation of the reduction in the balancing adjustment is illustrated in the following example.

Assume the facts in Example 10.4. If Trevor sells the computer on 1 July 2016 for $4500, in the absence of s 40-290 there would normally be an inclusion in assessable income equal to the excess of the termination value of $4500 over the adjusted value of $4000 (being cost less decline in value). This would give rise to a balancing inclusion of $500. Using the formula in s 40-290(2), the balancing adjustment is reduced by the following amount:

Hence, the balancing adjustment would be reduced from $500 to $250.

Normally, ITAA97 s 118-24 will mean that a capital gain or loss will not arise from a CGT event (that is also a balancing adjustment event) happening to a depreciating asset. A major exception to this rule is CGT event K7.15 Where a balancing adjustment event happens to an asset that has been used partly for a purpose other than a taxable purpose, and its termination value exceeds its cost, a capital gain will arise under CGT event K7 (s 104-240 applies for assets that are not pooled and s 104-245 for pooled assets). Note, however, that CGT event K7 will not

apply where roll-over relief for the balancing adjustment event applies under s 40-340. Section 40-340 is discussed at 10.67–10.69. In the case of non-pooled assets, the capital gain is calculated using the following formula set out in s 104-240: [page 671]

The calculation of the capital gain that arises under CGT event K7 is illustrated in the following example.

Assume the facts in Example 10.12 with the variation that Trevor sells the computer for $6500. In these circumstances, the balancing adjustment amount in the absence of s 40290 would be: $6500 (termination value) less $4000 = $2500 Section 40-290 would reduce the balancing adjustment as follows:

Hence, the balancing adjustment would be reduced from $2500 to $1250. As the asset’s termination value exceeded its cost a capital gain would arise under CGT event K7. The capital gain would be calculated as follows:

The logic behind the interaction of s 40-290 and CGT event K7

where a depreciating asset is sold for more than its cost is that a balancing inclusion arises for the portion of termination value over adjusted value that represents a decline in value due to business use that generated capital allowances while the portion of termination value over cost that represents the private use of the asset is taxed as a capital gain. It should be noted that the CGT discount (see 6.11), if otherwise available, can apply to a CGT event K7 capital gain.16 Where the asset’s cost is greater than its termination value then, in the case of non-pooled assets, the capital loss is calculated using the following formula set out in s 104-240: [page 672]

10.66 Prior to 1 July 2001, ITAA97 s 106-5(5) stated that, where the depreciating asset was a partnership asset, the general rule that any capital gain or loss arising from a CGT event happening to a partnership asset was made by the partners individually does not apply in the case of a depreciating asset. Hence, any capital gain or loss arising under CGT event K7 was taken into account in the partnership’s ITAA36 s 90 calculation. ITAA36 s 90 is discussed in 14.17. ITAA97 s 106-5(5) was repealed by Taxation Laws Amendment Act (No 5) 2002 (Cth), effective as from 1 July 2002. Thereafter, CGT event K7 is accounted for at the individual partner level.

Roll-over relief 10.67 Where roll-over relief applies, neither an inclusion in income nor a deduction arises on a balancing adjustment event. Rather, under ITAA97 s 40-345, the transferee is placed in the same position as the transferor would have been if the balancing adjustment event had not taken place. That is, the transferee can deduct the decline in value of the

depreciating asset using the same method and effective life that the transferor was using. Note that s 40-340(8) states that there can be no roll-over relief if Subdiv 170D (the linked group loss deferral provisions discussed in 12.147) applies to the relevant balancing adjustment event. 10.68 An automatic roll-over under ITAA97 s 40-340(1) can arise where the balancing adjustment event involves a disposal of a depreciating asset to another entity and the disposal amounted to a CGT event. The s 40-340(1) roll-over applies where any of the following CGT roll-overs under the ITAA97 are applicable: Subdiv 122-A (disposal of asset to a wholly owned company); Subdiv 122-B (disposal of asset by partnership to wholly owned company); Subdiv 126-A (disposal of asset on marriage breakdown); Subdiv 126-B (disposal of asset to another member of wholly owned group). In applying the s 40-340(1) roll-over, the Div 118 general exemptions from CGT and the s 122-25(3) exclusions from the Subdiv 122-A rollover are disregarded. Where the automatic roll-over under s 40-340(1) applies, the transferor must give the transferee notice within six months after the end of the transferee’s year of income in which the balancing adjustment event took place. The notice must provide enough information about the transferor’s holding of the property to enable the transferee to determine how Div 40 applies to the transferee’s holding of the depreciating asset. The transferee is required to retain the notice until five years after the first balancing adjustment event following the roll-over. The Subdiv 122-A and Subdiv 122-B roll-overs are discussed in 12.150–12.156, and the Subdiv 126-B roll-over is discussed in 12.158. 10.69 Under ITAA97 s 40-340(3), roll-over relief may also be available where a balancing adjustment event occurs under s 40-295(2). You will recall that a balancing adjustment event will occur on the formation or dissolution of a partnership or on a

[page 673] change in the interests of partners in a partnership asset. Roll-over relief is available in this situation if the transferor entity (or entities) and the transferee entity (or entities) jointly choose roll-over relief.

Relief for involuntary disposals 10.70 Where a depreciating asset is lost or destroyed, or is compulsorily acquired by a Commonwealth Government agency, or is disposed of with knowledge that it will otherwise be compulsorily acquired by a Commonwealth Government agency, then balancing adjustment relief may be available under ITAA97 s 40-365. Generally, for the relief to be available, you must incur expenditure on a replacement asset and start to hold it no earlier than one year before the balancing adjustment event occurred and no later than one year after the end of the income year in which the balancing adjustment event occurred. In addition, you must, at the end of the year of income in which you incurred the expenditure, start to use, or install ready for use, the replacement asset wholly for a taxable purpose. Any amount that would, in the absence of the relief, be included in your assessable income as a balancing adjustment is applied to reduce either: the cost of the replacement asset (in an income year which is the start time for the depreciating asset); or its opening adjustable value plus any amount included in the second element of its cost (for a later income year). Hence, the effect of the relief under s 40-365 is that there is no inclusion in your assessable income in the year in which the balancing adjustment event takes place but your future capital allowance deductions for the replacement asset are reduced.

Low-value and software development pools

Low-value pools 10.71 ITAA97 Subdiv 40-E allows low-cost and low-value plant to be allocated to a low-value pool. A low-cost asset is defined by s 40-425 as a depreciating asset (other than a horticultural plant) the cost of which at the end of the income year in which you start to use it, or have it installed ready for use, for a taxable purpose is less than $1000. However, the cost of the asset17 must exceed $300 and you must not use the asset for a purpose of producing assessable income other than carrying on a business. A low-value asset is defined in s 40-425(5)18 as a depreciating asset (other than a horticultural plant) that you hold, where you have deducted or can deduct capital allowances for it under the diminishing value method, where the opening adjustable value of the asset for the current year is less than $1000. A low-cost asset is excluded from the definition of low-value asset. A depreciating asset cannot be allocated to a low-value pool if you can deduct amounts for it under the capital [page 674] allowance provisions relevant to simplified tax system (STS) taxpayers. The STS depreciation provisions are discussed in 10.92–10.93. The cost of an asset allocated to a low-value pool is reduced under Subdiv 27B where the acquisition or importation of the asset was a GST creditable acquisition and the acquiring or importing entity becomes entitled to a GST input tax credit in the year of acquisition or importation. The reduction is equal to the amount of the input tax credit. GST input tax credits are discussed in Chapter 19. 10.72 Once you allocate a low-cost asset to a low-value pool, ITAA97 s 40-430(1) requires you to allocate all future low-cost assets that you subsequently hold to the pool. However, this rule does not apply to low-value assets. Hence if you allocate a low-value asset to a low-value pool in one income year, you are not required to allocate to the pool all subsequent low-value assets that you hold. Section 40-

430(3) states that once a depreciating asset has been allocated to a lowvalue pool it must remain in the pool. 10.73 When a low-cost depreciating asset is allocated to a low-value pool, ITAA97 s 40-435 requires you to make a reasonable estimate of the percentage of your use of the asset (including any past use) that will be for a taxable purpose over the effective life of the asset. Where a lowvalue depreciating asset is allocated to a low-value pool, you make an estimate of your use of the asset over any period of its effective life that is yet to elapse at the start of the income year in which the allocation is made. 10.74 The decline in value of depreciating assets allocated to a lowvalue pool in a given year is calculated by using a series of steps set out in ITAA97 s 40-440. 40-440 How you work out the decline in value of assets in low-value pools (1) You work out the decline in value of depreciating assets in a low-value pool for an income year in this way: Step 1. Work out the amount obtained by taking 18¾% of the taxable use percentage of the cost of each low-cost asset you allocated to the pool for that year. Add those amounts. Step 2. Add to the step 1 amount 18¾% of the taxable use percentage of any amounts included in the second element of the cost for that year of: (a) assets allocated to the pool for an earlier income year; and (b) low-value assets allocated to the pool for the current year. Step 3. Add to the step 2 amount 37½% of the sum of: (a) the closing pool balance for the previous income year; and (b) the taxable use percentage of the opening adjustable values of low-value assets, at the start of the income year, that you allocated to the pool for that year. Step 4. The result is the decline in value of the depreciating assets in the pool.

[page 675] 10.75 When depreciating assets are in a low-value pool, the ‘closing pool balance’ for the pool is calculated each year. Under ITAA97 s 40-

440(2), to determine the closing pool balance you first add together the following: 1. the closing pool balance of the pool for the previous income year; and 2. the taxable use percentage of the costs of low-cost assets that you allocated to the pool for that year; and 3. the taxable use percentage of the opening adjustable values of any low-value assets that you allocated to the pool for that year as at the start of the year; and 4. the taxable use percentage of any amounts included in the second element of the cost of: (a) assets allocated to the pool for an earlier income year; and (b) low-value assets allocated to the pool for the current year. You then subtract the decline in value of the depreciating assets in the pool for the current year. GST input tax credits will reduce the closing pool balance where the credit occurs in a year after the acquisition or importation. Increasing or decreasing GST adjustments may also affect the closing pool value. The calculation of the decline in value of depreciating assets in a lowvalue pool and of the closing pool balance is illustrated in the following example.

Jane runs a butcher’s shop. On 1 July 2015, she acquires three new chopping boards for use in the business. Each chopping board costs $1000. She estimates that the useful life of the chopping boards is 10 years. She estimates that the taxable use percentage of each chopping board is 100%. She decides to allocate the chopping boards to her low-value pool. On 1 September 2016, she decides to allocate two meat racks that she had previously used to the pool. Jane had previously used the diminishing value method to calculate the decline in value of the meat racks. The opening adjustable value of each meat rack as at 1 July 2016 was $1000 and Jane estimates that the remaining useful life of the meat racks as at 1 September 2016 is 14 years and nine months. Jane estimates that the taxable use percentage of each meat rack is 100%.

The decline in value of the assets in the pool for the year ending 30 June 2016 is calculated as follows: (a) 18.75% × $3000 (taxable use percentage of cost of new assets allocated to the pool in 2016) = $562.50; plus (b) 37.5% × $2000 (taxable use percentage of the opening adjustable value of low-value assets allocated to the pool during he year) = $750. [page 676] Total decline in value for 2016

$562.50 + $750 = $1312.50

The closing pool balance will be calculated as follows: Closing pool balance of previous income year

$0.00

Plus Taxable percentage of cost of low-cost assets allocated to pool

$3000.00

Plus Opening adjusted value of low-value assets allocated to pool

$2000.00 $5000.00

Minus Decline in value of pool assets in year

$1312.50

Closing pool balance as at 30 June 2016

$3687.50

1.

In Example 10.14, what would the decline in value of the chopping boards and meat racks have been in 2015 if Jane had used the diminishing value method and had not chosen to pool these items? 2. Which items in Example 10.14 would Jane be able to subsequently remove from the pool? 3. What would the result in Example 10.14 have been if Jane, in fact, used one of the chopping boards at home as well and estimated its taxable use percentage as 60%? 4. Assuming that no assets are added to or removed from the pool, and that no costs are incurred on pooled assets in 2017, what would the closing balance of the pool be as at 30 June 2017? Suggested solutions can be found in Study help.

10.76 Where a balancing adjustment event happens to a depreciating asset in a low-value pool, the closing balance for that year is reduced by the taxable use percentage of the asset’s termination value. However, the closing balance cannot be reduced below zero. Where the sum of the taxable use percentages of the termination values of pool assets to which balancing adjustment events happened in the year of income exceeds the closing pool balance for that year, the excess is [page 677] included in your assessable income. The operation of these rules is illustrated in the following example.

Assume the facts in Example 10.14 with the variation that Jane disposes of one of the chopping boards for $900 and disposes of one of the meat racks for $950 on 1 December 2016. The closing balance of the pool for 2016 will be reduced by: (100% × $900) + (100% × $950) = $1850 Hence the closing pool balance for 2016 will be calculated as follows: Closing pool balance at 30 June 2016

$3687.50

Less closing pool balance × 37.5%

$1382.81 $2304.69

Less balancing adjustment Closing pool balance at 30 June 2016

1.

$1850.00 $454.69

What would the result have been in Example 10.15 if Jane had disposed of an additional chopping board on the same day for $900? Assume that the taxable use

2.

percentage of the additional chopping board was also 100%. What would the result have been in Example 10.15 if the taxable use percentage of the chopping board disposed of in Example 10.14 had been 60% throughout Jane’s ownership of the chopping board?

Software development pools 10.77 In-house software was specifically listed as a depreciating asset in ITAA97 s 40-30(2). In 10.48, we extracted a provision (in Table 10.2) which stated that the effective life of in-house software is four years. Normally, expenditure on the development of software would be expenditure of a capital nature and would not be deductible under s 8-1 because of the ‘process–structure’ test discussed in 8.61–8.68. In the absence of the pooling provisions, a taxpayer would not be able to claim Div 40 deductions for the software until it was used in the taxpayer’s business. The creation of a software development pool can reduce compliance costs for taxpayers who are undertaking several internal software development projects at the same time. Software development pools can also be advantageous for taxpayers who undertake expenditure on software that is never used or where there is a lengthy delay between [page 678] the date of the development expenditure and the date when the software is first used in the taxpayer’s business. The expenditure in the pool is reduced, under Subdiv 27-B, if it relates, directly or indirectly, to a GST creditable acquisition, and the acquiring or importing entity becomes entitled to a GST input tax credit for the acquisition or importation. The reduction is equal to the amount of the input tax credit. Increasing or decreasing GST adjustments may also affect the expenditure allocated to the pool. 10.78 Under ITAA97 s 40-450, it is possible to allocate expenditure on in-house software to a software development pool if it is expenditure

incurred in developing, or having another entity develop, computer software. Note that, as discussed in 10.6, in-house software is specifically listed in s 40-30 as a depreciating asset. ‘In-house software’ is defined in s 995-1(1) as: … computer software, or a right to use computer software, that you acquire, develop or have another entity develop: (a) that is mainly for you to use in performing the functions for which the software was developed; and (b) for which you cannot deduct amounts under a provision of this Act outside Divisions 40 and 328.

10.79 Once you create a software development pool, any subsequent expenditure you incur on in-house software development must be allocated to a software development pool. Amounts can be allocated to a software development pool only if you intend to use the software solely for a taxable purpose. It would appear, therefore, that the requirement that in-house software development expenditure be allocated to a software development pool is subject to the requirement that you intend to use the software solely for a taxable purpose. As software that you do not intend to use solely for a taxable purpose cannot be allocated to a software development pool, it seems that you are able to calculate its decline in value under the core provisions in ITAA97 Subdiv 40-B. Separate software development pools must be created for each income year in which you incur software development expenditure. 10.80 Capital allowance deductions for expenditure in a particular year on in-house software development in a software development pool are calculated under ITAA97 s 40-455. In each successive year, you get deductions of the following amounts of expenditure: Year 1

Nil

Year 2

40%

Year 3

40%

Year 4

20%

Note that this method means that the total cost of the in-house

software development expenditure is deductible over a four-year period. Note also that the [page 679] useful life of the software is irrelevant to a determination of the capital allowances deductible in respect of a software development pool. The operation of this rule is illustrated in the following example.

Gamma Ltd incurs a total of $500,000 in Year 1 on development of in-house software. Assume that the expenditure is not otherwise deductible. Gamma Ltd decides to allocate the expenditure to a software development pool. Gamma also incurs $400,000 on development of in-house software in Year 2 and a further $600,000 on the development of in-house software in Year 3. Assume that Gamma Ltd intends to use the software wholly for a taxable purpose. Gamma Ltd’s capital allowances are calculated as follows: Pool created In Year 1:

Year 1

Nil

Year 2

$200,000

Year 3

$200,000

Year 4

$100,000

Total

$500,000

Pool created In Year 2:

Year 2

Nil

Year 3

$160,000

Year 4

$160,000

Year 5

$80,000

Total

$400,000

Pool created In Year 3:

Year 3

Nil

Year 4

$240,000

Year 5

$240,000

Year 6

$120,000

Total

$600,000

10.81 Where expenditure on in-house software is in your software development pool, ITAA97 s 40-460 states that any amount you receive as consideration in relation to the software is included in your assessable income. This would mean, for example, that where an exclusive licence is granted in relation to software for a consideration that is not calculated by reference to former or anticipated use, the consideration for the software would be included in the licensor’s assessable income. Note that under ordinary concepts, as discussed in 3.15–3.16, the [page 680] consideration would not normally be assessable income in these circumstances. The rule in s 40-460 does not apply where the parties choose roll-over relief on the formation or dissolution of a partnership or on a change in the composition of a partnership.

Project pools: Capital allowances for ‘black hole’ expenditure 10.82 Prior to the introduction of the uniform capital allowance provisions, several types of expenditure had been identified that were

denied ITAA97 s 8-1 deductibility and for which no capital allowances were available. The denial of s 8-1 deductibility was typically on the basis that the expense was either not incurred in gaining or producing assessable income or was expenditure of a capital nature or both. Most typically, these were expenses that were not regarded as being sufficiently connected with assessable income to be deductible under s 8-1. Such expenses could include: feasibility studies undertaken before the taxpayer was sufficiently committed to the project; expenses of setting up or closing down a business; and obligations incurred after a business had ceased that were not sufficiently connected with the production of assessable income. Under the previous capital allowance provisions, most notably ITAA97 Div 42, capital allowances were available only if the expenditure or the asset on which the expenditure was made had certain characteristics. In the case of the general depreciation provisions in Div 42, the asset in question was required to be plant and was required to be used or installed ready for use for the purpose of producing assessable income. Where no asset was produced by an expenditure, or where the asset produced was not ‘plant’, no deduction was available under Div 42. Even where the expenditure was on plant, when it was incurred before or after a taxpayer commenced the relevant business, the further issue that arose was whether, at the time of the expenditure, the plant was used or installed ready for use for the purpose of producing assessable income. Other provisions — for example, Div 373, which allowed amortisation of certain expenditure on intellectual property — were also limited in scope and, typically, would not allow deductions for expenditure of the types mentioned above. 10.83 The Review of Business Taxation (Ralph Review) in 2006 described business expenditure which was neither deductible under ITAA97 s 8-1 nor under any of the then current capital allowance provisions as ‘black hole’ expenditure. The Ralph Review recommended that black hole expenditures be either expensed, amortised or capitalised. More specifically, the Ralph Review recommended that expenditure giving rise to assets of indeterminate but finite lives be written off over a statutory period determined on a case-by-case basis.

The Ralph Review further recommended that all forms of capitalraising expenses be written off over a five-year maximum period.19 [page 681]

ITAA97 Subdiv 40-I: Capital allowances for black hole expenditure 10.84 ITAA97 Subdiv 40-I permits capital allowance deductions for certain expenditure which, previously would have been classified as black hole expenditure. Under s 40-830, you may allocate project amounts to a project pool. Project amounts are defined in s 40-840 as certain mining capital expenditures and certain transport capital expenditures,20 and another amount of capital expenditure that has the following characteristics: (a) it does not form part of the cost of a depreciating asset that you hold or held; and (b) you cannot deduct it under another provision of [the ITAA97] outside [Subdiv 40-I]; and (c) it is directly connected with a project you carry on or propose to carry on for a taxable purpose; and (d) it is one of these: (i) an amount paid to create or upgrade community infrastructure for a community associated with the project; or (ii) an amount incurred for site preparation costs for depreciating assets (except, for horticultural plants, in draining swamp or low-lying land or in clearing land); or (iii) an amount incurred for feasibility studies for the project; or (iv) an amount incurred for environmental assessments for the project; or (v) an amount incurred to obtain information associated with the project; or (vi) an amount incurred in seeking to obtain a right to intellectual property; or (vii) an amount incurred for ornamental trees or shrubs.

In a given income year, you are allowed the following deduction in relation to project amounts that are allocated to a project pool: For project amounts allocated to a project pool prior to 10 May

2006, taxpayers can continue to use the following formula to determine the depreciation deduction:

The deduction commences in the first income year in which the project starts to operate. Section 40-830(8) states that your deduction for a given year cannot exceed [page 682] the ‘pool value’ in the above formula. For you to understand how to calculate the deduction the terms used in the above formula need to be explained. ‘DV project pool life’ will normally be the project life of the project. Where the project life has been recalculated it will be the most recently recalculated project life. Section 40-845 explains that the ‘project life’ of a project is determined by estimating how long in years21 it will be from when the project starts to when it stops operating. ‘Pool value’ is defined in s 40-830(3). For the first income year that a project amount is allocated to the pool, the pool value will be the sum of the project amounts allocated to the pool for that year. For subsequent income years, the pool value will be the sum of the closing pool value for the previous year and any project amounts allocated to the pool in the year. Where the pooled expenditure relates directly or indirectly to a creditable acquisition or a creditable importation, and the acquiring or importing entity becomes entitled to a GST input tax credit in respect of the acquisition or importation, the pool value is reduced by the amount of the input tax credit. Increasing and decreasing adjustments may also affect the pool value. The ‘closing pool value’ for a project pool for an income year is defined in s 40-830(7). For the first income year that a project amount

is allocated to the pool, the closing pool value will be the sum of the project amounts allocated to the pool for the year less the amount you could deduct for the pool for that year (disregarding any reductions in your deductions under s 40-835 because the project operated for a purpose other than a taxable purpose). For a subsequent income year, the closing pool value will be the closing pool value for the previous year plus any project amounts allocated to the pool in the year less any amount you could deduct disregarding s 40-835. Under Subdiv 40-I, for project pools which contain project amounts incurred on or after 10 May 2006, taxpayers can calculate a deduction for an income year using the following formula:

On 9 May 2006, the then Treasurer, the Hon Peter Costello, announced that incentives for investing in plant and equipment would be enhanced. The Treasurer announced that the diminishing value rate used for calculating the decline in value of a depreciating asset should be raised from 150% to 200%. The new rate of 200% should apply to determine the decline in value of project pools: see Treasurer’s Press Release No 041 of 9 May 2006. Under s 40-72 (diminishing value method for post-9 May 2006 assets), the approved formula with the higher rate (200%) applies a higher rate for determining the decline in value of a depreciating asset. Under s 40-832 (project pools for post-9 May 2006 projects), the approved formula with the higher rate (200%) applies a higher rate for determining the decline in value of a project pool. [page 683] 10.85 The calculation of deductions for project pools is illustrated in the following example:

Hades Ltd incurs $1m on feasibility studies in relation to an aluminum smelter project in the year ending 30 June 2012. Hades Ltd’s business has previously been coal mining. Hades Ltd proceeds with the project, which starts operating on 1 July 2012. Hades Ltd estimates the project life will be 15 years. Hades Ltd allocates the $1m feasibility expenditure to a project pool on 1 July 2012. In the 2012–13 year of income, Hades Ltd incurs a further $500,000 on an environmental assessment in relation to the project. Hades Ltd allocates this expenditure to the pool in the year ending 30 June 2013. Hades Ltd will be entitled to the following project pool deductions: 2011–12 income year:

The closing pool balance as at 30 June 2012 will be: $1,000,000 − $133,333.34 = $866,666.67 2012–13 income year:

The closing pool balance as at 30 June 2013 will be: $866,666.67 + $500,000 − $182,222.23 = $1,184,444.44

10.86 Where the project operates in a given year for purposes other than taxable purposes, ITAA97 s 40-480 requires you, to the extent that the project so operates, to reduce your s 40-830 deduction by a reasonable amount. If you abandon, sell or otherwise dispose of a project for which you have a project pool, s 40-830(4) allows you a deduction equal to the sum of the pool’s closing value for the previous year and any project amounts allocated to the pool in the current year. Any amount that you receive for the sale, abandonment or other disposal is included in your assessable income for that year by s 40830(5). Other capital amounts that you derive in a given year in relation

to a project amount allocated to a project pool, or in relation to something on which a project amount is spent, are included in your assessable income for the year of derivation by s 40-830(6). [page 684]

1.

What requirements would the taxpayer in Softwood Pulp and Paper Ltd v FCT (1976) 7 ATR 101; 76 ATC 4439 (see 8.57) have had to satisfy to obtain project pool deductions if the facts in that case had occurred today? In your view, would the taxpayer have succeeded? 2. Can you think of a situation where a project could operate for purposes other than taxable purposes? Suggested responses can be found in Study help.

10.87 ITAA97 Subdiv 40-I also allows certain other capital expenditures relating to businesses to be deducted on a straight-line basis over five years. A s 40-880 deduction is not available to the extent to which: it forms part of the cost of a depreciating asset that you hold, used to hold or will hold; or it is otherwise deductible under the ITAA97, other than this section; or it forms part of the cost of land; or it is in relation to a lease or other legal or equitable right; or it would otherwise be taken into account in determining whether a profit is included in assessable income under ITAA97 s 6-5 or 15-15 or is a loss that you can deduct; or it could otherwise be taken into account in determining the capital gain or capital loss from a CGT event, or a provision of the

ITAA97 would expressly make the expenditure non-deductible if it was not of a capital nature; or a provision of the ITAA97 expressly prevents the expenditure being taken into account as described above for a reason other than the expenditure being of a capital nature; or it is expenditure of a private or domestic nature; or it is incurred in relation to gaining or producing exempt income or nonassessable non-exempt income. In 2005, the Commissioner released Interpretative Decision ATO ID 2005/157 ‘Income Tax Capital Allowances: Project Pools — Project Amount — Taxable Income’. In ATO ID 2005/157, the Commissioner reiterates that to qualify for a ‘project amount’ under s 40-840(2), ‘the amount must be capital expenditure which … [is] directly connected with a project that the taxpayer carries on or proposes to carry on for a taxable purpose’. Since the taxpayer’s project must be for taxable purposes, the project must be an income-producing activity. If a taxpayer merely realises a gain from the sale or disposal of a capital asset, the realisation of that investment is not income and the test under s 40-840(2)(c) is not satisfied. Hence, the project pooling provisions under Subdiv 40-I would not be available because there would be no project being carried on for a taxable purpose. [page 685] 10.88 On 27 August 2008, the Commissioner issued Taxation Ruling TR 2008/5. The main purpose of the ruling was for the Commissioner to consider and provide an opinion on the tax consequences for a company issuing shares in exchange for assets or for services. In relation to ITAA97 Div 40, the ruling examined the circumstances in which a company exchanges shares for depreciable assets. According to the Commissioner, the issuing of shares by a company in exchange for depreciating assets involves the provision of a non-cash benefit to the vendor of the assets. Hence, the cost of the asset is represented by the market value of the shares at the relevant time when the exchange

occurred. Capital allowances under Div 40 for the depreciating assets will be determined by reference to this cost: TR 2008/5 para 9. According to the Commissioner, when a company issues shares in exchange for depreciating assets, the company provides a non-cash benefit and will incur a liability at the time of issuing the shares. For the purposes of Div 40, the relevant cost of the depreciating asset will include the market value of the share. In the company’s balance sheet, the depreciating asset is likely to be shown in the company’s accounts at its fair market value instead of the market value of the company’s shares. However, for the purposes of Div 40, the cost of the depreciating asset would be represented by the market value of the share (used for its purchase and paid to the asset’s vendor) and not the market value of the asset, should the market values differ: TR 2008/5 para 70.

Business-related costs Interpretative Decision ATO ID 2009/6 10.89 On 7 January 2009, the Commissioner issued ATO ID 2009/6. The Commissioner examined the issue of whether a taxpayer could deduct, under ITAA97 s 40-880, the balance of any undeducted qualifying expenditure in the year in which the taxpayer ceases to carry on the business to which the expenditure relates. According to the Australian Taxation Office (ATO), the taxpayer cannot make the deduction. This is because s 40-880(2) provides that a deduction is allowed for qualifying expenditure in equal proportions over a period of five years, commencing in the year in which the expenditure is incurred. Under s 40-880(2), 20% of the qualifying expenditure is deductible by the taxpayer in the income year in which the expenditure is incurred. The remaining balance (80%) is deductible, 20% for each of the next four income years.

Interpretative Decision ATO ID 2009/42

10.90 On 11 June 2009, the Commissioner issued ATO ID 2009/42. The Commissioner examined the meaning of the phrase ‘proposed to be’ contained in ITAA97 s 40-880(2)(c). Section 40-880(2) provides that a taxpayer can deduct capital expenditure incurred, in equal proportions over a period of five income years, commencing in the year in which the capital expenditure is incurred: (a) in relation to your business; or (b) in relation to a business that used to be carried on; or

[page 686] (c) in relation to a business proposed to be carried on, or (d) to liquidate or deregister a company of which you were a member, to wind up a partnership of which you were a partner or to wind up a trust of which you were a beneficiary, that carried on a business.

According to the Commissioner, a taxpayer’s eligibility for deduction under s 40-880 is established at the time when the expenditure is incurred. Hence, for the taxpayer to satisfy eligibility requirements he or she needs to demonstrate that there exists a commitment to commence to carry on the business (eg, by identifying a specific business model and a concept to carry on the business in accordance with the model). In addition, the taxpayer will need to provide ‘sufficient identity about the business proposed to be carried on’. Factors such as a taxpayer’s industry knowledge, a history of employment within the relevant industry, the creation of a business model, identification of a business structure and a targeted approach to identify potential business acquisitions are all important factors demonstrating the taxpayer’s commitment to commence to carry on a business with sufficient identity.

Interpretative Decision ATO ID 2009/47 10.91 On 26 June 2009, the Commissioner issued ATO ID 2009/47, which examined the operation of ITAA97 s 41-20. Under s 41-20, at the time of ‘first use’, it must be reasonable to conclude that the

taxpayer will use the asset for the principal purpose of carrying on a business. According to the Commissioner, whether at the first-use time it is reasonable to conclude that the taxpayer will use an asset for more than 50% of the time for the purpose of carrying on its business will depend on the facts of the case and time. This will require a comparison between the asset’s use for the purpose of carrying on a business and its non-use for the purpose of carrying on the business. Hence, time is considered the most appropriate measure of use in this context.

Depreciation under the simplified tax system 10.92 From 1 July 2007, the simplified tax system (STS) was replaced with concessions available to small business entities (SBEs)22 that qualify.23 Generally, SBEs with aggregate turnover of less than $2m will qualify for concessional treatment for depreciation. SBEs that qualify for concessional treatment can claim a tax deduction of 50% of the cost of eligible new assets (for assets over $1000). This tax deduction which is available to SBEs is in addition to deductions available under the simpler depreciation rules or the normal depreciation rules (uniform capital allowances).24 [page 687] 10.93 ITAA97 Subdiv 328-D sets out the STS treatment of depreciating assets. Key features of that treatment are outlined below. Under s 328-180, you obtain an outright deduction of the adjustable value of a low-cost depreciating asset in the income year in which you start to use the asset or have it installed ready for use for a taxable purpose. For these purposes, a low-cost asset is defined in s 40-425(2) and will be an asset costing less than $1000. If the asset is subsequently sold, s 328-215(4) will include the taxable use portion of its termination value in the vendor’s assessable income. Outright deductions can also be

obtained under s 328-180(2) for additions to cost of less than $1000 at the time of purchase. Other depreciating assets are placed into pools based on the effective life of the asset. Additions to cost in excess of $1000 and any subsequent additions to cost regardless of their amount are also added to the relevant pool. Where the asset has an effective life of 25 years or more, s 328-185 requires that it be placed in the longlife STS pool. Other assets are placed in the general STS pool. Assets in the long-life pool qualify for a deduction of 5% of the pool balance per annum on a diminishing value basis. Assets in the general STS pool qualify for a deduction of 30% of the pool balance per annum on a diminishing value basis. Where the asset is used only partly for a taxable purpose, only the taxable purpose portion of the asset’s cost is allocated to the pool.25 Where a pooled asset is disposed of, s 328-215 will mean that there will be a balancing inclusion in your income for that year where the asset’s termination value exceeds the pool balance. The inclusion will be the amount of the excess. The cost of an asset allocated to a Div 328 pool is reduced under Subdiv 27-B where the acquisition or importation of the asset was GST creditable and the acquiring or importing entity becomes entitled to a GST input tax credit in the year of acquisition or importation. The reduction is equal to the amount of the input tax credit. Where the credit occurs in a year after the acquisition or importation, the opening pool balance for the credit year is reduced. Increasing or decreasing GST adjustments may also affect the opening pool value. Once the STS provisions apply to a depreciating asset, s 328-220(1) will mean that they continue to apply to the asset until it is disposed of. This is so, even if you cease to be an STS taxpayer. However, assets acquired for more than $1000 or additions to cost in excess of $1000 after you cease to be an STS taxpayer cannot be allocated to an STS pool while you are not an STS taxpayer. These assets are subject to the capital allowance provisions set out in Div 40. A review case study on Div 40 with references to particular paragraphs in this chapter is located in Study help.

Capital works in ITAA97 Div 43 10.94 In Australia, the existence in the ITAA36 and ITAA97 of capital allowances for buildings that are not plant dates only from 1979. The introduction of capital allowances for buildings, and many of the features of the capital allowances that [page 688] were introduced, arose out of recommendations made by the Australian Taxation Review Committee (the Asprey Committee), which submitted its final report in 1975. The first regime introduced was ITAA36 Pt III Div 10C, which allowed construction expenditure in respect of buildings used for short-term traveller accommodation to be amortised at a rate of 2.5% over a 40-year period. A further amortisation regime, ITAA36 Pt III Div 10D, was added in 1982. Division 10D allowed capital expenditure relating to the construction of all income-producing buildings, with the exception of residential buildings and certain exhibition buildings, to be amortised over the same period. Although the scope of these provisions and the amortisation rates changed over the years, their most distinctive features remained fairly constant. These features were carried over into ITAA97 Div 43. The first distinctive feature is that a capital works allowance is made in respect of construction expenditure incurred on a building rather than in respect of the purchase price of the building. Thus, if a building that was constructed and used for income-producing purposes is sold, in the usual case, the purchaser will effectively step into the vendor’s shoes so far as Div 43 deductions are concerned. This feature was incorporated in capital works allowances to avoid the need to dissect the purchase price of land and buildings into separate components representing the value of the land and the value of the buildings. This feature also causes another of the distinctive features of Div 43. Because a purchaser, in effect, takes over a vendor’s capital works allowances, balancing adjustments are not usually required on a sale of property that has been

the subject of capital works allowances. Another distinctive feature of capital works allowances, and one that distinguishes them from building depreciation for financial accounting purposes, is that they are based on arbitrary statutory rates. The effective life of a building is not relevant in determining the rate of capital works allowance that will be applicable. Note that, as discussed in 10.9–10.14, where a building or other structural improvement is ‘plant’, the decline in value of the building is deductible under Div 40 rather than Div 43. The effect of s 43-50(1) is that no part of a pool of construction expenditure for Div 43 purposes can be taken into account in calculating deductions under another Division of the ITAA97. In a decision by the Administrative Appeals Tribunal, Block v FCT 2007 ATC 2735, the tribunal highlighted the importance of providing clear evidence demonstrating a business or income-earning activity when claiming a capital allowance under Divs 40 and 43.

Block v FCT Facts: In this case, the taxpayers’ claim for capital allowance deductions under ITAA97 Divs 40 and 43 was challenged by the Commissioner on the basis that the taxpayers were not carrying on a business by reason of their horse- and sheep-related activities. The Commissioner submitted, among other things, that the taxpayers’ activities had consistently been making losses for a number of years [page 689] and it was not reasonably foreseeable that they would make a profit or gain from their horse-breeding activities. In response, the taxpayers submitted that they were, in fact, operating a business activity by reason of their extensive capital expenditures in setting up and maintaining sheep- and horse-breeding activities. Held: The tribunal concluded that the taxpayers were engaged in a business activity and conducted their activities in a business-like and commercial manner. The tribunal noted that the taxpayers maintained full and proper accounts in respect of the business and engaged accountants to prepare the relevant tax returns and accounts for the business.

As such, the taxpayers were entitled to make deductions under Divs 40 (capital allowances) and 43 (capital works).

The basic conditions for ITAA97 Div 43 deductibility 10.95 The basic entitlement to a deduction for capital works is set out in ITAA97 s 43-10 as are the basic conditions that must be satisfied to obtain a capital works deduction. The basic conditions are that: (a) the capital works have a construction expenditure area; and (b) there is a pool of construction expenditure for that area; and (c) [the taxpayer] uses the [taxpayer’s area] in the way set out in Table 43-140 (Current year use).

The table in s 43-140 sets out the current year uses to which the taxpayer’s construction expenditure area must be put in the relevant year of income to obtain a Div 43 deduction. The table classifies capital works according to commencement date and, where applicable, according to the type of works (eg, hotels). For capital works commenced after 30 June 1997, Table 43-140 indicates that the taxpayer’s area must be used either for producing assessable income or for carrying on research and development activities. Section 43-140(2) (a) indicates that generally Div 43 applies to an entity if it uses property for environmental protection activities or for the environmental impact assessment of a project. Special rules relating to use are contained in Subdiv 43-E, which deals with such matters as: a temporary cessation of use (this does not produce a loss of deductions); use of capital works (other than an hotel or apartment building) mainly for residential accommodation by the taxpayer (this does result in loss of deductions); special rules for hotel and apartment buildings; and special rules for display homes. A note to s 43-10 reminds you that the deduction is limited to capital works to which Div 43 applies and refers you to s 4320. 10.96 Note that ITAA97 Div 43 deductions are allowed in respect of construction expenditure incurred on certain ‘capital works’. The

expression ‘capital works’ has been used throughout Div 43 rather than the term ‘building’ which was used in the ITAA36. The ITAA36 employed the drafting fiction of deeming the term ‘building’ [page 690] to include structural improvements and earthworks. In the Tax Law Improvement Project, a conscious effort was made to avoid deeming things to be something they are not. The broader expression ‘capital works’ is more descriptive of the structures and improvements currently dealt with in Div 43 and will remain apt if the scope of Div 43 is extended in future.

Key elements in ITAA97 Div 43 Capital works 10.97 The capital works to which ITAA97 Div 43 applies are set out in s 43-20. In brief these are: buildings begun in Australia after 21 August 1979; buildings begun outside Australia after 21 August 1990; capital works begun after 26 February 1992 that are structural improvements, or extensions, alterations or improvements to structural improvements whether in or out of Australia; and environmental protection earthworks on which expenditure was incurred after 18 August 1992. Section 43-20(3) contains examples of structural improvements. Section 43-30 states that no deduction is available until the capital works are completed.

Use in the required manner 10.98

A taxpayer’s area is regarded by ITAA97 s 43-160 as being

used in the requisite manner, for all types of capital works used in the 1997–98 income year and subsequently, if it is maintained ready for use in that manner and is not used in any other way. Under the ITAA36, this rule did not apply to traveller accommodation buildings under Div 10C. Applying a standard rule for all types of capital works was clearly a sensible change. Similarly, the rule in s 43-165 that ignores a temporary cessation of use applies to all types of capital works whereas the equivalent rule in the ITAA36 applied only to Div 10D buildings.

Date of commencement of capital works 10.99 In applying ITAA97 Div 43, it is necessary to know when capital works began in order to know whether the works qualify for a deduction, in order to ascertain the rate of deduction, and to determine the method to be used to calculate the deduction. Section 43-80 deems capital works to begin when the first step in the construction phase starts. The sinking of pilings or pouring foundations are given as examples of the first step in the construction phase. The Explanatory Memorandum to the Tax Law Improvement Bill 1997 (Cth) states (at p 142) that preliminary work such as site preparation will not amount to the first step. It is not clear whether excavations that are specific to the particular structure to be built would be regarded as the first step in the construction phase. The examples given in s 43-80 suggest that they would not be. [page 691]

Construction expenditure 10.100 ITAA97 s 43-70(1) defines construction expenditure as capital expenditure incurred in respect of the construction of capital works. Several types of capital expenditure (such as expenditure on land, expenditure on demolishing existing structures and expenditure on plant) are expressly excluded from the definition of construction expenditure by s 43-70(2). As noted in 10.8, the effect of s 43-70(2) is

that Div 43 will apply only where other capital allowance regimes (most notably Div 40) do not. The definition of construction expenditure in s 43-70 amplifies what were the definitions of ‘qualifying expenditure’ in the ITAA36 by giving examples of expenditures that are not to be regarded as construction expenditure. In December 2014, the ATO released Interpretative Decision ATO ID 2014/37. ATO ID 2014/37 considered the issue of whether the capital expenditure incurred to build temporary roads and to restore the area afterwards pursuant to a development approval satisfies the definition of ‘construction expenditure’ as defined in s 43-70. In ID 2014/37, the ATO decided that the capital expenditure incurred to build temporary roads and the costs incurred in restoring the area afterwards pursuant to a development approval satisfied the definition of ‘construction expenditure’ under s 43-70. According to ID 2014/37, s 43-70 is a broad statement of inclusion, which is then subject to the specific exclusions as set out in the section. Since the costs for building temporary roads and restoring the area afterwards are not specifically excluded by the section and are costs that are necessary conditions for the development approval, the capital expenditure falls within the definition of construction expenditure as defined by s 43-70.

Construction expenditure area 10.101 The definition of ‘construction expenditure area’ in ITAA97 s 43-75 applies different rules where expenditure is incurred after 30 June 1997 to the rules applicable when expenditure was incurred before that date. For post-30 June 1997 expenditure, the ‘construction expenditure area’ is the part of the capital works that, at the time the expenditure was incurred, was to be owned, leased or held under a quasi-ownership right by the entity that incurred the expenditure. Where expenditure was incurred prior to 30 June 1997, the further requirement is added that the capital works were to be used in the way described in column 3 of the table in s 43-90 for the relevant time period. Each time an entity completes the construction capital works, a

separate construction expenditure area will be created. This is illustrated in Figure 10.1 below, which is a diagram found in s 43-75. In the diagram, area 1 relates to the original construction of the building which gives rise to one construction expenditure area. Area 2 is a subsequent extension of the same building which gives rise to another construction expenditure area, while area 3 is a later renovation of the entire building which gives rise to another construction expenditure area. [page 692]

Figure 10.1:

Construction expenditure areas

10.102 An important change introduced by the ITAA97 was that, where the construction of capital works commences after 30 June 1997, the effect of the definition of ‘construction expenditure area’ in s 4375(1) is that a Div 43 deduction will be available to the owner or quasiowner of the works provided they are used for the purpose of producing income or for research and development. This is the case, even though the person who actually constructed the capital works might not have used them for the requisite purpose at the time of construction. That is, although the person who constructed the capital works will not be entitled to a deduction, a subsequent owner who uses them for producing assessable income will be entitled to Div 43 deductions in respect of the construction expenditure. Under the ITAA36, a deduction

was only available if the first intended use after construction was for an eligible purpose. 10.103 A purchaser from a speculative builder is deemed by ITAA97 s 43-75(3) to have a construction expenditure area even though the builder might not have had a construction expenditure area in respect of the building. The builder would not have a construction expenditure area, as at the time when the construction expenditure was incurred, no part of the capital works were to be owned, leased or held by the builder under a quasi-ownership right. The rule in s 43-75(3) applies to both pre- and post-30 June 1997 capital works expenditure, and gives legislative effect to the Commissioner’s administrative practice set out in IT 2640.

Pool of construction expenditure 10.104 A ‘pool of construction expenditure’ is defined by ITAA97 s 43-85 as so much of the construction expenditure incurred by an entity on capital works as is attributable to the construction expenditure area. For example, say an entity incurred construction expenditure before 30 June 1997 and used only some of the capital works constructed by the expenditure for the requisite purpose. In this situation, only so much of the construction expenditure as was attributable to the capital works used for the requisite purpose would be a pool of construction expenditure.

‘Your area’ 10.105 The expression ‘your area’ is defined in ITAA97 s 43-115. Both owners and quasi-owners can have an area. For an owner, s 43115 states that ‘your area’ is the part of the construction expenditure area that you own, and that ‘your construction expenditure’ is the proportion of the pool of construction expenditure that is attributable to your area. For example, if two people, after 30 June 1997, each acquire a strata title home unit, for the purposes of letting, from a builder who

[page 693] constructed the units with the intention of letting them, then for each purchaser ‘your area’ will be the strata title home unit. In the same example, for each purchaser ‘your construction expenditure’ will be so much of the construction expenditure incurred by the builder as is attributable to the purchaser’s home unit. Re Darryl William Yaniuk and FCT [2001] AATA 851 provides an example.

Re Darryl William Yaniuk and FCT Facts: The Administrative Appeals Tribunal was asked to determine whether expenditures relating to sewerage treatment works, split-system air conditioners and other related mechanical installations within a strata lot were deductible as capital allowances (ITAA97 Div 40) or capital works (Div 43). Held: The tribunal concluded that sewerage treatment works were part of capital works and should not be treated as depreciable plant on the basis that the sewerage treatment works’ ‘function is not the means or apparatus by which the taxpayer’s income is produced’: at [52]. In relation to the split-system air conditioners, the tribunal found that split-system air conditioners form part of the ‘fabric of the setting in the circumstances of the [taxpayer’s] rental property that provides leisure and recreational accommodation’: at [55]. Hence, the expenditures on the air conditioners related to the part of the setting of the capital works, and were not plant.

Undeducted construction expenditure 10.106 Some limits on ITAA97 Div 43 deductions are set out in s 4315, which states the rule that the amount of the deduction is a proportion of the taxpayer’s construction expenditure and that the amount of the deduction cannot exceed the amount of undeducted construction expenditure for your area. As different amortisation rates are applicable for works begun and used in different periods, what the ‘undeducted construction expenditure’ is will vary according to when

the works were begun and what they were used for. The relevant definitions are contained in Subdiv 43-G, which deals with undeducted construction expenditure. In essence, undeducted construction expenditure represents the part of the taxpayer’s construction expenditure that has not yet been deducted. It is important to remember that the taxpayer does not actually have to incur the construction expenditure that is being deducted. As mentioned earlier, under the definition of ‘your construction expenditure’, construction expenditure incurred by someone else will be included to the extent that it relates to an area of capital works that you own. As the notes to s 43-15(1) explain, the effect of the subsection is that the deduction cannot exceed 100% of the taxpayer’s construction expenditure and a time limit is imposed on the period for which the expenditure can be deducted. The time limit arises because of the imposition of rates for the deductibility of the expenditure which are set out in s 43-25. [page 694]

How to calculate ITAA97 Div 43 deductions 10.107 Details on how to calculate ITAA97 Div 43 deductions are set out in Subdiv 43-F. The rate of and conditions for Div 43 deductions are different where the capital works are begun after 26 February 1992 and where the works began before that date. Hence, calculations of deductions for capital works constructed in these two periods are dealt with in separate subsections of s 43-25. In both cases, deductions are available only for the number of days in the income year in which the capital works were used in the manner required, for the application of the relevant deduction rate. The calculation provisions also provide for the reduction of the deduction where the capital works were used only partly for the purpose of producing assessable income. Special reduction provisions apply in some circumstances in the case of hotel and

apartment buildings and in the case of capital works used for carrying out research and development.

Rates for Div 43 deductions 10.108 The applicable rates for deductions are set out in ITAA97 s 43-25. Section 43-25 states: 43-25 Rate of deduction (1) [Post-26 February 1992 commencement] For capital works begun after 26 February 1992, there is a basic entitlement to a rate of 2.5% for parts used as described in Table 43-140 (Current year use). The rate increases to 4% for parts used as described in Table 43-145 (Use in the 4% manner). (2) [Pre-27 February 1992 commencement] For capital works begun before 27 February 1992 and used as described in Table 43-140, the rate is: (a) 4% if the capital works were begun after 21 August 1984 and before 16 September 1987; or (b) 2.5% in any other case.

Note that s 43-25 cross references you to Table 43-140 and Table 43145, which set out use requirements which must be satisfied before particular rates are applicable. Where capital works were commenced after 26 February 1992, a deduction at the higher rate of 4% is available only if the capital works are used for the relevant purpose specified in Table 43-145. After 30 June 1997, the 4% rate will be available only for hotels, motels and guest houses used wholly for shortterm traveller accommodation. [page 695]

Consequences of disposal of ITAA97 Div 43 capital works

10.109 It is important to note that there is no balancing adjustment on the sale of ITAA97 Div 43 capital works. Where all or part of a taxpayer’s area is destroyed, s 43-40 allows the taxpayer to deduct all the previously undeducted construction expenditure for that area. The details of the deduction are set out in s 43-250, which requires that the deduction be reduced by insurance and salvage receipts. There is, however, no inclusion in the taxpayer’s assessable income in these circumstances. 10.110 There was no need to substitute market value for actual consideration in the case of Div 43 as deductions under the Division are based on capital works expenditure rather than on the purchase price of the capital works constructed by that expenditure. For the same reason, there was no need for roll-over provisions. As quasi-owners can have an area for Div 43 purposes, and thus are entitled to Div 43 deductions, s 43-45 states that certain anti-avoidance provisions apply to the quasiowner’s Div 43 deductions as if he or she were the owner to the exclusion of any other person.

Uniform capital allowances: Proposed technical changes 10.111 The Rudd Government announced a number of proposed changes during the 2009–10 Federal Budget which provided for technical changes to the uniform capital allowance (UCA) regime. It was proposed that these amendments would include the following changes to the project pool provisions under ITAA97 Div 40. To date, these proposed amendments have not yet been enacted: 1. Project pool treatment of non-cash benefits. The current treatment of noncash benefits and termination of liabilities differs between a depreciating asset (when a balancing adjustment event occurs) and a project pool (when a project is abandoned, sold or disposed of). It was proposed that an amendment would be introduced to capture all amounts in assessable income and to ensure consistency of language.

2.

3.

4.

It was proposed that the project pool provisions in Subdiv 40-I be amended to capture non-taxable use in previous years when calculating the balance adjustment for abandonment, sale or other disposal of a project. It was further proposed to make an amendment to incorporate non-deductible expenditure under the uniform capital allowances regime for the purposes of the project pool provisions. A further issue that requires clarification involved the issue concerning expenditure on intellectual property satisfying both project pool amounts and cost of a depreciating asset. This is a live issue because taxpayers who incur expenditure on which they can claim a double deduction by allocating the amount to a project pool can also claim deductions for decline in value [page 696]

5.

where those amounts later come to form part of the cost of the depreciating asset. The proposed amendment aims to remove the double deduction in this situation. Section 40-40, in item 5 of the table, provides a right that an entity legally owns but which another entity (the economic owner) exercises or has a right to exercise immediately, where the economic owner has a right to become its legal owner and it is reasonable to expect that: (a) the economic owner will become its legal owner; or (b) it will be disposed of at the direction and for the benefit of the economic owner.

6.

It was proposed that amendments be introduced to clarify the application of the dual concepts of economic owner and legal owner. This is because there may be confusion as to the application of the concept of ‘economic owner’ with provisions of a legal owner in relation to a lease agreement. Section 40-95(5) and (6) is designed to prevent the acceleration of deductions within the UCA regime through the churning of assets

to associates or through sale and leaseback arrangements. The proposed amendment was intended to ensure that the new holder of the asset can use the lowest effective life in the range to which the relevant accelerated depreciation rate would apply. The proposed amendment was to overcome the harsh effects of the accelerated depreciation provisions if used prior to 1 July 2001. 1. 2.

3.

4. 5. 6. 7. 8.

9.

10. 11.

12. 13. 14.

This rule does not apply to depreciating assets allocated to a low-value pool. See the discussion in 10.71–10.76 of assets allocated to low-value pools. Deductions are also reduced under ITAA97 s 40-25(3) and (4), where the depreciating asset is a leisure facility or a boat. These reductions do not apply to depreciating assets allocated to a low-value pool nor do they apply to a car in an income year where the one-third of actual expenses method is used. The reasoning behind the prior case law was that the composite phrase ‘plant or articles’ used in the depreciation provisions in the ITAA36 did not limit the scope of the word ‘articles’, which had its normal, very general, meaning. Instead, the composite expression was regarded as having a wider connotation than ‘plant’ when used by itself: Quarries Ltd v FCT (1961) 106 CLR 310; 12 ATD 356; 8 AITR 383. See the discussion in the Explanatory Memorandum (EM) to the New Business Tax System (Capital Allowances — Transitional and Consequential) Bill 2001 (Cth), para 1.25. See the discussion in the EM, para 1.25. See the discussion in the EM, paras 1.50–1.62. The EM, at para 1.77, gives a sale and leaseback arrangement as an example of a situation where this provision would apply. Similarly, in Mt Isa Mines Ltd v FCT (1992) 176 CLR 141, the High Court held that expenses of demolishing an existing structure improved the land and were not deductible under ITAA36 s 51(1) (the equivalent of ITAA97 s 8-1). See the discussion in R W Parsons, Income Taxation In Australia, Law Book Co, Sydney, 1985, [10.182]. This approach was also taken in several of the Commissioner’s rulings. See, for example, IT 26, IT 2498 and IT 2038. This may be contrasted with the capital gains tax (CGT) position where incidental costs of disposal are included in the cost base of a CGT asset. See the discussion in 6.108. In the case of plant that you entered into a contract to acquire or that you started to construct before 11.45 am Australian Capital Territory time on 21 September 1999, the choice must be made at the time when you entered into the contract to acquire the plant or when you started to construct it. See AAT Case 5877 (1990) 21 ATR 3411; AAT Case 9465 (1994) 28 ATR 1144. The exception to this rule is set out in ITAA97 s 40-285(4), which deals with the situation where a balancing event occurs because you still hold an asset that you expected not to use. Any ambiguity in the legislation at this point is largely removed by the discussion in the EM to the New Business Tax System (Capital Allowances — Transitional and Consequential) Bill 2001 (Cth), para 3.43.

15. It should also be noted that capital gains and losses can still arise in relation to depreciating assets where CGT events happen that are not equivalent to balancing adjustment events. Examples of such events would appear to include: CGT event D1 (see 6.34–6.39); CGT event F1 (see 6.45); and CGT events I1 and I2. 16. ITAA97 s 40-345, which was inserted into the Income Tax (Transitional Provisions) Act 1997 (Cth) by the New Business Tax System (Capital Allowances — Transitional and Consequential) Act 2001 (Cth), has the effect of allowing a taxpayer a choice between a discount and a reduction under the former s 42-192(2) where the depreciating asset was acquired before 21 September 1999 and, hence, retained CGT indexation. The adjustment under the former s 42-192(2) reduced the inclusion of the excess of the asset’s termination value over the sum of its written-down value and any balancing adjustment in circumstances where the plant’s cost base at that time exceeded that sum. This could happen where the cost base had been indexed or where the cost base differed from cost for depreciation purposes. 17. Or the cost of a set of assets of which the asset is a part, or the cost of the asset and any other identical or substantially identical asset that you start to hold in the income year. 18. ITAA97 s 40-425(6) also expressly deems depreciating assets to which Div 58 (which deals with assets previously owned by an exempt entity) applied for an entity sale situation, for which you used the diminishing value method, and whose adjustable value for the income year before the current year is less than $1000, to be low-value assets. 19. Review of Business Taxation, A Tax System Redesigned, AGPS, Canberra, 1999, Recommendation 4.14, p 187. 20. Project amounts of this type are not discussed further in this chapter. 21. Including fractions of years. 22. An SBE includes an individual, partnership, trust or company with aggregated turnover of less than $2m. 23. Features of the STS as it affects tax accounting and trading stock matters are discussed in Chapter 4 and Chapter 11. Note that from 2007–08, the STS now applies only to SBEs with aggregate turnover of less than $2m. See Chapter 4 and Chapter 11 for details. 24. Go to and search for ‘Small business entity concessions’ (accessed 18 September 2017). 25. Special rules set out in ITAA97 s 328-225 apply if the taxable purpose usage changes.

[page 697]

CHAPTER

11

Trading Stock Learning objectives After studying this chapter, you should be able to: identify assets that are trading stock for purposes of the Income Tax Assessment Act 1997 (Cth) (ITAA97), and distinguish between trading stock (for tax purposes) and inventory (for accounting purposes); determine when specific assets, such as land, shares and spare parts, are trading stock; determine when trading stock is ‘on hand’ for tax purposes; apply the trading stock valuation options for stock ‘on hand’; calculate stock ‘on hand’ at the ‘cost’ option; calculate the allowable deductions and assessable amounts under ITAA97 Div 70 for a retailer or manufacturer; distinguish between ‘business’ and ‘non-business’ disposals of trading stock and identify the tax consequences of both.

Introduction 11.1 The provisions relating to trading stock comprise ITAA97 s 8-1 and Div 70. Purchases of trading stock or raw materials to be processed into trading stock are allowable deductions under ITAA97 s 8-1, the

general deduction provision. Division 70 provides for the treatment of opening and closing balances of stock on hand, valuation rules and the treatment of non-business disposals of stock. This machinery replaces the former provisions in the Income Tax Assessment Act 1936 (Cth) (ITAA36) ss 28–37 and s 51(1), (2) and (2A), from which the case law relating to trading stock issues is derived. Trading stock includes live stock, and provisions relating to primary production are located in ITAA97 Subdiv 385-E.

Scheme of ITAA97 Div 70 11.2 It has been noted on several occasions that the Act is not ordinarily concerned with the concept of profits or the accounting process of matching incomes with outgoings. Basically, it is concerned with transactions that are linked together in the course of operations directed to the production of assessable income. The trading stock provisions are an exception. The taxing scheme operates to defer deductibility [page 698] of the cost of inventory manufactured or purchased until such time as income is derived and, putting aside some definitional and valuation differences, the tax treatment corresponds to gross profit computed according to generally accepted accounting principles. This is achieved by providing an outright deduction for the cost of trading stock purchased (or manufactured) together with an adjustment for unsold stocks of inventory at the end of the year. It should be noted that the statute uses the term ‘trading stock’ instead of ‘inventory’, which is used in most of the accounting literature. Compare the tax and accounting treatment of the following data in Example 11.1.

Accounting treatment: Opening inventory

$60,000

Purchases

100,000 160,000

Closing inventory

(50,000)

Cost of goods sold

110,000

Debit to P&L account

Taxation treatment: Purchases Stock adjustment

100,000 10,000 $110,000

Tax deduction

This result is achieved in the following manner: Section 70-40 deems the value of the trading stock on hand at the beginning of a year of income to assume its tax value at the end of the preceding year, that is: Ending stock Year 1 = Beginning stock Year 2 Section 70-35 makes the appropriate adjustment either to assessable income or deductions having regard to the difference between the value of trading stock on hand at the beginning and end of a year of income: Closing stock > opening stock = assessable amount (s 70-35(2)) Closing stock < opening stock = allowable deduction (s 70-35(3)) Thus, in terms of the above example, an amount of $110,000 is deductible as follows: Purchases (s 8-1)

$100,000

Opening stock > closing stock (s 70-35(3)) Total deduction

10,000 $110,000 [page 699]

The bringing to account of unsold stock and flow-on of closing stock one year to opening stock the next year may seem self-evident to accountants and it underpins the structure of the trading stock provisions.

Consider Example 11.2 covering consecutive years.

Trading account 30 June 2016 Sales

$100,000

Opening stock

20,000

Purchases

50,000

Closing stock

(10,000)

60,000

Gross profit

$40,000 Trading account 30 June 2017

Sales

$100,000

Opening stock

10,000

Purchases

60,000

Closing stock

(20,000)

50,000

Gross profit

$50,000

Notice that although sales remain the same in both years, gross profit in fact rises. This occurs because closing stock rises in 2017 relative to opening stock.a An increase in closing stock is the same as an increase in income and this is explicitly recognised in ITAA97 s 70-35(2). A run-down in stocks is deductible under s 70-35(3): 30 June 2016 Assessable income Sales (s 6-5)

$100,000

Deductions Purchases (s 8-1)

50,000

Stock adjustment (s 7035(3))

10,000 60,000

Taxable income

$40,000 [page 700] 30 June 2017

Assessable income

Sales (s 6-5) Stock adjustment (s 7035(2))

$100,000 10,000 110,000

Deductions Purchases (s 8-1)

60,000

Taxable income

$50,000

a.

Clearly the variable in this example is sales revenue. In 2016, goods costing $60,000 are sold for $100,000 whereas in 2017 the same sales revenue is generated from the sale of only $50,000. Note that from 1 July 2001 to 30 June 2007, a simplified tax system (STS) applied to certain small business taxpayers with a turnover of less than $1m and depreciating assets of less than $3m. Under that system, STS taxpayers were not required to bring closing stock on hand to account where the difference between opening and closing stock was reasonably likely to be no more than $5000. From 2007–08, a ‘small business entity’ with aggregate turnover less than $2m enjoyed the same benefit: see 11.19.

1. 2.

What consequences would follow if the stock adjustments in ITAA97 s 70-35 were not made? Reference should be made to ITAA97 s 70-25: 70-25 Cost of trading stock is not a capital outgoing An outgoing you incur in connection with acquiring an item of trading stock is not an outgoing of capital or of a capital nature. Note: This means that paragraph 8-1(2)(a) does not prevent the outgoing from being a general deduction under section 8-1.

Does this provision affect the conclusion you reached in discussing Question 1, above?

The deeming of purchases of trading stock not to be of a capital nature has been the source of speculation and bemusement amongst commentators. In John [page 701] Fairfax & Sons Ltd v FCT (1959) 101 CLR 30; 7 AITR 346, Dixon CJ thought that the predecessor section (ITAA36 s 51(2)) was enacted to qualify and explain that an outgoing on trading stock, albeit working capital, was not excluded from deductibility by the wider capital exclusion of the general deduction provision: ITAA97 s 8-1 and the former ITAA36 s 51(1).1 Trading stock and trading stock-related expenditure are now widely recognised as being on revenue account: Lister Blackstone Ltd v FCT (1976) 134 CLR 457; 6 ATR 499; 76 ATC 4285; see also John v FCT (1989) 166 CLR 417; 20 ATR 1; 89 ATC 4101. The remainder of Div 70 is directed to the valuation of stocks, rules relating to the transfer of items into and out of stock, disposals of trading stock other than in the normal course of business, and revenue protection measures. One revenue protection measure that affects the timing of a deduction is ITAA97 s 7015. The predecessor to s 70-15, the former ITAA36 s 51(2A), was enacted to overcome the result of two decisions: FCT v Raymor (1990) 21 ATR 458; 90 ATC 4347 and All States Frozen Food Ltd v FCT (1990) 21 FCR 457; 20 ATR 1874; 90 ATC 4175. In the former case, the Full Federal Court held that a prepayment for trading stock to be received the following year was an allowable deduction. The payment was for the stock itself, not the right to receive the stock. In the latter case, the Full Federal Court held that stock en route by ship to Australia was trading stock ‘on hand’ because bills of lading had been

issued (that gave the taxpayer the right to dispose of the stock) even though it was not in the physical possession of the taxpayer.2 Clearly, it was possible to arrange for the prepayment of stock that would not be on hand at year’s end and so secure a deduction under ITAA97 s 8-1 but avoid the stock on hand adjustment under ITAA97 s 70-35. As a result, before a deduction is allowable for the purchase of trading stock, ITAA97 s 70-15 requires that either the stock must be on hand or an amount representing its disposal value is included in assessable income. [page 702]

Trading stock defined 11.3

‘Trading stock’ is defined in ITAA97 s 70-10 as follows:3

70-10 Meaning of trading stock Trading stock includes: (a) anything produced, manufactured or acquired that is held for purposes of manufacture, sale or exchange in the ordinary course of a business; and (b) live stock.

‘Live stock’ is defined in ITAA97 s 995-1: live stock does not include animals used as beasts of burden or working beasts in a business other than a primary production business.

In turn, primary production business is defined in s 995-1 essentially as cultivating or propagating plants or their products and maintaining animals for the purpose of selling them or their bodily produce (including natural increase). The definition of trading stock is expansive in that it builds on the ordinary understanding of the term to include the items mentioned in paras (a) and (b). In FCT v Suttons Motors (Chullora) Wholesale Pty

Ltd (1985) 157 CLR 277; 16 ATR 567; 85 ATC 4398 (Sutton Motors), the High Court said (at ATC 4400) of the definition in the former ITAA36 s 6(1): The definition is expansive in that it operates “cumulatively upon the ordinary meaning of trading stock” … It is not relevant here to consider the extent to which the “definition” actually widens the ordinary meaning of the term … What is important for present purposes is that it does not restrict that ordinary meaning. If goods are within the ordinary meaning of “trading stock”, they are, in the absence of contrary intention, trading stock for the purposes of the Act.

In Suttons Motors, the ordinary meaning was held to be ‘goods held by a trader in such goods for sale or exchange in the ordinary course of his trade’. What underpins [page 703] the revenue law concept of trading stock is that of trading or dealing in the particular property. It is not enough that an item is held as an inventory. What is required is that the person is or will be engaged in trading in the relevant good. Ordinarily, whether this is so will be a question of fact and, if trading has not commenced, the court may look to the taxpayer’s intention or purpose. This is clear from the High Court decision in John v FCT (1989) 166 CLR 417; 20 ATR 1 at 7–8; 89 ATC 4101: The Act defines “trading stock” in [ITAA36] s 6(1) as including “anything produced, manufactured, acquired or purchased for purposes of manufacture, sale or exchange, and also includes live stock”. The definition looks to the nature of goods that may constitute trading stock and posits that they will constitute trading stock if acquired for any of the specified purposes, including sale. It presupposes that the person by whom they are produced, manufactured, acquired or purchased is or will be engaged in a trade in those goods. But it does not render an inquiry into whether or not the person is or will be engaged in that trade irrelevant. A single transaction does not render a person a trader, although, of course, a single transaction may constitute an adventure in the nature of trade. Nor, we think, is a single item acquired for the purpose of manufacture, sale or exchange an item of trading stock, unless the purchaser is or will be engaged in trading goods of that nature. Thus it is relevant to inquire whether the person who acquires an item claimed to be trading stock is a trader in the sense that he is engaged or will be engaged in trading goods in the nature of the item acquired … Whether or not a person is a trader seems to us to be a question of fact, albeit that in some cases the determination of that fact may depend on questions of impression and

degree. If trading has not commenced or if there is no discernible trading pattern, the question of intention or purpose may be relevant in the sense that if there is an absence of intention or purpose to engage in trade regularly, routinely or systematically then the person may well not be a trader. … But if trading has commenced and the activities reveal a discernible trading pattern, then it seems to us that the motive for undertaking the activities or for undertaking a particular transaction cannot serve to characterise the person engaged in those activities as a non-trader, or as a non-trader in relation to a particular transaction.

The court went on to say that the definition of trading stock does not require that the relevant purpose be the sole or even dominant purpose. It is enough that the property is acquired with a purpose of manufacture, sale or exchange and when that is the case, by virtue of ITAA97 s 70-25, the outgoing to acquire the particular property is deemed not to be an outgoing of capital. A differentiation was made in John’s case between trading ‘regularly, routinely or systematically’, on the one hand, and being engaged in ‘a series of discrete transactions’, on the other hand. This distinction is important in appreciating that not all sales (and purchases) made by a taxpayer will be in the nature of trading stock, even if the proceeds (or indeed, the profit) are assessable income. That is, just because property is sold — even if the sale is a common feature of a particular business4 — it [page 704] does not follow that the item is trading stock. Whether a taxpayer is a trader and the relevant property is therefore trading stock is a question of fact, impression and degree. In the general case, this will be determined by a ‘discernible trading pattern’ but the property does not become trading stock simply because it is regularly sold, and recognition of this distinction is vital in understanding the reasoning in cases such as London Australia Investment Co Ltd v FCT (1977) 138 CLR 106; 77 ATC 4398 and Memorex Pty Ltd v FCT (1987) 19 ATR 553; 87 ATC 5034 (see below).5 Since live stock is also trading stock, it too derives its meaning from ordinary concepts except that, in the case of a primary producer, all live

stock is trading stock whereas in other businesses, beasts of burden are excluded from the definition. For example, a draught horse used on a wharf was held to be plant: Yarmouth v France (1887) 19 QBD 647. So, horses will be live stock and, therefore, trading stock in the hands of a breeder whose purpose of holding them is to sell them or their progeny, but will be depreciable plant in a business other than primary production. Domestic pets in the hands of a breeder would be live stock and in the hands of a dealer would be trading stock. Privately owned pets clearly fall outside the definitions. For an item to be trading stock, the owner must be a dealer. The inclusion of ‘live stock’ in the s 70-10 definition has the effect of widening the term because, by virtue of that inclusion, a dairy farmer’s herd of milking cows, being live stock, would be regarded as trading stock (see FCT v Wade (1951) 84 CLR 105; 5 AITR 214) whereas it would not be so by ordinary concepts. Similarly, bees kept for honey production are regarded as live stock and, therefore, trading stock: Taxation Determination TD 2008/26.

Inventory and trading stock compared 11.4 There are important differences between the accounting view of inventory and the judicial understanding of trading stock. There are also important differences in respective valuation rules. The accounting view of inventory derives from the former AASB 102 Inventories (para 6), in which: Inventories are assets: (a) held for sale in the ordinary course of business; or (b) in the process of production for such sale; or (c) in the form of materials or supplies to be consumed in the production process or in the rendering of services.

It is evident that ‘trading stock’ and ‘inventory’ cover much common ground, but the accounting view potentially admits a wider range of items than ITAA97 s 70-10(a). Accountants are concerned with measuring the consumption of all resources in the profit-making process. The trading stock provisions of Div 70 are concerned only with goods held for sale, not with all resources held by the entity.

[page 705] 11.5 Stocks of raw materials, work in progress and finished goods come within the definition in s 70-10. Other property, such as land, may also be trading stock, but acceptance of that has not been without some difficulty and qualifications: see 11.9. Property such as shares or investments may be held primarily for reasons other than sale, even though the items may be sold regularly. The decision in London Australia Investment Co Ltd v FCT (1977) 138 CLR 106; 7 ATR 757; 77 ATC 4398 provides a case in point. In that case, the taxpayer invested in shares and employed a strategy of selling shares when their yield fell below a benchmark rate. In pursuing this strategy, the company bought and sold shares on a large scale. The High Court held that the company’s business was investment. The shares were purchased and held for investment purposes. To that end, shares were bought and sold but they were not trading stock because the company was not a dealer in shares. The trading activities were part of its business even though its primary object was the purchase of shares for investment purposes. On the other hand, in Investment and Merchant Finance Corp Ltd v FCT (1971) 125 CLR 249; 2 ATR 361; 71 ATC 4140, the High Court held that shares in the hands of a dealer were trading stock: see 11.11. The court’s approach to characterising trading stock proceeds on a case-by-case basis and expansions of what is to be included in the concept develops incrementally. For example, in Modern Permanent and Investment Society (in liq) v FCT (1958) 98 CLR 187; 7 AITR 233, Williams J said that ‘whatever else trading stock may include, it does not include choses in action’6 (emphasis added). On that basis, current assets such as debts and investments would be excluded from trading stock. However, on the authority of Investment and Merchant Finance Corp and John v FCT (1989) 166 CLR 417; 20 ATR 1; 89 ATC 4101, it is clear the courts recognise that there are circumstances where shares may be trading stock; but, of course, it does not follow that all shares purchased and sold are always trading stock. Thus, there are occasions

when property other than raw materials and merchandise might or might not be trading stock. The exclusion from trading stock at different times and in different circumstances of items such as land, shares and choses in action (as well as other revenue assets still excluded) has resulted in a good deal of litigation and, in deciding in the circumstances that they are not trading stock, has forced the courts to assess ‘profit’ because the orthodox framework of assessment was inapplicable. If the items in dispute are trading stock, Div 70 applies to calculate the taxable amount. Sales proceeds are assessable under ITAA97 s 6-5, purchases are deductible under ITAA97 s 8-1, and the increase or decrease in stock on hand is reflected through the adjustment in ITAA97 s 70-35. If the property is not trading stock, Div 70 does not apply. The question then becomes whether the transaction is on revenue account and, if so, how the assessable [page 706] amount is to be calculated. This has led to the calculation of a specific profit — a net amount that is in the nature of income.7 11.6 A difference between the accounting and tax approaches to stocks lies in the treatment of consumables and other aids to manufacture and sale. The thrust of the definition in s 70-10 is items held for purposes of sale, while AASB 102 specifically includes inventories of consumables, supplies, and so on. Some stocks, such as raw materials, are meant for resale albeit in a refined form, but some items only facilitate the production process. Difficult questions arise at the margin, and items such as lubricants and manufacturing aids described as ‘indirect materials’ in the accounting literature are generally outside ‘trading stock’ because they are not produced, manufactured or acquired (or held) for purposes of sale: see 11.12. The inference is that it is the relevant item produced that must have the purpose of sale, not the means by which it is produced or sold.

A fine distinction must therefore be made between materials that become integrated with the final product and are part of trading stock and those that merely facilitate the production or sales efforts. Particular difficulties arise with packaging and labels. While returnable items such as pallets are in the nature of plant not stock, other packaging items such as containers, packaging and binding materials that pass to the purchaser are trading stock: see 11.13.8 Inventories of items such as stationery are not trading stock because they are not held for sale (other than in the hands of a stationery supplier). 11.7 Both ITAA97 s 70-10 and accounting standards include partially manufactured goods (work in progress), but each definition would be strained to include work in progress of professionals such as accountants or solicitors. On this point, the courts agree. The High Court decision in Henderson v FCT (1970) 119 CLR 612; 1 ATR 596 establishes that such amounts are not trading stock for tax purposes. At first instance (Henderson v FCT (1969) 1 ATR 133), Windeyer J said (at 146):9 In my opinion it is a mistake to suppose that the notion of work in progress, in the sense of things uncompleted by a manufacturer or craftsman, can be simply transferred to uncompleted services by a tradesman or practitioner of some profession, and to assume that it can there be applied in the calculation for taxation purposes, of income derived. I realise that in accountancy there is a similarity of sort between unfinished goods and uncompleted services, and that the latter are sometimes described as work in progress. No doubt accounts can be kept in which a value is ascribed to uncompleted tasks by

[page 707] persons engaged in the practice of various trades and professions and rewarded by fees. Such accounts may be useful for many purposes … But it is one thing to record when, and by whom, work is done which will produce income; it is another to say when income, the rewards of such work, was derived.

In the case of services provided by tradesmen, it is accepted that their stocks of supplies and spare parts are trading stock where those materials pass to customers and retain their form and character.10 Finally, it should be noted that accounting standards also required the

use of full absorption costing and the courts have endorsed this: Philip Morris Ltd v FCT (1979) 10 ATR 44. However, valuation options are not determined by accounting principles, only computation matters in relation to ‘cost’: see further 11.21.

Specific items of trading stock 11.8 Under the ITAA97 s 70-10 definition, trading stock ‘includes anything produced, manufactured or acquired that is held for purposes of manufacture, sale or exchange in the ordinary course of a business’. Arguably, provided an item is held for the relevant purpose, anything is capable of being trading stock. Thus, whether an item is trading stock is not determined by examining the inherent features of the particular item. The question is whether it is ‘held for purposes of manufacture, sale or exchange in the ordinary course of a business’. The definition in the former ITAA36 s 6(1) did not make reference to ‘in the ordinary course of a business’ but, certainly in more recent cases, that was an implied element of the definition: see FCT v St Hubert’s Island Pty Ltd (in liq) (1978) 138 CLR 210; 8 ATR 452.11 For a long time, however, the courts were ambivalent at best concerning whether land, or shares and other choses in action, could be trading stock. Consider the following judicial pronouncements on what is trading stock.

Land 11.9 Prior to the decision in the St Hubert’s Island case, the issue of whether land could be trading stock had been discussed by the courts on several occasions but the question remained open. The problem had much to do with statutory language that spoke of trading stock in words such as being ‘on hand’ or an ‘article’ and whether it could be ‘replaced’ or could become ‘obsolete’. Even whether land was capable of being within the term ‘anything’ was not without its difficulties.12 In St Hubert’s Island, land was specifically recognised as trading stock. The essential question before the court was whether a distribution of land by a liquidator was a disposal of trading stock other than in the course of the taxpayer’s normal business, assessable under

the former ITAA36 s 36 (ITAA97 s 70-90), but the application of that provision depended first upon a finding that the land was trading stock. That the land was partially developed presented a particular problem. [page 708]

FCT v St Hubert’s Island Pty Ltd (in liq) Facts: The taxpayer was a land developer. In the late 1960s, sub-development commenced on two islands to the north of Sydney. Substantial sums of money were expended, but before the land was fully developed the company went into voluntary liquidation in 1971. The liquidator transferred title to the land to the beneficial owner of the company in settlement of debt and as a final distribution of the taxpayer’s assets. The Commissioner contended the market value of the land was $2.25m and assessed the taxpayer under the former ITAA36 s 36 for that amount less approximately $906,000 in development costs financed by the controlling shareholder. The relevant section provided: 36 (1) Subject to this section, where (a) a taxpayer disposes by sale, gift, or otherwise of property being trading stock …; (b) that property constitutes or constituted the whole or part of the assets of a business which is or was carried on by the taxpayer; and (c) the disposal was not in the ordinary course of carrying on that business, the value of that property shall be included in the assessable income of the taxpayer, … The taxpayer’s primary argument was that the land was not trading stock. In the Supreme Court of New South Wales, Mahoney J agreed that the land was not trading stock because at the time of transfer it was not developed to a saleable condition (and at the time of the transfer the company was not carrying on a business). Held: A majority of the High Court (Mason, Jacobs and Murphy JJ; Stephen and Aickin JJ dissenting) allowed the Commissioner’s appeal. The court agreed unanimously that land was capable of being trading stock. In addition, as Mason J said (at ATR 461): … as applied to the business of a manufacturer of goods, accountants and commercial men by their use of the expression “trading stock” denote [sic] not only the goods which he has manufactured and holds for sale but his stock of raw materials, components and partly manufactured goods.

In Mason J’s view, it was not possible to distinguish between the work in progress of a manufacturer and partially developed land that was to be sold but which required additional work before it reached a saleable condition. Jacobs J agreed that undeveloped land could be trading stock because it was acquired with the intention [page 709] of subdivision and sale. Murphy J agreed. While admitting that land could be trading stock, Stephen J considered that to be trading stock, the land needed to be in substantially the same form at acquisition as at sale. Aickin J thought that until the land was developed it was not stock.

The product of land 11.10 Although land may be trading stock in the hands of a dealer or developer, neither land nor any other particular item is trading stock per se. In the case of land, trading stock must be distinguished from that which gives up or yields trading stock. For example, in the case of quarrying operations, until the sand, clay or gravel is quarried, it is not separate from the land. This is true too of growing crops, fruit on trees or other natural resources such as trees grown in forestry operations. They remain part of the land until harvested and the land itself is not trading stock. As a result, the only deduction available is the cost of extracting or severing the resource. The land remains after exploitation and no part of its cost is treated as the cost of trading stock. The cost of the land is capital as is the cost of a right to exploit the land.13 On the other hand, it seems that a taxpayer can obtain a deduction for the acquisition cost of sand, clay, gravel, blue metal and so on if the cost does not include the cost of the land or a right to enter another’s land but merely represents a royalty payment for the material extracted. As indicated, the distinction is between purchasing something which itself is trading stock and purchasing something which yields the trading stock; for example, a title to land. At least these seem to be the conclusions drawn from Stow Bardolph Gravel Co Ltd v Poole (1954) 35 TC 459. In that case, the taxpayer paid for a right to enter another’s land and extract gravel. The payment for the right to enter and take gravel was held to be of a capital nature. However, the payment for a

right to take a specified quantity of gravel would be deductible: McCauley v FCT (1944) 69 CLR 235.

Shares and choses in action 11.11 The statement by Williams J in Modern Permanent and Investment Society (in liq) v FCT (1958) 98 CLR 187; 7 AITR 233, that ‘whatever else trading stock may include, it does not include choses in action’ was described by Walsh J in Investment and Merchant Finance Corp Ltd v FCT (1971) 125 CLR 249; 2 ATR 361; 71 ATC 4140 (IMFC) as an unwarranted generalisation. Williams J’s finding was that book debts of a building society were not trading stock and that conclusion was not [page 710] questioned in IMFC. What IMFC decided was that shares acquired by a dealer in shares with the intention of resale were trading stock. Walsh J said (at ATR 373): I do not assert, of course, that shares are always trading stock in the hands of their owner; and even where the owner is a dealer in shares the circumstances may show that the particular shares are not trading stock. But when shares are bought by a dealer in shares and it is intended that they are to be resold and that this will probably occur in the not distant future, I do not think they are to be denied the description of trading stock, either because the trader expects or intends that they will be sold at less than their cost price or because he seeks to obtain a commercial advantage from the transaction otherwise than from a profit on the resale, that is, an advantage from an expected dividend and from an expected taxation benefit.

As in the case of land, the question whether shares and other choses in action could be trading stock had been discussed by the courts on several occasions. In Australian Machinery & Investment Co Ltd v DCT (1946) 180 CLR 9; 3 AITR 359, members of the High Court expressed a range of views. Like the land question, the issue had much to do with the language of the Act: whether intangible property could be ‘on hand’ in any meaningful sense; whether it is possible to contemplate a ‘cost price’, ‘market selling’ value and ‘replacement’ cost.14

The decision in IMFC — that shares could be trading stock — was confirmed by a majority of the High Court in FCT v Patcorp Investments Ltd (1976) 140 CLR 247; 6 ATR 420; 76 ATC 4225 and unanimously (including bonus shares) in John v FCT (1989) 166 CLR 417; 20 ATR 1; 89 ATC 4101. That the taxpayer is a dealer in shares is a critical factor and the trading stock provisions do not apply to an investor or mere speculator: AC Williams v FCT (1972) 128 CLR 645; 3 ATR 236; 72 ATC 4157.15 IMFC is a significant case in other respects. It is evident from Walsh J’s judgment cited above that the company’s actions were intended to secure a tax benefit. The taxpayer was involved in what is called a ‘dividend strip’. This is an operation whereby shares are purchased, a dividend declared and the shares then sold (or valued) at their muchreduced value. To be profitable, it is vital that the shares be classified as trading stock. The facts of the case are demonstrated in a generalised form. [page 711]

Investment and Merchant Finance Corp Ltd v FCT Facts: The facts of the case may be represented in the following simplified form. IMFC was a dealer in shares and at a cost of approximately $173,000 purchased shares in Macgrenor Ltd, a company with considerable retained profits represented by cash balances. IMFC then caused a dividend of $164,000 to be declared. The shares were then worth $42. The dividend was assessable under ITAA36 s 44 but also tax free by virtue of an intercorporate dividend rebate under ITAA36 s 46.a On the assumption that the shares are treated as trading stock, the company’s trading account may be represented as follows:

Purchases Closing stock ($42) >

$173,000 (42)

opening stock (0) $172,958 (Tax deductible: $172,958 × Company rate of tax (say 36%) = $62,265*) The company’s cash flow position belies the trading loss:

Cash flow Purchases Dividends (tax free) * Tax benefit

Inflow

Outflow $173,000

$164,000 62,265 $226,265

$173,000

The transaction has yielded an after-tax cash inflow of: 226,265 − 173,000 = $53,265 Held: A majority of the High Court (Barwick CJ, Menzies and Walsh JJ; McTiernan J dissenting) held that shares are capable of being trading stock and that shares intended for resale in the not-too-distant future were the trading stock of a company whose business it was to deal in shares. As a result, the company was entitled to value the shares at the options available (cost, replacement cost or market selling value) for the valuation of closing stock. That is, the company could value the shares at cost in the year of purchase and use the intercorporate dividend rebate. In the next year the company could claim the loss as a tax deduction.

a.

A dividend rebate formerly operated to prevent double taxation of dividends paid to corporate shareholders. This system no longer operates. [page 712]

Spare parts and stores 11.12 Spare parts held by a taxpayer involved in the sale of such parts fits comfortably within the trading stock definition. Stocks of spare parts and stores held by a manufacturer are in a different position,

as is illustrated by the decision in Guinea Airways Ltd v FCT (1949) 83 CLR 584; 4 AITR 299.

Guinea Airways Ltd v FCT Facts: The taxpayer carried on an airline business from premises in New Guinea. In 1942, its stores and workshops were bombed and a large quantity of spare parts and maintenance stores were destroyed. A deduction was claimed under the former ITAA36 s 51(1) (ITAA97 s 8-1) on the grounds that the loss was on revenue account. (Alternatively, it was argued that the stocks represented plant and a loss was deductible under the depreciation provisions.) Held: The loss was a loss of capital. Dixon J said (at AITR 301): To maintain an available stock of spares and stores at a proper level, the requisite amount of capital must be committed to the purpose … The existence of the stock of spares was a feature of the permanent organisation of the enterprise. It formed part of the general equipment. When spare parts were issued and taken into use, it was right, no doubt, to debit the cost to running expenses … But it by no means follows that the spare parts constituting the reservoir represented anything but capital. Moreover, the stocks did not represent circulating capital. Money was not laid out in the purchase of spare parts and then recovered, together with a profit, on their resale. Stock in trade, because of its nature and function, is valued at the beginning and end of an accounting period, and if any part of it is lost or destroyed in the interval, the loss is reflected in the comparison of the two values. But the permanent stock of spare parts and stores forms part of the profit-yielding subject …

It is clear that, in the case of a retailer of parts, the items are trading stock and losses, being on revenue account and being reflected in reduced closing stocks, will be an allowable deduction. In the case of a taxpayer like Guinea Airways holding spares and stores, the debiting of an expense (and the allowance of a tax deduction) at the time of use, as suggested by Dixon J, seems a sensible arrangement. Thus, a deduction is available on a usage basis. On the other hand, if no stock of parts is built up, expenditure is deductible in the year of purchase: see Taxation Ruling IT 333.

[page 713] The result is that stocks of spare parts, production consumables and other inventories (such as stationery etc) that are not trading stock may be accounted for tax purposes as if they were trading stock with the important qualification that Div 70 would not apply and the closing value of material on hand could be valued only at its cost, namely: Opening stock + Purchases − Closing stock = Cost of materials used Materials, spare parts and packaging held by a service provider such as a plumber, electrician or panel beater are considered to be trading stock where a separately identifiable item passes to a customer and retains its character. In many cases, the particular item will be priced separately on an invoice. However, glue used by a plumber is a consumable; it is expended in the course of providing a service. In TR 98/8, the view is expressed that side panels and doors held by a panel beater are trading stock, but paint is not because it does not exist in the same state or condition it was in when held by the panel beater.

Packing and wrapping materials 11.13 The focus of the definition of trading stock in s 70-10 is that the item be acquired for the purposes of manufacture, sale or exchange. Items that are integrated into the product sold are covered by the definition, and packing material, containers and labels are considered trading stock. These items are distinguishable from returnable material that is better described as an aid to distribution. Equipment such as returnable loading pallets is never intended for sale or exchange and would be regarded as depreciable plant. In Taxation Ruling TR 98/7, the view is expressed that packaging materials are trading stock if the taxpayer is trading in ‘core goods’ and the items are closely associated with the core goods in the sense that either they form part of the core goods or they bring the core goods to a condition in which the goods are intended to be sold and the items are disposed of in conjunction with the sale of the core goods.

Work in progress

11.14 In the accounting context, the term ‘work in progress’ describes an accumulation of inventoriable costs. In the case of a manufacturer, such costs represent trading stock. They fit comfortably with the ITAA97 s 70-10 definition and the Commissioner’s practice. In addition, in FCT v All States Frozen Food Pty Ltd (1989) 20 ATR 1454; 89 ATC 5135 at 5140, Davies J confirmed that: Work in progress is thus trading stock for the purposes of the Act, as it is in ordinary commercial and accounting concepts of stock on hand.

In a sense, this notion of work in progress corresponds to what should be described as ‘unbilled services’ of professional taxpayers. Such amounts are not trading stock. The legal basis for excluding unbilled services from trading stock is Windeyer J’s decision at first instance in Henderson v FCT (1969) 1 ATR 133; 69 ATC 4049. [page 714]

Disposals of professional work in progress 11.15 A consequence of the decision in Henderson’s case is that the specific mechanism which deals with trading stock disposals other than in the ordinary course of business does not apply because unbilled services are not trading stock. For example, if property is trading stock and is sold in the course of selling a business, ITAA97 s 70-90 deems the seller’s assessable income to include the market value of the stock on the day of sale. The purchaser is deemed to acquire the property at that market value: ITAA97 s 70-95. The outgoing by the purchaser is deemed not to be of a capital nature: s 70-25. The problem is illustrated in several cases: Stapleton v FCT (1989) 20 ATR 996; 89 ATC 4818; Coughlan v FCT (1991) 22 ATR 109; 91 ATC 4505; FCT v Grant (1991) 22 ATR 237; 91 ATC 4608. In Stapleton’s case and Grant’s case, payments to former members of a partnership representing a share of unbilled services prevailing at the time of retirement were held to be income. On the other hand, in Coughlan’s case, claims for a deduction under former ITAA36 s 51(1)

(ITAA97 s 8-1) of the cost of acquiring work in progress by a new partner were held to be on capital account: see 5.20 and 9.31.

Comment on whether the following items would be trading stock: paint held by a sign writer; spare tyres held by a car rental firm; milk cartons held by a dairy; plants in pots held by a nursery; fertiliser held by a nursery; eggs held by a poultry breeder; building materials held by a builder; milk crates used by a dairy; stationery held by a debt collector; a demonstration vehicle used by a car dealer. A suggested solution can be found in Study help.

Trading stock ‘on hand’ 11.16 Whether trading stock is ‘on hand’ is a vital consideration for the timing of a deduction (see ITAA97 s 70-15) and for the trading stock adjustment between trading stock on hand at the end of the year as compared to the beginning: see ITAA97 s 70-35. Stock for which the taxpayer has title and possession presents little difficulty but where one or other of these features is absent some difficult questions can arise. The general test is whether there is dispositive power, meaning that the taxpayer is in a position to sell or otherwise direct the use of the items in question. The High Court decision in Farnsworth v FCT (1949) 78 CLR 504; 4 AITR 258; 9 ATD 33 [page 715]

supports this view. In that case, the taxpayer was a member of a growers’ association and participated in a pooled marketing scheme. Under the arrangement, growers delivered their produce to a packing house for grading, packaging and sale. Payments were made to members on the basis of quality and quantity of fruit delivered. The Commissioner assessed the taxpayer on instalments received plus the estimated amount to be received based on the unsold fruit held at the packing house. The High Court held that the amount estimated was not assessable income because the stock was not ‘on hand’. The important factor in this decision was that the taxpayer had no dispositive power over the fruit at the packing house and could not direct its disposal by the packing house. The fruit ceased to be the taxpayer’s stock on hand when it was delivered to the packing house and was mixed with other members’ fruit. All that the taxpayer retained was a contractual right to have the fruit dealt with properly. Subsequent payments would clearly be income. Where a taxpayer has physical possession of property, there will normally (but not always) be power to dispose of it and, conversely, a taxpayer who does not have property in stock will normally be unable to dispose of it. An exception to the latter case is provided by the decision in FCT v Suttons Motors (Chullora) Wholesalers Pty Ltd (1985) 157 CLR 277; 16 ATR 567; 85 ATC 4398.

FCT v Suttons Motors (Chullora) Wholesalers Pty Ltd Facts: The taxpayer was a member of a group of companies (SM) engaged in retailing motor vehicles. The taxpayer acted as a wholesaler for SM. Vehicles were owned by a finance company (GMAC) but were displayed in SM’s showrooms under a ‘floor plan’ agreement. When a vehicle was sold by SM to a customer, the taxpayer immediately invoiced SM for the wholesale price and SM paid GMAC. The issue in dispute was a deduction under former legislation relating to trading stock valuation adjustments that depended upon the vehicles being on hand for the taxpayer despite that it did not own them and was under no obligation to buy them. The taxpayer’s argument was based on the commercial reality that parties to the agreement

regarded the vehicles as the taxpayer’s trading stock. The Commissioner argued that the vehicles were not trading stock on hand because they were the property of GMAC and stored at SM’s showrooms. In addition, the taxpayer was not carrying on a business, only shuffling paper. Held: The High Court (Brennan J dissenting) dismissed the Commissioner’s appeal holding that, although not owned or paid for by the taxpayer, the vehicles were held for the purpose of sale in the ordinary course of business. The majority said (at ATR 573):a [The Commissioner’s] proposition is untenable in the circumstances of the present case where it would be unreal to isolate the taxpayer’s activities of acquiring vehicles from [page 716] GMH and selling them to Suttons Motors from the context of the overall business of the Suttons group. It is plain that the group was, at the commencement of the tax year, carrying on a composite business including, among other things, the wholesale purchase and resale of the vehicles by the taxpayer and the purchase and retail sale of the vehicles by Suttons Motors … At the commencement of the tax year, the taxpayer was carrying on a business and the relevant vehicles were in the process of being acquired by the taxpayer from GMH and were held on hand in the possession of the taxpayer so as to be immediately available to be sold at any time in the ordinary course of that business. They were, at the commencement of the tax year, stock in trade held by the taxpayer on hand in relation to that business.

a.

The substance of Brennan J’s dissent was that the taxpayer held the vehicles as bailee, a conclusion reached in an English case based on similar facts: see General Motors Acceptance Corp (UK) Ltd v IRC [1985] STC 408. If property not owned by the taxpayer may be on hand, because there was dispositive power, the question arose whether property not physically held may yet be ‘on hand’. That question was considered in All States Frozen Foods Pty Ltd v FCT (1990) 21 FCR 457; 20 ATR 1874; 90 ATC 4175.

All States Frozen Foods Pty Ltd v FCT Facts: Before 30 June 1985, the taxpayer acquired trading stock and had received bills of lading. Under these bills of lading the taxpayer obtained legal title and control. It had power to dispose of the goods even though it had only constructive receipt. At 30 June, several containers were in transit and the taxpayer claimed and was allowed a deduction for the cost of purchase but argued that the goods were not on hand because they had not been received physically. Held: In holding that the stock was ‘on hand’, the Full Court referred to a number of accounting publications, including some well-known Australian texts, and concluded (at ATR 1881): Most of these publications support the view that goods in transit to which title has passed to the buyer (eg where the terms of the shipment are free on board, at shipping point, or, as here, cost, insurance and freight contracts where bills of lading had been delivered to the buyer) belong in the inventory of the buyer, not the seller, or, as is sometimes expressed, all goods [page 717] to which the purchaser has title should be regarded as in his inventory regardless of their location. In other words, the court noted that the definition of trading stock operated cumulatively on the ordinary meaning of the term and built on the meaning attributed to it by legal and commercial people for accounting and other purposes. The court could not help but note that in its balance sheet for the period, the company brought to account in its inventory the stock in transit.

Stock on consignment 11.17 In the circumstances, stock physically in possession but not owned may be ‘on hand’, and stock for which title has passed but is in transit will be ‘on hand’. The Commissioner accepts that goods the subject of ‘lay-by’ sale arrangements but in the seller’s possession at 30 June are ‘on hand’.16 Sales on consignment through agents present variations on these themes. Goods delivered on consignment for sale by an agent remain trading stock of the consignor and, where there is no sale to the consignee, goods provided on a sale or return basis (as in the case of newsagents and petrol retailers) also remain the consignor’s

stock. If there is a sale to the agent, the cost is deductible and the goods are ‘on hand’.

Stock for sale and other uses 11.18 In the case of a car dealer, vehicle stock used for demonstration purposes remains trading stock because its purpose and ultimate destination is sale. More difficult questions arise where equipment is acquired with the object of sale and/or rent. For example, in FCT v Cyclone Scaffolding Pty Ltd (1987) 19 ATR 674; 87 ATC 5083, the taxpayer derived 80% of its income from the hiring of equipment and the balance either from outright sale or payments for forfeiture through loss or damage. By an agreement many years earlier, the Commissioner accepted treating the plant as trading stock in the first year of ownership. If it was sold, the proceeds were returned as income and appropriate deductions were allowed. If it was not sold, the equipment was treated as plant and depreciated and the recoupment (if any) on subsequent sale was assessable under the depreciation provisions. As a result (as the legislation operated at the time), in respect of the sale of depreciated property, profits represented by the excess of sale price over the cost of the equipment was not assessable. The Commissioner assessed the taxpayer on such profits pursuant to the former ITAA36 s 25(1) (ITAA97 s 6-5). A majority of the Federal Court dismissed the Commissioner’s appeal. In the majority’s view, the accounting procedure adopted gave a substantially correct reflex of the company’s profit and the purpose of acquiring the plant was for hire, not sale. [page 718] Bowen CJ and Beaufort J distinguished the decision in Memorex Pty Ltd v FCT (1987) 19 ATR 553; 87 ATC 5034 on the basis that the goods in Memorex were ultimately destined for sale and, at the time of sale, were not plant. In Cyclone Scaffolding, under the accepted

accounting practice, equipment not sold in the first year thereafter was treated as plant.17 The difficulty with cases such as Cyclone Scaffolding was that the practice was contrary to perceived wisdom that once an item was trading stock, it remained trading stock, even after the taxpayer ceased to carry on business: FCT v Murphy (1961) 106 CLR 146; 8 AITR 388.18 Amendments forming part of the ITAA97 have addressed the problem as follows: Where an article is acquired as trading stock but ceases to be so held but is still owned and is used in some other manner, such as for use as plant as in Cyclone Scaffolding, or, more commonly, is appropriated for private use, ITAA97 s 70-110 deems the person to have sold the item for cost and immediately reacquired it before the change in use. On the other hand, where a person holds an item and ventures it as trading stock, ITAA97 s 70-30 deems the person to have sold the item and immediately reacquired it, at the taxpayer’s option, for its cost or market value before the change to trading stock: see further 11.27.

Valuation of trading stock 11.19 An important difference between the accounting and the tax treatment of stock lies in the valuation of closing stock. For accounting purposes, inventory must be valued at the lower of its cost or net realisable value. It will be appreciated that this is not a choice; the lower value applies. For taxation purposes, valuation of stock at the end of year is governed by ITAA97 ss 70-45(1) and 70-50: 70-45 Value of trading stock at end of income year (1) You must elect to value each item of trading stock on hand at the end of an income year at: (a) its cost; or (b) its market selling value; or (c) its replacement price.

[page 719] 70-50 Valuation if trading stock obsolete etc You may elect to value an item of your trading stock below all the values in section 70-45 if: (a) that is warranted because of obsolescence or any other special circumstances relating to that item; and (b) the value you elect is reasonable.

Section 70-45 applies to all items of trading stock, including live stock. The valuation options apply to each item and there is no requirement that the same valuation option be selected for a particular item in any particular year. It follows that a taxpayer with 100 items of trading stock with a cost price, replacement price and market selling value of $1, $2, and $3 respectively may value closing stock at any value between $100 and $300. As a result, taxable income may be increased by up to $200 in one year by switching from opening stock valued at cost price to some combination of replacement and market selling value for closing stock. Similarly, income may be decreased by up to $200 by switching from a market selling value for opening stock to some combination of the other values for closing stock. The only requirement is that the value of closing stock in any one year must be the opening stock value for the next year: ITAA97 s 70-40(1). The alternative valuation election in ITAA97 s 70-50 provides for stock that is out of use, out of date, outmoded or unfashionable having regard to its age, quantity on hand, last sales and industry experience in relation to the particular stock line. So, for example, a nil valuation would be acceptable for stock that was to be pulped, dumped or destroyed. General guidelines for valuations under s 70-50 are set out in TR 93/23. For an ‘eligible small business entity’ taxpayer choosing not to bring to account changes in trading stock of less than $5000, there is no requirement for a stock take and valuation by ss 70-35 and 70-45. Clearly, this requires some reasonable estimate of the value of closing stock on hand in order to determine that the change is in fact less than

$5000. If it is, the value of stock on hand at the end of the year is deemed to be the value at the start of the year. If it is not, the normal rules apply. Alternatively, a taxpayer may choose to account for changes on an annual basis: ITAA97 Subdiv 328-E. Live stock is valued under the same rules except that, in the case of natural increase, there is an election between determining cost under the full absorption method or adopting cost values prescribed by the Income Tax Assessment Regulations 1997 (Cth): s 70-55. Under the Regulations, for example, cattle, deer and horses are valued at $20, pigs at $12, and sheep and goats at $4: reg 70-55.01.

Each item of trading stock 11.20 The former ITAA36 s 31(1) provided the valuation options of ITAA97 s 70-45 but it referred to ‘each article of trading stock’ rather than ‘each item of trading [page 720] stock’. Reference has already been made to the fact that it was language such as this that contributed to, in part, the difficulty of accepting land as trading stock. In FCT v St Hubert’s Island (in liq) (1978) 138 CLR 210; 8 ATR 452, the High Court accepted that land could be trading stock and that partially developed land was analogous to a manufacturer’s work in progress. In that case, Stephen J said that the word ‘article’ used in the context of describing bulk commodities of stock such as wine, wheat or coal was ‘perhaps, not elegant’ but that it could not be intended to exclude such stock from the operation of the provisions. As a result, his Honour took the description to mean individual items of stock: at ATR 455. Whether undeveloped land could be notionally divided and constitute an article (or item) of trading stock was considered in Barina Corp Ltd v FCT (1985) 4 NSWLR 96; 17 ATR 134; 85 ATC 4847.

Barina Corp Ltd v FCT Facts: The taxpayer, a project builder, acquired four blocks of land that it intended to subdivide and sell. Approval was granted subject to conditions but, before development had commenced, the directors resolved to treat the land as subdivided such that a value of cost, market selling or nil could be assigned to each article. The Commissioner contended that an area of land is an article of trading stock only if it could be sold or transferred. As a result, there were only the four original parcels of land that were articles. The taxpayer submitted that, even though not formally subdivided, each proposed block of land was an ‘article’ for the purposes of (the former ITAA36) s 31(1). Held: In the Supreme Court of New South Wales, Rogers J dismissed the taxpayer’s appeal (at ATC 4855): It seems to me that proper effect can be given both to the text and legislative purpose if one regards, in the context of land proposed to be sold by subdivision, an article as trading stock only where the block of land is, in fact, marketable. Absent marketability and there can be no market selling value. If absence of marketability is due to the fact that the land has not yet been converted to a subdivisible state, then I do not think that its individual but unidentifiable and nonsegregated components can be said to be each an article of trading stock distinct from the land in globo.

The ‘cost’ option 11.21 The predecessor to ITAA97 s 70-45, the former ITAA36 s 31(1), made reference to ‘cost price’. In relation to ‘cost price’, Fullagar J said in Australasian Jam Co Pty Ltd v FCT (1953) 88 CLR 23; 5 AITR 566 at 570: [page 721] The words “cost price” are perhaps not literally appropriate to goods manufactured, as distinct from goods purchased, by a taxpayer but I feel no difficulty in reading them as meaning simply “cost”.

Later (at AITR 571) his Honour added: ‘I cannot regard “cost” as

meaning anything other than actual cost’. It may be inferred from these statements that the reference in the former ITAA36 s 31(1) to ‘cost price’ was a reference to ‘cost’ and that ‘cost’ means ‘actual cost’. The issue is not without importance because the cost price of an item of merchandise may well be its invoice price, but its actual cost arguably includes all of the costs and charges of bringing the item to its place of sale. Similarly, in a manufacturing context, actual cost clearly implies more than the invoice price of raw materials. The substitution of ‘price’ for ‘cost price’ as between ITAA97 s 70-45 and the former ITAA36 s 31(1) is consistent with these inferences. There is no direct authority on the matter,19 but it is accepted that ‘cost’ is broader than invoice price, and would include delivery and other costs incurred to bring the stock to the state it was in when it became ‘on hand’. In the case of a manufacturer, there is authority in Philip Morris Ltd v FCT (1979) 10 ATR 44; 79 ATC 4352. In that case, the taxpayer argued that, in the course of its manufacture of tobacco products, only direct materials and direct labour were included in the cost of its trading stock. This was rejected by Jenkins J in the Supreme Court of Victoria. His Honour said (at ATR 51–2): The development of the conception of cost in relation to a manufacturer’s trading stock which direct costing theory and practice involves is therefore, in my opinion a departure from the conception which I think that [former ITAA36] s 31(1) expresses. The concept expressed by the words “cost price” in [former ITAA36] s 31 in my opinion is, in its relation to an article of trading stock manufactured by a taxpayer, directed to ascertainment of the expenditure which had been incurred by the taxpayer in the course of his materials purchasing and manufacturing activities, to bring the article to the state in which it was when it became part of his trading stock on hand … [T]he ascertainment of expenditure referable to one of very many identical manufactured articles is, I think, ordinarily to be achieved by allocating to each of the articles manufactured during the year an equal share of the year’s expenditure incurred in manufacturing them all.

Cost in relation to a manufacturer therefore refers to full absorption costing as opposed to direct or variable costing. In the case of a taxpayer dealing in finished goods, cost is taken to mean all costs ‘to bring the article to the state in which it was when it became part of trading stock on hand’. Within the confines of these general rules, there are several acceptable trading stock models: Average cost

Where possible, the actual or specific cost of each item of stock should be identified but, where this is impossible (as, for example, in the case of bulk fuel) or it is impractical to determine the actual cost of each item of stock, a weighted average of opening stock on hand and purchases is acceptable. [page 722] Standard cost Standard costs are acceptable provided the standards are reviewed regularly (Australasian Jam Co) and variances are pro-rated between cost of goods manufactured and closing stocks of finished goods and work in progress. FIFO Under the first-in-first-out (FIFO) assumption, goods first purchased are the first sold and stock on hand consists of the most recently acquired. This is accepted provided the inventory movements approximate this cycle. The alternative assumption, last-in-first-out (LIFO), that the most recent acquisition is the first sold, is unacceptable. A variation on LIFO is the base stock method, which assumes that a minimum or base stock is necessary for a business to operate. The base stock is valued at the time of its manufacture and other stock valued by some other method. This method is also unacceptable. Retail inventory This is a method of inferring the cost of goods from their retail selling price. It assumes profit margins are known exactly. For example, if a stocktake indicates that inventory with a retail value of $100 is on hand and the mark-up is 25%, it follows that the cost is $80. This means that, from assessable sales of $50,000, deductions of $40,000 are allowable. The method is acceptable provided it can be demonstrated that mark-ups are clearly

established and that, if old stock is discounted, the mark-up is adjusted accordingly.

Cost of manufactured stock 11.22 The effect of the decision in Philip Morris is that, in the case of a manufacturer, ‘cost’ means full absorption cost, being: Actual cost = Direct material cost + Direct labour cost + Direct factory overhead cost + Allocation of indirect factory overhead cost Variable or direct costing is not acceptable. Direct material cost may be established under FIFO, average cost or standard cost, but what distinguishes full absorption cost from alternative valuation models, such as direct or variable cost, is that a proportionate allocation is made of direct and indirect overhead costs. Ordinarily, the amount of overhead to be allocated to the closing stock of goods on hand is given by the formula:

Taxation Ruling IT 2350 sets out the production overhead costs that should be taken into account in determining the cost value of closing stock: factory light and power; factory rent, maintenance and repair expenses; [page 723] factory rates and taxes; factory depreciation;

factory insurance; factory administration expenses; quality control and inspection; indirect labour (including production and supervisory wages, and including): – holiday pay, sick pay and tea money; – long service leave paid; – workers compensation; – superannuation; – payroll tax; indirect materials and supplies; tools and equipment not capitalised; insurance on plant and machinery; depreciation on plant and machinery; royalties in respect of any production process; raw materials — handling and storage. The following costs are excluded: storage costs (other than raw materials); marketing, advertising, selling and distribution costs; interest and other finance expenses; research and experimental expenses (including engineering and product development); income tax and fringe benefits tax; general administrative expenses; employee benefits (such as training, cafeteria, recreational facilities etc).

Accounting or tax values? 11.23 The reference to depreciation of factory, plant and machinery poses a problem: is the appropriate figure the amount calculated for financial reporting purposes or the amount allowable for taxation? In relation to holiday pay, does it include provisions for annual leave?

Arguably, all amounts should be accounting figures. This may be justified on the basis that absorption costing is an accounting notion that demands accounting measurements. There is in fact no such thing as ‘factory depreciation’ for tax purposes. Relevant tax deductions are allowable for direct and indirect labour costs, indirect materials, rent, repairs, insurance, depreciation and so on. The deductibility of these amounts is not affected by the calculation of closing stock value. The object of the calculation in ITAA97 s 70-35 is to quarantine costs associated with a build-up of unsold stocks until such time as the stocks are sold. If the taxpayer chooses to value closing stock at the cost option, and given that cost means absorption cost and that is an accounting measure, arguably accounting numbers apply. The alternative view is that, since IT 2350 is concerned with measurement for tax purposes, it is arguable that tax numbers should be used. [page 724] Consider the following simplified example.

Austco Pty Ltd Sales:

10,000 units @ $5

$50,000

Raw materials: Opening stock Purchases Freight

$1,000 4,500 500 6,000

Closing stock Cost of materials Direct labour Overheads:

(2,000) 4,000 20,000

Rent

3,000

Insurance

2,000

Depreciation

1,000

6,000

Selling & administration expenses

5,000

Equivalent units of finished goods Opening stock

2,000

Closing stock

4,000

1. 2. 1.

@ $2.25

What is the ITAA97 s 70-35 cost valuation? What amounts are allowable deductions for tax (assuming FIFO and that accounting depreciation equals tax depreciation)? Finished goods

Opening stock Sales Closing stock Units produced

2,000 10,000 4,000 12,000

Variable costs Materials used

4,000

Direct labour

20,000 24,000 ÷ 12,000 = $2/unit [page 725]

Fixed costs Overheads

6,000 ÷ 12,000 = $0.50/unit

Closing stock

4,000 @ $2.50 = $10,000

2.

Deductions (ITAA97)

Raw materials purchased (s 8-1)

$5,000

Stock adjustment (s 70-35(2))

(1,000)

Direct labour (s 8-1)

20,000

Overheads (ss 8-1, 42-15 etc)

6,000

Stock adjustment (s 70-35(2))

(5,500)

Selling & administration costs (s 8-1)

5,000 $29,500

The ‘market selling value’ option

4,000

20,500

11.24 The second valuation option is market selling value in ITAA97 s 70-45(1)(b). This valuation option carries the following note: Note: An item’s market selling value at a particular time may not be the same as its market value.

Market selling value is not the same as net realisable value for accounting purposes. There is no authority to support the anticipation of selling costs that would be required by net realisable value. If the realisable value is less than market selling or cost, it may be appropriate to consider whether there are circumstances that allow the option under ITAA97 s 70-50. Market selling value contemplates a sale in the taxpayer’s normal market in the ordinary course of business. In Australasian Jam Co Pty Ltd v FCT (1953) 88 CLR 23; 5 AITR 566 at 572, Fullagar J said: But it is not to be supposed that the expression “market selling value” contemplates a sale on the most disadvantageous terms conceivable. It contemplates, in my opinion, a sale or sales in the ordinary course of the company’s business — such sales as are in fact effected. Such expressions in such provisions must be interpreted in a commonsense way with due regard to business realities, and it may well be — it is not necessary to decide the point — that, in arriving at market selling value, it is legitimate to make allowance for the fact that normal selling will take place over a period. But the supposition of a forced sale on one particular day seems to me to have no relation to business reality.

[page 726] In Barina Corp Ltd v FCT (1985) 4 NSWLR 96; 17 ATR 134; 85 ATC 4847, it was held that without marketability there can be no market selling value. Rogers J (at ATC 4855) employed the following example to illustrate that the item of stock must be one to which a market value can be ascribed: Let it be assumed that on 30 June … there are on the floor of the plant of a motor vehicle manufacturer a motor car chassis, an engine, doors, wheels, tyres and so on. Could it be said that the value to be ascribed to those items together is the value of the motor car? The manufacturer trades in motor vehicles, not in chassis, doors etc. Let it be assumed that by dint of using a robot machine it would require only an hour or two’s work to assemble all those items into a motor vehicle. Is the relevant article a motor vehicle? It defies common sense or reality to say so.

It would follow from this decision that for a manufacturer only

finished goods could be valued at market selling value. Work in progress, even when expressed in terms of equivalent units of finished goods, would be items of trading stock but they could be valued only at cost or replacement value (which, in the case of a manufacturer, is cost anyway).

Why would a taxpayer elect to value closing stock at ‘market selling value’?

The ‘replacement price’ option 11.25 The third valuation option under ITAA97 s 70-45 is ‘replacement price’. In the case of a dealer in goods, it is the last sale made in the buyer’s normal market. In the case of a manufacturer in times of constant prices, it will usually be cost. The term has been the subject of little judicial comment. In Parfew Nominees Pty Ltd v FCT (1986) 17 ATR 107; 86 ATC 4673, Gobbo J indicated the option may well be available only where there is a viable market for the relevant item. His Honour said (at ATC 4677): Where there is replacement stock available I am of the view that replacement price is in the great majority of cases to be ascertained by identifying the price that is to be paid to secure that replacement item. This needs to reflect a price that is the relevant one for a particular taxpayer. Thus it would not be appropriate for a retailer to use a price that is the retail cost of replacement. The correct price would be the price that is normally paid by a retailer when buying in his own stock …

In Parfew Nominees, the court refused to accept a replacement price valuation for trading stock consisting of strata title units in a city building because replacements were not available and it was necessary to reconstruct a notional development to impute a value. To be a valuation option, it would seem a requirement that a market trading in substantially identical items is available. This decision sits comfortably with the Barina Corp case in relation to the market selling option.

[page 727]

Non-business disposals 11.26 Income derived from the disposal of trading stock in the ordinary course of business is brought to account as ordinary income under ITAA97 s 6-5. In addition to routine selling, ITAA97 s 70-80(3) identifies four other occasions when an item ceases to be trading stock: (a) (b) (c) (d)

you dispose of it outside the ordinary course of business; or interests in it change; or you die; or you stop holding it as trading stock.

Outside the ordinary course of business 11.27 In CT (WA) v Newman (1921) 29 CLR 484, it was held that proceeds for the sale of trading stock on the termination of business were not assessable. This decision led to legislative amendments that extended assessment to include such disposals and deemed the purchaser to have acquired the trading stock at the value attributed to the seller. Such disposals extended to property that included standing or growing crops, crop stools, and trees planted and tended for sale. It will be appreciated that these items of property are not trading stock until they are severed from the ground. For the purposes of ITAA97 ss 70-80, 70-85 and 70-90, these assets are treated as if they were trading stock. Note that professional work in progress is not included in this expanded coverage. Under ITAA97 s 70-90, the market value of the item on the day of disposal is included in assessable income. 70-90 Assessable income on disposal of trading stock outside the ordinary course of business (1) If you dispose of an item of your trading stock outside the ordinary course of a business: (a) that you are carrying on; and

(b) of which the item is an asset; your assessable income includes the market value of the item on the day of the disposal.

The former legislation made reference to disposals ‘by sale, gift, or otherwise … property … not in the ordinary course of business’. This suggests one may well make a disposal ‘by sale, gift, or otherwise’ that is in the ordinary course of business. Sales in the ordinary course of business are obvious but it must be possible to dispose of property by way of ‘gift or otherwise’ and not attract the [page 728] current ITAA97 s 70-90 even though that provision uses language that does not open up the same possibility. A sale in Newman’s circumstances triggers ITAA97 s 70-90. Whether a disposal by gift or otherwise is in the ordinary course of business is a question of fact to be determined having regard to the following: the nature of the business; the character of transactions falling within that business; and the character of the disputed transaction. It is arguable that stock given away as part of promotional activities and the like is not affected by the provision where, having regard to the three considerations, the disposal is in the ordinary course of the taxpayer’s business. Similarly, a disposal resulting from theft of property is outside the provision because, however unwelcome the event, it is not outside the normal course of business: compare Charles Moore & Co (WA) Pty Ltd v FCT (1956) 95 CLR 344; 6 AITR 379; 11 ATD 147. In FCT v Wade (1951) 84 CLR 105; 5 AITR 214, the compulsory acquisition and destruction of live stock was not a disposal outside the ordinary course of a dairy farmer’s business (although the compensation was assessable income). The dumping or destruction of obsolete stock is also outside the ambit of the provisions. On the other hand, the personal use of trading stock is caught, as would be the use of

trading stock to make personal donations to charitable institutions. A distribution of trading stock in specie by a liquidator is also a disposal outside the normal course of business: FCT v St Hubert’s Island (in liq) (1978) 138 CLR 210; 8 ATR 452. The assessable amount is the market value of the item on the day of disposal (ITAA97 s 70-90(1)), and the amount actually received (if anything) is not included in assessable income. Predecessor legislation (ITAA36 s 36(8) and (9)) specified the market value on the day of disposal or, if in the Commissioner’s opinion there was insufficient evidence of the market value, a reasonable amount having regard to the original cost of the property to the taxpayer and any amount specified in any agreement connected with the disposal. There is New Zealand authority indicating that, where the legislation does not specify any particular market, the market in which the disposal occurs is the relevant market: CIR(NZ) v Edge (1956) 11 ATD 91. This view is consistent with the former ITAA36 s 36(9). Where a disposal occurs to which ITAA97 s 70-90 applies, an entity acquiring the property is deemed to acquire it at the value assessed under s 70-90. If it is trading stock of the purchaser, ITAA97 s 70-25 deems the acquisition value not to be an outgoing of capital. Gifts of trading stock that would trigger ITAA97 s 70-90 may be an allowable deduction under ITAA97 s 30-15 where they exceed $2 in value and otherwise satisfy specified conditions. The requirement that gifted property be less than 12 months old does not apply to gifts of trading stock. As a result, the Act would operate as follows: the initial purchase of stock would be deductible under ITAA97 s 8-1 (or ITAA97 s 70-35); the disposal would be assessable under ITAA97 s 70-90; and the gift would be deductible under ITAA97 s 30-15 at the value made assessable under ITAA97 s 70-90. [page 729]

Interests in ownership change 11.28 Where there is a change in the ownership interests of trading stock — such as a variation of membership in a partnership — provided there is a continuing 25% interest, the parties can elect to treat the transfer as if no disposal took place: ITAA97 s 70-100. The Act provides the following example: A grocer decides to take her daughters into partnership with her. Her trading stock becomes part of the partnership assets owned by the partners equally. As a result, it becomes trading stock on hand of the partnership instead of the grocer. This section treats the grocer as having disposed of the trading stock to the partnership outside the ordinary course of her business.

Under ITAA97 s 70-100(4), the parties can elect (in writing) to transfer the stock at the transferor’s value. As a result, any profit on the sale of the trading stock is deferred until the stock is sold in the course of business. Consider Example 11.4:

Assume Mum and Dad are in equal partnership.

Trading stock:

Cost Market value (s 70-90)

$9,000 $20,000

Mum and Dad wish to admit Dave and Mabel as equal partners. Mum and Dad are deemed to have disposed of their respective share of trading stock to the partnership Mum, Dad, Dave and Mabel. Mum and Dad —

deemed sale under s 7090(1)

$20,000

The normal mechanism would provide a deduction:

Less s 70-35(3) deduction

9,000

Net ‘assessable income’

$11,000

The deemed net assessable amount of $11,000 would be shared in accordance with the partnership agreement (assuming no election is made). Assuming an equal partnership, each would have an assessable amount of 50% of $20,000 less $9000 (= $5500). Mum and Dad are assessed on that amount even though they may not have received that much consideration for that ‘disposal’. In any event, at best they would have each received only 1/4 of $20,000, being $5000, from the incoming partners.a

a.

It might be observed that, without some other compensation, incoming partners would be ill-advised to enter into s 70-100 elections — in the above example, [page 730]

Dave and Mabel each pays $5000 for a 1/4 interest in trading stock for which they each only benefit from an ultimate tax deduction of $2250 (being 1/4 of $9000). Thus, such elections are usually made in the context of a family partnership. To avoid the adverse effect of s 70-90, it is necessary for all parties to give notice, within the prescribed time, that the previous tax value of $9000 carries forward into the new partnership. There are four conditions that must be satisfied: 1. immediately after the item ceases to be trading stock on hand of the transferor, it is an asset of a business carried on by the transferee (this means that Mum, Dad, Dave and Mabel continue to carry on business); 2. immediately after the item ceases to be trading stock of the transferor, the owners of the stock immediately beforehand have at least a 25% interest in the market value of the stock (in this case, there is a continuing interest of 50%); 3. the elected value is less than market value; and 4. the item is not a chose in action.

Death of the owner 11.29 By virtue of ITAA97 s 70-80(3)(c), an item ceases to be your trading stock when ‘you die’. Under s 70-105, on the death of an owner, the market value of trading stock on hand is included in the deceased’s assessable income up to the date of death. Where the business continues to be run by the administrator or executor, the date of death can, in effect, be treated as an end of year and stock may be valued as under s 70-45.

You stop holding items as trading stock 11.30 Under ITAA97 s 70-110, on ceasing to hold an item as trading stock (but continuing to own it), the taxpayer is deemed to have sold it for cost and immediately reacquired it for the same amount. The provision provides the following example: You stop holding an item as trading stock and begin to use it as a depreciating asset for the purpose of producing your assessable income. You are treated as having sold it for its cost. This amount is assessable income, just like the proceeds of sale of any of your trading stock. You are also treated as having bought the item for the same amount, which is relevant to working out the item’s cost for capital allowance purposes (see Subdivision 40-C) and the item’s cost base for CGT purposes (see Division 110).

If a taxpayer ceases to hold trading stock because it is lost or destroyed, s 70-115 assesses any amount received by way of insurance or indemnity that would not fall under s 6-5. [page 731] In cases where an item was not trading stock but becomes so, the change is treated as a disposal and reacquisition at cost or market value, at the taxpayer’s option: s 70-30. The Act provides the following example:

You start holding a depreciating asset as part of your trading stock. You are treated as having sold it just before that time, and immediately bought it back, for its cost or market value, whichever you elect. (Subdivision 40-D provides for the consequences of selling depreciating assets.)

A hire company holds an item of plant that cost $10, which has been depreciated to an adjustable value of $8 and has an arm’s length value of $12. The item is transferred from plant to trading stock. The taxpayer is deemed to sell and immediately reacquire the item for either $10 or $12. (a) Assume the taxpayer elects a value of $10 (cost): under Subdiv 40-D, the taxpayer’s assessable income includes $2 (being $10 – $8); the amount of $10 is deemed not to be an outgoing of capital (s 70-25) and is deductible under s 8-1; if the item is on hand at 30 June, it may be valued at cost, market selling value or replacement price; if the item is sold, the sale price ($12) is assessable income; the net taxable amount is therefore $4. (b) Assume the taxpayer elects a value of $12 (market value): under Subdiv 40-D, the taxpayer’s assessable income includes $4 (being $12 – $8); the amount of $12 is deemed not to be an outgoing of capital (s 70-25) and is deductible under s 8-1; if the item is on hand at 30 June, it may be valued at cost, market selling value or replacement price; if the item is sold, the sale price ($12) is assessable income; the net taxable amount is therefore $4.

Section 70-110 applies where a taxpayer takes an item of trading stock for personal consumption. The assessable amount is the cost. It is conceded in Taxation Ruling IT 2659 that the maintenance of records to determine the assessable amount might be difficult in some occupations. As a result, TD 2015/9 provides standard values for trading stock so taken. For example, for a mixed business (milk bar, general

[page 732] store) the amount per adult is $4710 (2014–15); for a take-away food shop, $3350; a licensed restaurant, $4490. Greater or lesser amounts could be appropriate.

Non-arm’s length transactions 11.31 ITAA97 s 70-20 is a revenue protection measure designed to overcome an arrangement illustrated by Cecil Bros Pty Ltd v FCT (1964) 111 CLR 430; 9 AITR 246; 13 ATD 261, and replaces the former ITAA36 s 31C. The facts of the case are presented in a stylised form.

Cecil Bros Pty Ltd v FCT Facts: The taxpayer was a shoe retailer that formerly purchased its stock from independent wholesalers. In 1960, it purchased stock from a family company (Breckler Pty Ltd) that purchased the stock and on-sold it to Cecil Bros at a 10% mark-up. As a result, Cecil Bros paid approximately $40,000 more for its stock of shoes than it could have. The amount of $40,000 was channelled to family members.

Held: At first instance, Owen J held that apportionment could not be contemplated under

the former ITAA36 s 51(1) but that the general anti-avoidance provision, the former ITAA36 s 260, applied to void the arrangement. On appeal, the Full High Court held that s 260 did not apply. (The question of s 51(1) was not appealed.) Dixon CJ (with whom the other members of the court agreed) said (at AITR 247): [O]nce it was held that the payment of the amount received by Breckler Pty Ltd from the taxpayer company was paid for boots and shoes as stock in trade, there could, I think, be no ground for excluding any part of it from the allowable deductions from assessable income. In my opinion, s 260 of the [1936] Act can have no application to such a case as the present. … I have great difficulty in seeing how it could apply to defeat or reduce any deduction otherwise truly allowable under s 51(1).

[page 733] Section 70-20 is designed to counter these arrangements. It provides: 70-20 Non-arm’s length transactions If: (a) you incur an outgoing that is directly attributable to your buying or obtaining delivery of an item of your trading stock; and (b) you and the seller of the item did not deal with each other at arm’s length; and (c) the amount of the outgoing is greater than the market value of what the outgoing is for; the amount of the outgoing is instead taken to be that market value. This has effect for the purposes of applying this Act to you and also to the seller.

The effect of ITAA97 s 70-20 is to substitute an arm’s length value as the amount deductible under ITAA97 s 8-1 or the amount brought to account as the s 70-45 ‘cost’ valuation option of closing stock on hand. The buyer is denied a deduction and the seller’s assessable income is reduced from the inflated price to the arm’s length price.

1. Indicate how the trading stock provisions of Div 70 apply to the following events: (i) The proprietor of a men’s clothing store took a suit from trading stock for his own use. The suit cost $350 and had a retail value of $500. (ii) The owner of a confectionery store presented two staff members with a box of chocolates as Christmas presents. (iii) Local retailers donate items to fill a Christmas hamper to be raffled by the Carlyle Bowling Club. (iv) O Owner sold the ‘Corner Store’ for $100,000 plus stock as valued (SAV). Stock was valued at $25,000. (v) PhotoCo is in the business of leasing photocopying equipment. At the conclusion of a lease agreement, equipment more than five years old is sold. (vi) BuildCo carries on business preparing building sites. This involves supplying and compacting sand. BuildCo pays $100,000 for title to a property containing sand reserves. (vii) A concrete manufacturer pays a land owner $2 per cubic metre to extract gravel from a quarry on the owner’s land. [page 734]

2.

3.

(viii) A quantity of paint owned by a sign writer is destroyed in a fire. (ix) A viticulturist is forced to dispose of quantities of pesticides and fertiliser that have been contaminated. (x) A toy retailer acquired 2000 yoyos for 0.50 cents each. Not one item has been sold in five years. Bacchus Wines carries on business as a viticulturist and wine maker. For income tax purposes, it elects to value stock on hand at cost price. Comment on the tax treatment of the following items of expenditure relating to stock on hand at 30 June: land preparation costs; storage costs for bottled wine; interest on money borrowed to finance business operations; rent on wine-bottling machine; labour costs attributable to grape growing; and pesticides and fertilisers. Glo-worm Pty Ltd manufactures torch batteries. During the year ended 30 June, 10 million packets were manufactured and the following (taxation) costs incurred:

administration costs direct labour factory overheads interest on overdraft

$27,500 $210,000 $130,000 $7,500

raw materials purchased sales expenses warehouse rent

$160,000 $45,000 $15,000

(a) Raw materials:

opening stock of raw materials closing stock

$30,000 $25,000

(b) Work in progress:

Opening stock:

Nil

Of the 10 million units manufactured during the year, 9.7 million were sold (in addition to opening stock); 100,000 units complete and 200,000 units 50% complete remain ‘on hand’. (c) Opening stock of finished goods was 100,000 ($5000). [page 735] Required: (i)

What amounts are deductible/assessable to Glo-worm under Div 70 (and other provisions)? (ii) Calculate Glo-worm’s closing stocks of raw material, work in progress and finished goods at the ‘cost’ option. A suggested solution can be found in Study help.

1.

2.

3.

The cost of trading stock acquired in the ordinary course of business has long been deductible but the cost of stock acquired as part of the acquisition of a business was capital. Similarly, in CT (WA) v Newman (1921) 29 CLR 484, the High Court held that proceeds of the sale of stock in the course of selling the business was not assessable income. Amendments to the 1927 Act contained provisions assessing the sale of stock in such circumstances and deeming the purchaser not to have expended a capital amount. The essential feature of a CIF (cost, insurance, freight) contract is that delivery of goods is affected by the delivery of documents and, as a result, the taxpayer had constructive receipt rather than actual possession: All States Frozen Food Ltd per Bowen CJ, Lockhart and Gummow JJ at ATR 1877. The former ITAA36 s 6(1) definition of trading stock referred to items acquired rather than held. The former requirement suggests that the character of an item is indelibly established

4.

5.

6.

7.

8. 9.

10. 11. 12. 13.

14.

at the time of acquisition whereas the latter implies that the character of an item may change. For example, in Kratzmann’s Hardware Pty Ltd v FCT (1985) 75 FLR 186; 85 ATC 4138, shares acquired as trading stock continued to have that character after the taxpayer ceased the business of share trading. Subsequent provisions within ITAA97 Div 70 accommodate situations where an item becomes or ceases to be trading stock. Note that the former definition did not include the words ‘in the ordinary course of business’. For example, the ‘banking and insurance’ cases such as Colonial Mutual Life Assurance Society Ltd v FCT (1946) 73 CLR 604, Australasian Catholic Assurance Co Ltd v FCT (1959) 100 CLR 502 and National Bank of Australasia Ltd v FCT (1969) 118 CLR 529 (see 3.52 and 3.54) where profits on the sale of investments were assessable even though neither the taxpayers nor the Commissioner treated the sales as falling within the trading stock provisions. The distinction also serves to reinforce an appreciation of the normal operation of the Acts and when it has been necessary for the courts to resort to the assessment of specific profit. Property normally and routinely bought and sold will be trading stock accounted for within ITAA97 Div 70. The sale of property that is not trading stock may yet generate income that may be in the form of profit. A chose in action is a property right that exists due to the recognition given to it by law. Put simply, it is a right enforceable by a court action. Choses in action include debts, bank deposits, shares and rights to sue. Whether a chose in action could be trading stock was long doubted: see conflicting views in Australian Machinery & Investment Co Ltd v DCT (1946) 180 CLR 9; 3 AITR 359. In the London Australia Investment Co case, the court was forced to assess the profit on the sale of shares, calculated on the basis of the average cost of shares sold, because the shares were not trading stock and so predecessor legislation to ITAA97 Div 70 did not apply. Barwick CJ (dissenting) described the transactions as being the result of the nature of the company’s business but not part of that nature. The measurement of specific profit and its assessment is discussed in Chapter 3. The Commissioner’s view on the treatment of these items is set out in TR 98/7. In the context of the current legislation (s 70-35), the object is to measure changes in the value of stock. With respect, Windeyer J has blurred the question of what is trading stock and its role in the computation of gross profit under Div 70 with the question of when income is derived. That is, the question whether or not there has been an increase in stock does depend for an answer on whether the work in progress is income-derived. See Taxation Determination TD 92/124. The implication was reinforced by ITAA36 s 36, which assessed the value of trading stock disposed of otherwise than in the normal course of business. See Aickin J’s judgment in St Hubert’s Island at ATR 470–2. Post-August 1989 ‘allowable capital expenditure’ on quarrying operations is deductible in the same way as capital expenditure of mining operations. That is, the expenditure is deductible over the life of the mine or a lesser period (currently 10 years) as determined by Parliament from time to time. In addition, ITAA97 s 70-120 provides for a deduction of the cost of acquiring land containing trees or the right to fell trees as the trees are harvested. In Modern Permanent and Investment Society (in liq) v FCT (1958) 98 CLR 187; 7 AITR 233, Williams J said that the former ITAA36 s 6(1) (ITAA97 s 70-10) definition of trading

15. 16.

17.

18.

19.

stock referred only to tangible things. The difficulty accommodating intangible choses in action is evident. However, the definition is not exhaustive and ‘trading stock’ merely includes anything produced, manufactured or acquired etc. It may be that at times it is read as if the critical word was means. Acceptance that shares are trading stock leaves it open to argue that other choses in action may also be trading stock, including items such as factored debts: contrast Commercial and General Acceptance Corporation Ltd v FCT (1977) 137 CLR 373; 77 ATC 4375 and Avco Financial Services Ltd v FCT (1982) 150 CLR 510; 82 ATC 4246. However, the exclusion of financial instruments from the accounting concept of inventory provides a counterpoint. In Wong v FCT [2012] AATA 245, property trust units were held to be trading stock. See Taxation Ruling TR 95/7. Under the Arthur Murray principle, income from sale in such arrangements would not be derived until title passed: see Arthur Murray (NSW) Pty Ltd v FCT (1965) 114 CLR 314; 9 AITR 673. See also FCT v GKN Kwikform Services Pty Ltd (1991) 21 ATR 1532; 91 ATC 4336; FCT v Hyteco Hiring Pty Ltd (1992) 24 ATR 218; 92 ATC 4694. The Commissioner’s views on these cases is set out in IT 2550. For example, in Kratzmann’s Hardware Pty Ltd v FCT (1985) 16 ATR 274; 85 ATC 4138, it was held that the former ITAA36 s 36(1) (ITAA97 s 70-90) applied to shares that were initially purchased as trading stock but later held as investments. The decisions in Australasian Jam Co and Philip Morris are consistent with the view expressed by the Board of Review in (1946) 12 CTBR Case 19 that ‘cost price’ meant invoice price plus freight, duty and delivery costs.

[page 737]

CHAPTER

12

Taxation of Companies Learning objectives After studying this chapter, you should be able to: identify a company for tax purposes; distinguish between public and private companies for tax purposes; list some distinctive features of the tax treatment of companies; outline the basics of the Australian dividend imputation system; calculate some major credits and debits in a franking account; determine the maximum franking credit for a distribution; explain what the consequences of not franking a distribution to the benchmark franking percentage are; outline the rules aimed at curtailing dividend streaming, franking credit trading and the streaming of capital benefits; identify when a company is able to carry a loss forward; explain the basic framework of consolidation of groups for tax purposes; list some capital gains tax (CGT) provisions that are particularly relevant to companies.

Introduction

12.1 Up to this point in this book, we have largely been looking at principles that could apply to most taxpayers. In particular, we have focused on rules for ascertaining what will be included in a taxpayer’s assessable income and what expenditures will be allowed as deductions. In the next three chapters, our focus shifts to looking at what happens to income when it moves through what can be described as intermediate entities. Intermediate entities are forms of business organisation through which taxable income may flow. In Australia, the principal forms of business organisation are companies (both public and private), partnerships and trusts (which may take several different forms). It is possible for two or more individuals to use one, or a combination of, these forms to combine their resources for business purposes. From a legal point of view, each of these forms involves a complex of rights and obligations between either the persons combining their resources, or those persons and the entity itself or a third person such as a trustee. [page 738] 12.2 Of the three main forms of business organisation, only the company is recognised as a legal person as such. Under this basic rule of company law, a company is a separate legal entity from its members. A company may enter into contracts, sue and be sued, own property, and will continue as the same entity despite changes in the identity of the persons who own shares in it. In the most common form of company used in business in Australia, the liability of shareholders to outsiders in the event of a winding-up of the company is limited to the amount, if any, that is unpaid on their shares. 12.3 By contrast, a partnership is not recognised as a separate legal person. From a legal point of view, a partnership is thought of more as a relationship between persons. State Partnership Acts throughout Australia define a partnership as ‘the relation that subsists between persons carrying on business in common with a view to profit’. A partnership will be dissolved by the death or bankruptcy of a member

or by agreement. A partnership as such does not own property; rather, the legal title to partnership property is vested in one or more of the partners subject to equitable obligations to the other partners. Partners in a general partnership also have unlimited liability to outsiders. In a limited partnership, only the general partners have unlimited liability to outsiders. Limited partners in a limited partnership are liable to outsiders only up to the amount of capital that they agree to contribute to the partnership. In a limited partnership, only general partners take part in management of the partnership business. 12.4 There is no statutory definition of a trust for general law purposes. A synthesis of definitions proposed by text writers1 would be: a trust is the relationship that exists when equity imposes an obligation on a person (the trustee) to hold property (trust property) for the benefit of other persons (the beneficiaries) or for certain purposes. Note that, although the trustee is a distinct person from the beneficiaries,2 the trust, as such, is not a separate legal entity from the beneficiaries. Rather, the trust is the whole relationship that exists between the parties in relation to the trust property.3 Hence, where the trustee is a company, although the liability of the shareholders in the company may be limited, the liability of the trustee to third parties is unlimited. Moreover, in certain circumstances, the trustee has rights of indemnity against the trust property and against the beneficiaries. Sometimes third parties may be subrogated to these rights, which, in effect, means that they can indirectly claim against the trust property or the beneficiaries. A trust is not terminated when the trustee dies or retires but it is necessary to have a new trustee appointed. Trusts other than charitable trusts cannot be set up for indefinite periods but are subject to the ‘rule against perpetuities’. This means that the trust property must ‘vest’ in capital beneficiaries within a prescribed time period. [page 739] 12.5 While recognising that the legal differences, discussed in 12.2–12.4, between the different forms of business entities exist, the

question that needs to be asked is: ‘Should these differences affect the tax treatment of income derived through these entities?’ Even if the answer to that question is ‘yes’, then a second question needs to be asked: ‘To what extent?’ Income, from an economic viewpoint, is sometimes seen as accretions to wealth in a period (usually one year). To the extent that membership of a form of business organisation gives you command over any accretions to the wealth of that organisation, there is an arguable case that your own wealth has increased. Under the tax policy principles of horizontal equity and neutrality, it can be argued that members of different forms of business organisation should be taxed according to the command they have over any increases in the net wealth of that organisation. Some argue that, from an economic perspective, legal differences between forms of business organisation should not affect their tax treatment. A more sophisticated position, however, is that legal differences between forms of business organisation should only affect their tax treatment if they affect the command of their members over accretions to the net wealth of the organisation. For example, the fact that a company has perpetual succession, while a partnership does not, would not appear to amount to a significant difference between the command that members of each organisation have over its wealth. By contrast, clauses in a company’s constitution that limit the rights of certain classes of shareholder to dividends or other corporate distributions could significantly limit the command that those shareholders have over the company’s wealth. Practical, rather than strictly legal, considerations may also be relevant. For example, a small shareholder in a widely held listed company may, as a practical matter, have little or no command over the distribution policy of the company. 12.6 In this chapter and in Chapter 13 and Chapter 14, we shall show that, currently, there are significant differences in the way that various forms of business organisation are treated for Australian tax purposes. Sometimes these differences are present because of legal or practical considerations that affect the command that members of the organisation have over its wealth. In other cases, however, these differences reflect variations in legal form that appear which have little

or no bearing on the command that members of an organisation have over its wealth. In 1999, the Review of Business Taxation recommended that, in future, all companies and most trusts should be taxed under what is to be known as a ‘unified entity regime’.4 In 2000, the Howard Government circulated an exposure draft Bill which would have given effect to this recommendation. The government then received submissions from stakeholders and engaged in a further process of consultation involving the Board of Taxation. A Bill simplifying the dividend imputation system was introduced and the changes made by this Bill took effect on 1 July 2002. The Board of Taxation’s report Taxation of Discretionary Trusts was released in December 2002. The board considered that there were no compelling arguments to align the tax treatment of discretionary trusts and companies more closely, and [page 740] that the flow-through treatment of tax preferred that income in discretionary trusts should be retained.5 12.7 The Income Tax Assessment Act 1997 (Cth) (ITAA97) currently refers to several types of entities (eg, companies, limited partnerships, corporate unit trusts and public trading trusts) as ‘corporate tax entities’. In this chapter and in Chapter 13, we shall take the tax treatment of a company and its shareholders as the paradigm case of how corporate tax entities and their members are taxed. Additional comment will be made in relation to limited partnerships and foreign hybrid business entities (such as US or UK limited partnerships) in Chapter 14, and in relation to corporate unit trusts and public trading trusts in Chapter 15.

Types of corporate tax systems 12.8

There are several different possible ways that the movement of

income through a company could be taxed. These include:6 The ‘classical’ system: In this system, the company is subject to company tax on its taxable income. When the after-tax income of the company is distributed as a dividend, the shareholder is taxed at marginal rates on the dividend as a gain from property. No relief is given at the shareholder level for tax paid at the company level. A full integration system: In this system, no tax is paid at the company level but the net income of the company, whether actually distributed to shareholders or not, is included in the assessable income of shareholders on the basis of their proportionate shareholdings. A dividend exemption system: In this system, a company pays tax on its taxable income at the corporate rate. However, under this system, the whole or part of a dividend paid to a shareholder is exempt from tax in the shareholder’s hands. A dividend deduction system: In this system, a company pays tax on its taxable income but receives a deduction for dividends paid to shareholders. Dividends received by shareholders are taxed at their marginal rates. For a dividend deduction system to achieve full integration of the corporate and personal income taxes, it is necessary for corporate tax losses arising from the deductibility of dividends to be able to be carried both forward and back indefinitely. [page 741] A shareholder relief system: In this system, a credit is provided for the shareholder by ‘grossing up’ the dividend by the tax assumed to have been paid at the company level, calculating tax at the shareholder’s marginal rate, and giving the shareholder credit for the amount of the gross-up. The distinctive feature of this system is that gross-up and credit occur at the shareholder level whether or not corporate tax has been paid on the funds distributed by the

company. A dividend imputation system: In this system, the company pays tax on its taxable income. When the after-tax income of the company is distributed to a shareholder as a dividend, tax at the shareholder level is calculated in a way which means that the portion of the pre-tax income of the company that the shareholder is regarded as receiving is taxed at the shareholder’s marginal rate.7 This is done by ‘grossing up’ the dividend received by the shareholder by the tax paid at the company level, calculating tax at the shareholder’s marginal rate on the grossed-up amount of the dividend, and giving the shareholder credit for tax paid at the company level. A simplified version of a dividend imputation system is shown in Figure 12.1 and Example 12.1.

Figure 12.1:

Dividend imputation system

[page 742]

Assume that Divi Ltd resides in the state of Euphoria, which has a dividend imputation system. The company tax rate in the country is 30%. Divi Ltd has a taxable income of $100,000 and a pre-tax distributable profit of $100,000. It pays all of its after-tax income to Holder, its sole shareholder, who is a natural person resident in Euphoria. Holder’s marginal tax rate is 45%. The tax effects for Divi Ltd and Holder will be as follows: Divi Ltd Income

$100,000

Company tax @ 30%

$30,000

After-tax income

$70,000

Dividend paid

$70,000

Holder Dividend

$70,000

(included in Holder’s assessable income)

Gross-up for corporate tax

$30,000

(included in Holder’s assessable income)

Grossed-up dividend

$100,000

Tax on dividend @ 45%*

$45,000

Credit for company tax paid

$30,000

Net tax payable

$15,000

After-tax dividend

$55,000

*In reality, in many imputation systems, including the Australian system, dividends would be pooled with the taxpayer’s income and would effectively be taxed at the taxpayer’s average tax rate plus Medicare and other applicable levies. However, using marginal rates of tax is appropriate in the circumstances where a taxpayer wants to assess the additional tax that will be payable where the taxpayer derives additional dividend income.

Advantages of dividend imputation systems 12.9 When compared with most other systems of corporate tax integration, dividend imputation systems have several attractions for governments. First, they can ensure that income which flows through a company to a shareholder is taxed only at the shareholder’s marginal rate (if the perspective is taken that the dividend income is additional to and derived after the shareholder’s other income; when total income is

pooled, the dividend bears tax at the shareholder’s average rate). Second, they are not biased towards either domestic debt or equity financing. For the last 30 years, however, an important reason for their popularity has been [page 743] that, as compared with dividend deduction and full integration systems, dividend imputation systems facilitate a greater level of source taxation on income that passes through a company to a non-resident investor. This is because dividend imputation countries typically, in the absence of a double tax treaty (DTA), deny a non-resident shareholder the benefit of credits for corporate tax paid. Because the credit is denied to the shareholder, this practice is not usually regarded as infringing the non-discrimination article in the OECD Model Tax Convention: see 18.82. This means that, when a dividend paid to a non-resident shareholder is wholly funded from fully taxed corporate income, it will, at least, have borne source-country tax at the corporate rate. In some dividend imputation countries, withholding tax is payable on top of corporate tax when a dividend is paid to a non-resident. Currently in Australia, as will be explained in more detail in Chapter 13, no withholding tax is payable where a dividend paid to a non-resident shareholder is wholly funded from fully taxed corporate profits. A further advantage of dividend imputation systems for governments is that, typically, in imputation systems, shareholders are given credit for domestic tax paid but not for foreign tax paid. In some circumstances, this may mean that domestic companies are encouraged to invest in the domestic economy rather than offshore. Australia currently uses a form of dividend imputation system. The Australian dividend imputation system is discussed in detail in 12.34–12.75.

Disadvantages of dividend imputation systems 12.10

The main problem with dividend imputation systems is their

relative complexity when compared with other systems of corporate tax integration. The root cause of most of the complexities in dividend imputation systems is arguably differences that exist between the taxable income of a company and its distributable profits. If a company’s taxable income and distributable profits were always the same, then dividend imputation systems would need to be no more complex than the system shown in Example 12.1. If this were the case, then it could always be assumed that a dividend paid by a company had been sourced in fully taxed profits. The dividend would, therefore, represent income minus tax paid: Y – Yc, where Y represents taxable income and c represents the company tax rate. The tax that had been paid at the company level on the profits in which the dividend was sourced could be calculated by multiplying the dividend (Y – Yc) by [c/(1 – c)]:

The calculation of tax paid could then be added to the dividend in grossing it up and would be the amount of the credit given for tax paid at the company level. Two further problems with dividend imputation systems have led to a decline in their international popularity in recent years. The first is that, as noted above, it is unusual for them unilaterally to give imputation credits to non-resident shareholders. The second is that, as noted in 12.9, typically they do not allow payments of foreign tax to generate imputation credits for resident companies. This creates a bias against [page 744] investment by residents in resident companies with taxed foreign income. Although, in 12.9, we noted that this feature of dividend imputation systems can sometimes be seen by governments as one of their advantages, in the context of the globalisation of the world

economy and the development of trading blocs, it can be seen as a disadvantage of dividend imputation systems. In Europe, these features of imputation systems have led several countries to abandon them on the basis that they may infringe the obligations of member states under the European Union treaty.8 Australia’s Future Tax System: Report to the Treasurer (the Henry Review) recognised that the increasing globalisation of the Australian economy raised questions about the appropriateness of the current Australian company income tax and imputation systems.9 The Henry Review considered that, while the existing company income tax and the dividend imputation system should be maintained for the short to medium term, in the longer term business level expenditure taxes (such as an allowance for corporate equity or an allowance for corporate capital) could suit Australia and were worth further consideration and debate.10

The problem of ‘superintegration’ 12.11 As we have pointed out at a number of places throughout this book, there are many reasons why a company’s taxable income and its distributable profit, for company law or financial accounting purposes, may differ. Where a company’s distributable profit is greater than its taxable income, then it is possible that all or part of a dividend that it distributes will not have been sourced in taxed profits. If a dividend paid by a company in these circumstances is simply grossed up by multiplying it by c/(1 – c), then a country will be giving the shareholder credit for more corporate tax than has actually been paid at the company level. In the literature, this phenomenon is sometimes called ‘superintegration’. At its worst, superintegration could mean that a country is refunding tax at the shareholder level when in fact no corporate tax was paid on the profits from which the dividend was funded. This is shown in Example 12.2. [page 745]

Assume the facts in Example 12.1, with the variation that Divi Ltd’s taxable income is zero while its distributable profits are $10,000. Assume that Holder is on a 10% marginal tax rate and that excess imputation credits are fully refunded to shareholders. Assume that all dividends were grossed-up using the c/(1 – c) formula. Divi Ltd Taxable income

$0

Distributable profit

$10,000.00

Corporate tax paid

$0

Dividend

$10,000.00

Holder Dividend

$10,000.00

Gross-up

$4,285.71

Grossed-up dividend

$14,285.71

Tax @ 10%

$1,428.57

Credit for company tax

$4,285.71

Refund of excess credit

$2,857.14

The ‘compensatory tax’ solution to superintegration 12.12 Example 12.2 is by no means totally fanciful. Under the Canadian corporate tax system, shareholders receive credit for corporate tax whether or not that amount of tax has been paid at the company level. Note, however, that excess imputation credits are not refunded in Canada and the credit provided is equal to only two-thirds of the gross-up.11 To prevent superintegration from occurring, a government has to ensure that an imputation gross-up and credit is available only on the part of distributed profits that has been taxed at the company level. There are two ways in which countries can ensure that this happens, and the record-keeping requirements associated with both are a major source of complexity for dividend imputation systems.

[page 746] One way is to ensure that all distributions of corporate income have borne tax at the corporate level. Systems of this type are known as ‘compensatory tax’ (CT) or ‘equalisation tax’ (ET) systems. The operation of a type of CT system is shown in Example 12.3. Systems of this type have been widely used in Europe and also been used in countries like Malaysia and Singapore. As noted above, however, many European countries are now abandoning these systems, as have Singapore and Malaysia.

Assume the facts in Example 12.1 with the following variations: 1. Euphoria uses a compensatory tax dividend imputation system. 2. Divi’s taxable income is $100,000 but its pre-tax distributable profit is $200,000 (which includes the taxable income of $100,000). 3. Divi distributes all of its after-tax profit to Holder. It is assumed that the compensatory tax takes the form of a deferred company tax on previously untaxed profits. Divi Ltd Taxable income (TI)

$100,000

Distributable profit

$200,000

Company tax @ 30% Dividend Deferred company tax on untaxed distributed profits After-tax dividend

(including $100,000 TI)

$30,000 $170,000 $30,000

(ie, $100,000 × 0.30)

$140,000

Holder Dividend

$140,000

Gross-up

$60,000

Grossed-up dividend

($140,000 x 30/70 = 60,000)

$200,000

Tax @ 45%

$90,000

Credit for company tax

$60,000

($30,000 + 30,000 deferred

company tax) Net shareholder tax After-tax dividend

$30,000 $110,000

Compensatory or equalisation tax systems used throughout the world differ considerably in their detailed operation. All compensatory tax systems require some mechanism for reconciling the compensatory or equalisation tax paid on corporate [page 747] distributions with the mainstream tax that the company pays on its income.12 This is because the basic idea of the system is to ensure that all, but nothing more than, the distributed profits of the company are subject to tax at the corporate rate.

The ‘variable credit’ solution to superintegration 12.13 The other method that can be used to prevent superintegration occurring is the one that was chosen by Australia and New Zealand. Under this approach, imputation gross-ups and credits are limited to the amount stated to be the ‘franking credit’ on a distribution statement issued to the shareholder at the time the dividend is paid. This approach is referred to in the literature as either a ‘variable credit’ system or a ‘shareholder credit account’ (SCA) system. Rules within the Australian and New Zealand systems produce the effect that the franking credits allocated to a distribution reflect corporate tax that has been attributed to the distribution representing either corporate tax that has already been paid or an attribution of corporate tax that will be funded by a compensatory tax that will be payable in the future. The operation of this type of dividend imputation system is shown in Example 12.4.

Assume the facts in Example 12.1 with the following variations: 1. Euphoria uses a shareholder credit account or variable credit dividend imputation system. 2. Divi’s taxable income is $100,000 but its pre-tax distributable profit is $200,000 (which includes the $100,000 taxable income). 3. Divi distributes all of its after-tax profit to Holder. Divi Ltd Taxable income

$100,000

Distributable profit

$200,000

Company tax @ 30%

$30,000

Franking credits

$30,000

After-tax income

$70,000

After-tax profits

$170,000

Dividend

$170,000

Holder Dividend Franking credit attached

$170,000 $30,000 [page 748]

Gross-up Grossed-up dividend

$30,000 $200,000

Tax @ 45%

$90,000

Credit for company tax

$30,000

Net shareholder tax

$60,000

After-tax dividend

$110,000

12.14 An SCA, or variable credit system, needs some mechanism determine how much corporate tax paid is available to be attributed a dividend and how much future compensatory tax will be required fund any additional corporate tax attributed to the dividend.

to to to In

Australia and New Zealand, the ‘franking account’ performs this function.13 Currently, in both Australia and New Zealand, the franking account tracks corporate tax paid either by the company paying the dividend or by other resident companies in a chain of companies paying dividends. Details of the basic rules relevant to the conduct of franking accounts are discussed in 12.37–12.50.

The company as a tax entity 12.15 Notice that under most of the corporate tax systems discussed in 12.8, a company is regarded as a taxpayer. If corporate income is not attributed directly to shareholders then imposing tax on companies virtually becomes a necessity. If company tax were not imposed, and corporate income not attributed to shareholders, then the separate legal entity doctrine would mean that controlling shareholders could postpone the payment of tax on corporate income indefinitely simply by never distributing corporate profits. 12.16 Under the ITAA97 and Income Tax Assessment Act 1936 (Cth) (ITAA36), the separate legal entity status of a company is generally respected. The definition of ‘person’ in ITAA97 s 995-1 includes a company. A ‘company’ is defined in s 995-1 as meaning a body corporate or any other unincorporated association or body of persons but not including a partnership or a non-entity joint venture.14 The definition of ‘entity’ in s 960-100 includes a body corporate and an unincorporated association or body of persons. Hence, all the provisions in the ITAA97 that affect a ‘person’ or an ‘entity’ apply to companies. Moreover, under s 4-5, the expression ‘you’ applies to entities generally. Consequently, the combined operation of s 4-5 and the definition of ‘entity’ in s 960-100 is that every reference to ‘you’ in the ITAA97 applies to companies unless the reference expressly states that it does not apply to companies. 12.17 A company is required to lodge a return disclosing its taxable income for each income year. ITAA97 s 4-1 tells us, among other things, that income tax is

[page 749] payable by each company. As is the case with other entities subject to income tax, tax is levied on the taxable income of the company under ITAA97 s 4-10. Under s 4-10, for a company, the income year is the previous financial year not the current financial year. A full selfassessment system operates in relation to companies. Under this system, the company’s return is deemed to be a notice of assessment which is deemed by ITAA36 s 166A to have been served on the company. Companies pay tax under an instalment system, details of which are discussed at 12.20 and in Chapter 16.

Some distinctive features of the tax treatment of companies 12.18 From the discussion in 12.15–12.17, you may appreciate that, in many respects, a company, as a legal person, is treated just like a natural person for tax purposes. The fundamental obligations to lodge a return and to pay tax on your taxable income are common to both natural and legal persons. This feature makes the basics of the tax treatment of companies easy to understand. Despite these similarities, however, there are several rules that apply to corporate tax entities that do not apply to other taxpayers. At 12.25, we shall examine the classification under the debt and equity rules of interests issued by companies. Classifying an interest as debt or equity will affect the tax treatment for the company of returns (such as dividends or interest) paid by the company on the interest. Other rules, which do not apply to natural person taxpayers, affect the way the taxable income of a company is computed. Other special features relate to the rate of tax paid by companies and the way that it is paid. Another major feature is that only a company, and corporate unit trusts and public trading trusts which are taxed as companies under ITAA36 Pt III Div 6C respectively, can be a head entity in a consolidated group. These features will now be briefly discussed. Other distinctive features that relate to distributions of corporate profits and other benefits will be discussed in 12.34–12.88.

Special rules relevant to the application of CGT to companies are discussed in 12.132–12.159. Provisions that look through the separate legal entity status of companies will be discussed at 12.89–12.111. The consolidation regime will be discussed at 12.112–12.131.

Flat rate of company tax 12.19 The most obvious of the distinctive features of the tax treatment of companies is that a flat rate of tax applies to the taxable income of resident companies. Since 1 July 2001, the general company tax rate has been 30%. For the 2015–16 year of income, the tax rate for companies with a turnover of less than $2m is 28.5%. For the 2016–17 year of income up to the 2023–24 year of income, the tax rate for companies with an aggregated turnover of less than $10m is 27.5%. For the 2024–25 year of income, the tax rate for all companies will be 27% reducing to 26% for the 2025–26 year of income and further reducing to 25% for the 2026–27 year of income and subsequent years.

Payment of tax by companies 12.20 Formerly, one of the distinctive features of the tax treatment of companies was that they paid tax under a distinct instalment system which was different from [page 750] that which applied to non-corporate business or investment income. However, from 1 July 2000 onwards, the same instalment system in relation to business and investment income, the Pay-As-You-Go (PAYG) instalment system, applies to both corporate and non-corporate taxpayers. Briefly, under the PAYG instalment system, a company will usually be required to pay, after the end of each quarter of the year of income (being the previous financial year in the case of companies), instalments of tax based on the income of that quarter. For a company whose tax year ends on 30 June Y2, the quarters of the year of income end on: 1st quarter — 30 September Y1; 2nd quarter — 31 December

Y1; 3rd quarter — 31 March Y2; and 4th quarter — 30 June Y2. For companies that are not deferred BAS taxpayers, instalments of tax in respect of the income for these quarters will be due as follows: 1st quarter — 21 October Y1; 2nd quarter — 21 January Y2; 3rd quarter — 21 April Y2; and 4th quarter — 21 July Y2. For deferred business activity statements (BAS) taxpayers, instalments are due on the 28th rather than the 21st day of these months except in the case of the January instalment which is deferred until 28 February. When the company lodges its tax return for the income year, it is deemed to be a notice of assessment of the company’s taxable income and of the tax payable on that income. The company is allowed a credit for the tax instalments paid throughout the year and, in general, must pay the excess of the tax payable over the instalments paid, within 21 days. Instalments will generally be based on an instalment rate notified by the Commissioner multiplied by the company’s instalment income for the quarter. Companies below certain income thresholds are also eligible to elect to pay instalments using the GDP-adjusted notional tax method. It is important to note that, under the former method, PAYG instalments are payable only in respect of a company’s ordinary income for the year of income and not in respect of its statutory income (such as net capital gains). This means that the company’s taxable income for the year, as disclosed in its tax return, may be higher than its instalment income for the year. This is one reason why the tax payable by the company on assessment may be more than the total of the company’s PAYG instalments for the year. On the other hand, deductions are not allowed in calculating a company’s PAYG instalment income. This can mean that the total of a company’s PAYG instalments for an income year can exceed its tax payable on assessment. When instalments are based on GDP-adjusted notional income, they will not necessarily bear any relationship to the actual income of the company for the quarter. Hence, instalments paid under this method may be more or less than the actual tax payable on the company’s income for the year. The PAYG instalment system is also discussed in Chapter 16.

Consolidation regime

12.21 As from 1 July 2002, wholly owned groups of entities can elect to be consolidated for income tax (but not FBT or GST) purposes. Although partnerships and trusts can be subsidiary entities in a consolidated group, only a company (or a public trading trust which is taxed like a company under ITAA36 Pt III 6C) can be the head entity of a consolidated group. Where the election to consolidate is made, the group is treated as a single entity (the head entity) for income tax purposes. The consolidation rules are discussed in detail in this chapter at 12.112–12.131. [page 751]

Examining underlying beneficial ownership 12.22 Another distinctive feature of the tax treatment of companies that we shall mention is the tendency of the ITAA97, in some circumstances, to look through the separate legal entity status of the company and examine the underlying share ownership in the company. We will see in 12.90–12.105 that the ability of a company to carry losses forward or to deduct current year losses can, in part, depend on whether it passes what is known as the ‘continuity of ownership’ test. In 12.117–12.122, we shall see that similar rules also apply when losses are being transferred to a consolidated group, and a variation on these rules affects the extent to which the head entity in a consolidated group can use transferred losses. As is discussed in 12.107–12.111, the ability of a company to obtain a bad debt deduction also depends, in part, on the company satisfying the ‘continuity of ownership’ test. 12.23 For CGT purposes, as we will see in 12.144–12.146, similar restrictions apply to the carry forward of capital losses and the offsetting of current year capital losses. CGT event J1, discussed in 12.138, takes place when a subsidiary company ceases to be a member of a wholly owned group of companies following a roll-over. When the majority underlying beneficial ownership of a company changes, ITAA97 Div 149 (discussed in detail in 12.140–12.143) will mean that

the company is, in effect, deemed to have acquired its pre-CGT assets for their market value at the time of the change of ownership.

Definition of ‘resident’ 12.24 The final difference difference between the basic tax treatment of natural persons and companies that we shall note at this point is the applicable definition of resident. The definition of ‘resident’ applicable to natural persons is discussed in 2.37–2.39. The definition of ‘resident’ applicable to companies is discussed in 2.40.

Classification of interests in companies under the debt and equity rules 12.25 As from 1 July 2001, the debt and equity rules distinguish for tax purposes between ‘debt’ and ‘equity’ interests in a company. In determining whether a scheme, or the combined operation of a number of schemes, gives rise to a debt interest or to an equity interest, regard is had to the economic substance of the scheme or schemes rather than to the legal form of the scheme or schemes. It is important to determine whether an interest is classified as a debt interest or as an equity interest for tax purposes. This is because returns (such as interest or dividends) on debt interests are not frankable (this is the combined effect of: the definition of ‘frankable distribution’ in ITAA97 s 202-40; s 202-45(d); and the definition of ‘distribution’ in ITAA97 s 960-120) but may be deductible: see s 25-85. By contrast, returns on equity interests are frankable (s 202-40 and the definition of ‘distribution’ in s 960-120) but are not deductible (see ITAA97 s 26-26). The distinction is also relevant for the operation of the thin capitalisation rules discussed in Chapter 18. When a distribution is ‘frankable’ then, subject to conditions, the company can attach franking credits to the distribution. In broad terms, franking credits reflect [page 752]

tax paid by the company (or by earlier companies in a chain of companies) on income which is then distributed to shareholders. Resident shareholders include the franking credit in their assessable income, have tax calculated on the dividend and the franking credit but then receive a tax offset equal to the amount of the franking credit. This treatment is all part of Australia’s dividend imputation system. The basic operation of the dividend imputation system as it affects companies paying dividends is discussed at 12.34–12.62. The basic operation of the dividend imputation system as it affects shareholders is discussed at 13.33–13.55. Under ITAA97 s 974-5(4), if an interest could otherwise be characterised as both a debt interest and an equity interest, it will be treated as a debt interest only. A share that is classified as a debt interest will be a non-equity share. Note that s 202-45 states that a distribution in respect of a non-equity share is not frankable. Under ITAA97 s 974100, the conversion of a debt interest into an equity interest gives rise to a new equity interest and is not seen as the continuation of the debt interest. Conversely, the conversion of an equity interest into a debt interest gives rise to a new debt interest and is not seen as the continuation of the equity interest. The main test for whether something is a debt interest, as a matter of economic substance, is the non-contingent nature of the returns on the interest. More technically, under ITAA97 s 974-15, a scheme gives rise to a debt interest if it, either by itself or in certain circumstances set out in s 974-15(2), satisfies the debt test set out in s 974-20(1). The essence of the debt test in ITAA97 s 974-20(1) is that an entity (or an entity connected with it) will receive a financial benefit or benefits under the scheme and the entity (or an entity connected with it) has an effectively non-contingent obligation to provide financial benefits under the scheme. It must be substantially more likely than not that the value of the financial benefits provided will at least equal the value of the financial benefits that the entity receives under the scheme. The value of neither the financial benefits provided nor received can be nil. As a general rule, the financial benefits received and provided under a scheme are valued on a nominal basis where the benefits are provided

for 10 years or less. Financial benefits are valued in present-value terms where they are provided for more than 10 years. An effectively non-contingent obligation is in turn defined in ITAA97 s 974-135. Under that definition, an obligation is non-contingent if it is not contingent on any event, condition or situation (including the economic performance of the entity or a connected entity) other than the willingness of the entity or a connected entity to meet the obligation. A specific provision, s 974-135(4), in effect, states that the certain or possible convertibility of an interest does not of itself make the issuer’s obligation contingent.15 A further provision, s 974-135(5), expressly states that an obligation to redeem a preference share is not contingent merely because there is a legislative requirement that the redemption be met out of profits or from a fresh issue of equity interests. These specific provisions mean that it will be possible to classify convertible notes and redeemable preference shares as debt interests. Whether redemption is [page 753] at the option of the issuer or at the option of the holder is likely to be a relevant factor in determining whether or not obligations under redeemable preference shares are effectively contingent. In the former case, the obligations are more likely to be effectively contingent. Examples given in the Explanatory Memorandum to the New Business Tax System (Debt and Equity) Bill 2001 (Cth) indicate that, while, generally, converting preference shares will not be regarded as debt, they may be so regarded where the shares convert into shares in another company or where the company is effectively obliged to buy back the shares before they convert into ordinary shares. In determining whether an obligation is effectively non-contingent, regard is to be had to the artificiality or the contrived nature of any contingency on which the obligation depends. A contingent obligation will remain so even though you will suffer detrimental practical or commercial consequences if the obligation is not fulfilled. Under ITAA97 s 974-85, a return will be contingent on the economic

performance of the entity (or a part of its activities) if the return is contingent on the economic performance of that entity (or that part of those activities), but not solely because of one of the following: the ability or willingness of the entity to meet its obligations to satisfy the right to the return; or the receipts or turnover of the entity, or the turnover generated by those activities. The Regulations may specify circumstances in which a return is or is not contingent on aspects of the economic performance of an entity. The Regulations may also specify that certain interests that would otherwise be equity interests under the equity tests will not be equity interests in certain circumstances. For something to amount to an equity interest, it must satisfy the equity test (set out in ITAA97 s 974-75(1)); it must not be characterised as a debt interest and not form part of a larger interest that is characterised as a debt interest in the company or a connected entity. The equity test is set out in s 974-75, which states that the interests set out in Table 12.1 will be equity interests. Table 12.1: Item

Equity interests Interest

1

An interest in the company as a member or stockholder of the company.

2

An interest that carries a right to a variable or fixed return from the company if either the right itself, or the amount of the return, is in substance or effect contingent on aspects of the economic performance (whether past, current or future) of: (a) the company; or (b) a part of the company’s activities; or (c) a connected entity of the company or a part of the activities of a connected entity of the company. The return may be of an amount invested in the interest.

[page 754] Table 12.1:

Equity interests (cont’d)

Item

Interest

3

An interest that carries a right to a variable or fixed return from the company if either the right itself, or the amount of the return, is at the discretion of: (a) the company; or (b) a connected entity of the company. The return may be a return of an amount invested in the interest.

4

An interest issued by the company that: (a) gives its holder (or a connected entity of the holder) a right to be issued with an equity interest in the company or a connected entity of the company; or (b) is an interest that will, or may, convert into an equity interest in the company or a connected entity of the company.

Notwithstanding the above table, ITAA97 s 974-75(2) says that interests, other than stockholder and other membership interests (eg, in a company limited by guarantee) in a company, will only amount to equity interests if they are produced by a scheme that is a financing arrangement for the company. A financing arrangement is defined in s 974-130 as an arrangement that is entered into to raise finance for the company, or to fund another financing arrangement, or to fund a return under another financing arrangement. Issues of bills of exchange, income securities and convertible interests that will convert into equity interests are given as examples of schemes that are generally entered into or undertaken to raise finance. On the other hand, derivatives used solely for managing financial risk, and contracts for personal services entered into in the ordinary course of business are given as examples of schemes that are generally not entered into to raise finance. Certain schemes are taken not to be entered into to raise finance. These include certain leases or bailments, securities lending arrangements under ITAA36 s 26BC, life insurance and general insurance contracts undertaken in the insurer’s ordinary course of business, and certain schemes for the payment of royalties. Equity interests in a company that are not shares will be classified as non-share equity. So, too, will equity interests that are not solely shares: the example given in the Explanatory Memorandum to the New Business Tax System (Debt and Equity) Bill 2001 (Cth) is of a preference share stapled to a note. A distribution that a company makes to a holder of a non-share

equity interest in the company in his or her capacity as a holder of that interest is a ‘non-share distribution’. By virtue of ITAA97 s 974-115, a distribution of money or other property or a crediting of an amount to the holder will be a distribution for these purposes. Under s 974-120, all non-share distributions will be ‘non-share dividends’ except to the extent that they are debited against the company’s ‘non-share capital account’ or its share capital account. A non-share distribution that is not a non-share dividend will be a ‘non-share capital return’. A company’s non-share capital account is a record of contributions made to the company in respect of non-share equity interests and returns of those contributions: s 164-5(1). [page 755] The provisions relating to tainting and untainting the share capital account, discussed at 12.76–12.83, do not apply to a company’s nonshare capital account, but special rules in ITAA97 Div 215 will mean that non-share distributions will only be frankable to the extent that the company has available profits at the time of the distribution. The ITAA36 definition of ‘share capital account’ is discussed at 13.14–13.15. Note that a ‘tainted share capital account’ will not be a share capital account for these purposes. A note to ITAA97 s 164-15 explains that, where a company issues non-share equity that consists partly of a share and partly of non-share equity (eg, a stapled security), the component of the issue price that relates to the share will be a credit in the company’s share capital account while the component of the issue price that relates to the note will be a credit in the company’s non-share capital account.

What is a company for tax purposes? 12.26 It is important to realise that, for the purposes of both the ITAA97 and ITAA36, the definition of a company is broader than the

general law notion of what a company is. Generally, if we are asked what a company is for general law purposes most of us would think of companies incorporated under the Corporations Act 2001 (Cth). If pressed, some of us might think of bodies that are incorporated under other state laws, such as the incorporated associations legislation or, perhaps, state cooperatives legislation. We might also think of foreign companies that are registered with the Australian Securities and Investments Commission. Even when we stretch the general law notion of a company this far, it is still not as broad as the definition of a company in the ITAA97 and ITAA36. The definition of ‘company’ in the ITAA9716 is contained in s 995-1(1), the relevant portion of which is stated below. company means: (a) a body corporate; or (b) any other unincorporated association or body of persons; but does not include a partnership or a non-entity joint venture. Note 1: Division 830 treats foreign hybrid companies as partnerships. Note 2: A reference to a company includes a reference to a corporate limited partnership: see section 94J of the Income Tax Assessment Act 1936.

The following questions highlight the breadth of the ITAA97 definition of ‘company’. Suggested responses to these questions are located in Study help. [page 756]

1. 2.

What incorporated bodies would be regarded as companies under the ITAA97 s 9951 definition even though they are not incorporated under the Corporations Act? What bodies that are not, for general law purposes, regarded as separate legal entities from their members would be regarded as companies under the ITAA97 s

3.

995-1 definition of a company? In Malaysia, and several other countries, a company is defined for tax purposes as meaning a body corporate including any body of persons established as a separate legal entity by or under the laws of a territory outside Malaysia. Would a body corporate incorporated under the law of a foreign state be a company under the ITAA97 definition? Would a foreign unincorporated association be a company under the ITAA97 definition?

12.27 Note that the ITAA97 definition of ‘company’ specifically excludes a partnership. The ITAA97 definition of ‘partnership’ in s 9951 states: partnership means: (a) an association of persons (other than a company or a limited partnership) carrying on business as partners or in receipt of ordinary income or statutory income jointly; or (b) a limited partnership. Note 1: Division 830 treats foreign hybrid companies as partnerships. Note 2: A reference to a partnership does not include a reference to a corporate limited partnership: see section 94K of the Income Tax Assessment Act 1936.

There is a catch-22 in the relationship between the two definitions. You are only a company if you are not a partnership, but you are only a partnership if you are not a company. The practice is first to work out if a body of persons is a partnership under the ITAA97 definition and to apply the definition of ‘company’ only if it is not a partnership. The ITAA97 definition of ‘partnership’ is discussed in Chapter 14. A ‘non-entity joint venture’ is defined in ITAA97 s 995-1(1) as meaning an arrangement, which the Commissioner is satisfied is contractual, under which two or more parties undertake economic activity which is subject to their joint control, and that is entered into to obtain individual benefits for the parties in the form of [page 757]

a share of the output of the arrangement, rather than to obtain joint or collective profits for all of the parties.

The distinction between private and public companies 12.28 For tax purposes, an important distinction is drawn between ‘public’ and ‘private’ companies. The distinction is different from the distinction between ‘public’ and ‘proprietary’ companies that is made for Corporations Act 2001 (Cth) (Corporations Act) purposes. As a rule of thumb, we can say that the distinction between public and private companies for tax purposes more closely corresponds with the distinction between ‘listed’ and ‘unlisted’ companies for Corporations Act purposes.

The definitions of public and private companies 12.29 The full definitions of public and private companies for tax purposes are extremely lengthy and complex: see ITAA36 s 103A. The following is a summary of the key elements of the ITAA36 s 103A definitions: The characterisation of a company as private or public is made in relation to each year of income. If a company is not a public company in relation to a year of income, then it is a private company: s 103A(1). A company is a public company if its shares without fixed dividend entitlements were listed on an Australian or foreign stock exchange on the last day of the year of income: s 103A(2)(a). A company that, at all times during the year of income, is a cooperative company as defined in ITAA36 s 117 is a public company: s 103A(2)(b). Non-profit companies that are prohibited from making distributions to their members are public companies: s 103A(2)(c).

Mutual life assurance companies, friendly society dispensaries, bodies established for public purposes that are not companies under the Corporations Act, and a company in which a government or a body established for public purposes has a controlling interest, are, subject to certain conditions being met, public companies: s 103A(2)(d)(i)–(iv). A subsidiary of a public company is a public company: s 103A(2) (d)(v).

The 20 persons or fewer 75% test 12.30 Listed companies and co-operative companies might not be public companies if they fail what is known as the 20 persons or fewer 75% test. Under this test, as set out in ITAA36 s 103A(3), if, at any time during the year of income, 20 or fewer persons held or were entitled to: shares representing 75% or more of the paid-up capital of the company; 75% of the voting power of the company; or 75% of the total amount of all dividends paid by the company in the year of income; [page 758] then, subject to the exercise of the Commissioner’s discretion discussed in 12.31, the company will not be a public company. company also fails the test if it has not paid a dividend in the year income but the Commissioner forms the opinion that, if it had, 20 fewer persons would have been entitled to 75% of that dividend.

as A of or

Commissioner’s discretion 12.31 The tests in ITAA36 s 103A(2) and (3) are themselves subject to s 103A(5), which gives the Commissioner a discretion to treat a company, which otherwise fails the tests, as a public company in

relation to the year of income. In exercising this discretion, the Commissioner is to have regard to: the number of persons who were capable of controlling the company at any time during the year of income; whether any of those persons was a public company; the paid-up value of shares issued by the company before the end of the year of income; the number of persons who were beneficial owners of the company’s shares at the end of the year of income; and any other matter that the Commissioner thinks is relevant. To exercise this discretion, the Commissioner must, in the light of these factors, form the opinion that it is reasonable that the company be treated as a public company for tax purposes.

Subsidiaries of public companies 12.32 Note that, under ITAA36 s 103A(2)(d)(v), a subsidiary of a public company will itself be a public company. The definition of a subsidiary of a public company for these purposes is set out in s 103A(4)–(4E). A company that is a 100% subsidiary of a public company (other than a non-profit company prohibited from making distributions to its members) will be a public company. As a 100% subsidiary of a public company will be a public company, it follows that a 100% subsidiary of the first subsidiary will itself be a public company. Under s 103A(4B), a partly owned subsidiary of a listed company that passes the 20 persons or fewer 75% test17 (discussed at 12.30) will also be a public company where the listed company: (a) directly or indirectly controls the subsidiary’s voting power; and (b) has rights to receive, directly or indirectly, more than 50% of the dividends from the subsidiary and more than 50% of the capital distributions of the subsidiary company. Note that a 100% subsidiary (company C) of a company (company B) that, because of s 103A(4B), is a subsidiary of a public company (company A), and thereby

[page 759] is a public company, is not a subsidiary of a public company under s 103A(4): see s 103A(4)(a)(ii). In other words, in this situation, company B will be a public company but company C will not be a public company even though it is a 100% subsidiary of company B. Notwithstanding these tests, the Commissioner has power under s 103A(4D) and (4E) to treat a company that passes the tests as not being a subsidiary of a public company where the affairs of the subsidiary are managed and controlled in the interests of persons other than the relevant holding company or holding companies or, in the case of partly owned subsidiaries, without proper regard to the interests of the relevant holding company or holding companies. Conversely, under s 103A(5), the Commissioner may treat a company that does not pass the tests as being a subsidiary of a public company where, having regard to a number of factors set out in s 103A(5), it is reasonable to assume that the company should be treated as a subsidiary of a public company.

Would the following company be considered a public or a private company for taxation purposes? Beta Ltd is a company listed on the Australian Securities Exchange. All shares in Beta Ltd are ordinary shares. Twenty per cent of the shares in Beta Ltd are held by Beta in its own right. Twenty per cent of the shares in Beta Ltd are held by Beta as trustee of the Beta Family Discretionary Trust; 10% are held by Alpha Beta Pty Ltd, a closely held proprietary company whose shareholders are all members of the Beta family and are all beneficiaries in the Beta Family Discretionary Trust; and 50% of the shares are widely held and traded. An analysis of the share register reveals that there are 100 unrelated shareholders in the company, none of whom (together with relatives) controls more than 1% of the shares. A suggested solution can be found in Study help.

Significance of the distinction between public and private companies

12.33 The distinction between public and private companies for tax purposes is significant for several reasons. These include the following: The rules (discussed in 12.92–12.96) for determining whether the ‘continuity of ownership’ test is passed for the purposes of the loss carry forward and bad debt provisions vary according to whether the company is a public or private company. Some of the rules in the Simplified Imputation System (discussed in 12.34–12.75) vary according to whether the company is a public or a private company (eg, the benchmark franking rule does not apply to certain distributions by public companies). [page 760] Provisions (discussed in Chapter 13) that deem certain distributions (such as loans and salaries) from a company to be dividends apply only to private companies. The rules for determining whether Div 149 applies (discussed in 12.140–12.143) differ according to whether the company is a public or a private company for tax purposes. In addition, it should be noted that CGT event K6 (discussed in Chapter 13) does not apply in relation to shares in companies that have been listed on an Australian or foreign stock exchange at any time in the five-year period before the CGT event that triggered CGT event K6 took place.

The Australian dividend imputation system: The company’s perspective 12.34 In 12.13, we noted that Australia currently uses a dividend imputation system of corporate and shareholder taxation. We noted that the Australian dividend imputation system is what is known as a ‘variable credit’ or ‘shareholder credit account’ system. That is,

Australia limits the amount of a dividend that is grossed up, and to which a credit for corporate tax paid applies, to an amount representing corporate tax paid or payable on the distribution. It does this by requiring companies to maintain an account (called the ‘franking account’) that, in effect, tracks the tax paid or payable by the company on its retained taxable income or paid by other resident companies in a chain of companies paying dividends. As mentioned in 12.13, this approach is one possible response to the problem known in the literature as ‘superintegration’. Superintegration occurs when a shareholder receives credit for company tax paid that exceeds the company tax that has been paid. The root cause of superintegration is differences between a company’s taxable income and its distributable profit.

New Zealand companies may enter Australian imputation system 12.35 From 30 June 2003, a New Zealand (NZ) resident company can choose, under ITAA97 s 220-35, that the Australian dividend imputation system applies to it. If an NZ company makes this choice then, under ITAA97 s 220-25, the provisions of the Australian dividend imputation system (subject to some modifications) apply to it as if it were an Australian resident. The NZ company is treated, under ITAA97 s 220-100, as satisfying the relevant Australian residency requirements to enable it to maintain an Australian franking account and attach Australian franking credits to dividends that it pays to its Australian shareholders. The end effect of the election is that a NZ company which makes the election can attach Australian franking credits to a dividend in essentially the same way as an Australian company can. When the company receives dividends with Australian franking credits attached, that receipt generates Australian franking credits in the NZ company’s franking account. In attaching Australian franking credits to the dividends that it pays, the NZ company is governed by essentially the same rules as those that apply to Australian companies. The effect is that the NZ company is constrained from streaming its

[page 761] Australian franking credits to Australian resident shareholders. Rather, the effect of the rules is that Australian franking credits are allocated proportionately over all shareholders irrespective of the residence of the shareholder. Moreover, the election under ITAA97 s 220-35 does not make the NZ company an Australian company for all purposes. The election does not entitle the NZ company to a gross-up and credit in relation to the franking credit attached to the dividend it receives. Rather, in the case of a dividend franked to 100%, the combined operation of ITAA36 ss 128B(3) (ga) and 128D will mean that the dividend paid to the NZ company is neither subject to withholding tax nor subject to Australian tax on an assessment basis. Nor is the NZ company regarded as a resident company for Australian dividend withholding tax purposes. Hence, when it pays a dividend to an Australian resident shareholder, the dividend is not subject to Australian withholding tax.

Diagrammatic overview of the Australian system 12.36 Figure 12.2 represents a basic diagrammatic overview of the current Australian dividend imputation system. The steps in the diagram are examined in more detail below.

Figure 12.2:

Australian dividend imputation system

The franking account 12.37 Note, from Figure 12.2, that one obligation that the Australian dividend imputation system imposes on a company is to maintain a franking account. In 12.14, we stated that a franking account, in effect, tracks tax paid by the company on its taxable income, or tax paid by other resident companies in a chain of companies paying dividends, which has not yet been imputed to non-corporate shareholders. How a franking account does this can be seen by examining the major credit and debit entries in a franking account. Before looking at those entries in detail, it is important to note that the actual funds of a company are neither increased nor [page 762]

decreased by credit and debit entries in its franking account. What a franking account does, in effect, is tell us how much tax has been paid by the company or by other resident companies in a chain of companies on the retained earnings of a company. We shall see that, where franking deficit tax (FDT) is payable, the franking account is also tracking tax paid by the company on distributions of previously untaxed profits. It is also important to remember that the rules for operating a franking account are exhaustively set out in ITAA97 Pt 3-6. Rules used in financial accounting are not relevant to the operation of the franking account.

Some major franking credits Residency requirements for credits to arise 12.38 Under the Simplified Imputation System, certain franking credits arise only if the company ‘satisfies the residency requirement’ for a year of income specified in the case of each credit. The credits to which this requirement applies are: credits arising on a payment of a PAYG instalment; credits arising on a payment of income tax; and credits arising on receipt of a franked distribution. Under ITAA97 s 205-25(1)(a), a company18 satisfies the residency requirement for an income year in relation to which one of the events (set out in the tables in ss 205-15 and 205-30) giving rise to a franking debit or credit occurs if: (i)

the entity is an Australian resident for more than one half of the 12 months immediately preceding the event if the event occurs before the end of the income year; [or] (ii) the entity is an Australian resident at all times during the income year when the entity exists if the event occurs at or after the end of the income year; [or] (iii) the entity is an Australian resident for more than one half of the income year (whether or not the event occurs before the end of the income year); …

For example, if the relevant event (such as a payment of a franked dividend) occurs before 30 May 2017, then the paying company will

meet the residency requirement for the year ending 30 June 2017 if: (a) it is an Australian resident for more than one-half of the 12 months from 1 April 2016 to 30 May 2017; or (b) it is an Australian resident for more than one-half of the income year ending 30 June 2017. Where the relevant event (such as a payment of a franked dividend) occurs on 1 July 2017, then the paying company would satisfy the residency requirement for the income year ending 30 June 2017 if: (a) where the paying company came into existence on 2 February 2017, it were an Australian resident from 2 February 2017 [page 763] to 30 June 2018; or (b) if it were an Australian resident for more than one-half of the income year ending 30 June 2017.

Conversion of credits accrued under former system 12.39 In the former dividend imputation system that applied until 30 June 2002, franking accounts essentially tracked a company’s taxable income less tax paid. By contrast, the Simplified Imputation System works on a ‘tax paid’ basis and, essentially, tracks tax that the company or other companies that have made distributions to it have paid. Here, any credit balance that was in a company’s franking account at the commencement of the Simplified Imputation System on 1 July 2002 needs to be converted so that it represents tax paid. In the case of a company’s class C franking account under the former system, the balance is converted by multiplying it by 30/70 (ie, c/(1 – c), where c is the company tax rate).

Reconciliation at end of franking year 12.40 Franking credits in the simplified system do not die at the end of the franking year. Any credit balance at the end of an income year simply remains in the franking account as a credit. Where a corporate entity’s franking account is in deficit at the end of an income year then, under ITAA97 s 205-45(2), it is liable to pay

franking deficit tax imposed by the New Business Tax System (Franking Deficit Tax) Act 2002 (Cth). A liability to pay franking deficit tax gives rise to a credit in the corporate entity’s franking account under s 205-15 equal to the amount of the entity’s liability for franking deficit tax. The credit arises immediately after the liability for franking deficit tax is incurred. As the franking deficit tax is equal to the amount of the franking deficit, the credit that arises on the franking deficit tax liability eliminates the franking deficit. This means that, in effect, franking deficits can never be carried forward. Note that, under s 205-40(1), an entity’s franking account will be in surplus at a particular time if the sum of the franking credits in the account exceeds the sum of the franking debits in the account at that time. The corporate entity’s franking surplus is the amount of the excess. Conversely, an entity’s franking account is in deficit at a particular time if the sum of the franking debits in the account exceeds the sum of the franking credits in the account at that time. The corporate entity’s franking deficit is the amount of the excess.

Payment of company tax and PAYG instalments 12.41 As from 1 July 2002, when a company pays a PAYG instalment or pays income tax, a franking credit equal to the part of the payment that is attributable to the period when the company was a franking entity arises under ITAA97 s 205-15 (items 1 and 2 in the table). This important credit means that one of the major things that the franking account tracks is tax paid by the company. Hence, if a company with a 30 June year end pays an instalment of tax of $7500 on 21 October, the payment would generate a credit of $7500 in the company’s franking account. The way that this credit would appear in the company’s franking account is shown in Example 12.5. [page 764]

Date

Entry

1/7/X1

Opening balance

21/10/X1

Payment of company tax instalment

Dr

Cr

Balance Nil

$7500

$7500

12.42 Where several instalments are payable throughout a year, each payment generates a credit equal to the amount of the payment. This can be shown by varying the facts in Example 12.5. Assume that the company’s instalment income for each quarter of the year ending 30 June X2 is $25,000. Assume that the company’s instalment rate is 30%. This means that each instalment of tax payable will be $7500. The first instalment would be paid on 21 October X1, the second instalment would be payable on 21 January X2, the third on 21 April X2 and the fourth on 21 July X2. The way that the credits arising from these instalments would appear in the company’s franking accounts is shown in Example 12.6.

Date

Entry

Dr

Cr

Balance

21/10/X1

Payment of company tax instalment

$7,500

$7,500

21/1/X2

Payment of company tax instalment

$7,500

$15,000

21/4/X2

Payment of company tax instalment

$7,500

$22,500

30/6/X2

Closing balance

$22,500

1/7/X2

Opening balance

$22,500

21/7/X2

Payment of company tax

$7,500

$30,000

instalment

12.43 At 12.20, we noted that the total of a company’s PAYG instalments for a year might not be the same as the tax payable by the company on assessment. If the tax payable on the company’s taxable income is greater than the PAYG instalments that it has made, for example, because a net capital gain has accrued to the company in the income year, then, after allowing for the credits for the company tax paid through the income year, the company will be liable for company tax on the excess of its taxable income over its instalment income. When the company pays company [page 765] tax on this excess a franking credit equal to the amount of the payment arises under ITAA97 s 205-15 (item 2 in the table). For example, assume the company in Example 12.6 also made a net capital gain of $100,000 in the year ending 30 June X2. Assume that the company had deductions of $30,000 relevant to deriving its instalment income of $100,000. The company’s taxable income would therefore be: $100,000 ordinary income + $100,000 net capital gain − $30,000 deductions = $170,000 Assuming that the company was taxed at the 2017–18 small business corporate tax rate of 27.5%, tax assessed on this taxable income would be $46,750. The company would receive credit for the instalments paid in respect of the year ending 30 June X2, namely $27,500. This would leave $19,250 of tax payable by the company on 1 December X2. The payment of tax of $19,250 on 1 December X2 would give rise to a credit of $19,250 in the company’s franking account. This would mean that the credit balance in the company’s franking account after the payment of tax of $19,250 would be $46,750.

Note that the amount of the credit for a payment of a PAYG instalment or a payment of income tax may be reduced under s 20515(4) where the company has received a refund of income tax attributable to a tax offset that was subject to the refundable tax offset rules because of ITAA97 s 67-30 (dealing with Research and Development).

Receipt of a franked distribution 12.44 Another important franking credit arises when a resident company receives a franked distribution. Under s 205-15 (item 3 of the table), a franking credit arises when a franked distribution is made to a corporate entity that satisfies the residency requirement. The amount of the credit is equal to the franking credit on the distribution. Remember that the franking credit on the distribution will represent a portion of the tax paid by the paying corporate entity or by other tax-paying resident corporate entities further up the distribution chain. The credit arises on the day when the distribution is made. Details on the process of franking a distribution are discussed in 12.51–12.62. Hence, if a company received a dividend of $7000 with a franking credit of $3000 attached on, say, 1 April X2, the receipt of the franked dividend will generate a franking credit of $3000. The way that this credit would appear in the company’s franking account is shown in Example 12.7.

Assume the facts in Example 12.6 with the variation that a dividend of $7000 with a franking credit attached of $3000 is received on 1/4/X2. Date

Entry

Dr

Cr

Balance

21/1/X2

Payment of company tax instalment

$7,500

$15,000

1/4/X2

Receipt of franked distribution

$3,000

$18,000

[page 766]

Other franking credits19 12.45 A franking credit arises where a franked distribution flows indirectly to a company via a partnership or a trust. The amount of the credit is the company’s share of the franking credit on the distribution. The provisions relating to a flow of franking credits through partnerships and trusts are discussed in Chapter 14 and Chapter 15 respectively. A franking credit also arises when a company incurs a liability to pay franking deficit tax. The credit is equal to the amount of the franking deficit tax liability and arises immediately after the liability is incurred. See the discussion at 12.55 for examples of how franking deficit tax may arise and how it is calculated. A franking credit also arises under s 205-25 (item 8 in the table) when a resident entity that is a franking entity20 for the whole or part of the year of income pays diverted profits tax. The credit is the part of the payment referable to the period when the entity was a franking entity multiplied by the standard corporate rate (currently 30%) divided by 40%. In other words, currently the credit is equal to the amount of the payment multiplied by 30/40. The circumstances in which diverted profits tax may arise are discussed in Chapter 18.

Some major franking debits 12.46 Certain franking debits occur only if the company satisfies the residency requirement at the relevant time. Most relevantly, for present purposes, the debit under item 2 in the table in ITAA97 s 205-30 that arises on receipt of a refund of income tax arises only if the company satisfies the residency requirements for the income year in which the refund was made. Note also that, under s 202-5, a company must satisfy the residency requirement before it can frank a distribution. This, in turn, means that the company must satisfy the residency requirement before a franking debit arises under item 1 in the table in s 205-30 on

the payment of a franked distribution. The residency requirement was discussed in 12.38.

Debit arising when company tax is refunded 12.47 As we have seen in 12.20 and 12.43, the sum of the PAYG instalments paid throughout a year might differ from the tax that a company is ultimately liable to pay on its taxable income for the year. For example, one reason why these two amounts might differ is that, in general, deductions are not taken into account in calculating a company’s instalment income. This, in turn, can mean that part of the prior instalments of tax paid by the company will be refunded. When a refund of tax is made, it is necessary for a franking debit to arise if the franking account is to [page 767] reflect the tax paid by the company. These debits reverse the credits that arose when the tax instalments were paid. 12.48 A franking debit arises under ITAA97 s 205-30 (item 2 in the table) when a company receives a refund of income tax. The debit is equal to the part of the refund that is attributable to the period during which the entity was a franking entity. The debit arises on the day that the refund is received. The refund is necessary if the franking account is to keep track of the tax actually paid by the company.

Incorporate the facts from Example 12.6 and Example 12.7. Assume that, on 15/12/X2, a company tax instalment of $7500 is refunded. The relevant debit in the company’s franking account will be as follows: Date 15/12/X2

Entry Refund of company tax instalment

Dr $7,500

Cr

Balance $10,500

Debit when company franks a distribution 12.49 The most significant franking debit arises under ITAA97 s 205-30 (item 1 in the table) when a corporate entity franks a distribution. The debit is equal to the franking credit on the distribution. Under s 202-60, the ‘franking credit on a distribution’ is the credit stated in the relevant distribution statement unless that amount exceeds the maximum franking credit for the distribution. Section 202-65 provides that, where the amount stated exceeds the maximum franking credit for the distribution, the franking credit on the distribution is taken to be the amount of the maximum franking credit on the distribution. The method for determining the ‘maximum franking credit for a distribution’ is discussed at 12.53. Example 12.9 illustrates the debit that arises when a company franks a distribution to an amount not exceeding the maximum franking credit for the distribution.

Assume that the company in Example 12.7 paid a dividend of $50,000 franked with a franking credit on the distribution stated to be $15,000 on 16/12/X2. We will see at 12.53 that, in these circumstances, the maximum franking credit on the distribution will be $15,000 and that the dividend will be franked to 100%. The relevant entry in the company’s franking account would be as follows: [page 768] Date 16/12/X2

Entry Franking a distribution

Calculation Franking credit on the distribution $15,000

Dr $15,000

Cr

Balance $3,000

Other franking debits 12.50 The other franking debits that arise include: debits arising if the company franks a distribution in contravention of the benchmark franking rule (see the discussion at 12.60); debits arising when an entity receives a tax offset refund where the entity did not satisfy the residency requirement for the year to which the refund relates but was a franking entity during that period and had a franking account surplus on the day when the refund was made; debits arising where the company franking account is in surplus if it ceases to be a franking entity — the debit is equal to the amount of the surplus; debits arising under the anti-dividend streaming provisions dealing with linked distributions (see the discussion at 12.68); debits arising under the anti-dividend streaming provisions dealing with the substitution of tax-exempt bonus shares for franked distributions (see the discussion at 12.68); debits arising under the provisions dealing with the streaming of franking credits to advantaged shareholders (see the discussion at 12.69); debits arising when an amount to which Div 197 (tainting and untainting the share capital account) applies is transferred to the company’s share capital account — see the discussion at 12.76–12.83); debits arising when a company chooses to untaint its share capital account (see the discussion of the provisions relating to tainting and untainting the share capital account in 12.76–12.83); debits arising on a market buy-back by a company of a membership interest in the company. The debit is equal to the one that would have arisen if the buy-back had been off-market and had been franked to the company’s benchmark franking percentage. Where the company does not have a benchmark

franking percentage for the franking period, the franking debit arises as if the distribution that would have been taken to have arisen in an off-market buy-back had been franked to 100%. Proposed changes to the treatment of off-market buy-backs are discussed at 13.61; debits arising when an entity which satisfies the residency requirements and was a franking entity for the whole or part of the relevant income year receives a refund of diverted profits tax. Diverted profits tax is discussed in more detail in Chapter 18. [page 769]

Franking a distribution 12.51 A company franks a distribution if: it satisfies the residency requirement when the distribution is made (residency requirements were discussed at 12.38); the distribution is a frankable distribution; and the company allocates a franking credit to the distribution. ITAA97 s 202-35 states that the object of Subdiv 202-C is to ensure that only distributions equivalent to realised taxed profits can be franked. When a company makes a frankable distribution, it must give the recipient a distribution statement: ss 202-70 and 202-75(1). Among other things, the distribution statement must state that there is a franking credit of an amount specified on the distribution and must state the franking percentage of the distribution: s 202-80(3).

Frankable distributions 12.52 As noted at 12.51, only frankable distributions can be franked. Under ITAA97 s 202-40(1), a distribution will be a frankable distribution to the extent that it is not unfrankable under s 202-45. A non-share dividend will be a frankable distribution under s 202-40(2) to

the extent that it is not unfrankable under s 202-45. The meaning of ‘non-share dividend’ was discussed at 12.25. Note that a distribution in respect of non-share equity will only be a ‘non-share dividend’ to the extent that it is not debited against the company’s non-share capital account. It is important to distinguish between ‘non-share equity’ and ‘non-equity shares’. Non-share equity is an interest in a company that is not, as a matter of legal form, an equity interest but which is classified as an equity interest under the debt and equity rules discussed at 12.25. Hence, returns paid to holders of non-share equity will not be deductible to the paying company but, provided they are not debited against the company’s non-share capital account, they will be frankable. By contrast, a ‘non-equity share’ is an interest in a company which, as a matter of legal form, is a share but which is classified as debt under the debt and equity rules discussed at 12.25. As such, returns to holders will be deductible to the paying company but will not be frankable. Under ITAA97 s 960-120, in the case of a company, a dividend, or something that is taken to be a dividend, is a distribution. The distribution is made on the day when the dividend is paid or is taken to have been paid. Under the amendments to s 254T of the Corporations Act 2001 (Cth) (Corporations Act) by the Corporations Amendment (Corporate Reporting Reform) Act 2010 (Cth), companies may pay a dividend where: (a) consistent with accounting standards, immediately before the declaration of the dividend, the company’s assets exceed its liabilities by an amount sufficient for the payment of the dividend; (b) payment of the dividend is fair and reasonable to the company’s shareholders as a whole; and (c) the payment of the dividend will not materially prejudice the company’s ability to pay its creditors. Some commentators questioned whether a dividend paid in excess of the company’s distributable profits will be a ‘dividend’ as defined in ITAA36 s 6(1). As discussed at 13.5 and at 13.14–13.15, the definition of ‘dividend’ in ITAA36 s 6(1) excludes amounts debited against the company’s share capital account. [page 770]

Hence, in circumstances where a company pays a dividend that is greater than its distributable profits and debits that payment against its share capital account, it is argued by some commentators that the payment is not a dividend for purposes of ITAA36 s 6(1). It is argued that this, in turn, means that the payment is not a ‘distribution’ as defined in ITAA97 s 960-120 and, hence, is not frankable.21 The Australian Taxation Office (ATO) released Taxation Ruling TR 2012/5 on this and related issues on 27 June 2012. TR 2012/5 states, inter alia, that s 202-45(e) does not prevent a company franking a dividend; (a) paid out of profits merely because the company has unrecouped accumulated accounting losses or has lost part of its share capital; or (b) out of an unrealised capital profit of a permanent character and available for distribution provided the company’s net assets exceed its liabilities by at least the amount of the dividend, and the payment of the dividend does not breach relevant provisions in the Corporations Act. On the other hand, TR 2012/5 states that ITAA97 s 202-45(e) will mean that a distribution which is a reduction or return of capital to shareholders will not be frankable. TR 2012/5 considers that the better view is that, notwithstanding s 254T of the Corporations Act, dividends can only be paid from profits and not from amounts other than profits. Section 254T is regarded as prohibiting distributions that do not comply with it but not as authorising distributions. TR 2012/5 also states that if, contrary to the view expressed in it, a dividend can be paid out of an amount other than profits; then, provided that it complies with the Corporations Act, it will be a dividend for the purposes of ITAA36 s 6(1) and will not be prevented from being frankable by ITAA97 s 202-45(e). The following distributions are deemed by s 202-45 to be unfrankable: where the purchase price of an off-market buy-back is taken to be a dividend, so much of the purchase price as exceeds what would be the market value of the share at the time of the buy-back if the buy-back did not take place and was never proposed to take place (see the discussion of proposed changes to the treatment of offmarket buy-backs at 13.61);

a distribution in respect of non-equity shares (see the discussion of non-equity shares at 12.25); a distribution that is sourced directly or indirectly from the company’s share capital account (see the discussion in Chapter 13); an amount taken to be an unfrankable distribution under ITAA97 s 215-10 or s 215-15 (dealing with non-share dividends paid by authorised deposit-taking institutions and non-share dividends paid when the company does not have available profits); an amount that is taken to be a dividend for the purpose of any of the following provisions: — ITAA36 Pt III Div 7A (subject to exceptions, see the discussion of Div 7A in 13.21–13.30); — ITAA36 s 109 (see the discussion of s 109 in 13.18–13.20); — ITAA36 s 47A (dealing with distribution benefits by controlled foreign companies); [page 771] an amount that is taken to be an unfranked dividend for any purpose: — under ITAA36 s 45; or — because of a determination of the Commissioner under ITAA36 s 45C (see the discussion of ss 45–45C in 12.84–12.88); a demerger dividend (see the discussion of the demerger relief provisions in 13.159–13.163); a distribution which ITAA97 s 152-125 (certain payments to company’s or trust’s CGT concession stakeholders for purposes of the CGT small business concessions) or s 220-105 (certain distributions by New Zealand companies that have elected to enter the Australian imputation system) say is unfrankable.

Allocating a franking credit to a distribution 12.53 A company franks a distribution by allocating a franking credit to the distribution. Generally, a franking credit is allocated to a distribution by the company stating in its distribution statement what the franking credit is that is allocated to the distribution: see ITAA97 s 202-60(1). Where the amount of a franking credit stated in a distribution statement exceeds the ‘maximum franking credit for the distribution’ then s 202-65 deems the amount of the franking credit on the distribution to be the maximum franking credit for the distribution. The maximum franking credit for a distribution is determined using the following formula in s 202-60(2):

The ‘corporate tax gross-up rate’ is defined in ITAA97 s 995-1(1) as the amount determined using the following formula:

The ‘corporate tax rate for imputation purposes’ is defined in ITAA97 s 995-1(1) as the entity’s corporate tax rate for the income year calculated on the assumption that the entity’s aggregated turnover for that year was equal to its aggregated turnover for the previous year. Where the entity did not exist in the previous year the rate will be 27.5%, being the tax rate in respect of the taxable income of a company covered by s 23(2)(a) of the Income Tax Rates Act 1986 (Cth). Hence, for companies with an aggregated turnover of $10m or greater, the corporate tax gross-up rate will be 70/30 = 2.33. This means that the maximum credit for a distribution will be the amount of the frankable distribution × 1 ÷ 2.33. This will equal the amount of the frankable distribution × 0.4292. For companies with an aggregated turnover of less than $10m, the corporate tax gross-up rate will be 72.5/27.5 = 2.64. The maximum credit that can be attached to a distribution by

these companies will be the amount of the frankable distribution x 1 ÷ 2.64. This will equal the amount of the frankable distribution x 0.3788. [page 772] Where a dividend is paid from profits, the amount of the dividend will be a frankable distribution. This is so, even if the paying corporate entity’s distributed profits exceed its taxable income for the income year. Hence, the effect of the formula in s 202-60(2) is that the maximum franking credit for a distribution is the maximum amount of income tax that the company making the distribution could have paid, at the standard company tax rate, on the pre-tax distributed profits if they had been fully taxable. In situations where the company’s distributed profits have equalled its taxable income for the same period, the maximum franking credit for a distribution should for companies subject to the standard corporate tax rate of 30% equal the corporate tax that the company has paid on its taxable income. The calculation of the maximum franking credit on a distribution is illustrated by Example 12.10. In the example, it is assumed that the company is liable to a corporate tax rate of 30%.

Profits $1000 Income $1000 Corporate tax $300 Amount of frankable distribution $700 Distribution $700 Maximum franking credit on distribution $700 × 0.4292 = $300.44

Note that in this instance, as the company’s distributed profits equal its taxable income, the maximum franking credit on the distribution equals the tax paid by the company.

Where a company has a turnover of less than $10m and, hence, is subject to a corporate tax rate of 27.5% as from 1 July 2016, the maximum franking credit that it can allocate to a distribution would be determined as follows. If the 27.5% rate had applied to the company in Example 2.10, it would have paid corporate tax of $275 and had sufficient after-tax profits to pay a dividend of $725. The maximum franking credit that it would be able to attach to the dividend would be $725 × 0.3788 = $274.63. Where the company’s distributed profits have exceeded its taxable income, the maximum franking credit that can be attached to a dividend can exceed the corporate tax that the company has paid on its taxable income. In these circumstances, if the company distributes all its after-tax distributable profits and allocates the maximum franking credit to the distribution, then the franking credit allocated will exceed the credits balance of its franking account. The result will be a deficit balance in the company’s franking account. If no other franking credits arise in the company’s franking account between the date of the distribution and the end of the company’s franking year, then, as explained in 12.55, it will be liable for franking deficit tax. The liability for franking deficit tax will generate a franking credit equal to the amount of the liability thus restoring the balance of the franking account to zero. [page 773] In these circumstances, the franking deficit tax liability is, in effect, making the company pay the tax to justify the franking credits that it has already allocated to shareholders. The calculation of the maximum franking credit on a distribution in these circumstances is illustrated by Example 12.11. In the example, the company is assumed to be on a corporate tax rate of 30%.

Profit

$2000

Income

$1000

Corporate tax

$300

Amount of frankable distribution

$1700

Distribution

$1400

Maximum franking credit on distribution

$1400 × 0.4292 = $600.88

(Retained earnings $300)

12.54 Note that in Example 12.11, if the franking credit allocated to the distribution were to be $600, that would exceed the franking credits of $300 that the company generated by paying corporate tax. If no other debits or credits occurred in the company’s franking account between the date of the dividend and the end of the income year, then the franking account would have a deficit balance of $300. This would give rise to a liability for franking deficit tax of $300, which would, in turn, produce a credit in the company’s franking account of $300. In situations where a company’s pre-tax taxable income has been greater than its pre-tax distributed profit (eg, where the company has been denied deductions for client entertainment), the tax that it pays on its taxable income will generate franking credits in excess of the maximum franking credit that it can attach to a distribution of its aftertax distributable profit. In this situation, if the company tries to allocate those excess credits to the distribution, ITAA97 s 202-65 will mean that its actions are ineffective. The debit in the company’s franking account will equal the maximum franking credit that can be allocated to the distribution as will the franking credit that the shareholder receives. The excess credits will remain in the company’s franking account. The calculation of the maximum franking credit on a distribution in these circumstances is illustrated by Example 12.12. In the example, the company is assumed to be subject to a corporate tax rate of 30%.

Profit

$1000

Income

$2000

Corporate tax

$600

Amount of frankable distribution

$400 [page 774]

Distribution

$400

Maximum franking credit on distribution

$400 × 0.4292 = $171.68

Note that, in this instance, the company had franking credits of $600 but will only be able to frank the distribution to $171.68. This will leave $428.32 of franking credits unused in the company’s franking account.

Franking deficit tax 12.55 We saw at 12.54 that where a company’s distributable profits prior to a distribution have exceeded its taxable income to that point, the maximum franking credit for a distribution can be greater than the credit balance in the company’s franking account. In these circumstances, if the company franks the distribution with the maximum franking credit then it will have a debit balance in its franking account at the end of its franking year unless other credits (in excess of the debit balance created by the distribution) arise in its franking before then. This will give rise to a liability for franking deficit tax under ITAA97 s 205-45. Under s 5(a) of the New Business Tax System (Franking Deficit Tax) Act 2002 (Cth), the amount of the franking deficit tax will be equal to the amount of the franking deficit. As noted at 12.40, the franking deficit tax liability will give rise to a credit in the company’s franking account equal to the amount of the franking deficit tax liability thus restoring the franking account to a zero balance. The franking deficit tax liability, in effect, is just a

deferred collection of tax at the company level for franking credits that have already been allocated to shareholders. A liability for franking deficit tax also arises under s 205-45(3) where a company with a deficit balance in its franking account ceases to be a corporate tax entity. The franking deficit tax is equal to the debit balance in the company’s franking account at that time. ITAA97 s 205-70 allows franking deficit tax to be offset against the company’s mainstream company tax liability, provided the company satisfies the residency requirement in the year of offset. The offset of franking deficit tax is applied only after the other tax offsets (such as foreign tax credits or franking credits on inter-corporate dividends). Where the franking deficit tax exceeds 10% of the total franking credits for the year then, subject to exceptions set out in s 207-70(5) and (6), the offset is reduced by 30%. Example 12.13 illustrates the treatment of franking deficit tax and excessive franking under s 205-70. The example also illustrates potential problems with s 205-70. [page 775]

Assume the facts in Example 12.11. If the company franks the dividend of $1400 to $600, this will produce a deficit balance of $300 in its franking account. At year end, if no other credits have arisen in the company’s franking account, it will be liable for franking deficit tax equal to the amount of the franking deficit; that is, $300. As the franking deficit of $300 is greater than 10% of the total franking credits for the year of $300, the offset of its franking deficit tax liability against its future company tax instalments is reduced by the additional franking deficit tax liability (ie, $300 × 30% = $90). Assume that the company’s instalment income for the first quarter of X2 is $1000 and that a PAYG instalment of $300 is payable on 28 July X2. If the company were able to fully offset its franking deficit tax against its company tax instalments, the $300 of franking deficit tax would be offset against its company PAYG instalment on 28 July, and the company would have to pay only $300 of franking deficit tax and would not have to pay the $300 PAYG instalment. Note, however, that the offset against mainstream company tax does not itself generate a

franking credit. Because franking deficit tax exceeds 10% of the total franking credits for the year, the offset of franking deficit tax against mainstream company tax is reduced to $210. This means that, in addition to the franking deficit tax paid of $300, the company has to pay mainstream company tax of $90, which will generate a franking credit of $90. This is to be contrasted with the position under the previous dividend imputation system where a payment of ‘franking additional tax’ did not reduce the franking deficit tax offset against mainstream company tax and did not generate a franking credit.

1.

2.

Do you regard the end result in Example 12.13 as appropriate if the reduction in the offset of franking deficit tax against company tax is meant to be a ‘penalty’ to discourage excessive over-franking of dividends? How would you ensure that a reduction in the offsetting of franking deficit tax against mainstream company tax instalments did not ultimately result in additional franking credits being generated?

Deferring franking deficit to avoid franking deficit tax 12.56 The ITAA97 contains provisions aimed at preventing companies from avoiding a franking deficit tax liability by paying excessive company tax instalments [page 776] before the end of the year of income. In the absence of these provisions, the excessive instalment payments could generate sufficient franking credits to mean that any debit balance in the franking account was eliminated by the end of the year. The excessive payment of company tax instalments would then be refunded in the following year when the company self-assessed its tax liability. To circumvent planning of this nature, s 205-50(2) deems a refund of income tax that the company receives within three months after the end of the previous income year to have been paid to it immediately before the end of that year where

the company’s franking account would have been in deficit or in deficit to a greater extent if the refund had actually been received in that year. The effect of s 205-50(2) is that, as the refund is deemed to have been received immediately before the end of the first income year, the franking account will be in deficit or will be in deficit to a greater extent at the end of that year thus producing a franking deficit tax liability or a greater franking deficit tax liability.

Given that franking deficit tax can be offset against a company’s mainstream company tax liability, what advantages would companies that overpaid their company tax instalments to avoid payment of franking deficit tax be trying to achieve? A suggested solution can be found in Study help.

The benchmark franking rule 12.57 Generally,22 all frankable distributions made by a company within particular periods must be franked to the benchmark franking percentage. ITAA97 s 203-15 states that the object of the benchmark rule is to ensure that one member of a company is not preferred over another when the company franks distributions. In other words, the object of the benchmark rule is to curtail the practice known as dividend streaming. Dividend streaming and anti-dividend streaming provisions are discussed in 12.63–12.71. The benchmark franking percentage for a company for a franking period is the same as the franking percentage for the first frankable distribution that the company makes in the period: s 203-30. The franking percentage for a frankable distribution is calculated using the following formula set out in s 203-35(1): [page 777]

Assuming that the distributions shown in Examples 12.10–12.12, above, were the first distributions for the company in the relevant franking period, calculation of the franking percentage for each distribution can be illustrated in Examples 12.14–12.16 as follows.

Assume the facts in Example 12.10.

Distribution Maximum franking credit on distribution

$700 $300.44

To simplify calculations in the example, the maximum franking credit has been rounded down to $300. If the company were to attach $300.44 of franking credits to the distribution then the franking percentage of the distribution would be: 300/300 × 100% = 100% There is nothing that prevents a company from allocating less than the maximum franking credit to its initial distribution in a franking period. Thus, if the company chose to allocate franking credits of $200 to the distribution the franking percentage of the distribution would be: 200/300 × 100% = 66.67%

Assume the facts in Example 12.11.

Distribution Maximum franking credit on distribution

$1400 $600.88

To simplify calculations in the example, the maximum franking credit has been rounded down to $600. We saw earlier in Example 12.11 that the company would have credits of only $300 in its

franking account. If the company wished to avoid placing its franking account into deficit, then it might choose to attach only $300 of franking credits to the distribution. If it did this, then the franking percentage of the distribution would be: 300/600 × 100% = 50%

[page 778]

Assume the facts in Example 12.12.

Distribution Maximum franking credit on distribution

$400.00 $171.68

In this situation, the company is likely to want to frank the distribution to the maximum amount. If it does this, it will allocate $171.68 of franking credits to the distribution. The franking percentage for the distribution will be: $171.68/171.68 × 100% = 100% Although it will have an additional $428.32 of credits in its franking account, the effect of s 202-65 is that attempts to allocate these credits to the distribution will be ineffective.

The franking period for an entity that is a private company for an income year is the same as the income year: s 203-45. Where the entity is not a private company for the income year, the franking period is determined using the following rules set out in s 203-40: Where the entity’s income year is a period of 12 months, the following are franking periods: – the period of six months beginning at the start of the entity’s income year; – the remainder of the income year. Where the entity’s income year is a period of six months or less, the franking period for the entity is the same as the income year. If the entity’s income year is a period of more than six months but

less than 12 months, the following are franking periods: – the period of six months beginning at the start of the entity’s income year; – the remainder of the income year. If the entity’s income year is a period of more than 12 months, the following are franking periods: – the period of six months beginning at the start of the entity’s income year (the first franking period); – the period of six months beginning immediately after the end of the franking period; – the remainder of the income year.

Commissioner may permit franking to a different percentage 12.58 In extraordinary circumstances, the Commissioner may, on application by the company in writing, permit a company to frank a distribution at a percentage that differs from the company’s franking percentage for the franking period: ITAA97 s 203-55(1) and (2). In deciding whether there are extraordinary circumstances, the Commissioner must have regard to (s 203-55(3)): [page 779] (a) the [company’s] reason for departing, or proposing to depart, from the benchmark rule; (b) the extent of the [company’s] departure, or proposed departure, from the benchmark rule; (c) if the circumstances which give rise to the [company’s] application are within the [company’s] control, the extent to which the [company] has sought the exercise of the Commissioner’s powers under [s 203-55] in the past; (d) whether a member of the [company] has been or will be disadvantaged as a result of the departure, or proposed departure, from the benchmark rule; and (e) whether a member of the [company] will receive greater imputation benefits than another member of the [company] because a distribution franked at a franking percentage that differs from the benchmark franking percentage for the franking

(f)

period is made to one of them; and any other matters that the Commissioner considers relevant.

All information relevant to these matters must be included in the application to the Commissioner under s 203-55. The Commissioner’s powers under s 203-55 may be exercised before or after the frankable distribution is made. An allocation of a franking credit at a percentage specified by the Commissioner in a s 203-55 determination is taken to comply with the benchmark rule. Note that imputation benefits are defined in s 204-30, which is discussed below in the context of anti-streaming provisions.

Over-franking tax 12.59 Where the franking percentage for a distribution exceeds the company’s benchmark franking percentage for the franking period, the entity is liable to pay ‘over-franking tax’: ITAA97 s 203-50(1)(a). The over-franking tax is calculated using the following formula set out in s 203-50(2):

Figure 12.3:

Over-franking tax formula (s 203-50(2))

[page 780] In the formula above Figure 12.3, the ‘franking % differential’ is the difference between the franking percentage for the frankable distribution and the entity’s benchmark franking percentage for the franking period unless the Commissioner, under s 203-55, permits the company to frank the distribution to a different percentage. In the latter case, the ‘franking % differential’ will be the difference between the franking percentage for the frankable distribution and the percentage to which the Commissioner, under s 203-55, permitted the company to frank the distribution. We noted at 12.53 that, where the 30% corporate tax rate applies to a company, the corporate tax gross-up rate works out at 2.33 (to 2 decimal places). Where the 27.5% corporate rate applies to a company, the corporate tax gross-up rate works out at 2.64 (to 2 decimal places). Note that a payment of over-franking tax does not generate a

franking credit and is not creditable against the entity’s mainstream income tax liability. The operation of over-franking tax can be illustrated by Example 12.17, which is a continuation and variation of Example 12.15.

Assume that after payment of the dividend of $1400 in Example 12.15, the company receives a further $1000 taxable income/distributable profit. Assume that the receipt of the $1000 generated $300 in PAYG instalments which, in turn, generated $300 in franking credits. Assume that, to avoid paying franking deficit tax, the company allocated only $300 of franking credits to the first dividend of $1400. The franking percentage of this dividend was 50%. If the company distributes the $700 of after-tax income/profit, the maximum franking amount for the distribution will be: $700 × 0.4292 = $300.44 To simplify the example, the 44c will not be taken into account as it is only a product of the number of decimal places to which the corporate rate gross-up rate was taken. However, as the franking percentage for the company’s first dividend in the franking period was only 50%, it should frank the dividend of $700 to 50%, that is, $150/$300. If it, nonetheless, franks the dividend to $300, the franking percentage of the dividend will be 100%, that is, 300/300. This will generate over-franking tax calculated as follows: 700 × 50%/2.33 = $150.21

What would have been the result in Example 12.17 if the company, instead of franking the second dividend to 100%, franked it to 75%? A suggested solution is in Study help.

[page 781]

Position where franking percentage for a distribution is

less than the benchmark percentage 12.60 Where the franking percentage for a distribution is less than the company’s benchmark franking percentage for the franking period, a debit arises in the franking account under ITAA97 s 203-50(1)(b). The debit is calculated under the same formula as is used to calculate over-franking tax. Note that, although there is a debit in the company’s franking account in this situation, no additional credit is allocated to the shareholder. Therefore, the end result of franking a dividend to less than the benchmark percentage for a period is a loss of franking credits for the company with no corresponding benefits being derived by its shareholders. The calculation of the s 203-50(1)(b) franking debit is illustrated by Example 12.18.

Assume the facts in Example 12.17 with the variation that the company franks the dividend of $700 to 0%. In this situation, the company should have franked the dividend to its benchmark percentage of 50% for the franking period. Hence, a franking debit will arise under s 203-50(1)(b), calculated as follows: 700 × 50%/2.33 = $150.21

What would have been the result in Example 12.18 if the company, instead of franking the second dividend to 0%, had franked it to 25%? A suggested solution is in Study help.

Distribution statement 12.61 A company that makes a frankable distribution is obliged by ITAA97 s 202-75(1) to give the recipient shareholder a distribution

statement. Companies other than private companies are required by s 202-75(2) to give the statement on or before the day when the distribution is made. Private companies are required by s 202-75(3) to give the statement before the end of four months after the end of the income year in which the distribution is made or such later time as the Commissioner determines under s 202-75(5). Thus, a private company that made a distribution in an income year that ended on 30 June would have until 31 October of the following income year to give the distribution statement to shareholders, unless the Commissioner made a determination under s 202-75(5). Distribution statements are required by s 202-80(3) to be in the approved form and must: [page 782]

(a) (b) (c) (d) (e) (f)

identify the entity making the distribution; and state the date on which the distribution is made; and state the amount of the distribution; and state that there is a franking credit for an amount specified on the distribution; and state the franking percentage for the distribution; and state the amount of any withholding tax that has been deducted from the distribution by the entity; and (g) include any other information required by the approved form that is relevant to imputation generally or the distribution.

12.62 A company is allowed by ITAA97 s 202-85(1) to apply to the Commissioner for a determination that the company may amend the franking credit relating to a specified distribution on a distribution statement. In making this determination, the Commissioner is required by s 202-85(2) to have regard to: whether the date for lodgment of the income tax return by the recipient of the specified distribution for the income year of the distribution has passed; whether the change in the franking credit on the specified distribution would produce any difference in the recipient’s

withholding tax liability; whether the amendment would lead to a breach of the benchmark rule or any of the anti-dividend streaming rules; whether the amendment would lead to a new benchmark franking percentage being set for the company for the franking period in which the distribution was made; and any other matters that the Commissioner considers relevant.

Anti-dividend streaming rules 12.63 One of the shortcomings of the variable credit or SCA-style dividend imputation system that Australia uses is the opportunity that it presents for what is known as ‘dividend streaming’. It is common enough for a company to have a taxable income and yet have distributable profits that exceed that taxable income. If so, then the franking credits that the company generates from the payment of tax on its taxable income will be insufficient to frank a distribution of all its distributable profit to the maximum amount. The following activity asks you to consider what the preferences of Australian resident and foreign resident shareholders will be for different types of dividends that such a company could pay. Referring to the discussion and accompanying examples in 13.41–13.55 will assist you in answering this activity. [page 783]

Wagner Pty Ltd has two shareholders, Richard (an Australian resident natural person on a marginal tax rate of 45%) and Siegfried (a foreign resident who resides in a country with which Australia has a double taxation agreement (DTA), which relieves international double taxation by using an exemption system). Richard owns one A class share and

Siegfried owns one B class share in Wagner Pty Ltd. The after-tax distributable profit of Wagner Pty Ltd was calculated as follows: Wagner Pty Ltd (resident company) Profit (including income)

$200,000

Income

$100,000

Tax @ 27.5% (assuming a 27.5% corporate rate)

$27,500

Franking credits

$27,500

After-tax income

$72,500

After-tax profit

$172,500

Calculate the after-tax effects for Richard and Siegfried of the following distributions: (i) a dividend of $86,250 franked to 50% paid to each of them; (ii) a dividend of $36.250 franked to 50% paid to each of them followed by a dividend of $50,000 franked to 0% paid to each of them; (iii) a dividend of $72,500 franked to 100% paid to Siegfried followed by a dividend of $100,000 franked to 0% paid to Richard; and (iv) a dividend of $72,500 franked to 100% paid to Richard followed by a dividend of $100,000 franked to 0% paid to Siegfried. To simplify the calculations, ignore the cents. How would the position differ in each of these scenarios if Siegfried were a resident of a non-DTA country? Suggested solutions are in Study help.

12.64 Activity 12.2 illustrates that a shareholder who is a natural person, and who is a resident on the top marginal tax rate, will be indifferent as to whether he or she receives a dividend franked to 100%, a larger dividend franked to 50%, or a larger-still dividend franked to 0%. In all of these situations, the dividend and the attached franking credit can be set at levels which mean that the after-tax dividend to the shareholder is the same. By contrast, the non-resident natural person shareholder in Activity 12.2 was considerably better off receiving a dividend of $100,000 franked to 0% than in any of the other scenarios. Given these differences in preferences between resident and non-resident shareholders, some companies may be likely to try to achieve the result in scenario (iv). That is, they may try to ensure that franked dividends are received by resident shareholders who can fully use the franking credits attached to

[page 784] them while non-resident shareholders receive only unfranked dividends. This strategy is known as ‘dividend streaming’. The opportunity for dividend streaming in Australia’s dividend imputation system arises because the system allows a company, in appropriate circumstances, to declare dividends to be franked to anywhere between 0% and 100%. The ITAA97 contains several provisions that aim to prevent dividend streaming. Note that, since the New Business Tax System (Miscellaneous) Act (No 1) 2000 (Cth), excess imputation credits have been fully refundable to Australian resident natural person shareholders. This should mean that companies should not be tempted to stream franked dividends away from low marginal tax rate resident natural person shareholders.

The benchmark franking rule and dividend streaming 12.65 The benchmark franking rule is clearly intended to curtail opportunities for dividend streaming by inhibiting the ability of a company to vary its level of franking within a franking period. ITAA97 s 203-15 states that the object of Div 203 (which deals with the benchmark rule) is to ensure that one member of a corporate tax entity is not preferred over another when the entity franks distributions. The Review of Business Taxation also saw a benchmark rule as a means of curtailing dividend streaming.23 The Henry Review recommended that, while dividend imputation was retained, dividend streaming and franking credit trading practices should, in general, continue to be prohibited.24 12.66 Under the Australian dividend imputation system that applied between 1987 and 2002, a company with different classes of shareholders and an excess of distributable profits over taxed income could exhaust the credits in its franking account by paying a fully franked dividend to its Australian resident shareholders and then paying a subsequent unfranked dividend to its foreign resident shareholders.

Under the former system, a narrow definition of ‘class of shares’ was used to curtail this type of streaming. In the Simplified Imputation System, the benchmark rule will mean that, without there being a need to define ‘class of shares’ narrowly, simple streaming of this kind will no longer be possible within franking periods. This is because the benchmark rule (provided it applies to the company) will mean that all distributions within a franking period are required to be franked to the benchmark percentage notwithstanding that some distributions may be made to different classes of shareholders. The way that the benchmark rule operates to prevent this simple form of dividend streaming is illustrated by the Examples 12.19–12.21.

Assume a private company for tax purposes receives $1000 of income/profit in the first half of the year, pays tax of $300, and pays a dividend of $700 franked to 100% to a resident shareholder. In the second half of the year, the company receives $1000 of taxpreferred profit which is not subject to tax. If it pays a dividend of $1000 to a [page 785] foreign resident shareholder, the benchmark franking rule will mean that it will be required to frank the dividend to 100%. The maximum franking credit has been rounded down for cents. The assumption has been made that a corporate tax rate of 30% applies to the company.

Income/Profit Tax Distribution No 1 Maximum franking credit Franking % Franking credits allocated Profit Income

$1000.00 $300.00 $700.00 $300.00 100% $300.00 $1000.00 $0.00

Tax Distribution No 2 Maximum franking credit Required franking % Franking credits allocated Subsequent franking deficit tax

$0.00 $1000.00 $428.57 100% $428.57 $428.57

Assume that a company in the first half of a franking period has a tax-preferred profit on which no tax is payable. Assume that it pays a dividend of $1000 to a foreign resident shareholder and franks it to 0%. Assume that, in the second half of the year the company derives $1000 of income and pays $300 of tax that generates $300 of franking credits. If the company pays a dividend of $700 to an Australian resident shareholder the benchmark franking rule will mean that it is obliged to frank the dividend to 0%. Again, the maximum franking credit has been rounded down for cents. It is assumed that a corporate tax rate of 30% applies to the company.

Profit Income Tax Distribution No 1 Maximum franking credit

$1000 $0 $0 $1000 $428 [page 786]

Franking % Franking credits allocated Income Tax Franking credit

0% $0 $1000 $300 $300

Distribution No 2

$700

Maximum franking credit Required franking % Franking credits allocated Unused franking credits

$300 0% $0 $300

Assume that in the first half of a franking period, a company has a taxable income of $2000 but a distributable profit of only $1000. The company pays tax of $600 which generates franking credits of $600. Assume that it makes a distribution of $400 to a resident shareholder being its after-tax profit. The dividend is franked to 100%. Assume that in the second half of the franking period, the company has a tax preferred profit of $1000 on which no tax is payable. If it pays a dividend of $1000 to a non-resident shareholder, the benchmark franking rule will mean that it is obliged to frank the dividend to 100%. The maximum franking credit has been rounded down and rounded up for cents. It is assumed that a corporate tax rate of 30% applies to the company.

Income Profit Tax Franking credits generated Distribution No 1 Maximum franking credit Franking % Remaining franking credits Profit Income Tax

$2000 $1000 $600 $600 $400 $171 100% $429 $1000 $0 $0 [page 787]

Distribution No 2 Maximum franking credit Required franking % Franking credits allocated

$1000 $429 100% $429

12.67 In the absence of other anti-streaming provisions, however, as illustrated in Examples 12.22–12.24, it would be possible to stream dividends to different classes of shareholders over two or more franking periods:

Assume the facts in Example 12.19 with the variation that the second dividend is not paid until the start of the next franking period. Year 1

Income Tax Distribution Maximum franking credit Franking % Franking credits allocated

$1000.00 $300.00 $700.00 $300.00 100% $300.00

Year 2

Profit Income Tax Distribution Maximum franking credit Franking % Franking credits allocated Subsequent franking deficit tax

$1000.00 $0.00 $0.00 $1000.00 $428.57 0% $0.00 $0.00

Assume the facts in Example 12.20 with the variation that the second dividend is not paid until the start of the next franking period. [page 788] Year 1

Profit Income Tax Distribution Maximum franking credit Franking % Franking credits allocated

$1000 $0 $0 $1000 $428 0% $0

Year 2

Income Tax Franking credit Distribution Maximum franking credit Franking % Franking credits allocated

$1000 $300 $300 $700 $300 100% $300

Assume the facts in Example 12.21 with the variation that the second dividend is not paid until the start of the next franking period. Year 1

Income Profit

$2000 $1000

Tax Franking credits generated Distribution Maximum franking credit Franking % Remaining franking credits

$600 $600 $400 $171 100% $429

Year 2

Profit Income Tax

$1000 $0 $0 [page 789]

Distribution Maximum franking credit Franking % Franking credits allocated

$1000 $429 0% $0

These examples highlight the need for provisions in addition to the benchmark rule to prevent dividend streaming across franking periods. Specific anti-streaming provisions in the ITAA97 also try to prevent other forms of dividend streaming.

Specific anti-streaming rules Dividend selection schemes 12.68 ITAA97 Subdiv 204-B applies where a member of one entity (the first entity) is given a choice which has the effect of determining (to any extent) whether another entity makes a distribution (a ‘linked distribution’) to its members that is: in substitution (in whole or in part) for a distribution by the first

entity to that member or to any other member of the first entity; and either unfranked or franked to a percentage that differs from the first benchmark franking percentage for the franking period. Where Subdiv 204-B is triggered, it gives rise to a debit in the franking account of the company with the higher benchmark franking percentage in the franking period. The debit arises on the day when the linked distribution is made and is equal to the debit that would have arisen if the entity, in whose franking account the debit is made, had made a franked distribution equal to the linked distribution with a franking percentage equal to the benchmark franking percentage of that entity. If the company has no benchmark franking percentage for the franking period then: where the linked distribution has a franking percentage of less than 50%, the company is treated as having a franking percentage of 100%; and where the linked distribution has a franking percentage of more than 50%, the company is treated as having a franking percentage of 0%. In the absence of Subdiv 204-B, one company could avoid the operation of the benchmark franking rule by giving its members the choice of a distribution from another entity franked to a greater or lesser franking percentage in substitution in whole or part for a distribution from the company. ITAA97 Subdiv 204-C applies where a member of a company is given a choice which has the effect of determining (to any extent) whether the company issues tax exempt bonus shares,25 to that member or to another member of the company, [page 790] in substitution (in whole or in part) for one or more franked distributions by the company to that member or another member.

Where Subdiv 204-C applies, a franking debit arises in the entity’s franking account equal to the debit that would have arisen if the company made a distribution equal to the franked distributions (that the bonus shares were in substitution for) franked at the entity’s benchmark franking percentage for the franking period in which the bonus shares were issued. The debit arises on the day the bonus shares are issued.

Streaming of franking credits to advantaged shareholders 12.69 ITAA97 Subdiv 204-D is directed at preventing dividend streaming of this nature. Under s 204-30(1), the Commissioner may make a determination if a company streams one or more distributions or other benefits in one or more franking periods so that: an imputation benefit is, or would be apart from s 204-30, received by a member of the company as a result of the distribution; the member (the favoured member) ‘would derive greater benefit from franking credits’ than another member (the disadvantaged member) of the company; the ‘other member’ of the company ‘will receive lesser imputation benefits, or will not receive any imputation benefits, whether or not [that member] receives other benefit’. Section 204-30(6) deems a member to receive an imputation benefit as a result of a distribution if: (a) the member is entitled to a tax offset under Div 207 [discussed in 13.43–13.55] as a result of the distribution; (b) an amount would be included in the member’s assessable income as a result of the distribution because of the operation of s 207-35 [dealing with the flowing of franking credits through partnerships and trusts]; or (c) a franking credit would arise in the franking account of the member as a result of the distribution; or (d) an exempting credit would arise in the exempting account of the member as a result of the distribution; or (e) the member would not be liable to pay withholding tax on the distribution, because of the operation of [ITAA36 s] 128B(3)(ga) [see the discussion of s 128B(3)(ga) in 13.53]; (f) the member is entitled to a tax offset under s 210-170 [dealing with distributions

franked with venture capital credits] as a result of the distribution.

The following are given in s 204-30(2) as examples of the giving of ‘other benefits’: (a) (b) (c) (d)

issuing bonus shares; returning paid-up share capital; forgiving a debt; the [company] or another entity making a payment of any kind, or giving any property, to a member or to another person on a member’s behalf.

[page 791] A non-exhaustive list of cases in which a member derives a ‘greater benefit from franking credits’ than another member of the entity is set out in s 204-30(8). These are where the following circumstances exist in relation to the other member in the income year in which the relevant distribution is made but not in relation to the first member: (a) the other member is a foreign resident; (b) the other member would not be entitled to any tax offset under Div 207 [discussed in 13.43–13.55] because of the distribution; (c) the amount of income tax that [would otherwise] be payable by the other member because of the distribution is less than the tax offset to which the other member would be entitled; (d) the other member is a corporate tax entity at the time of the distribution but no franking credit arises for the entity as a result of the distribution; (e) the other member is a corporate tax entity at the time of the distribution but cannot use franking credits received on the distribution to frank distributions to its own members because: (i) it is not a franking entity; or (ii) it is unable to make frankable distributions.

The legislation does not tell us what ‘streams one or more distributions’ means. The Joint Explanatory Memorandum to the New Business Tax System (Franking Deficit Tax) Bill 2002 (Cth) at paras 3.28–3.34 contains the following comments on what is meant by streaming: Joint Explanatory Memorandum to the New Business Tax System (Franking Deficit Tax) Bill 2002 (Cth)

What is streaming? 3.28 Streaming is selectively directing the flow of franked distributions to those members who can most benefit from imputation credits. 3.29 The law uses an essentially objective test for streaming, although purpose may be relevant where future conduct is a relevant consideration. It will normally be apparent on the face of an arrangement that a strategy for streaming is being implemented. The distinguishing of members on the basis of their ability to use franking benefits is a key element of streaming. 3.30 Thus, streaming is unlikely to occur when a corporate tax entity, in making franked distributions, distinguishes between two classes of members, both of which comprise members who can and who cannot benefit from imputation credits. However, where one class is predominantly able to use imputation credits, and the other is predominantly not, it may be apparent that an arrangement is streaming, notwithstanding the presence in each class of a small minority of the other type of member. [page 792] 3.31 Broadly speaking, any strategy directed to defeating the policy of the law by avoiding wastage of imputation benefits through directing the flow of franked distributions to members who can most benefit from them to the exclusion of other members, may amount to streaming. While it is not possible to specify in detail every combination of circumstances which can constitute the streaming of franking credits (which in some cases may involve questions of degree), some guidance is given below. 3.32 In the simplest case of streaming, the members who can benefit from imputation credits receive a franked distribution, while members who cannot benefit to the same degree (eg non-residents) or who receive no benefit (eg tax-exempt organisations) simultaneously receive an unfranked distribution (normally adjusted in amount for the lack of franking). 3.33 However, it is not necessary for there to be two distributions by the corporate tax entity for streaming to occur. For example, in more complex cases of streaming, while the members who benefit most from imputation credits will receive a franked distribution from the entity, the other members may receive benefits from persons other than the entity, or they (or the entity) may defer the realisation of their share of the profits derived by the entity. Benefits may also be directed to associates of members. In some cases where the member less able to benefit from imputation is a corporate tax entity, trust or partnership, streaming may involve by-passing the member in favour of its ultimate owners. 3.34 Members less able to benefit from imputation credits may not receive unfranked distributions at the time the other members get franked distributions, and instead realise their interest in the corporate tax entity’s profits in some other way, either at the same time or in the future. In this case, streaming will occur where it is apparent that the corporate tax entity or the members less able to benefit from imputation credits have deferred or avoided the distribution of their interest in

profits as part of a strategy to avoid the wastage of imputation benefits. On the other hand, it would not be streaming if there is merely a deferred distribution of profits to one group of members which it is reasonable to expect will be franked (to a similar percentage) when it is distributed, or, if it is unfranked, will not be unfranked as the result of any strategy to direct franking to members most able to benefit from franking. In these cases it is appropriate to look to the intentions of the entity and members, and to the pattern of distributions among the members.

Examples of streaming provided in Memorandum are extracted in Study help.

the

Joint

Explanatory

[page 793] Subdivision 204-D may be criticised on the grounds that it appears to deem certain members to gain a greater benefit from franking credits in circumstances where, as a matter of fact, this might not be the case. Activity 12.3 seeks to illustrate this point.

1.

2.

Assume that Divi Pty Ltd, a resident company subject to a corporate tax rate of 30%, has after-tax distributable profits of $170 and has credits in its franking account of $30. On 30 June X1, Divi Pty Ltd pays a dividend of $70 franked to 100% to Ocker, a resident. On 1 July X2, it pays a dividend of $100 franked to 0% to Alien, a nonresident. Assuming that this amounts to a streaming of dividends, will Subdiv 204-D be triggered? There are a number of sub-questions that we need to ask and answer when answering this question: First, who receives the franking credit benefits (as defined)? Second, under s 204-30(1)(b), would Ocker derive greater benefits from franking credits than Alien? Now consider whether, as a matter of fact, Ocker in the year of income would actually derive a greater benefit from franking credits than Alien. A set of methods that you might consider using in answering this question can be found in Study help. Would Subdiv 204-D apply where a company between franking periods streams:

3.

(a) 100% franked dividends to one class of shareholders comprising 99% resident individuals and 1% non-resident individuals; and (b) 0% franked dividends to another class of shareholders comprising 99% nonresident individuals and 1% resident ndividuals? Would Subdiv 204-D apply where a company between franking periods streams: (a) 100% franked dividends to a class of shareholders comprising non-resident individuals; and (b) 0% franked dividends to a class of shareholders comprising resident individuals?

Where Subdiv 204-D applies, the Commissioner may make one or more of the following determinations under s 204-30(3): (a) that a specified franking debit [calculated using a franking percentage that the Commissioner may specify] arises in the franking account of the [company] for a specified distribution or other benefit to a disadvantaged member; (b) that no imputation benefit is to arise in respect of a distribution that is made to a favoured member and specified in the determination.

[page 794]

Information to be provided to the Commissioner where the benchmark percentage differs significantly between franking periods 12.70 ITAA97 Subdiv 204-E, via s 204-70, applies to a company (to which the benchmark franking rule applies) where the difference between its benchmark franking percentage for the current franking period and its benchmark franking percentage for the last franking period in which a distribution was made (the last relevant franking period) is more than the amount calculated under the following formula set out in s 204-70: Number of franking periods starting immediately after the last relevant franking period and ending at the end of the current franking period

x

20 percentage points

Subdivision 204-E applies irrespective of whether the company’s franking percentage for the current period is more or less than its

franking percentage for the last relevant franking period. Where Subdiv 204-E applies, s 204-75 requires the company to notify the Commissioner: (a) of the difference; (b) of the company’s benchmark franking percentage for the current period; and (c) of the company’s benchmark franking percentage for the last relevant franking period. The guide to Subdiv 204-E indicates that the purpose of this requirement is so that the Commissioner can assess whether there is streaming. The operation of the formula in s 204-70 is illustrated in Example 12.25, which is a continuation and variation of Example 12.17.

Assume that the company does not receive any further taxable income in Year 1 after the payment of the dividend of $1400. Assume that the franking percentage for the dividend was 50%. Assume that in Year 2 the company derives $1000 of taxable income/profit and pays corporate tax of $300. If the company distributes its after-tax income/profit of $700 as a dividend, the maximum franking amount for the dividend will be $700 × 0.4292 = $300.44 (which is rounded down to $300 for the purposes of this example). If the company allocates the maximum franking credit to the dividend, the franking percentage of the dividend will be 100%, calculated as: 300/300 × 100% = 100% As the dividend is paid in a new franking period, the company will not breach the benchmark franking rule. Rather, 100% will be the new benchmark percentage for the new franking period. However, the company’s franking percentage of 100% for Year 2 has increased from 50% in the previous franking period which is a 100% increase. [page 795] The legislation does not specify how the difference between the two benchmark percentages is to be determined. One possibility is to look at the number of percentage points difference between the previous benchmark percentage and the current benchmark percentage. Under this approach, in the example above, the percentage increase would be 50%. Another approach would be to ask what percentage of the previous benchmark percentage the increase in the benchmark percentage represents of the previous benchmark percentage. Under this approach, in the example above, the percentage increase would be 100%. An example in the Joint Explanatory Memorandum appears to

use the former approach which appears to be more consistent with the use of the expression ‘difference between’ used in s 204-70.

In the example above, assuming that the percentage increase is 50%, the increase is greater than the amount calculated under the formula in s 204-70(2), which will be 20% assuming that there has been only one franking period between the payment of the dividend of $1400 and the payment of the dividend of $700. If there had been two franking periods between the dividends, the amount calculated under s 204-70(2) would have been 40%. Where Subdiv 204-E applies, the Commissioner, under s 204-80(1), may request26 the entity to provide the following information: (a) the entity’s reasons for setting a benchmark franking percentage for the current franking period that differs significantly from the benchmark franking percentage for the last relevant franking period; and (b) the franking percentages for all frankable distributions made in the current franking period and the last relevant franking period; and (c) details of any other benefits given to the entity’s members, either by the entity or an associate of the entity, during the period beginning at the beginning of the last relevant franking period and ending at the end of the current franking period; and (d) whether any member of the entity has derived, or will derive, a greater benefit from franking credits than another member of the entity as a result of the variation in the benchmark franking percentage between the current franking period and the last relevant franking period; and (e) any other information required by the approved form that is relevant in determining whether the entity is streaming distributions.

[page 796]

Anti-avoidance rule: Dispositions of shares or interests 12.71 A general anti-avoidance rule which could apply to franking credit trading was introduced in 1998. ITAA36 s 177EA applies as from 13 May 1997. For s 177EA to apply, the following conditions must be satisfied:

there must be a scheme for the disposition of membership or an interest in membership in a corporate tax entity (membership interests are defined in s 177EA(13)) in terms which will include, for example, dividend access shares or an interest held via a discretionary trust; a frankable distribution must be paid, payable or expected to be paid to a person (the relevant taxpayer — note, the provisions also apply to indirect flows of frankable distributions); the distribution was franked, or expected to be franked, or franked with an exempting credit; except for s 177EA, the relevant taxpayer would receive, or could reasonably be expected to receive, imputation benefits as a result of the distribution; and having regard to the relevant circumstances of the scheme (as defined in s 177EA(17)), it would be concluded that a person entered into or carried out the scheme for a (non-incidental but not necessarily dominant) purpose of enabling the relevant taxpayer to obtain an imputation benefit. Where s 177EA applies, the Commissioner may determine that a franking debit or an exempting debit arises for the entity or determine that no imputation benefit arises for the recipient in respect of the distribution. In Electricity Supply Industry Superannuation (Qld) Ltd v FCT (2003) 53 ATR 120, the Full Federal Court held that s 177EA applied to a scheme involving a transfer in 1990 (prior to the introduction of s 177EA) by the trustee of a superannuation fund of the fund assets to the Queensland Investment Corporation Trust (QT) in exchange for units in the QT. The QT was a master trust fund for various Queensland public-sector superannuation funds, certain non-taxable funds and for the investment of Queensland Government cash surpluses. Queensland Government documentation indicated that one reason for the transfer of assets was to reduce the tax obligations of the member superannuation funds by streaming imputation credits to tax-paying members. The taxpayer was the successor to the original transferor superannuation fund. In the 1997–99 years, QT made distributions to

the taxpayer funded from franked dividends received by QT. In effect, the distributions represented a disproportionate share of the total franked dividends received by QT. The Full Federal Court held that s 177EA applied to the distributions made in the years 1997–99. When the taxpayer became a member of QT, there was a disposition to it of shares in companies to the extent that the assets of QT included shares. Thereafter, as QT acquired shares as further trust assets, there was a disposition of an interest in those shares in favour of the taxpayer and other members of QT. It did not matter that the subsequently acquired shares were not identified or identifiable at the time the taxpayer’s predecessor became a member of QT. QT was constituted and administered on the basis that distributions to taxable members would be disproportionately sourced in franked dividends. This meant that it could be concluded that the acquisition of interests in QT was not [page 797] merely an acquisition of an interest in shares but was made with a nonincidental purpose of enabling the taxpayer to obtain a franking credit benefit. Section 177EA was also considered in the High Court decision in Mills v FCT (2012) 83 ATR 514. The Commonwealth Bank of Australia (CBA) had issued stapled securities (in this instance, a subordinated unsecured note issued by the New Zealand branch of the bank stapled to a preference share issued by CBA) known as ‘PEARLS V’. PEARLS V were offered only to Australian resident shareholders of CBA or holders of PEARLS IV or certain other securities previously issued by CBA. PEARLS V were classified as equity for the purposes of the debt and equity rules (discussed at 12.25). Holders of PEARLS V were entitled to interest on the notes with an attached franking credit. The interest was funded from profits of the New Zealand branch which, under ITAA 1936 s 23AH, were non-assessable non-exempt income for Australian tax purposes but were deductible for New Zealand tax purposes. The Australian Commissioner of Taxation denied franking

credits to the taxpayer (a representative nominated investor) under s 177EA(5)(b) and issued Class Ruling CR 2009/78, which stated that the conditions in s 177EA(3)(a)–(d) were satisfied. The taxpayer’s appeals to the Federal Court and the Full Federal Court were unsuccessful, but on appeal the High Court unanimously allowed the taxpayer’s appeal. Although CBA obviously issued PEARLS V with the intention that holders would obtain franking credits, CBA’s overarching purpose in making the issue was to raise Tier 1 capital to satisfy prudential regulation requirements. The purpose of enabling holders of PEARLS V to obtain franking credits was merely to facilitate the capital raising and hence was merely an incidental purpose. Consequently, s 177EA did not apply. Section 177EA is also relevant in the anti-franking credit trading context. See the discussion of franking credit trading at 12.72–12.73.

Anti-franking credit trading rules 12.72 Like dividend streaming, franking credit trading occurs because franked dividends are more valuable to some shareholders than to others. Franking credit trading differs from dividend streaming in that it only needs to involve a transaction between two shareholders in a company rather than involving the company itself in the transaction. Example 12.26 shows how franking credit trading could occur.

Assume that a foreign resident shareholder anticipated that the company was about to pay a franked dividend of $70. Assume that the shares are worth $170 cum dividend and $100 ex dividend. As we have seen, a franked dividend of $70 is worth $70 to a foreign resident shareholder and will have an after-tax value of $51 to a resident shareholder after taking into account the 2% Medicare levy and the 2% Temporary Budget Repair levy for taxpayers with taxable [page 798]

incomes over $180,000. However, if the foreign resident is a portfolio shareholder, the shares will not be taxable Australian property. In these circumstances, a resident shareholder may be prepared to pay between $170 and $200 for the shares cum dividend. The logic would be that the resident shareholder would make an after-tax return of $51 on the shares when the dividend has been paid and would obtain a capital loss of up to $100 on a subsequent sale of the shares at the ex dividend price of $100. If the resident shareholder had capital gains to set the capital loss against, the shareholder would value the capital loss as equal to a full deduction. That is, the capital loss would be worth $100 × 49% = $49 to the resident shareholder. Thus, the resident shareholder would calculate the price to pay for the shares as: $100 (being their ex dividend price) + $51 (being the after-tax value of the dividend) + $49 (being the value of a capital loss made on resale of the shares) = $200 If the foreign resident shareholder agreed to sell the shares for $200, then the foreign resident would obtain an Australian tax-free capital gain of $100 (assuming that the nonresident purchased the shares at their ex dividend price) instead of an Australian taxfree dividend of $70. The resident shareholder would then resell the shares to the foreign resident for $100 and realise a capital loss of $100 on the shares. The resident shareholder would also obtain a fully franked dividend of $70. If the resident shareholder was a company, then it would obtain $70 (being the after-tax value of the dividend) + $30 (being the after-tax value of the capital loss) and $70 worth of credits in its franking account. It would also be possible, and more common, to achieve equivalent results by using derivatives such as call or put options.

12.73 Specific provisions, ITAA36 ss 160APHC–160APHU, aimed at curtailing franking credit trading, were introduced in 1999.27 The provisions made extensive use of complex finance concepts. The provisions affected shares or interests acquired on or after 1 July 1997 except where the shares or interests were acquired under a contract made before 13 May 1997. The key features of the anti-franking credit trading provisions were as follows: [page 799] Small investors were exempt from the regime. Originally, the exception was $2000 of franking rebates. Following recommendations by the Review of Business Taxation, the

exemption threshold was increased to $5000. Taxpayers were required to hold shares ‘at risk’ for more than 45 days from the date when the taxpayer acquired the shares to obtain any franking benefit (including the former inter-corporate rebate) from a dividend (the period is 90 days in case of some preference shares). In addition to the 45-day rule, taxpayers who were obliged or reasonably expected to make a related payment regarding the dividend to another person were required to hold the shares at risk for more than 45 days from the date at which the shares went ex dividend to obtain any franking benefit (the period is 90 days in the case of some preference shares). Whether or not shares were at risk was determined using finance concepts that take into account hedging arrangements such as options and other derivatives. Shares would not be at risk if the taxpayer had less than 30% of the risks and opportunities relating to the shares and interests. Where the holding period was not met, the taxpayer was denied a franking credit on the dividend and, hence, was denied an imputation rebate and (in the case of a company) the former intercorporate rebate. The denial of a franking credit and imputation rebate came about because a taxpayer who did not satisfy the qualification period was not a ‘qualified person’ for the purposes of ITAA36 s 160AQT(1AB)(ba). In the case of the inter-corporate rebate, s 46(2B) stated that a shareholder was not entitled to an inter-corporate dividend rebate unless the shareholder was a qualified person. Where a recipient company was not a qualified person in relation to shares, s 160APP(6) stated that no credit arose in its franking account when it received a franked dividend. The provisions referred to above were repealed in 2006. At the time of writing, a rewriting of the 45-day rule and associated payments rule in consequence of the introduction of the Simplified Imputation System had been announced but legislation giving effect to this announcement had not been introduced into the Commonwealth Parliament. The

Howard Government also announced its intention to adopt the Review of Business Taxation recommendation that the 45-day rule be replaced by a 15-day rule but legislation giving effect to this announcement also was not introduced into the Commonwealth Parliament. The Rudd– Gillard Government announced that legislation inserting holding period and related payment rules into the Simplified Imputation System would be introduced.28 At the time of writing, legislation implementing this announcement had not been introduced into the Commonwealth Parliament. Taxation Determination TD 2007/11 states that the repealed rules have an ‘ongoing’ application by being ‘imported’ into the ITAA97 via the denial of a gross-up and tax offset by s 207-145(1) (a) (discussed at 13.95) where the imputation system has been manipulated. [page 800]

Dividends paid by exempting companies and former exempting companies 12.74 As tax-exempt and non-resident shareholders have less use for franking credits, companies controlled by such shareholders are more likely to engage in dividend streaming, franking credit trading, or capital benefit streaming. As from 13 May 1997, special provisions have applied to franked distributions paid by ‘exempting companies’. The current version of these provisions is in ITAA97 Div 208. In general, the gross-up and tax offset procedure in ITAA97 Div 207 does not apply to a distribution by an exempting entity. Division 207 does apply, however, to franked distributions made by exempting entities to other exempting entities or which flow indirectly to another exempting entity in circumstances where distribution gives rise to a franking credit for the recipient exempting entity. The gross-up and credit mechanism in Div 207 also applies to franked dividends paid to distributions made under certain employee share schemes where the recipient of the distribution is an employee of the exempting company or of a subsidiary29 of the exempting company.

12.75 Under ITAA97 s 208-25, an exempting entity is one that is ‘effectively owned’ by ‘prescribed persons’. The combined effect of the definitions of ‘effective ownership’ in s 208-25 and of ‘prescribed persons’ in ss 208-40 and 208-45 is, broadly, that 95% or more of the ‘accountable membership interests’ or the ‘accountable partial interests’ in an entity are held30 by tax-exempt or foreign resident individuals, companies, partnerships or trusts (where all the partners or beneficiaries are either exempt from tax or are foreign residents), or by the Commonwealth, a state or a territory. However, under s 208-25(1)(b), a company will only be ‘effectively owned’ by prescribed persons if it is reasonable to conclude that the risks and opportunities arising from holding accountable membership interests in the entity are substantially borne by and accrue to prescribed persons. Companies, trustees and partnerships that are not otherwise prescribed persons are taken to be prescribed persons under s 208-45 if the risks involved in, and the opportunities resulting from, the membership interest substantially accrue to one or more prescribed persons. A trustee that is not otherwise a prescribed person can (subject to the exercise of the Commissioner’s discretion in certain cases) be taken to be a prescribed person if the trust is controlled by one or more prescribed persons or the beneficiaries who are or become presently entitled to the income from the trust in the relevant year of income are prescribed persons. Exempt institutions that are eligible for refunds cannot be prescribed persons. Exempt institutions that are eligible for refunds are discussed at 13.50. [page 801] When a corporate tax entity ceases to be an exempting entity then, under s 208-50(1), it becomes a ‘former exempting company’ and converts its franking account balances for the period in which it was an exempting company into ‘exempting account’ entries. In general, dividends paid from the exempting account to resident shareholders are treated as if they were unfranked dividends. The exceptions are where

distributions are made to ‘eligible substantial continuing members’ or to employees under certain employee share schemes. Eligible substantial continuing members are defined in s 208-155 in terms which include foreign residents, life insurance companies, exempting entities, and former exempting entities which are entitled to not less than 5% interest in the entity. After they cease to be exempting entities, former exempting entities maintain an ordinary franking account that tracks the tax paid by the entity since it ceased to be an exempting entity.

Tainting and untainting the share capital account 12.76 For company law purposes, a company’s share capital is the total amount of money that members (as members and not as creditors) have provided (or agreed to provide) to the company for use in its business.31 When a company has distributable profits, it may choose to capitalise them. Under the Corporations Act 2001 (Cth), a company may make a direct capitalisation of profits without issuing new shares.32 Prior to the capitalisation, the profits are able to be distributed to shareholders as dividends. After the capitalisation, the moneys applied are no longer available for distribution as a company law dividend. Rather, the capitalised profits are regarded as forming part of the company’s share capital. A company may also capitalise profits by issuing bonus shares. This may be done through either the indirect or the direct method. Under the indirect method, the company declares a dividend that is satisfied by an issue of bonus shares that have a paid-up value equal to the amount of the dividend. Under the direct method, the company transfers profits from its profit and loss account to its share capital account. At the same time, the amount transferred is rateably distributed among members as bonus shares.33 As we will see in Chapter 13, generally, a distribution from a company’s share capital account will not be treated as a dividend for tax purposes. This is because, to the extent that a company’s share capital account represents moneys contributed by shareholders for the

conduct of the company’s business, a distribution from that account simply represents a return of contributions. However, as a company can capitalise profits, the share capital account, at any particular point, may include amounts other than shareholders’ contributions. If no distributions from the share capital account were ever regarded as dividends for tax purposes, then planning opportunities would arise. Controlling shareholders who held pre-CGT shares could avoid tax at the shareholder level entirely by arranging for the company to capitalise profits and then make a return of capital. The ITAA97 deals with planning [page 802] of this nature by regarding certain share capital accounts as ‘tainted’. As discussed in more detail in Chapter 13, distributions from a tainted share capital account will be dividends for tax purposes and will not be frankable. It should be noted that non-share capital accounts, discussed at 12.25, do not become tainted. Rather, distributions paid from nonshare capital accounts are frankable only to the extent the company has available profits immediately before the distribution. The rules relating to calculation of available profits for these purposes are discussed in Study help.

When the share capital account becomes tainted 12.77 Under ITAA97 s 197-50, subject to exceptions, a company’s share capital account becomes tainted if it transfers an amount to its share capital account from any of its other accounts. More technically, tainting occurs only if the amount transferred is an amount to which ITAA97 Div 197 applies. Subject to exceptions,34 s 197-5 states that an amount to which Div 197 applies is an amount that a company, which is an Australian resident at the time, transfers to its share capital account from another of the company’s accounts. Thus, a direct capitalisation of profits will taint a company’s share capital account as

will an indirect capitalisation through a bonus issue. Note, however, that ITAA36 s 6BA(5) provides that the share capital account of a company does not become tainted where a share issue is a deemed dividend under that section. Section 6BA(5) deals with shares issued under dividend reinvestment plans and, subject to an exception in s 6BA(6), deems shares issued under the plan to be a dividend. For a discussion of the tax effects of dividend reinvestment plans, see the Study help link for 13.58.

Effects of tainting Franking debit 12.78 For most companies,35 a franking debit arises under ITAA97 s 197-45 immediately before the end of the franking period in which an amount is transferred to the share capital account from another account. The franking debit is calculated using the following formula set out in s 197-45(2):

The ‘applicable franking percentage’ is defined in s 197-45(2). Where the company’s benchmark percentage for the franking period has already been set, the ‘applicable franking percentage’ will be the company’s benchmark percentage. If a benchmark [page 803] percentage has not already been set for the period, then the ‘applicable franking percentage’ will be 100%. The applicable gross-up rate, as discussed at 12.53, will be 2.33 for companies subject to a corporate tax rate of 30%. For companies subject to a 27.5% corporate tax rate, the applicable gross-up rate will be 2.64. The calculation of the s 197-45 franking debit is illustrated in

Example 12.27. It is assumed that the 30% corporate rate applies to the company in Example 12.27.

Alpha Pty Ltd has paid-up capital of $100,000. It has a retained profits reserve of $70,000 and a credit balance in its franking account of $30,000. It capitalises its retained profits reserve, which increases the balance in its share capital account to $170,000. Assume that, prior to the capitalisation of the retained profits reserve, Alpha Pty Ltd had not paid a dividend in the franking period and, hence, did not have a benchmark percentage for the period prior to the capitalisation of the profits. The capitalisation of the profits taints the share capital account and causes a debit in the franking account calculated as: $70,000 × 100%/2.33 = $30,042 (Note that here the $42 is merely a product of calculating the applicable gross-up rate to two decimal places only. In practice, the amount of the debit would be $30,000.) This would mean that the balance in Alpha Pty Ltd’s franking account would be reduced to zero.

Distribution from tainted account is a dividend 12.79 A company’s share capital account when tainted, subject to some exceptions, will not be regarded as a share capital account for the purposes of the ITAA36. The most significant exceptions are for the purposes of: the definition of ‘paid-up share capital’ (discussed in Chapter 13); ITAA36 s 44(1B) (discussed in Chapter 13); ITAA36 s 159GZZZQ(5) dealing with off-market buy-backs (discussed in Chapter 13); ITAA97 Div 197 dealing with tainted share capital accounts; and ITAA97 s 202-45(e), which deems a dividend funded from a company’s share capital account to be unfrankable. This means that a tainted share capital account is not a share capital account for the purposes of para (d) of the ITAA36 s 6(1) definition of ‘dividend’. This means that, as discussed in more detail in Chapter 13, a distribution (such as a return of capital) from a tainted share capital

account will be a dividend. The effect of ITAA97 s 202-45(e) is that the dividend will not be frankable. [page 804]

Untainting the share capital account 12.80 A company at any time may irrevocably choose to ‘untaint’ a tainted share capital account. ITAA97 s 197-55 provides that the choice must be in the approved form given to the Commissioner. After a share capital account is untainted, a distribution from it will not be a dividend unless it becomes tainted again. The steps necessary to untaint a share capital account vary according to whether a company has only lowertaxed shareholders (broadly, other companies and foreign residents) or has some higher-taxed shareholders. In both cases, a debit of the company’s franking account may arise due to the decision to untaint the share capital account.

Franking debit may arise on untainting 12.81 A franking debit may arise under ITAA97 s 197-65 when a company chooses to untaint its share capital account. The debit will arise where the applicable franking percentage, as defined in s 19765(3), is higher than the company’s benchmark percentage for the period in which a transfer of an amount that was, or was part of, a tainting amount occurred. The applicable franking percentage, as defined in s 197-65(3), will be the company’s benchmark percentage at the time the choice to untaint was made, provided the company had established a benchmark percentage for the franking period prior to deciding to untaint its share capital account. Where the company has not established a benchmark percentage for that franking period, then the applicable franking percentage will be 100%. The debit is the excess of the amount determined under a formula set out in s 197-65(3) over the amount of the s 197-45 debit that arose when the share capital account was tainted. The formula in s 197-65(3) is:

Note that the formula is the same as the formula in s 197-45 (discussed at 12.78). The difference between the formulae is that, for s 197-45 purposes, the ‘applicable franking percentage’ is defined by reference to the company’s benchmark percentage at the time the share capital account becomes tainted through a transfer of funds into it. By contrast, for s 197-65 purposes, the ‘applicable franking percentage’ is defined by reference to the company’s benchmark percentage at the time the choice to untaint the share capital account is made. Where the company’s benchmark percentage at the later time is greater than its benchmark percentage at the former time, a franking debit will arise under s 197-65(3). A debit will also arise under s 197-65(3), where the company’s benchmark percentage at the former time was less than 100% if it had not established a benchmark percentage for the franking period prior to making the choice to untaint its share capital account. Example 12.28 illustrates the circumstances in which a franking debit can arise under s 197-65(3).

Assume the facts in Example 12.27 with the variation that Alpha Pty Ltd’s benchmark percentage at the time it capitalised the profit was 60%. This would mean that the debit in its franking account [page 805] that arose when its share capital account became tainted would be calculated as follows: $70,000 × 60%/2.33 = $18,025 (Note that here the $25 is merely a product of calculating the corporate tax gross-up rate to two decimal places only. In practice, the amount of the debit would be $18,000.) Assume that Alpha Pty Ltd subsequently chooses to untaint its share capital account in a franking period in which it has established a benchmark percentage of 80%. The amount calculated under ITAA97 s 197-65(3) will be: $70,000 × 80%/2.33 = $24,034

(Note here the $34 is merely a product of calculating the corporate tax gross-up rate to two decimal places only. In practice, the amount of the debit would be $24,000.) Hence, the debit that will arise on untainting the share capital account will be: $24,000 − $18,000 = $6000

1.

2.

What would the s 197-65(3) debit be if the company had not established a benchmark percentage for the franking period prior to choosing to untaint its share capital account? What do you think is the logic behind a franking debit arising in the circumstances set out in Example 12.28?

Payment of untainting tax Company with higher-taxed members 12.82 A company with higher-taxed shareholders will be required to pay untainting tax to untaint its share capital account. Untainting tax is calculated using the following formula in ITAA97 s 197-60(2): Applicable tax amount – (Section 197-45 franking debits + Section 19765 franking debits) The ‘applicable tax amount’ in the formula is defined in s 197-60(3) as:

The ‘tainting amount’ is defined in s 197-50(3) as the sum of: (i) the amount transferred to the company’s share capital account that most recently caused the [page 806]

account to become tainted; and (ii) any subsequent amounts to which Div 197 applies (see the discussion of amounts to which Div 197 applies at 12.77) that were subsequently transferred to the company’s share capital account. In other words, the ‘tainting amount’ is the sum of the initial amount transferred which tainted the company’s share capital account and all subsequent amounts transferred to that account other than amounts within the exceptions noted at 12.77. The reference to the amount transferred that most recently caused the account to become tainted contemplates a situation where a company might have previously tainted its share capital account, then untainted it, and then tainted it again. In that situation, only the amount which tainted the share capital account on the second occasion (and any subsequent amounts to which Div 197 applies) would be taken into account as part of the ‘tainting amount’ for purposes of calculating untainting tax if the company chose to untaint its share capital account for a second time. The ‘notional franking amount’ is defined in s 197-60(4) as:

The ‘applicable tax rate’ is defined in s 197-60(3). Where a company has higher-taxed members in relation to the tainting period, the applicable tax rate is the sum of the top marginal rate plus 3%. The logic of adding the 3% is to produce a rate equivalent to the top marginal rate plus Medicare levy and Medicare levy surcharge. For years where the 2% Temporary Budget Repair levy applies, the applicable rate is increased by two percentage points. Example 12.29 illustrates the calculation of untainting tax where a company has higher-taxed shareholders.

Assume the facts in Example 12.27. Assume that the company chooses to untaint its share capital account at the time it has some higher-taxed shareholders. Assume also that,

at the time it chooses to untaint, Alpha Pty Ltd’s benchmark percentage was again 100%. As the benchmark percentage at the time of tainting and the benchmark percentage at the time of untainting were both 100%, no franking debit will arise at the time of untainting under s 197-65: see the discussion at 12.81. Alpha Pty Ltd will, however, be liable for untainting tax calculated as follows. First, calculate Alpha Pty Ltd’s ‘applicable tax amount’. This is: [$70,000 (tainting amount) + $30,000 (tainting amount × 1/2/33] × 51% = $51,000 The untainting tax payable is equal to the ‘applicable tax amount’ less the sum of the s 197-45 franking debit and the s 197-65 franking debit. Hence, the untainting tax payable in this situation is: $48,000 – [$30,000 (s 197-45 debit) + 0 (s 197-65 debit)] = $21,000

[page 807] Although a distribution from an untainted share capital account will be at least partly sourced in profits that were capitalised, para (d) of the definition of ‘dividend’ in ITAA36 s 6(1) will mean that the distribution will not be a dividend. However, as noted above, the combined company and untainting tax on those profits will be equal to tax at the top marginal rate plus Medicare levy. Thus, the combined company level and shareholder level tax (excluding any CGT liability) will equal the top marginal rate plus Medicare levy.36 Note that a payment of untainting tax does not generate a franking credit.

Company with only lower-taxed members 12.83 Where a company has only lower-taxed shareholders, the same formula discussed in 12.82 is used in calculating any untainting tax that is payable when it chooses to untaint its share capital account. However, in this situation, the ‘applicable tax rate’ used in calculating the ‘applicable tax amount’ in ITAA97 s 197-60(3) is the company’s corporate tax rate for imputation purposes for the income year in which the choice was made. Currently, for a company with an aggregated turnover of less than $10 million, the rate will be 27.5%. For other companies, the rate will be 30%. This means that a company with only lower-taxed shareholders will be liable for untainting tax only where its benchmark percentage was its applicable franking percentage at either

the time of tainting or at the time of the choice to untaint, and its benchmark percentage at either or both of those times was less than 100%.

Anti-capital benefit streaming rules 12.84 In Chapter 13, we discuss the tax effects of different forms of corporate distribution. From that discussion, it should become apparent that, in some circumstances, shareholders may prefer to receive a return of capital or bonus shares rather than a cash dividend. The most obvious example would be shareholders who hold pre-CGT shares. In 1998, provisions that were aimed at discouraging the streaming of capital benefits (such as bonus issues or returns of capital) to these shareholders were inserted into the ITAA36. Note also that the following rules also apply to returns of non-share equity. 12.85 ITAA36 s 45 applies where a company streams the provision of shares37 so that only some shareholders receive shares while some or all of the remaining shareholders receive minimally franked dividends. A dividend will be minimally franked if it is franked to less than 10% or is not franked at all. Shares to which s 45(1) applies are taken to be unfrankable dividends paid to the shareholder out of profits. [page 808] 12.86 ITAA36 s 45A applies where a company streams the provision of capital benefits and the payment of dividends to shareholders, and: the capital benefits are received by shareholders who would derive the greatest benefit from the capital benefits; and ‘it is reasonable to assume that the remaining shareholders … have received, or will receive, dividends’. Section 45A does not apply where s 45 does. Nor does s 45A apply where it is reasonable to assume that the remaining shareholders have

received, or will receive, fully franked dividends. The ‘provision of capital benefits’ is defined as: the provision of shares (such as a non-assessable bonus issue) in the company; the distribution of share capital to the shareholder; and something done in relation to a share (eg, a variation of rights) that increases its value. The circumstances in which a shareholder (the advantaged shareholder) would derive greater benefit from capital benefits than another shareholder (the disadvantaged shareholder) include: where some or all of the advantaged shareholder’s shares are preCGT while none of the disadvantaged shareholder’s shares are; where the advantaged shareholder is a non-resident while the disadvantaged shareholder is a resident; where the cost base of the relevant share to the advantaged shareholder is not substantially less than the value of the capital benefit where this is not the case for the disadvantaged shareholder; where the advantaged shareholder has a net capital loss for the year that the capital benefit is provided while the disadvantaged shareholder does not; where the advantaged shareholder is a private company that, because of former ITAA36 s 46F, would not have been entitled to an inter-corporate rebate on the dividend while the disadvantaged shareholder would have been entitled to an inter-corporate rebate; where the advantaged shareholder has income tax losses while the disadvantaged shareholder does not. 12.87 ITAA36 s 45B applies where, under a scheme in which a person is provided with a capital benefit38 by a company, a taxpayer obtains a tax benefit and, in all the circumstances, it would be concluded that the person, or one of the persons, who entered or carried out the scheme did so for a purpose of enabling the taxpayer to obtain a tax benefit. The definition of ‘capital benefit’ under s 45B is virtually

identical to the definition in relation to ITAA36 s 45A discussed in 12.86. The relevant circumstances to be taken into account in determining the purpose of the person who entered into or carried out the scheme are set out in s 45B(6). Where the scheme involves an increase in the value of a share and a later disposal of the share, or an [page 809] interest in that share, matters set out in s 45B(6) are also relevant circumstances to be taken into account. Under s 45B(9), a relevant taxpayer obtains a tax benefit if the amount of tax payable by him or her would, apart from s 45B, either be less or payable later than the tax that would have been payable if the capital benefit had been a dividend. 12.88 Where the Commissioner makes a determination under ITAA36 s 45A or s 45B, the amount of the capital benefit (or, where relevant, the part of the benefit) is taken via s 45C to be an unfranked dividend paid by the company to the shareholder out of profits. In addition, where the Commissioner has made a determination under s 45B, and makes a further written determination that the whole or part of the capital benefit was paid under a scheme for a non-incidental purpose of avoiding franking debits arising on the distribution, then a franking debit will arise under s 45C(3) in the company’s franking account equal to the debit that would have arisen if the company had paid a dividend equal to the amount of the capital benefit and had fully franked the dividend.39

Changes in corporate ownership: Tax effects other than CGT 12.89 We noted in 12.16 that the separate legal entity status of the company is generally respected for tax purposes. In closely held companies, however, the separate legal entity status of the company

does not reflect economic realities. Such companies are often little more than the alter ego of their controlling shareholder(s). In all companies, many benefits and detriments at the company level will ultimately flow through to shareholders. This can be in the form of higher or lower dividends or liquidator’s distributions or can be reflected in the price of the company’s shares. In determining tax consequences for some transactions, the ITAA97 looks through the separate legal entity doctrine and examines the underlying share ownership in the company. This approach is largely aimed at minimising planning opportunities involving changes in corporate ownership. We shall now discuss some of the more important of these provisions. In 12.140–12.147, we shall discuss some CGT effects of changes in corporate ownership.

Previous loss carry backwards provisions 12.90 In Chapter 9, we noted that a tax loss is deductible to a taxpayer under ITAA97 s 36-10. On 6 May 2012, the then Treasurer announced that companies and entities that are taxed like companies would be permitted to carry back tax losses.40 Legislation giving effect to the announcement was passed by the Commonwealth Parliament as the Tax and Superannuation Laws Amendment (2013 Measures No 1) Act 2013 (Cth), which inserted new ITAA97 Subdiv 160-B dealing with loss carry backs. The loss carry backward provisions were included in the measures to be [page 810] repealed with effect from the start of the 2013–14 income year and later income years by the Minerals Resource Rent Tax Repeal And Other Measures Act 2014 (Cth), which received the Royal Assent on 5 September 2014. As a transitional measure, it was possible to carry back losses to the 2012–13 income year to the extent that the carry back would have been possible had the provisions not been repealed.

Conditions for deducting losses carried forward41 12.91 For a company to deduct a tax loss of a prior year, however, it must pass either the ‘continuity of ownership’ test (set out in ITAA97 s 165-12) or the ‘business continuity’ test. In the absence of these tests, a trade in loss companies might well develop. This is illustrated by Activity 12.4.

If the ‘continuity of ownership’ and ‘business continuity’ tests did not exist, what would a taxpayer who was not in a loss position pay for all the shares in a company which had assets of $2, share capital of $1,000,002 and accumulated losses of $1,000,000? A suggested solution can be found in Study help.

We will now look at the ‘continuity of ownership’ and the ‘business continuity’ tests in more detail.

The ‘continuity of ownership’ test 12.92 Prior to 21 September 1999, the same owners test required that a group of persons have more than 50% control of the company for the whole of the loss year. That same group of persons42 must also have had more than 50% control of the company for the whole of the income year. Under amendments introduced by the New Business Tax System (Integrity and Other Measures) Act 1999 (Cth), the ownership test period is now the period from the start of the loss year to the end of the income year in which the loss deduction is claimed.43 In 12.33, we noted that the ‘continuity of ownership test’ varies according to whether the company is a public or private company for tax purposes. Here, the differences in treatment reflect operational difficulties in applying the same owners test in the context of widely held companies. A private company must actually satisfy the ‘continuity of ownership’ test to obtain a deduction. A public company will pass the ‘continuity of ownership’

[page 811] test if it is reasonable to assume that the test is satisfied. In the case of a listed public company, special rules set out in Div 166 apply.44 These special rules are discussed in Study help.

The primary test 12.93 The primary test of control applies where no other company has a beneficial interest in shares in the company. Under the primary test, to determine whether this substantial continuity of control exists, you must examine the beneficial ownership of: shares carrying voting power (ss 165-12(1) and 165-150); shares carrying dividend rights (ss 165-12(2) and 165-155); and shares carrying rights to capital distributions (ss 12-165(3) and 165-160).45 Special provisions in s 165-180 apply where tax avoidance arrangements are entered into relating to the beneficial ownership of shares, or the nature or exercise of share rights. 12.94 Prior to 21 September 1999, there was no need for a person to own exactly the same shares during either period to satisfy the ‘continuity of ownership’ test. See ITAA97 s 165-165(1) prior to its amendment by the New Business Tax System (Integrity and Other Measures) Act 1999 (Cth). Nor, prior to 21 September 1999, was it necessary for the group of persons who had more than 50% control of the company to hold their shares in the same proportions throughout either period. All that a person needed to show to pass the same owners test was that the same group of persons who held more than 50% control of the company for the whole of the income year also held more than 50% control for the whole of the loss year. Amendments were made to the ‘continuity of ownership’ test in response to recommendations by the Review of Business Taxation. Under amended s 165-165, for shares to be taken into account in determining whether the ‘continuity of ownership’ test is satisfied, a person must own or beneficially own interests in exactly the same shares46 at all relevant

times. Activity 12.5 illustrates the operation of the same owners test in its present form. [page 812]

Blaxland and Wentworth each has 30% control (as defined above) of Blue Mountain Trails Pty Ltd in Year 1. Lawson has 40% control of the company. Is the same owners test passed if Blaxland purchases 50% of Wentworth’s shares in Year 2? Assume that all events take place after 21 September 1999. A suggested solution can be found in Study help.

The alternative test 12.95 An alternative test of control applies where one or more other companies beneficially owned shares or interests in shares in the company at any time during a period commencing at the start of the loss year and ending at the end of the income year: see ITAA97 s 16512. Examples of situations where the test would apply include: where shares in the company are held by another company; where shares in the company are held by a trustee on trust for another company; where shares in the company are held by another company in partnership with another entity.47 It is possible that several layers of interposed entity may be involved. Note, however, that for the alternative test to apply, we need to find that, at some point in a chain of interposed entities, another company48 is the beneficial owner of shares in the company.

[page 813] 12.96 When the alternative test applies, we are looking for a group of natural persons who control, or are capable of controlling, more than 50% of: shares carrying voting power (ss 165-12(1) and 165-150(2)); shares carrying dividend rights (ss 165-12(2) and 165-155(2)); and shares carrying rights to capital distributions (ss 165-12(3) and 165-160(2)). It is enough if it can be shown that it is reasonable to assume that such control exists. Where there are several companies in the chain, control is calculated by successively multiplying ownership interests that the companies hold in each other. This is shown in Figure 12.4.

Figure 12.4:

Applying the alternative test

Applying the alternative test, Johnnie’s interest in Banana Pty Ltd would be calculated by multiplying the interest that he has in Pine Pty

Ltd (100%) by the interest that Pine Pty Ltd has in Orange Pty Ltd (50%) by the interest that Orange Pty Ltd has in Banana Pty Ltd (40%): 100% × 50% × 40% = 20% Thus, under the alternative test, Johnnie would have 20% control of Banana Pty Ltd. Until 21 September 1999, once it had been ascertained who controlled the company under the alternative test, all that was necessary to show to pass the same owners test was that the same group of persons who held more than 50% control of the company for the whole of the income year also held more than 50% control for the whole of the loss year. Following the amendments introduced by the New Business Tax System (Integrity and Other Measures) Act 1999 (Cth), the rule in amended s 165-165 applies, so that for shares to be taken into account in determining if the test is passed, a person must beneficially own, or beneficially own interests in, exactly the same shares at all relevant times. [page 814]

Assume that the facts in Figure 12.4 represent the ownership of Banana Pty Ltd in Year 1. Will Banana Pty Ltd pass the same owners test if Annabel sells her shares in Mango Pty Ltd to Helen and if Pine Pty Ltd sells one-half of its shares in Orange Pty Ltd to Mango Pty Ltd? A suggested solution can be found in Study help.

The ‘business continuity’ test 12.97 Under ITAA97 s 165-10(b), if a company fails the ‘continuity of ownership’ test, it can still deduct its tax loss if it meets the

conditions set out in s 165-13. Section 165-13 applies the ‘business continuity’ test in a way which treats the income year as the ‘business continuity test period’. The ‘business continuity’ test is satisfied if the company, subject to the qualifications discussed in 12.98, throughout the business continuity test period, either carries on the ‘same business’ or a ‘similar business’ as it carried on immediately before the ‘test time’ as set out in a table in s 165-13(2). The test time will usually be the time at which the company first fails the ‘continuity of ownership’ test.49 The legislation provides for a default test time where the company cannot identify the precise time when it failed the ‘continuity of ownership’ test. The default time for tax losses will be the start of the loss year except where the company came into existence during the loss year. In the latter case, the default time will be the end of the loss year. The ‘same business’ test and the qualifications to the test are contained in s 165-210. 12.98 Note that the ‘same business’ test really amounts to one positive test and a series of negative tests that qualify the positive test. In the positive test, a comparison is made between what the company does throughout the ‘same business test period’ (ie, the income year) and what it did immediately before the ‘test time’ (ie, the time after the commencement of the loss year that is immediately before the company first failed the ‘continuity of ownership’ test). The positive test, set out in s 165-210(1), requires that the company carry on the same business in both of these periods. The first qualification to the positive test, set out in s 165-210(2)(a), can be called the ‘new business’ test. The company will fail this test if, at any time during the same business test period, it carried on a business of a kind that it did not carry on before the test time. The second qualification to the positive test, set out in s 165-210(2)(b), can be called the ‘new transaction’ test. The company will fail this test if, at any time during the same business test period, it entered into a transaction of a kind that it had not entered into in the course of its business operations before the test time. Note that further qualifications to the ‘same business’ test are set out in s 165-210(3) and (4).

[page 815] 12.99 The positive ‘same business’ test was strictly interpreted in the High Court decision in Avondale Motors (Parts) Pty Ltd v FCT (1971) 124 CLR 97; 2 ATR 312; 71 ATC 4101.

Avondale Motors (Parts) Pty Ltd v FCT Facts: Prior to 1 April 1968, the taxpayer company was called C & G Parts Pty Ltd. Prior to June 1967, the taxpayer’s business involved selling motor parts and accessories to another company in the same group as well as to other motor dealers and the general public. Seventy-five per cent of the parts sold were for use only in vehicles the subject of the other group company’s franchise. The remainder of the parts sold could be used in other motor vehicles as well. In 1967, as a result of financial difficulties, the taxpayer closed all its business premises, paid off its employees, and sold all its stock and most of its plant. Its business activities until February 1968 were confined to collecting and paying debts. The taxpayer’s parent company sold all its shares in the taxpayer on 15 March 1968 to Avondale Motors Pty Ltd. The taxpayer’s name was subsequently changed to Avondale Motors (Parts) Pty Ltd. Following the change of name, the taxpayer took over a business of supplying motor parts and accessories previously conducted by another company in the Avondale Motors group. The taxpayer’s business was thereafter conducted at new premises, with new stock in trade and with different employees. The motor vehicle parts supplied were suitable for different makes of vehicle from those that it had supplied previously. Some of its suppliers and customers, however, were the same. Issue: Given that the taxpayer did not pass the same owners test, could it claim a deduction for its prior year losses on the basis that it passed the ‘same business’ test? Held: Gibbs J held that the taxpayer did not pass the ‘same business’ test. This was so, even assuming that the taxpayer’s business was merely suspended and had not ceased between June 1967 and March 1968. The taxpayer’s business after the change of ownership was not identical with the business that it carried on immediately before the change. This was simply a question of fact. A taxpayer may expand or contract its activities without starting a new business. Here, the taxpayer carried on the same kind of business but under a different name, at different places, with different directors and employees, with different stock and plant and in conjunction with a motor dealer having different franchises. Thus, the only conclusion that could be drawn was that, after 15 March 1968, the taxpayer’s business was different from the business it carried on before that date.

[page 816] Importantly, Gibbs J held (at CLR 105–6) that it was not enough that the businesses were similar in their nature: The meaning of the phrase “same as”, like that of any other ambiguous expression, depends on the context in which it appears. In my opinion, in the context of the section, the words “same as” import identity and not merely similarity and this is so even though the legislature might have expressed the same meaning by a different form of words. It seems to me natural to read the section as referring to the same business, in the sense of the identical business, and this view is supported by a consideration of the purposes of the section. The relevant sections of the Act show an intention on the part of the legislature to impose, in the case of companies, a special restriction on the ordinary right of a taxpayer to treat losses incurred in previous years as a deduction from income. The company cannot take the losses into account if there has been a change in the beneficial ownership of its shares, or of the shares in the company of which it is a subsidiary, of the kind mentioned in s 80A or s 80C. This restriction is imposed to prevent persons from profiting by the acquisition of control of a company for the sole purpose of claiming its accrued losses as a tax deduction. However, the restriction if imposed absolutely would lead to injustice in cases where a company, notwithstanding substantial changes in the ownership of its shares, continued to carry on the same business. No injustice would, in my opinion, result from a refusal to treat an accrued loss as a tax deduction where the company, after the change, carried on a different business, although one of a similar kind. In such a case, as a general rule, there would have been no business reason for the purchase of the shares, but only the wish to obtain the right to claim another’s losses as a deduction from one’s own income. To allow the accrued losses to be claimed as deductions in a case where shares in a company had been acquired, not for the purpose of carrying on any existing business of the company, but simply for the purpose of “buying” its accrued losses, would be to reward an obvious device for no intelligible reason.

12.100 The Commissioner’s views of the meaning of ‘business’ and ‘same business’ in the positive same business test have been set out in Taxation Ruling TR 1999/9. [page 817]

TR 1999/9 12. … For the purpose of the same business test, a company is treated as carrying on one overall business at the change-over and during [the same business test period] since

the reference to ‘business’ in the same business test is a reference to all of the activities carried on by the company at the change-over and during [the same business test period], irrespective of whether those activities constitute or are treated by the company as constituting separate or distinct activities, enterprises, divisions or undertakings carried on by the company. 13. In the same business test, the meaning of the word ‘same’ in the phrase ‘same business as’ imports identity and not merely similarity; the phrase ‘same business as’ is to be read as referring to the same business, in the sense of the identical business. However, this does not mean identical in all respects: what is required is the continuation of the actual business carried on immediately before the change-over. Nevertheless, it is not sufficient that the business carried on after the change-over meets some industry wide definition of a business of the same kind; nor would it be sufficient for there to be mere continuance of business operations from immediately before the change-over into the period of recoupment, if the business had so changed that it could no longer be described as the same business. The analysis of whether the same business continues after the change-over may give rise to questions of degree and ultimately depends on the facts of the case. In making the analysis it needs to be acknowledged that a company may expand or contract its activities without necessarily ceasing to carry on the same business. The organic growth of a business through the adoption of new compatible operations will not ordinarily cause it to fail the same business test provided the business retains its identity; nor would discarding, in the ordinary way, portions of its old operations. But, if through a process of evolution a business changes its essential character, or there is a sudden and dramatic change in the business brought about by either the acquisition or the loss of activities on a considerable scale, a company may fail the test. 14. …The new business test puts a limit on the type of expansion the company may undertake if it is to retain the benefit of accumulated losses; for the taxpayer may not engage in an undertaking or enterprise of a kind in which it did not engage before the change-over and still benefit from accumulated losses. [Footnotes omitted]

12.101 In Taxation Ruling TR 1999/9, the Commissioner notes that the meaning of ‘business’ in the ‘new business test’ in s 165-210(2)(a) is different from its meaning in the positive ‘same business’ test. The Commissioner’s comment on this test is as follows. [page 818]

TR 1999/9

14. … In the new business test the word ‘business’ has a different meaning from the word ‘business’ in the same business test; it refers to each kind of enterprise or undertaking comprised in the overall business carried on by the company at the change-over and during the period of recoupment.

12.102 In Taxation Ruling TR 1999/9, the Commissioner sees the ‘new transactions’ test as being primarily directed at transactions motivated by tax avoidance. TR 1999/9 15. … The new transactions test is directed to preventing the injection of income into a loss company that has satisfied the same business test and the new business test. The new transactions test includes all transactions entered into in the course of the company’s business operations and not merely those that are ‘isolated’ or ‘independent’. However, generally speaking, the new transactions test is not failed by transactions of a type that are usually unmotivated by tax avoidance, namely, transactions that could have been entered into ordinarily and naturally in the course of the business operations carried on by the company before the change-over. Conversely, a transaction entered into during [the same business test period] and which is outside the course of the business operations before the change-over, or which is extraordinary or unnatural when judged by the course of the business operations before the change-over, is usually a transaction of a different kind from the transactions actually entered into by the company before the change-over.

Example 12.30 illustrates how the ‘same business’ test would apply.

Giant Pty Ltd made a tax loss in Years 1 and 2. For the whole of Years 1 and 2, the sole shareholder in Giant Pty Ltd was Jack. On 1 July Year 3, Jack sold all his shares in Giant Pty Ltd to Fasholt and Fafner. At all times in Years 1 and 2, the business of Giant Pty Ltd consisted of the sale of golden eggs laid by a special hen. On 1 August Year 3, Giant Pty Ltd had the hen mated and allowed one of the golden eggs to hatch. The chick that hatched was a female and she soon began laying golden eggs. [page 819]

In Year 3, due to oversupply from the use of two hens, the price of gold was falling. On 1 October Year 3, Giant Pty Ltd decided to add value to its product by producing golden rings from the eggs laid by the second hen. After 1 July Year 3, Giant Pty Ltd fails the ‘same owners’ test. Thus, whether it can carry forward the tax losses from Years 1 and 2 depends on whether it passes the ‘same business’ test. Under Taxation Ruling TR 1999/9, the mere expansion of Giant Pty Ltd’s business by the acquisition of an extra golden-egg-laying hen will not mean that it fails the same business test. However, diversification of the business into the production of golden rings may mean that Giant Pty Ltd fails the ‘new business’ test as it has not conducted an enterprise or undertaking of this type before.

More recent cases illustrate how strictly the same business test is applied by the courts. The Full Federal Court held, in Coal Developments (German Creek) Pty Ltd v FCT 2008 ATC 20-011, that a company which failed the ‘continuity of ownership’ test in 1998 was unable to deduct a loss incurred before that time in its income tax year ending 31 December 2001 (a substituted accounting period used by the company). It was agreed that the company had carried on the same business (an interest in a coal mining joint venture) until 25 June 2001. On 25 June 2001, the taxpayer company sold its interest in the coal mining joint venture to Anglo Coal Australia Pty Ltd. Between 25 June 2001 and 31 December 2001, the taxpayer company carried on activities (the computation of the purchase price of assets and of a ‘tax adjustment’, the novation of agreements, the finalisation of the taxpayer company’s obligations under mining leases, and the preparation and finalisation of financial statements and statutory returns, including income tax returns, of the taxpayer company) which it claimed amounted to it continuing to carry on the joint venture business. The Full Federal Court held that the taxpayer ceased to carry on the business on 25 June 2001 when it disposed of it to Anglo Coal Australia Ltd. While it was possible that some of the activities of the company could, in other circumstances, be part of carrying on a business, given that all the assets of the business were sold to a single purchaser they were more explicable as being engaged in as a consequence of winding down the business. In Lilyvale Hotel Pty Ltd v FCT 2008 ATC 20-038, Stone J, at first instance, held that a business of managing a hotel carried on by the

taxpayer immediately after it failed the continuity of ownership test was not identical to the business that it carried on prior to that time when another company managed the hotel as agent for the taxpayer. On appeal, Lilyvale Hotel Pty Ltd v FCT 2009 ATC 20-094; [2009] FCAFC 21, the Full Federal Court (Edmonds, Graham and Perram JJ) held that the same business test had been satisfied. At all times, the taxpayer had conducted a business of owning and operating a hotel. Edmonds and Graham JJ stated that the fact that, at one stage, the taxpayer managed the hotel by using a hotel management company and, at another time, managed the hotel itself was a distinction without a [page 820] difference having no bearing on the identification of the business which the appellant carried on. Perram J held that the management company’s business was not the business of operating a hotel but of providing management services. At all times, the taxpayer was carrying on a business of operating a hotel. Perram J observed (at [56]): … a person does not cease to carry out an activity because he or she carries out the activity through an agent. The whole point of the law of agency involves the attribution of the activities in fact carried out by one person to the legal account of another.

12.103 As noted at 12.97, under amendments to be introduced by Treasury Laws Amendment (2017 Enterprise Incentives No 1) Bill 2017, a company will also satisfy the ‘business continuity’ test if it satisfies the ‘similar business’ test in relation to a loss year starting on or after 1 July 2015. The conditions for satisfying the ‘similar business’ test are set out in proposed ITAA97 s 165-211. To satisfy the test, the company must carry on throughout the business continuity test period50 a business (‘its current business’) that is similar to the business it carried on immediately before the test time51 (‘its former business’). Subsection 165-211(2) requires that the following matters52 be taken into account in ascertaining whether the company’s current business is similar to its former business:

the extent to which the assets (including goodwill) that are used in the current business to generate assessable income throughout the business continuity test period were also used in the former business; (b) the extent to which the activities and operations from which its current business generated assessable income throughout the business continuity test period were also the activities and operations from which its former business generated assessable income; (c) the identity of its current business and the identity of its former business; and (d) the extent to which any changes to its former business result from development or commercialisation of assets, products, processes, services or marketing or organisational methods of the former business. However, in a similar fashion to the requirements of the same business test, s 165-211(3) provides that a company does not satisfy the business continuity test under s 165-211 if before the test time it either: (a) started a new business; or (b) entered into a new kind of transaction for the purpose, or for purposes that included the purpose, of being taken to have carried on a similar business throughout the business continuity test period to the business it carried on before the test time. (a)

12.104 Companies are able to choose the proportion of their prior year losses which they deduct in the current year. Where a company’s deductions, other than loss carry forward deductions mean that it has excess franking credit offsets, other amendments convert the excess offsets into a tax loss. The effects of these amendments in the context of inter-corporate dividends are discussed at 13.90–13.93. [page 821]

Current year loss provisions 12.105

The current year loss provisions are contained in ITAA97

Subdiv 165B. These provisions apply the ‘same owners’ and ‘business continuity’ tests where a company has a ‘notional loss’ for the period of the income year up to the time ownership of the company changed. A notional loss will arise where the company’s deductions for the year of income up to the time of change of ownership exceed its assessable income for that period. Where the company fails both the ‘same owners’ and the ‘business continuity’ tests, it is not permitted to deduct the notional loss in ascertaining its taxable income for the year. Rather, the notional loss gives rise to a tax loss which can be carried forward and offset against assessable income in future years provided the company satisfies the ‘same owners’ and ‘business continuity’ tests.

Group loss transfers 12.106 ITAA97 Subdiv 170-A formerly permitted tax losses to be transferred between companies in the same wholly owned group. As from 1 July 2003, losses may be transferred between companies in nonconsolidated wholly owned groups only in limited circumstances. The circumstances in which losses can be transferred within nonconsolidated wholly owned groups on or after 1 July 2003 are discussed in Study help.

Bad debt deductions 12.107 Bad debt deductions, discussed generally in Chapter 7, are only available to a company if it satisfies the ‘continuity of ownership’ and ‘business continuity’ tests set out in ITAA97 Subdiv 165-C. The tests applied here are much the same as those discussed in 12.91–12.103 in the context of carrying forward a loss. The main differences relate to the periods in which the tests must be satisfied. To pass the ‘continuity of ownership’ test, the same owners must control the company, in the sense discussed in 12.92–12.96, for the whole of the period from the ‘first continuity period’ to the end of the ‘second continuity period’: see ss 165-120 and 165-123. 12.108 Where the bad debt deduction53 was incurred in a previous income year, the ‘first continuity period’ starts when the bad debt was

incurred and ends at the end of that previous year. In these circumstances, the ‘second continuity period’ is the current income year. 12.109 Where the bad debt deduction is incurred in the current year, the ‘first continuity period’ starts at the start of the current year and ends on the day the bad debt was incurred. The ‘second continuity period’ starts on the day after the bad debt is incurred and ends on the last day of the current year. Note, however, that s 165-120(3) provides that a bad debt that a company incurs on the last day of a current income year is not deductible. [page 822] 12.110 The alternative ‘continuity of ownership’ test, discussed in 12.95–12.96, is applied where one or more companies beneficially owned shares, or an interest in shares, in the company at any time during the first or second continuity periods. 12.111 The ‘business continuity’ test also applies for bad debt purposes, if the company fails to pass the ‘continuity of ownership’ test. In applying the ‘business continuity’ test, a comparison is made between the business that the company carried on for the minimum continuity period with the business that it carried on during the second continuity period. The minimum continuity period is the part of the first continuity period, commencing at the start of the period, during which the company satisfied the continuity of ownership test in all respects. There is a default test time where the company cannot identify the precise time when it failed the continuity of ownership test. Where the debt was incurred during the current year, the default time will be the start of the current year, provided the company was in existence throughout the current year. Where the debt was incurred prior to the current year or where the company was not in existence throughout the current year, the default time will be the end of the day on which the debt was incurred.

Consolidated groups Overview of consolidations for income tax purposes 12.112 As from 1 July 2002, wholly owned groups of entities can elect to be consolidated for income tax (but not FBT or GST) purposes. Where this election is made, the consolidated group is treated as a single entity (the head entity) for tax purposes: see ITAA97 s 701-1. In other words, the subsidiary companies, partnerships and trusts that may form part of the consolidated group are not treated as being separate from the head entity.54 Intra-group transactions (such as the payment of dividends) are ignored for income tax purposes, although special rules (discussed at 12.117–12.130) apply in relation to losses and the cost base of assets. All wholly owned Australian entities in a group are required to be included once the irrevocable choice to consolidate has been made. A single income tax return, based on a common accounting period, is lodged for a consolidated group. Tax for the consolidated group is paid by the head entity. In a consolidated group, any accounts that the ITAA97 requires a company to maintain (such as a franking account) are kept on a consolidated basis. Following a transitional period, the previous grouping rules (such as those relating to the transfer of group losses and intra-group roll-overs) generally ceased to apply [page 823] as from 1 July 2003. The previous rules relating to intra-group dividends, intra-group loss transfers and intra-group asset roll-overs are discussed in Study help. In general, the head company is regarded as taking over the tax characteristics, such as capital allowances or loss carry forwards (subject to a continuity of ownership/or business continuity test being

satisfied as discussed below), that a subsidiary member of the group had before it joined: see ITAA97 s 701-5. Subsidiaries that leave a consolidated group take with them the assets, liabilities and businesses that they brought into the group. When a subsidiary leaves the group, it is regarded as taking with it the assets, liabilities and business as affected by events that happened while they were the assets, liabilities and businesses of the head company: see s 701-40. Note that subsidiaries that leave a group do not take with them tax losses that they brought into the group. The consolidation provisions also contain rules for determining the cost bases to a head company of the assets of a company that joins a consolidated group. These rules are mirrored by provisions that determine the cost base of interests in a subsidiary that leaves a consolidated group. Other rules determine the cost base of assets in several other situations such as when a consolidated group is formed or when a head company is acquired by another consolidated group.

Forming a consolidated group 12.113 Under ITAA97 s 703-50, the head company of a group makes the choice in writing to consolidate the group for income tax purposes and is required to give the Commissioner a notice in the approved form containing information about the group. Under s 703-58, the consolidated group comes into existence on the date the choice in writing is made. The notice to the Commissioner must include: (a) the identity of the head company; (b) the day specified in the choice on which the consolidatable group is taken to be consolidated; (c) the identity of each subsidiary member of the group on that day; (d) the identity of each entity that was a subsidiary member of the group on that day but was not such a subsidiary member when the notice is given; (e) the identity of each entity that was not a subsidiary member of the group on that day but was such a subsidiary member when the notice is given; (f) the identity of each entity that became a subsidiary member of the group after that day but was not such a subsidiary member when the notice is given.

The notice must be signed by an authorised person. The notice must be given when the head company lodges its tax return for the year in which it makes the choice in writing to consolidate the group. Where the head company is not required to lodge [page 824] an income tax return for that year the notice must be given by the last day on which it would have been required to lodge an income tax return for the year in which the choice was made if it were required to lodge an income tax return for that year. A notice must also be given within 28 days when an entity enters or exits from the group or when the group ceases to exist. The effect of s 703-10 is that a consolidatable group must have a head company with at least one subsidiary entity. A consolidatable group cannot consist of a head company alone. Note, however, that if all the subsidiary entities in the group left the group after it consolidated, under s 703-5(2) and (3) the group would continue to be a consolidated group until the head company ceased to be a head company or became a member of a multiple entry consolidated (MEC) group. (MEC groups are discussed at 12.116.) The head entity of a consolidated group is (subject to the operation of ITAA97 Subdiv 713C discussed below) required to be a company (which can for these purposes include a corporate limited partnership). Item 1 in the table in s 703-15(2) sets out the conditions that a company must satisfy to be a head entity for a consolidated group. 703-15 Members of a consolidated group or consolidatable group (2) At a particular time in an income year, an entity is: (a) a head company if all the requirements in item 1 of the table are met in relation to the entity; or (b) a subsidiary member of a consolidated group or consolidatable group if all the requirements in item 2 of the table are met in relation to the entity: Head companies and subsidiary members of groups Column 1

Column 2

Column 3

Column 4

Entity’s role in relation to group 1 Head company

Income tax treatment requirements

Australian residence requirements

Ownership requirements

The entity must be a company (but not one covered by section 703-20) that has all or some of its taxable income (if any) taxed at a rate that is or equals the corporate tax rate

The entity must be an Australian resident (but not a prescribed dual resident)

The entity must not be a wholly-owned subsidiary of another entity that meets the requirements in columns 2 and 3 of this item or, if it is, it must not be a subsidiary member of a consolidatable group or a consolidated group

The requirements that must be met before an entity can be a subsidiary member of a consolidated group are set out in item 2 in the table in s 703-15(2): [page 825] Head companies and subsidiary members of groups Column 1

Column 2

Column 3

Column 4

Entity’s role in relation to group

Income tax treatment requirements

Australian residence requirements

Ownership requirements

2 Subsidiary member

The requirements are that: (a) the entity must be a company, trust or partnership (but not one covered by section 703-20); and (b) if the entity is a company all or some of its taxable income (if any) must be taxable apart from this Part at a rate that is or equals the

The entity must: (a) be an Australian resident (but not a prescribed dual resident), if it is a company; or (b) comply with section 703-25, if it is a trust; or (c) be a partnership

The entity must be a wholly-owned subsidiary of the head company of the group and, if there are interposed between them any entities, the set of requirements in section 703-45, section 701C-10 of the Income Tax (Transitional Provisions) Act 1997

corporate tax rate; and (c) the entity must not be a non-profit company (as defined in the Income Tax Rates Act 1986)

or section 701C-15 of that Act must be met

Note that certain entities, set out in s 703-20, cannot be members of a consolidated group. These are: entities that are tax exempt under ITAA97 Div 50; certain credit unions; pooled development funds; licensed film investment companies; complying superannuation funds; non-complying approved deposit funds; and non-complying superannuation funds. Certain subsidiaries of life insurance companies cannot be members of a consolidated or a consolidatable group in circumstances set out in s 713-510. It should be noted, however, that public trading trusts that are effectively taxed as companies under ITAA36 Pt III 6C can, under ITAA97 Subdiv 713-C, be head [page 826] entities of a consolidated group.55 A corporate limited partnership will also be regarded as a company for these purposes. In general, a subsidiary member must be a wholly owned subsidiary of the head company of the consolidated group. For these purposes, a wholly owned subsidiary of a holding entity is defined in s 703-30. 703-30 When is one entity a wholly-owned subsidiary of another? (1) One entity (the subsidiary entity) is a wholly-owned subsidiary of another entity (the holding entity) if all the membership interests in the subsidiary entity are beneficially

(a) (b) (c) (2) (a)

owned by: the holding entity; or one or more wholly-owned subsidiaries of the holding entity; or the holding entity and one or more wholly-owned subsidiaries of the holding entity. An entity (other than the subsidiary entity) is a wholly-owned subsidiary of the holding entity if, and only if: it is a wholly-owned subsidiary of the holding entity; or

12.114 The membership interests in a subsidiary entity are determined under the debt/equity rules discussed at 12.25. Under ITAA97 s 960-130(1), a member of a company or a stockholder in a company will have a membership interest in the company. If, however, a person holds an interest (such as finance shares) that the debt/equity rules classify as a debt interest, then the effect of s 960-130(2) is that the person will not have a membership interest in the company unless the person also holds ordinary shares in the company. Moreover, even though the debt/equity rules might classify an interest (such as a convertible note) as a non-share equity interest, a person who holds only convertible notes will not have a membership interest in the company. This is because the person will not be a member or stockholder in the company. Nonetheless, under amendments introduced by the Tax Laws Amendment (2010 Measures No 1) Act 2010 (Cth), the allocable cost amount for an entity joining a consolidated group is increased to reflect the amount received by the joining entity for the issue of such interests (described for these purposes as ‘non-membership equity interests’). Asset cost setting in consolidation is discussed at 12.123–12.126. In addition, it should be noted that entities can be subsidiary members even though they are not wholly owned by a head company or by a subsidiary member. The principal situations where this can occur are where the entity is held through a non-fixed trust or where up to 1% of the issued shares in the company are held [page 827]

under an employee share scheme. The provisions dealing with these situations are discussed in Study help.

Interposed shelf company 12.115 Where a company is interposed between a head company of a consolidated group and its shareholders via a share-for-share exchange, the interposed company can elect that the consolidated group continue with the interposed company as the new head company: ITAA97 ss 615-30(2), 703-65 and 703-70. If the interposed company makes this irrevocable choice, the former head company becomes a subsidiary member of the consolidated group. The interposed company becomes the new head company and everything that happened to the original head company is regarded as having happened to the interposed company as if it had been the head company at all times during the group’s existence. The circumstances in which an interposed company may elect for a consolidated group to continue are shown in Figure 12.5.

Figure 12.5:

Consolidated group prior to new head company being interposed

Multiple entry consolidated groups 12.116 Two or more Australian subsidiaries (eligible ‘tier one companies’) of a foreign company (the ‘top company’) may elect to form a multiple entry consolidated

[page 828] (MEC) group. In addition, an existing consolidated group will be converted into an MEC where the head company of the group becomes an eligible tier one company and one or more other members of the group are eligible tier one companies. In an MEC group, one of the eligible tier one companies is required to be the head company of the group. The other companies in the group are regarded as subsidiaries of the head company. Because of the distinctive characteristics of an MEC group, modifications are made to the rules relating to: the cost base of assets of eligible tier 1 companies in the group; the effects of transfers of assets within the MEC group; the effects of disposals of membership interests; the rate of utilisation of losses when a new eligible tier 1 company joins the MEC group; and the application of the continuity of ownership test after the MEC group is formed. Under amendments introduced by the Tax Laws Amendment (2010 Measures No 1) Act 2010 (Cth), subject to certain integrity rules, only minimal tax consequences will arise for ongoing members of a group when a consolidated group converts to an MEC group or where an MEC group converts to a consolidated group.

Tax losses in consolidation 12.117 Under ITAA97 s 707-120(1), when an entity has tax losses, net capital losses or foreign losses when it becomes a member of a consolidated group, those losses are transferred to the head company to the extent that the entity joining the group could have utilised them if it had not joined the group (but had remained a wholly owned subsidiary of the head company where the joining entity is not the head entity). For these purposes, the joining entity’s income or gains for the relevant trial year are not relevant in determining the extent to which the joining entity could have utilised the losses. Where the joining entity is a

company, s 707-120(1) will mean that the losses will only be able to be transferred to the head company if the joining entity passes the ‘continuity of ownership’ test for the period between the start of the loss year and the end of a trial year that, generally, will be a 12-month period ending immediately after the entity joined the consolidated group. The ‘continuity of ownership’ test is discussed in detail at 12.91–12.96.

Ravine Ltd is the head company in a consolidated group. For the year ending 30 June 2013, Cavern Pty Ltd incurred a tax loss of $500,000. As at 1 July 2012, Cave Pty Ltd had a 60% shareholding in Cavern Pty Ltd. The shareholders in Cave Pty Ltd were Anna and Tony, who each own 50% of the shares in the company. All shares in the company have the same rights. The remaining shares in Cavern Pty Ltd were held by Ravine Ltd (neither Anna nor Tony own any shares in Ravine Ltd). [page 829] On 1 July 2015, Ravine Ltd acquires all the remaining shares in Cavern Pty Ltd, which becomes part of the Ravine Ltd consolidated group. The ‘continuity of ownership’ test will not be passed immediately after Cavern Pty Ltd joined the consolidated group as, during the loss year, Anna and Tony held the majority underlying interests but they did not hold majority underlying interests in Cavern Pty Ltd after Cavern Pty Ltd joined the consolidated group. Hence, Cavern Pty Ltd’s loss carry forward will be able to be transferred to the consolidated group only if Cavern Pty Ltd passes the ‘same business’ test.

12.118 If the company fails the ‘continuity of ownership’ test, then its losses can still be transferred to the group if the transferor company satisfies the ‘business continuity’ test in a period which varies according to when the loss was incurred. The effect of the legislation is that, where the loss was incurred before 1 July 1999, the joining company must carry on the same business during a trial year being the 12-month period ending immediately prior to the time when it joined the group as it carried on immediately before it failed the ‘continuity of ownership’

test. Where the loss was incurred on or after 1 July 1999 and before 1 July 2015 then, under s 707-125, the joining company must carry on the same business immediately before the end of the income year in which the loss was incurred, immediately before it failed the ‘continuity of ownership’ test, and during the trial year being 12-month period ending immediately prior to when it joined the group. From 1 July 2015, under the business continuity test the company can either carry on the same business for these periods or carry on a similar business for these periods. The ‘business continuity’ test is discussed in detail at 12.97–12.132. Under ITAA97 s 707-150, to the extent that a loss cannot be transferred from the joining entity to the head company, the loss cannot be utilised by any entity for an income year ending after the time when the joining entity joined the group.

Assume the facts in Example 12.31. As the loss was incurred after 1 July 1999, for the loss incurred in the year ending 30 June 2013 to be transferred to the consolidated group, it must be shown that Cavern Pty Ltd carried on the same business or a similar business immediately before 30 June 2013 as it carried on immediately before it joined the group on 1 July 2015, and as it carried on during the year commencing on 2 July 2014 and ending immediately before it joined the group on 1 July 2015.

12.119 Where losses are transferred to the head company on the basis that the ‘continuity of ownership test’ was passed, then (provided the ‘business continuity’ test [page 830] was not also passed) subsequent changes in the underlying beneficial ownership of the head company may mean that the head company is able to utilise the loss only if it passes the ‘business continuity’ test. It is important to remember that the only changes that take place after the

entity joins the group that are taken into account in determining whether or not the loss can be utilised are changes in the ownership of the head company. This is because the loss year is regarded as starting when the loss was transferred to the head company. It is equally important to note, however, that changes in the ownership of the subsidiary entity in the period between the start of the actual loss year and immediately after the entity joins the group are taken into account. In simple terms, what the rules do here is check whether changes in the underlying ownership of the head company after the subsidiary entity joins the group mean that the ‘continuity of ownership’ test is not passed in relation to the loss for the period between the start of the actual loss year and the time when the change in ownership of the head company occurs. If the ‘continuity of ownership’ test is failed, then the head entity will be able to utilise the loss only if the ‘business continuity’ test is passed by the head company.

Assume the facts in Example 12.31 with the variation that, for the year ending 30 June 2012, Ravine Ltd held 60% of the shares in Cavern Pty Ltd while Cave Pty Ltd held 40% of the shares. In these circumstances, Cavern Pty Ltd did pass the ‘continuity of ownership’ test at the time it entered the consolidated group. Assume, however, that Cavern Pty Ltd failed the ‘business continuity’ test at the time it joined the consolidated group. Assume that on 1 December 2014, Magnate Ltd acquires a 40% interest in Ravine Ltd. After taking into account the pre-consolidation change in the ownership of Cavern Pty Ltd (40%) and the post-consolidation change in the ownership of Ravine Ltd (40%), there has been only a 60% × 60% = 36% continuity in relation to the ultimate ownership of Cavern Pty Ltd since the start of the loss year. Thus, Ravine Ltd will only be able to utilise the loss if it passes the business continuity test.54

12.120 Somewhat strangely, where the ‘business continuity’ test is passed at the time of consolidation, the ‘continuity of ownership’ test is applied only in relation to the head entity and not in relation to the subsidiary entity whose losses were transferred when it joined the consolidated group.56

[page 831]

Assume the facts in Example 12.32 and assume that Cavern Pty Ltd did pass the business continuity test at the time it joined the consolidated group. Remember that Magnate acquired 40% of the shares in Ravine Ltd on 1 December 2014. As the business continuity test was passed at the time when Cavern Pty Ltd joined the consolidated group, we only look at subsequent changes in the ownership of Ravine Ltd in determining whether the continuity of ownership test is passed. As there has only been a 40% change in ownership of Ravine Ltd in the relevant period, the continuity of ownership test has been satisfied.

12.121 Further rules limit the extent to which a head company can utilise transferred losses. In broad terms, these rules mean that the head company is only able to utilise transferred losses in an income year: up to the income or gains that it has for that year; up to an amount which approximates the extent to which the joining entity would have been able to utilise them if it had not become a part of the group. The latter amount is determined by multiplying the income and gains less deductions and losses of the group by a fraction in which the market value (determined using certain assumptions such as ignoring the value of franking account balances and interests in other group entities) of the joining entity at the time of joining is the numerator while the denominator is the market value (again determined using certain assumptions such as ignoring losses and franking account balances) of the head entity at the time of transfer. Previously, where the joining entity’s liabilities exceeded its assets, it was regarded as having a market value of nil. This meant that any losses transferred to the head company would have an available fraction of nil and would never be able to be used by the consolidated group. Under amendments introduced by the Tax Laws Amendment (2009 Measures

No 4) Act 2009 (Cth), in these circumstances, the head entity is able to apply the losses to either: reduce a net forgiven amount under the commercial debt forgiveness rules; reduce a capital allowance that is adjusted under the limited recourse debt rules; or reduce the capital gain that arises under CGT event L5 when the joining entity subsequently leaves the group. 12.122 Losses are categorised into bundles for the purpose of determining the extent to which transferred losses can be utilised by a head company. Losses that are transferred at a particular time are bundled together and treated as being made by the head company in the same income year. Losses are also categorised into different sorts on the basis of whether they were transferred to the head company via the ‘continuity of ownership’ or the ‘same business’ tests. Loss fractions are calculated for each bundle of losses. [page 832]

Asset cost setting in consolidation 12.123 The basic rules for asset cost setting in consolidation are set out in ITAA97 Subdiv 705-A.57 These rules deal with the situation where an entity becomes part of a consolidated group. In that situation, in effect, the consolidation rules look through the subsidiary entity and regard the head company as owning the underlying assets of the subsidiary entity. However, the head company will not have acquired the assets directly — rather, the head company will have acquired the assets indirectly by a purchase of interests (such as shares) in the joining entity. The consolidation provisions contain a set of rules for determining the cost bases of the assets of the subsidiary to the head company by working from the greater of the amount paid for interests (such as shares) in the subsidiary or the market value of those interests. Under amendments introduced by the Tax Laws Amendment (2010

Measures No 1) Act 2010 (Cth), the head company is able to use the cost setting amount of an asset for other income tax law purposes such as depreciation. When a company joins a consolidated group, the asset cost setting process involves three basic steps: 1. determining the allocable cost amount for the joining entity; 2. reducing the allocable cost amount by the sum of the tax cost setting amounts for retained cost base assets of the subsidiary member; and 3. apportioning the balance of the allocable cost amount to the subsidiary member’s reset cost base assets in proportion to their market values. We shall now examine each of these steps in more detail.

Determining the allocable cost amount for joining entity 12.124 The allocable cost amount for a joining entity is determined using a series of steps set out in ITAA97 s 705-60. Figure 12.6 is a simplified58 account of the steps. [page 833] Note that Step 3A (which relates to pre-joining time intra-group rollovers from foreign resident companies) has been omitted.59

Figure 12.6:

Determining the allocable cost amount

The steps in the process are illustrated in Example 12.35.

Magnate Ltd acquires all the shares in Minor Pty Ltd from Mr and Mrs Mini on 1 July 2017 for $450,000. At the time of the acquisition, the market value of the shares was $500,000 and Minor Pty Ltd owed $100,000 to Big Bank Ltd. At the time of the share acquisition, Minor Pty Ltd had $70,000 in taxed profits accrued and [page 834] a credit balance in its franking account of $30,000. Minor Pty Ltd incurred a tax loss of $50,000 in the year ending 30 June 2014. Minor Pty Ltd has carried on the same business at all times between 1 July 2014 and 1 July 2017. On 1 July 2013, Minor Pty Ltd spent $100,000 on a feasibility study for a project that it subsequently proceeded with on 1 July 2015, and claimed deductions for the feasibility study under ITAA97 s 40-880. Note that the deductions will be amortised over a five-year period. The allocable cost amount would be calculated as follows:

Costs of membership interests in Minor

$450,000*

Pty Ltd Add value of liability to Big Bank Ltd Add undistributable taxed profits accruing to the joined group Subtract losses transferred to head company Subtract deductions to which the head company is entitled Allocable cost amount

$100,000 $70,000** $50,000*** $60,000**** $510,000

*

Note that where the market value of the shares is more than their cost, the allocable cost amount will be the cost of the shares. In other cases, the allocable cost amount is the greater of the market value of the interest or its reduced cost base of the interest. ** The undistributed taxed profits are calculated under s 705-90. The calculation starts with the undistributed profits of the company as determined under the joining entity’s accounting principles for cost setting. The franking account balance of the company is then grossed up by the applicable gross-up rate. Only so much of the accounting profit as does not exceed the grossed-up franking account balance will be regarded as undistributed taxed profits. *** Although Minor Pty Ltd fails the continuity of ownership test, the same business test has been passed so the losses may be transferred to the head company. **** Calculated as the outstanding Subdiv 40-I deductions that Magnate Ltd will be entitled to after consolidation after allowing for a $40,000 deduction that Minor Pty Ltd was entitled to in the years ending 30 June 2013 and 30 June 2016.

Reducing allocable cost amount by tax cost setting amounts of retained cost base assets 12.125 The next step in the process involves reducing the allocable cost amount by the tax cost setting amounts of the retained cost base assets of the subsidiary member. These are assets that are treated as having the same cost base to the head [page 835]

company as they had for the subsidiary member. The retained cost base assets as set out in ITAA97 s 705-25 are: Australian currency, other than trading stock or collectables of the joining entity; a right to receive a specified amount of Australian currency other than a right that is a marketable security for purposes of ITAA36 s 70B; a unit in a cash management trust provided the redemption value of the unit is expressed in Australian dollars and the redemption value of the unit cannot increase; rights, in relation to which expenditure has been incurred, to have something done or to cease being done in the future; or a right to future income other than a work in progress (WIP) amount asset. A ‘WIP amount asset’ is defined in s 701-63(6) as meaning ‘an asset that is in respect of work (but not goods) that has been partially performed by [the potential payee] but not yet completed to the stage where a recoverable debt has arisen in respect of the completion or partial completion of the work’. A WIP amount asset will be a reset cost base asset. The tax cost setting amounts for each of these assets as set out in s 705-25 are summarised in Table 12.2. Table 12.2: Tax cost setting amounts for cost base assets Asset

Tax cost setting amount

Amounts within s 705-25(5)(a) or (b) or (ba) The amount of the Australian currency that are not qualifying securities for purposes concerned of ITAA36 Pt III Div 16E Qualifying securities under ITAA36 Pt III Div 16E

The joining entity’s terminating value for the asset

Amounts within s 705-25(5)(c)

The amount of the deductions to which the head company is entitled under the entry history rule in respect of the expenditure that gave rise to the entitlement

Amounts within s 705-25(5)(d)

The joining entity’s terminating value for the asset

The reduction under s 705-25 is illustrated by Example 12.36.

Assume the facts in Example 12.35. Assume that one of the assets of Minor Pty Ltd was $100,000 in a bank account with Big Bank Ltd. The bank account will be a retained cost asset and its tax cost setting amount will be $100,000. The balance of the allocable cost amount will be $410,000.

[page 836]

Apportioning allocable cost amount to subsidiary member’s reset cost base assets 12.126 Once the allocable cost amount has been reduced by the tax cost setting amounts of the retained cost base assets, it is apportioned over the reset cost base assets of the subsidiary member in proportion to their market values. All assets of the subsidiary member other than excluded assets and retained cost base assets will be reset cost base assets. Where an amount is reduced in relation to an asset in determining the allocable cost amount for a joining entity, the asset will be an excluded asset. Under ITAA97 s 705-35(3), goodwill associated with the ownership and control of the joining entity is taken to be an asset of the joining entity that becomes an asset of the head entity because of the single entity rule. For purposes of determining the tax cost setting amount for the goodwill, it is taken to have a market value just before the joining time equal to its market value just after the joining time. Rules for determining the termination value of different classes of assets to the joining entity are set out in s 705-30. Adjustments to the tax cost setting amount for reset cost base assets are made in certain circumstances. For example, in the case of trading stock, revenue assets or depreciating assets, where the calculated tax cost setting amount is

greater than both the market value of the asset and its terminating value of the tax, s 705-40 reduces the cost setting amount to the greatest of these. Example 12.37 illustrates the apportionment of the allocable cost amount to reset cost base assets:

Assume the facts in Example 12.35 with the following variations: 1. The market value of the shares was $450,000. 2. The other tangible assets of Minor Pty Ltd were trading stock on hand with a cost of $200,000 and a market value of $250,000. 3. The market value of the goodwill of Minor Pty Ltd was $200,000. The remaining $410,000 of the allocable cost amount is apportioned between the trading stock and the goodwill on the basis of their relative market values. Under s 705-40, the tax cost setting amount for the trading stock cannot be greater than the joining entity’s terminating value for the asset or its market value. Under s 705-30(1) the joining entity’s terminating value for the asset will be its value for Div 70 purposes at the start of the income year in which the joining time occurs (ie, $200,000). Hence, if the $410,000 is apportioned on the basis of relative market values, the apportionment to the trading stock will be: $410,000 × 250,000/450,000 = $227,777.75 As this amount is greater than the joining entity’s terminating value in respect of the trading stock, but not greater than the market [page 837] value of the trading stock, the sum of $227,777.75 will be the tax cost setting amount for the trading stock. The tax cost setting amount for the goodwill is calculated as: $410,000 × 200,000/450,000 = $182,222.20

Modifications to the basic rules 12.127 The basic rules for asset cost setting in ITAA97 Subdiv 705-A are modified by subsequent Subdivisions in the following situations: Subdiv 705-B — where a consolidated group is formed;

Subdiv 705-C — where the head company of a consolidated group is acquired by another consolidated group; Subdiv 705-D — where linked entities become members of the consolidated group as a result of an event which happens to one of them; Subdiv 705-E — adjustments for errors in making tax cost setting amount calculations. Special provisions also modify the rules so that the cost base of assets held by a discretionary trust that joins a consolidated group can be determined. Special provisions also exist in Subdiv 715-D, and elsewhere, which deal with the interaction of the consolidation regime with the taxation of financial arrangements provisions in new Div 230.

Position where subsidiary member leaves consolidated group 12.128 The rules that apply when a subsidiary member leaves a consolidated group are virtually a mirror image of those that apply when a subsidiary joins a group. The steps involved in this process are shown in Table 12.3, which is based on one contained in ITAA97 s 711-20. Table 12.3: Steps when subsidiary member leaves consolidated group Step

What the step requires

Purpose of the step

1

Add together the head company’s terminating values of the assets that the leaving entity takes with it.

To ensure that the allocable cost amount includes the cost of the assets.

2

Add the value of deductions inherited by the To ensure that the value of the leaving entity that are not reflected in the deductions is reflected in the terminating value of the assets that the allocable cost amount. leaving entity takes with it.

3

Add the market value (or the cost in certain circumstances) of all assets of the leaving entity that correspond to liabilities owed by the old group to the leaving entity.

To ensure that the liabilities, which are not recognised while the leaving entity is taken to be part of the head company by s 701-1(1),

are reflected in the allocable cost amount.

[page 838] Step

What the step requires

4

Subtract from the result of Step 3 the Step 4 amount worked out under s 711-45, which is about: (a) the leaving entity’s liabilities just before the leaving time; and (b) *membership interests in the leaving entity that are not held by *members of the old group.

5

If the amount remaining after Step 4 is positive, it is the old group’s allocable cost amount for the leaving entity. Otherwise the old group’s allocable cost amount is nil.

Purpose of the step To ensure that the allocable cost amount is reduced to reflect the liabilities and the value of the membership interests.

The head entity is taken as making a capital gain equal to the amount of any negative allocable cost amount result. In these circumstances, the allocable cost amount of the leaving entity will be nil. Where the allocable cost amount result is a positive amount, it is apportioned between the membership interests of the leaving entity and forms the cost base for those interests. In cases where there is only one class of membership, interests in the leaving entity, the cost base of an individual interest in the leaving entity is determined simply by dividing the allocable cost amount by the number of membership interests in the leaving entity. Where there is more than one class of membership interest in the leaving entity, the allocable cost amount is apportioned between the different classes according to their aggregate market values. It is then allocated to membership interests within each class by dividing the classes’ share of the allocable cost amount by the number of membership interests in that class.60

Preservation of pre-CGT status of assets and membership interests

12.129 When a subsidiary entity joins a consolidated group, the preCGT status of its assets is inherited by the head company in the group. Conversely, when a subsidiary entity leaves a consolidated group, any pre-CGT assets that it takes with it retain (subject to the operation of ITAA97 Div 149, discussed at 12.140–12.143) their pre-CGT character. Under amendments introduced by the Tax Laws Amendment (2010 Measures No 1) Act 2010 (Cth), the pre-CGT status of membership interests in the joining entity is determined by calculating the proportion (measured by market value) of pre-CGT membership interests in the joining entity and, when the entity leaves the group, by using that proportion to determine the number of its membership interests that [page 839] are pre-CGT assets. Extracts from the Explanatory Memorandum to the Tax Laws Amendment (2010 Measures No 1) Bill 2010 (Cth) are contained in Study help.

CGT events triggered by cost setting process 12.130 As can be seen from the foregoing discussion, the asset cost setting process can trigger CGT events. The events that may be triggered by the process are: CGT event L2, which happens when a negative amount remains after Step 3A when a subsidiary joins a consolidated group; CGT event L3, which happens when the tax cost setting amount for retained cost base assets exceeds the joining allocable cost amount;61 CGT event L4, which happens when there are no reset cost base assets and there is an excess allocable cost amount when a subsidiary joins a consolidated group; CGT event L5, which happens when a negative amount remains after Step 4 in calculating the allocable cost amount for a leaving

entity;62 CGT event L6, which happens when there is an error in the calculation of the tax cost setting amount for a joining entity’s assets; CGT event L8, which happens when a reduction in tax cost setting amounts under ITAA97 s 705-40(1) cannot be allocated as mentioned in s 705-40(2).63

Franking accounts and consolidated groups 12.131 If the franking account of a subsidiary entity has a credit balance when it joins a consolidated group, a franking debit equal to the amount of the balance arises in its franking account. A corresponding credit for the same amount arises in the franking account of the head company. If the subsidiary entity has a debit balance in its franking account when it joins the consolidated group, it is liable to pay franking deficit tax at that time equal to the amount of the franking deficit. A corresponding credit equal to the franking deficit arises in the franking account of the head company. The head company operates the franking account for the consolidated group. Any frankable dividends paid outside the consolidated group (eg, to members of employee share schemes) are treated as being frankable distributions paid by the head company. [page 840]

CGT from a company’s perspective 12.132 The application of the basic CGT rules to companies is fairly simple. As a form of assessable income, net capital gains derived by a company when CGT events happen to it are included in calculating the company’s taxable income. Because companies are taxed at flat rates, the former CGT rate averaging provisions discussed in 6.22 did not

apply to companies. The CGT discount, discussed in 6.11, does not apply to companies.

Modifications of CGT events for companies Issues or allotments of shares 12.133 When a company issues equity interests, it creates rights in the interest holder. In the absence of specific provisions to the contrary, a creation of rights in another entity would normally trigger CGT event D1. However, amounts subscribed towards equity interests issued by the company do not truly represent a gain by the company. This is because, in the winding up of the company, after the company’s debts have been satisfied, its share capital will be distributed among its members. Hence, it would not be appropriate for CGT event D1 to be triggered when the company issues or allots equity interests to an interest holder. For this reason, ITAA97 s 104-35(5)(c) tells us that CGT event D1 does not happen if a company issues or allots equity interests in the company.

Company-issued rights 12.134 Where a company issues rights to shares, it creates rights in the shareholder. This will trigger CGT event D1. However, consideration is payable only if the shareholder elects to exercise the rights. Hence, under the principles discussed in Chapter 6, there will be no capital proceeds for creating the right until this contingency is satisfied. Remember that the market value substitution rule in ITAA97 s 116-30 does not apply to CGT event D1. The contingency will be satisfied when the shareholder elects to pay the exercise price and take up the shares. At this point, however, s 104-35(5)(c) should prevent CGT event D1 from happening as the company will be issuing or allotting equity interests. In principle, this is the correct result as, for the same reasons as in 12.133 in relation to amounts subscribed for shares, the exercise price does not represent a true gain to the company.

Company-issued options

12.135 Similarly, the grant of an option by a company would, in the absence of a specific provision, trigger either CGT event D1 or CGT event D2 (discussed in Chapter 6). However, where the option is exercised, the exercise price is applied towards company-issued shares or convertible notes. In these circumstances, for reasons similar to those discussed in 12.133 neither the issue price nor the exercise fee represent a true gain to the company. For this reason, ITAA97 s 104-35(5)(e) provides that CGT event D1 does not happen if a company grants options to acquire equity interests or non-equity shares or debentures in the company and ITAA97 s 104-40(6) provides that CGT event D2 does not operate on the grant, renewal or extension of an option by a company to acquire equity interests or debentures in the [page 841] company. Tax Laws Amendment (2008 Measures No 3) Act 2008 (Cth) amended the treatment of shareholders receiving company-issued options. These amendments are discussed at 13.115. 12.136 What happens, however, if the shareholder pays for an option to be granted but then does not exercise it? Here, the issue price is a true gain to the company and it is appropriate that it should trigger a CGT event. CGT event C3 happens if company-issued options to acquire shares or debentures are not exercised, are cancelled or are released or abandoned by the grantee. The event occurs when the option ends by any of these means. Capital gains and losses for the event are calculated by comparing the capital proceeds for the grant of the option with expenditure incurred in granting it.

Company-issued debentures 12.137 Similarly, when a company issues debentures it creates rights in the debenture holder. In the absence of a specific provision to the contrary, this would trigger CGT event D1. It may be that the moneys borrowed under the debenture can properly be described as the capital proceeds from creating the rights under the debenture. The borrowed

funds could be regarded, for the purposes of ITAA97 s 116-20, as money received in respect of CGT event D1 happening. However, by issuing the debentures, the company has created the rights by borrowing money from another entity (ie, the debenture holder). This means that CGT event D1 will not apply because of s 104-35(5)(a). In addition, s 104-35(5)(e) (discussed at 12.135) would also be applicable and would mean that CGT event D1 did not happen on the issue of debentures by the company.

Company-issued convertible interests 12.138 For the same reasons stated in 12.135, in the absence of a specific provision to the contrary, CGT event D1 would occur when a company issued convertible interests. For the same reasons stated in 12.135, ITAA97 s 104-35(5)(a) should mean that a CGT event will not apply. Neither a capital gain nor a capital loss will arise when this CGT event occurs. When the notes are converted into shares, s 104-35(5)(c) will mean that CGT event D1 does not take place in relation to the share issue.

CGT event J1 applicable only to companies: Subsidiary stops being member of wholly owned group following Subdiv 126B roll-over 12.139 CGT event J1 takes place where companies that have previously rolled over an asset between them under ITAA97 Subdiv 126-B (discussed in 12.159) cease to be members of the same wholly owned group. The event only takes place if, just before the time of cessation, and at the time of the roll-over, the recipient company in the roll-over was a 100% subsidiary of the originating company in the rollover or another group company. In addition, at a time when it still owns the roll-over asset, the recipient company must stop being a 100% subsidiary of the ultimate holding company in the group. This time is regarded as the ‘break-up time’. Further preconditions apply where the roll-over event was the last in a series of Subdiv 126-B roll-overs involving the asset. The time of the CGT event is the break-up time. A capital gain or loss to the recipient

[page 842] company at the break-up time is calculated by comparing the market value of the asset at the break-up time with its cost base or reduced cost base at that time. The recipient company is thereafter regarded as acquiring the asset at the break-up time. Thereafter, the cost base of the asset to the recipient company will be its market value at the breakup time. This will ensure that the gain taxed under CGT event J1 is not taxed again when the recipient company actually disposes of the asset. Under s 104-175(6), CGT event J1 does not happen if the conditions set out in s 104-180 are satisfied. In broad terms, the conditions in s 104-180 will be satisfied where a subgroup break-up occurs, provided that the recipient company and the originating company were members of the same subgroup at the time of each relevant Subdiv 126-B rollover, and provided no shares in the recipient company are owned just after the break-up time by the ultimate holding company of the group or one of its 100% subsidiaries. Nor, under s 104-182, does CGT event J1 happen if the recipient company ceases to be a subsidiary member of a consolidated group at the break-up time.

Provisions affecting CGT characteristics of assets: Deemed acquisition of assets where change in majority underlying interests 12.140 An owner of the majority of shares in a company has effective control of the company’s assets. Planning opportunities could arise where the controlling shares in a company with pre-CGT assets are themselves pre-CGT. Instead of purchasing the assets of the company, and thus converting them into post-CGT assets, a buyer might wish to purchase the controlling shareholders’ shares. No CGT would be payable by the controlling shareholders as their shares would be preCGT. Nor would CGT be payable by the company when its assets were sold as they would also be pre-CGT assets. Tax on any gains made by the company on the realisation of its pre-CGT assets would be deferred

until those gains were distributed or until the shareholders sold their shares. ITAA97 Div 149 is aimed at preventing planning of this nature. 12.141 Under ITAA97 Div 149, an asset stops being a pre-CGT asset64 of a company where a change in the majority underlying interests in the asset takes place. ‘Majority underlying interests’ are defined in ITAA97 s 149-15 as more than 50% of the (direct or indirect) beneficial interests that ultimate owners have in the asset or in any ordinary income derived from it. An individual natural person is included in the definition of ‘ultimate owner’ in s 149-15(3). Section 149-15(4), in effect, deems a natural person shareholder to have a beneficial interest in an asset of the company if he or she would beneficially receive any of the capital distributed by the company or successively distributed through a chain of companies or other entities. For the purposes of Div 149, s 149-15(4) effectively displaces the company law rule that a shareholder has no beneficial interest in the assets of the company. Section 14915(5), in effect, deems a natural person shareholder to have a beneficial interest in the ordinary income of a company, if he or she would be beneficially entitled to receive dividends paid by the company or successively distributed through a chain of companies or other entities. [page 843] 12.142 For entities other than those referred to in s 149-50, the consequences when Div 149 is triggered are set out in ss 149-30 and 149-35. In broad terms, these provisions will apply to companies other than public companies for tax purposes.65 The pre-CGT assets of the company will stop being pre-CGT on the day that majority underlying interests change. The CGT provisions will apply to the company as if it had acquired the asset at that time. However, under s 149-30(2), Div 149 will not be triggered if the Commissioner is satisfied that, at all times on or after 20 September 1985 and before a particular time, the majority underlying interests were held by the same persons. Under s 149-35, the cost base of the deemed post-CGT assets to the company

will be their market value at the time of the change in majority underlying interests. 12.143 The rules for applying Div 149 are more complex in relation to public companies.66 Under ITAA97 s 149-55, a public company must give the Commissioner written evidence about majority underlying interests in its pre-CGT assets: every five years from 20 January 1997; or where there is abnormal trading67 in the company or in its holding company. The Commissioner must be satisfied, or think it reasonable to assume solely on the basis of this evidence, that, at the end of the test day (the day when majority underlying interests are being tested), majority underlying interests in the asset were held by the ultimate owners who also held majority underlying interests in the asset at the end of the starting day (ie, 19 September 1985 or at the end of such day between 1 July 1985 and 30 June 1986 as the company elects under s 149-60(2)). Under s 149-60(3), if the evidence does not show who held underlying interests at the starting day, it must be treated on the assumption that those interests are not held by persons who held underlying interests at the end of the test day. If the Commissioner is not satisfied under s 14960(1): the asset stops being a pre-CGT asset; and the CGT provisions (except Div 149) apply to the asset as if the company acquired it at the end of the test day. Under ITAA97 s 149-75, the cost base of the deemed post-CGT assets will be their market value at the time of the deemed Div 149 acquisition. [page 844]

Corporate CGT loss provisions Restrictions on carrying forward capital losses

12.144 Under ITAA97 Subdiv 165-CA, a company cannot apply a net capital loss from an earlier income year in calculating its net capital gain for the current year if Subdiv 165-A (discussed in 12.91–12.103) would have prevented it from deducting a carried forward tax loss. An exception to this rule is contained in s 165-96(2). A company can offset a net capital loss incurred in part of a prior year if it would have passed the ‘continuity of ownership’ test or the ‘business continuity’ test if that part of the prior year had been treated as the whole of the year.

Restrictions on offsetting current year capital losses 12.145 Where a company does not satisfy the same owners test and does not satisfy the business continuity test then, under ITAA97 Subdiv 165-CB, it cannot offset a notional net capital loss against its capital gain for the current year. The net capital loss that is not able to be offset against current year capital gains can itself be carried forward as a net capital loss. These restrictions apply where the company is required to calculate its taxable income and tax loss for the income year under Subdiv 165B (discussed in 12.105) because it failed the ‘same owners’ and the ‘business continuity’ tests. Under Subdiv 165-CB, the current year is divided into the same periods as those that apply for purposes of Subdiv 165-B and ‘notional capital losses’ and ‘notional capital gains’ are calculated.

Restrictions applying on change in ownership or control of a company with unrealised net loss 12.146 As from 11 November 1999, ITAA97 Subdiv 165-CC applies where a company fails the ‘continuity of ownership’ test at a time when it has unrealised net losses. The effect of Subdiv 165-CC is that the company is denied a capital loss that arises from a CGT event following the change in ownership unless it satisfies the ‘business continuity’ test. Subdivision 165-CC may also deny the company certain deductions unless it passes the ‘business continuity’ test. Subdivision 165-CC does not apply to a company which, at the time of the change in ownership or control, has a net asset value of not more than $6,000,000 under the test applicable for small business CGT relief. The small business CGT

relief provisions are discussed at 6.149–6.160. In addition, a company, if it calculates the market value of its assets individually for Subdiv 165CC purposes, may exclude every asset that it acquired for less than $10,000. If it does this, its unrealised gains and losses on those assets will not be taken into account in calculating the company’s net loss, and losses on those assets will be allowed without the company being subject to the ‘business continuity’ test. When Subdiv 165-CC applies to a consolidated group, only changes in the ownership of the head company are relevant and any realised or unrealised losses are taken to be in the head company.

Transferring capital losses within wholly owned groups 12.147 ITAA97 Subdiv 170-B permits net capital losses to be transferred between companies which are members of the same wholly owned group. In general, losses [page 845] are not able to be transferred within wholly owned groups under these provisions after 1 July 2003. The circumstances where losses are able to be transferred under Subdiv 170-B are discussed in Study help.

Cost base and reduced cost base adjustments where losses are transferred within a corporate group 12.148 As from 22 February 1999, the cost base and reduced cost base of equity and debt interests held by group companies in a loss company may be reduced under ITAA97 Subdiv 170-C where a revenue loss or a net capital loss is transferred within a group. Subdivision 170C may also increase the cost base or reduced cost base of equity or debt interests held by group companies in the gain company in these circumstances. In the absence of Subdiv 170-C, losses could be duplicated when transferred within groups by a parent company selling its shares in the loss subsidiary after the transfer had been made. As revenue and capital losses can only be transferred within a non-

consolidated wholly owned group in limited circumstances on or after 1 July 2003, the scope of Subdiv 170-C is thereafter similarly limited.

Deferral of recognition of capital losses arising from intragroup transactions 12.149 ITAA97 Subdiv 170-D defers recognition of a capital loss (or, in certain cases, a deduction) that would otherwise arise when a company that is a member of a linked group disposes of a CGT asset to (or creates a CGT asset in) a company68 that is a member of the linked group. Companies are members of a linked group if the same entity has a controlling stake in both of them or if one of them has a controlling stake in the other. Recognition of the capital loss or of the deduction is deferred until the disponor company or the asset disposed of ceases to belong to the linked group.

Loss multiplication rules: ITAA97 Subdiv 165-CD 12.150 As from 11 November 1999, the reduced cost bases and deduction entitlements (eg, losses deductible under s 8-1 where the assets are trading stock or are otherwise held on revenue account) of a controlling stakeholder’s equity and debt interests in a company that has realised and/or unrealised losses (the loss company) are adjusted if an alteration takes place in the ownership or control of the loss company or if a liquidator declares shares in the loss company to be worthless. An entity has a controlling stake in a company where the entity and its associates between them control more than 50% of the voting power in the company and have the right to receive more than 50% of the dividend or capital distributions of the company. The provisions do not apply to individuals who hold a controlling interest in a company. [page 846] Only direct or indirect equity interests in excess of 10% held by a controlling stakeholder and debt interests of at least $10,000 owed to

the controlling stakeholder are adjusted. In cases where the controlling stakeholder has a direct equity interest in the loss company, or where the debt consists of either a single debt or of two or more debts of the same kind, the adjustment to the controlling stakeholder’s reduced cost base or deductions is the controlling stakeholder’s pro rata proportion of the loss company’s overall loss (this includes both its realised and unrealised losses). In other cases, the adjustment is of ‘the amount that is appropriate’ having regard to a number of specified factors including the extent to which the loss has reduced the market value of the controlling stakeholder’s debt and equity interests in the loss company. When ITAA97 Subdiv 165-CD applies to a consolidated group, only changes in the ownership of the head company are relevant and any realised or unrealised losses are taken to be in the head company. The provisions are aimed at preventing multiple recognition of losses within a group of companies. In the absence of the adjustments, a company (Company 2) that sold a controlling interest in a loss company (Company 3) could make a capital loss (or, in some cases, a revenue loss) on the realisation of the shares. A company further up the chain of ownership (Company 1) could then make a further loss on the realisation on liquidation of its shares in Company 2. In this scenario, subject to satisfying the same business test, the purchaser of shares in Company 3 would (in effect) be allowed a deduction for the loss made by Company 3, Company 2 would incur a capital loss (or, in some cases, a revenue loss) on the realisation of its shares in Company 3, and Company 1 would incur a capital loss on the realisation of its shares in Company 2. The multiplication of capital or revenue losses could be continued almost indefinitely up a chain of corporate ownership. The Tax Laws Amendment (2010 Measures No 1) Act 2010 (Cth) introduced amendments under which widely held entities are not regarded as having a relevant equity or debt interest in a loss company unless an entity has a controlling stake in the loss company and that entity has a direct or indirect interest in, or is owed a debt by, the widely held company where: (a) the entity could, if a CGT event happened to the interest or debt, make a capital loss that would reflect part of the loss company’s overall loss; or (b) the entity has deducted an

amount in respect of the interest or debt where the deduction reflects part of the loss company’s overall loss.

CGT roll-overs and companies Incorporation roll-overs 12.151 Two CGT roll-overs apply where an asset held through one form of business organisation is rolled over into a company without there being a change in the underlying beneficial ownership of the asset. These roll-overs are: 1. ITAA97 Subdiv 122-A ‘Disposal or creation of assets by individual or trustee to a wholly-owned company’; and 2. ITAA97 Subdiv 122-B ‘Disposal or creation of assets by partners to a wholly-owned company’. [page 847] The following conditions must be satisfied for the Subdiv 122-A rollover to be available: one of the CGT events listed (the ‘trigger event’) in a table in s 122-15 must happen and must involve you and the company;69 the consideration received for the trigger event must be either: – shares in the company;70 or – shares in the company and (where you dispose of all the assets of a business to the company) an undertaking to discharge liabilities in respect of the assets of the business; the market value of the shares71 you receive must be substantially the same as, in the case of a disposal to the company, the market value of the assets disposed of less any liabilities the company undertakes to discharge in respect of the assets; and you must be the beneficial owner of all the shares in the company just after the trigger event.

The residency requirements set out in the table in s 122-55(6) must be satisfied. 12.152 The Subdiv 122-A roll-over does not apply in certain situations or to certain assets. These are set out in s 122-25(2), (3) and (4). In practical terms, the most important excluded asset is something that either is trading stock or becomes trading stock just after the company acquires it. Another important exclusion relates to depreciating assets.

What planning would be possible if a ITAA97 Subdiv 122-A roll-over was available where the rolled-over asset became trading stock immediately after it was acquired by the company? Think about the situation where the cost of the asset to the transferor was $100 but its market value at the time of roll-over was $150.

12.153 Where you dispose of a CGT asset to a company, and the company undertakes to discharge liabilities in respect of it, ITAA97 s 122-35(1) sets limits on the liabilities that can be undertaken. Where the asset is a post-CGT asset to you, the liabilities assumed cannot exceed the cost base of the asset. Where the asset is a pre-CGT asset to you, the liabilities assumed cannot exceed the market value of the asset. Where you dispose of all the assets of a business to a company, s 122-35(2) sets limits on the liabilities that can be assumed. Where all the assets are post-CGT to you, the liabilities assumed cannot exceed the sum of the market values of the precluded assets (such as cars and trading stock) and the cost bases of the other assets. Where all the assets are pre-CGT [page 848] to you, the liabilities assumed cannot exceed the sum of the market

values of the assets. Where some of the assets are pre-CGT and some are post-CGT to you, the former rule applies to the liabilities assumed in respect of the post-CGT assets and the latter rule applies to the liabilities assumed in respect of the pre-CGT assets. Under s 122-37(2), a liability that is not in respect of a specific asset or assets of a business is taken to be in respect of all the assets of the business. If a liability is in respect of two or more assets of a business, the liability is pro-rated between the assets according to their relative market values. 12.154 Where less than all the assets of a business are rolled over, the consequences of the ITAA97 Subdiv 122-A roll-over in a disposal case are as follows: A capital gain or loss you make from the trigger event is disregarded. Where the rolled-over asset is post-CGT to the transferor: – the cost base of the shares the transferor receives is the cost base of the rolled-over asset (less any liabilities assumed); – the cost base of the asset to the company is the asset’s cost base to the transferor. Where the rolled-over asset is pre-CGT to the transferor: – the shares the transferor receives are taken to be pre-CGT; – the company is taken to have acquired the asset pre-CGT. 12.155 Where all of the assets of a business are rolled over in a disposal case, any capital gain or loss that the transferor would otherwise make from the disposal is disregarded. The remaining consequences of the roll-over for the transferor vary according to whether the assets were: (a) all post-CGT; (b) all pre-CGT; or (c) a mixture of pre- and post-CGT assets. For each group of rolled-over assets, the consequences are as follows: (a) Where all rolled-over assets are post-CGT, the cost base of each share to the transferor is the sum of the cost bases of the rolledover assets and the market value of the precluded assets (less any liabilities assumed) divided by the number of shares. (b) Where all rolled-over assets are pre-CGT:

all the shares are regarded as pre-CGT assets to the transferor if none of the assets of the business is a precluded asset; if one or more of the assets is a precluded asset: – a proportion of the shares, equal to the proportion that the non-precluded assets (less liabilities assumed) bears to the total assets, is regarded as being pre-CGT assets to the transferor; – the cost base of each of the remaining shares is the sum of the market values of the precluded assets (less any liabilities assumed) divided by the number of remaining shares. (c) Where some of the rolled-over assets are pre-CGT and some are post-CGT: a proportion of the shares, equal to the proportion that the sum of the market values of the pre-CGT assets (other than precluded assets), less [page 849] liabilities assumed, bears to the total assets, is regarded as being pre-CGT assets to the transferor; the cost base of each of the remaining shares is the sum of the market values of the precluded assets and the cost bases of the post-CGT assets divided by the number of remaining shares. 12.156 Note that neither roll-over applies when an asset is transferred from a company to an individual, nor to a trustee, nor from a company to a partnership. 12.157 The conditions for, and the consequences of, a roll-over under Subdiv 122-B substantially parallel those that apply under Subdiv 122-A with appropriate changes in wording reflecting the fact that the roll-over is from a partnership to a company.

Reorganisation roll-overs 12.158 Several CGT roll-overs are relevant when taxpayers reorganise their form of business organisation. The roll-overs that are particularly relevant in the company context are ITAA97: Subdiv 124-E ‘Exchange of shares or units’; Subdiv 124-F ‘Exchange of rights or options’; Subdiv 124-I ‘Change of incorporation’ (conversion of body to an incorporated company); Subdiv 124-N ‘Disposal of assets by a trust to a company’; Div 615 ‘Roll-overs for business restructures’ (note these rollovers also apply for trading stock and revenue asset purposes); and Div 620 ‘Assets of wound-up corporation passing to corporation with not significantly different ownership’ (note this roll-over also applies for capital allowance and revenue assets purpose). Mention should also be made of the scrip for scrip roll-over and the roll-over under the demerger relief provisions. These roll-overs are discussed in Chapter 13.

The group roll-over 12.159 As from 1 July 2003, the group roll-over under ITAA97 Subdiv 126-B is available only to companies in non-consolidated wholly owned groups in restricted circumstances. 1.

2. 3. 4. 5.

See the definitions in: L A Sheridan and G W Keeton, The Law of Trusts, 11th ed, Rose, Chichester, 1983, p 3; Sir Arthur Underhill, Law of Trusts and Trustees, 13th ed, Butterworths, London, 1979, p 3; H A J Ford and W A Lee, Principles of the Law of Trusts, 2nd ed, Law Book Co, Sydney, 1990, p 3; and R P Meagher and W M C Gummow, Jacobs’ Law of Trusts in Australia, 5th ed, Butterworths, Sydney, 1986, p 8. A trustee may be one of several beneficiaries and a beneficiary may be one of several trustees. A point emphasised in the definition in Meagher and Gummow, Jacobs’ Law of Trusts in Australia, p 8. Review of Business Taxation, A Tax System Redesigned, AGPS, Canberra, 1999, pp 61–2. The board did recommend that the deemed dividend rules be improved, that s 109UB of

6.

7.

8.

9.

10. 11.

12.

13. 14. 15.

the Income Tax Assessment Act 1936 (Cth) (ITAA36) be modified, and that the Commissioner’s views about the deductibility of interest on borrowings used to finance non-assessable distributions to beneficiaries of discretionary trusts be clarified and published. The government then announced that s 109UB would be amended to remove the unfairness in its operation. Section 109UB was repealed in 2004 and replaced by ITAA36 ss 109XA and 109XB. Some other possible approaches to corporate–shareholder taxation use a different tax base to the one currently employed in Australia. These include the ‘dual income tax’ used in Nordic countries and the Allowance For Corporate Equity currently used in countries such as Belgium. In the current Australian system, grossed-up dividends are added to the shareholder’s assessable income. This has the effect of pooling them with other forms of income. This in turn means that they are taxed at the shareholder’s average rate. Analysis is aided, however, if we assume that dividend income is received after all other income. On that assumption, the effect of the dividend imputation system is to tax the dividend at the shareholder’s marginal rate. For a discussion of the implications of European Union law for cross-border dividends, see U Ilhi, K Malmer, P Schonewill and I Tuominen, ‘Dividend Taxation in the European Union’ in Cahiers de Droit Fiscal International, vol LXXXVIIIa, International Fiscal Association, Rotterdam, 2003, pp 7–96. Dr Ken Henry (Chair) et al, Australia’s Future Tax System: Report to the Treasurer (Henry Review), Commonwealth Attorney-General’s Department, Canberra, December 2009, pp 163–5. Publications associated with the review may be found at . See further 1.20. Following a tax forum in Canberra in 2011, the government established a Business Tax Working Group with personnel from Treasury and the private sector. In its August 2012 discussion paper, the Business Tax Working Group (at paras 25–29) concluded that an allowance for corporate equity should not be pursued in the shorter term but may worthy of further consideration and public debate in the longer term. Henry Review, p 165. See the discussion of the Canadian system in M Brender and P J Woolford, ‘Trends in Company/Shareholder Taxation: Single or Double Taxation?’, National Report, Canada, Cahiers de Droit Fiscal International, vol LXXXVIIIa, International Fiscal Association, Rotterdam, 2003, pp 239–41. Relevant rates and the limits on the credit have changed from time to time since 2003. For a summary of the Canadian rules at the time of writing, see B Dwyer, ‘Canada – Corporate Taxation – Country Analyses’, IBFD Tax Research Platform, at heading ‘6, Shareholders and Directors of Resident Companies, available online at . See the discussion of different types of compensatory tax system and their reconciling mechanisms in P A Harris, Corporate/Shareholder Income Taxation, and Allocating Taxing Rights Between Countries: A Comparison of Imputation Systems, IBFD Publications BV, Amsterdam, the Netherlands, 1996, especially Ch 3. See the discussion of different types of variable credit systems and their tracking mechanisms in Harris, Corporate/Shareholder Income Taxation, especially Ch 3. The definition of ‘company’ in ITAA97 s 995-1 is discussed in more detail at 12.26–12.27. The provision actually says that convertibility does not of itself make the obligation not

16. 17.

18. 19.

20.

21. 22.

non-contingent. The ITAA36 s 6(1) definition of ‘company’ formerly read: ‘company includes all bodies or associations corporate or unincorporate but does not include partnerships’. ITAA36 s 103A(4B) does not expressly require that the listed company has passed the 20 persons or fewer 75% test, but if that test were failed, then, subject to the exercise of the Commissioner’s discretion, the listed company would not be a public company. It would be absurd if a subsidiary of a listed company was categorised as a subsidiary of a public company because of the s 103A(4B) definition and, hence, as a public company where its listed parent was not itself a public company. A public trading trust will also satisfy the residency requirements: see ITAA97 s 205-25(1) (c). Franking credits also arise under ITAA 1997 s 316-275 for friendly societies and their subsidiaries where the society receives a refund of income tax. Franking credits also arise under s 418-50(1) in relation to exploration credits. Neither of these credits are discussed further in this chapter. A ‘franking entity’ is defined in s 202-15 as a corporate tax entity that is not a mutual life insurance company and where it is the trustee of a trust is not acting in its capacity as trustee of the trust at that time. See, for example, M Fry and R O’Brien, ‘New Dividend-paying Rules Raise Tax Issues of Concern’ (2010) 42 Weekly Tax Bulletin, [1594]. Under ITAA97 s 203-20, the benchmark rule does not apply to: a company that, at all times during the franking period is a listed public company that, under its constitution, must frank distributions to its members under a single resolution at the same franking percentage provided that all distributions made by the company during the franking period are made to all members of the company; or a company that, at all times during the franking period was a listed public company with a single class of membership interest.

23. Review of Business Taxation, A Tax System Redesigned, AGPS, Canberra, 1999, p 420. 24. Henry Review, note 9 above, Part One, Overview, Recommendation 39. 25. For a company whose shares have no par value ‘tax exempt bonus share’ means a share issued by the company in the circumstances mentioned in ITAA36 s 6BA(6). The subsection is discussed in more detail in Chapter 13 and Study help. 26. The company is required to comply with the Commissioner’s request: ITAA97 s 204-80(2). 27. These provisions were repealed in 2006 but, at the time of writing, no replacements have been introduced. 28. Treasurer’s Press Release No 53, 13 May 2008. 29. Note that under the definition of ‘subsidiary’ in ITAA97 s 995-1, whether a company is a subsidiary of another company for these purposes is determined using the rules in s 46 of the Corporations Act 2001 (Cth). 30. Membership interests where there are no risks or opportunities associated with holding the membership interest are excluded from being taken into account in determining whether the entity is effectively owned by prescribed persons. In particular, ‘finance membership interests’ and ‘distribution access membership interests’ are specifically excluded by ITAA97 s 208-30. Accountable partial interests are defined in s 208-35.

31. 32. 33. 34.

35. 36.

37. 38.

39. 40. 41.

42. 43. 44.

45.

See H A J Ford, R P Austin and I M Ramsay, Ford’s Principles of Corporations Law, 11th ed, LexisNexis Butterworths, Sydney, 2003, [17.100]. Ford’s Principles of Corporations Law, [18.240]. Ford’s Principles of Corporations Law, [18.240]. There are several exceptions to this rule. These include: (a) amounts that could be identified as share capital in the books of the company (s 197-10); (b) amounts transferred under debt and equity swaps within limits (s 197-15); (c) amounts transferred from share premium account, or the company’s capital redemption reserve in a company that is not incorporated under the Corporations Act 2001 (Cth) as part of a process that leads to there being no shares in the company that have a par value (s 197-20); (d) transfers from an option premium reserve because of the exercise of options to acquire shares in the company (s 197-25); and several transfers associated with the demutualisation of companies (ss 19730, 197-35, 197-38, 197-40). Special provisions apply to life assurance companies. In effect, the levying of untainting tax and the exemption of a distribution from an untainted share capital account from the definition of ‘dividend’ amounts to the insertion of a dividend exemption system within Australia’s dividend imputation system. Dividend exemption systems were discussed in 12.8. Other than shares to which ITAA36 s 6BA(5) (dealing with dividend re-investment schemes) applies. ITAA36 s 45B also applies to schemes where a person is provided with a demerger benefit. This aspect of s 45B is not discussed in detail at this point. The demerger provisions are discussed at 13.158–13.162. Section 45C(3) was amended in 2011 to remove references to franking debits that arose under the former dividend imputation system in ITAA36 Pt IIIAA. Treasurer’s Press Release 31, 6 May 2012. The Treasury Laws Amendment (2017 Enterprise Incentives No1) Bill 2017 proposed to amend the law in relation to the carry forward of losses by companies. At the time of writing, the Bill had passed the House of Representatives but had not passed the Senate. The text has been amended on the assumption that the Bill will pass the Senate. If the Bill passes the Senate the changes proposed in it will come into effect on the earlier of the 1st January, the 1st April, or the 1st October after the Act receives the Royal Assent. Once in effect, the changes will apply to income years starting on or after 1 July 2015. ITAA97 s 165-175 makes it clear that the test can be satisfied by a single person. Note, this corresponds with requirements of the trust loss rules discussed in Chapter 15. In the 2011–12 Federal Budget, the Gillard Government announced that these provisions would be amended to remove certain technical deficiencies in their operation. The Abbott Government announced that it would not proceed with these amendments. The Tax and Superannuation Laws Amendment (2015 Measures No 2) Act 2015 (Cth) inserted new Div 167, which applies when shares in a company carry unequal rights to dividends, capital distributions or voting power. If the unequal share structure means that it cannot be determined whether the continuity of ownership test has been satisfied, the company can choose to reconsider the test in one of three ways. The first way is by disregarding debt interest. The second way is by disregarding debt interests and secondary share classes. The third way is to disregard debt interests and secondary class shares and to

46. 47.

48.

49. 50. 51. 52. 53.

54.

55.

56.

treat the remaining shares as carrying certain percentages of the rights to receive dividends and capital distributions. The effect of s 165-165(2) is that a shareholder will be regarded as holding the same shares notwithstanding a share division or consolidation. Concessional tracing rules in ITAA97 Div 166 apply to widely held companies. Under these rules, tracing occurs through certain entities (examples include complying superannuation funds and complying approved deposit funds). The Tax and Superannuation Laws Amendment (2015 Measures No 2) Act 2015 (Cth) introduced concessional tracing rules for companies other than widely held companies. The effect of the concessional rules will be that these companies do not have to trace through a complying superannuation fund, a superannuation fund that is established in a foreign country and is regulated under a foreign law, a complying approved deposit fund, a special company, a managed investment scheme or a first home savers account trust. Where no other company appears in the chain of interposed entities, as a matter of general law in the case of partnerships and some trusts, each partner or beneficiary may be regarded as having a beneficial interest in the shares. Thus, an application of the primary test will trace through ownership to natural person individuals in these circumstances. This will not happen, however, in the case of trusts like discretionary trusts or trusts of incompletely administered estates where the object/beneficiaries do not have an interest in the trust assets. At least in some circumstances it will not happen in fixed trusts. This is the combined effect of item 1 in the table in s 165-13(2) and the operation of ss 165-12(2), (3) and (4). The definition of ‘business continuity test period’ was discussed at 12.97. The effect of the definition of ‘test time’ was discussed at 12.97. Subsection 165-211(2) makes it clear that it will be permissible to take matters into account in addition to the matters set out in s 165-211(2). Although the legislation refers to the ‘debt’ being incurred rather than to the ‘bad debt’ being incurred, it is submitted that references to the ‘debt’ should be read as a shorthand reference to the writing off or other disposal of the debt. Normally, the debt itself would be regarded as accruing not as being incurred; rather, the bad debt or a loss is incurred when the debt is written off or is disposed of for less than its cost. In FCT v Macquarie Bank Ltd [2013] FCAFC 13, the Full Federal Court held that a subsidiary member of a consolidated group was a taxpayer for the purposes of ITAA36 s 177A in ITAA36 Pt IVA. This meant that the actions of a subsidiary member could result in Pt IVA applying to the head entity of the group. However, as a subsidiary member does not have a tax liability of its own, only the head entity of a group could obtain a tax benefit which would trigger the operation of Pt IVA. The Commissioner’s application for leave to appeal to the High Court was refused. In Intoll Management Pty Ltd v FCT [2012] FCAFC 179, the Full Federal Court held that a unit trust that elected to be taxed like a company and was the head entity of a consolidated group received foreign source non-portfolio dividends for its own benefit as an ‘assumed company’ and head of the consolidated group because of the consolidation rules and not in the capacity of a trustee. An amendment introduced by the Tax and Superannuation Laws Amendment (2015 Measures No 2) Act 2015 (Cth) provides that for the purpose of a head entity in a consolidated group satisfying the ‘same business’ test, the entry history rule in ITAA97 s

57.

58.

59.

60.

61.

62. 63.

701-5 does not apply. This appears to mean that in the situation in Example 12.33, it would only be necessary to show that Ravine Ltd has passed the ‘same business’ test. As from 1 July 2015, the position would appear to be that it will only be necessary to show that Ravine Ltd has passed the ‘business continuity’ test. Following Board of Taxation recommendations in June 2012 and April 2013, successive governments have announced that significant changes would be made to the asset cost setting rules to, inter alia, prevent entities from claiming double deductions. On 11 September 2017, the government released Exposure Draft Treasury Laws Amendment (2017 Measures No 9) Bill 2017: Consolidation. The Exposure Draft proposes to improve the operation of the asset cost setting rules by: (a) preventing a double benefit from arising in relation to deductible liabilities when an entity joins a consolidated group; (b) ensuring that deferred tax liabilities are disregarded; (c) removing anomalies that arise when an entity holding securitised assets joins or leaves a consolidated group; (d) preventing unintended benefits from arising when a foreign resident ceases to hold membership interests in a joining entity in certain circumstances; (e) clarifying the outcomes that arise when an entity holding financial arrangements leaves a consolidated group; and (f) clarifying the treatment of intra-group liabilities when an entity leaves a consolidated group. At the time of writing, the period for comment on the Exposure Draft had not closed and a Bill dealing with these changes had not been introduced into Federal Parliament. Section references have been deleted as have provisions dealing with the situation where the joining entity is a trust and provisions dealing with situations involving pre-joining time intra-group roll-overs from foreign resident companies. The Tax Laws Amendment (2010 Measures No 1) Act 2010 (Cth) introduced amendments to the tax cost setting rules that prevent duplication of adjustments to the allocable cost amount (eg, where integrity rules prevent the duplication of losses by reducing the cost base of shares). In addition, this amending Act introduced amendments to ITAA97 s 705-65(6) which mean that certain non-membership equity interests (such as rights or options to acquire membership interests and convertible notes issued by the entity) are treated as membership interests for the purposes of Step 1 in determining the allocable cost amount. The 2010 changes also involved amending s 705-85(3)(a) with the effect that the Step 2 amount in the asset cost setting process is effectively increased by the amount received by the joining entity from issuing non-membership equity interests to a person who is not a member of the joined group. Extracts from the Explanatory Memorandum to the Tax Laws Amendment (2010 Measures No 1) Bill 2010 (Cth) discussing these amendments are contained in Study help. Tax Laws Amendment (2010 Measures No 1) Act 2010 (Cth) amended s 711-15(2) so that non-membership equity interests (such as convertible notes) in the leaving entity are treated as if they were a different class of membership interest in the leaving entity. Amendments introduced by the Tax Laws Amendment (2010 Measures No 1) Act 2010 (Cth) adjust the calculation of the capital gain under CGT event L3 where the asset in question is an impaired debt. Corresponding adjustments are made to the tax cost setting amount of an impaired debt held by a joining entity. Amendments introduced by the Tax Laws Amendment (2010 Measures No 1) Act 2010 (Cth) reduce the capital gain arising under CGT event L5 in certain circumstances. Mention should also be made of CGT event L7, which was repealed by the Tax Laws

64. 65.

66.

67.

68.

69. 70. 71.

Amendment (2010 Measures No 1) Act 2010 (Cth) with effect from 3 June 2010. Note that under the ITAA97 s 149-10 definition of ‘pre-CGT asset’, a prior application of ITAA97 Div 149 or ITAA36 s 160ZZS will mean that an asset is not a pre-CGT asset. There are some differences between the entities referred to in ITAA97 s 149-50 and the definition of ‘public company’ (discussed in 12.29–12.32) but there is a very considerable degree of overlap between the two concepts. The entities affected are set out in ITAA97 s 149-50. In brief, the companies affected are: (a) companies with shares (except shares with fixed dividend entitlements) listed for quotation in the official list of an approved stock exchange; (b) a mutual insurance company; (c) a mutual affiliate company; and (d) an unlisted company in which all the shares are owned by one or more of the types of company referred to in (a) to (c) above or by a publicly traded unit trust. ‘Abnormal trading’ is defined in ITAA97 Subdiv 960-H. Abnormal trading will take place where a merger or acquisition is suspected or where more than 20% of a company’s shares are traded in a 60-day period. The rule in Subdiv 960-H that trading more than 5% of shares in one transaction is abnormal trading is disregarded for purposes of Div 149: see s 14955(7). The provisions can also apply where the disposal is to a connected entity. Under ITAA97 s 170-265, a connected entity can be a fixed trust where companies that are members of the linked group (or their associates) are directly or indirectly entitled to receive more than 50% of any distribution of income or corpus of the trust. A connected entity can also be a non-fixed trust where any company that is a member of the linked group (or an associate) is capable of benefiting under the trust. An individual can be a connected entity if the individual has a controlling stake in the company. The listed events are A1, D1, D2, D3 and F1. The text discusses what the rules are in an A1 case. The rules are slightly different in the other cases. The shares cannot be redeemable shares. If the market value is less than it otherwise would be only because of contingent liabilities, such as income tax or accrued annual leave entitlements, attaching to the shares, the difference is disregarded.

[page 851]

CHAPTER

13

Taxation of Shareholders Learning objectives After studying this chapter, you should be able to: identify the distributions by a company to its shareholders that are treated as dividends for tax purposes; calculate the tax effects for resident shareholders of receipt of franked distributions; explain what is meant by ‘income derived by the company’ in ITAA36 s 47(1); identify the circumstances where a shareholder will not obtain a tax offset on receipt of a distribution.

Introduction 13.1 In Chapter 12, among other things, we discussed the taxation of corporate tax entities and the operation of the dividend imputation system as it affects corporate tax entities. So far we have looked in detail at only half the story of how income is taxed as it moves through a corporate tax entity to a member. In this chapter, as was the case in Chapter 12, we shall take the tax treatment of a company and its shareholders as the paradigm case of how corporate tax entities and their members are taxed. In this chapter, we shall examine what tax effects the receipt of a dividend or another form of corporate

distribution has for a shareholder. This involves explaining what a dividend is for tax purposes and how the dividend imputation system works at the shareholder level. In Chapter 12, we also discussed capital gains tax (CGT) from a company’s perspective. As a sale of shares is one method by which a shareholder can realise the benefits of a company’s retained earnings (rather than waiting for them to be distributed) this chapter will also examine CGT from a shareholder’s perspective.

Dividends as income under ordinary concepts 13.2 In Chapter 3, we noted that dividends paid out of profits are income under ordinary concepts as a gain from property. In terms of the horticultural metaphors that substitute for analysis in the ordinary concept, the shareholder’s investment in [page 852] the company can be seen as the tree while the dividend is the ‘fruit from the tree’.1 Alternatively, the share can be seen as the source of the dividend that is the flow from that source. Traditionally, as a matter of company law, dividends have been able to be paid only out of profits.2 As we saw in Chapter 12, to the extent that those profits represent taxable income to the company, those profits are subject to taxation. Although companies are separate legal persons from their shareholders, ultimately all companies must be owned by natural person shareholders. In Chapter 12, we saw that under the classical system of corporate taxation a company pays tax on its taxable income and a shareholder pays tax when the company’s after-tax income is distributed as a dividend. When this happens, the criticism can be made that the same gain is subject to economic double taxation. Ultimately, the same natural persons are taxed twice on the same gain because of the

separate legal entity fiction and because it is regarded as fitting within two different aspects (business gain and income from property) of the ordinary concept of income. 13.3 In Chapter 12, we noted that Australia tries to eliminate economic double taxation of income flowing through companies to shareholders by using a dividend imputation system. The effect of the dividend imputation system is that a company is really treated as a separate legal entity only in relation to retained income. Once taxed corporate income is distributed to shareholders, the corporate tax, in effect, [page 853] functions as a withholding tax. This is because the shareholder is given credit for the corporate tax paid and can apply that credit against the shareholder’s tax liability on the dividend. Note, however, that the taxability of the whole amount of a dividend to the shareholder remains an integral feature of the Australian dividend imputation system. We shall see that s 44(1) of the Income Tax Assessment Act 1936 (Cth) (ITAA36), in the case of a resident shareholder, includes the whole amount of a dividend paid out of profits in the shareholder’s assessable income. In the case of a non-resident shareholder (other than a nonresident carrying on business in Australia through a permanent establishment), the inclusion is limited to dividends paid out of profits derived from sources in Australia. Where the shareholder is a nonresident carrying on business through a permanent establishment in Australia, dividends paid to the shareholder that are attributable to the permanent establishment are included in the shareholder’s assessable income to the extent to which they are paid out of profits from sources outside Australia. The treatment of non-resident shareholders is discussed in more detail in Chapter 18. Although a dividend represents ordinary income as a gain from property, s 6-25 of the Income Tax Assessment Act 1997 (Cth) (ITAA97) will mean that the dividend will be included only once in

your assessable income. Moreover, the effect of ITAA97 s 6-25 is that the specific provisions in ITAA36 ss 44–47 prevail over the rules about ordinary income.3 We shall also see that, following the introduction of the debt and equity legislation, all non-share dividends paid to a shareholder by a company are included by ITAA36 s 44(1) in the assessable income of a resident shareholder. All non-share dividends derived from sources in Australia are included in the assessable income of a non-resident shareholder. In addition, all non-share dividends derived from sources outside Australia that are attributable to a permanent establishment in Australia are included in the assessable income of a non-resident carrying on business in Australia through the permanent establishment. Note also that, under the Australian system, taxation at the shareholder level in general only occurs when some form of distribution of profits is made to shareholders. This treatment is arguably appropriate from a theoretical perspective for companies, other than small closely held companies. It is strongly arguable that taxing shareholders in companies, other than small closely held companies, on corporate profits regardless of their distribution would be unfair.

The Australian dividend imputation system: The shareholder’s perspective 13.4 Figure 13.1 provides an overview of Australia’s dividend imputation system. In Chapter 12, we examined aspects of the dividend imputation system as it affects [page 854] companies. In this chapter, we will examine those aspects of the dividend imputation system that affect shareholders. This will involve discussing the following questions: What is a dividend or a non-share dividend for tax purposes?

How is a dividend or a non-share dividend included in a shareholder’s assessable income? How are natural person shareholders given credit for tax paid at the company level?

Figure 13.1: Australia’s dividend imputation system (assuming shareholder is a resident)

The ITAA36 definition of ‘dividend’ 13.5 There are strong policy reasons for trying to ensure that all possible types of distributions that a company may make to its

shareholders have similar tax consequences for the shareholders. If this is not the case, then the company may be subject to shareholder pressure to make the kind of distributions that are most tax advantageous to shareholders. One of the ways the income tax legislation tries to ensure that all corporate distributions are treated in a similar way is by using a very broad definition of ‘dividend’. The current basic definition of ‘dividend’ for purposes of both the ITAA36 and ITAA97 is contained in ITAA36 s 6(1). The definition is as follows: [page 855]

dividend includes: (a) any distribution made by a company to any of its shareholders, whether in money or other property; and (b) any amount credited by a company to any of its shareholders as shareholders; (c) [repealed] but does not include: (d) moneys paid or credited by a company to a shareholder or any other property distributed by a company to shareholders (not being moneys or other property to which this paragraph, by reason of subsection (4), does not apply or moneys paid or credited, or property distributed for the redemption or cancellation of a redeemable preference share), where the amount of the moneys paid or credited, or the amount of the value of the property, is debited against an amount standing to the credit of the share capital account of the company; or (e) moneys paid or credited, or property distributed, by a company for the redemption or cancellation of a redeemable preference share if: (i) the company gives the holder of the share a notice when it redeems or cancels the share; and (ii) the notice specifies the amount paid-up on the share immediately before the cancellation or redemption; and (iii) the amount is debited to the company’s share capital account; except to the extent that the amount of those moneys or the value of that property, as the case may be, is greater than the amount specified in the notice as the amount paid-up on the share; or (f) a reversionary bonus on a life assurance policy. Note: Subsection (4) sets out when paragraph (d) of this definition does not apply.

Note that paras (d), (e) and (f) expressly deem distributions that would otherwise be dividends under paras (a) or (b) of the definition not to be a dividend. Note also that the definition is inclusive. That is, something that would be a dividend under the ordinary meaning of the word ‘dividend’ will also be a dividend for the purposes of the ITAA36 even if it is not specifically mentioned in the s 6(1) definition. The ordinary meaning of ‘dividend’ was the subject of some comment by French J in the Full Federal Court decision in FCT v McNeil (2005) 144 FCR 514; 60 ATR 275 at 289. French J held that an issue of put options by a company to a trustee for shareholders was not within the ordinary usage notions of a dividend as income. This was because the entitlement was not a product of the shareholder’s shares, it was not an entitlement derived from profits earned by the company; rather, it arose through the decision of the company to reduce its capital through a buyback process. In McNeil in the Full Federal Court, the Commissioner of Taxation [page 856] had not argued that the put options were a dividend assessable to the shareholder under s 44(1) and, hence, French J’s comments appear to be obiter. Moreover, the decision of the Full Federal Court was reversed on appeal to the High Court on the basis that the market value of the put options was ordinary income to the shareholder but not on the basis that the issue of put options was a dividend. One of the functions of an inclusive definition can be to deem something to have characteristics that it would not otherwise have. There is authority that this is one of the effects of the inclusive definition of ‘dividend’ in s 6(1). See FCT v Uther (1965) 112 CLR 630 per Kitto J (dissenting) at 634 approved by the Full High Court in FCT v Slater Holdings Ltd (1984) 156 CLR 447. See also the judgment of Dowsett J in the Full Federal Court decision in FCT v McNeil (2005) 144 FCR 514; 60 ATR 275 at 320–1.

Any distribution made by the company 13.6 Paragraph (a) of the ITAA36 s 6(1) definition of ‘dividend’ includes any distribution made by a company to any of its shareholders. A ‘distribution’ can be a non-cash or in specie distribution. This is evident from the reference in para (a) to ‘any distribution made by a company … whether in money or other property’. In CT (NSW) v Stevenson (1937) 59 CLR 80 at 101, Rich, Dixon and McTiernan JJ commented that the word ‘distributed’ covers distributions in specie. See also CT (Vic) v Nicholas (1938) 59 CLR 230 at 238 per Latham CJ. 13.7 An informal appropriation of a company’s assets by shareholders can be a distribution for these purposes. In CT (NSW) v Stevenson (1937) 59 CLR 80, the High Court regarded a distribution made in an informal liquidation that was never properly authorised by law as a distribution.4 In FCT v Blakely (1951) 82 CLR 388, Fullagar J (with whom Dixon J agreed) held that an appropriation of a company’s assets by its sole shareholders after it had ceased to carry on business was a distribution for the purposes of the ITAA36 s 6(1) definition. This was so notwithstanding the fact that the company as a distinct legal entity had not taken any active steps to make a distribution to shareholders.5 13.8 It appears that a distribution must involve a passing of money or other property from the company to a shareholder. Hence, a mere release of rights that a company has against a shareholder will not be a distribution. In FCT v Black (1990) 25 FCR 274; 21 ATR 701; 90 ATC 4699, Sweeney J held that in para (a) of the definition of ‘dividend’ in ITAA36 s 6(1) ‘distribution’ involves, at the least, a dealing out or bestowal. Hence, a resolution to forgive a debt owing to the company by a shareholder was not a distribution but merely an indication by the company that it ‘forwent the receipt of payment by the taxpayer’. [page 857]

Any amount credited to shareholders as shareholders

13.9 Paragraph (b) of the ITAA36 s 6(1) definition of ‘dividend’ includes an amount credited by the company to any of its shareholders as shareholders. Several High Court cases have considered the meaning of ‘credited’ in similar contexts. In Webb v FCT (1922) 30 CLR 450 at 478–9, Isaacs J (as he then was) commented on the use of the terms ‘credited and paid’: The employment of all these terms marks the anxiety of the Legislature that, in whatever form profits of a company are “credited or paid” to the members, &c, “credited or paid” shall be regarded as the recipient’s income for the purposes of taxation … The Legislature, as it appears to me, has by the word “credited” sought to reach cases where, though a member or shareholder who has not been “paid” the dividend or bonus, there has been credit in the company’s books imputed to the share he holds … But, at all events, “profits credited or paid” are, as it seems to me, pointed to “profits” which have in some way been made a debt by the company to the shareholder, &c. In the case of a shareholder, that would be by a “dividend or bonus” — or even by “interest” used in the sense of a distribution of profits. But the declaration of a “dividend” creates a debt … Where there is no debt, or “debit”, the word “credit” or the word “pay”, in relation to profits, is meaningless, for there is nothing calling for payment and there is no balance to be struck.

In CT (Vic) v Nicholas (1938) 59 CLR 230 at 244, Rich J (in a passage subsequently approved by the Privy Council) considered whether a direct capitalisation of profits amounted to a crediting: … it has become common practice to adopt articles of association authorising the direct issue of paid-up shares. But the shares must be paid out of something and that something must be susceptible of application or appropriation to answer what would otherwise be a liability to the face value of the shares. Unless the prima-facie liability is extinguished by an application of money or money’s worth available for that purpose, the shares are unpaid, and that means the shareholder is liable for their amount and upon the capital being called up would owe a debt in praesenti … When a company appropriates or applies its profits to satisfy or extinguish this liability, it appears to me quite clear that it credits them to the shareholder. It applies them to his use. When an Act of Parliament speaks of “crediting” it is not discussing bookkeeping, but the appropriation of profits to answer the purposes of the shareholder. If the shareholder obtains shares, stock, debentures, bonds or any other negotiable or transferable form of obligation of the company or interest in its assets, and the consideration which would otherwise be supplied by him consists in an appropriation by the company of profits to that end it would seem to me to be the very thing meant by “crediting” of profits.

13.10 Note that the amount credited must be credited ‘to shareholders as shareholders’. In FCT v Black (1990) 25 FCR 274; 21 ATR 701; 90 ATC 4699, Sweeney J held that this phrase should be construed as meaning ‘in the capacity of a shareholder’. Thus, in Black,

a crediting of an amount to a shareholder in the capacity of a debtor was not within para (b) of the ITAA36 s 6(1) definition. 13.11 It is currently unclear whether a capitalisation of profits by means of an issue of bonus shares will amount to a dividend under para (b) of the ITAA36 s 6(1) definition. Taxation Ruling IT 2603 ‘Income Tax: Scrip Dividends’ takes the view that the par value of a bonus share made in satisfaction of a dividend previously [page 858] declared may be an amount credited to a shareholder as shareholder and hence be a dividend under para (b). The following passage from the judgment of Brennan J in John v FCT (1989) 166 CLR 417; 20 ATR 1 at 18 provides some support for this view: The capitalising of profits and the distribution of bonus shares have been analysed in a series of cases under different taxing statutes. When profits are capitalised, the assets which represent the profits and which have theretofore been available for distribution to shareholders as dividends cease to be available for distribution. The assets do not leave the company’s hands. However, as bonus shares have to be paid for and as the company cannot pay for its own shares out of its own money, the amount applied to payment for bonus shares is treated as credited to shareholders to whom the shares are allotted though the shareholders acquire no right to the credit anterior to or independent of the allotment of the bonus shares.

Earlier High Court and Privy Council authority6 supports the view that an issue of bonus shares funded from a direct or indirect capitalisation of profits is a dividend within para (b) of the ITAA36 s 6(1) definition of ‘dividend’. 13.12 The Taxation Laws Amendment (Company Law Review) Act 1998 (Cth) (Company Law Review Act 1998) amended the ITAA36 s 6(1) definition of ‘dividend’. Among the amendments was the omission of para (c) of the definition. The former para (c) of the definition of ‘dividend’ expressly included the paid-up value of shares issued by a company to shareholders to the extent that it represented a capitalisation of profits. Paragraph 1.90 of the Joint Explanatory Memorandum to Taxation Laws Amendment (Company Law Review)

Bill 1998 (Cth) and Income Tax (Untainting Tax) Bill 1998 (Cth), which amended the ITAA36 s 6(1) definition of ‘dividend’, appears to take the view that, subject to some exceptions (discussed in 12.84–12.88 and in the Study help accompanying 13.58), bonus issues, including those funded from a capitalisation of profits, will not in future be dividends. However, the Joint Explanatory Memorandum does not contain an explanation of why a bonus issue funded by a capitalisation of profits would not be a dividend under para (b) of the definition. Given the inconsistency between the Joint Explanatory Memorandum and IT 2603 (discussed in 13.11) the question of whether such a bonus issue is a dividend under the amended s 6(1) definition should be clarified either by a public ruling or by legislative amendment. 13.13 It should be noted that following the Company Law Review Act 1998, it is possible for a company to make a bonus issue without consideration being payable to the company and without increasing its share capital. The effect of such an issue is merely to dilute the value of shares already issued. Arguably, in this situation, the bonus [page 859] issue, in effect, amounts to a subdivision of existing share capital and does not involve the crediting of any additional amounts to the shareholder. Under this analysis, such a bonus issue would not be a dividend within para (b) of the ITAA36 s 6(1) definition.

Amounts debited against share capital account 13.14 Amounts debited against share capital accounts generally will not be dividends under the ITAA36 s 6(1) definition. Under the Corporations Act 2001 (Cth) (Corporations Act), a company may, if authorised by an appropriate resolution by its members, return its capital to its members.7 Subject to the qualifications discussed in 12.84–12.88 and the Study help accompanying 13.58, such a return of

capital will not be a dividend because of para (d) of the ITAA36 s 6(1) definition. The Corporations Amendment (Corporate Reporting Reform) Act 2010 (Cth) amended the Corporations Act by removing the requirement that companies pay dividends only out of profits. Under amended s 254T of the Corporations Act, with effect from 28 June 2010, a company can pay a dividend only where: the company’s ‘assets exceed its liabilities by an amount sufficient to fund the dividend at the time the dividend is declared; paying the dividend is ‘fair and reasonable to the company’s shareholders as a whole’; and paying the dividend ‘does not materially prejudice the company’s ability to pay its creditors’. The Corporations Amendment (Corporate Reporting Reform) Act 2010 (Cth) also inserted ITAA36 s 44(1A), which states, for the purposes of the ITAA36, that ‘a dividend paid out of an amount other than profits is taken to be a dividend paid out of profits’. Note that s 44(1A) does not deem a distribution from an amount other than profits to be a dividend; rather, it states that, where such a distribution is a dividend, it will taken to be a ‘dividend paid out of profits’. The second use of the word ‘dividend’ in the subsection cannot deem the distribution to be a dividend as the subsection applies only to distributions that are dividends. Rather, the intent of the section is clearly to deem the dividend distribution to be ‘paid out of profits’. The section assumes that a distribution paid out of an amount other than profits can be a ‘dividend’ within the ITAA36 s 6(1) definition, which means that it can be an amount that is not debited against the share capital account. Some commentators questioned whether some dividend payments that are permitted under amended s 254T of the Corporations Act will be characterised, at least by the Australian Taxation Office (ATO), as not being a dividend under the ITAA36 s 6(1) definition on the basis that they represent amounts debited against the share capital account.8 [page 860]

Taxation Ruling TR 2012/5 ‘Income Tax: Section 254T of the Corporations Act 2001 and the Assessment and Franking of Dividends Paid From 28 June 2010’ released on 27 June 2012 takes the view (in paras 33 and 36), that: 33. In particular, the new section 254T does not “otherwise authorise by law” a reduction of share capital for the purposes of section 256B and Part 2J.1 of the Corporations Act. It appears that the procedures to approve a share capital reduction in Part 2J.1 of the Corporations Act would also have to be met for a company to pay a dividend not prohibited by section 254T of the Corporations Act that was sourced from share capital. … 36. The better view appears to be that for the purposes of the Corporations Act and company accounting, dividends can only be paid from profits and not from “amounts other than profits”. The new section 254T of the Corporations Act imposes three specified additional prohibitions on the circumstances in which a dividend can be paid, as inherently a dividend can only be paid out of profits, having regard to the ordinary and legal meaning of the word dividend.

Paragraph 37 of TR 2012/5 goes on to state, however: 37. If, contrary to the Commissioner’s view, a dividend can be paid out of an “amount other than profits” and the distribution satisfies the definition of dividend under subsection 6(1) of the ITAA 1997, it would be taxable as follows. A company that pays a dividend to its shareholders in accordance with its constitution and without breaching section 254T or Part 2J.1 of the Corporations Act that is paid out of an amount other than profits is not prevented by paragraph 202-45(e) of the ITAA 1997 from franking the dividend provided the company’s net assets exceed its share capital by at least the amount of the dividend. That dividend will be assessable income of its resident shareholders under paragraph 44(1)(a) of the ITAA 1936 as a result of the deeming in subsection 44(1A) of the ITAA 1936.

Subsequent paragraphs (41–43) of the ruling argue that, notwithstanding s 44(1A), distribution funded from share capital account will not be frankable because of ITAA97 s 202-45(e): 41. A payment that is a dividend paid or credited in compliance with the new section 254T of the Corporations Act will be an assessable dividend for taxation law purposes as well, provided it is not debited against an amount standing to the credit of the share capital account of the company. However, this is not the basis upon which the ability to frank dividends is determined under Part 3-6 of the ITAA 1997. Section 202-45 of the ITAA 1997 identifies those distributions which are not frankable. Paragraph 202-45(e) of the ITAA 1997 provides that a distribution that is sourced, directly or indirectly, from a company’s share capital account is unfrankable. 42. Paragraph 202-45(e) of the ITAA 1997 is considered to be a structural integrity rule as that term was used in paragraph 3.18 of the Explanatory Memorandum to the CACRRA. Subsection 44(1A) of the ITAA 1936 does not have the effect that all dividends that are paid out of profits or amounts other than profits are frankable

distributions for the purposes of Part 3-6 of the ITAA 1997. Such an interpretation would render the structural integrity rules in Part 3-6 of the ITAA 1997 redundant and the Explanatory Memorandum to the CACRRA indicates that was not intended. The structural integrity rules were not repealed and both the ITAA 1936 and the ITAA 1997 should be interpreted to retain practical scope for their application. 43. The guide to the imputation system in section 202-25 of the ITAA 1997 states: ‘Generally, distributions that are made out of realised profits can be franked’. However,

[page 861] the payment of a dividend out of profits is not a requirement for a distribution to be frankable under section 202-40 of the ITAA 1997. Although the deeming in subsection 44(1A) of the ITAA 1936 applies for the purposes of ‘this Act’ (which includes the ITAA 1997), that does not assist in the satisfaction of section 202-40 of the ITAA 1997. Whether a dividend is sourced directly or indirectly from a company’s share capital account within paragraph 202-45(e) of the ITAA 1997 does not turn on whether the distribution is deemed to be paid out of profits. [Footnotes omitted]

In April 2014, the Abbott Government released a draft Corporations Legislation Amendment (Deregulatory and Other Measures) Bill 2014 (Cth) and called for submissions in response to the draft. The draft Bill proposed amendments to the test for payment of dividends but was not designed to change existing taxation arrangements. Although a final Bill with the same title was subsequently passed by the Commonwealth Parliament, that Bill did not propose amendments to s 254T of the Corporations Act. At the time of writing, final legislation proposing amendments to s 254T had not been introduced into the Commonwealth Parliament. ITAA97 s 975-300 states that, subject to some exceptions, a company’s share capital account that is tainted is taken not to be a share capital account for purposes of the ITAA97. As discussed in more detail at 12.77, under s 197-50, subject to exceptions, a company’s share capital account is tainted if the company transfers an amount to its share capital account from any of its other accounts. For example, a company’s share capital account will become tainted if the company capitalises profits. Once a company’s share capital account is tainted, a distribution from that account will not be excluded, by para (d) of the ITAA36 s 6(1) definition of ‘dividend’, from being a dividend until the

account becomes untainted again. The tax effects for the company when its share capital account becomes tainted are discussed in 12.78–12.79. How a company may untaint its share capital account is discussed in 12.80–12.83. 13.15 Paragraph (d) of the ITAA36 definition of ‘dividend’ does not apply where ITAA36 s 6(4) applies. Section 6(4) appears to be primarily directed at schemes like the following in Example 13.1.

Oscar is the sole shareholder in Wilde Pty Ltd. His shares are post-CGT shares. Oscar owns 100,000 shares in Wilde Pty Ltd on each of which $1 has been paid. The current market value of the net assets of Wilde Pty Ltd is $200,000. Alfred offers to purchase one-half of Oscar’s shares in Wilde Pty Ltd for $100,000. Assuming that there had been no indexation on Oscar’s shares, if Oscar sold one-half of his shares to Alfred at this price he would make a capital gain of $50,000. If a discount were available then the capital gain would be reduced to $25,000. Oscar, instead of selling one-half of his shares to Alfred, arranges for Wilde Pty Ltd to issue 100,000 shares on which $1 each has been paid to Alfred. Wilde Pty Ltd then uses the $100,000 to fund a selective return of capital (not involving a cancellation of the shares) to Oscar. [page 862] In the absence of s 6(4), the return of capital of $100,000 would not be a dividend as it would be within the exception in para (d) of the ITAA36 s 6(1) definition of dividend. ITAA36 s 6(4) will mean that, if the issue of shares to Alfred and the return of capital to Oscar amounts to an arrangement, para (d) of the definition of dividend will not apply. This would mean that the return of capital to Oscar would be a dividend under para (a) of the definition.

Redemption or cancellation of redeemable preference shares 13.16 Paragraph (e) of the definition of ‘dividend’ excludes certain amounts returned to shareholders by way of redemption or cancellation of redeemable preference shares. The exclusion only operates if the

redemption or cancellation is debited against the company’s share capital account. If the share capital account is tainted it will not be a share capital account for these purposes and the exclusion will not apply. Any excess of the amount returned over the amount paid-up on the shares will not be within the exclusion and, hence, will be a dividend under para (a) of the definition. Logically, an amount returned from a share capital account by way of redemption or cancellation of shares would only be able to exceed the amount paid-up on the shares for either of two reasons. One reason is if the share capital account had previously been tainted by transferring amounts to it from other accounts. The second reason is if the redemption payment was sourced, in part, from amounts paid-up in relation to ordinary shares. Amounts distributed from an untainted share capital account would be excluded from being dividends by para (d) of the definition in any event. The para (e) exclusion, in effect, functions to qualify the para (d) exclusion. Even though a distribution is from an untainted share capital account, if it is by way of redemption or cancellation of redeemable preference shares, it will only be excluded from being a dividend if it does not exceed the amount paid-up on the shares. Note that if a redemption or (more probably) a cancellation of redeemable preference shares is debited against an account other than the company’s share capital account, it would appear to be a dividend under paras (a) or (b) of the ITAA36 s 6(1) definition of ‘dividend’.

Deemed dividends 13.17 Despite the width of the ITAA36 definition of ‘dividend’, parliament has found it necessary to deem certain distributions that fall outside the definition to be dividends. These include the following:9 ITAA36 s 109 deems to be a dividend so much of payments made by a private company to an associate for services rendered, or in consequence of the retirement of the associate from an office or employment held by the associate

[page 863] with the company, and which exceed what the Commissioner considers to be a reasonable payment. By making excessive payments to shareholders or directors, a company would be obtaining deductions for the payments and hence reducing its taxable income. ITAA36 Pt III Div 7A (ss 109B–109ZE), which deems certain, otherwise nonassessable advances, loans and other credits (such as debt forgiveness) by private companies to shareholders and associates to be dividends to the extent that the company has realised or unrealised profits. The anti-capital benefit streaming rules (discussed in 12.84–12.88) will deem capital benefits to which they apply to be unfrankable dividends paid by the company out of profits. ITAA36 s 47 deems liquidator’s distributions, to the extent to which they represent income derived by the company, other than income properly applied to make good a loss of paid-up capital, to be dividends. ITAA36 s 47(1) and associated sections are discussed in 13.62–13.86. We will see in 13.62 that in the absence of s 47(1) a liquidator’s distribution would be regarded as representing a realisation of the shareholder’s investment in the company and would only be taxable as a capital gain. ITAA36 s 159GZZZP(1) deems to be a dividend so much of the buy-back price in an off-market buy-back as is not debited against untainted share capital account. A summary of the tax treatment of off-market buy-backs is contained in 13.56 and the Study help accompanying 13.61. In the absence of the deemed dividend provisions, the buy-back price would simply represent the capital proceeds for the shares and would only be subject to CGT. Note that, in all these instances, the dividend is deemed to be paid by the company out of profits derived by it. Hence, these deeming provisions trigger the operation of ITAA36 s 44(1), which will include

the deemed dividend in the shareholder’s assessable income. ITAA36 s 44(1) is discussed in detail in 13.32–13.40.

Excessive payments to associates: ITAA36 s 109 13.18 ITAA36 deems excessive payments by a private company to associated persons, purportedly for services rendered, to be dividends paid out of profits to the associated person as a shareholder. Thus, a s 109 deemed dividend will trigger ITAA36 s 44(1): see 13.33–13.40. This will mean that the deemed dividend is included in the shareholder’s assessable income. A s 109 deemed dividend is deemed to be an ‘unfrankable distribution’ by ITAA97 s 202-45(g)(iii). Moreover, s 109 expressly states that the payment is not an allowable deduction to the paying company. The substantive provision is s 109(1), which states as follows: 109 Excessive payments to shareholders, directors and associates deemed to be dividends (1) If a private company pays or credits to an associated person an amount (in this subsection called the excessive amount) that is, or purports to be (a) remuneration for services rendered by the associated person; or [page 864] (b) an allowance, gratuity or compensation in consequence of the retirement of the associated person from an office or employment held by the associated person in the company, or upon the termination of any such office or employment; so much (if any) of the excessive amount as exceeds an amount that, in the opinion of the Commissioner, is reasonable: (c) is not an allowable deduction; and (d) shall, for the purposes of this Act other than Division 11A of Part III, be deemed to be a dividend paid by the company: (i) to the associated person as a shareholder in the company; (ii) out of profits derived by the company; and (iii) on the last day of the year of income of the company in which the excessive payment or credit is made.

13.19

Section 109(2) states that, for s 109 purposes, a transfer of

property is deemed to be a payment of an amount equal to the value of the property. Section 109(2) goes on to define, for s 109 purposes, an ‘associated person’ in relation to a company as: (i) a person who is, or has been, a shareholder in, or a director of, the company; or (ii) a person who is an associate, within the meaning of section 318, of a person who is, or has been, a shareholder in, or director of, the company.

The definition of ‘associate’ in ITAA36 s 318 defines associates of a natural person, associates of a company, associates of a trust and associates of a partnership. These definitions share many common features including genetic and conjugal relationships and required degrees of influence and control. The definition of ‘associates of a natural person’ in s 318(1) is typical of the way ‘associate’ is defined in s 318. 318 Associates (1) For the purposes of this Part, the following are associates of an entity (in this subsection called the primary entity) that is a natural person (otherwise than in the capacity of trustee): (a) a relativea of the primary entity; (b) a partner of the primary entity or a partnership in which the primary entity is a partner; [page 865] (c) if a partner of the primary entity is a natural person otherwise than in the capacity of trustee the spouse or a child of that partner; (d) a trustee of a trust where the primary entity, or another entity that is an associate of the primary entity because of another paragraph of this section, benefits under the trust; (e) a company where: (i) the company is sufficiently influenced by: (A) the primary entity; or (B) another entity that is an associate of the primary entity because of another paragraph of this subsection; or (C) another company that is an associate of the primary entity because of another application of this paragraph; or

(D) 2 or more entities covered by the preceding sub-subparagraphs; or (ii) a majority voting interest in the company is held by: (A) the primary entity; or (B) the entities that are associates of the primary entity because of subparagraph (i) of this paragraph and the preceding paragraphs of this subsection; or (C) the primary entity and the entities that are associates of the primary entity because of subparagraph (i) of this paragraph and because of the preceding paragraphs of this subsection.

a.

The combined effect of ITAA36 s 6(1) and ITAA97 s 995-1 is that a ‘relative’ means: (a) a person’s spouse; (b) the parent, grandparent, brother, sister, uncle, aunt, nephew, niece, lineal descendant or adopted child of that person, or of that person’s spouse; or (c) the spouse of a person referred to in (b). The combined effect of ITAA36 s 6(1) and ITAA97 s 995-1 is that ‘spouse’ includes a de facto spouse or, more technically, a person who, although not legally married to the person, lives with the person on a genuine domestic basis as the person’s husband or wife. Under ITAA36 s 318(7), however, a reference to the spouse of a person does not include: (a) a reference to a person who is legally married to that person but is living separately and apart from that person on a permanent basis; or (b) a spouse within the meaning of paragraph (a) of the definition of ‘spouse’ in ITAA97 s 995-1(1) who is living separately and apart from the person on a permanent basis.

13.20 Some features of s 109 may be noted. First, note that s 109 expressly states that the payment is not deductible to the paying company. Second, note how broad the definition of ‘associated person’ in s 109 is. Third, if s 109 applies to a payment, ITAA36 Pt III Div 7A (discussed in 13.21–13.30) does not apply. [page 866]

Excessive payments for services rendered by associates would be assessable income to the associates in any event. Deeming the payments to be dividends will not increase the amount that is regarded as income in the associate’s hands. Why then would ITAA36 s 109 discourage a private company from making excessive payments to associated persons?

Loans and other credits where company has profits: ITAA36 Pt III Div 7A 13.21 The operation of the former s 108 depended on the Commissioner forming the opinion that the payment or crediting of the amount by the private company represented a distribution of profits. The Administrative Appeals Tribunal had held that the principal factor to be considered in making this determination was whether the recipient had an intention to repay. Whether or not the loan was on commercial terms was regarded as less significant. To exercise the discretion properly, the Commissioner would also have had to determine that the company had profits but not that those profits had been set aside for the payment of a dividend: MacFarlane v FCT (1986) 17 ATR 808; 86 ATC 4477. The Commissioner might not have felt in a position to make this determination without first auditing the company. 13.22 By contrast, ITAA36 Pt III Div 7A prima facie deems a payment, a loan or debt forgiveness by a private company to be a dividend where the other party was a shareholder or associate. Subsequent provisions in Div 7A exclude certain payments, loans and debts forgiven from being dividends. Among the loans excluded are loans made in the ordinary course of business and on usual terms, and loans meeting certain criteria relating to minimum interest rate and maximum term. Thus, in the case of loans, the emphasis has shifted from the Commissioner, under s 108, making a determination that focuses on the recipient’s intention to pay, to, under Div 7A, a loan

being regarded as a dividend unless it has certain objective characteristics.

2007 amendments 13.23 Several significant amendments were made to ITAA36 Pt III Div 7A by the Tax Laws Amendment (2007 Measures No 3) Act 2007 (Cth). Generally, the amendments apply to the year in which 1 July 2006 occurs and later income years. One change implemented by the amendments was to repeal a franking debit which previously arose under ITAA97 s 205-30 when a Div 7A deemed dividend arose. As discussed at 13.29, Div 7A deemed dividends are assessable and are unfrankable. The previous rule that, in addition, imposed a franking debit was regarded as a double penalty and was repealed for that reason. 13.24 Another of the 2007 amendments relates to the amount of the deemed dividend that arises when a company fails to make the minimum required payment against an amalgamated loan. Previously, this resulted in a deemed dividend equal to [page 867] the entire loan balance. By contrast, under the 2007 amendments, the amount of the deemed dividend is limited to the amount by which the payment falls short of the required minimum. 13.25 A further 2007 amendment, the insertion of ITAA36 s 109RB, gives the Commissioner a discretion (which applies from 1 July 2001) to determine either that a Div 7A deemed dividend does not arise in circumstances where it otherwise would or that a Div 7A deemed dividend may be franked. The discretion may be exercised where the Div 7A deemed dividend arose because of an honest mistake or an inadvertent omission by either the recipient, the private company or by any other entity whose conduct contributed to the deemed dividend arising. The Commissioner has issued Practice Statement Law

Administration PS LA 2007/20 in relation to the exercise of his discretion under s 109RB and has issued Draft Taxation Ruling TR 2010/D3 on this topic.

2010 amendments 13.26 Further amendments were introduced by the Tax Laws Amendment (2010 Measures No 2) Act 2010 (Cth). Subject to specified exceptions, most notably the use of certain residences, this Act extended the meaning of ‘payment’ to include the provision of an asset for use by an entity. Also under the amendments, payments to private companies in relation to loans are not taken into account in determining whether the loans have been repaid where, at the time the payment was made, a reasonable person would conclude that the payer either: (a) intended to obtain a loan (or loans) from the private company of an amount similar to or larger than the amount of the payment; or (b) before the payment, obtained loans from the private company of an amount similar to or larger than the payment. Amendments introduced with the Act also apply Div 7A in the context of unpaid trust distributions. Another amendment introduced was to apply Div 7A to corporate limited partnerships in the same way as it applies to private companies. More details of the amendments made by the Act are contained in the Explanatory Memorandum to Tax Laws Amendment (2010 Measures No 2) Bill 2010 (Cth), relevant extracts from which are contained in Study help.10 [page 868]

Structure of Pt III Div 7A 13.27 The structure of ITAA36 Pt III Div 7A may be summarised as follows: Subdivision AA (s 109BA) This Subdivision applies Div 7A to non-share equity interests, equity holders and dividends.

Subdivision B (ss 109C–109F) This Subdivision treats certain transactions, namely payments,11 unrepaid loans, and debt forgiveness, by a private company as dividends provided:12 – the other party to the transaction was a shareholder or associate at the time when the transaction took place; or – a reasonable person would conclude that the transaction was entered into because the other party was a shareholder or associate at some time.13 Subject to Subdiv F, the amount of the dividend will be the amount of the payment, the amount of the unpaid loan or the amount of the debt forgiven. Subdivision B is subject to Subdivs C and D which deem certain transactions not to be dividends. Subdivision C (s 109G) Subdivision C deals with certain forgiven debts that are not treated as dividends. These are: – forgiveness of a debt owed by another company (s 109G(1)); – debts forgiven because the debtor becomes bankrupt (s 109G(2)); – forgiveness of loan where loan itself gave rise to a dividend (s 109G(3)); – where the Commissioner (having regard to specified factors) treats the forgiveness as not giving rise to a dividend (s 109G(4)). Subdivision D (ss 109H–109R) Subdivision D sets out rules about payments that are not treated as dividends. These are: – payment of an obligation not in excess of what would have been required if dealing at arm’s length (s 109J); – inter-company payments and loans (note, however, Subdiv E below) (s 109K); [page 869]

–

otherwise assessable payments and loans (eg, under s 109 but not under s 108: see 13.19–13.20) or payments specifically excluded from being assessable (s 109L); – loans made in the ordinary course of business and on usual terms (s 109M); – loans meeting criteria for minimum interest rate and maximum term (s 109N); – amalgamated loans if the Commissioner is satisfied that to treat them as dividends would cause undue hardship (s 109Q). Subdivision DA (s 109RA) Subdivision DA states that Div 7A does not apply to demerger dividends to which s 45B does not apply. Subdivision DB (ss 109RB–109RD) Subdivision DB deals with certain other exceptions. Subdivision E (ss 109S–109X) Subdivision E deals with payments and loans through interposed entities. Subdivision EA (ss 109XA–109XC) Subdivision EA deals with payments, loans and debt forgiveness by a trustee in favour of a shareholder or associate of a shareholder of a private company with an unpaid present entitlement. Subdivision EB (ss 109XE–109XI) Subdivision EB deals with payments and loans by an entity interposed between a trustee and a target entity. Subdivision F (ss 109Y–109ZC) Subdivision F sets out general rules applying to all amounts treated as dividends under Div 7A. These rules are discussed below. Subdivision G (ss 109ZD–109ZE)

Subdivision G defines certain terms used in Div 7A.

General rules 13.28 ITAA36 s 109Y proportionately reduces the Div 7A dividends that the company would otherwise be taken to pay where they would exceed the company’s distributable surplus for the year. This is done using the formula:

A private company’s distributable surplus for purposes of ITAA36 s 109Y is determined using the formula:

where: Division 7A amounts is the total of any amounts the company is taken under ss 109C or 109F to have paid as dividends in the year of income apart from this section. [page 870] Net assets for these purposes is defined as meaning the excess of the company’s assets over its present legal obligations14 and provisions for depreciation, annual leave and long service leave, amortisation of intellectual property rights and other provisions prescribed under the Regulations. Non-commercial loans refers to: (a) amounts taken under ss 108, 109 or 109E to have been paid as dividends in earlier years of income and which are shown as assets in the company’s accounting records at the end of the year of income; and (b) any amounts that are included in the

assessable income of shareholders (or their associates) of the company under s 109XB as if the amounts were dividends paid by the company in earlier years of income. Paid-up share value is defined as meaning the paid-up share capital of the company at the end of its year of income. Repayments of non-commercial loans is defined as meaning the total of: (a) any repayments to the company of loans or amounts that have been taken by former section 108, or section 109D or 109E, to be dividends; and (b) amounts set off against loans that have been taken by former section 108, or section 109D or 109E, to be dividends, other than such amounts that are set off as a result of: (i) a dividend (being a later dividend for the purposes of section 109ZC or a subsequent dividend for the purposes of former subsection 108(2)) being paid by the company to the extent of the unfranked part of the dividend; or (ii) a loan, or a part of a loan, being forgiven. The effect of the formula in ITAA36 s 109Y is shown in Example 13.2 below.

Scrooge Pty Ltd has a paid-up share value of $45,000. Scrooge Pty Ltd forgives a debt of $65,000 that Donald, one of its shareholders, owes it. The circumstances are such that s 109F will deem the forgiveness to be a dividend. At the time of the forgiveness, Scrooge Pty Ltd’s accounting records show that it has assets of $35,000, present legal obligations of $6000 and provisions of $4000 for long service leave and holiday pay. Thus, its net assets will be $25,000. The distributable surplus will be: $25,000 (net assets) + $65,000 (s 109F dividend) − $45,000 (paid-up value) = $45,000 [page 871]

As the amount of the debt forgiven exceeds the distributable surplus of the company, the provisional Div 7A dividend of $65,000 will be reduced using the s 109Y formula. When we apply the formula, the Div 7A dividend is calculated as: $65,000 × $45,000/$65,000 = $45,000

As can be seen from Example 13.2, the effect of the s 109Y formula is that the ITAA36 Pt III Div 7A dividend will never exceed the amount of distributable profit which that company has. Note that that profit need not be realised. 13.29 Under ITAA36 s 109Z, Div 7A deemed dividends are taken to be paid to the recipient as a shareholder in a private company out of its profits. This means that the Div 7A deemed dividend will be included in a resident shareholder’s assessable income via ITAA36 s 44(1). Under s 109ZA, a deemed dividend is disregarded for the purposes of withholding tax and for the collection of withholding tax. As a Div 7A deemed dividend is not subject to withholding tax, it will be assessable to a nonresident shareholder under s 44(1)(b)(i). Amounts taken to be dividends under Div 7A are deemed to be ‘unfrankable’ distributions by ITAA97 s 202-45(g)(i). ITAA36 s 109ZB states that Div 7A applies to loans and debt forgiveness that would otherwise amount to a fringe benefit but does not apply to other payments that are fringe benefits.

Proposed changes to Div 7A 13.30 The Board of Taxation conducted a post-implementation review of Div 7A which was completed in 2014. The board’s final report, released by the previous government in June 2015, made several recommendations for further amendments to Div 7A. In the 2016–17 Budget, the previous government announced that amending legislation would be introduced following further consultation with stakeholders. The proposed amendments included: a self-correction mechanism to assist taxpayers in promptly rectifying inadvertent breaches of Div 7A; simplified rules in relation to complying Div 7A loans; and safe harbour rules to simplify compliance and to provide certainty for taxpayers. At

the time of writing, legislation giving effect to this announcement had not been introduced into Federal Parliament.

Anti-capital benefit streaming rules 13.31 The anti-capital benefit streaming rules, discussed in 12.84–12.88, will deem capital benefits to which they apply to be unfrankable dividends paid by the company out of profits to shareholders. This will trigger the operation of ITAA36 s 44(1) (see 13.33–13.40), which will include the deemed dividend in the shareholder’s assessable income. It is anticipated that the anti-capital benefit streaming provisions will be re-enacted so as to be consistent with the Simplified Imputation System. [page 872]

Non-share dividends 13.32 The definition of a ‘non-share dividend’ was discussed at 12.25 in the context of the debt and equity legislation. You will recall from that discussion that a distribution that a company makes to a holder of a non-share equity interest in the company in his or her capacity as a holder of that interest is a ‘non-share distribution’. By virtue of ITAA97 s 974-115, a distribution of money or other property or a crediting of an amount to the holder will be a distribution for these purposes. Under ITAA97 s 974-120, all non-share distributions will be ‘non-share dividends’ except to the extent that they are debited against the company’s ‘non-share capital account’ or its share capital account. A non-share distribution that is not a non-share dividend will be a ‘nonshare capital return’. You will recall also that, under ITAA97 s 20240(2), a non-share dividend will be a frankable distribution unless it is stated to be an unfrankable distribution by ITAA97 s 202-45. Note that a non-share dividend does not have to be paid out of profits. We shall see that under ITAA36 s 44(1), a non-share dividend will be assessable

to a shareholder even though it was not paid out of profits. The combined effect, however, of ITAA97 s 202-45(f) and either (as the case may be) s 215-10 or s 215-15 is that non-share dividends paid when the company does not have available profits will not be frankable distributions. ITAA97 Div 215 is discussed in more detail in Study help.

Tax effects for shareholders of a receipt of dividends Inclusion of dividends in shareholder’s assessable income 13.33 ITAA36 s 44(1)(a)(i) includes dividends (other than non-share dividends)15 paid by a company out of profits derived by it from any source in the assessable income of a resident shareholder. Section 44(1) (a)(ii) includes all non-share dividends paid to the shareholder by the company in the assessable income of a resident shareholder. Note that non-share dividends do not have to be paid out of profits to be included in the shareholder’s assessable income but that non-share dividends will only be frankable where the company has available profits under rules contained in ITAA97 Div 215. [page 873] Where the shareholder is a non-resident, ITAA36 s 44(1)(b)(i) includes dividends (other than non-share dividends) in the shareholder’s assessable income to the extent to which they are paid from profits derived from sources in Australia. Section 44(1)(b)(ii) includes nonshare dividends paid by the company in the assessable income of a nonresident shareholder to the extent that they are derived from sources in Australia. Where a non-resident shareholder carries on business in Australia through a permanent establishment, s 44(1)(c)(i) includes in the shareholder’s assessable income dividends (other than non-share

dividends) paid to the shareholder that are attributable to the permanent establishment, to the extent to which the dividends are paid out of profits derived by the company from sources outside Australia. Section 44(1)(c)(ii) includes non-share dividends, to the extent to which they are derived from sources outside Australia, in a non-resident shareholder’s assessable income where the non-resident carries on business in Australia through a permanent establishment and the nonshare dividends are attributable to the permanent establishment. It does not matter, under ITAA36 s 44(1), whether the paying company is a resident or non-resident. Somewhat curiously, it appears that, if the holder of the non-share equity interest is not also a shareholder, no amount will be included in the holder’s assessable income in respect of the non-share dividend. ITAA36 s 6(1) defines ‘shareholder’ as including a member or stockholder. Even more curiously, such a holder of a non-share equity interest appears to be entitled to a ITAA97 s 207-20 franking credit gross-up and tax offset. The taxation of non-resident shareholders is discussed in more detail in Chapter 18. In FCT v McNeil (2007) 229 CLR 656; 2007 ATC 4223 at 4232–3; [2007] HCA 5, a majority of the High Court rejected an argument that ITAA36 s 44 and companion sections in Pt III Div 2 Subdiv D constituted a complete code with respect to the taxation of receipts by companies. In McNeil, the majority of the High Court held that the market value of put options issued to a trustee for shareholders who held shares in the company at a record date was ordinary income to a shareholder who did not exercise the options.

Meaning of ‘paid’ 13.34 Note that to be included in assessable income by ITAA36 s 44(1), both a dividend and a non-share dividend must be ‘paid’. The ITAA36 definition of ‘paid’ in s 6(1) includes ‘credited or distributed’. That is, a dividend may be paid without there, in fact, being an actual distribution of cash to the shareholder. In CT (Vic) v Nicholas (1938) 59 CLR 230 at 238, Latham CJ commented on the phrase ‘credited, paid or distributed’:

The term “payment” plainly covers a payment of money by the company to a shareholder … The term “distribution”, whether or not it includes a payment of money, is wide enough to cover other benefits received by a shareholder, for example, a distribution of assets other than money. The term “crediting” relates to something of which the shareholder receives the benefit in account with the company, even if there is no actual payment or distribution of anything to him.

Under s 254V(1) of the Corporations Act 2001 (Cth), a company does not incur a debt merely by fixing the amount or time for payment of a dividend. A debt arises only when the time fixed for payment arrives and the decision to pay the dividend [page 874] may be revoked at any time before then. Once the time for payment arrives, the company has an obligation to pay the shareholder. The crediting by the company must be one which discharges the company’s obligation to the shareholder. A mere crediting to a ‘dividends payable’ account will not be sufficient. For the obligation to pay to be discharged it must first have arisen. See Brookton Co-operative Society Ltd v FCT (1981) 147 CLR 441, extracts from which are contained in Study help.

Meaning of ‘out of profits’ 13.35 ITAA36 s 44(1) includes a dividend (as distinct from a nonshare dividend) in the assessable income of a shareholder only if it is paid ‘out of profits’. Here the High Court decision in FCT v Slater Holdings Ltd (1984) 156 CLR 447 is authority that, in determining whether a dividend is paid out of profits, you must ask whether the source of funds from which the dividend was paid was a profit to the company. In determining whether the distributions in Slater Holdings Ltd were paid out of profits, Gibbs CJ applied authorities on what were profits out of which a dividend could be paid for company law purposes. Under those authorities, a capital profit will be distributable as a dividend and, in some circumstances, an unrealised capital profit will be distributable as a dividend.16 This means that a company can pay a dividend out of profits that will not have represented taxable

income to it. For example, a capital gain on one of a company’s preCGT assets will be distributable as a profit but will not be included in the company’s taxable income. The Corporations Amendment (Corporate Reporting Reform) Act 2010 (Cth) removed the requirement that, for company law purposes, dividends could be paid only out of profits. Under the amended company law provisions, a dividend can be paid only if: the company’s assets exceed its liabilities by an amount sufficient to fund the dividend immediately before the dividend is declared; paying the dividend is fair and reasonable to the company’s shareholders as a whole; and paying the dividend does not materially prejudice the company’s ability to pay its creditors. In April 2014, the Abbott Government released a draft Corporations Legislation Amendment (Deregulatory and Other Measures) Bill 2014 (Cth) and called for submissions in response to the draft. The draft Bill proposed amendments to the test for payment of dividends but was not designed to change existing taxation arrangements. A subsequent final Bill of the same name was passed by the Commonwealth Parliament, but that Bill did not contain proposals to amend s 254T of the Corporations Act 2001 (Cth). At the time of writing, a final Bill proposing changes to s 254T had not been introduced into the Commonwealth Parliament. The Corporations Amendment (Corporate Reporting Reform) Act 2010 (Cth) also introduced ITAA36 s 44(1A), which provides: [page 875]

For the purposes of this Act, a dividend paid out of an amount other than profits is taken to be a dividend paid out of profits.

Note that s 44(1A) applies only to a distribution that is already a

dividend and hence it does not deem the distribution to be a dividend but is confined to deeming the distribution to be paid ‘out of profits’. The Commissioner’s views on the effect of these amendments on the tax effects of distributions by companies have been set out in Taxation Ruling TR 2012/5, extracts from which are contained at 13.14. 13.36 It is conceivable that none of a company’s profits in a given year might be taxable income to it. If the company had no credits in its franking account carried forward from a previous year and did not want to put its franking account into deficit and incur a franking deficit tax liability it might, subject to the operation of the benchmark franking rule (discussed at 12.57–12.60), choose to frank its dividend to 0%. This would mean that no franking credits would be attached to the dividend. The effect of s 44(1) on the shareholder when the dividend was paid in these circumstances is shown in Example 13.3.

Joyce Pty Ltd has profits for the year ending X2 of $100,000. Its taxable income for that year is $0. It had a zero balance in its franking account for the year ending 30 June X1. No events which would give rise to franking credits occurred for Joyce Pty Ltd from 1 July X1 to 30 June X2. Joyce Pty Ltd pays a dividend of $100,000 to Stephen (a resident sui juris natural person) on 1 July X2. Stephen’s assessable income from other sources is $60,000 and he has no deductions. No franking credits are allocated to the dividend. The tax effects for Stephen will be as follows: Assessable income

Dividend from Joyce Pty Ltd

Other sources

Total assessable income Allowable deductions

$100,000 (included in assessable income via ITAA36 s 44(1)(a)(i)) $60,000 (included in assessable income via ITAA97 s 6-5) $160,000 $0

Taxable income

$160,000

Tax payable at 2017–18 rates

$50,032 (including Medicare levy of $3200)

[page 876] 13.37 Certain distributions, which are not out of profits in the sense discussed in 13.35, are nonetheless deemed to be out of profits for the purposes of the ITAA36. First, ITAA36 s 44(1B)(a) deems the portion of a dividend, paid by a company, that is debited against an amount standing to the credit of the share capital account of the company to be paid by the company out of profits derived by it. 13.38 In 13.14, we saw that a return of capital from a tainted share capital account is a dividend under para (a) of the ITAA36 s 6(1) definition of ‘dividend’. However, such a distribution would not be paid out of profits for company law purposes as it would be funded from the company’s share capital account. The s 6(1) definition of ‘share capital account’, which excludes tainted share capital accounts, does not apply for company law purposes. Note also that the statement in ITAA97 s 975-300, that a tainted share capital account is taken not to be a share capital account, does not apply for the purposes of ITAA36 s 44(1B): see the discussion of the definition of ‘share capital account’ in 13.14. Hence, a return of capital funded from a tainted share capital account is a dividend representing a repayment of moneys paid-up on a share. Then s 44(1B) deems it to be paid out of profits. This, in turn, triggers s 44(1) which means that the deemed dividend is included in the shareholder’s assessable income. 13.39 As discussed in 13.15, ITAA36 s 6(4) can deem certain returns of capital made as part of an arrangement to be dividends. As these deemed dividends are paid from the company’s share capital account, they would not, in the absence of ITAA36 s 44(1B), be regarded as

being paid out of profits in the sense discussed in 13.35. This would mean that they would not be included in the shareholder’s assessable income via s 44(1). By deeming such dividends to be paid out of profits, s 44(1B) in turn triggers s 44(1) which means that the dividend is included in the shareholder’s assessable income. 13.40 Under ITAA36 s 44(1B)(b), where a dividend is a repayment of moneys paid-up on a share, it is deemed to have been paid by the company out of profits. We saw at 13.16 that amounts paid or credited or property distributed by a company for the redemption or cancellation of a redeemable preference share will be dividends if they are debited against a share capital account and are greater than the amount paid-up on the share. We also noted that a redemption or cancellation that is not funded from a share capital account will be a dividend under para (a) of the ITAA36 s 6(1) definition. Any redemptions or cancellations that are funded from a share capital account will be deemed by s 44(1B)(a) to be paid out of profits. Section 44(1B)(b) appears, therefore, to be directed at repayments of moneys paid-up on a share where the repayment was funded otherwise than from profits or a (tainted or untainted) share capital account. At 13.35, we noted that the Corporations Amendment (Corporate Reporting Reform) Act 2010 (Cth) inserted ITAA36 s 44(1A), which states that ‘a dividend paid out of an amount other than profits is taken to be a dividend paid out of profits’, but did not amend s 44(1B)(b). If s 44(1B)(b) is confined to redemptions or cancellations funded from a share capital account, then the insertion of s 44(1A) may leave little scope for an independent operation of s 44(1B)(b). [page 877]

Giving shareholders credit for tax paid at the company level What franking credits represent

13.41 We saw in 12.53–12.54 that a company making a distribution may allocate franking credits to the distribution. Where the benchmark franking rule applies to a company, then the percentage to which the first distribution that it makes in a franking period will establish its benchmark franking percentage for that period. We saw at 12.57–12.60 that, where a company’s benchmark franking percentage for a franking period has been established, adverse consequences (in the form of overfranking tax or a loss of franking credits) may result if the company franks subsequent distributions in the period to a percentage that is greater or less than its benchmark percentage. We also saw that if, at the end of a franking year, a company has a deficit balance in its franking account, it will be liable for franking deficit tax. A prime cause of a company being liable for franking deficit tax will be that the franking credits that it has allocated to the distributions that it has made throughout the franking year have exceeded the franking credits that it has generated (eg, by paying corporate tax) throughout the franking year. Hence, we can say that when franking credits are allocated to a distribution, they will represent either corporate tax that has been paid by the company or a future franking deficit tax liability (which can be offset against future corporate tax liabilities, although the offset is reduced by 30% where the franking deficit at year end exceeds 10% of the company’s total franking credits for the year) of the company. At the shareholder level, Australia’s dividend imputation system treats franking credits allocated to a distribution as representing the shareholder’s portion of corporate-level taxes that have been paid or will be payable by the company. It does this by allowing the shareholder to use the franking credits allocated to a distribution as tax offsets in determining the tax payable by or refundable to the shareholder. We shall now explain these points in more detail.

Relationship between franking credits and corporate level taxes 13.42 We saw in Chapter 12 that Australia’s dividend imputation system obliges companies to maintain a franking account. We noted that, under the Simplified Imputation System, the franking account,

broadly, tracks the corporate tax paid by the company and corporate tax that has been attributed to shareholders although it has not yet been paid by the company. If the company has attributed corporate tax to shareholders without paying sufficient corporate tax to justify that attribution, this will generally mean that the company will be liable for franking deficit tax at the end of the year. Hence, when a franking credit is allocated to a distribution, it generally will not exceed the sum of the corporate tax paid by the company up to the end of the franking year and the franking deficit tax liability (if any) that the company will incur at the end of the franking year. Among other things, these features of franking credits prevent the phenomenon of ‘superintegration’, described in 12.11, from occurring.

Gross-up and tax offset at the shareholder level 13.43 Where franking credits are allocated to a distribution made by a resident company to a member (the receiving entity), the assessable income of the receiving entity [page 878] includes the franking credit on the distribution: ITAA97 s 207-20(1).17 This is commonly referred to as ‘grossing up’ the dividend. The receiving entity is entitled to a tax offset equal to the franking credit on the distribution: s 207-20(2). Where the receiving entity is an individual or a corporate tax entity, no inclusion in assessable income is made and the receiving entity is not entitled to a tax offset unless the residency requirement is satisfied by the receiving entity at the time of the distribution: s 207-70. The residency requirement is satisfied in the cases where the receiving entity is an individual or a company if the receiving entity is an Australian resident at the time the distribution is made: s 207-75(1). An individual or a company that is a foreign resident also satisfies the residency requirement where the individual or the company carries on business in Australia through a permanent establishment and the distribution is attributable to the permanent

establishment. The definition of ‘permanent establishment’ for these purposes is discussed in Chapter 18. Note that s 220-210 provides that a New Zealand company that has elected to join the Australian dividend imputation system, as discussed in 12.35, is not entitled to a tax offset under Div 207. Dividends flowing to such New Zealand companies are treated like dividends flowing to other foreign residents (see the discussion in Chapter 18), but where dividend withholding tax is payable on such dividends, the New Zealand company obtains a credit in its Australian franking account for the Australian withholding tax paid. ITAA97 s 207-20 reads as follows. 207-20 General rule — gross-up and tax offset (1) If an entity makes a franked distribution to another entity, the assessable income of the receiving entity, for the income year in which the distribution is made, includes the amount of the franking credit on the distribution. This is in addition to any other amount included in the receiving entity’s assessable income in relation to the distribution under any other provision of this Act. (2) The receiving entity is entitled to a tax offset for the income year in which the distribution is made. The tax offset is equal to the franking credit on the distribution.

[page 879] The interaction of ITAA36 s 44(1) and ITAA97 s 207-20(1) and (2) is shown in Example 13.4. In the example, it is assumed that the company is subject to a corporate tax rate of 30%.

In the year ending 30 June X1, Joyce Pty Ltd had a taxable income of $100,000,000. In the year ending 30 June X2, after it had paid tax of $30,000.000 on its taxable income, it paid a dividend of $70,000,000. Stephen, a sui juris resident natural person shareholder holds 0.1% of the shares in Joyce Pty Ltd and his share of the dividend is $70,000. At the time it paid the dividend, the credit balance in its franking account was $30,000,000.

Note that the maximum franking credit that Joyce Pty Ltd could have attached to the dividend was $70,000,000 × 0.4292 = $30,000,000. Joyce Pty Ltd allocated $30,000,000 of franking credits to the dividend, hence franking it to 100%. Hence a franking credit of $30,000 was attached to the dividend of $70,000 that Stephen received. Stephen’s income from other sources for the year ending 30 June X2 was $60,000. The effect of the receipt of the dividend on Stephen would be as follows: Assessable income

Dividend from Joyce Pty Ltd s 207-20(1) inclusion Grossed-up dividend Other sources Assessable income Deductions Taxable income Tax payable at 2017–18 rates s 207-20(2) offset Net tax After-tax income

$70,000 $30,000 $100,000 $60,000 $160,000 $0 $160,000 $50,032 $30,000 $20,032 $109,968

(included in assessable income via s 44(1))

(including Medicare levy) ($50,032 − $30,000) ($130,000 − $20,032)

Position where maximum franking credit allocated to dividend 13.44 You will recall from 12.53 that determining the maximum franking credit that can be allocated to a distribution does not involve any reference to the entity’s franking account at all. Rather, calculation of the maximum franking credit on a distribution only involves reference to the amount of the frankable distribution. However, allocating franking credits to a distribution will produce a franking debit equal to the amount of the allocation. If the debit arising on the allocation of franking credits to a distribution

[page 880] means that the franking account is in deficit at the end of the year, then franking deficit tax equal to the amount of the deficit will be payable. Thus, the franking account and the franking mechanism function to ensure that tax is ultimately paid at the corporate rate on distributions to which franking credits have been allocated. 13.45 In Example 13.4, notice that the entire dividend is included in the shareholder’s assessable income under ITAA36 s 44(1). The franking credit on the distribution is then included in the shareholder’s assessable income under ITAA97 s 207-20(1). The purpose of this inclusion is to ‘gross up’ the dividend so that it represents a figure equal to the pre-tax income of the company. The reason for doing this is so that tax on that pre-tax corporate income can be calculated at the shareholder’s marginal rate. To gross up a dividend which wholly represents after-tax income of a company, we need to add back into the dividend the tax paid at the company level on the income from which the dividend was sourced. In algebraic terms, if we add Yc to Y − Yc the result is: Y − Yc + Yc = Y where Y represents taxable income and c represents the company tax rate. Thus, in Example 13.4, the company had a pre-tax income of $100,000,000. It paid tax of $30,000,000, giving it an after-tax income of $70,000,000. By paying tax of $30,000,000 it generated franking credits of $30,000,000. It paid a dividend of $70,000,000 which was franked to 100%. At the shareholder level, in Stephen’s case, the $30,000 of company tax paid was added back into the dividend to gross it up. Once this was done, the grossed-up amount of the dividend was $100,000 which was 0.1% (representing Stephen’s share) of the income on which the company originally paid tax. 13.46 As from 1 July 2016, the corporate tax rate applicable to companies with an aggregated turnover of less than $10 million is 27.5%. We noted at 12.53 that where a company is subject to a

corporate tax rate of 27.5%, as from 1 July 2016, the maximum franking credit that it can allocate to a distribution is the amount of the distribution x 0.3788. So where a company taxed at this rate has $100,000 of taxable income it would pay tax of $27,5000 and would generate $27,500 of franking credits. It would be able to pay a dividend of $72,500 and could attach $27,500 × 0.3788 = $27,463 of franking credits to the dividend. That this calculation does not correspond with the tax paid by the company is simply the result of the number of decimal places to which calculations have been made in determining the 0.3788 figure. 13.47 The grossed-up dividend is included in the shareholder’s assessable income. Any allowable deductions are subtracted and the shareholder’s taxable income is determined. Tax and Medicare levy are then calculated on the shareholder’s taxable income. This will have the effect of taxing the grossed-up dividend at the shareholder’s marginal rate if we assume that dividend income is derived after the shareholder’s other income. If we ignore Medicare levy, in algebraic terms the amount of tax payable on the grossed-up dividend, paid by a company subject to tax at the applicable corporate tax rate, will be Ym where m is the rate of tax payable by the shareholder as a result of the application of the marginal rate scale. In actual practice, the imputation system does not contain an ordering rule which regards dividend income as being received last. Hence, the actual effect of the dividend imputation system is the net tax on the dividend represents tax at the shareholder’s average rate. In algebraic terms, the amount of tax payable on the grossed-up dividend will be Ya where a is the shareholder’s average rate of tax. [page 881] The next feature of the dividend imputation system that is illustrated in Example 13.4 is allowing the shareholder a tax offset for the corporate tax already paid on the dividend the shareholder receives. ITAA97 s 207-20(2) tells us that the amount of the tax offset is equal to the amount of the franking credit on the distribution. Remember that

the franking credit on the distribution in Example 13.4 was equal to the tax that had been paid at the company level or Yc. Thus, the effect of allowing the shareholder a tax offset of $30,000 or Yc in Example 13.4 is, in the absence of a ‘dividend last’ ordering rule, that only net tax equal to the excess of Ya or $50,032 over the Yc or $30,000 is payable on the dividend at the shareholder level. In algebraic terms, the tax payable on the dividend at the shareholder level will be: Ya − Yc This means that $30,000 or Yc of tax was paid on the income at the company level, and $20,032 or Ya − Yc of tax was paid at the shareholder level on the dividend. The total of company and shareholder tax paid on the income which was distributed as a dividend was $30,000 or Yc + $20,032 or Ya − Yc = $50,032 or Ya. That is, the end effect of the dividend imputation system in Example 13.4 has been to tax the income of the company of $100,000 (which, after paying corporate tax of $30,000 was distributed as a dividend of $70,000) at a rate of 0% for the first $18,200, 19% between 18,201 and 37,000, 32.5% between 37,001 and 87,000 and 37% between 87,001 and $130,000, which is the shareholder’s marginal rate assuming that the dividend was derived after all Stephen’s other income. The Medicare levy at 2% was charged on the whole of Stephen’s taxable income including the franking credit on the distribution.18 It is worth noting, however, that under the Simplified Imputation System, franking credits allocated to a dividend will not always represent tax that has been paid by the entity making the distribution. It is possible that a company may be distributing tax-preferred income (eg, gains on pre-CGT assets). In this instance, the profits will be frankable profits and will be taken into account in determining the maximum franking credit for the distribution. If the distribution is franked to the maximum amount, in these circumstances it could mean that the company’s franking account is in deficit at the end of the franking year. This would give rise to franking debits equal to the amount of the deficit. In this instance, any franking credit on the distribution would not represent tax that had already been paid by the company. Rather, the franking credit on the distribution would represent the future

franking deficit tax liabilities of the company. In all cases, the problem of ‘superintegration’ identified at 12.11 (which arises when the shareholder is given credit for corporate tax assumed to have been paid when none, in fact, has been paid) will be avoided as the franking credit that the shareholder receives will always represent either tax that has been paid by the company or future tax liabilities of the company. [page 882]

Position where dividend franked to less than 100% 13.48 Note, however, that a company is not obliged to frank a distribution to the maximum extent possible. However, even where the dividend is franked to less than 100%, the ITAA97 s 207-70(1) inclusion and the s 207-70(2) tax offset will still be equal to the franking credits allocated to the distribution. The operation of the Simplified Imputation System in relation to distributions franked to less than 100% is illustrated in Example 13.5 and Example 13.6.

Assume the facts in Example 13.4 with the variation that Joyce Pty Ltd franks the distribution to 50%. This will mean that the entity will allocate $15,000,000 of franking credits to the distribution. The effects for Stephen will be as follows: Individual member

Dividend

s 207-20(1) inclusion Grossed-up dividend Other sources Assessable income

$70,000 (included in assessable income via ITAA36 s 44(1)) $15,000 $85,000 $60,000 $145,000

Deductions Taxable income Tax payable at 2017–18 rates s 207-20(2) tax offset Net tax After-tax income

$0 $145,000 $44,182 (Medicare levy included) $15,000 $29,182 $100,818 ($130,000 − $29,181.63)

Assume the facts in Example 13.5 with the variation that, although Joyce Pty Ltd’s taxable income remains $100,000,000 its pre-tax distributable profit (which includes the $100,000,000 of pre-tax taxable income) is $200,000,000. After paying tax of $30,000,000, it pays a dividend of $170,000,000. Stephen’s share of this dividend is $170,000. The franking credit on this distribution to Stephen is $30,000. The franking percentage on the dividend and the tax effects for Stephen would be as follows: Assessable income Joyce Pty Ltd

Profit Income

$200,000,000 $100,000,000 [page 883]

Tax Distribution Maximum franking credit Franking credits allocated Franking percentage

$30,000,000 = $30,000,000 franking credits $170,000,000 $60,000,000 = $170,000,000 × 0.4292 $30,000,000 50%

Stephen Distribution s 207-20(1) inclusion Other sources Assessable income Deductions Taxable income Tax payable at 2017–18 rates s 207-20(2) tax offset Net tax payable After-tax income

$170,000 (included in income via ITAA36 s 44(1)) $30,000 $60,000 $260,000 $0 $260,000 $95,432 (Medicare levy included) $30,000 $65,432 $164,568 ($230,000 – $65,432)

In Example 13.6, the member was on a marginal rate of 32.5% before receiving the distribution. The distribution placed Stephen in the top marginal rate. Example 13.7 illustrates what the position would have been if the member had been on a lower marginal rate and the dividend had been smaller:

Assume the facts in Example 13.6 with the following variations: 1. Stephen receives a dividend of $170 with a franking credit of $30. 2. Stephen’s income from other sources is $5900. Stephen

Distribution s 207-20(1) inclusion Other sources

$170 (included in income via ITAA36 s 44(1)) $30 $5900

Assessable income

$6100

Deductions Taxable income

$0 $6100 [page 884]

Tax payable at 2017–18 rates s 207-20(2) tax offset Refund of excess offset

$0 (Medicare levy not payable as below threshold) $30 $30

Note that other potential tax offsets have not been taken into account in this example.

13.49 Notice that in Example 13.6, grossing up the dividend by the amount of the franking credit on the distribution meant that the grossed-up dividend represented Stephen’s share of the pre-tax profits of $200,000,000 of Joyce Pty Ltd. The tax offset was limited to the franking credit on the dividend of $30,000 which represented tax paid by Joyce Pty Ltd on the proportion of its pre-tax taxable income of $100,000,000 that it distributed to Stephen. One way of viewing what the dividend imputation system is doing here is to regard it as: (i) grossing up and allowing a tax offset against the portion of the dividend ($70,000) which was funded from taxed profits; and (ii) applying the progressive rate scale to the portion of the dividend ($100,000) which was funded from untaxed corporate profits. This result occurred because the whole of the dividend ($170,000) is included in the shareholder’s assessable income under ITAA36 s 44(1), while the grossup and tax offset is limited to the franking credit of $30,000 on the dividend. Notice that in Example 13.6, Joyce Pty Ltd’s after-tax distributed profit exceeded its after-tax taxable income. This excess would have arisen because of tax preferences (such as gains on pre-CGT assets, CGT indexation for inflation, or accelerated depreciation) that Joyce Pty Ltd enjoyed. Example 13.6 shows that currently the Australian dividend imputation system ‘washes out’ corporate tax

preferences when dividends are distributed to resident natural person shareholders in circumstances where the franking credit on the distribution is limited to the corporate tax previously paid by the distributing company and not previously allocated to dividends. Where the franking credit on the distribution is not so limited, for example, if the maximum franking credit had been allocated to the dividend in Example 13.6, any subsequent franking deficit tax liability that the distributing company incurs will have the effect of washing out the corporate tax preference.

1.

2.

Is a wash out of corporate tax preferences on distribution consistent with a policy that the tax system should be neutral as between different forms of business organisations? Some countries, such as New Zealand and the USA, permit corporate tax preferences enjoyed by small closely held companies to pass through to natural person resident shareholders (ie, the preferred corporate income is not taxed at all at the shareholder level). Is there any justification for allowing the pass through of preferences in closely held companies but not allowing pass through in widely held companies? [page 885]

3.

If a company’s distributable profit exceeded its taxable income so that it could not frank a dividend equal to the amount of its after-tax distributable profit to 100%, what could the company do if it still wished to pay a dividend that was franked to 100%?

Refunds of excess tax offsets 13.50 Prior to 1 July 2000, an excess tax offset was not refunded and could not be carried forward. It was simply wasted. Under ITAA97 s 67-25, a tax offset under ITAA97 Div 207 is subject to the refundable tax offset rules unless otherwise stated in Div 67. The excess is refunded if the total tax offset exceeds the tax that the shareholder would have paid if the shareholder had not obtained the Div 207 tax offset but had

obtained all other tax offsets (except a tax offset that can arise in certain circumstances under s 205-70 due to a payment of franking deficit tax) that were applicable to the shareholder. This is one effect of the priority rules for tax offsets contained in s 63-10. Under s 63-10, the amount refundable is the amount remaining after all prior tax offsets have been taken into account. Thus, after 1 July 2000, the excess offset of $30 in Example 13.7 is refunded to Stephen (assuming for the sake of illustrating the point that Stephen was not entitled to any other tax offsets). It should also be noted that, as from 1 July 2000, certain taxexempt institutions are, subject to certain conditions, entitled to tax offsets for franking credits. As these institutions are tax-exempt, granting them a tax offset for franking credits will mean that the rebate is fully refunded to them.

Franked dividends flowing through intermediate entities 13.51 Australia’s dividend imputation system is designed to let imputation credits pass through intermediate entities (such as interposed companies, partnerships and trusts) to underlying stakeholders. The effect of a franked dividend flowing through an interposed resident company to a natural person shareholder is discussed in 13.88–13.94. 13.52 The effect of a dividend flowing through a trust is discussed in Chapter 15. The effect of a franked dividend flowing through a partnership is discussed in Chapter 14. Of course, it may be possible for a franked dividend to flow through several interposed companies, partnerships or trusts before a natural person stakeholder receives it.

Dividends paid to non-residents 13.53 The franked part of a dividend paid to a non-resident shareholder is exempt from dividend withholding tax19 because of ITAA36 s 128B(3)(ga). Under ITAA97 s 976-1, the franked part of a distribution is calculated as follows:

[page 886] The ‘applicable gross-up rate’ will be the ‘corporate tax gross-up rate’ of the entity making the distribution for the income year in which the distribution is made. As discussed at 12.53, the corporate tax gross-up rate for companies with an aggregated turnover equal to or greater than $10m will be 70/30. For companies with an aggregated turnover of less than $10m the corporate tax gross-up rate will be 72.5/27.5. ITAA36 s 128D means that a dividend that has been subject to withholding tax, or would have been but for ITAA36 s 128B(3)(ga), is assessable income and not exempt income of the non-resident shareholder. A natural person non-resident shareholder is not entitled to either a ITAA97 s 207-20(1) gross-up or a s 207-20(2) tax offset. A non-resident corporate shareholder is not entitled to a franking credit on the franked portion of dividends received. The unfranked part of a dividend paid to a non-resident will be subject to dividend withholding tax. Where the non-resident shareholder resides in a country with which Australia does not have a double tax agreement (DTA), the rate of dividend withholding tax will be 30%. Where the non-resident shareholder resides in a country with which Australia does have a DTA, the rate of dividend withholding tax will depend on the terms of the treaty. In Australia’s older DTAs, the rate of dividend withholding tax will be 15% but under more recent DTAs and Protocols (such as the Protocol to the Australia–United States DTA and under the Australia– United Kingdom DTA), the rate of withholding tax on non-portfolio dividends (ie, paid to shareholders with a holding between 10% and 80%) is 5%, while no dividend withholding tax applies to corporate shareholders who own 80% or more of the company’s issued shares. Example 13.8 below is a summary of the Australian tax levied on nonresident shareholders, to whom ITAA36 s 128B(3E) (discussed below) does not apply, who receive fully franked and unfranked dividends. As from 26 June 2005, ITAA36 s 128B(3E) exempts dividends from withholding tax where: the dividend is paid to a non-resident carrying on business in

Australia at or through a permanent establishment; the dividend is attributable to the permanent establishment; and the dividend is not paid to the non-resident in that person’s capacity as a trustee. Note that dividends that are exempt from withholding tax under ITAA36 s 128B(3E) are not listed in the amounts that are deemed to be non-assessable non-exempt income under ITAA36 s 128D. Hence, a dividend paid by a resident company to the Australian permanent establishment of a non-resident will be taxed on a net assessment basis and subject to the relevant tax rate applicable to non-residents. As noted at 13.43, an individual or company which carries on business in Australia at or through a permanent establishment satisfies the residency requirement for ITAA97 Div 207 purposes in respect of dividends received from an Australian resident company that are attributable to the permanent establishment. Hence, such a non-resident shareholder is entitled to a franking gross-up and tax offset but ITAA97 s 67-25(1DA) will mean that the shareholder is not entitled to a refund of an excess tax offset. [page 887] From 1 July 2005 onwards, a resident company may declare a dividend paid to a non-resident to be ‘conduit foreign income’. Such a dividend will not be subject to withholding tax and will be nonassessable non-exempt income to the non-resident shareholder. Conduit foreign income will include redistributions of: ITAA36 s 23AH or ITAA97 Subdiv 768-A non-assessable non-exempt income; reductions in capital gains via ITAA97 s 768-505; and foreign income where foreign income tax offsets have meant that no additional Australian tax is payable on the income.

Alpha Pty Ltd (Resident company)

Beta Pty Ltd (Resident company) $

$

Profit

100,000

Profit

100,000

Income

100,000

Income

0

Company tax

30,000

Company tax

0

Franking credit

30,000

Franking credit

0

Dividend

70,000

Dividend

100,000

Gamma

Delta

Epsilon

Non-resident shareholder

Delta DTA resident

Epsilon Non-DTA resident

____________ Dividend

$

$

70,000

100,000

100,000

0

15,000

30,000

70,000

85,000

70,000

Withholding tax After-tax dividend

$

Yankee

Yankee

US resident 100% corporate shareholder

US resident 100% corporate shareholder

____________ $ Dividend from Alpha Withholding tax After-tax dividend

$

70,000 0 70,000

Dividend from Alpha

100,000

Withholding tax After-tax dividend

0 100,000

* In Example 13.8, for the sake of simplicity it is assumed that the 30% corporate tax rate applies to the resident companies.

13.54

Example 13.8 takes into account only Australian tax on the

dividend. It is possible that, depending on the system of relief from international double taxation [page 888] used in the country where the shareholder is resident, the after-tax dividend figures may be the same after both Australian and foreign tax is taken into account. The tax treatment of non-resident shareholders is discussed in more detail in Chapter 18. 13.55 Note from Example 13.8 that the after-tax value of a franking credit might not always be the same for all shareholders. Prior to 1 July 2000, a rule that excess ITAA36 s 160AQU imputation rebates could neither be refunded nor carried forward meant that some low-income shareholders should have placed less value on the receipt of a franked dividend than did higher-income shareholders. This is no longer the case following the introduction of full refundability of excess tax offsets for franking credits to resident shareholders as from 1 July 2000. Example 13.8 showed that, depending on the system of relief from international double taxation used by the country where the shareholder resides, an unfranked dividend of $100,000 may be more valuable to a nonresident shareholder than a franked dividend of $70,000 will be. By contrast, as Example 13.9 shows, a resident natural person shareholder who is on the top marginal rate prior to receipt of the dividend will receive the same after-tax benefit from an unfranked dividend of $100,000 as he or she receives from a franked dividend of $70,000. The example treats the dividend as the last income that the shareholder receives and hence as being taxed at the shareholder’s marginal rate. Note that the Medicare levy has not been taken into account in Example 13.9. It is assumed in Example 13.9 that the 30% corporate rate applies to Alpha Pty Ltd.

Alpha Pty Ltd (Resident company)

Beta Pty Ltd (Resident company) $

$

Profit

100,000

Profit

100,000

Income

100,000

Income

0

Company tax

30,000

Company tax

0

Franking credit

30,000

Franking credit

0

Dividend

70,000

Dividend

Zeta (Resident natural preson)

100,000

Omega (Resident natural preson) $

$

Dividend

70,000

Dividend

Franking credit

30,000

Franked to

Gross-up

30,000

Tax at 45%

45,000

After-tax dividend

55,000

Grossed-up dividend

100,000

Tax at 45%

45,000

Tax offset

30,000

Net tax

15,000

After-tax dividend

55,000

100,000 0

[page 889]

Alternative forms of corporate distribution: ITAA rules

13.56 For company law purposes, there are several ways in which a company’s funds can be distributed to its shareholders.20 We shall now examine how each of these types of distribution is treated for tax purposes. Table 13.1 summarises the current tax treatment. You will see that the table indicates what portion of a distribution will be regarded as a dividend for tax purposes and what the CGT effects of each type of distribution will be for a shareholder. The treatment of liquidator’s distributions is discussed in detail in 13.62–13.86. Table 13.1: Tax effects of alternative forms of corporate distribution Type of distribution

Portion that is a dividend for tax purposes

CGT effects

Cash dividend 100% paid from profits

No effect on cost base. Distribution could reduce market value.

Reduction in capital not involving a cancellation of shares and funded from untainted share capital account

Paragraph (d) of ITAA36 s 6 definition of ‘dividend’ means that not a dividend so long as s 6(4) does not apply.

ITAA97s 104-135 reduces cost base of shares by so much of distribution as is not a dividend. Section 104135 produces immediate capital gain where non-dividend distribution exceeds cost base of the shares.

Reduction in capital involving a cancellation of the shares and funded from untainted share capital account

Paragraph (d) of ITAA36 s 6 definition of ‘dividend’ means not a dividend so long as s 6(4) does not apply. Where a redemption or cancellation of redeemable preference shares within para (d) but para (e) will mean excess over amount paid-up on the share is a frankable dividend.

Cancellation triggers CGT event C2. Amount of capital returned will be capital proceeds for shares. ITAA97 s 116-30(2) will deem disposal to be at market value if distribution is greater or less than market value of shares. Where the company is widely held, ITAA97 s 116-30(2A) ‘will mean that the market value substitution rule in s 116-30(2)(b) does not apply. The logic here is that in a widely held company, dealings between the company and its shareholders are at arm’s length.

[page 890] Table 13.1: Tax effects of alternative forms of corporate distribution (cont’d)

Type of distribution

Portion that is a dividend for tax purposes

CGT effects

Reduction in capital not involving a cancellation of shares and funded from tainted share capital account

Dividend under para (a) of ITAA36 s 6 definition of ‘dividend’ not excluded via para (e). Combined effect of ITAA97 s 202-45(e) and the s 975-300 definition of ‘share capital account’ is that dividend is not frankable.

ITAA97 s 104-135 will not reduce cost base if return of capital is a dividend.

Reduction in capital involving a cancellation of shares and funded from tainted share capital account

Dividend under para (a) of ITAA36 s 6 definition of ‘dividend’ not excluded via paras (d) or (e). ITAA97 s 116-30(2) will deem disposal to be at market value if distribution is greater or less than market value of shares. Combined effect of ITAA97 s 20245(e) and the s 975-300 definition of ‘share capital account’ mean that the dividend is not frankable.

Cancellation triggers CGT event C2. Where the company is widely held, ITAA97 s 116-30(2A) will mean that the market value substitution rule in s 116-30(2)(b) does not apply. The logic here is that in a widely held company, dealings between the company and its shareholders are at arm’s length. Any capital gain triggered should be eliminated by ITAA97 s 118-20.

Off-market share The difference between the buybuy-back back price and the part of the buyback price that is debited against share capital account will be a dividend. See ITAA36 s 159GZZZP. A tainted share capital account will not be regarded as a share capital account for these purposes. Where actual price exceeds market value so much of dividend as exceeds market value is not frankable. See ITAA97 s 202-45(c).

Buy-back triggers CGT event C2. Buy-back price is capital proceeds for the shares for CGT but where buy-back price is less than market value of shares, ITAA36 s 159GZZZQ(2) deems disposal to be at market value for CGT and ordinary income purposes but not for determining whether part of price is a dividend. Section 159GZZZQ(3) prevents double taxation by reducing buy-back price by amount that is a dividend.

On-market share Nil. See ITAA36 s 159GZZZR. buy-back Franking debit arises under ITAA97 s 205-30 item 9 in the table equal to what would have been the franked amount of the dividend component in the buy-back price if it had been an off-market buy-back and had been franked to the company’s benchmark franking percentage or 100% if the company does not have a

Buy-back triggers CGT event C2. Buy-back price, in effect, is deemed to be capital proceeds for shares. See ITAA36 s 159GZZZS.

benchmark percentage.

[page 891] Table 13.1: Tax effects of alternative forms of corporate distribution (cont’d) Type of distribution

Portion that is a dividend for tax purposes

CGT effects

Liquidator’s distribution

So much as represents income derived by the company other than income properly applied to make good a loss of paid-up capital is deemed to be a dividend by ITAA36 s 47(1). Income derived by the company is defined in s 47(1A).

ITAA97 s 104-135 operates on nonassessable interim distributions to the extent that they are not dividends and to the extent that final distribution is not made within 18 months. Final distribution triggers CGT event C2 and, subject to prior operation of s 104-135, normal CGT rules will apply on final distribution. If final distribution takes place within 18 months of non-assessable interim distribution, s 104-135 does not operate on interim distribution and interim and final distribution are added together in determining capital proceeds. Section 118-20 is regarded as preventing double taxation where part of interim or final distribution is a dividend. If liquidator declares shares worthless, CGT event G3 takes place when declaration is made. Shareholder may choose to make a capital loss on post-CGT shares equal to reduced cost base of shares at time of declaration. If choice is made, cost base and reduced cost base of shares are reduced to nil just after declaration is made.

Bonus issue

Not a dividend unless ITAA36 s 45 or s 45C applies or unless paid by public company as part of a dividend reinvestment plan. If part of a dividend reinvestment plan and funded by capitalising profits,

Original shares pre-CGT Where the original shares are pre-CGT, no part of the bonus issue is a dividend and the bonus issue is fully paid, ITAA97 s 130-20(3) will deem the bonus shares to be pre-CGT.

then is a frankable dividend.

Where the original shares are preCGT, no part of the bonus issue is a dividend and the bonus issue is partly paid, s 130-20(3) deems the bonus issue to be acquired when a call on the bonus issue is first made. The market value of the bonus shares

[page 892] Table 13.1: Tax effects of alternative forms of corporate distribution (cont’d) Type of distribution Bonus issue (cont’d)

Portion that is a dividend for tax purposes

CGT effects at the time of the call and any actual call paid is included in the cost base of the bonus shares. Where the original shares are preCGT, part of the bonus issue is a dividend (eg, because the bonus issue is part of a dividend reinvestment plan) and the bonus issue is fully paid, s 130-20(2) deems the bonus shares to be acquired when issued and to have a cost base equal to the amount of the dividend. Where the original shares are preCGT, part of the bonus issue is a dividend (eg, because the bonus issue is part of a dividend reinvestment plan) and the bonus issue is partly paid, s 130-20(2) deems the bonus shares to be acquired at the time of issue. The cost base of the bonus shares will be the amount of the dividend and any actual calls paid. Original shares post-CGT Where the original shares are post-CGT and part of the bonus issue is a dividend (eg, where the bonus issue is made under a dividend reinvestment plan), what would be

cost base under normal CGT rules is increased by so much of the bonus issue as is a dividend. See s 130-20(2). The time of acquisition will be when the bonus shares are issued. Where the bonus shares are partly paid, their cost base will include any actual calls paid. Where no part of the bonus issue is a dividend, s 130-20(3) spreads the cost base of the original shares over the original and bonus shares. The bonus shares are deemed to

[page 893] Table 13.1: Tax effects of alternative forms of corporate distribution (cont’d) Type of distribution Bonus issue (cont’d)

Portion that is a dividend for tax purposes

CGT effects be acquired when the original shares were. Where the bonus shares are issued partly paid, their cost base will include any actual calls paid. Where part of a bonus issue is a dividend, it appears that the bonus shares will be deemed by s 130-20(2) to be acquired on issue. The cost base of the bonus issue will include the part that is a dividend plus a reasonable proportion of the cost base of the original shares. See s 130-20(3A). Where the bonus shares are issued partly paid, their cost base will include any actual calls paid.

Bonus issues 13.57 A discussion of the treatment of bonus issues, including examples, can be found in Study help.

Dividend reinvestment plans 13.58 A discussion of the treatment of dividend reinvestment plans, including examples, can be found in Study help.

Returns of capital with cancellation 13.59 A discussion of returns of capital with cancellation can be found in Study help.

Returns of capital without cancellation 13.60 A discussion of returns of capital without cancellation can be found in Study help.

Buy-backs 13.61 A discussion of the treatment of buy-backs, including an example and questions, can be found in Study help. The Gillard Government announced that it would implement recommendations made by the Board of Taxation for changes in the treatment of offmarket buy-backs. A summary of these recommendations is contained in Study help. Treasury had released a discussion paper, ‘Taxation [page 894] Treatment of Off-Market Share Buybacks’, setting out how the principles recommended by the Board of Taxation might operate. The Gillard Government also released the Exposure Draft Tax Laws Amendment (2011 Measures No 9) Bill 2011: Buy-backs, which may be accessed at (accessed 28 September 2017). Final legislation implementing these proposals had not been introduced into the Commonwealth Parliament prior to its dissolution for the 2013 Federal Election. By media release dated 14 December 2013, the then Assistant Treasurer, Senator Sinodinis, announced that

the Abbott Government would not be proceeding with the changes to the treatment of off-market buy-backs that had been recommended by the Board of Taxation.

Liquidator’s distributions 13.62 A liquidation has been described for company law purposes as ‘a form of external administration under which a liquidator assumes control of a company’s affairs to discharge its liabilities in preparation for its dissolution’.21 The liquidation process will, at some point, involve the dissolution of the company and the cancellation of the shareholders’ shares. At that point, or earlier, the shareholders will either receive a distribution of their share of the net assets of the company or (in the case of a company limited by shares) they will be required to contribute to the discharge of the company’s liabilities over its assets. In the absence of specific provisions deeming a liquidator’s distribution to be a dividend, it was seen as the price a shareholder received for disposing of shares. This was so even though distributable profits might have been included in the liquidator’s distribution. The logic behind this approach was explained by Rich, Dixon and McTiernan JJ in CT (NSW) v Stevenson (1937) 59 CLR 80 at 99: In the liquidation (of a company) the excess of its assets over its external liabilities is distributed among the shareholders in extinguishment of their shares. The shareholders, in other words, as contributories receive nothing but the ultimate value of the intangible property constituted by their shares. The res itself ceases to exist. The profits are not detached, released or liberated, leaving the share intact as a piece of property. There is no dividend upon the share. There is no distribution of profits even though there are profits. The shareholder simply receives his proper proportion of the total net fund without distinction in respect of the source of its components and he receives it in replacement for his share.

In the days before Australia had a general capital gains tax, this approach would have meant that companies with accumulated profits could avoid taxation at the shareholder level entirely simply by going into voluntary liquidation. For this reason, in a series of provisions in successive Income Tax Assessment Acts, an effort was made to deem certain components in a liquidator’s distributions to be dividends paid

out of profits. The current provisions that are most relevant for these purposes are ITAA36 s 47(1) and (1A), stated below. [page 895]

47 Distributions by liquidator (1) Distributions to shareholders of a company by a liquidator in the course of windingup the company, to the extent to which they represent income derived by the company (whether before or during liquidation) other than income which has been properly applied to replace a loss of paid-up share capital, shall, for the purposes of this Act, be deemed to be dividends paid to the shareholders by the company out of profits derived by it. (1A) A reference in subsection (1) to income derived by a company includes a reference to: (a) an amount (except a net capital gain) included in the company’s assessable income for a year of income; or (b) a net capital gain that would be included in the company’s assessable income for a year of income if the Income Tax Assessment Act 1997 required a net capital gain to be worked out as follows: Method statement

Step 1.

Step 2.

Work out each capital gain (except a capital gain that is disregarded) that the company made during that year of income. Do so without indexing any amount used to work out the cost base of a CGT asset. Total the capital gain or gains worked out under Step 1. The result is the net capital gain for that year of income.

13.63 A ITAA36 s 47(1) deemed dividend is frankable under ITAA97 s 202-40 as it is not included in the list of unfrankable distributions in ITAA97 s 202-45. The dividend is deemed to be paid by the company out of profits derived by it. In Harrowell v FCT (1967) 116 CLR 607 at 612, the High Court observed that it was clear that these words were introduced to accommodate s 47(1) to the language of ITAA36 s 44(1). In other words, ITAA36 s 47(1) triggers the operation of s 44(1) which will include the deemed dividend in the shareholder’s assessable income.

The court in Harrowell’s case (at 612) also regarded it as clear that the reference to ‘profit’ in s 47(1) was to a profit derived by the company on revenue account and not otherwise. Note that only so much of a liquidator’s distribution as represents income derived by the company is deemed by s 47(1) to be a dividend paid out of profits. The phrase ‘income derived by the company’ is defined in s 47(1A) but the definition is inclusive. That is, s 47(1A) deems only certain amounts to be income derived by the company. It is still possible that amounts not mentioned in s 47(1A) could be ‘income derived by the company’ under what the courts have regarded as the ordinary meaning of that phrase.

Meaning of ‘income derived by the company’ 13.64 The company’s ordinary and statutory income, other than net capital gains, will be income derived by the company under ITAA36 s 47(1A). Thus, a liquidator’s [page 896] distribution, which is a deemed dividend under s 47(1) and is included in the company’s assessable income under s 44(1), will be part of the income derived by the recipient company. This is so even though, as discussed in 13.62, the liquidator’s distribution would not, under ordinary concepts, be included in the recipient company’s assessable income.

Why is CGT indexation not allowed in the ITAA36 s 47(1A) calculation? 13.65 Notice that under ITAA36 s 47(1A)(b), no allowance is made for CGT indexation or for offsetting either capital losses or net capital losses in calculating net capital gains that are regarded as income derived by the company. We need to explain why CGT indexation is not allowed in calculating income derived by the company under s 47(1A). A cash dividend distributed by a company, prior to liquidation, from untaxed profits

will be wholly unfranked (assuming that the distributing company wishes to avoid a subsequent franking deficit tax liability). This will mean that, where the cash dividend is paid to a resident natural person shareholder, it will be taxed at the shareholder’s marginal rate. Indexation of the cost base of corporate CGT assets can be one reason why a company may have distributable profits that have not been taxed at the company level. By ignoring CGT indexation, ITAA36 s 47(1A) aims to produce the result that a liquidator’s distribution of the untaxed indexation component in a capital gain is taxed at the shareholder’s marginal rate. That is, so far as a distribution of the indexation component is concerned, s 47(1A) means that a liquidator’s distribution produces the same after-tax result as does a cash dividend paid pre-liquidation. This is shown in Example 13.10. In Example 13.10, it is assumed that the 30% corporate rate applies to Empire Pty Ltd.

Napoleon, a resident natural person on a 45% marginal tax rate after receiving income from other sources, is the sole shareholder in Empire Pty Ltd. The paid-up capital of Empire Pty Ltd is $100,000. Until recently, the whole of the paid-up capital of Empire Pty Ltd was invested in shares in armaments companies. The shares cost Empire Pty Ltd $100,000. Empire Pty Ltd recently sold the shares for $200,000 at a time when their cost base (including frozen indexation) for CGT purposes was $200,000. The financial accounting and tax position of Empire Pty Ltd will be as follows:

Empire Pty Ltd Financial accounting position Capital profits $100,000

Income tax position Taxable $0 income

If Empire Pty Ltd pays a cash dividend of $100,000 to Napoleon, assuming that Empire Pty Ltd has no credits in its franking account, and assuming that Empire Pty Ltd does not want to incur [page 897]

a subsequent franking deficit tax liability, the dividend will have no franking credits allocated to it. The tax effects for Napoleon of receipt of the dividend will be as follows:

Napoleon Dividend Tax @ 45%

$100,000 $45,000

After-tax dividend

$55,000

(Medicare levy is ignored in this example)

If, instead of paying a dividend Empire Pty Ltd went into liquidation, the funds that Empire Pty Ltd would have available for distribution in liquidation would be:

Empire Pty Ltd Paid-up capital Capital profits reserve

$100,000 $100,000

Of the liquidator’s distribution of $100,000, ITAA36 s 47(1) would characterise so much of it as represented income derived by the company as a dividend. Under s 47(1A), in calculating income derived by the company, CGT indexation will not be allowed in calculating net capital gains. If indexation had not been allowed, Empire Pty Ltd would have made a net capital gain of $100,000 on the sale of the shares in the armaments companies. Hence, under s 47(1), $100,000 of the liquidator’s distribution of $200,000 will be regarded as a dividend. However, as the company does not have any franking credits, the dividend will be wholly unfranked. Thus, the tax effects for Napoleon of the liquidator’s distribution will be as follows:

Napoleon Liquidator’s distribution s 47(1) deemed dividend Tax on deemed dividend After-tax distribution

$200,000 $100,000 $45,000

(Medicare levy is ignored in this example)

$155,000

Note: Assuming that the cost base (including indexation) of Napoleon’s shares in Empire Pty Ltd was $200,000, no capital gain would accrue to Napoleon on the cancellation of the shares. Unless the cost base of Napoleon’s shares was below $100,000, ITAA97 s 11820 would mean that any capital gain on the shares would be reduced to zero because the distribution triggered the ITAA36 s 47(1) deemed dividend.

[page 898]

Why are net capital loss offsets not allowed in the ITAA36 s 47(1A) calculation? 13.66 The explanation for the disallowance of net capital loss offsets that are the product of capital losses being carried forward from previous years may be similar. The general CGT rule that net capital losses carried forward can be offset only against capital gains in calculating net capital gains may sometimes produce disparities between a company’s taxable income and its distributable profit for financial accounting and company law purposes. How these disparities can arise is shown in Example 13.11 below.

Year One BG Pty Ltd Company law position Paid-up capital $1,000,000 Revenue profit $100,000 Capital loss ($100,000) (abnormal item) Distributable $0 profit Year Two BG Pty Ltd Company law position

Taxable income Revenue profit Net capital loss Taxable income

Taxable income

$100,000 ($100,000)

$100,000

Paid-up capital Capital profit (abnormal item) (abnormal item) Distributable profit Less tax on Y1

After-tax distributable

$1,000,000 $100,000

$100,000 $30,000

$70,000

Capital gain

Net capital loss offset Taxable income Payment of tax income on Y1 income Credit balance in franking profit account

$100,000

$100,000 $0

$30,000

$70,000

In this situation, if BG Pty Ltd then paid a dividend of $70,000 to its shareholders, Barry and Robin, it would be able to fully frank the dividend. Say, instead of paying a dividend, BG Pty Ltd went into voluntary liquidation. The liquidator makes a distribution of $1,070,000 [page 899] representing the paid-up capital and the after-tax distributable profit of the company. The question is how much of the distribution should be regarded as representing income derived by the company. If net capital losses were allowed in calculating the ‘income derived by the company’ then none of the distribution would be income derived by the company. By not allowing net capital loss offsets, $100,000 less tax paid of $30,000 = $70,000 is regarded as income derived by the company. Thus, in this situation, not allowing an offset of net capital losses means that a shareholder receiving a liquidator’s distribution is placed in the same position as one who receives a cash dividend. In both cases the dividend would be able to be franked to 100%.

Why are capital loss offsets not allowed in the s 47(1A) calculation? 13.67 The disallowance of capital loss offsets in calculating income derived by the company under ITAA36 s 47(1) is more controversial. In

13.72, we discuss a view that an automatic application of a capital profit against a capital loss is a proper application of income to make good a loss of paid-up capital for s 47(1) purposes. If this view is accepted, then the reason for not allowing capital loss offsets in calculating income would be that offsetting was redundant due to the automatic offset rule. This is shown in Example 13.12.

GB Pty Ltd Company law position Paid-up capital

Taxable income $1,000,000

Capital profit (extraordinary item)

$200,000 Capital gain

$200,000

$100,000 Offset capital loss

$100,000

Capital loss (extraordinary item)

Net capital gain Tax on net capital gain After tax capital profits reserve

$30,000 Tax on net capital gain

$100,000 $30,000

Balance in franking $70,000 account

$70,000

If GB Pty Ltd then paid a dividend to its sole shareholder, Maurice, company law rules would permit it to pay a dividend of $70,000. The required franking amount for the dividend would be $70,000. Say, instead of paying a dividend, GB Pty Ltd went into voluntary liquidation. If the liquidator makes a distribution of $1,070,000, the [page 900] question will be how much of this will be a deemed dividend under ITAA36 s 47(1). This will depend on how much of the distribution represents income derived by the company (as defined in s 47(1A)) other than income properly applied to make good a loss of paidup capital. If capital losses were allowed to be offset in calculating ‘income derived by the company’, then the income derived by the company would be $100,000. Assume that an automatic

application of capital profits against capital losses is regarded as a proper application to make good a loss of paid-up capital. The legislature’s concern here may have been that someone would then argue that some or all of the net capital gain of $100,000 was not a dividend because it was properly applied to make good a loss of paid-up capital. Under s 47(1A), as it currently stands, the capital loss of $100,000 is not allowed to be offset in calculating income derived by the company. This means that the income derived by the company will be $200,000. However, in calculating the portion of the liquidator’s distribution that is a dividend we have to exclude income properly applied to make good a loss of paid-up capital. Assume that the automatic offset of $100,000 from the capital profit of $200,000 is regarded as a proper application to make good a loss of paid-up capital. This would mean that only the remaining $100,000 of the deemed income less tax of $30,000, that is, $70,000, would be a deemed dividend. The explanation for not allowing capital losses to be offset would be that the automatic application rule had already fulfilled the function of a capital loss offset.

13.68 In Archer Brothers Pty Ltd v FCT (1953) 90 CLR 140, Williams ACJ, Kitto and Taylor JJ, in the course of holding that a s 47(1) deemed dividend would be a ‘dividend’ for the purposes of the undistributed profits tax provisions that then existed in the Act, made the following observations (at 155): If there had been sufficient surplus assets, other than the income included in this taxable income, to distribute as a replacement of paid-up capital, the liquidator could have made a sufficient distribution of this taxable income to the shareholders to satisfy (the undistributed profits tax provisions) … On the other hand he could have paid additional tax and then distributed the balance of the fund to the shareholders. These distributions would it seems be dividends within the meaning of the definition of dividend in s 6 of the Act and would certainly be deemed to be dividends paid to the shareholders out of profits or income derived by the company within the meaning of s 47. By a proper system of book-keeping the liquidator, in the same way as an accountant in a private company which is a going concern, could so keep his accounts that these distributions could be made wholly and exclusively out of those particular profits or income, and the shareholders would become entitled to a rebate under (the undistributed profits tax provisions).

[page 901] In Taxation Determination TD 95/10, the Commissioner accepts that these statements by way of obiter dicta in Archer Brothers establish the principle that: … if a liquidator appropriates (or ‘sources’) a particular fund of profit or income in making a distribution (or part of a distribution), that appropriation ordinarily determines the character of the distributed amount for the purposes of section 47 and other provisions of the Income Tax Assessment Act 1936.

A liquidator may rely on the Archer Brothers principle except where a specific provision of the ITAA36 or ITAA97 specifies the order in which different types of funds are to be distributed. The Commissioner accepts that the principle means that where a liquidator ostensibly distributes capital contributed by shareholders, the distribution will be a non-dividend return of capital even though the funds from which it was sourced could be traced to a receipt of income or profit.22 For the Archer Brothers principle to apply, the liquidator must be able to identify a fund or profit from which a distribution is made. It is not necessary, however, for the liquidator to keep separate accounts for each specific fund or profit although, from a practical point of view, this is preferable to assist in identification. 13.69 In TD 95/11 (now withdrawn), the Commissioner accepted that, as was shown in Example 13.12, capital losses may have produced a loss of distributable funds so that a notional capital gain under ITAA36 s 47(1A)(b) could not be distributed. Here, the Commissioner recognised that the requirement to disregard capital losses in calculating income derived by the company might not have a practical effect. TD 2000/5 recognises that s 47(1) cannot deem more than the amount actually distributed to be a dividend. TD 2000/5 goes on to give examples which indicate that, in the Commissioner’s view in the determination since withdrawn, the way that s 47(1) will operate in a liquidation will depend on whether the liquidator, by using the principle in Archer Brothers, appropriates specific identified funds to

the distribution. In the situation shown in Example 13.12, it appears that the Commissioner would only accept that $1,000,000 of the distribution represented a return of capital if the liquidator had kept accounts so that the paid-up capital at the time of the distribution was shown as $1,000,000 (including the $100,000 automatically applied against the capital loss) and the appropriation was made from this account. An acknowledgment that capital gains may properly be applied by a liquidator to make good a loss of paid-up capital appears to be implicit in both TD 95/10 and TD 2000/5. Note In conducting a liquidation, the liquidator should maintain accounts that enable items which are and are not income under ITAA36 s 47(1A) to be identified clearly. When making distributions, the liquidator should indicate which identified funds are being appropriated to the distributions and in what proportions.

[page 902]

Income properly applied to make good a loss of paid-up capital 13.70 Income derived by the company and which has been properly applied to make good a loss of paid-up capital will not be a deemed dividend under ITAA36 s 47(1). The meaning of the phrase ‘income properly applied to make good a loss of paid-up capital’ was considered in the High Court decision in Glenville Pastoral Co Pty Ltd v FCT (1963) 109 CLR 199.

Glenville Pastoral Co Pty Ltd v FCT Issue: Was the distribution by the liquidator of Glenville Pastoral a dividend for determining whether the company had made a sufficient distribution for undistributed

profits tax purposes? This was a tax that applied to companies when Australia had a classical system of corporate taxation. The Commissioner argued that only the excess of the distribution over the loss of paid-up capital was a dividend and that the balance represented moneys properly applied to make good a loss of paid-up capital. Held: The whole of the distribution was a dividend. For an application of income to make good a loss of paid-up capital to be ‘proper’, it needed to take place before the company went into liquidation. Since the income represented by the relevant distribution was received during the winding up, no part of it could have been properly applied to make good a loss of paid-up capital. Kitto, Taylor and Owen JJ held (at CLR 208): If the case of Re Hoare & Co Ltd [1904] 2 Ch 208 be read … it will be seen what is meant in company law by applying profits to replace share capital that has been lost. Profits may, of course, be distributed by a company while a going concern even though a loss of paid-up capital previously incurred has not been made good. The profits may be distributed as soon as ascertained, or they may be carried to a reserve. Carrying an amount of profits to a reserve is not enough to convert it into capital, and accordingly it continues to be distributable. But … the directors (or the general meeting, whichever is the appropriate body under the articles) may, by some positive and final decision, apply distributable profits to make good lost share capital. The amount of the profits is then carried forward to a capital account, and loses its identity as a detachable fund of profit. Thereafter the company cannot utilise the amount for the payment of dividends, any more than it can use for that purpose other moneys representing share capital … It is this method of capitalisation of profits that s 47(1) recognises and allows for in pursuing the policy [page 903] of assimilating a distribution in a winding-up so far as it represents income it does not apply to capital profits to a dividend paid by the company which is a going concern. In so far as income has been properly applied to replace lost share capital, a distribution of it while the company was a going concern would have had to be by way of reduction of share capital; it could not have been a dividend. Words are accordingly introduced into s 47(1) to ensure that a distribution of it in the course of winding up is not regarded differently for the purposes of tax. One further point is to be noticed. The expression in the section is “has been applied”, not “is applied”. The explanation is clear enough: the application of the income to replace lost capital could not be contemporaneous with the making of the distribution, because it could not properly be made once the company has ceased to be a going concern, a liquidator having no power to capitalise profits … Nothing that was said in Archer Brothers Pty Ltd v Federal Commissioner of Taxation (1953) 90 CLR 140 should be taken as supporting a different viewa… There is nothing in s 47 to support the notion underlying the assessment in the present case that if capital had been lost a distribution which represents income must be treated as excluded from the operation of the section on the ground that to the extent of the lost capital it has necessarily been applied to make good the

loss … a distribution of moneys which have been derived by the company as income is to be deemed a dividend paid out of profits, notwithstanding that the remaining assets are insufficient to provide the full amount of the paid-up capital, except insofar as the income, having been derived before the liquidation, has been applied to replace the lost capital, the application having been effected “properly”, that is to say by a decision intended to be definitive made by a person or persons having power under the articles so to act (and therefore before the liquidation), and otherwise in conformity with the articles and the company’s legal obligations.

a.

The Archer Brothers ‘principle’ was seen as relating only to the selection of one source of income rather than another for the payment of a particular distribution. The explanation for the assumption in Archer Brothers that the proportion of the liquidator’s distribution that was out of profits had been to make good a loss of paid-up capital was that the court was obliged to follow the view of the facts taken by the parties. Kitto and Taylor JJ were members of the courts that heard both cases.

[page 904] In the following paragraphs, we shall refer to an application of income to make good a loss of paid-up capital of the type discussed in Glenville Pastoral Co as a ‘formal application’. 13.71 In Glenville Pastoral Co Pty Ltd v FCT (1963) 109 CLR 199, Kitto, Taylor and Owen JJ noted that the formal application that ITAA36 s 47(1) requires did not apply to capital profits. This is consistent with the general company law rule that a capital profit can only be distributable as a dividend if a profit exists on the whole of the company’s accounts (including its capital account).23 In other words, capital profits, in effect, are applied to make good a loss of paid-up capital without the need for a formal application of the kind described in Glenville Pastoral Co. The better view of s 47(1) is that such an ‘automatic’ application of capital profits should be seen as a ‘proper’ application to make good a loss of paid-up capital. This would be so whether or not the ‘application’ takes place before or after liquidation.24 13.72

Notice that in Glenville Pastoral Co, the High Court applied

the formal application rule to receipts that, but for ITAA36 s 47(1), would have been capital receipts of Glenville Pastoral Co Pty Ltd. Some commentators have argued that this means that the formal application rule applies to any receipts which the ITAA deems to be income which would otherwise be capital profits.25 This would mean, for example, that capital gains, calculated according to s 47(1A), could only be applied to make good a loss of paid-up capital via a formal application prior to liquidation. One difficulty with this view is that, as the judgment of the High Court in Glenville Pastoral Co expressly acknowledges, as a matter of company law, the formal application rule does not apply to capital profits. Thus, requiring a formal application of capital profits that the ITAA deems to be income would be requiring the company to do something which is impossible as a matter of company law.26 13.73 It is worth pointing out that the liquidator of Glenville Pastoral Co Pty Ltd had initially characterised the distributions from the Killen liquidator as capital receipts, which initially produced a small credit in Glenville Pastoral Co Pty Ltd’s capital account. The liquidator included the distributions from the Killen liquidator in Glenville Pastoral Co Pty Ltd’s profit and loss account only after the ATO advised him that the distributions would be regarded as income to Glenville Pastoral Co Pty Ltd under ITAA36 s 47(1). This would not appear to be sound accounting practice. The fact that a receipt is regarded as assessable income under the ITAA36 should not change what would otherwise be the characterisation of the receipt for financial accounting purposes. In modern accounting parlance, the Glenville [page 905] Pastoral liquidator appears to have initially characterised the receipt from the Killen liquidator as an extraordinary item which was not included in Glenville Pastoral Co Pty Ltd’s operating profit. It is hard to see why this characterisation should have changed merely because ITAA36 s 47(1) deemed the distribution to be a dividend. There is no

indication, however, in Glenville Pastoral Co that the Commissioner argued that the liquidator’s actions were ineffective for financial accounting or company law purposes. As the matter was not argued, the High Court did not need to examine whether the Glenville Pastoral Co Pty Ltd’s action was effective for financial accounting or company law purposes. The better view, therefore, is that Glenville Pastoral Co does not mean that the formal application rule applies to any otherwise capital receipts of a company which the ITAA deems to be income. Rather, the decision in Glenville Pastoral Co should be confined to its own facts.27

The ordinary meaning of ‘income derived by the company’ 13.74 We noted that the ITAA36 s 47(1A) definition of ‘income derived by the company’ is inclusive. That means that there may be receipts that are ‘income derived by the company’ under the ordinary meaning of that phrase that are not within the s 47(1A) definition. Such receipts would still be income derived by the company. Case law on the meaning of ‘income derived by the company’ prior to the introduction of s 47(1A) was confusing. The issue was considered in Gibb v FCT (1966) 118 CLR 628. The facts in Gibb v FCT are shown in Figure 13.2.

Figure 13.2:

Facts in Gibb v FCT

[page 906] In Gibb, the majority of the High Court held that, although the bonus issue from Gibb and Miller Ltd was a dividend, within the then ITAA36 s 6(1) definition, it was not ‘income derived by the company’ (Gibbsons Investments Ltd) for the purposes of s 47(1). Under ordinary principles, the bonus issue was not a receipt of income by Gibbsons Investments Ltd. Nor was the effect of the ITAA36 to attribute the character of income to the bonus issue. The s 6(1) definition merely said what a dividend was; it did not, of itself, mean that a dividend was income. Before the dividend could be assessable income to Gibbsons Investments Ltd, ITAA36 s 44(1) needed to be triggered. Rather than this happening, then s 44(2)(b)(iii) meant that the bonus share dividend was never included in assessable income. The majority did observe, however, that it would have been possible for the definition to have been drawn so as to give the character of income to a bonus issue. The majority also noted that there could be some classes of dividends which, because of then s 44(2) were not included in assessable income that, nonetheless, were income of the taxpayer and hence could amount to income derived by the company for purposes of s 47(1). However, this would be because they were income according to ordinary concepts, not because s 44(1) made them assessable income. 13.75 By contrast, in Harrowell v FCT (1967) 116 CLR 607, the High Court held that a distribution by the liquidator of Glenville Pastoral Co Pty Ltd to a shareholder was income for the purposes of ITAA36 s 47(1) as it was sourced in a distribution from the Killen liquidator which was deemed by s 47(1) to be a dividend paid out of profits. The facts in Harrowell were identical with the facts in Glenville Pastoral Co Pty Ltd v FCT (1963) 109 CLR 199 but the issue was the character of Glenville Pastoral Co’s liquidator’s distributions when viewed from the shareholder’s perspective. The facts in Glenville Pastoral Co are set out in 13.70. In Harrowell, the High Court held that the effect of s 47(1) was to give liquidator’s distributions the character of a dividend paid out of

revenue profits which would, therefore, be income in the hands of the recipient.28 Thus, as the distribution from the Killen liquidator was funded from ordinary income, s 47(1) meant that Glenville Pastoral Co received the distribution as a dividend paid out of Killen’s revenue profits. This meant that the dividend was income in Glenville Pastoral’s hands. Hence, the distribution by Glenville Pastoral’s liquidator funded from this deemed dividend represented a distribution of income derived by Glenville Pastoral. The decision in Gibb v FCT (1966) 118 CLR 628 was distinguished on the basis that a s 47(1) deemed dividend could never be regarded as a capital profit whereas a dividend within the then ITAA36 s 6(1) definition could be. This aspect of the judgment in Harrowell v FCT (1967) 116 CLR 607 appears to conflict with the following obiter dicta in relation to s 47(1) in the judgment of Barwick CJ, McTiernan and Taylor JJ in Gibb at 637: [page 907] But although in the language of the Act they may to this extent be properly described as “dividends” they do not, by force of their character as such, assume the character of assessable income, or, for that matter, of income.

Note that the decision in Harrowell was not based on the reasoning that the s 47(1) deemed dividend was assessable income to Glenville Pastoral. Rather, the language used by the High Court in Harrowell suggests that, as the distribution was deemed to be a dividend paid from revenue profits, it was income under ordinary concepts. 13.76 Subsequently, in the Full Federal Court decision in FCT v Brewing Investments Ltd (2000) 44 ATR 471, Hill J (with whom Heerey and Sundberg JJ agreed) reconciled the decision in Harrowell with the obiter dicta in Gibb v FCT (1966) 118 CLR 628 at 637 by noting that, in the passage quoted from Gibb, it was merely stated that deeming a liquidator’s distribution to be a dividend under ITAA36 s 47(1) did not make it assessable income or, for that matter, income. In order to make a s 47(1) deemed dividend assessable income, it was necessary for it to trigger the operation of s 44(1) as s 47(1) of itself has

no territorial limitation. It was also true to say that merely deeming a liquidator’s distribution to be a dividend did not make it income under ordinary concepts. However, deeming a liquidator’s distribution to be a dividend paid out of profits did mean, as was (in effect) held in the decision in Harrowell, that the deemed dividend was income under ordinary concepts. On the facts in Brewing Investments, the effect of this conclusion was that s 47(1) deemed a distribution by a liquidator of a non-resident company to another non-resident company to be a dividend paid out of profits. This, in turn, meant that the deemed dividend represented income derived by the second company for s 47(1) purposes when its liquidator made a distribution to its sole shareholder which was an Australian resident company. This, in turn, meant that the distribution by the liquidator of the second non-resident company was deemed by s 47(1) to be a dividend paid out of profits. This triggered the operation of s 44(1)(a), which included the amount of the deemed dividend in the Australian resident shareholder’s assessable income. 13.77 Prior to the insertion of ITAA36 s 47(1A), the better view was that income derived by the company was generally confined to receipts that were income under ordinary concepts or were deemed by the ITAA36 and ITAA97 to have characteristics that would make them income under ordinary concepts.29 If this is the ordinary meaning of the phrase ‘income derived by the company’, then what, if anything, does that phrase include that is not included within the s 47(1A) definition? Note that s 47(1A)(a) refers to ‘an amount (except a net capital gain) included in the company’s assessable income for a year of income’. For a receipt to be within para (a) of the s 47(1A) definition, it has to be included in the company’s assessable income. Some receipts that are income under ordinary concepts will not be included in the company’s assessable income because they will be exempt income to the company. [page 908]

1. 2.

Draw a diagram that represents the receipts that will be regarded as ‘income derived by the company’ for the purposes of ITAA36 s 47(1). Identify any profits that will form part of a company’s distributable profits for company law purposes that will not form part of its taxable income. If the company derives these profits and then goes into liquidation, which of them, if distributed in the liquidation, will represent income derived by the company as defined in s 47(1A)?

CGT effects of liquidator’s distribution for shareholders 13.78 A liquidator’s distribution may also have CGT effects for shareholders. The CGT effects vary according to whether the distribution is an interim or final distribution. In the case of interim distributions, the CGT effects vary according to whether or not the interim distribution is a deemed dividend. 13.79 A liquidator’s final distribution will involve a cancellation of the shareholder’s shares. This will trigger CGT event C2. Provided the company is dissolved within 18 months of the interim distribution, the capital proceeds for CGT event C2 will include the final distribution and any prior interim distributions. ITAA97 s 104-135 (discussed in 13.119–13.121) will not operate where the company is dissolved within 18 months of the interim distribution. In these circumstances any excess of the capital proceeds over the cost base of the shares (including indexation) will be a capital gain. Any excess of the reduced cost base of the shares over the capital proceeds will be a capital loss. 13.80 ITAA97 s 104-135 may apply to interim distributions where the company is not dissolved within 18 months of the distribution. Where s 104-135 has operated in relation to an interim distribution, that distribution will not form part of the capital proceeds for the CGT C2 event that takes place when the shares are cancelled. Interim distributions to which s 104-135 did not apply, however, will still form part of the capital proceeds for the CGT event C2. When s 104-135

applies to an interim distribution, it may reduce the cost base or reduced cost base of the shareholder’s shares. Thus, a prior operation of s 104-135 may mean that any capital gain that arises when CGT event C2 takes place (ie, on the final distribution) is increased. A prior operation of s 104-135 may also mean that any capital loss that arises when CGT event C2 takes place is reduced. 13.81 A liquidator’s interim distribution does not involve a cancellation of the shareholder’s shares and does not trigger CGT event C2. To the extent that a liquidator’s distribution is a deemed dividend, or is otherwise assessable to the shareholder, s 104-135 will not apply to the distribution. In these circumstances, the distribution will form part of the capital proceeds of the CGT C2 event that ultimately takes place when the shares are cancelled. [page 909] 13.82 A liquidator’s distribution that is wholly or partly nonassessable to the shareholder will trigger the operation of ITAA97 s 104-135, provided the company is not dissolved within 18 months of the distribution. Section 104-135 may reduce the cost base of the shareholder’s shares in the company, or may, in some circumstances, produce an immediate capital gain for the shareholder. Details of the operation of s 104-135 are discussed in 13.119–13.121. 13.83 Where a company is dissolved within 18 months of a wholly or partly non-assessable interim distribution, ITAA97 s 104-135 will not apply to the interim distribution: see s 104-135(6). In these circumstances, the interim distribution will form part of the capital proceeds for the CGT C2 event that takes place when the shares are cancelled. 13.84 Sometimes, in the winding up of an insolvent company, the liquidator may come to the conclusion that the shareholders in the company, or shareholders of a particular class of shares, will not receive any further distribution. CGT event G3 happens when a liquidator

declares in writing that he or she has reasonable grounds to believe that there is no likelihood that the shareholders in the company,30 or shareholders of the relevant class of shares, will receive any further distribution in the course of winding up the company. CGT event G3 can only give rise to a capital loss. CGT event G3 is discussed in more detail in 13.122. 13.85 Where all or part of an interim or final liquidator’s distribution is deemed to be a dividend by ITAA36 s 47(1), the amount of any capital gain that arises via CGT event C2 on the final distribution is reduced by ITAA97 s 118-20. Section 118-20 was discussed in detail in 6.135–6.138. Arguably, s 118-20(1) cannot reduce the capital gain by an amount included via an interim distribution. The reason is that s 118-20(1) reduces a capital gain only where an amount is included in assessable income under another part of the ITAA because of the CGT event. As the inclusion in assessable income via the interim distribution takes place before CGT event C2 is triggered, it could be said that the inclusion was not ‘because of’ the CGT event. Note, however, that under s 118-20(1A) the reduction will take place where the inclusion in the shareholder’s assessable income via the combined operation of ITAA36 ss 47(1) and 44(1) is ‘in relation to’ a CGT asset. As the inclusion in assessable income could be said to be in relation to the shares, ITAA97 s 118-20(1A) overcomes any objection that s 118-20 could not reduce the capital gain by an amount that is included in assessable income (ie, via an interim distribution) prior to the CGT event taking place. Note that, unlike the position in the case of an offmarket buy-back, the capital proceeds for the shares are not reduced by the part of the distribution that is a deemed dividend. 13.86 The Commissioner’s views on the interaction of CGT event C2, ITAA97 s 104-135 and ITAA97 s 118-20 are set out in TR 2001/27. The operation of CGT event C2, ITAA97 s 104-135, ITAA36 s 47(1) and ITAA97 s 118-20 in relation to liquidator’s distributions is illustrated in Example 13.13 and Example 13.14. In Example 13.14 it is assumed that the 30% corporate tax rate applies to T Rex Pty Ltd.

[page 910]

T Rex Pty Ltd (an Australian resident private company for tax purposes) is placed in voluntary liquidation. The paid-up capital in T Rex Pty Ltd is $200,000 represented by 100,000 shares on which $2 has been paid. At the time it goes into voluntary liquidation, T Rex Pty Ltd has a retained profits reserve of $70,000 (assume that this represents income derived by the company for the purposes of ITAA36 s 47(1)) and a credit balance in its franking account of $30,000. On 1 July Y1, the liquidator makes an interim distribution of $100,000 funded from the company’s share capital account. The liquidator’s final distribution of $170,000 is made on 30 June Y1. $70,000 of the final distribution will be a deemed dividend under s 47(1) and will be able to be franked to $30,000. Because the final distribution took place within 18 months of the interim distribution, ITAA97 s 104-135 does not operate on the interim distribution. Rather, the interim distribution forms part of the capital proceeds for CGT event C2 which takes place when the shares are cancelled. This means that the capital proceeds for each shareholder a will be $2.70 per share. Assuming that all the shareholders were subscribers and that there is no indexation, each shareholder will make a prima facie capital gain of 70c per share. However, as $70,000 (or 70c per share) of the capital proceeds was a deemed dividend under ITAA36 s 47(1) and was included in the assessable income of shareholders under ITAA36 s 44(1), ITAA97 s 118-20 should reduce the capital gain to zero in these circumstances.

Assume the facts in Example 13.13 with the variation that the final distribution does not take place until two years after the interim distribution. Here, ITAA97 s 104-135 will reduce the cost base of the shares by the amount of the nonassessable interim distribution. That is, the cost base of each share will reduce from $2 to $1. Again 70c per share of the final distribution will be a dividend. However, the amount of the interim distribution will not be included in calculating the capital proceeds of CGT event C2. Hence, the capital proceeds will be $1.70 per share. As the cost base of each share will have been reduced by ITAA97 s 104-135 to $1, ignoring indexation, each shareholder will make a prima facie capital gain of 70c per share. However, as was the

case with Example 13.13, ITAA97 s 118-20 will reduce the capital gain to zero because 70c per share of the capital proceeds was taxed as a dividend via the combined operation of ITAA36 ss 47(1) and 44(1).

[page 911]

1. 2.

What planning would be possible if ITAA97 s 104-135 could never apply to an interim liquidator’s distribution? In both Example 13.13 and Example 13.14, the prima facie capital gain made by shareholders was reduced by ITAA97 s 118-20. Can you think of a situation where s 118-20 would not reduce the capital gain to zero?

Benson Pty Ltd is an Australian resident private company for tax purposes. Its only shareholders are Ben and Son who are both resident natural persons who prior to the receipt of distributions from Benson Pty Ltd are on a 45% marginal tax rate. On 1 January 2001, both Ben and Son subscribed $500,000 for their shares in Benson Pty Ltd pre-CGT. Benson Pty Ltd’s balance sheet is as follows:

Current assets Cash Liabilities Shareholders’ equity Paid-up capital Capital profits reserve*

$3,000,000 Nil $1,000,000 $2,000,000

*Profit arose from the sale of a pre-CGT asset. Benson Pty Ltd is no longer involved in active trading and Ben and Son want the assets of the company distributed to them in the most tax-effective way. To simplify calculations, assume that a corporate tax rate of 30% applies to Benson Pty Ltd.

Advise them as to what is the most tax-effective way to distribute the assets of the company. A suggested solution can be found in Study help.

Inter-corporate dividends 13.87 As explained in 13.2, dividends are a form of income from property and fall within the concept of ordinary income. This is true whether the recipient of a dividend is a company or a natural person. A principal reason why most countries impose a corporate tax is that, in its absence, tax on income flowing through a company to shareholders could be deferred indefinitely simply by retaining it in the company. However, once income starts to flow through a chain of two or more companies to a shareholder, tax deferral can be prevented simply by imposing corporate tax on the [page 912] first company in the chain to derive it. Because this point is most readily apparent in a classical corporate tax system, Example 13.15 will be based on the assumption that a classical system of corporate taxation is used. In the example, to simplify calculations, it has been assumed that the companies are subject to a corporate tax rate of 30%.

Company 1 Income Tax @ 30% After-tax income

$1000 $300 $700

Dividend Company 2 (Sole shareholder in Company 1) Dividend income No tax as dividend sourced in taxed income After-tax income Dividend Natural person shareholder

$700

$700 $0 $700 $700

(Sole shareholder in Company 2 — assumed to be on a 45% marginal rate prior to receipt of the dividend. Medicare levy is not taken into account for the purposes of this example.)

Dividend income Tax at 45% After-tax dividend

$700 $315 $385

Note that once the income from which the dividend paid by Company 1 has been taxed to Company 1, no additional tax deferral advantage exists if no tax is imposed on the dividend that Company 2 receives.

13.88 Conversely, if income flowing through a chain of companies to a shareholder is fully taxed when derived by each company in the chain, the result will be what is known as a ‘cascading of tax’. As this point is most readily apparent in a classical corporate tax system, Example 13.16 is based on the assumption that a classical system of corporate taxation is used. Again, to simplify calculations, the assumption has been made in this example that the companies are subject to a corporate tax rate of 30%. [page 913]

Company 1 Income Tax @ 30% After-tax income Dividend Company 2 (Sole shareholder in Company 1) Dividend income Tax @ 30% After-tax income Natural person

$1000 $300 $700 $700

$700 $210 $490

(Sole shareholder in Company 2 — assumed to be on a 45% marginal rate prior to receipt of the dividend. Medicare levy is not taken into account for the purposes of this example.)

Dividend income Tax @ 45% After-tax income

$490.00 $220.50 $269.50

If the view is taken that the aim of corporate taxation is to ensure that increases in a company’s wealth should be brought to tax to the extent that a shareholder has command over them, then a cascading of corporate tax is undesirable. This is because for one increase in wealth, the tax ultimately paid will vary according to the number of companies it passes through on the way to a natural person shareholder. In turn, this would mean that other, similarly placed taxpayers, receiving dividends, would be treated differently for tax purposes depending on how long a chain of companies those dividends had passed through.

13.89 Currently, Australia prevents a cascading of corporate tax when dividends flow between companies outside consolidated groups by using the same gross-up and credit method as applies when dividends flow to other resident shareholders. That is, the franking credit on the distribution is included in the recipient company’s assessable income under ITAA97 s 207-20(1) and the dividend itself is included in the recipient company’s assessable income under ITAA36 s 44(1)(a)(i). The recipient company is entitled to a tax offset under ITAA97 s 207-20(2) equal to the franking credit on the distribution. Under ITAA97 s 6725(1C), corporate tax entities (other than certain tax-exempt entities and certain insurance companies) are not entitled to refunds of excess tax credits. Where the recipient company’s deductions do not exceed its assessable income from its other operations, the end effect of the grossup and credit mechanism is that no additional tax should be paid by the recipient company on a dividend that is franked to 100%. Note, however, [page 914] that any franking credit attached to a dividend will generate a franking credit in the recipient company’s franking account. Where a dividend is franked to less than 100% and the recipient company’s deductions exceed its assessable income from its other operations, the end effect of the gross-up and credit mechanism is that some corporate tax will be payable by the recipient company on the dividend received. The payment of tax will, in turn, generate franking credits for the recipient company as will any franking credits that were attached to the dividend received. The position of a recipient resident company receiving a dividend franked to 100% is shown in Example 13.17 while the position of a resident company receiving a dividend franked to less than 100% is shown in Example 13.18. In both cases, it is assumed that the recipient company’s deductions do not exceed its assessable income from its other operations. Example 13.17 and Example 13.18 also show the effects on a resident natural person top marginal rate

shareholder if the recipient company immediately redistributes the dividend. In Example 13.17 and Example 13.18, to simplify calculations, the assumption has been made that a corporate tax rate of 30% applies to the companies.

Dividend franked to 100% received by resident company.

Company 1 Income Tax @ 30%

$1000 $300 (generates $300 of franking credits) After-tax income $700 Dividend (franked to 100%) $700 Franking credit attached $300 Company 2 Dividend $700 ITAA36 s 44(1) inclusion Franking credit attached $300 ITAA97 s 207-20(1) inclusion Grossed-up dividend $1000 Other income Nil Tax @ 30% $300 Tax offset $300 ITAA97 s 207-20(2) Net tax $0 Receipt of the franked distribution generated a credit in Company 2’s franking account equal to the franking credit on the distribution, that is, $300. Hence, assuming that there have been no other relevant credits or debits in Company 2’s franking account, it would be able to fully redistribute the dividend of $700 and to attach $300 of franking credits to it, thus franking it to 100%. The position of [page 915]

a sole natural person resident shareholder on a 45% marginal rate prior to receipt of the dividend would be as follows: Natural person (Sole shareholder in Company 2 — assumed to be on a 45% marginal rate. Medicare levy is not taken into account for the purposes of this example.)

Dividend Franking credit attached

$700 $300

ITAA36 s 44(1) inclusion ITAA97 s 207-20(1) inclusion

Grossed-up dividend Tax @ 45% Tax offset Net tax payable After-tax dividend

$1000 $450 $300 ITAA97 s 207-20(2) $150 $550

Dividend franked to 50% received by resident company.

Company 1 Distributable profit Income (included in profit) Tax @ 30% After-tax income After-tax profit Dividend Franking credit attached Company 2 Dividend Franking credit attached

$1700 $300

$1000 (generates $300 of franking credits)

$700 $1400 $1400 (franked to 50%) $300 $1400 ITAA36 s 44(1) inclusion $300 ITAA97 s 207-20(1)

inclusion Grossed-up dividend Other income Tax @ 30% Tax offset Net tax

$1700 Nil $510 $300 ITAA97 s 207-20(2) $210 [page 916]

Receipt of the franked distribution generated a credit in Company 2’s franking account equal to the franking credit on the distribution, that is, $300. The payment of net tax would generate a further $210 of franking credits. Hence, assuming that there have been no other relevant credits or debits in Company 2’s franking account, it would, after payment of the net tax of $210, be able to pay a dividend of $1190 and to attach $510 of franking credits to it, thus franking it to 100%. The position of a sole natural person resident shareholder on a 45% marginal rate prior to receipt of the dividend would be as follows: Natural person (Sole shareholder in Company 2 — assumed to be on a 45% marginal rate)

Dividend Franking credit attached Grossed-up dividend Tax @ 45% Tax offset Net tax payable After-tax dividend

$1190 ITAA36 s 44(1) inclusion $510 ITAA97 s 207-20(1) inclusion $1700 $765 $510 ITAA97 s 207-20(2) $255 $935

13.90 Where the receiving company has deductions (other than loss carry forwards) in addition to its dividend income, the inclusion of the franking credit and the allowance of the tax offset will produce an excess tax offset for the recipient company. In these circumstances, the excess tax offset is converted into a tax loss under s 36-55 by dividing it

by the entity’s corporate tax rate for imputation purposes for that year. For the 2017–18 year for companies with an aggregated turnover equal to or greater than $10 million the rate will be 30%. For companies with an aggregated turnover of less than $10 million the rate will be 27.5%. The operation of ITAA97 s 36-55 in these circumstances is shown in Example 13.19. In the example, to simplify calculations, the assumption has been made that a corporate tax rate of 30% applies to the company.

Company Income/profit Tax Distribution Maximum franking credit Franking credit allocated Franking %

$100,000 $30,000 = $30,000 franking credits $70,000 $30,000 $30,000 100% [page 917]

Corporate tax entity member Dividend $70,000

s 207-20(1) inclusion Grossed-up dividend Assessable income Deductions

$30,000 $100,000 $100,000* $90,000

(included in assessable income via ITAA36 s 44(1))

Taxable income

$10,000

Tax payable s 207-20(2) tax offset Excess tax offset**

$3,000 $30,000 $27,000

*Assume that recipient has no other income. **Excess tax offsets are generally not refundable to companies; however, life insurance companies can be entitled to refunds of tax offsets in some circumstances. The receipt of the distribution would also generate $30,000 in franking credits for the recipient company. Here, ITAA97 s 36-55(2) will convert the excess tax offset to a tax loss (which can be carried forward) by dividing it by the corporate rate of 30%. Hence, the tax loss that the corporate tax entity member can carry forward will be $90,000.

13.91 Where the recipient company has tax losses carried forward then the rules relating to deducting the tax losses of corporate tax entities set out in ITAA97 s 36-17 must be borne in mind. Under s 3617, a company may choose to deduct a nil amount for a loss carried forward. Section 36-17(5) places two restrictions on the ability of the recipient company to choose how much of the tax loss carried forward it will deduct in the income year. The first restriction, contained in s 3617(5)(a), is that the recipient company must choose to deduct a nil amount for the tax loss carried forward if, disregarding the tax loss and other tax losses of the recipient company, it would otherwise have an excess franking offset for the income year. The effect of the rule is that the company’s prior year loss carried forward is preserved and the excess franking offset is converted into a tax loss under s 36-55. The combined operation of ss 36-17(5)(a) and 36-55 is illustrated in Example 13.20. In the example, to simplify calculations, it has been assumed that a corporate tax rate of 30% applies to the company. [page 918]

Assume the facts in Example 13.19 with the variation that, in addition to the deductions of $90,000, the recipient company has a loss carry forward of $60,000. The position of the recipient company would be as follows: Corporate tax entity member

Dividend

$70,000

s 207-20(1) inclusion Grossed-up dividend Assessable income Deductions Taxable income Tax payable s 207-20(2) tax offset Excess tax offset

$30,000 $100,000 $100,000* $90,000 $10,000 $3,000 $30,000 $27,000

(included in assessable income via ITAA36 s 44(1))

The excess tax offset is then converted into a tax loss by multiplying it by 1/0.30 to produce a tax loss of $90,000. As the recipient company has an excess franking offset for the year, disregarding the tax loss of $60,000, the recipient company is required by ITAA97 s 36-17(5)(a) to deduct a nil tax loss in respect of the loss carried forward. This will mean that the recipient will have a total loss carry forward of $150,000 which can be deducted in later years. The losses would be deducted in the order in which they were made. That is, the $60,000 loss would be deducted first in a subsequent year and then the $90,000 loss would be deducted. * Assume that the recipient has no other income.

13.92 Further restrictions on the ability of the recipient company to choose how much of the loss it will deduct are contained in ITAA97 s 36-17(5)(b). Under s 36-17(5)(b), where, disregarding the tax loss and its other tax losses, the recipient company would not have an excess franking offset, the recipient company must not choose to deduct an

amount for the tax loss that would result in it having an excess franking offset in the income year.

Assume the facts in Example 13.20 with the variation that the recipient company has no deductions other than the $60,000 loss [page 919] carry forward. What is the maximum amount of loss carried forward that ITAA97 s 3717(5)(b) will permit the recipient company to deduct in the income year? A suggested solution can be found in Study help.

13.93 Note that as a consolidated group is treated as a single entity for income tax purposes, intra-group distributions generally are ignored for income tax purposes. The tax treatment of consolidated groups is discussed at 12.112–12.131. 13.94 Prior to 1 July 2002, Australia prevented the cascading of corporate tax by using an inter-corporate dividend rebate. Between 1 July 2000 and 1 July 2002, both public and private companies were entitled to an inter-corporate rebate only on the franked portion of nongroup dividends they received. Prior to 1 July 2000, public companies were entitled to an inter-corporate rebate on all dividends they received whereas, for some time, private companies had obtained an intercorporate rebate only on the franked portion of dividends that they received.

Gross-up and tax offset denied where imputation system manipulated 13.95

ITAA97 Subdiv 207-F will mean that the franking credit on a

distribution is not included in the assessable income of a recipient entity and that the recipient entity is denied a tax offset for the amount of the franking credit on the distribution. Subdivision 207-F operates in the following circumstances: where the receiving entity is not a qualified person for the purposes of the anti-franking credit trading provisions (see 12.72–12.73); where the Commissioner has made a determination under the anti-dividend streaming rules (see 12.63–12.71); where the distribution is made as part of a dividend-stripping operation; where the Commissioner has made a determination under ITAA36 s 177EA (see 12.71); and where s 207-157 (about dividend washing) applies. Section 207-157 was introduced in 2014 to combat what is known ‘dividend washing’, which involves effectively obtaining double franking credits on substantially identical shares by utlising a special ASX market for trading in cum-dividend shares. The provision applies where an entity disposes of shares ex dividend but retains the right to receive the franked dividend that has been declared and then the entity or a connected entity acquires substantially identical shares in a special cumdividend market and a franked distribution is then made in relation to the shares acquired cum dividend. The concept of dividend stripping is explained at 13.96–13.97. [page 920]

Dividend stripping 13.96 One of the most notorious tax-avoidance strategies of the 1970s was what is known as ‘dividend stripping’. A classic example of dividend stripping can be seen in Slutzkin v FCT (1977) 140 CLR 314; 7 ATR 166; 77 ATC 4076. There, the shareholders in a company were

trustees of a family trust for MrSlutzkin’s children. They decided to sell the shares in the company rather than have its assets paid out as dividends as, in the days before CGT, the profit on the share sale would be tax free. The trustees sold the shares to Cadiz Corporation Pty Ltd, a company involved in dividend-stripping operations. The sale price was approximately equal to the value of the net assets of the company. Pursuant to the terms of the contract for sale, the assets of the company were converted into cash prior to completion of the sale. Following completion of the sale, the company then paid a dividend to Cadiz Corporation Pty Ltd, thus largely reimbursing it for the purchase price. At the time, because of the ITAA36 s 46 rebate, the dividend was tax free to Cadiz Corporation Pty Ltd. Cadiz Corporation Pty Ltd then sold its shares in the company for more than the net value of its assets. This was possible because the dividend paid meant that the company had made an excess distribution which would have been valuable to a private company purchaser that had a liability for what was then known as undistributed profits tax.31 In Slutzkin, the High Court held, for reasons that need not concern us here, that the then general antiavoidance provision ITAA36 s 260 did not apply to the trustees.

1.

2.

3.

What tax advantages did the trustees in Slutzkin obtain from the arrangement with Cadiz Corporation Pty Ltd? Even in the absence of specific rules directed against dividend stripping would this sort of arrangement be as advantageous to the trustees if it were carried out today? What tax advantages did Cadiz Corporation Pty Ltd gain from the dividend-stripping operation? Since the abolition of undistributed profits tax, what other advantages might a company like Cadiz Corporation Pty Ltd be able to obtain through a dividend-stripping operation? If you were asked to draft legislation specifically designed to combat dividend stripping, what approach would your legislation take?

[page 921]

Measures to combat dividend stripping 13.97 Three provisions in the ITAA36 were specifically aimed at combating dividend stripping. Both ITAA36 ss 46A and 46B were aimed at curtailing (by limiting or denying inter-corporate dividend rebates) the incentive for the purchaser of shares to engage in dividend-stripping operations. Sections 46A and 46B were repealed in 2006. ITAA97 Subdiv 207-F, as discussed below, curtails the incentive for the purchaser to engage in dividend stripping by denying a franking credit and tax offset. ITAA36 s 177E, in Pt IVA (the general anti-avoidance provisions), also applies to dividend stripping. Section 177E applies to certain disposals of property of the company as a result of a scheme that, in relation to a company is either a scheme by way of or in the nature of dividend stripping, or is a scheme having substantially the effect of a scheme by way of or in the nature of dividend stripping. The disposals of property at which s 177E is directed are disposals representing, in the opinion of the Commissioner, a distribution of profits of the company. In addition, it must be the case that if, immediately before the scheme was entered into, the company had paid a dividend equal to the profits represented by the disposal of property, then an amount (the notional amount) would have been included in the assessable income of a taxpayer in the year of income. An example of the kind of situation that s 177E appears to have been designed to deal with can be seen from the facts in Slutzkin v FCT (1977) 140 CLR 314; 7 ATR 166; 77 ATC 4076. There, the dividend paid to Cadiz Corporation Pty Ltd would probably be regarded as a disposal of the property of the company representing a distribution of its profits. It would then be necessary to ask whether, if a dividend (equal to the profits represented by the disposal of the company’s property) had been paid to the trustees of the Slutzkin family trust prior to the scheme being entered into, an amount would have been included in the assessable income of the trustees in a year of income. Probably the answer to this question would have been ‘yes’, which would mean that if the facts in Slutzkinhad occurred after the enactment of s 177E,

then s 177E would have been triggered. Where s 177E applies to a scheme, the effect is that the scheme is deemed by s 177E(1)(e) to be a scheme to which the general anti-avoidance provisions of ITAA36 Pt IVA apply. Then, for the purposes of s 177F, the taxpayer (the trustees of the family trust in the Slutzkin example) is taken to have obtained a tax benefit in connection with the scheme. The tax benefit is not having the notional amount being included in assessable income in a year of income. The amount of the tax benefit is taken to be the notional amount. Where Pt IVA applies to a scheme from which the taxpayer has obtained a tax benefit then, subject to the comments on ‘purpose’ in FCT v Consolidated Press Holdings Ltd; CPH Property Pty Ltd v FCT (2001) 207 CLR 235; 47 ATR 229 (Consolidated Press Holdings), the Commissioner is given power to cancel the tax benefit and make compensating adjustments. For example, in the Slutzkin situation, the Commissioner would have power to regard the profits of the company as being distributed as a dividend to the trustees of the Slutzkin family trust before the scheme was entered into. In these circumstances, it would also be appropriate for the Commissioner to make compensating adjustments in relation to Cadiz Corporation [page 922] Pty Ltd. For example, the Commissioner would have power to regard no dividend as having been paid to Cadiz Corporation Pty Ltd. Part IVA is discussed in detail in Chapter 17. In FCT v Consolidated Press Holdings Ltd (2001) 207 CLR 235; 47 ATR 229, the High Court discussed the meaning of ‘dividend stripping’ in s 177E. In a joint judgment, Gleeson CJ, Gaudron, Gummow, Hayne and Callinan JJ commented that ‘dividend stripping’ was not a term of art with a defined or definable literal meaning that could be identified separately from the context in which it appeared. In framing ITAA36 s 177E, the legislature had adopted the language of tax avoidance and had placed s 177E in Pt IVA as a necessary supplement to the general

anti-avoidance provisions. Their Honours stressed that, in this context, a purpose of avoiding the shareholders in the target company from being liable to tax on dividends paid out of the accumulated profits of the target company was the hallmark of a dividend-stripping scheme. For this reason, a mere purchase of shares cum dividend did not amount to a dividend-stripping scheme. Their Honours also held that an equivalent purpose was required before a scheme could be said to be one that had substantially the effect of a scheme by way of, or in the nature of, dividend stripping. In their Honours’ view, a scheme having substantially the effect of a dividend-stripping scheme would be one where, although the purpose and effect of the scheme was substantially the same as in a dividend-stripping scheme, some means other than a dividend or deemed dividend was employed to make the distribution to the dividend stripper. For purposes of the ITAA97 Subdiv 207-F denial of the franking credit gross-up and tax offset, ITAA97 s 207-155 provides that a distribution made to a member of a corporate tax entity will be part of a ‘dividend-stripping operation’ where the distribution arose out of, or was made in the course of, a scheme that: (a) was by way of, or in the nature of, dividend stripping; or (b) had substantially the effect of a scheme by way of, or in the nature of, dividend stripping.

In the light of the High Court’s decision in Consolidated Press Holdings, discussed above, it may be that a tax-avoidance purpose will be required before a distribution will be part of a dividend-stripping operation as defined in ITAA97 s 207-155. It is probable, though, that the tax-avoidance purpose will be viewed from the perspective of the dividend stripper, that is, as a purpose of obtaining distributions from the company tax free because of the franking credit tax offset coupled with a purpose of obtaining either a revenue loss or a capital loss on a subsequent realisation of the shares in the target company.

Other circumstances where a franking credit tax offset will not be available 13.98 There are several other circumstances where a distribution by a company will not give rise to a franking credit tax offset for the shareholder. Obviously, any distributions [page 923] which are not frankable will not give rise to a franking credit tax offset. Distributions that are deemed to be unfrankable by ITAA97 s 202-45 were discussed at 12.52. At this point, further discussion of some of these types of distributions is appropriate.

Non-equity shares 13.99 A distribution in respect of a non-equity share will be an unfrankable distribution under ITAA97 s 202-45(d) and will not generate a franking credit tax offset. The concept of ‘non-equity shares’ was discussed at 12.25. In essence, these will be shares that pass the debt test set out in ITAA97 s 974-135. Non-equity shares are classified as a debt interest. Returns on debt interests are deductible but not frankable. Some redeemable preference shares might be classified as non-equity shares. An important factor here may be whether or not the company issuing the shares or the shareholder has the right to call for their redemption. In the former case, the shares are more likely to be equity and, in the latter case, the shares are more likely to be debt. Whether preference dividends payable on the shares are cumulative or not is also likely to be a factor. If the preference dividends are cumulative, the shares are more likely to be debt. Consistently with the decision of the Full Federal Court in FCT v Radilo Enterprises Pty Ltd (1997) 34 ATR 635, the Explanatory Memorandum to the New Business Tax System (Debt and Equity) Bill 2001 (Cth) comments that converting preference shares are unlikely to be classified as debt

interests unless there is an obligation on the issuing company to repurchase the shares before they convert into ordinary shares. 13.100 Redeemable preference share financing schemes were once popular in Australia. The inter-corporate dividend rebate was the foundation of these schemes. This meant that, under the rebate rules of the time, dividends received on redeemable preference shares were tax free to a corporate lender. This meant that the lender was prepared to obtain a lower rate of return on redeemable preference share financing than it would expect on loan financing. For example, under current Australian corporate rates, a tax-free return of $70 is equivalent to a fully taxed return of $100. In Chapter 17, we shall see that this aspect of redeemable preference share financing was crucial to the High Court decision in FCT v Peabody (1994) 181 CLR 359; 94 ATC 4663. However, redeemable preference share financing meant that the borrower paid non-deductible dividends instead of deductible interest. This meant that there were few or no advantages in redeemable preference share financing for a borrower except where the borrower had tax losses from previous years. Where the borrower had losses, redeemable preference share financing meant that the lender could receive a tax-free return, and the borrower could obtain funds at a lower cost without paying any additional tax. Under the ITAA36, s 46D combated redeemable preference share financing by denying a recipient an inter-corporate rebate on the unfranked part of a ‘debt dividend’. As no part of a debt dividend could be franked, s 46D meant that a recipient company could never obtain an inter-corporate rebate on a debt dividend. A debt dividend was one which, having regard to a variety of factors, could reasonably be regarded as being equivalent to interest on a loan. The ITAA97 combats redeemable preference share financing by deeming, in ITAA97 s 202-45(d), distributions in respect of non-equity shares to be unfrankable which, in turn, means that no shareholder obtains a franking credit tax offset in respect of them. [page 924]

Dividends funded from share capital account 13.101 Under s 202-45(e), a distribution that is sourced, directly or indirectly, in a company’s share capital account is unfrankable. Note that under s 975-300, a tainted share capital account is still a share capital account for purposes of s 202-45(e). We also noted at 13.14 that a distribution funded from a tainted share capital account will be a dividend within the ITAA36 s 6(1) definition of ‘dividend’. Following amendments to s 254T of the Corporations Act 2001 (Cth) by the Corporations Amendment (Corporate Reporting Reform) Act 2010 (Cth), a company may fund a dividend from an amount other than profits. The effect of para (d) of the ITAA36 s 6(1) definition of ‘dividend’ is that for such distributions to be dividends for tax purposes they would have to not be debited against the company’s untainted share capital account. Nonetheless, such dividends might still be unfrankable because of ITAA97 s 202-45(e) if they are sourced ‘directly or indirectly’ from the company’s share capital account.32 It should be noted, however, that the Explanatory Memorandum to the Corporations Amendment (Corporate Reporting Reform) Bill 2010 (Cth) stated that, subject to the operation of existing integrity rules, Corporations Act s 254T dividends would be frankable under ITAA97 s 202-40. The Commissioner’s views on these and related issues have now been set out in Taxation Ruling TR 2012/5. Relevant paragraphs from TR 2012/5 have been extracted at 13.14. 13.102 As discussed in 12.72–12.73, the previous anti-franking credit trading provisions contained in ITAA36 ss 160APHC–160APHU denied franking credit benefits and the inter-corporate rebate to dividends to which they applied. It is anticipated that these provisions will be re-enacted so as to be consistent with the Simplified Imputation System. As at the time of writing, a Bill re-enacting these provisions had not been introduced into the Commonwealth Parliament.33

Some other distributions where a franking credit tax offset is not available 13.103

Distributions that are taken to be unfranked dividends under

the anti-capital benefit streaming provisions, discussed in 12.84–12.88, are unfrankable distributions under ITAA97 s 202-45(h). 13.104 Demerger dividends are deemed to be unfrankable by ITAA97 s 202-45(i). Hence, a franking offset is not available in respect of a demerger dividend. The demerger relief provisions are discussed at 13.159–13.163. 13.105 As noted at 13.32, the combined effect of ITAA97 s 20245(f) and either (as the case may be) s 215-10 or s 215-15 is that a nonshare dividend will not be frankable where the company does not have available profits at the time the non-share dividend is paid. [page 925]

CGT from a shareholder’s perspective CGT aspects of acquisition and disposal of equity interests 13.106 An equity interest in a company (such as a share) is a CGT asset. Thus, unless an equity interest is trading stock to a taxpayer, disposals and other CGT events that take place in relation to an equity interest will have potential CGT consequences for the holder of the equity interest. In the case of an ordinary subscription for or purchase of equity interests such as shares, the normal cost base rules (see 6.100–6.112) as varied by any relevant adjustments (see 6.113–6.118) will determine the cost base of the equity interests. An adjustment to cost base that applies in the case of company-issued put options is discussed at 13.115. The normal rules relating to capital proceeds (see 6.89–6.92) as varied by any relevant adjustments (see 6.93–6.99) will determine the capital proceeds that relate to relevant CGT events that take place in relation to equity interests. Amendments to the rules adjusting capital proceeds that will only apply in the case of shares in a

widely held company or units in a widely held unit trust are discussed at 13.111. 13.107 Where equity is acquired by an issue or allotment, ITAA97 s 109-10 provides that you acquire the equity interests when the contract34 is entered into or, if there is no contract, when the equity interests are issued or allotted. Section 109-10 thus appears to assume that an issue or allotment of equity interests such as shares is not itself a contract between the company and the issuee or allottee. Case law which has regarded an allotment as a contract to issue shares includes FCT v St Helens Farm (ACT) Pty Ltd (1981) 146 CLR 336 and National Westminster Bank plc v IRC (UK); Barclay’s Bank plc v IRC (UK) [1994] 3 All ER 1. An allotment itself, however, will not necessarily be under a contract. For an example of an allotment that was not under a contract, see Elmslie v FCT (1993) 26 ATR 611. 13.108 Where equity interests are issued partly paid, then the decision of O’Loughlin J in Dingwall v FCT (1995) 57 FCR 274; 130 ALR 297; 30 ATR 498, discussed in 6.105, should mean that the uncalled portion of the issue price will not form part of the first element of the cost base of the equity interests. This is because the liability to pay the call will be contingent until the call is actually made. Note, however, that if the date for payment of the issue price is merely deferred, it will be included in the first element of the cost base of the equity interests. This is due to the operation of ITAA97 s 103-15, under which you will be regarded as being required to pay money at a particular time even if you do not have to pay it until a later time or if it is payable by instalments. 13.109 The market value substitution rule will not apply to an issue or allotment of shares for no consideration as ITAA97 s 112-20(1)(a) expressly provides that, where you did not incur expenditure to acquire an asset, the market value substitution rule does not apply where your acquisition resulted from either: [page 926]

(i) CGT event D1 happening; or (ii) another entity doing something that did not constitute a CGT event happening …

Note also that ITAA97 s 104-35(5)(c) (discussed at 12.133) will mean that CGT event D1 will not apply to an issue or allotment of equity interests for no consideration. Hence, s 112-20(1)(a) will not apply the market value substitution rule to an issue or allotment of equity interests for no consideration as the equity holder’s acquisition of the equity interest resulted from the company doing something that did not constitute a CGT event happening. Note that the table in s 11220(3) expressly states that the market value substitution rule does not apply to the acquisition of a share in a company where it was issued or allotted to you by the company and you did not pay or give anything for it. Note also, that, where you do not deal at arm’s length with the other entity and your acquisition of the CGT asset resulted from another entity doing something that did not constitute a CGT event happening, the market value is substituted only if the non-arm’s length cost was more than market value. These limitations on the market value substitution rule can be traced back to amendments made to ITAA36 s 160ZH(9) following the decision of the Full Federal Court in Allina v FCT (1991) 28 FCR 203; 21 ATR 1320; 91 ATC 4195. In Allina, the taxpayer acquired company-issued rights in BHP Gold Mines Ltd for no consideration. The taxpayer then sold the rights for $34,373. Under ITAA36 s 160ZH(9)(a), as it then stood, the market value of an asset was substituted for the actual consideration paid where ‘the taxpayer acquired the asset from another person and did not pay or give any consideration in respect of the acquisition of the asset’. The Full Federal Court held that the taxpayer acquired the shares from the company even though the company had never owned the shares. Hence, no capital gain accrued to the taxpayer as the cost base of the rights and the consideration in respect of their disposal were both equal to their market value. The court’s logic was that the taxpayer must have acquired the shares from someone as it did not create them.

What would be the CGT effects if a company issued shares for no consideration to a shareholder who then sold them for their market value of $5 each?

13.110 Shares are what is known as ‘fungible’ assets. That is, normally, when you buy shares in a particular company, you are merely interested in buying a number of shares of a particular class. As long as the shares you acquire have these characteristics, you would not normally be concerned about other characteristics (such as certificate numbers) that the shares might have. The fungibility of shares creates difficulties, however, if it is necessary to know for CGT purposes precisely which particular shares you are disposing of. For CGT purposes, it will usually be necessary to know [page 927] which particular shares you are disposing of because the CGT effects of the disposal will vary according to the precise time at which the shares were acquired. The precise time of acquisition of shares may be relevant in determining whether shares are pre- or post-CGT assets in calculating the indexation component in the cost base of the shares and in determining whether or not a discount is allowable in respect of the shares. CGT Determination TD 33 expresses the Commissioner’s views on this issue where the shares are capital assets to the taxpayer. TD 33 1. Where a disposal of shares occurs and those shares are able to be individually distinguished, eg, by reference to share numbers or other distinctive rights or obligations attached to them, those shares are identifiable; their date of acquisition and cost base will be a matter of fact. 2. However, on the disposal of shares which form part of a holding of identical shares, ie, of the same class and in the same company, which are acquired over a period of

time, it may not always be possible for a taxpayer to distinguish or identify the particular shares that have been disposed of. 3. In these circumstances, the taxpayer will need to decide which particular shares are being disposed of. Taxpayers in this situation will need to keep adequate records of the transaction so that the decision can be supported should the income tax return be subject to Tax Office scrutiny at a later date. 4. In the past, where unidentifiable shares have been disposed of, the Commissioner has accepted ‘first-in first-out’ as a reasonable basis of identification. For CGT purposes, the Commissioner will also accept the taxpayer’s selection of the identity of shares disposed of. Addendum 1. Taxation Determination TD 33 is concerned with the identification of shares for capital gains tax purposes. It states that if it is not possible individually to distinguish the shares, we accept either the FIFO (first in, first out) method or the taxpayer’s selection of the identity of shares disposed of. 2. We have decided to accept a limited exception to our view that average cost is not an acceptable method. We will accept average cost to work out the acquisition cost of shares provided that the shares satisfy all of the following requirements: (a) they are in the same company; and (b) they are acquired on the same day; and (c) they confer identical rights and impose identical obligations. Any shares for which subsection 160ZH(9) [the ITAA36 market value substitution rule] deems a market value cost of acquisition needs to be excluded from the average cost calculation.

[page 928] Taxation Ruling TR 96/4 deals with the related issue of valuing shares acquired as revenue assets. The substance of this ruling is that, if possible, the actual cost of the actual shares disposed of should be identified. This can be done where shares have numbered certificates. Where numbered certificates are not available, the actual shares sold can be identified if accounting records of the type specified in the rulings are maintained. Where the actual shares sold cannot be identified by using either of these methods the taxpayer is generally required to use the first-in-first-out (FIFO) method to determine which shares were sold and their cost price. Use of the average cost method

will be acceptable where it is not practicable to ascertain the actual cost of the shares. 13.111 The market value substitution rule for capital proceeds in ITAA97 s 116-30 was discussed at 6.93–6.94. There, it was noted that, under s 116-30(2)(b)(ii), market value will be substituted where actual capital proceeds are more or less than the market value of the asset and the CGT event is CGT event C2. There is no requirement in this situation for the parties to not be dealing at arm’s length for the market value substitution to be made. The Tax Laws Amendment (2008 Measures No 2) Act 2008 (Cth) added s 116-30(2B). Under this amendment, the market value substitution rule does not apply where CGT event C2 happens to a share in a company that has at least 300 members and does not have concentrated ownership. The tests for determining whether the ownership of the company is concentrated are set out in s 116-35 and require 75% of rights to income, rights to capital or voting power being concentrated in 20 or fewer persons. The assumption of the legislature in this case is that transactions between a widely held company and its shareholders are at arm’s length and, hence, there is no need for the application of the market value substitution rule where CGT event C2 happens to a share in a widely held company. This is so even though the assumption must also be that market value in these circumstances must be something other than the actual consideration, otherwise s 116-30(2B) would be otiose.

Company-issued rights and options 13.112 ITAA97 Subdiv 130-B deals with rights and options including, but not limited to, company-issued rights and options acquired for no consideration. Where a company issues rights or options to you for no consideration, Subdiv 130-B will only apply if you already owned shares or convertible interests in the company or in another company that is a member of the same wholly owned group. 13.113 Under ITAA97 s 130-45, you are taken to have acquired the rights or options when you acquired the original shares or interests. Thus, if the original shares or interests are pre-CGT assets to you, the rights and options will be pre-CGT assets also. The new shares or

options that you acquire on the exercise of the rights or options are taken to be acquired when the rights or options are exercised. Thus, even though the rights or options themselves may be pre-CGT assets to you, the shares that you acquire on their exercise will be post-CGT assets to you. 13.114 When rights or options to which ITAA97 Subdiv 130-B applies are exercised, s 130-40(7) will mean that any capital gain or loss that you make from the exercise is disregarded. Note that the rules set out in Subdiv 130-B remain relevant only for determining the cost base and reduced cost base of shares or options to [page 929] acquire shares in a company (or units or options to acquire units in a unit trust) and have not been extended to cover non-share equity interests other than options. The method for calculating the cost base and reduced cost base of shares and options acquired on the exercise of company-issued rights is set out in Table 13.2, which is in s 130-40(6). Table 13.2: Modifications on exercise of rights Item

In this situation:

The modification is:

1

You exercise rights issued to you to The first element of your cost base for the acquire the shares, units or options. shares, units or options is the sum of: (a) the cost base of the rights at the time of exercise; and (b) any amount paid to exercise the rights, except to the extent that the amount is represented in the paragraph (a) amount; and (c) all the amounts to be added under subsection (6A). The first element of their reduced cost base is worked out similarly.

2

You exercise rights you acquired from another entity to acquire the shares, units or options.

The first element of your cost base for the shares, units or options is the sum of: (a) the cost base of the rights at the time of exercise; and

(b) any amount paid to exercise the rights, except to the extent that the amount is represented in the paragraph (a) amount; and (c) all the amounts to be added under subsection (6A). The first element of their reduced cost base is worked out similarly. 3

You exercise rights issued to you to acquire the shares, units or options, and you acquired the original shares or convertible interests, or the original units or convertible interests, before 20 September 1985.

The first element of your cost base for the shares, units or options is the sum of: (a) the market value of the rights when they were exercised; and (b) any amount paid to exercise the rights, except to the extent that the amount is represented in the paragraph (a) amount; and (c) all the amounts to be added under subsection (6A). The first element of their reduced cost base is worked out similarly.

Note that s 130-40(6A) adds an amount to the cost base of the shares or options acquired on the exercise of the rights where a capital gain made from the right has been reduced under s 118-20. The example given in the legislation is where a capital gain made on the exercise of a right has been reduced under s 118-20 because an amount was included in the owner of the right’s assessable income under the traditional security provisions. Division 134 (see 6.43–6.44) applies to options to which Subdiv 130-B does not apply. [page 930] 13.115 The Tax Laws Amendment (2008 Measures No 3) Act 2008 (Cth) inserted ITAA97 s 112-37, which affects the cost base of put options (ie, an option giving the grantee of the option the right to dispose of an asset to the grantor of the option) to dispose of a share in the company where the grantee acquired the put option as a result of CGT event D2 (discussed at 6.40–6.42) happening to the company. In other words, s 112-37 applies where a company issues put options to a

shareholder where the put options enable the shareholder to require the company to purchase the shareholder’s shares. As noted at 13.33, in FCT v McNeil (2007) 229 CLR 656; 2007 ATC 4223 at 4232–3; [2007] HCA 5, the majority of the High Court held that the market value of put options issued to a trustee for shareholders who held shares in the company at a record date was ordinary income to a shareholder who did not exercise the options. Section 112-37 includes in the cost base of the put options to the shareholder any amount that is included in the shareholder’s ordinary income as a result of the shareholder’s acquisition of the put options. In addition, the Tax Laws Amendment (2008 Measures No 3) Act 2008 (Cth) amended the market value substitution rule for cost base in s 112-20(3) by adding item 7 in the table so that the rule does not apply to a holder of a company-issued put option who exercises the option. Furthermore, the Tax Laws Amendment (2008 Measures No 3) Act 2008 (Cth) inserted a specific provision, ITAA97 s 104-155(5)(ea), which means that CGT event H2 (discussed at 6.48–6.53) does not apply where a company grants put options in relation to its shares. The end result is that, where an issue of put options by a company to its shareholders for no consideration produces an inclusion in ordinary income, s 112-37 will mean that any capital gain that arose on a transfer of the put options will be limited to the difference between the amount included in assessable income on the issue of the put options and any amount received by the shareholder on a transfer of the put options. The Tax Laws Amendment (2008 Measures No 3) Act 2008 (Cth) also made amendments relating to the tax treatment of company-issued call options. ITAA97 s 59-40 deems the market value of companyissued call options to be non-assessable non-exempt income to the shareholder to whom they are issued, provided that the original shares were not: (a) revenue assets to the shareholder; (b) acquired under an employee share scheme (where neither Subdivs 83A-B nor 83A-C applied to the beneficial interest); (c) traditional securities; and (d) convertible interests.

Company-issued convertible interests

13.116 Where convertible interests are traditional securities, gains and losses made in relation to them may be taxed under the traditional security provisions. Following amendments introduced by the New Business Tax System (Taxation of Financial Arrangements) Act 2003 (Cth), as from 1 July 2003, no gain or loss will be accounted for under the traditional security provisions in respect of convertible interests that convert into ordinary shares. Any gains and losses on the ultimate disposal of the ordinary shares will be accounted for under the CGT provisions. The traditional security provisions were discussed in 5.45. Rules governing the determination of the cost base of shares or units acquired by converting a convertible interest are set out in ITAA97 Subdiv 130-C. Note that these rules are only relevant for determining the cost base and reduced cost base of shares in a company or units in a unit trust acquired on the conversion of a convertible [page 931] interest and have not been extended to non-share equity interests acquired on the conversion of a convertible interest. The method for calculating the cost base and reduced cost base of shares and units acquired on the conversion of company-issued convertible interests is set out in Table 13.3, which is in s 130-60(1). Table 13.3: Conversion of a convertible interest Item 1

In this situation:

The modification is …

You acquire shares or units in a unit The first element of the cost base of the trust by converting a convertible shares or units is the sum of: interest that is a traditional security. (a) the cost base of the convertible interest at the time of conversion; and (b) any amount paid to convert the convertible interest, except to the extent that the amount is represented in the paragraph (a) amount; and (c) all the amounts to be added under subsection (1A). The first element of their reduced cost base is worked out similarly.

2

You acquire shares (except shares acquired under an employee share scheme) by converting a convertible interest that is not a traditional security.

The first element of the cost base of the shares is the sum of: (a) the cost base of the convertible interest at the time of conversion; and (b) any amount paid to convert the convertible interest, except to the extent that the amount is represented in the paragraph (a) amount; and (c) all the amounts to be added under subsection (1A). The first element of their reduced cost base is worked out similarly.

3

You acquire units in a unit trust by converting a convertible interest (except one that is a traditional security) that was issued by the trustee of the unit trust after 28 January 1988.

The first element of the cost base of the units is the sum of: (a) the cost base of the convertible interest at the time of conversion; and (b) any amount paid to convert the convertible interest, except to the extent that the amount is represented in the paragraph (a) amount; and (c) all the amounts to be added under subsection (1A). The first element of their reduced cost base is worked out similarly.

13.117 In all cases, ITAA97 s 130-60(2) will mean that the shares acquired on conversion are regarded as being acquired when the conversion of the convertible interest happened. Under s 130-60(3), any capital gain or loss from the conversion of a convertible interest is disregarded.35 [page 932]

Capital payments for shares: CGT event G1 13.118 We saw in 13.5–13.16 that certain distributions by a company to its shareholders will not be dividends under the ITAA36 s 6(1) definition of ‘dividend’. This is so even though such distributions (eg, a return of capital funded from an untainted share capital account) do not represent a disposal of the shareholder’s interest in the company. In the absence of CGT event G1, if a company were sufficiently

capitalised, it could make non-assessable returns of capital to shareholders until the share capital of the company was virtually exhausted. Subject to the anti-capital benefit streaming rules (see 12.84–12.88), this would be an effective tax deferral technique. 13.119 CGT event G1 short circuits tax deferral planning of this type by reducing the cost base of post-CGT shares each time a corporate distribution occurs, which, in whole or part, is not a dividend and is not part of a CGT A1 or C2 event. The cost base of the shares is reduced by the non-assessable component in the distribution. From 1 July 2006 onwards, in calculating the non-assessable component of the distribution, the small business 15-year exemption (discussed at 6.156) is disregarded. This means that, to the extent that a distribution to which CGT event G1 applies represents a distribution of a small business 15-year exemption in the manner referred to in ITAA97 s 152125, it will not reduce the cost base of the shareholder’s shares in the company. You make a capital gain where the non-assessable component in the distribution is more than the cost base of the shares. When you make a capital gain through the operation of CGT event G1, s 104135(3) reduces the cost base and reduced cost base of the shares to nil. This means that you cannot make a capital loss through the operation of CGT event G1. 13.120 CGT event G1 does not apply to interim distributions by a liquidator where the company is dissolved within 18 months of the payment. In these circumstances, the interim distribution by the liquidator is regarded as forming part of the capital proceeds for CGT event C2 which occurs when the shares are cancelled. Where the company is not dissolved within 18 months of the interim distribution, CGT event G1 will write down the cost base of the shares by any part of the liquidator’s distribution that is not a ITAA36 s 47(1) deemed dividend. 13.121 ITAA97 s 104-135 does not appear to have been extended to non-share equity interests. This appears to mean that a non-share capital return that does not involve a cancellation of the non-share equity interest will not reduce the cost base of the non-share equity

interest. Where the non-share return of capital involves a cancellation of the non-share equity interest, the cancellation will trigger CGT event C2. It is likely that the capital proceeds for CGT event C2 in these circumstances will include any non-share returns of capital.

Liquidator declares shares worthless: CGT event G3 13.122 CGT event G3 takes place when a liquidator or administrator declares shares in a company, or financial instruments issued by, created by or in relation to, the company to be worthless. The event takes place when the liquidator makes the declaration. Obviously, a capital gain cannot arise in this situation. Rather, a capital loss equal to the reduced cost base of the shares at the time of the declaration will [page 933] be incurred. The effect of CGT event G3 is to advance the date of recognition of the capital loss that the shareholders will make on the worthless shares to the date of declaration rather than to the date of cancellation of the shares which would otherwise trigger CGT event C2. If the shareholder chooses to incur a capital loss at the time of the declaration, then the cost base and reduced cost base of the shareholder’s shares are reduced to nil just after the liquidator makes the declaration. Examples of the financial instruments to which CGT event G3 applies are found in ITAA97 s 104-145(1): (a) debentures, bonds or promissory notes issued by the company; (b) loans to the company; (c) futures contracts, forward contracts or currency swap contracts relating to the company; (d) rights and options to acquire one of the assets previously referred to; and (e) rights or options to acquire shares in the company.

You cannot choose to make a capital loss under CGT event G3 where: (a) the shares or financial instruments are pre-CGT assets; (b) the shares or financial instruments were revenue assets to you at the time the declaration was made; (c) the shares were qualifying shares for

purposes of the employee share scheme provisions and you did not elect that the discount on the issue of the shares be included in your assessable income; and (d) in relation to financial instruments that you acquired under an employee share scheme.

Pre-CGT shares or interests and company with post-CGT assets: CGT event K6 13.123 In the absence of CGT event K6, pre-CGT shareholders in a company with post-CGT assets would favour a sale of all their shares in the company over a sale of the company’s assets. This is because the sale of the shares would, in the absence of CGT event K6, not be subject to CGT while the sale of the company’s assets would be subject to CGT at the company level. CGT event K6 is aimed at discouraging planning of this nature. 13.124 Four prerequisites must be satisfied before CGT event K6 will occur in relation to a shareholder. These are: 1. you must own pre-CGT shares in a company (s 104-230(1)(a)); 2. one of several listed CGT events must happen in relation to the shares (s 1042-30(1)(b)), the more important of these being: (a) CGT event A1 — disposal of an asset; (b) CGT event C2 — cancellation, surrender or similar endings of an asset; (c) CGT event J1 — cessation of membership of wholly owned group after rollover; (d) CGT event K3 — passing of asset to tax-advantaged entity on death; 3. the market value of the post-CGT property of the company (other than trading stock) or the market value of the interests that the company owned through [page 934]

interposed companies or trusts in post-CGT property (other than trading stock) is at least 75% of the net value of the company (s 104-230(2)); and 4. the company must not have been listed on an Australian or foreign stock exchange at the time of the other CGT event and at all times in the five-year period before the other CGT event took place (s 104-230(9)).36 Any capital gain made under CGT event K6 is disregarded in relation to a share or unit where, if it had been a post-CGT share or unit, you could have chosen a scrip for scrip roll-over for the other CGT event. 13.125 The ‘net value’ of an entity is defined in ITAA97 s 995-1(1) as the amount by which the sum of the market values of the assets of the entity exceeds the sum of its liabilities. In working out the net value of the company, s 104-230(8) directs you to disregard the discharge or release of liabilities or the market value of assets acquired for a purpose that included ensuring that post-CGT assets represented less than 75% of the net value of the company. 13.126 CGT event K6 takes place when a specified CGT event referred to in ITAA97 s 104-230(1)(b) happens. Under s 104-230(6), you make a capital gain equal to the part of the capital proceeds from the shares that is reasonably attributable to the excess (if any) of the market value of the post-CGT underlying property (referred to in s 104230(2)) over the sum of the cost bases of that property. You cannot make a capital loss under CGT event K6. The operation of CGT event K6 at its simplest is illustrated in Example 13.21 below.

Omega Pty Ltd is a resident private company for tax purposes and has not ever been listed on an Australian or foreign stock exchange. Alpha owns all the shares in Omega Pty Ltd. Alpha acquired all her shares in Omega Pty Ltd pre-CGT. As at 1 January 2017, the assets of Omega Pty Ltd consisted of land and buildings purchased on 2 January 2003 for $1m and pre-CGT shares in other companies worth $400,000. The liabilities of Omega

Pty Ltd consisted of a mortgage of $500,000 to Big Bank Ltd secured over the land and buildings. The current market value of the land and buildings at that time was $1.2m. On 2 January 2017, Alpha sells her shares in Omega Pty Ltd to Beta for $1.1m. The net value of Omega at the time was $1,600,000 less $500,000 = $1.1m. The market value of the post-CGT assets was $1.2m. Hence, the market value of the post-CGT assets owned by Omega Pty Ltd was equal to at least 75% of the net value of Omega Pty Ltd. This means that when CGT event A1 (the disposal of the shares) happens in relation to Alpha’s shares, CGT event K6 will occur. Alpha [page 935] will make a capital gain equal to that part of the capital proceeds for the shares ($1.1m) that is reasonably attributable to the excess of the market value of the post-CGT underlying property over the sum of the a cost bases of that property. The sum of the cost bases of the post-CGT underlying property is $1m. The market value of the post-CGT assets is $1.2m. Hence the excess is $0.2m. How much of the $1.1m capital proceeds was reasonably attributable to the $0.2m excess of the market value of the post-CGT assets over their cost base? If we regard the mortgage as being applied against the land and buildings first on the basis that it was secured against those assets, then the net value of the land and buildings would be $700,000 which would represent 63.64% of the capital proceeds. Using this logic, the capital gain would be $0.2m × 63.64% = $127,280. However, if we regard the mortgage as being applied against the assets of the company generally in proportion to their relative values, then 75% of the mortgage would be applied against the land and buildings. This would mean that the net value of the land and buildings would be $825,000 which would represent 75% of the net assets of the company. Using this logic the capital gain would be $0.2m × 75% = $150,000.

13.127 Note that ITAA97 s 104-230(2) refers to the market value of the post-CGT underlying property of the company in which you own shares or the market value of the interests in post-CGT property that the company held through interposed companies or trusts. The better view is that the use of the conjunction ‘or’ suggests that the two tests should not be aggregated. Otherwise, as the interest that the company holds in another company or trust may itself be a post-CGT asset to the company, it would be possible for the same interest to be counted twice. The better view is also that a construction of s 104-230 that involves a double counting of interest would not result in a calculation of capital proceeds that are reasonably attributable to the underlying post-CGT assets. It is also worth noting that, as a matter of company law, a

shareholder in a company does not have an interest in the property of the company.37 Hence, s 104-230(2)(b) which speaks of the company owning an interest in property through an interposed company, appears to be based on false assumptions about the general law position. 13.128 In Taxation Determination TD 24 (now withdrawn), the Commissioner stated that he considered that cash would be underlying property for the purposes of ITAA36 s 160ZZT (the ITAA36 equivalent to ITAA97 s 104-230). The determination directed that FIFO should be used in determining whether the cash was a pre- or post-CGT property. The Commissioner also stated that the capital gain attributable [page 936] to cash would be nil as the value of Australian dollars does not appreciate against Australian dollars. Taxation Ruling TR 2004/18 states that ‘property’ in s 104-230 has its ordinary legal meaning and does not correspond with ‘assets’ or ‘CGT assets’. The effect of this approach can be seen in Example 13.22.

Assume the facts in Example 13.21 with the variation that both the buildings and the shares are pre-CGT assets to Omega Pty Ltd. Assume that on 1 January 2017, Omega Pty Ltd sells the shares for $400,000 and sells the buildings for $1.2m. Omega Pty Ltd uses $500,000 from the proceeds of the sale to discharge its debt to Big Bank Ltd. Under TD 24, the net cash asset of $1.1m will be post-CGT property to Omega Pty Ltd. This will represent 100% of the net value of Omega Pty Ltd. Hence, CGT event K6 will be triggered when Alpha disposes of her shares in Omega Pty Ltd. However, Alpha will not make a capital gain. Even though all the capital proceeds from the shares ($1.1m) are attributable to the post-CGT underlying cash, they do not exceed the cost base ($1.1m) of the cash asset.

Review your answer to Activity 13.1. How, if at all, would consideration of ITAA97 s 104-230 affect your response?

Value shifting provisions 13.129 The ITAA97 contains three Divisions dealing with value shifting transactions. The first of these, Div 723, need not involve any transactions in relation to shares in a company, and Divs 725 and 727 can apply to shifts in value affecting interests in trusts in addition to value shifts affecting shares. Nonetheless, it is convenient to discuss the three Divisions consecutively and, as they will most commonly be relevant in the context of value shifts affecting shares, this is an appropriate chapter to discuss them in.

Rights over non-depreciating assets: ITAA97 Div 723 13.130 ITAA97 Div 723 can apply where value is shifted out of a (non-depreciating) asset by the owner of the asset creating a right over the asset (such as an option, a covenant, a lease or a licence) in an associate provided that the value shift was not brought to tax at the time the right was created (eg, by operation of the CGT [page 937] market value substitution rule) and was not brought to tax on realisation of the right. The definition of ‘associate’ used in the controlled foreign company (CFC) provisions in ITAA36 Pt X applies for purposes of Div 723. That definition includes: relatives of the primary entity; partners of the primary entity and their spouses and

children; the trustee of a trust under which the primary entity benefits; and a company that is either sufficiently influenced by the primary entity or in which the primary entity holds the majority voting interest. If Div 723 applies, it reduces the loss on realisation of the underlying asset by the lesser of the ‘shortfall on creating the right’ and the ‘deficit on realisation’. The shortfall on creating the right is the capital proceeds for the underlying asset less the market value of the right. The deficit on realisation is the amount by which the market value of the underlying asset at the time of realisation is less than it would have been if the right had not been created. Division 723 will only apply where the shortfall on creating the right is more than $50,000. Nor does Div 723 apply where the right created is a conservation covenant over land nor to rights created by will or codicil or by total or partial intestacies or by court orders varying or modifying the operation of a will or codicil or varying or modifying the law of intestate succession.

Direct value shifting: ITAA97 Div 725 13.131 Transactions (such as share buy-backs, redemptions of shares at less than market value, or alterations of rights) in relation to particular interests (such as shares) in a company or a trust may affect the relative values of those interests when compared with other interests in the company or trust. Where an entity controls the operations of the company or trust, such transactions can result in the artificial creation of capital or revenue losses or a reduction in CGT or other tax liabilities that would otherwise arise. ITAA97 Div 725 combats direct value shifting schemes by controlling entities or their associates or by active participants in the value shifting scheme. Depending on the type of value shifting involved, Div 725 can either produce a cost base adjustment in relation to the assets involved in the value shifting or can produce a taxing event. The way direct value shifting could occur in the absence of Div 725 is shown in Example 13.23, which is based on an example contained in the legislation.

Dad and Dave each owns 1000 shares on which $1 has been paid in Snake Gully Pty Ltd. The net assets of Snake Gully Pty Ltd are worth $1,000,000. Snake Gully Pty Ltd issues a further 1000 shares on which $1 is paid to Mabel. In the absence of Div 725, Dad and Dave would have each shifted 1/3 of the value of their shares to Mabel. To avoid a value shift in these circumstances Mabel would have had to pay market value of $333,333.33 in respect of the shares issued to her.

[page 938]

Requirements for the operation of Div 725 13.132 For ITAA97 Div 725 to be triggered in relation to direct value shifting, the following requirements must be met: the target entity must be a trust or a company; an entity is required to ‘control’ the target entity at some time (but not at all times) during the value shifting period; the controller of the target entity, an associate of the controller, or an active participant in the scheme must have caused the value shift; there must be an affected owner of an ‘up interest’ or an affected owner of a ‘down interest’ or both; it must be more likely than not that the direct value shift will not be reversed within four years; the sum of all decreases in market value of all ‘down interests’ under the scheme must be at least $150,000.

The control requirement 13.133 Where the target entity is a company, ITAA97 s 727-355 applies a three-pronged test of control (somewhat similar to the control test applied in the CFC rules). First, an entity will control a company if

the entity (together with associates) holds a 50% interest in either the voting power, dividend distribution entitlements or capital distribution entitlements of the company. The 50% control can be held either directly or through interposed entities. Alternatively, a single entity (with associates) will be regarded as controlling a company if it holds a 40% interest in the company unless it can be shown that other entities actually control the company. Finally, an entity will control a company if it, in fact, controls the company as a matter of general law. The provisions also contain tests for determining control of fixed and nonfixed trusts. Note that these tests are not mutually exclusive and it is conceivable that under them there could be more than one controller of a target company at a particular time.

The causation requirement 13.134 Under ITAA97 s 725-65, for the direct value shifting provisions to apply, either: the target entity; the controller; an associate of the controller; or an active participant in the scheme, must have done one or more things under the scheme to which the decrease in the market value of the down interests (interests which decrease in value because of the scheme) or to which the increase in the market value of the up interests (interests which increase in value because of the scheme) or the issue of up interests at a discount is reasonably attributable. [page 939]

The concept of ‘active participant’ 13.135 An entity will be an ‘active participant’ in a scheme, if the target entity has fewer than 300 members38 and the entity actively participated in or directly facilitated the entering into or carrying out of

the scheme. To be an active participant, the entity must either own a down interest at the decrease time or an up interest at the increase time or must have had an up interest issued to it at a discount as a result of a direct value shift. The Explanatory Memorandum to the New Business Tax System (Consolidation, Value Shifting, Demergers and Other Measures) Bill 2002 (Cth) states that whether or not an entity has actively participated will be a question of fact. The Explanatory Memorandum also states that actions such as voting for a value shift proposal or arranging for economic benefits to be provided under a scheme would typically amount to active participation. As noted in the Explanatory Memorandum, there is no requirement that the participation involve other entities, nor is the importance of the participation to the success of the scheme relevant. Furthermore, there is no need to show a connection between the participation and the value shift.

The concept of ‘affected owners’ 13.136 The affected owners of a down interest are defined in ITAA97 s 725-80 while the affected owners of an up interest are defined in s 725-85. In the case of a down interest, an affected owner is an entity who owns the down interest at the decrease time and is one or more of the following: the controller; an associate of the controller at some time during the scheme period; or an active participant in the scheme. In the case of an up interest, an affected owner is an entity if there is at least one affected owner of a down interest and either the entity owns the up interest at the increase time or the up interest was issued to the entity at a discount. The interest issued to Mabel in Example 13.22 illustrates the issuing of an interest at a discount. In addition, for an entity to be an affected owner, at least one of the following requirements must be satisfied: (a) the entity is the controller; (b) the entity was an associate of the controller at some time during or after the scheme

period; (c) at some time during or after the scheme period, the entity was an associate of an entity that was an affected owner of down interests because it was an associate of the controller at some time during or after that period; (d) the entity was an active participant in the scheme.

[page 940]

Review the facts in Example 13.23. What additional information would you require before you could establish whether Dad and Dave were affected owners of down interests and that Mabel was an affected owner of up interests?

Different consequences that may be triggered by Div 725 13.137 The consequences that Div 725 triggers vary depending on who the owners of interests are and whether assets are held on capital account, as trading stock, or as CGT assets. The three basic possibilities are: 1. disposal treatment — taxable gain (assessable income or capital gain) and changes to adjustable values; 2. roll-over treatment — cases where there are merely changes to adjustable values; and 3. other cases — where CGT adjustable values receive disposal treatment while other adjustable values receive roll-over treatment. Figure 13.3, which is taken from the Explanatory Memorandum to the New Business Tax System (Consolidation, Value Shifting, Demergers and Other Measures) Bill 2002 (Cth), summarises the situations where each treatment will apply.

Figure 13.3:

Treatment of interests under the direct value shift (DVS) rules

[page 941]

CGT consequences triggered by Div 725 13.138 For an affected owner of down interests, the CGT consequences of a direct value shift can be: the triggering of one or more taxing events generating a gain;

and/or a reduction in the cost base or reduced cost base of the interests. For an affected owner of up interests, the CGT consequences of a direct value shift can be the uplifting of the cost base and reduced cost base of the interests. The circumstances where a direct value shift produces an adjustment to cost base are set out in the Table 13.4, which is in ITAA97 s 725250(2): Table 13.4: Consequences of the direct value shift for adjustable values of CGT assets Item

To the extent that the value shift is from:

To:

The decrease or uplift is worked out under:

1

down interests that: (a) are owned by you; and (b) have pre-shift gains; and (c) are post-CGT assets

up interests owned by you that do not give rise to a taxing event generating a gain for you on those down interests under section 725-245 for the up interests: section 725370

for the down interests: section 725-365; and for the up interests: section 725-370

2

down interests that: (a) are owned by you; and (b) have pre-shift gains; and (c) are pre-CGT assets

up interests owned by you for the down interests: that are pre-CGT assets section 725-365; and for the up interests: section 725-370

3

down interests that: (a) are owned by you; and (b) have pre-shift gains; and (c) are pre-CGT assets

up interests owned by you for the down interests: that are post-CGT assets section 725-365; and for the up interests: section 725-375

4

down interests owned by you that have pre-shift gains

up interests owned by you that give rise to a taxing event generating a gain on those down interests under section 725-245

5

down interests owned by you that have pre-shift losses

up interests owned by you for the down interests: section 725-380; and for the up interests: section 725-375

6

down interests owned by

up interests owned by

for the down interests: section 725-365; and for the up interests: section 725-375

for the down interests:

you that have pre-shift gains

other affected owners

section 725-365

[page 942] Table 13.4: Consequences of the direct value shift for adjustable values of CGT assets (cont’d) Item

To the extent that the value shift is from:

To:

The decrease or uplift is worked out under:

7

down interests owned by you that have pre-shift losses

up interests owned by other affected owners

for the down interests: section 725-380

8

down interests owned by other affected owners

up interests owned by you for the up interests: section 325-375

9

down interests owned by you

up interests owned by entities that are not affected owners

10

down interests owned by entities that are not affected owners

up interests owned by you (there are no decreases or uplifts)

(there are no decreases or uplifts)

Two or more items in the table may increase or decrease the same up or down interest (as the case may be). The increases and decreases operate cumulatively with the effect that the increase or decrease is the total of the amounts calculated under each relevant item in the table. However, under s 725-250(3), which was inserted in 2011, if, apart from the adjustments made pursuant to the table above, an amount is included in the cost base or reduced cost base of an up interest as a result of a scheme under which the direct value shift happens, the uplift in the adjustable value of the interest pursuant to the table is reduced by the amount otherwise included as a result of a scheme. Example 13.24 illustrates the adjustments to the CGT cost base of assets that can arise due to a direct value shift.

Assume the facts in Example 13.23. Assume that Dad and Dave are affected owners of down interests and that Mabel is an affected owner of up interests. Assume that Dad and Dave’s shares were post-CGT assets. In these circumstances, Dad and Dave’s interests will have pre-shift gains as defined in ITAA97 s 725-210, as the market value of their interests immediately before the decrease time was greater than their adjustable value. (Note that in these circumstances the ‘adjustable value’ will be the cost base of the interests.) Under item 6 in the table, the adjustment to the cost base of the down interests is determined under s 725-365. Under that formula, Dad and Dave’s interests will be grouped together. In these circumstances, the relevant formulae simplify to the following: The notional adjustable value of the value shifted from Dad and Dave’s group of down interests is calculated as: $2000a × 333,333.33b/1,000,000c = 666.67 [page 943] a

Adjustable value of total down interests of same kind, adjustable value and market value pre-shift. b Value shifted. c Market value of total down interests of same kind, adjustable value and market value pre-shift. The decrease in the cost base of each of Dad and Dave’s shares is calculated as: $666.67/2000 = 33.33c Hence the adjustable value of each of Dad and Dave’s shares after the value shift will be reduced from $1 to 66.67c. The adjustment in Mabel’s cost base will be calculated under s 725-375. In these circumstances, the formula for calculating the value shifted to Mabel’s shares becomes: $333,333.33d × $333,333.33e/$333,333.33f = $333,333.33 d Sum of discounts at which Mabel’s shares were issued because of the direct value shift. e Sum of decreases in market value of Dad and Dave’s shares. f Total value of direct value shift which in these circumstances will be the sum of the decreases in the market value of Dad and Dave’s shares. The uplift in the cost base of each of Mabel’s shares is calculated as: $333,333.33/1000 = $333.33 per share That is, the cost base of Mabel’s shares will be uplifted to $333.33 from $1.

The circumstances where a direct value shift from down interests to up interests gives rise to a taxing event generating a capital gain are set out in Table 13.5, which is in ITAA97 s 725-245. In all cases, the gain is calculated under s 725-365. Table 13.5: Taxing events generating a gain for down interests as CGT assets

Item 1

Down Interests: down interests that: (a) are owned by you; and (b) are neither your revenue assets nor your trading stock; and (c) have pre-shift gains; and (d) are post-CGT assets

Up Interests: up interests owned by you that: (a) are neither your revenue assets nor your trading stock; and (b) are pre-CGT assets

[page 944] Table 13.5: Taxing events generating a gain for down interests as CGT assets (cont’d) Item

Down Interests:

Up Interests:

2

down interests that: (a) are owned by you; and (b) are neither your revenue assets nor your trading stock; and (c) have pre-shift gains

up interests owned by you that are your trading stock or revenue assets

3

down interests owned by you that: up interests owned by you that: (a) are of the one kind (either your (a) are of the other kind (either your trading stock or your revenue assets); revenue assets or your trading stock); and or (b) have pre-shift gains (b) are neither your revenue assets nor your trading stock

4

down interests owned by you that have pre-shift gains

up interests owned by other affected owners

Note: If there is a taxing event generating a gain on a down interest, CGT event K8 happens: see section 104-250. However, a capital gain you make under CGT event K8 is disregarded if the down interest: 1.

is your trading stock (see section 118-25); or

2.

is a pre-CGT asset (see subsection 104-250(5)).

Example 13.25 illustrates the calculation of the gain on the down interests.

Assume the facts in Example 13.24. The value shift in these circumstances is covered by item 4 in the table. Hence, CGT event K8 is triggered. Under the method statement in ITAA97 s 725-365, the gain taxable on each of Dad and Dave’s shares will be calculated as: $333,333.33* − $666.67** 2000*** = $166.35 per share * Value shifted ** Notional adjustable value *** Number of down interests in group

Consequences of Div 725 for trading stock and other revenue assets 13.139 The consequences of ITAA97 Div 725 where your interests as an affected owner are either trading stock or revenue assets can be either: a reduction in the adjustable values of your down interests; [page 945] an uplift in the adjustable values of your up interests; and/or the triggering of a taxing event generating a gain for your down interests. Table 13.6 is extracted from s 725-335(3), and summarises the circumstances in which reductions and uplifts in adjustable values take place and shows the provision under which the reduction or uplift is calculated. Table 13.6: Consequences for down interest or up interest as trading stock or revenue asset Item 1

To the extent that the direct value shift is from: down interests owned by you that: (a) are of the one kind

To:

The decrease or uplift is worked out under:

up interests owned by you for the down interests: that are of that same kind section 725-365; and for the up interests: section

(either your trading stock or your revenue assets); and (b) have pre-shift gains

725-370

2

down interests owned by you that: (a) are of the one kind (either your trading stock or your revenue assets); and (b) have pre-shift gains

up interests owned by you that are of the other kind (either your revenue assets or your trading stock)

for the down interests: section 725-365; and for the up interests: section 725-375

3

down interests owned by up interests owned by you you that: that are of that same kind (a) are your trading stock or of the other kind or revenue assets; and (b) have pre-shift losses

for the down interests section 725-380; and for the up interests: section 725-375

4

down interests owned by you that: (a) are your trading stock or revenue assets; and (b) have pre-shift gains

up interests owned by you for the down interests: that are neither your section 725-365 revenue assets nor your trading stock

5

down interests owned by you that: (a) are your trading stock or revenue assets; and (b) have pre-shift losses

up interests owned by you for the down interests: that are neither your section 725-380 revenue assets nor your trading stock

6

down interests owned by you that are neither your revenue assets nor your trading stock

up interests owned by you for the up interests: that are your trading stock section 725-375 or revenue assets

[page 946] Table 13.6: Consequences for down interest or up interest as trading stock or revenue asset (cont’d) Item 7

To the extent that the direct value shift is from:

To:

down interests owned by up interests owned by you that: other affected owners (a) are your trading stock or revenue assets; and (b) have pre-shift gains

The decrease or uplift is worked out under: for the down interests: section 725-365

8

down interests owned by up interests owned by you that: other affected owners (a) are your trading stock or revenue assets; and (b) have pre-shift losses

for the down interests: section 725-380

9

down interests owned by other affected owners

up interests owned by you for the up interests: that are your trading stock section 725-375 or revenue assets

10

down interests owned by you that are your trading stock or revenue assets

up interests owned by entities that are not affected owners

11

down interests owned by entities that are not affected owners

up interests owned by you (there are no decreases or that are your trading stock uplifts) or revenue assets

(there are no decreases or uplifts)

Where the direct value shift is from down interests, specified in items 2, 4 or 7 of the table, of which you are an affected owner, to the up interests specified in those items, then a taxing event generating a gain occurs in relation to each down interest. The gain is calculated under ITAA97 s 725-365. Section 725-335(3A) provides that, if, apart from the adjustments made pursuant to the table above, ‘an amount is included, as a result of the scheme under which the direct value shift happens, in the adjustable value of an up interest that is your trading stock or revenue asset, the uplift in the adjustable value of the interest under that paragraph is reduced by that amount’.

Neutral value shifts 13.140 Note that in the case of neutral value shifts (where the total decrease in market value of your down interests is equal to the total increase in market value of your up interests and the total discounts given to you on the issue of your up interests), the rules are applied as if the only up and down interests that existed were your interests. This means that the direct value shift is regarded as being only between your up and down interests. [page 947]

Special rules for bonus issues 13.141 Special rules can apply where the value shift is the product of a bonus issue being made to a member at a discount. To the extent that the direct value shift is from post-CGT original interests to bonus interests which are not a dividend, the cost base and reduced cost base of the original interests are not reduced and the bonus interests do not give rise to a taxing event generating a gain. To the extent that the direct value shift is from original interests to bonus interests which are not a dividend where either the original interests are post-CGT, or where the bonus interests were issued partly paid, the cost bases and reduced cost bases of the bonus interests are not uplifted. The tax treatment of bonus issues outside the direct value shifting provisions is summarised in the table at 13.56 and is discussed in more detail in the Study help accompanying 13.57.

Special rules for buy-backs 13.142 Special rules can also apply where the decrease in a down interest is reasonably attributable to the company proposing to buy back that interest in an off-market buy-back at less than its market value. If the company does buy back that down interest, the adjustable value of the down interest is not reduced and there is no taxing event generating a gain where ITAA36 s 159GZZZQ(2) treats the interest holder as having received the down interest’s market value calculated as if the buy-back had not occurred and was never proposed to occur. To the extent that there is a value shift from the down interests bought back to up interests held by that interest holder, the uplift in the adjustable value of the up interests is calculated under item 8 in the table in s 725-250(2) (set out in 13.137) for CGT cost base adjustments and under item 9 in the table in s 725-335(3) (set out in 13.138) for adjustments to the cost of trading stock and revenue assets. In calculating the uplift under these items, the down interest is treated as if it were owned by another affected owner. The tax treatment of offmarket buy-backs outside the direct value shifting provisions is summarised in the table at 13.56.

Indirect value shifting: ITAA97 Div 727 13.143 ITAA97 Div 727 is aimed at preventing what is known as indirect value shifting. Indirect value shifting can occur when economic benefits are provided by one entity to a sufficiently related entity resulting in a reduction in the value of loan or equity interests in one of the entities. The transaction must either be not at arm’s length or for less than the market value of the economic benefits. The losing entity in the transaction must be either a company or a trust but the gaining entity need not be. If the indirect value shifting provisions are triggered then, subject to numerous exceptions and the operation of an antioverlap provision, adjustments will be made in the CGT cost bases of interests in the losing entity and in the gaining entity. ITAA97 s 7275(5) states that an indirect value shift distorts the relationship between the market value of an equity or loan interest in an entity and its value for income tax purposes, and, in the absence of Div 727, could produce an inappropriate loss and/or gain for income tax purposes. Example 13.26, based on one in the legislation, illustrates how indirect value could arise in the absence of Div 727. [page 948]

The following diagram shows the structure of the Conrad group of companies:

Assume that Conrad Pty Ltd subscribed $5,000,000 for shares in each of Nostromo Pty Ltd and Marlow Pty Ltd which, in turn, each subscribe $5,000,000 for shares in Verloc Pty Ltd and Antonia Pty Ltd. Verloc Pty Ltd transfers land that it owns to Antonia Pty Ltd. The market value of the land is $5,000,000 but Antonia Pty Ltd pays only $500,000 for the land. The undervalued transfer produces a shift of value from Verloc Pty Ltd to Antonia Pty Ltd of $4,500,000. The shift in value also decreases the value of Nostromo Pty Ltd’s shares in Verloc Pty Ltd and increases the value of Marlow Pty Ltd’s shares in Antonia Pty Ltd. In turn, the shift of value will decrease the value of Conrad Pty Ltd’s shares in Nostromo Pty Ltd and will increase the value of Conrad Pty Ltd’s shares in Marlow Pty Ltd. Apart from ITAA97 Div 727, if Conrad Pty Ltd sold its shares in Nostromo Pty Ltd following the indirect value shift, then Conrad Pty Ltd would make a capital loss of $4,500,000. Recognition of any capital gain of $4,500,000 on the shares in Marlow Pty Ltd would be deferred until the shares in Marlow Pty Ltd were sold.

Required degree of relationship 13.144 Except where both entities are closely held, under ITAA97 s 727-105, the indirect value shifting provisions will apply only where, at some time during the indirect value shifting period: [page 949]

(a) the losing entity and the gaining entity have the same ultimate controller; or (b) the ultimate controller of the losing entity is the same entity that was the ultimate controller of the gaining entity at a different time during that period; or

(c) the gaining entity is the ultimate controller of the losing entity; or (d) the losing entity is the ultimate controller of the gaining entity.

Under s 727-350, an entity will be the ultimate controller of another entity if it controls the other entity and no other entity controls the other entity. The tests for determining the controller of a company are the same as those that apply for purposes of the direct value shifting provisions. Those tests were discussed at 13.134. The legislation also contains tests for determining the ultimate controller of fixed and nonfixed trusts. The concepts of ‘losing entity’ and ‘gaining entity’ for these purposes are explained in s 727-150. In Example 13.25, Verloc Pty Ltd would be the losing entity while Antonia Pty Ltd would be the gaining entity. 13.145 Alternatively, under ITAA97 s 727-110, if neither the losing nor the gaining entity has more than 300 members (or beneficiaries in the case of a trust) during the indirect value shifting period, then the indirect value shifting provisions will be triggered if there is a common ownership nexus between the entities. Where the entities are both companies, a common ownership nexus will exist, under s 727-400, if (after tracing through interposed entities) two or more owners have 80% or more stakes in one company during the indirect value shift period and, at the same or a different time in the period, have 80% or more stakes in the other company. An 80% ultimate stake test also applies where one of the entities is a fixed trust but where one of the entities is a non-fixed trust; the value shifting control test for non-fixed trusts applies in relation to that entity. Under s124-810 where 75% of the interests in an entity are held by fewer than 20 persons, it will be regarded as not having 300 or more members or beneficiaries. Also, s 727-100(3) provides that a non-fixed trust will be regarded as not having 300 or more beneficiaries.

Affected interests 13.146

It is important to note that the indirect value shifting

provisions apply only to ‘affected interests’. Under ITAA97 s 727-460, the affected interests in the losing entity are: (a) each equity or loan interest that an affected owner owns in the gaining entity immediately before the IVS time; and (b) each equity or loan interest that: [page 950] (i)

an affected owner owns in another affected owner immediately before the IVS time; and (ii) is an indirect equity or loan interest in the gaining entity; …

Under s 727-465, the affected interests in the gaining entity (being a company or a trust other than a superannuation entity) are: (a) each equity or loan interest that an affected owner owns in the losing entity immediately before the IVS [indirect value shift] time; and (b) each equity or loan interest that: (i) an affected owner owns in another affected owner immediately before the IVS time; and (ii) is an indirect equity or loan interest in the losing entity; …

An equity interest, under s 727-520, is a share in a company or an interest in a trust (or an interest as a joint owner of a share or a trust interest) or a right or an option to acquire either of these. A loan interest is a loan to the entity (or an interest as joint owner of a loan to an entity) or a right or option to acquire an existing loan or to require the entity to issue a new loan interest. In Example 13.26, Conrad Pty Ltd has an equity interest in Nostromo Pty Ltd and Marlow Pty Ltd. Nostromo Pty Ltd has an equity interest in Verloc Pty Ltd while Marlow Pty Ltd has an equity interest in Antonia Pty Ltd. Under s 727525, an equity or loan interest in an entity (the first entity) is an indirect equity or loan interest if the first entity in turn owns an equity or loan interest in another entity (the second entity). In Example 13.26, Conrad

Pty Ltd would have an indirect equity interest in both Verloc Pty Ltd and in Antonia Pty Ltd. An interest that an entity holds in an entity (the first entity) that is an indirect equity or loan interest in another entity (the second entity) because of a prior application of s 727-525, is also an indirect equity or loan interest in the second entity. If the facts in Example 13.26 were varied by adding Don Martin Pty Ltd as a wholly owned subsidiary of Antonia Pty Ltd, then Marlow Pty Ltd would have an indirect equity interest in Don Martin Pty Ltd. This would mean that the equity interest that Conrad Pty Ltd has in Marlow Pty Ltd was also an indirect equity interest in Don Martin Pty Ltd. Note, however, that where neither the losing nor the gaining entity has more than 300 members, interests that an active participant in the scheme owns in another active participant in the scheme will only be ‘affected interests’ in the losing or gaining entity if one of the active participants is covered by items 1–4 in the table in s 727-530, reproduced below in Table 13.7. Note also that under the definition of ‘active participant’ for these purposes in s 727-530(3), an active participant cannot be either the losing entity or the gaining entity. [page 951] The ‘affected owners’ for an indirect value shift are set out in Table 13.7, which is in s 727-530. Table 13.7: Affected owners Item 1

In this case:

The affected owners include:

At least one condition in section 727105 (ultimate controller test) is satisfied

each ultimate controller because of which a condition in that section is satisfied; and each entity that, at a time during the IVS period when such an ultimate controller controlled (for value shifting purposes) the losing entity, was an intermediate controller of the losing entity; and each entity that, at a time during the IVS period when such an ultimate controller controlled (for value shifting purposes) the gaining entity, was an intermediate controller of the

gaining entity 2

The conditions in section 727-110 (common-ownership nexus test) are satisfied in respect of: (a) one or more times; or (b) one or more sets of 2 times

each ultimate owner who is one of 2 or more ultimate owners because of whom the condition in the applicable item of that table is satisfied in respect of any of those times; and each entity through which ownership or rights are traced to such an ultimate owner in applying the applicable item of that table in respect of any of those times

3

Any case

the losing entity and the gaining entity

4

Any case

each entity, that, at any time after the scheme was entered into, is an associate of an entity that is an affected owner because of Item 1, 2 or 3 of this table

5

Any case

each active participant in the scheme

Note that under item 1 in Table 13.7, an entity can be an affected owner if it is an ‘intermediate controller’ of a losing or a gaining entity. An entity (the first entity) that controls another entity (the second entity) will be an intermediate controller under the definition in s 727530(2) if the first entity is in turn controlled by the ultimate controller of the second entity. In Example 13.26, the affected entities would be Conrad Pty Ltd (under item 1 as ‘ultimate controller’ of Verloc Pty Ltd and Antonia Pty Ltd), Nostromo Pty Ltd (under item 1 as ‘intermediate controller’ of Verloc Pty Ltd), Marlow Pty Ltd (under item 1 as ‘intermediate controller’ of Antonia Pty Ltd), Verloc Pty Ltd as the losing entity, and Antonia Pty Ltd as the gaining entity.

Examples of provision of economic benefits 13.147 For the indirect value shifting provisions to be triggered, one or more economic benefits have to be provided in connection with the scheme. The examples

[page 952] given in ITAA97 s 727-155 of an entity providing an economic benefit to another entity are: paying an amount to the other entity; providing an asset or services to the other entity; creating an asset in the hands of the other entity (eg, by issuing shares); incurring or increasing a liability owed to the other entity; terminating all or part of a liability owed to the other entity; doing something that increases the market value of an asset that the other entity holds. The ending of a share, or an interest in a trust, or an interest such as a right or option is treated by s 727-155(3) as if it were an economic benefit that the owner of the relevant interest provides to the company or trust as the case may be. 13.148 ITAA97 s 727-160 deals with what it means when an economic benefit is provided under a scheme. Note that, under s 727160, an economic benefit can be regarded as being provided under a scheme where its provision is reasonably attributable to something being done or omitted under the scheme by one of the entities or by a third party that need not be a party to the scheme. 13.149 To prevent double counting, a right to have an economic benefit provided is regarded as the provision of an economic benefit and the subsequent actual provision of the benefit is disregarded. For similar reasons, an economic benefit in the form of an increase in the market value of direct or indirect equity or loan interests in an entity that are reasonably attributable to the provision of another economic benefit are disregarded: ITAA97 s 727-165(1) and (2).

Exclusions

13.150 There are numerous exclusions from the indirect value shifting provisions. Some of the more important exclusions are: entities with net assets not exceeding the CGT small business threshold (discussed at 6.150); simplified tax system taxpayers; indirect value shifts not exceeding $50,000 in value (antiavoidance provisions prevent splitting of schemes to take advantage of this exclusion); certain exclusions relating to the provision of services (eg, where the price is at least equal to the direct cost to the losing entity of providing the services); value shifts down a chain of entities from holding to subsidiary entities; where a CGT asset is disposed of for not less than the greatest of its cost base, its cost and its market value.

Anti-overlap provision 13.151 ITAA97 s 727-250 is an anti-overlap provision which, in certain circumstances, prevents distributions or rights to distributions from a losing entity to a gaining entity as a shareholder or as the holder of an interest in a trust from having consequences under the indirect value shifting rules. For s 727-250 to apply, [page 953] one or the total of no more than two of the following amounts must equal or exceed the amount of the distribution: an amount included in the assessable income or exempt income of the gaining entity for any income year because of the distribution or right to a distribution; an amount by which the cost base or reduced cost base of the gaining entity’s shares or trust interests changes because of the distribution or right to a distribution;

an amount taken into account under s 116-20 in calculating the capital proceeds of a CGT event that happens during any income year to some or all of the gaining entity’s shares or trust interests; an amount taken into account in calculating a capital gain that an entity makes from CGT event G1 or E4 happening during the income year to some or all of the gaining entity’s shares or trust interests; an amount taken into account in calculating whether a gain or loss is realised for income tax purposes where a realisation event happens to some or all of the gaining entity’s shares or trust interests in their capacity as trading stock or revenue assets. A specific provision has the effect of regarding deemed dividends as distributions of income or capital for the purpose of determining whether s 727-250 applies.

Consequences of application of indirect value shifting provisions 13.152 If triggered, the indirect value shifting provisions result in adjustments to the cost bases of interests in both the losing entity and the gaining entity. The adjustment will be at the time of realisation of the interest in the entity unless the ultimate owners or the ultimate controller(s) choose for the adjustment to be made at the time of the value shift. Two further exclusions apply to the realisation method. These are: 1. where a value shift of less than $500,000 occurred more than four years before the realisation of the affected interest; and 2. subject to numerous conditions, where 95% of the economic benefits provided by the losing entity to the gaining entity are services. Note that adjustments under the realisation method are made on the first realisation event that happens to an affected interest after the IVS time. Example 13.27 illustrates the cost base adjustments that would be made under the realisation method.

Assume the facts in Example 13.26. Assume also that Conrad Pty Ltd elects to use the realisation method when Conrad Pty Ltd sells its shares in Nostromo Pty Ltd. In these circumstances, ITAA97 s 727-615 will reduce the capital loss of $4,500,000 that Conrad Pty Ltd makes on the sale of the shares by a reasonable estimate of [page 954] the amount by which the indirect value shift reduced the interest’s (ie, the shares in Nostromo Pty Ltd) market value. Here, it would be reasonable to assume that the value shift reduced the market value of the shares in Nostromo Pty Ltd by $4,500,000. Hence, the capital loss would be reduced to zero. If Conrad Pty Ltd subsequently sold its shares in Marlow Pty Ltd for $9,500,000, then s 727-620 would decrease the capital gain of $4,500,000 that would otherwise accrue to Conrad Pty Ltd by a reasonable estimate of the amount by which the indirect value shift increased the market value of the shares in Marlow Pty Ltd. In those circumstances, it would be reasonable to assume that the value shift increased the market value of the shares in Marlow Pty Ltd by $4,500,000. Hence, the capital gain that would otherwise accrue to Conrad Pty Ltd would be reduced to zero.

CGT roll-overs and shareholders The scrip for scrip roll-over Position in the absence of a roll-over 13.153 In broad terms, scrip for scrip roll-overs deal with the situation where shareholders in a target company transfer their shares in that company to a bidder company in exchange for shares in the bidder company. If all the shares in the target company are transferred in this manner, then the end result is that the bidder company will own all the shares in the target company while the previous shareholders in the target company will own shares in the bidder company. In the absence of a roll-over, an exchange of shares would trigger CGT event A1 for the shareholder in the original company. The capital proceeds would be

equal to the market value of the shares in the acquiring company (plus any cash or the market value of any other consideration received) that were exchanged for the shares in the original company. If the market value exceeded the cost (plus indexation for inflation where applicable) of the shares in the original company to the shareholder, the exchange would produce a capital gain for the shareholder. Assuming that the shares given by the acquiring company were a new issue, the issue of the shares in itself would not be a CGT event for the acquiring company. The cost base of the shares in the acquiring company to the shareholder would be the market value of the shares in the original company that were exchanged for shares in the acquiring company. Where shares in the original company were exchanged for shares in the acquiring company and cash (or other consideration such as shares in another company), the cost base of the shares in the acquiring company to the shareholder would have been so much of the market value of the shares in the original company as was attributable to the shares in the acquiring company. [page 955] Where the shareholder acquired the shares in the original company before 20 September 1985, the exchange would not normally trigger a CGT event for the shareholder, and would not normally result in an amount being included in the shareholder’s assessable income.

Current preconditions for the scrip for scrip roll-over 13.154 The scrip for scrip roll-over is contained in ITAA97 Subdiv 124-M, inserted by the New Business Tax System (Capital Gains Tax) Act 1999 (Cth).39 The current provisions apply to CGT events happening on or after 10 December 1999. Under the current scrip for scrip roll-over provisions, a roll-over is available when: the shareholder acquired shares in the original company after 19 September 1985;

apart from the roll-over, the original shareholder would make a capital gain from the exchange; the shareholder exchanges shares in the original company in consequence of a single arrangement for a ‘replacement interest’ in another company that either: – as a result of the arrangement (without previously being a member of a wholly owned group) became the owner of 80% or more of the voting shares in the original company; or – is the ultimate holding company in a wholly owned group where, as a result of the arrangement, a company that prior to the arrangement was a member of a wholly owned group increased the percentage of voting shares that it owned in the original entity and that company (or members of the wholly owned group to which it belongs) became the owner of 80% or more of the voting shares in the original company; where the arrangement is one in which at least all owners (other than the acquiring company) of voting shares in the original company could participate on substantially the same terms;40 [page 956] the original shareholder chooses to obtain the roll-over (where the original shareholder’s cost base is transferred or allocated to the acquiring company, there must be a joint election by the original shareholder and the acquiring company — note this will only happen where the original shareholder is a significant or common stakeholder for the arrangement: see below); where a joint election is required, the original shareholder must advise the acquiring company of the cost base of its original shares just before the CGT event happened. Further conditions may apply where the shareholder and the acquiring company did not deal with each other at arm’s length. Then,

in certain circumstances that are explained in Study help, the roll-over is only available if: the market value of the capital proceeds (ie, the shares in the acquiring company and any other consideration received by the shareholder) for the exchange must be substantially the same as the market value of the shareholder’s shares in the original company; and each of the shares acquired by the shareholder in the acquiring company must have carried the same rights and obligations as attached to the shares that the shareholder held in the original company.

Effect of the roll-over on the acquiring shareholder 13.155 The effect of the scrip for scrip roll-over on the shareholder who acquires shares in the bidding company may be summarised as follows: the capital gain that the shareholder would make from his, her or its shares in the original company is disregarded; the cost base of each CGT asset that the shareholder receives as a result of the exchange is determined by reasonably attributing to it all or part of the cost base of the shareholder’s shares in the original company. If the consideration for the original shares is something other than the replacement interest, for example, cash, there is only a partial roll-over. No roll-over is obtained for the part of the original shares that is exchanged for something other than the replacement interest. This is known as the ‘ineligible part’. Hence, a capital gain or loss could be triggered in relation to the ineligible part. The cost base of the ineligible part is so much of the cost base of the original interest as is reasonably attributable to it. See the example in ITAA97 s 124-790. Presumably, this means that the cost base of the part of the shares that is rolled over will be the balance of the cost base of the original shares. It also appears that a slice of each share is rolled over and a slice of each share is subject to CGT.

The end effect of the roll-over from the shareholder’s perspective is that, rather than having the capital gain recognised at the time of the share exchange, it is deferred until the shares in the acquiring company or its ultimate holding company are realised. The gain is deferred rather than ignored because the shareholder is only given a cost for the new shares that is equal to the cost base of the old shares to it. [page 957]

Transfer or allocation of cost base to acquiring company and ultimate holding company and cost base of shares acquired under corporate restructure 13.156 Where the original shareholder is a significant stakeholder or a common stakeholder41 in the original company and the replacement company, provisions exist for the transfer of the original shareholder’s cost base in the shares in the original company to the acquiring company. Provisions also exist for allocating the cost base of cancelled shares in the original company to new shares issued to an acquiring entity where the original shareholder is a significant or common stakeholder. These provisions were amended by the Tax Laws Amendment (2013 Measures No 1) Act 2013 (Cth). The effect of the 2013 amendments to these provisions was that the significant and common stakeholder tests in the scrip for scrip roll-over provisions are now based on who owns an interest in an entity. Previously, the tests were based on who benefited from an interest in the entity. This meant that it was arguable that these tests did not apply to interests held by life insurance companies, superannuation funds or trusts as these entities did not hold their interests for their own benefit but for the benefits of policy holders, members and beneficiaries. Under the amendments, the connected entity and stakeholder tests are applied having regard to the legal ownership of interests but treat the relevant interest as an asset of absolutely entitled beneficiaries, bankrupt individuals, companies in liquidation and certain security providers. The

amendments in relation to absolutely entitled beneficiaries, bankrupt individuals, companies in liquidation and certain security providers apply for CGT purposes generally. Provisions also allocate an appropriate cost base to new equity issued or new debt owed by an acquiring entity to its ultimate holding company in cases where such a transfer or allocation was made. The Tax Laws Amendment (2008 Measures No 6) Act 2009 (Cth) introduced ss 124-784A–124-784C, which affect the cost base of shares and certain other interests acquired via a scrip for scrip roll-over under a ‘restructure’. In broad terms, a restructure occurs if the market value of the replacement interests issued by the acquiring entity under the scrip for scrip arrangement represents more than 80% of the market value of all shares (and other similar interests) issued by the replacement entity. [page 958]

Exceptions 13.157 The scrip for scrip roll-over provisions do not apply where: the shareholder was a foreign resident (for tax purposes) at the time of the exchange unless the replacement shares were taxable Australian property just after they were acquired (the concept of ‘taxable Australian property’ is discussed in 6.54); the capital gain from the exchange would otherwise be disregarded (eg, if the shareholder was a share trader and the shares were trading stock); the shareholder and the acquiring entity were members of the same wholly owned group just before the exchange and the acquiring entity was a foreign resident; or where the shareholder can choose either an ITAA97 Div 122 or Div 615 roll-over for the relevant CGT event.

The integrity provisions introduced in 2015 13.158

The Tax and Superannuation Laws Amendment (2015

Measures No 4) Act 2015 amended the scrip for scrip roll-over provisions by adding further integrity provisions. The Explanatory Memorandum to the Tax and Superannuation Laws Amendment (2015 Measures No 4) Bill 2015 summarised the effect of the amendments as follows: Options, variations, rights and other things that affect membership interests and other rights are taken into account for the purposes of the significant and common stakeholder tests. A capital gain arising on the settlement of a debt owed, as part of a scrip for scrip acquisition, by an acquiring company to its parent company is no longer disregarded. The cost base allocation rules for debt owed and equity issued by an acquiring entity apply regardless of whether it is to the group’s parent company or to another member of the group. In downstream acquisitions, roll-over relief is not available where new debt is owed or equity (other than a replacement interest) has been issued to an entity outside the wholly-owned group in relation to the issue of replacement interests and as part of the arrangement. The restructure provisions that apply to companies were amended so that they apply correctly to trusts.42

Demerger relief 13.159 A CGT roll-over can be available for owners of interests in a head entity when a demerger takes place in relation to a group.43 Under ITAA97 s 125-55, for [page 959] the roll-over to be available, a CGT event must happen to the original interest of the owners in the head entity and the owners must acquire a new or replacement interest in the demerged entity. For the roll-over to

be available, at least 80% of the group’s interest in the demerged entity must be acquired by the owners of interests in the head entity in proportion to their interests in the head entity just before the demerger. The combined market value of the interests that each owner acquires in the demerged entity and retains in the head entity must not be less than the market value of the interests that each owner had in the head entity before the demerger. It is important to note that s 125-70(4) explicitly states that an off-market buy-back is not a demerger. Furthermore, a demerger roll-over is not available to interest owners who are foreign residents where the new interest that they obtain under the demerger is not taxable Australian property just after they acquire it. The circumstances in which an asset will be taxable Australian property are discussed at 6.54. If the conditions for the roll-over are satisfied, an owner of interests in the head entity can choose the roll-over in relation to all or some of the owner’s interests in the head entity prior to the demerger. Where no CGT event happens to the owner’s original interest in the head entity, but the owner acquires a new interest under the demerger then, although a roll-over is not available, a cost base adjustment must be made under s 125-90. Where a CGT event happens, but an interest owner does not choose a demerger roll-over, a cost base adjustment nonetheless is required by s 125-85. Example 13.28, based on an example in the legislation, illustrates circumstances in which a demerger roll-over would be available.

Group before demerger Amundsen and Nansen each subscribed $500,000 for 50% of the shares in Fram Pty Ltd on 1 July 2015. Fram Pty Ltd in turn subscribed $500,000 for 100% of the shares in Discovery Pty Ltd on 2 July 2015 and $500,000 for 100% of the shares in Terra Nova Pty Ltd on 2 July 2015.

[page 960] On 1 January 2017, Fram Pty Ltd then makes a proportionate reduction in capital by transferring all its shares in Terra Nova Pty Ltd to Amundsen and Nansen in equal proportions. Assume that, at the time of the reduction in capital, the total value of the shares in Terra Nova Pty Ltd is (due to appreciation in the value of underlying assets of Terra Nova Pty Ltd) $600,000. The result of the demerger would be as follows:

In the absence of the roll-over, if the return of capital did not involve a cancellation of any of Amundsen and Nansen’s shares in Fram Pty Ltd, it would trigger CGT event G1 for Amundsen and Nansen. Assuming that each share had a cost base of $1, the effect of CGT event G1 would be to reduce the cost base of each remaining share in Fram Pty Ltd by 60c ($300,000/500,000) to 40c. If the return of capital did involve a cancellation of some of Amundsen’s and Nansen’s shares in Fram Pty Ltd, it would trigger CGT event C2. Assuming that the cost base of each share in Fram Pty Ltd was $1 and that Amundsen

and Nansen each has 250,000 shares cancelled, then the capital proceeds for each share cancelled would be $1.20 ($300,000/250,000). Hence, Amundsen and Nansen would both make a capital gain of 20c per cancelled share. Note, also, that Amundsen and Nansen acquire a new or replacement interest in the demerged company (ie, Terra Nova Pty Ltd). The market value substitution rule would mean that the cost base of each share in Terra Nova Pty Ltd to both Amundsen and Nansen would be $1.20. Note, also, that in the absence of demerger relief, CGT event A1 would happen for Fram Pty Ltd and that Fram Pty Ltd would make a capital gain of 20c per share in Terra Nova Pty Ltd transferred.

[page 961]

Given the statement of the preconditions for the demerger roll-over set out above, identify any further information you would require before you could determine whether the demerger roll-over was available in the circumstances set out in Example 13.28. A suggested solution is contained in Study help.

Effects of the roll-over 13.160 If an interest owner in the head entity chooses a demerger roll-over, any capital gain or loss that the interest owner made from the CGT event happening to the interest in the head entity is disregarded under ITAA97 s 125-80(1). The cost base and reduced cost base of the post-CGT interests that the owner had in the head entity prior to the demerger are apportioned between those interests and the interests acquired by the owner in the demerged entity in a reasonable manner. In determining what is a reasonable apportionment, regard is had to the market values of the interest owner’s remaining interests in the head entity after the demerger and the market values of the owner’s interests in the demerged entity. Where all or some of the owner’s interests in the head entity were acquired pre-CGT then, in the former case, all of the owner’s interests in the demerged entity will be regarded as being

acquired pre-CGT, while, in the latter case, a reasonable proportion will be regarded as being acquired pre-CGT. If the demerger involves some of the owner’s interests in the head entity ending then, and some of the owner’s interests were acquired pre-CGT, the same proportion of the owner’s pre-CGT interests is regarded as ending. The consequences of the demerger roll-over and cost base adjustments are illustrated in Example 13.29.

Assume the facts in Example 13.28 and assume that the return of capital involved a cancellation of 50% of each of Amundsen’s and Nansen’s shares in Fram Pty Ltd. Assume also that Amundsen, Nansen and all companies in the group are Australian residents. As a cancellation of shares was involved, CGT event C2 would have applied when the shares in Terra Nova Pty Ltd were transferred to Amundsen and Nansen. If Amundsen and Nansen choose a roll-over, the capital gain of 20c per share that they each would otherwise have made from the C2 CGT events is disregarded. Here, the cost base of each share that Nansen and Amundsen hold in Terra Nova Pty Ltd and of each of their remaining shares in Fram Pty Ltd will be a reasonable proportion of the cost base of their original shares in Fram Pty Ltd. In determining what is a reasonable proportion, regard is had to the relative market values of their remaining shares in Fram Pty Ltd and of their shares in Terra Nova Pty Ltd. [page 962] Assume that the market value of Fram Pty Ltd’s shares in Discovery Pty Ltd has not changed since 1 July 2015. In these circumstances, the market value of Nansen’s and Amundsen’s remaining shares in Fram Pty Ltd will continue to be $1 per share. The market value of their shares in Terra Nova Pty Ltd will be $1.20 per share. Hence, the cost base ($1.00 per share) of the original shares in Fram Pty Ltd will be apportioned between the shares in Terra Nova Pty Ltd and the remaining shares in Fram Pty Ltd in a ratio of 1.2:1. This will mean that each share in Terra Nova Pty Ltd will have a cost base of 55c while each remaining share in Fram Pty Ltd will have a cost base of 45c. Calculations have been made to the nearest cent.

Consequences for members of a demerger group

13.161 Capital gains or losses that the group entity (the ‘demerging entity’) that disposed of interests in a subsidiary entity, in circumstances where the demerger rollover was available to owners of interests in the head entity, would make under CGT events A1, C2, C3 or K6 are disregarded. Note that the capital gains and losses are disregarded for the demerging entity whether or not the interest owners in the head entity choose the demerger roll-over. The head entity will often be the demerging entity in a demerger. The effects of disregarding capital gains and losses for the demerging entity are shown in Example 13.30.

Assume the facts in Example 13.29. CGT event A1 happens for Fram Pty Ltd when it transfers the shares in Terra Nova Pty Ltd to Amundsen and Nansen, but the capital gain of 20c per share that it would otherwise make is disregarded.

13.162 ITAA97 s 125-160 provides that CGT event J1 does not happen to a demerged entity or a member of a demerged group under a demerger. CGT event J1 was discussed at 12.139. 13.163 Where a demerger reduces the market value of a CGT asset (typically, an interest in a member of the demerged group), any capital loss made by a member of the demerged group from a CGT event happening to that asset under the demerger is reduced under ITAA97 s 125-165. The reduction is to the extent that the capital loss is reasonably attributable to the reduction in the market value of the asset because of the demerger. [page 963]

2016 Tax incentives for investment in

early stage innovation companies 13.164 The Tax Laws Amendment (Tax Incentives for Innovation) Act 2016 introduced new Subdiv 360-A ‘Tax incentives for early stage investors in innovation companies’. Subject to conditions, Subdiv 360-A provides for a non-refundable carry forward tax offset of 20% of the value of investment in newly issued shares in an Australian early stage innovation company. The value of the tax offset is subject to an annual cap of $200,000. The investment may be made as an individual, or through a company, a partnership or a trust. The incentive is not available where the investment is made through a ‘widely held company’ (as defined in ITAA97 s 995-1) and 100% subsidiaries of widely held companies. Where the investment is made through a partnership or trust, rules provide for the tax offset to flow to the partners or beneficiaries as the case may be. Investors who do not meet the requirements of the ‘sophisticated investor test’ in s 708 of the Corporations Act 2001 (Cth) will be limited to investing $50,000 in any given income year. In addition, investors meeting the requirements may disregard capital gains on shares in the early stage innovation company held for between one and 10 years and are required to disregard capital losses on the shares held for less than 10 years. 1.

2.

In FCT v McNeil (2007) 229 CLR 656; 2007 ATC 4223; [2007] HCA 5, a majority of the High Court held that an issue of put options to a trustee to be held on behalf of shareholders who owned shares at record date were ordinary income, as a gain from property, to a shareholder who did not exercise the option. The Tax Laws Amendment (2008 Measures No 3) Act 2008 (Cth) inserted s 12-37, which includes in the cost base of put options that you acquire as a result of CGT event D2 happening to the issuing company the amount that is included in your ordinary income as a result of the acquisition of the right and any amount that you pay to acquire the right. The Corporations Amendment (Corporate Reporting Reform) Act 2010 (Cth) amended the Corporations Act 2001 (Cth) by changing the prerequisites that had to be met before a company could pay a dividend. A company can now only pay a dividend if: (a) the company’s assets exceed its liabilities by an amount sufficient to fund the dividend immediately before the time of declaration; (b) paying the dividend is fair and reasonable to the company’s shareholders as a whole; and (c) paying the dividend does not materially prejudice the company’s ability to pay its creditors. The implications of this amendment for the tax treatment of corporate distributions are discussed subsequently in this chapter.

3.

4.

5.

6.

7.

8.

9.

Taxation Ruling TR 2012/5 takes the view that, notwithstanding these changes to corporations law, dividends can still only be paid out of profits. TR 2012/5 and the implications of the amendment of corporations law for the tax treatment of corporate distributions are discussed later in this chapter. In response to stakeholder concerns about the 2010 amendments, the former Commonwealth Government released a discussion paper on 28 November 2011 and subsequently released exposure draft legislation proposing further changes to the circumstances in which a company may pay a dividend. In April 2014, the Abbott Government released a draft Corporations Legislation Amendment (Deregulatory and Other Measures) Bill 2014 (Cth) and called for submissions in response to the draft. The draft Bill proposed amendments to the test for payment of dividends but was not designed to change existing taxation arrangements. Subsequently, a Bill titled Corporations Legislation Amendment (Deregulatory and Other Measures) Bill 2014 (Cth) was passed by the Commonwealth Parliament but the Bill did not contain the proposed changes to the test for payment of dividends. For a discussion of possible circumstances where ordinary usage concept of dividends as a gain from property may be wider than ITAA36 ss 44–47, see R W Parsons, Income Taxation in Australia, Law Book Co, Sydney, 1985, [2.260]–[2.263]. For a discussion of whether ITAA36 ss 44–47 are an exclusive code in relation to all distributions by a company, see Parsons at [2.264]–[2.269]. The majority of the High Court held, however, that the distribution extinguished the shareholder’s shares and therefore was not a ‘dividend, profit or bonus’ under ss 11(b) and 4 of the Income Tax Management Act 1928 (NSW). The majority of the High Court held that the distribution represented the realisation of the taxpayer’s share investment and was a capital receipt. The distribution was not a dividend within ITAA36 s 47(1), as it then stood, as the company was not wound up and no distribution was made by the liquidator. In James v FCT (1924) 34 CLR 404, the High Court unanimously held that an indirect capitalisation of profits (by declaring a bonus which was satisfied by an issue of bonus shares) was ‘profits or bonus credited’ to the shareholder under s 14(b) of the Income Tax Assessment Act 1915 (Cth). In CT (Vic) v Nicholas (1938) 59 CLR 230, a majority of the High Court held that a direct capitalisation of profits (by transferring funds from a reserve account to pay up an issue of bonus shares) represented ‘profits or bonus credited’ to the shareholders under s 4(a) of the Unemployment Relief (Assessment) Act 1933 (Vic) and under s 1(g) of the Income Tax Act 1935 (Vic). The decision of the High Court was upheld on appeal to the Privy Council in Nicholas v CT (Vic) (1940) 63 CLR 191; [1940] AC 744. See the discussion in H A J Ford, R P Austin and I M Ramsay, Ford, Austin and Ramsay’s Principles of Corporations Law, [24.520]–[24.600], available online at . See, for example, M Fry and R O’Brien, ‘New Dividend-paying Rules Raise Tax Issues of Concern’ (2010) 42 Weekly Tax Bulletin [1594]. Fry and O’Brien point out that Taxpayer Alert TA 2009/11 considers that remittance of certain retail premiums on renounceable rights issues to be distributions of the company’s share capital and unfrankable dividends under ITAA36 s 6(4). ITAA36 s 6(4) is discussed at 13.15. Prior to its repeal in 2007 (effective for assessments for years in which 1 July 2006 occurred and later income years), ITAA36 s 108 deemed to be a dividend so much of a loan by a private company to an associated person as in the opinion of the Commissioner represented

10.

11.

12.

13.

14.

15.

a distribution of profits. On 18 May 2012, the then Assistant Treasurer asked the Board of Taxation to undertake a post-implementation review of ITAA36 Pt III Div 7A. The board was asked to consider whether there were any options to simplify the operation of Div 7A while maintaining the integrity and fairness of the tax system: see David Bradbury, Assistant Treasurer, Minister Assisting for Financial Services and Superannuation and Minister for Competition Policy and Consumer Affairs, media release, 18 May 2012. The Board of Taxation released a discussion paper in December 2012 which included options for reform but which also sought submissions on how Div 7A could be expressed more clearly and simply. On 8 November 2013, the then Assistant Treasurer, Senator Sinodinis, announced extended terms of reference for the review and set 31 October 2014 as the date on which the board should report to the government. On 25 March 2014, the Board of Taxation released a second discussion paper and called for submissions to assist in addressing the issues raised in the extended terms of reference. Following amendments introduced by the Tax Laws Amendment (2010 Measures No 2) Act 2010 (Cth), the provision of an asset for use by another entity is, subject to certain exceptions, deemed to be ‘payment’ for these purposes. In FCT v Rozman (2010) 186 FCR 1; [2010] FCA 324, Perram J held that a ‘payment to an entity’ for the purposes of s 109C(1) included a payment by direction and not just payments made by the company directly to a shareholder. The actual rules applicable to payments, loans and forgiven debts differ slightly from each other in the terms they use. The following statements use neutral terms and focus on the common elements in all three rules. ITAA36 Pt III Div 7A Subdiv B also deems certain amalgamated loans by private companies to be dividends. Additional conditions, set out in s 109G, must be satisfied before an amalgamated loan will be regarded as a dividend. In FCT v H [2010] FCAFC 128; BC201007680, the Full Federal Court held that the obligation to pay income tax properly assessed was a present legal obligation at the end of the relevant income year in which the income is received and that the general interest charge was a present legal obligation for each day on which tax, which should have been paid, remained unpaid. It is not obvious that it was necessary to expressly exclude non-share dividends from the operation of ITAA36 s 44(1)(a)(i). All distributions in respect of non-share equity to a holder of a non-share equity interest in that capacity will be non-share dividends. It would seem, however, that such distributions might not be ‘dividends’ under para (a) of the ITAA36 s 6(1) definition of ‘dividend’ as it may be that they are not to be made to ‘shareholders’. It could be though that the drafter believed that para (a) of the s 6(1) definition of ‘dividend’ did not require that a distribution be made to shareholders in their capacity as shareholders in contrast to para (b) of the definition which, as was seen in 13.10, does require that the amount be credited to shareholders ‘as shareholders’. Hence, it may be that a distribution in respect of a stapled security is, so far as it relates to the nonshare equity component of the member’s interest in the company, at once both a s 6(1) dividend and a non-share dividend. If this is the case, the effect of s 44(1)(a)(i) and 44(1)(b) (i) is that, to the extent that it is a non-share dividend, it is assessable to the shareholder under s 44(1)(a)(ii) (in the case of a resident interest holder) or under s 44(1)(b)(ii) (in the case of a non-resident interest holder).

16. See the discussion of the company law principles in H A J Ford, R P Austin and I M Ramsay, Ford, Austin and Ramsay’s Principles of Corporations Law, [18.130]–[18.260], available online at . 17. More technically, ITAA97 s 207-20(1) applies where a corporate tax entity makes a ‘franked distribution’ to an entity. Section 995-1 states that a distribution is franked if an entity franks it in accordance with s 202-5. Section 202-5 in effect tells us that, among other things, a distribution has to be a ‘frankable distribution’ to be franked. A distribution is defined in s 960-120. In the case of a company, s 960-120 will mean that a dividend is a distribution. Technically, a non-share distribution, defined in s 974-115, is not a distribution within the s 960-120 definition. A non-share distribution, however, will generally be a ‘frankable distribution’ under s 202-40 even though it is not a distribution as defined in s 960-120. There seems little point in defining frankable distributions as including non-share dividends if non-share dividends are not regarded as ‘distributions’ with the effect that no franking credit can be attached to them and no gross-up can be allowed on them. It is clear from the Explanatory Memorandum to the New Business Tax System (Imputation) Bill 2002 (Cth) that the intention was that franking credits would be able to be allocated to non-share distributions and that gross-ups and tax offsets would be available in respect of them. 18. In actual practice, the effect of ITAA97 s 207-20(1) is to increase the shareholder’s assessable income. This, in turn, increases the Medicare levy that is payable by the shareholder even though the shareholder has not, in fact, received any additional income. The tax offset is not applied to reduce the Medicare levy but any excess of the tax offset against the taxpayer’s income tax liability will (subject to some exceptions) be refunded. 19. The exemption does not apply where the Commissioner determines that the company has streamed the dividends or that the payment is part of a franking credit scheme. See the discussion of the anti-dividend streaming provisions in 12.63–12.71. 20. See the discussion in H A J Ford, R P Austin and I M Ramsay, Ford, Austin and Ramsay’s Principles of Corporations Law, Ch 18 and Ch 24, available online at . 21. H A J Ford, R P Austin and I M Ramsay, Ford, Austin and Ramsay’s Principles of Corporations Law, [27.010], available online at . 22. The decision in Glenville Pastoral Co Pty Ltd v FCT (1963) 109 CLR 199 (see 13.70) is not considered to be authority for a contrary result. 23. See the discussion in H A J Ford, R P Austin and I M Ramsay, Ford, Austin and Ramsay’s Principles of Corporations Law, [18.210], available online at . 24. See the argument to this effect in C J Taylor, Capital Gains Tax: Business Assets and Entities, Law Book Co, Sydney, 1994, [9.68]. See also S J Gates, Tax Aspects of Corporate Restructuring, Australian Tax Practice, Sydney, 1996, [8.35]–[8.36]. 25. See T W Magney, ‘Liquidators, Receivers and Managers — Income Tax Aspects’ in Intensive Seminar on Acquisitions, Mergers and Liquidations, Taxation Institute of Australia, Terrigal, November 1983, pp 106–7. 26. For a discussion of other difficulties with this approach see Taylor, Capital Gains Tax: Business Assets and Entities, [9.68]. 27. See the more detailed argument to this effect in Taylor, Capital Gains Tax: Business Assets and Entities, [9.68]. See also the discussion in Gates, Tax Aspects of Corporate

28.

29. 30. 31.

32. 33.

34.

35.

36.

37.

38.

39.

Restructuring, [8.36]. It appears that the Commissioner’s view is that Glenville Pastoral Co should be narrowly applied: see TD 95/10. It may have been significant that in Harrowell v FCT (1967) 116 CLR 607, the High Court was dealing with a provision, s 47(1), which deemed a distribution to be a dividend. By contrast, in Gibb v FCT (1966) 118 CLR 628, the High Court was dealing with a provision, s 6(1), which merely defined what a dividend was for the purposes of the operative provisions of the ITAA36. This was the view taken in the Explanatory Memorandum (Pt B) to the Taxation Laws Amendment (Company Distributions) Bill 1987 (Cth), p 8. CGT event G3 also applies to holders of certain financial instruments issued by the company. When Australia had a classical system of corporate taxation, undistributed profits tax applied to private companies that had not made a sufficient distribution in the year of income. Undistributed profits tax was phased out when the Australian dividend imputation system was introduced. See the discussion of this point in M Fry and R O’Brien, ‘New Dividend-paying Rules Raise Tax Issues of Concern’ (2010) 42 Weekly Tax Bulletin [1594]. TD 2007/11 states that the repealed rules have an ‘ongoing’ application by being ‘imported’ into ITAA97 via the denial of a gross-up and tax offset by ITAA97 s 207-145(1)(a) (see the discussion of ITAA97 Subdiv 207-F at 13.95 and at 12.72–12.73) where the imputation system has been manipulated. Presumably the contract referred to is a contract for the issue or allotment of equity interests between the company and the issuee or allottee. This, however, is not expressly stated in ITAA97 s 109-10. Special rules set out in ITAA97 s 130-100 apply in the case of ‘exchangeable interests’ where a traditional security is redeemed or disposed of to the issuer in exchange for shares in a company other than the issuer. Technically, ITAA97 s 104-230(6) states an exception rather than a prerequisite. It is convenient, however, to discuss s 104-230(6) together with the prerequisites for the operation of CGT event K6. Section 104-230(9A) is a special provision containing rules for the application of this exception in the context of demerged entities. See the discussion in H A J Ford, R P Austin and I M Ramsay, Ford, Austin and Ramsay’s Principles of Corporations Law, [4.170], available online at . It can also be possible for there to be an ‘active participant’ in relation to a company or a trust where s 124-810 regards it as not having more than 300 members or beneficiaries. In addition it should be noted that Div 725 applies to a non-fixed trust as if it did not have 300 members. The original provisions were amended by the New Business Tax System (Miscellaneous) Act (No 2) 2000 (Cth) with effect from 10 December 1999. Differences between the original and amended scrip for scrip roll-over provisions are discussed in Study help. In the 2012 Federal Budget, the government announced that it would amend the integrity provisions in the scrip for scrip roll-over provisions to remove what it regarded as significant tax minimisation opportunities. The amendments were proposed to have effect from 7.30 pm AEST on 8 May 2012. By a media release dated 14 December 2013, the then Assistant Treasurer, Senator Sinodinis, announced that the Abbott Government would

40.

41.

42. 43.

proceed with these proposals. These amendments have now been enacted by the Tax and Superannuation Laws Amendment (2015 Measures No 4) Act. The effect of these amendments is summarised at 13.158. The Tax Laws Amendment (2010 Measures No 4) Act 2010 (Cth) amended the scrip for scrip roll-over provisions so that the arrangement does not have to be one in which the target company’s shareholders can participate on substantially the same terms if the arrangement includes either: (a) a takeover bid that does not contravene relevant provisions in Ch 6 of the Corporations Act; or (b) a scheme of arrangement approved by a court under Pt 5.1 of the Corporations Act 2001 (Cth). The terms ‘significant stakeholder’ and ‘common stakeholder’ are defined in s 124-783. In broad terms an entity will have a significant stake in a company if the entity and its associates between them have: (a) shares carrying 30% or more of the voting rights in the company; (b) or have the right to receive 30% or more of the dividends that the company may pay; or (c) have the right to receive 30% or more of the distributions that the company make. A ‘common stakeholder’: Where the original entity and the replacement entity are companies, an entity or an entity with its associates will have a common stake in the original entity just before the arrangement and in the replacement entity just after the arrangement where they: (a) had 80% or more of: (i) the voting rights in the original entity just before the arrangement started; and (ii) the voting rights in the replacement entity just after the arrangement was completed; or (b) had the right to receive 80% or more of: (i) any dividends that the original entity may pay just before the arangement started; and (ii) any dividends that the replacement entity may pay just after the arrangement was completed; or (c) had the right to receive 80% or more of: (i) any distribution of capital of the original entity just before the arrangement started; and (ii) any distribution of capital of the replacement entity just after the arrangement was completed. Explanatory Memorandum to the Tax and Superannuation Laws Amendment (2015 Measures No 4) Bill 2015 at 1.24. The Tax Laws Amendment (2011 Measures No 9) Act 2011 (Cth) extended demerger relief to allow another member of the demerger group to be treated as the head entity of the group where the actual head entity cannot demerge its interests in the group. Previously, groups could not access demerger relief where the head entity is a complying superannuation entity or a corporation sole.

[page 965]

CHAPTER

14

Taxation of Partnerships Learning objectives After studying this chapter, you should be able to: identify when a partnership exists for tax purposes; explain the scheme of ITAA36 Pt III Div 5; calculate the net income of a partnership; calculate a partnership loss; discuss the tax treatment of salaries and interest paid to partners; explain what uncontrolled partnership income is; calculate the imputation rebate for a partner in a partnership that receives franked dividends; determine the tax effects of an assignment of partnership income; explain the capital gains tax (CGT) effects of a change in composition of a partnership; calculate the capital gain or loss that accrues when a partnership asset is sold.

What is a partnership for tax purposes? The ITAA meaning of ‘partnership’ 14.1

The Income Tax Assessment Act 1997 (Cth) (ITAA97) s 995-

1(1) and the Income Tax Assessment Act 1936 (Cth) (ITAA36) s 6(1) define ‘partnership’ as: (a) an association of persons (other than a company or a limited partnership) carrying on business as partners or in receipt of ordinary income or statutory income jointly; or (b) a limited partnership.

The first part of the ITAA97 and ITAA36 (the ITAA) definition is usually regarded as referring to an association that is a partnership for general law purposes. The second part of the ITAA definition treats as partnerships certain associations which would not be partnerships for general law purposes. For example, the mere sharing [page 966] of gross receipts, as we shall see, does not amount to a partnership for purposes of the various state and territory Partnership Acts,1 but a joint receipt of income from a financial investment or from the rental of real property will make persons partners for tax purposes. 14.2 Where persons are partners for tax purposes, because they are in receipt of income jointly, but are not general law partners, their shares of income from jointly owned property will be determined according to their respective property interests. Thus, in FCT v McDonald (1987) 18 ATR 957; 87 ATC 4541, Beaumont J held that the husband and wife were only partners under the ITAA36 s 6(1) definition on the basis that, as joint owners of two investment properties, they were in receipt of income jointly, and could only claim deductions for ‘partnership’ losses equally in accordance with their proportionate ownership of the investment property. This was notwithstanding the fact that in an oral agreement, subsequently reduced to writing, the husband and wife agreed that the husband would be liable for all losses of the partnership. The agreement was ineffective as the relationship between the husband

and wife did not constitute a partnership under the Partnership Act definition, since they were not carrying on a business. See 14.14 for problems that highlight the manner in which the ITAA definition of ‘partnership’ is broader than the meaning of ‘partnership’ in general partnership law. You may find it helpful to refer to 14.1–14.2 when trying to answer those problems.

The general law meaning of ‘partnership’ 14.3 As the ITAA definition of ‘partnership’ includes any association that is a partnership for general law purposes, it is important to examine the definition of partnership for general law purposes. Partnership Acts in the different Australian jurisdictions define ‘partnership’ as ‘the relation which subsists between persons carrying on a business in common with a view to profit’. This definition was based on the definition in the Partnership Act 1890 (UK). Numerous English and Australian cases have construed the Partnership Acts’ definition of ‘partnership’. 14.4 In determining whether a general law partnership exists or not, the courts have always concerned themselves with ascertaining whether or not the parties truly intended to conduct business in partnership. This is because partnership is a relationship founded on agreement. The agreement need not necessarily be in writing. It should be noted, however, that, in some cases, the agreement will not be enforceable unless it is evidenced in writing. Nonetheless, partnership is not merely a simple contractual relationship. Rather, the relationship is one of mutual agency. Mutual agency means that each partner acting within the course of the partnership business has power to enter into contracts [page 967] with outsiders that will bind the other partners. Agency is a fiduciary relationship.2 Thus, mutual agency implies that the partners have

mutual rights and obligations. This means that each partner must have rights (such as a right to share in the capital and profits of the partnership, and a right to an indemnity against personal liability) which he or she can enforce against each other partner and all other partners. In addition, each partner will owe obligations (such as a fiduciary duty to act in utmost good faith, and an obligation to indemnify other partners against personal liability) to each other partner and all other partners. 14.5 The definition in the Partnership Acts can be broken up into several constituent elements. While this is a useful aid to understanding, it risks being somewhat misleading. The elements are interrelated. Each element emphasises a particular feature of the nature of partnerships. It is important to remember, however, that only when considered together do the elements describe the relationship that is partnership. Remember this as we discuss each element.

The relation which subsists between persons 14.6 Note that the definition in the Partnership Acts refers to ‘the relation which subsists between persons’. That is, a partnership is a relationship between people. It is not a legal entity that is separate and distinct from those people. This is an important respect in which a partnership differs from a company. We shall see in Chapter 15 that a trust can also be thought of as a relationship and, as such, is not a separate legal entity. Although they are both relationships between people, and not separate legal entities, partnerships and trusts differ from each other in several respects. First, as we shall see in Chapter 15, a trust cannot exist without there being trust property. By contrast, while a partnership will usually have partnership property, it is not an essential element in the existence of a partnership. Where a business mainly provides services, such as cleaning, maths tutoring, or personal fitness consulting, there may be little or no property employed in the business and yet it may still be a partnership if it is carried on by persons, in common, and with a view to profit. Second, while trustees may be beneficiaries in a trust, they cannot be the only beneficiaries in the trust.

The fundamental concept of a trust is the holding of property subject to fiduciary obligations owed to other people. While partners owe fiduciary duties to each other, they do not, in the absence of special relationships outside the partnership itself, owe fiduciary duties to persons who are not partners. Hence, in a partnership, there is identity between the persons who owe fiduciary duties and the persons to whom those duties are owed. [page 968]

Carrying on a business 14.7 For a relationship between persons to amount to a general law partnership, those persons must be carrying on a business. This is another respect in which a partnership differs from a trust. While a trust may carry on a business, a valid trust can exist without carrying on a business at all. In Chapter 3, we noted some of the factors that the courts take into account in determining whether a taxpayer is carrying on a business for the purpose of the application of the business gains principle. Review Chapter 3 and then write some responses to Activity 14.1.

List some of the factors that the courts take into account in determining whether or not a taxpayer’s activities amount to a business.

How important is recurrence or continuity of operations in determining whether a taxpayer’s operations amount to a business? Consider, in particular, cases like FCT v

Whitfords Beach Pty Ltd (1982) 150 CLR 355; 12 ATR 692; 82 ATC 4031 and FCT v Myer Emporium Ltd (1987) 163 CLR 199; 18 ATR 693; 87 ATC 4363.

14.8 The requirement of carrying on a business assists in distinguishing a general law partnership from certain unincorporated non-profit associations. So, too, as we shall see in 14.12–14.13, does the requirement that the business be carried on with a view to making a profit. Does the requirement that business be ‘carried on’ imply that the business must be a continuous business? If so, this could be a feature that would distinguish a partnership from an unincorporated joint venture. Consistently with the recognition that an isolated venture business can exist for tax purposes, more recent cases recognise that a partnership could carry on a one-off business: see Canny Gabriel Castle Jackson Advertising Pty Ltd v Volume Sales (Finance) Pty Ltd (1974) 131 CLR 321. The question of whether a joint venture amounts to a partnership or not is now seen as turning on whether there is mutual agency between the parties and on whether the agreement involves sharing of profits as distinct from a sharing of product. See the discussion at 14.11–14.12. 14.9 The requirement that a business be carried on distinguishes a partnership from the mere co-ownership of property. In FCT v McDonald (1987) 18 ATR 957; 87 ATC 4541, Beaumont J held that a husband and wife who derived rental income from two home units were not partners under the Partnership Acts definition: see 14.3. This was because they were merely co-owners of an investment property and were not carrying on business. Co-ownership of the investment property involved little, if any, active participation by the husband and wife. [page 969]

In common 14.10 Under the Partnership Acts definition, a partnership will only exist where a business is carried on ‘in common’. It is possible for a

business to be carried on for profit without certain persons who are associated with the business in some way becoming partners. For example, although the effort of employees of a partnership may be crucial to the profitability of the partnership, employees of a partnership will not be partners. Although beneficiaries of a trust may benefit when the trust carries on business, the beneficiaries will not be partners: see Inland Revenue Commissioners v Lebus’s Exors (1946) 27 TC 136; [1946] 1 All ER 476 and Smith v Anderson (1880) 15 Ch D 247. Both these examples may be thought to depend on the fact that neither the employees nor the beneficiaries carry on the business. We would normally say that the partners carry on the business and that the employees are merely one of the resources which the partners use in carrying on the business. In the trust example, we could say that the beneficiaries do not carry on business but merely benefit from the business which the trustees carry on. Despite the examples just given, the requirement that the business be carried on ‘in common’ is not merely superfluous. In Checker Taxicab Co Ltd v Stone [1930] NZLR 169, both the Checker Taxicab Co Ltd and Thompson, one of its drivers, were carrying on businesses. Each party appears to have benefited from the carrying on of business by the other. They were not, however, carrying on a business in common. The businesses were, in fact, distinct. In carrying on his business, Thompson did not act as agent for Checker Taxicab Co Ltd. The fiduciary relationship of mutual agency that is characteristic of partnership was absent. Mutual agency does not mean, however, that all partners need to be actively involved in the business carried on by the partnership. In Lang v James Morrison & Co Ltd (1911) 13 CLR 1, Griffith CJ said that it was necessary for the person who actively carried on the business to do so as agent for all the partners. This does not mean that it must be a partner who is agent for the other partners. A person can employ a manager to carry on a business. The manager will be the agent of the employer but will not be a partner of the employer. The manager can enter into contracts that bind the employer but the employer cannot enter into contracts that bind the manager. Hence, the relationship

between the employer and the manager is not one of mutual agency. Thus, partners in a partnership could employ a manager, who is not a partner, to carry on their business so long as the manager is agent for all the partners. 14.11 This element in the definition of partnership also assists in distinguishing a partnership from a joint venture. In United Dominions Corp Ltd v Brian Pty Ltd (1985) 157 CLR 1 at 10, Mason, Brennan and Deane JJ saw the crucial factor in determining whether a joint venture was a partnership as being whether the parties were in a fiduciary relationship to each other. Whether or not the relationship is fiduciary depends on the form which the joint venture takes and the content of the parties’ obligations. What is particularly important is whether the relationship is one of mutual agency. If the relationship is fiduciary then what might otherwise be a joint venture is likely to be a partnership. See also Television Broadcasters Ltd v Ashton’s Nominees Pty Ltd (No 1) (1979) 22 SASR 552 at 564–6, where a finding that there was no mutual agency between the parties appears to have been critical in Mitchell J [page 970] holding that there was no partnership. See further the High Court’s decision in Hospital Products Ltd v United States Surgical Corporation (1984) 156 CLR 41.

With a view to profit 14.12 To fall within the Partnership Acts definition of ‘partnership’ (at 14.3), it is necessary for the association of persons to carry on a business ‘with a view to profit’. Profit here is used in distinction from gross receipts. In United Dominions Corp Ltd v Brian Pty Ltd (1985) 157 CLR 1, Dawson J suggested (at 15) that, for practical purposes, the distinction between a partnership and an unincorporated joint venture was: … between an association of persons who engage in a common undertaking for profit

and an association of those who do so in order to generate a product to be shared among the participants. Enterprises of the latter kind are common enough in the exploration for and exploitation of mineral resources and the feature which is most likely to distinguish them from partnerships is the sharing of product rather than profit.

14.13 The requirement that a partnership carry on a business ‘with a view to profit’ helps distinguish partnerships from unincorporated nonprofit associations such as clubs. As the profit-making intention is a factor which is taken into account in deciding whether a business is being carried on, there is some overlap between this element and the first element of the definition of partnership. At the same time, even where the motive of making profits is absent, some organisations which, in fact, have made profits have been held to be in business for tax purposes. See, for example, IRC v Incorporated Council of Law Reporting (1889) 22 QBD 279. The requirement that a profit-making intention be present means that an association which makes such ‘incidental profits’ will not be a partnership under the Partnership Acts definition. Also, a distinctive feature of non-profit associations such as clubs is that, while the association is a going concern, a distribution of profits cannot be made to the members. A corollary of the lack of the entitlement of members to the profits of a non-profit association is that the members are not liable for the losses of the association. This represents a clear difference between a non-profit association and a partnership in which the members are entitled to share in the profits and are jointly and severally liable for the losses. The mutual agency which is present in a partnership is absent in a non-profit association. For tax purposes, as discussed in Chapter 12, an unincorporated nonprofit association that is not a partnership will be a company.

Taxation Determinations TD 2008/D1 and TD 2008/15 14.14 In 2008, the Commissioner issued draft Tax Determination TD 2008/D1. According to the draft determination, the Commissioner is of the view that an Australian-formed unincorporated association of persons who do not carry on a business in common with a view to profit cannot be a corporate limited partnership within the meaning of ITAA36 s 94D. The Commissioner has justified his position on the basis that an unincorporated association that does not carry on a business

with a view to profit, therefore, cannot be in a position where one of its members has limited liability. The members/partners of a not-for-profit unincorporated association cannot limit their liability since their association does not carry on a business with a view to profit. Under existing state and territory laws, an association [page 971] cannot be considered to be a partnership because the state partnership legislation requires partnerships to be carrying on a business in common with a view to profit. On 25 June 2008, the Commissioner issued his final determination on the issue: TD 2008/15. According to the Commissioner, an unincorporated association of persons, acting only in Australia, who do not carry on a business in common with a view to profit cannot be a corporate limited partnership within the meaning of ITAA36 s 94D. Hence, the Commissioner’s latest determination confirms his position in his previous draft determination, TD 2008/D1.

Use the Internet or the library to identify a group of separate statutes that apply to the same tax, but which are separately enacted so as to meet the Constitutional list of some respects in which a general law partnership differs from the following: 1. a company limited by shares; 2. a trust; 3. a joint venture; 4. a non-profit unincorporated association.

James and Andrew are tuna fishermen who agree to cooperate so as to balance out their good and bad days thus producing a more steady income flow. Each owns his own fishing boat. James paid cash for his boat but Andrew borrowed to purchase his. Andrew is solely responsible for interest on the borrowed moneys. They agree to divide any fish that their two boats catch between them equally by weight. They also agree that each will be responsible for the expenses of running his own boat. Will the relationship between James and Andrew amount to a partnership for general law purposes?

Would the relationship between James and Andrew (above in Problem 14.1) amount to a partnership for purposes of the ITAA97 s 995-1(1) and ITAA36 s 6(1) definitions? Would your answer differ if they had agreed to share the gross proceeds of the sales of their fish equally? In this scenario, what would the position be if the gross sales in Y1 were $200,000 and the expenses of running James’s boat were $60,000 while the expenses of running Andrew’s boat (including interest) were $105,000?

[page 972]

On 10 February 2015, Jill and Bill purchase a block of six flats for $600,000 and enter into a partnership agreement that provides that all losses will be borne by Bill and that profits will be split 50/50. For the year ended 30 June 2016, the block of flats produced a loss of $40,000. Advise how the loss will be treated for tax purposes. Suggested solutions to the problems can be found in Study help.

The basic tax treatment of partnership income

14.15 ITAA36 Pt III Div 5 is concerned with the taxation of partnership income. Consistently with the general law principle that a partnership is not a separate legal entity from its members, Div 5 does not tax a partnership, other than certain limited partnerships, on its income. Thus, partnerships are not taxpaying entities. They can be described, however, as tax accounting entities. ITAA36 Div 5 imposes an obligation on a partnership to furnish a return of its income. The ‘net income of the partnership’ or the ‘partnership loss’ is calculated in the partnership return. Division 5 then includes the individual interest of each partner in the net income of the partnership in the assessable income of that partner. Where a partnership loss is made, Div 5 allows each partner a deduction for his or her individual interest in that loss. The deductibility of a share of losses at the partner level is one of the tax advantages of partnership as a form of business organisation. You will recall from Chapter 12 that a company’s tax losses are deducted and carried forward at the company level and cannot be distributed to shareholders. We shall see in Chapter 15 that trusts are treated similarly to companies in this respect. The scheme of Div 5 is shown in Figure 14.1 below.

Figure 14.1:

The basic tax treatment of partnership income

[page 973]

Obligation to furnish a return 14.16 ITAA36 s 91 states that a partnership is obliged to ‘furnish a return of the income of the partnership’. Section 91 also states that the partnership is not obliged to pay tax on the income disclosed in the return. The main function of the partnership return is to calculate the ‘net income of the partnership’ or the ‘partnership loss’ as the case may be.

Meaning of ‘net income’ and ‘partnership loss’ 14.17 ITAA36 s 90 defines the terms ‘exempt income’, ‘net income’ and ‘partnership loss’ in relation to a partnership. The approach used in s 90 is to treat the partnership as if it were a resident taxpayer. The items which would be included in the assessable income of the

partnership if it were a resident taxpayer are added together. Most items which would be allowable as deductions to the partnership if it were a resident taxpayer are also added together. The deductions which are not taken into account in this calculation are deductions for losses carried forward. If the total of the deductions exceeds the total of the assessable income then there is a partnership loss. In all other cases, the partnership will have a net income. Following amendments inserted by the Taxation Laws Amendment Act (No 4) 2003 (Cth), the ITAA36 s 90 calculation also identifies what non-assessable exempt income is in relation to a partnership. 90 Interpretation In this Division: exempt income, in relation to a partnership, means the exempt income of the partnership calculated as if the partnership were a taxpayer who was a resident. net income in relation to a partnership, means the assessable income of the partnership, calculated as if the partnership were a taxpayer who was a resident, less all allowable deductions except deductions allowable under section 290-150 or Division 36 of the Income Tax Assessment Act 1997. non-assessable non-exempt income, in relation to a partnership, means the non-assessable non-exempt income of the partnership calculated as if the partnership were a taxpayer who was a resident. partnership loss, in relation to a partnership, means the excess (if any) of the allowable deductions, other than deductions allowable under section 290-150 or Division 36 of the Income Tax Assessment Act 1997, over the assessable income of the partnership calculated as if the partnership were a taxpayer who was a resident.

[page 974]

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In what respects does the definition of ‘exempt income’ in relation to a partnership differ from the definition of ‘net income’ in relation to a partnership? Why do you think these differences exist? What are ITAA97 s 290-150 and Div 36 concerned with? Why do you think these

3.

deductions are not taken into account in calculating the net income in relation to a partnership or a partnership loss? If a partnership’s return showed that the assessable income calculated as if the partnership were a resident was exactly equal to the allowable deductions so calculated what would be the result?

Inclusion in partner’s assessable income 14.18 ITAA36 s 92 deals with the allocation of the net income of a partnership and partnership losses to individual partners. The amount allocated differs according to whether the partner’s interest in the net income or the partnership loss is attributable to a period when the partner was a resident of Australia. The situation where the partner’s interest in the net income of the partnership is attributable to a period when the partner was a resident is dealt with in s 92(1)(a). 92 Income and deductions of partner (1) The assessable income of a partner in a partnership shall include: (a) so much of the individual interest of the partner in the net income of the partnership of the year of income as is attributable to a period when the partner was a resident;

The situation where the partner’s interest in the net income of the partnership is attributable to a period when the partner was a nonresident is dealt with in ITAA36 s 92(1)(b). 92 (1) The assessable income of a partner in a partnership shall include: … (b) so much of the individual interest of the partner in the net income of the partnership of the year of income as is attributable to a period when the partner was not a resident and is also attributable to sources in Australia.

[page 975] Following amendments inserted by the Taxation Laws Amendment

Act (No 4) 2003 (Cth), the non-assessable non-exempt income of a partner includes (via ITAA36 s 92(4)): 92 (4) The non-assessable non-exempt income of a partner in a partnership shall include: (a) so much of the individual interest of the partner in the nonassessable nonexempt income of the partnership of the year of income as is attributable to a period when the partner was a resident; and (b) so much of the individual interest of the partner in the nonassessable nonexempt income of the partnership of the year of income as is attributable to a period when the partner was not a resident and is also attributable to sources in Australia.

Allowing a partner a deduction for interest in partnership loss 14.19 The situation where a partner has an individual interest in a partnership loss is dealt with in ITAA36 s 92(2). Where the loss is attributable to a period when the partner was a resident, the relevant provision is s 92(2)(a). 92 (2) Subject to section 830-45 of the Income Tax Assessment Act 1997, if a partnership loss is incurred by a partnership in a year of income, there shall be allowable as a deduction to a partner in the partnership: (a) so much of the individual interest of the partner in the partnership loss as is attributable to a period when the partner was a resident; …

14.20 The situation where the individual interest of the partner in the partnership loss is attributable to a period when the partner was a nonresident is dealt with in s 92(2)(b). 92 (2) Subject to section 830-45 of the Income Tax Assessment Act 1997, if a partnership loss is incurred by a partnership in a year of income, there shall be allowable as a deduction to a partner in the partnership: … (b) so much of the individual interest of the partner in the partnership loss as is attributable to a period when the partner was not a resident and is also attributable to sources in Australia.

[page 976] The deductibility of losses at the partner level is an important distinctive feature of partnerships. By contrast, company losses and trust losses cannot be allocated to shareholders or beneficiaries but remain locked in at the company or trust level.

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True/False Quiz ITAA36 s 92(2)(b) only deals with the situation where a partnership loss is attributable to foreign source income. True/False Only so much of a partner’s interest in the net income of a partnership as is attributable to sources in Australia is included in the partner’s assessable income where the partner’s interest in the net income of the partnership is attributable to a period when the partner was a resident. True/False Where a partner’s interest in a partnership loss is attributable to a period when the partner was a non-resident, only so much of that interest as is attributable to sources in Australia is allowable as a deduction to the partner. True/False Solutions to these quiz questions can be found in Study help.

Derivation of partnership income and incurring a partnership loss 14.21 We have seen that a partner’s individual interest in the net income of a partnership or in a partnership loss is allocated to the partner via ITAA36 s 92. This raises two questions. First, how do we ascertain the individual interest of a partner in the net income of the partnership (or, for that matter, in the partnership loss)? Second, having ascertained the individual interest of the partner in net income, when does the partner derive that interest? Where the s 95 calculation produces a partnership loss, the second question becomes, when does a partner incur his or her interest in a partnership loss?

How is a partner’s individual interest ascertained? 14.22 A partner’s individual interest in the net income of a partnership or in a partnership loss is ascertained by the taking of partnership accounts. Where a partnership is a partnership under the Partnership Acts definition, discussed at 14.3–14.13, the extent of a partner’s individual interest will be ascertained according to the partnership agreement. Where persons are partners for tax purposes merely because they are in receipt of income jointly, their individual interests will be determined by their proportionate ownership of the income-producing asset: see FCT v McDonald (1987) 18 ATR 957; 87 ATC 4541, discussed in 14.2 and 14.9. [page 977]

When do partners derive? 14.23 In Chapter 12, we saw that, generally, a shareholder in a company derives corporate income only when the company pays a dividend and then derives it as a dividend and not as a share of the corporate income itself. This is because, while corporate income is retained, the ITAA36 generally respects the separate legal entity status of a company. By contrast, as we have seen, the ITAA36 does not treat a partnership as a tax-paying entity but only as a tax-accounting entity. When partners derive an individual interest in the net income of the partnership, it is income to them, not because it is a distribution from a partnership, but because of the income qualities that it had when the partners received it. A consequence of this approach is that derivation of partnership income does not depend on that income being distributed to the partners. As the High Court stated in Rose v FCT (1951) 84 CLR 118 at 124: … the collective income earned by the partnership belongs according to their shares to the partners regardless of its liberation from the funds of the partnership, that is, its actual distribution.

14.24

Rather than fixing on the point of actual distribution as the

moment of derivation of partnership income, the courts have held that derivation takes place when the individual interest of a partner in the net income of the partnership is ascertained. We have seen in 14.22 that this happens when the partnership accounts are taken or should have been taken. It is at that point that the partners are regarded as deriving their individual interests in the net income of the partnership. The application of these principles is illustrated in the High Court decision in FCT v Galland (1986) 162 CLR 408; 68 ALR 403; 18 ATR 33.

FCT v Galland Facts: The taxpayer, a solicitor practising in partnership, on 27 June 1980 assigned 49% of his interest in the partnership to the trustee of his family discretionary trust. The objects of the discretionary trust were the taxpayer, his wife and their children and their spouses and their grandchildren. It was expressly provided that the assignment would, in respect of the year ended 30 June 1980, take effect in relation to the taxpayer’s share of the partnership profits of the whole year, without any apportionment, and the taxpayer’s share in the partnership assets on dissolution. In his personal return for the year ended 30 June 1980, the taxpayer included 51% of his half share in the net income of the partnership for that year. The taxpayer’s return also included a statement to the effect that 49% of the taxpayer’s income shown in the partnership return had been assigned to the trustee of the discretionary trust on 27 June 1980. The taxpayer’s calculations were made on the basis that the assignment was effective to assign 49% of his share of the partnership profits for the whole year notwithstanding that the assignment was only made [page 978] on 27 June 1980. The Commissioner assessed the taxpayer on the basis that the assignment was only effective as from 27 June 1980 and that the taxpayer derived 100% of his share of the net income of the partnership for the period from 1 July 1979 to 26 June 1980. Issue: (before the High Court) Did Galland derive 100% of his share of the net income of the partnership up to 27 June 1980? Held: The taxpayer did not derive any net income from the partnership until the accounts were taken for the year ending 30 June 1980. By the time the accounts were taken, the taxpayer had assigned 49% of his interest in the partnership which carried with it the

right of the taxpayer’s interest in the net income of the partnership for the whole of the year. Mason and Wilson JJ held (at ALR 406–8): The Commissioner’s principal submission in support of the appeal is that partners, like individual taxpayers, derive income when they can sue for it, so that they derive income for the purposes of the Act before the accounts of the partnership are prepared for the year of income and the amount of the distribution to each partner is ascertained. This submission cannot be sustained. Section 92(1)(a) of the Act includes in the assessable income of a partner, not his share of the gross income derived, but his individual interest in the net income of the partnership for the year of income. The expression “net income” is defined by s 90, in relation to a partnership, to mean “the assessable income of the partnership, calculated as if the partnership were a taxpayer who was a resident, less all allowable deductions” except certain concessional and other deductions. These provisions are essentially for accounting purposes. They reflect the basic legal principle that the profits or net income of a partnership are the profits or net income of those who constitute it. It follows that, although a partner is not usually entitled to call for a distribution of profits or net income until accounts have been prepared, he has an individual interest in the net income of the partnership, notwithstanding that the precise amount of his interest cannot be determined until the accounts are prepared in respect of the relevant period. All this is made clear by the judgment of the Federal Court in Rowe v FCT (1982) 60 FLR 475 at 476; 82 ATC 4243 at 4244, and the decision of this court in Rose v FCT (1951) 84 CLR 118 at 124. The judgment in Rowe then makes the fundamental point that net income must ordinarily be related to a period and that for tax purposes, in the case of a partnership, that means [page 979] the relevant year of income … The flaw in the Commissioner’s argument is that, by virtue of s 92, a partner’s assessable income is ascertained by reference to the net income, not the gross income of the partnership for the year of income. Therefore it matters not that the partner derives gross income when the partnership earns recoverable fees during the year of income. The point is that, in general, the partner’s assessable income for the year of income can only be ascertained at the end of that year when the net income of the partnership is ascertained. Accounts for that purpose cannot be taken until the expiration of the year of income, unless there is some independent reason for taking accounts at an earlier date, as, for example, a dissolution of the partnership. [A]s Beaumont J correctly pointed out in his judgment in the Federal Court, these cases [Rowe; FCT v Melrose (1923) 26 WALR 22; and FCT v Happ (1952) 5 AITR 290 at 294–5; [1952] ALR 382 at 386] are all instances of dissolution or notional dissolution of partnership in the course of what would otherwise have been the partnership’s year of income. Accordingly, there was an independent obligation or

reason to take partnership accounts on the dates when they were taken. The decisions provide no support at all for the proposition that in cases such as the present, where these factors do not operate, the net income of the partnership and the assessable income of the partners must be ascertained at a date which differs from that provided for in the partnership agreement, or, perhaps, a date otherwise agreed by the partners. Although the assignment in Everett differed from this assignment … Their Honours discussed respects in which Everett differed from Galland and continued (at ALR 408): The important point for present purposes is that an assignment of a share of an interest in a partnership carries with it the income attributable to that share unless the assignment limits the entitlement to income as it did in Everett. The decision therefore establishes that a partner may during the year of income of a partnership assign a share of his interest in the partnership so that the assessable income attributable to that share during the year of income is that of the assignee, not of the assignor, for tax purposes. For these reasons the appeal must be dismissed. Brennan, Deane and Dawson JJ delivered separate concurring judgments.

[page 980]

When should partnership accounts be taken? 14.25 In Hughes v Fripp (1922) 30 CLR 508, the High Court held that the date on which partnership profits are to be taken to have accrued depends on the date on which accounts were taken, or ought, according to the partnership agreement or the partnership’s course of business, to have been taken. Until the net income is required to be ascertained by the taking of accounts, partners do not derive their interest in the net income of the partnership. The consequence of the application of this rule in Galland was that the gross income of the partnership up to the date of the assignment was not derived by the assigning partner. The reason was that the assignment was expressed to include the income for the year ending 30 June, and that partnership accounts were not required to be taken as at the date of the assignment. 14.26

Note that in Hughes v Fripp, the High Court stated that the

date of accrual of partnership profits depends on when accounts were taken or ought, according to the partnership agreement or the partnership’s course of business, to have been taken.3 Thus, as the Full Federal Court noted in Rowe v FCT (1982) 13 ATR 110, it is not possible for partners to avoid deriving partnership income by simply never taking partnership accounts. Even though accounts have not in fact been drawn up when they should have been, Rowe suggests that partners will derive the share of net income that the accounts would have disclosed if they had been drawn up. This is so, even though the precise quantum of a partner’s interest in the net income of the partnership has not been ascertained by an actual taking of accounts and even though a partner, for that reason, cannot call for a distribution of profits or net income.

The tax treatment of partners’ salaries and other internal transactions 14.27 Because a partnership is not a separate legal entity from its members, it cannot contract with one of its members. This is because, as a matter of contract law, you cannot enter into a contract with yourself. Using this reasoning, two Commonwealth Taxation Board of Review (Board of Review) decisions4 have treated payments of salaries to partners as agreements to vary the partners’ entitlements to partnership profits and not as deductible expenses in determining partnership profits. This approach is illustrated in Example 14.1, which is based on the decision in Case S75 85 ATC 544. Note that in light of the Commissioner’s ruling in TR 2005/7, a different outcome would be achieved: see further in Example 14.2. [page 981]

(Based on Case S75 85 ATC 544) Clive and Raffles are in partnership in a business of tea importing. The partnership agreement states that they are each entitled to 50% of the partnership profits and are required to bear partnership losses equally. The partners independently agree to pay Clive a salary of $60,000 per year for services he performs in negotiating tea purchasing contracts in India and Sri Lanka. In the year ending 30 June 2015, the partnership made a loss of $40,000 after allowing for payment of Clive’s salary. The reasoning of the Board of Review decision in Case 75 would treat this situation as follows: The agreement to pay Clive a salary of $60,000 would be treated as varying the partners’ entitlements to sharing profits. The agreement would be regarded as being varied so that Clive would be entitled to the first $60,000 of profits and any profit made thereafter would be divided equally between the partners. The calculations using this approach would be as follows: $60,000 would be added back into the calculation of the net income of the partnership Hence, the net income of the partnership would be: $60,000 − $40,000 = $20,000 As the partners would be taken to have agreed to pay Clive the first $60,000 of net income, he would be assessed on 100% of the $20,000 and Raffles would not have any amount included in his assessable income or allowed as a deduction.

14.28 Following Case S75 85 ATC 544, the Commissioner issued Taxation Ruling IT 2218 (withdrawn on 22 May 2002 and replaced by TR 2005/7) setting out his then view of the effects of payments of salaries to partners. IT 2218 ‘Income Tax: Partners’ Salaries’ Preamble [The preamble noted the decision in Case S75 85 ATC 544.] Ruling 4. The decision of the Board [in Case S75] is not to be taken as altering the long established practice of this office in relation to partners’ [page 982]

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salaries. Although a salary paid to a partner does not represent salary or wages for the purposes of the tax instalment deduction provisions in Division 2 of Part VI of the Act and is not in itself a loss or outgoing within the meaning of subsection 51(1), nevertheless it may well constitute a legitimate distribution of the profits of a partnership which should be taken into account in determining a partner’s individual interest in the net income of a partnership. In genuine cases involving the payment of a salary to a partner, ie where the payment of the salary is bona fide and is not only reasonable in amount but has its origin in the terms of the partnership agreement, it has been the practice of this office to take the salary into account in determining the individual interest of each partner in the net income or loss of the partnership. This practice will continue. Situations may arise, however, where it becomes apparent that the salary paid to a partner is excessive in the light of the duties and responsibilities of the particular partner. In many of these situations it will emerge that there is a disparity between the incomes of the partners and a salary is paid to one partner for the purposes of minimising overall tax liability. In other situations the agreement to pay a salary to one partner may not be entered into until or after the end of the year of income — it is well settled that an agreement of this nature would not have retrospective effect. In situations to which this paragraph applies distribution of partnership net income taking into account the payment of salary should not be accepted. The net income of the partnership should be distributed according to the basic agreement between the partners for the sharing of profits and losses.

14.29 In FCT v Beville (1953) 5 AITR 458, the High Court took a similar approach in relation to interest payments on a partner’s current account with the partnership. Payments of interest by a partner on overdrawn current accounts are regarded as reducing a partner’s share in the net income of the partnership. Conversely, crediting interest to a partner’s current account is regarded as increasing the partner’s interest in the net income of the partnership. In neither case are the interest receipts or payments taken into account in calculating the net income of the partnership or the partnership loss. Logically, the same approach would apply to interest received and payable on a partner’s capital account. On the other hand, in Beville the High Court held that interest paid to one of the partners on two loans made to the partnership was properly included by the lender partner in his assessable income and should not be set off or deducted against any interest debit made to the partner’s current account. This approach may be compared with the earlier High Court decision in Leonard v FCT (1919) 26 CLR 175. In Leonard, interest paid to a partner as an external lender was

included in his assessable income as ‘income derived by him separately’. The partnership had made a loss for the year and had taken the interest paid to the partner into account in [page 983] calculating the loss. The partner claimed a deduction for his share of the extent to which the loss was greater because the interest paid to him had been taken into account in the calculation of the partnership loss. The court disallowed the partner’s claim for a deduction but did not suggest that the interest had not been properly deducted by the partnership in calculating the partnership loss. To understand the decision in Leonard, it is necessary to note that the scheme for taxing partners and partnerships under the then applicable income tax legislation, the Income Tax Assessment Act 1915 (Cth) (ITAA15), differed from the ITAA36 scheme. Under the ITAA15, partnerships were assessed on the income derived by the partnership as if it had been derived by an individual. Partners were separately assessed on their individual interest in the partnership income and on any other income that they derived separately. Partners were not allowed a deduction for any individual interest that they might have in a partnership loss. No specific provision dealt with the treatment of prior year partnership losses. It is arguable that the ITAA15 envisaged that prior year losses could be deductible to the partnership under the ITAA15 equivalent of ITAA97 s 8-1. Double taxation of partnership income was prevented by allowing the partnership a rebate of a part of the tax otherwise payable by the partnership that bore the same proportion to the tax otherwise payable as the distributed income of the partnership bore to the whole income of the partnership. The High Court in Leonard commented that, even in the absence of the specific statutory provisions in the ITAA15, the general principles of law would have rendered the partner liable in some way on the interest received as an external lender. When viewed in the context of the

statutory scheme of the ITAA15, Leonard appears to be authority that a payment to a partner as an external lender does not represent a distribution of partnership income but does represent income derived by the partner independently of the partnership. Leonard also appears to say indirectly that interest paid to a partner as an external lender should be taken into account in calculating a partnership loss (or, by implication, the net income of the partnership). The Commissioner issued Taxation Ruling TR 2005/7 in May 2005, which replaced IT 2218 (see above in 14.28). TR 2005/7 considers the assessability of a partner’s salary to a partner and the deductibility of the partner’s salary to the partnership. TR 2005/7 ‘Income Tax: The Taxation Implications of ‘Partnership Salary’ Agreements’ Explanation [of the ruling] The legal nature of ‘partnership salary’ agreements 16. The courts have characterised agreements under which a ‘partnership salary’ is to be drawn by a partner from partnership funds as not creating a contract of employment or contract for the services of the partner, but rather as an agreement to vary the sharing of partnership profits between the partners (Ellis v Joseph Ellis & Co [1905] 1 KB 324; MacKinlay (Inspector of Taxes) v Arthur Young McClelland Moores & Co [1990] 2 AC 239). [page 984] An agreement to pay a ‘partnership salary’ to a partner for his work as a partner is an internal agreement as to how the partnership’s funds will be applied as between the partners, and is enforceable on the taking of partnership accounts. A ‘partnership salary’ is a distribution of partnership funds to the partner, and does not have the character of an expense of the partnership. … ‘Partnership salary’ is not deductible to the partnership 18. As the ‘partnership salary’ payment is a distribution or drawing in respect of partnership profits it cannot be characterised as an expense of the business and therefore is not taken into account as an allowable deduction under section 8-1 of the ITAA 1997 in calculating the net income or partnership loss of the partnership under section 90 of the ITAA 1936 ((1952) 3 CTBR(NS) Case 11; 3 TBRD Case C22 142, (1966) CTBR(NS) Case 110; 16 TBRD Case R59 271, (1968) 14 CTBR(NS) Case 59; 18 TBRD Case T69 353, (1985) 28 CTBR(NS) Case 81; Case S75 85 ATC 544 and Scott v FC of T (2002) 50 ATR 1235; 2002 ATC 2158). Therefore, the payment of ‘partnership salary’ to a partner cannot result in or contribute to a partnership loss for the purposes of section 90 of the ITAA 1936.

Assessability of the ‘partnership salary’ to the partner 19. Under subsection 92(1) of the ITAA 1936 the individual interest of a partner in the net income of the partnership is included in the assessable income of the partner. A partner’s assessable income from a partnership is ordinarily derived at the end of the income year when the net income of the partnership is ascertained (Galland). Therefore derivation of income by a partner occurs independently of distributions to, or drawings by, the partners during the year, including ‘partnership salary’ amounts received by a partner. 20. However, although the ‘partnership salary’ amounts have no effect on the recipient partner’s liability for tax under the partnership they are taken into account in determining the recipient partner’s interest in the net income (or partnership loss) of the partnership at the end of the income year under section 92 of the ITAA 1936. 21. This means that where available partnership profits are sufficient, the distributions or drawings of ‘partnership salary’ increase that partner’s share in the net income of the partnership before the remaining profits are divided among the other partners and are assessable to the partner under subsection 92(1) of the ITAA 1936 at the end of the income year (refer example 1). 22. However, there may be cases where partnership profits in a particular income year are not sufficient to cover the ‘partnership salary’. Usually, ‘partnership salary’ is payable out of profits, and thus drawings of ‘partnership salary’ are made in advance or anticipation of future profits. [page 985] The entitlement to ‘partnership salary’ affects the partners’ interests in the profits in respect of more than one year. Thus, if partnership profits are not sufficient in one income year the ‘partnership salary’ may be met from profits of subsequent years (refer to example 2 and example 3). 23. The effect of this is that the excess distributions or drawings will be assessable to the recipient partner under subsection 92(1) of the ITAA 1936 in the future income year when profits are sufficient (and are debited against profits in that year). In the event that sufficient profits are not otherwise made by the partnership before retirement or the partnership dissolves, it is expected that the partner would be liable to repay them. Drawings, or otherwise repayable amounts, are not derived as income at the time of advance under section 6-5 of the ITAA [1997].

The Commissioner’s tax ruling in TR 2005/7 creates a different outcome when determining the assessability of a partner’s salary for income tax purposes. The key paragraphs are paras 21 and 22, which provide that, in determining the partner’s assessability of a partnership salary, any excess salary distributions over partnership profit that are made in one income year will be assessable in later years when sufficient

profits of the partnership are available. It is submitted that the requirement under TR 2005/7 differs from the approach taken by the Board of Review in Case S75. This is because, under the new ruling, income tax is levied not at the time the salary is drawn, but instead at the time the partnership has sufficient profit to meet the excess distribution. Example 14.1 above is reworked in Example 14.2 to demonstrate the difference in approach.

(Based on TR 2005/7) Assume the same set of facts as outlined in Example 14.1 above. The net income of the partnership would be $20,000 ($60,000 minus $40,000). As the partnership agreement provides for Clive to receive 100% of the partnership’s net income, he would be assessed for income tax on $20,000 in the current tax period. His remaining salary of $40,000 would be assessed for income tax when the partnership returned to profit in subsequent years. Hence, if the partnership profit was insufficient in any one given year, the ‘partnership salary’ would be met from later years and assessed for income tax in subsequent years. The Commissioner has justified his approach for assessing partners’ salaries in the manner contemplated by TR 2005/7 by using the accounting ‘matching principle’ in determining taxable income. [page 986] The Commissioner states this preferred approach in para 22 of TR 2005/7, where he says: Usually, “partnership salary” is payable out of profits, and thus drawings of “partnership salary” are made in advance or [in] anticipation of future profits.

1.

Does the approach taken in Case S75 85 ATC 544 and illustrated in Example 14.1 seem fair to a working partner who is actually providing specialist services to the

2.

3. 4.

partnership? Is this approach more or less fair than merely adding back the salary and dividing the partnership income in accordance with the partnership agreement (ie, 50/50 in Example 14.1)? Is the approach in Case S75 consistent with the treatment of external loans by a partner to a partnership by the High Court in FCT v Beville (1953) 5 AITR 458 and in Leonard v FCT (1919) 26 CLR 175? Can a basis be found in partnership law for drawing a distinction between a partner providing services to a partnership and making ‘external’ loans to the partnership? Should the nature of the services provided and the nature of the partnership’s business be relevant factors? What would be the result if the facts in Leonard occurred under the ITAA36? Do you agree with the Commissioner’s position, as expressed in TR 2005/7, in adopting the accounting matching principle to determine taxable income for partners’ salaries?

The consequences of a change in the composition of a partnership 14.30 As a matter of partnership law, a partnership may be dissolved by: the expiration of the term of the partnership (where the partnership is for a fixed term); by notice where the partnership is not for a fixed term (‘a partnership at will’); by the happening of an event which makes it unlawful for the business of the firm to be carried on or for the members to carry it on in partnership; [page 987] by the death or bankruptcy of one of the partners; or by court order.5 In the case of a partnership at will, this, in effect, means that a change in the composition of a partnership (occasioned by the retirement or death of a partner), in the absence of a provision in the partnership

agreement to the contrary, dissolves the partnership. On the dissolution of a partnership because of a change in its composition, partnership accounts would normally be required to be taken. The rights of partners to distributions of profits accrue at the time the accounts should have been taken.

Position where change in composition dissolves partnership 14.31 The principles mentioned in 14.30 were applied in the context of the death of a partner in the High Court decision in Hughes v Fripp (1922) 30 CLR 508. There, the High Court held that a partnership at will was dissolved, both as a matter of general principle and in accord with the partnership agreement, as at the date of death of one of the partners. This meant that an account of the partnership profits should have been taken as at the date of death of the partner. Hence, the deceased partner’s right to a share of profits accrued as at the moment of his death. This meant that, in the absence of specific statutory provisions to the contrary, the profits that would have been ascertained by a taking of accounts as at the moment of the partner’s death accrued at that time and, as a matter of trust law, became part of the corpus (capital) of the deceased partner’s estate. This was so even though the amount of the profit could not be ascertained until some time after the date of death. The judgment of Starke J (at 520–1) contains the clearest explanation of the reasoning behind this approach: Prima facie the estate of a testator at the time of his death comprises every asset to which he was entitled at that time. If the profits of a partnership have been ascertained and declared before a testator’s death, or ought, according to the agreement or course of business of the partners, to have been ascertained before, but are not in fact ascertained till some time after, the testator’s death, then those profits are treated as part of the corpus of the testator’s estate. The reason, I apprehend, is that as the right of the testator to the profits had accrued at the time of his death, then the profits must be treated as having fallen into the hands of the testator, and so to form part of the corpus of his estate. If, on the other hand, the right of the testator to the profits of a partnership business accrues, according to the agreement or the course of business of the partners, at some time subsequent to his death, then those profits have not fallen into the hands of the testator at the time of his death, and cannot be treated as an asset or as part of the corpus of his estate.

Note that Hughes v Fripp was not a tax case but a case that was concerned with the characterisation of the receipt by the testator’s estate. In the subsequent High Court decision in FCT v Lawford (1937) 4 ATD 253, it was held that fees received by the executor of a deceased partner for accounts rendered as at the date of the deceased’s death were not derived as income by either the deceased partner nor by the executor. The deceased was a cash basis taxpayer and, as such, did not derive the amounts [page 988] as he never received them. Consistently with the decision in Hughes v Fripp, the amounts actually received by the executor were regarded as part of the corpus of the estate and hence were capital. Consistently with the passage from the judgment of Starke J in Hughes v Fripp quoted above, if the taxpayer in Lawford had been on an accruals basis, he would have derived the fees as income when the accounts were taken as at the date of his death. Following the decision in Lawford, ITAA36 s 101A was inserted. Under ITAA36 s 101A, amounts received by the trustee of a deceased estate, which would have been assessable income if received by the deceased person during his or her lifetime, are included in the assessable income of the trust estate. ITAA36 s 101A is discussed in more detail at 15.48. 14.32 In FCT v Happ (1952) 9 ATD 447; 5 AITR 290, the taxpayer had, until 22 December 1944, carried on a business called ‘Leather Fanciers’ in partnership with three others. On 22 December 1944, the partners purported to dissolve the partnership as from 30 June 1944. Under the agreement of 22 December 1944, the taxpayer purported to assign his interest in the business and, consequently, his interest in the partnership income to the two continuing partners as from 30 June 1944. Williams J in the High Court held that the purported retrospective dissolution of the partnership was ineffective. As a matter of fact, the partnership continued to 22 December 1944 when it was dissolved by agreement. Accounts of partnership profits should have

been taken as at 22 December 1944 and the partners derived the share of the profits of the partnership which those accounts would have disclosed if they had been taken. This meant that the taxpayer’s purported assignment on 22 December 1944 of his interest in the business and its consequent income as from 30 June 1944 did not prevent him from deriving the income that arose in that period and which would have been ascertained by taking accounts as at 22 December 1944.

Position where change in composition does not dissolve partnership 14.33 The Partnership Acts envisage that a partnership agreement may contain a clause to the effect that the death or bankruptcy of a partner will not dissolve the partnership. In neither Hughes v Fripp (1922) 30 CLR 508 nor FCT v Happ (1952) 9 ATD 447; 5 AITR 290 did the partnership agreement contain such a provision. The precise effect of provisions of this kind is unclear. In Peterson v FCT (1960) 106 CLR 395, the partnership agreement contained a provision that, in the event of the death of a partner, permitted the surviving partners to carry on the partnership for the benefit of the surviving partners and the estate of the deceased partner. The deceased partner died on 29 December 1954. For the period from 1 July 1954 to 28 December 1954, the partnership made a loss but made an overall profit for the year from 1 July 1954 to 30 June 1955. Windeyer J in the High Court held that, as the deceased’s death did not dissolve the partnership, the deceased’s entitlement to a share of the partnership profits could not be regarded as having accrued until the profits were ascertained and declared or should have been ascertained and declared by a taking of accounts. This meant that there was no derivation by the deceased partner’s estate until partnership accounts were taken in the normal course of events at 30 June 1955. Note that the derivation of the receipt of income by the deceased partner’s estate when the accounts were taken is consistent with the passage from the judgment of Starke J in Hughes v Fripp (1922) 30 CLR 508 at 520–1 quoted in

[page 989] 14.31. Because there was no account as at the date of death, and hence no derivation by the deceased at that time, the deceased had no right to payment of the share of income which was ascertained by the subsequent taking of accounts. Consistently with the judgment of Starke J in Hughes v Fripp, this would mean that the subsequent payment could not form part of the corpus (or capital) of the deceased’s estate. Rather, the payment was income to the executor as a flow from rights that formed part of the capital of the estate.

In Peterson v FCT (1960) 106 CLR 395, the Commissioner, in effect, assessed on the basis that an account should have been taken as at the date of the deceased partner’s death and that the deceased’s share of any profits or losses disclosed by the accounts should have been assessable or deductible to the deceased. Why do you think the Commissioner favoured this approach? How was the approach adopted by Windeyer J more favourable to the deceased partner’s estate?

14.34 Given that a partnership is not a separate legal entity from its members, then every death of a partner must, by reason, amount to a dissolution of the old partnership and the formation of a new partnership. What then could the effect of a ‘non-dissolution’ clause be and what could Windeyer J have meant when he said in Peterson v FCT (1960) 106 CLR 395 that the deceased’s death did not dissolve the partnership? Note that Windeyer J contemplated that the clause in the partnership agreement in Peterson might have had two possible legal effects: 1. that the trustee of the deceased’s estate should be regarded as carrying on business with the surviving partners; and 2. that the trustee of the deceased’s estate should be regarded as

being entitled to a share of the profits of a business carried on by the surviving partners in partnership. Note that in both of these scenarios the association of persons that is carrying on business after the deceased’s death is a different association of persons from the one that carried on business before the deceased’s death. A third possible analysis of the effect of a clause that the death of a partner does not dissolve a partnership was made by Kitto J in Single v FCT (1964) 110 CLR 177 at 187–8: The general rule that by the death of a partner a partnership is dissolved as regards all the partners is subject to any agreement between the partners … From the stated case it appears that in the partnership agreement there was a term that the death of a partner should not operate to dissolve the partnership, and that the partnership would be continued by the surviving partners. The operation of this term and the term already mentioned [requiring payment to the deceased’s estate of an amount representing: (a) the amount standing to the credit of his capital account; and (b) a share of book debts and costs collected after the date of death for work done by the firm up to the

[page 990] date of death whether or not the work was complete], taken together, was that after the death of the testator the surviving partners became automatically partners together in a new firm to take over and carry on the business of the old partnership, and that the share and interest of the testator in the business and assets of the old partnership passed to the surviving partners in return for their obligation to make to his estate the payments that have been mentioned. That obligation constituted the consideration for what may be called, with sufficient approximation to accuracy, the sale of rights which otherwise would have formed part of the capital of the estate.

Again note that under this analysis the association of persons who will be carrying on business as partners after the death of the testator will be different from the association of persons who carried on business prior to that date. Under Kitto J’s analysis, the surviving partners effectively step into the shoes of the deceased partner and take over his or her share and interest in the business and assets of the old partnership. Kitto J’s analysis in Single differs from Windeyer J’s second analysis in Peterson. Under Kitto J’s analysis, the payment made to the deceased’s estate was:

the credit in the deceased’s capital account as at the date of death; and the value of the deceased’s share of book debts and work in progress as at the date of death. The payment, it seems, was made by the continuing partners outside the partnership accounts. Under Windeyer J’s second analysis in Peterson, the payment to be made to the deceased’s estate was a share of the profit ascertained by a taking of partnership accounts at the end of the year of income. The judgment of Owen J in Single at 192–3 makes it clear that a key effect of a non-dissolution clause is that, although the old partnership is dissolved, in the sense that a new partnership carries on its business, it is not wound up. That is, at the time of the change in the composition, final accounts are not taken and there is no actual or notional distribution of the net surplus assets of the partnership. This point would appear to be valid in the case of each of the three scenarios discussed above. In cases such as Single, where a payment is made to the estate of a deceased partner in respect of the deceased’s interest in the partnership, the effect of a non-dissolution clause is that no account is taken at the date of death, no distribution of surplus is made at that time but the surviving partners, in effect, purchase the deceased partner’s interest in the partnership. Consistently with this analysis, when accounts are subsequently taken, the surviving partners derive the share of net income of the partnership that the deceased partner would have derived had he or she lived. More recently, the Commissioner has indicated that, in the case of professional partnerships with more than 20 members, where the partnership agreement contains a non-dissolution clause and the change represents less than a 10% change in the interests in the partnership, a return will not be required at the time of the change in composition. Nonetheless, the Commissioner requires that details of the change in composition be included in the end of year return which should show allocations of net income between the new, retiring, deceased and continuing partners as the case may be. The Commissioner’s requirements on a change in the composition of a partnership where the

partnership agreement contains a non-dissolution clause appear to be inconsistent with the authorities discussed above and with partnership law. [page 991]

Payments for work in progress on a change in composition 14.35 Single v FCT (1964) 110 CLR 177 concerned a payment to the executrix of the estate of a deceased partner of: the credit balance of the deceased partner’s capital account including undrawn profits and a share of goodwill; and 25% of book debts and costs collected by the firm after the date of death for work done up to the date of death whether or not an account could have been rendered in respect of the work as at the date of death. A majority of the High Court held that so much of the payment as related to incomplete and unbilled work as at the date of death was assessable to the executrix under ITAA36 s 101A. Section 101A is discussed at 15.48. On the s 101A issue, Single is authority that s 101A will include an amount in the income of a deceased estate even though it was not receivable as at the date of death of the deceased. As noted at 14.34, in Single, the partnership agreement contained a clause to the effect that the death of a partner would not dissolve the partnership. In Single, Owen J stated (at 192–3) that, in the absence of s 101A, if the partnership had been wound up, a payment of surplus assets to the executrix of the estate of the deceased partner would have been on capital account. Owen J also considered that, in the absence of s 101A, the payment to the executrix under the non-dissolution clause would have been on capital account as representing the deceased’s share in the assets of the partnership. By contrast, Kitto J6 in Single at 187 held that, although the payment was for rights which would otherwise have

formed part of the capital of the deceased estate, this did not determine the income or capital nature of the payment when received. Kitto J characterised the payments, so far as they related to work that was incomplete at the date of death, as a share of the income receipts and considered that the share of the relevant income receipt should have the same income character as the whole receipt. The difference of opinion in Single on this issue is significant in the context where a change in composition is caused by reasons other than the death of a partner with the consequence that s 101A is not applicable. 14.36 Subsequent Australian cases have confirmed that a payment, outside the partnership accounts, by continuing partners to a retiring partner, where the change in composition did not dissolve the partnership, in respect of professional work in progress is assessable income to the retiring partner under ITAA97 s 6-5. [page 992] 14.37 In Stapleton v FCT 89 ATC 4818, a former member of a partnership of solicitors received, after his retirement, several amounts representing a share of unbilled services prevailing at the time of his retirement. Partnership accounts were not taken as at the date of the partner’s retirement and the partnership agreement contained a nondissolution clause and clauses permitting calculation of the value of the partner’s interest in the partnership on retirement. In his return, the taxpayer disclosed and described the relevant amount as capital but the Commissioner relied on certain partnership documents which described the amount as a ‘future income entitlement’ and issued an amended assessment. 14.38 The taxpayer’s appeal was upheld because, in the circumstances of the time, legislation did not allow for an amended assessment. However, Sheppard J expressed the view that the calculation of the retiring partner’s interest on retirement enabled the value of potential income to be taken into account. So far as the

payment to the retiring partner related to the value of work in progress, it represented the partner’s share of profits to the date of his retirement. It was thus an income rather than a capital receipt. 14.39 A similar conclusion was reached in FCT v Grant (1991) 22 ATR 237. There too, retiring partners were paid amounts representing a share in unbilled services. The partnership agreement contained a nondissolution clause. An account was taken at the time of retirement for the purposes of calculating the payment to the retiring partners. It appears, however, that the account was not compiled for the purpose of calculating the entitlement of the continuing partners to profits and that there was no derivation by the continuing partners at the time the other partners retired. The retiring partners argued the item was capital and represented repayment of unbilled services credited in the partnership’s accounts at the time of its formation. Jenkinson J did not regard this feature as materially distinguishing the case from Stapleton and noted that there was no evidence that any item of work in progress brought at the formation of the partnership was still an item of work in progress at the retirement of the partners. Jenkinson J agreed with the reasoning in Stapleton and held the amounts were revenue in nature, assessable to the retiring partners under the former ITAA36 s 25(1) (ITAA97 s 6-5). Jenkinson J saw the following factors as being significant similarities between Grant and Stapleton: the agreement contained a contractual provision for payment, on the retirement of one or more partners without dissolution, to the retiring partners by the continuing partners for an amount in respect of work in progress at the date of retirement; and the payment was measured by the agreed value of the work in progress. 14.40 In Crommelin v FCT (1998) 39 ATR 377, Foster J held that the part of a payment to a retiring partner7 that was for the value of work in progress to the date of retirement was assessable as income under ITAA36 s 25(1). This was so, notwithstanding that the retiring partner did not agree that a distinct and identified amount be paid to him in respect of work in progress. All that was necessary was that

[page 993] part of the amount paid to the retiring partner could be identified as being paid in respect of the value of work in progress to the date of retirement. 14.41 On the basis of the Australian decisions, it seems settled that payments that are made outside the partnership accounts and pursuant to a non-dissolution clause, and which are received by retiring partners representing a share in unbilled services are income in nature being either a share in the future partnership income or a substitute for such share. Note that under Stapleton v FCT (1989) 20 ATR 996, FCT v Grant (1991) 22 ATR 237 and Crommelin v FCT (1998) 39 ATR 377, the amount received by the retiring partner is included in income directly by ITAA97 s 6-5 not via the mechanism in ITAA36 Pt III Div 5. It would seem, therefore, that when the unbilled services ultimately mature, the amounts derived would form part of the partnership net income: ITAA36 s 90. This raises the question of whether there is a deduction available to the partnership for amounts paid to former partners or for the purchase of unbilled services. This issue was considered in Coughlan v FCT (1991) 22 ATR 109. Following a dissolution of one partnership and the formation of a new partnership, professional work in progress was acquired by the new partnership. The new partnership claimed a deduction under former ITAA36 s 51(1) (ITAA97 s 8-1) for the cost of acquiring the incomplete and unbilled services or, alternatively, maintained that only the incremental value of the services was assessable. Heerey J rejected both claims. In respect of the first, his Honour found (at 112) ‘that work in progress was acquired by the new firm as part of the assets of a business with the intention of using those assets to produce revenue’. That conclusion in itself was enough to dismiss the second claim. In the context of the fruit and tree metaphor to which his Honour referred, some fruit was simply riper. In McNally v FCT (2007) 65 ATR 738; [2007] FCA 51, the Federal Court was asked to determine a dispute between the taxpayer and the

Commissioner of Taxation involving the retirement of the taxpayer from a partnership of accountants. The dispute concerned the assessability of $559,219 which was paid by the partnership to the taxpayer as part of a settlement arising from contemplated legal proceedings, involving himself and his former partnership, Deloittes. The Commissioner assessed the sum of $559,219 as taxable income, which included a sum of $322,890 for opening timing differences made up of: a sum for work in progress of $89,428; prepayments of $56,997; and other payments of $176,465. The taxpayer objected to the Commissioner’s assessment on the basis that the moneys he had received from Deloittes were not assessable under ITAA36 s 92(1) and, instead, involved a settlement sum arising from contemplated legal proceedings between Deloittes and himself. The Administrative Appeals Tribunal (AAT) found in favour of the taxpayer in relation to the assessability of the settlement sum and in favour of the Commissioner for opening timing differences. According to the AAT, the settlement sum should not be assessed as taxable income on the basis that it involved payments of a capital nature. In relation to the opening timing differences, the AAT was of the view that the payments should have been included in the taxpayer’s 1998 return, on the basis that the opening timing differences were allowed as deductions in the taxpayer’s 1997 return in the form of closing [page 994] timing differences. The taxpayer appealed to the Federal Court on the said grounds (at [32]) that the AAT had erred by: (a) including work-in-progress in the net income of Deloittes; (b) including amounts deducted in the computation of income for a prior year in the net income of Deloittes; (c) including amounts of a capital nature in the net income of Deloittes; (d) including amounts which were not the net income of Deloittes in the assessable income of the taxpayer; (e) including amounts referrable to Deloittes, in which the taxpayer was not a partner, in his assessable income. …

The Commissioner also appealed to the Federal Court on the ground that the AAT had erred in holding that no part of the settlement sum paid to the taxpayer was assessable income. The Federal Court found in favour of the taxpayer in relation to the opening timing differences and held that the payments relating to work in progress ($89,428), prepayments ($56,997) and other payments ($176,465) were not assessable income under ITAA36 s 92(1). Jessup J in McNally was of the view that work in progress could not be treated as assessable income in the partner’s return because it was not treated as income by the partnership (at [46]): The Commissioner accepted that the valuation of work in progress in a business such as that conducted by Deloittes is not as such income according to ordinary concepts. When, as appears to have been the case here, accrual accounting is employed for the purpose of calculating the income of a partnership, only when a sum has become recoverable is it to be regarded as part of that income. These propositions were, it seems to me, propounded as matters of law by the High Court in Henderson v FCT (1970) 119 CLR 612 at 650–1.

His Honour went on further to add (at [48]–[50]): Internally, Deloittes includes work-in-progress in the calculation of its income — ‘accounting income’ as it has been called. However, since work-in-progress is not income for the purposes of taxation law, when calculating the figure that will be returned as the income of the partnership under s 91 of the 1936 Act, Deloittes takes the value of workin-progress out of the accounting income figure. This procedure is intended to produce the correct figure to be returned under s 91 — one which is confined to the assessable income of the partnership as though it were an individual taxpayer, as required by ss 90 and 92 of the 1936 Act … By the method of maintaining their accounts in the way I have described, Deloittes ensures that only income within the meaning of the legislation — ie never including work in progress — is treated as income of the partnership for taxation purposes. As I have said, the result is in harmony with the tax law as stated in Henderson.

Importantly, Jessup J in McNally was equally critical of recognising and treating unrealised income as taxable income (at [57]): I cannot accept that an item should be treated as part of the assessable income of Deloittes merely because there is an expectation that it will become fiscal income at some time in the year in question. In the present case, the taxpayer has had attributed to him what is said to be a share in the income of Deloittes, where that income is as appears in the accounts on 1 July 1997. On Ms Symon’s explanation, there was then

[page 995]

only an expectation that relevant items in that income would fall into the category of fiscal income. The Tribunal accepted that approach without any investigation of whether, before the taxpayer’s interest in that income was calculated and for the purpose of that calculation, such an expectation had become reality. … That approach is, I consider, wrong in law.

Jessup J in McNally was of the view that only $190,000 of the settlement sum (excluding all of the payments relating to work in progress, prepayments and other payments unbilled) received by the outgoing partner was assessable because it was in the nature of an income distribution to the taxpayer. In his Honour’s view, the $190,000 payment as part of the settlement sum related to ‘taxpayer’s interest in the net income of the partnership, not to distributions to, or drawings by, the taxpayer qua partner’: at [59]. 14.42 As a result of these decisions, it is not entirely clear that payments made representing a share in unbilled services that involve work in progress, prepayments or other unbilled payments are on revenue account and assessable as ordinary income. It is equally unclear whether such payments amount to an interest in the net income of the partnership and to the recipient. Payments to acquire assets which include unbilled services are on capital account and fail under the general deduction provision. In itself, this conclusion is not remarkable. As Heerey J observed in Coughlan v FCT (1991) 22 ATR 109 at 114, ‘it is trite law’ that capital outgoings may represent income to the recipient. Nonetheless, the combined effect of the decisions discussed in 14.35–14.43 is double taxation. This is because the retiring partner is taxed on the whole of the receipt on retirement for the value of work in progress and the continuing partners are taxed on the whole of the receipt via the Div 5 mechanism when the work in progress matures into a recoverable debt. If one accepts the conclusion of the Federal Court in McNally, a payment to a retiring (or outgoing) partner for work in progress, prepayments and other payments would not be included as assessable income for the outgoing partner. Instead, those payments will be assessable as partnership income in the year that the income is billed and/or received by the partnership. It is submitted that the conclusion reached by the Federal Court in McNally makes sense because it avoids the problem of double taxation for the same

payments: once for an outgoing partner who would be assessed on any moneys received from the partnership which relates to work in progress or prepayments; and again at the partnership level when the work in progress is completed and billed.

1.

2.

What would the result be when payments were made to retiring partners in respect of professional work in progress if professional work in progress was regarded as forming part of trading stock? Would the decision in Coughlan v FCT (1991) 22 ATR 109 have been any different if the payment to the retiring partners had been made pursuant to a non-dissolution clause in the [page 996]

3.

4.

5.

partnership agreement? Compare the decision in Rutherford v IRC (1926) 10 TC 683. Should it make any difference if the payment to the retiring partner represents the product of an attempt to estimate the value of the work in progress or is it merely an ex gratia payment to facilitate the retirement? Read the speech of Lord Sands in Rutherford on this issue. Does the decision in Crommelin v FCT (1998) 39 ATR 377 mean that, so long as a partnership has work in progress as at the date of a partner’s retirement, any payment made to the partner for his or her interest in the partnership will be income to the extent that it can be identified as being paid in respect of the value of work in progress to the date of retirement? Is the decision in Crommelin consistent with the statements by Owen J in Single v FCT (1964) 110 CLR 177, referred to in 14.35? Is the decision in Crommelin consistent with the statements by Kitto J in Single v FCT (1964) 110 CLR 177, referred to in 14.35? Do you agree with the decision of the Federal Court in McNally v FCT (2007) 65 ATR 738; [2007] FCA 51 that payments relating to work in progress, prepayments and other payments for unbilled work should not be assessable in the hands of the outgoing partner? How do you reconcile the earlier decisions of the Federal Court in Crommelin with the decision of the court in McNally? Which approach do you think is correct and why?

14.43

As a result of the anomalies discussed in 14.42, ITAA97 s 25-

95 was introduced. Under s 25-95(1), an entity can deduct a ‘work in progress amount’ paid in an income year to the extent that, as at the end of the income year, either: (a) a recoverable debt has arisen in respect of the completion or partial completion of the work to which the amount related; or (b) you reasonably expect a recoverable debt to arise in respect of the completion or partial completion of that work within the period of 12 months after the amount was paid.

A ‘work in progress amount’ is defined in s 25-95(3) as an amount that an entity agrees to pay to another entity (the recipient) where the amount can be identified as being in respect of work partially performed by the recipient for a third party but not completed to a stage where a recoverable debt has arisen in respect of the work. A payment in [page 997] respect of partially incomplete goods is not a work in progress amount. Such payments are dealt with under the trading stock provisions. The language of s 25-95 is clearly apt in the circumstances in Coughlan v FCT (1991) 22 ATR 109, namely where the old partnership has been dissolved and a payment for work in progress is made by the new partnership. The language of s 25-95 is less obviously apt in the situation where the change in composition does not dissolve the partnership and the payment is made outside the accounts to the retiring partner or to the estate of a deceased partner. In the latter situation, it may be questioned whether the payment can properly be described as being in respect of work that has been partially performed by the recipient (the retiring partner as was the case in McNally v FCT (2007) 65 ATR 738; [2007] FCA 51). It would be more accurate in these circumstances to describe the payment as being in respect of the retiring partner’s interest in work that has been partially performed by

the various partners in the firm. Where the payment is made by the continuing partners outside the partnership accounts, the issue also arises of whether the payment is made by the partners in their capacity as partners or not. In the latter case, it is arguable that the individual partners should be allowed the deduction and that it should not be taken into account in the partnership’s ITAA36 s 90 calculation.

Statutory provisions applicable on a change in composition Capital allowance balancing adjustment relief on a change in composition of a partnership 14.44 Item 7 in the table in ITAA97 s 40-40 indicates that, for Div 40 purposes, a depreciating asset that is a partnership asset is regarded as being held by the partnership and not by the individual partners. The effect of this rule is that Div 40 capital allowances are accounted for at the partnership level as part of the partnership’s ITAA36 s 90 calculation. 14.45 When a change in the composition of a partnership occurs, the interests of the partners in the partnership asset change. ITAA97 s 40295(2) has the effect of deeming a balancing adjustment to occur when a partner’s personal property that is a depreciating asset becomes partnership property. Section 40-295(2) also deems a balancing adjustment event to occur where, typically because of a change in composition, the interests of partners in a partnership asset change. Under item 5 in the table in s 40-300, the termination value of the depreciating asset when a s 40-295(2) balancing adjustment event occurs is the market value of the asset at that time. Note also that, as stated in item 6 in the table in s 40-180, the cost of the depreciating asset to the partnership, where it continues to own the asset after the change in interests, is the market value of the asset when the partnership started to hold it or when the change referred to in s 40-295(2) occurred. The same cost rule applies where a partner’s personal

property becomes partnership property that is a depreciating asset. Note that there will not necessarily be a taking of accounts and a derivation at the time of the change in composition. Whether or not there will be a taking of accounts will depend on the factors discussed at 14.25–14.26 and 14.30. The most obviously relevant [page 998] factor will be whether the partnership agreement contains a provision to the effect that change in the composition of the partnership will not dissolve the partnership. 14.46 Where a s 40-295(2) balancing adjustment event takes place in relation to a partnership asset, and the entity or entities that had an interest in the asset before the change in interests in the asset, and the entity or entities that have an interest in the asset after the change jointly elect, then a roll-over is available under s 40-340(3). Remember that item 7 in the table in s 40-40 will mean that, for Div 40 purposes, a depreciating asset that is a partnership asset will be regarded as being held by the partnership and not by the individual partners. Where s 40295(2) would otherwise be triggered in relation to a depreciating asset by a change in the composition of a partnership, the entities that had interests in the asset before the change will be the partners in the original partnership. In this situation, the other parties to the joint election are ‘the entities that have an interest in the asset after the change’. 14.47 The effect of the s 40-340(3) roll-over is that neither balancing inclusions nor balancing deductions will take place at the time of the s 40-295(2) balancing adjustment event. Under s 40-345(2), the transferee can deduct8 the decline in value of the depreciating asset using the same method and effective life that the transferor had been utilising.9 Item 5 in the table in s 40-180 will mean that the cost of the depreciating asset to the new partnership is the adjusted value of the asset to the old partnership at the time of the change. Note that, even

though the s 40-340(3) roll-over effectively puts the transferee partners/partnership in the same position as the transferor partnership, choosing the roll-over does not necessarily prevent partnership accounts from being taken and a consequent derivation by the transferor partners. Again, whether or not there will be taking of partnership accounts will depend on the factors discussed at 14.25–14.26 and 14.30. The operation of the ss 40-295(2) and 40-340(3) roll-over is illustrated in Example 14.3.

Abbott and Costello are partners as comedians. Bean is admitted as a new partner on 1 July Y1. The assets of the partnership include a joke machine that cost $15,000 and currently has an adjustable value of $10,000. Under the admission agreement, the joke machine is transferred at its market value, namely $12,000. For ITAA97 Div 40 purposes, the Abbott and Costello partnership is treated as disposing of the joke machine to the Abbott, Costello and [page 999] Bean partnership. Section 40-285 will include $2000 in calculating the net income of the partnership or partnership loss for the partnership consisting of Abbott and Costello. If Abbott, Costello and Bean jointly elect, no balancing adjustment will be made and the new partnership of Abbott, Costello and Bean will take over the joke machine at the adjusted value that it had to the old partnership. Thus, one effect of the operation of the s 40-340(3) roll-over here would be that the old Abbott and Costello partnership is better off by not having a balancing adjustment included in its ITAA36 Div 5 of Pt III calculation. By contrast, the new partnership of Abbott, Costello and Bean is worse off because it will not receive capital allowance deductions on the $2000 excess of the cost above the adjustable value of the joke machine.

Trading stock provisions applicable on a change in composition 14.48

Trading stock is accounted for at the partnership level as part

of the partnership’s ITAA36 s 90 calculation. As discussed at 11.28, where there is a change in the ownership interests in trading stock, ITAA97 s 70-100, in effect, deems there to be a disposal of the stock at market value. A change in the composition of a partnership is given in s 70-100 as a specific example of a situation where there is a relevant change in ownership interests. Thus, where the deemed disposal applies, the net effect of it and the opening and closing stock adjustments is to recognise the difference between the item’s cost and its market value at the time of the change in composition in the transferee partnership’s ITAA36 s 90 calculation. However, where there is a 25% or more continuity between the transferor and transferee partners, they can elect under ITAA97 s 70-100(4) for the transfer to be at the closing stock value of the item to the transferor partnership at the end of the previous year. This election is not available if the item was valued at market value at the end of the previous year. If the election is made, taxation of any difference between the cost and market value of the item would normally be deferred until the item is sold to a third party. Note that, as was the case with the capital allowance provisions, whether or not the election is made does not determine whether or not partnership accounts are taken at that time. Again, whether or not there will be a taking of partnership accounts will depend on the factors discussed at 14.25–14.26 and at 14.30–14.34.

Anomalies arising on changes in composition 14.49 The combined operation of the statutory provisions relating to depreciated plant and trading stock that apply on changes in a partnership, and the rule that partners only derive income when partnership accounts are, or should be, taken, can produce anomalous results in some circumstances. Consider Example 14.4. [page 1000]

Anne, Bob and Martin are in partnership together. The partnership assets are trading stock, which cost $18,000 and has a current market value of $36,000, and a depreciating asset, which cost $90,000 and has a written-down value of $70,000 and a current market value of $55,000. The partnership agreement contains a provision to the effect that the retirement of a partner will not dissolve the partnership. Bob retires from the partnership. If the partners do not elect for a ITAA97 s 40-340(3) rollover to apply in relation to the depreciating asset, the result will be that a balancing adjustment of $15,000 will be deductible in calculating the net income/partnership loss of the partnership when its accounts are taken. If the partners do not make the election under s 70-100(4) in relation to the trading stock, then s 70-90 will include the market value ($36,000) of the trading stock in the partnership’s ITAA36 s 90 calculation when its accounts are taken. The net income that will ultimately arise from the deemed disposal of the trading stock will be $36,000 less the cost of the stock $18,000 = $18,000. Thus, when the partnership accounts are taken, the partnership will have a net income calculated as follows:

‘Net income’ from deemed disposal of trading stock Less

$18,000

Balancing deduction on plant

$15,000

Net income

$3000

However, because the partnership agreement contained a non-dissolution clause, accounts are not taken at the time of Bob’s retirement but would normally be taken at the end of the partnership’s normal accounting period. At that time, only Anne and Martin will be partners and they will each derive $1500 of net income from the partnership. Assume that Anne and Martin make a payment to Bob outside the accounts of $6000 (being 1/3 of the unrealised profit component in the trading stock) and $18,333 (being 1/3 of the market value of the plant), making a total of $24,333. The assessability of this receipt to Bob may depend on considerations analogous to those discussed at 14.35–14.43. The judgment of Owen J in Single v FCT (1964) 110 CLR 177 (discussed in 14.35) would suggest that the receipt would be wholly capital to Bob. The judgment of Kitto J in Single’s case (see 14.35) and the cases on professional work in progress (14.35–14.43) might suggest that, at least, the $6000 profit on the trading stock component in the receipt would be assessable to Bob. Note that, in this situation, if Bob is not taxed at all, Anne and Martin will bear all the tax on the unrealised profit component in the trading

[page 1001] stock. This will be so even though Bob receives $6000 representing his share of the unrealised profit component in the trading stock. If Bob is taxed on the $6000 then, although Anne and Martin enjoy the entire depreciation balancing deduction of $15,000, they will each still wind up paying tax of $1500 each in relation to the unrealised profit on the trading stock. This is so despite the fact that they paid Bob $6000 for his share of the unrealised profit in the trading stock. Hence, if Bob is taxed on the $6000 there will be an element of double taxation if Anne and Martin are each taxed on the whole of the $1500.

Now consider the following problems, which highlight further difficulties in this area.

1.

What would the position be in Example 14.4 if the parties had made the ITAA97 s 70-100(4) election and elected that s 40-340(3) roll-over apply to the depreciating asset? 2. What would the position be in Example 14.4 if the partnership agreement had not contained a non-dissolution clause and the parties did not make a ITAA97 s 70100(4) election and did not elect that a s 40-340(3) roll-over apply to the depreciated property? 3. What would the position be in Example 14.4 if the partnership agreement had not contained a non-dissolution clause and the parties made the ITAA97 s 70-100(4) election and elected that s 40-340(3) roll-over apply to the depreciated property? Suggested solutions to this problem are contained in Study help.

Note that the Commissioner’s practice, discussed at 14.34, appears to resolve the anomalies shown in Example 14.4; it appears to be inconsistent with the case law discussed at 14.30–14.34.

The assignment of partnership interests 14.50

Prior to the introduction of capital gains tax (CGT), the

assignment by high marginal tax rate partners of fractions of their interest in the partnership to lower marginal rate relatives was an effective income-splitting strategy. The strategy was tax effective because High Court cases held that, following an assignment of an interest in a partnership, the low marginal rate assignee (rather than the high [page 1002] marginal rate assignor partner) would derive the income attributable to the fraction of the interest assigned. This paragraph explains what an assignment of an interest in a partnership involves from a general law perspective. The tax consequences (other than CGT consequences) of an assignment of an interest in a partnership are then examined in 14.52–14.53. The CGT effects of an assignment of part of an interest in a partnership are discussed in 14.85. We have noted that partners in a partnership have mutual rights and obligations. Some of a partner’s rights include a right to share in the partnership profits, a right to participate in management of the partnership, a right to a share of the net assets of the partnership on dissolution, and a right to indemnity from other partners in respect of certain personal liabilities. Likewise, partners owe obligations to their partners. These include obligations to act in good faith and to indemnify their partners against certain personal liabilities. The bundle of rights and obligations that a partner owes to his or her partners when taken together amounts to a chose in action. As a chose in action, the whole of a partner’s interest in a partnership can be assigned (or transferred) either in equity or by statute to another person. The better view is that part of a partner’s interest in a partnership can only be assigned in equity. In FCT v Everett (1980) 143 CLR 440, the High Court noted that an assignment of an interest in a partnership does not make the assignee a partner unless the other partners consent to the admission of the assignee to the partnership. This means that the assignee does not have a right to participate in management decisions of

the partnership and is not liable for the obligations of the partnership and is not obliged to indemnify his or her partners. Rather, the effect of an assignment of an interest in a partnership is that the assignor partner is regarded as holding his or her interest in the partnership on trust for the assignee. 14.51 The discussion in 14.50 of the general law effects of an assignment of an interest in a partnership gives rise to the question of who derives a partner’s share of the net income of a partnership after the partner’s interest in the partnership has been wholly or partially assigned. Is the income derived by the assignor partner or by the assignee? These questions were the subject of the High Court decision in FCT v Everett (1980) 143 CLR 440.

FCT v Everett Facts: The taxpayer was a partner in a firm of solicitors. On 7 January 1969, he assigned to his wife (who was also a qualified solicitor but not a partner in the partnership) sixthirteenths of his share in the partnership together with all rights, including the right to receive an appropriate share of the profits of the partner to which an assignee of a share in a partnership is entitled by virtue of s 31 of the Partnership Act 1892 (NSW). [page 1003] Issues: Was the share of net income of the partnership for the year ending 30 June 1973 that, in accordance with the assignment, was paid to or applied for the benefit of the taxpayer’s wife derived by the taxpayer? Held: Their Honours Barwick CJ, and Stephen, Mason and Wilson JJ discussed the nature of a partner’s interest in a partnership and how it may be assigned, and then continued (at CLR 450–1): It is, of course, well established that an equitable assignment of, or a contract to assign, future property or a mere expectancy for valuable consideration will operate to transfer the beneficial interest to the purchaser immediately upon the property being acquired, but not before: Holroyd v Marshall (1862) 10 HLC 191 at 211; 11 ER 999; Tailby v Official Receiver (1888) 13 App Cas 523; Re Lind; Industrials Finance Syndicate Ltd v Lind [1915] 2 Ch 345; Norman, at 109 CLR 24; 9 AITR 99.

On the other hand, an equitable assignment of, or a contract to assign, present property for value takes effect immediately and passes the beneficial interest to the assignee. The distinction between present property and future property or mere expectancy gives rise to some borderline cases. For present purposes the point to be made is that an equitable assignment of present property for value, carrying with it a right to income generated in the future, takes effect at once whereas a like assignment of mere future income, dissociated from the proprietary interest with which it is ordinarily associated, takes effect when the entitlement to that income crystallises or when it is received, and not before. Their Honours discussed Norman v FCT (1963) 109 CLR 9 and Kelly v IRC (NZ) (1969) 1 ATR 380, and then continued (at CLR 451–2): Here, the deed dated 7 January 1969 expressly assigned six-thirteenths of the respondent’s interest in the partnership “together with all those rights including the right to receive an appropriate share of the profits of the partner to which an assignee of a share in a partnership is entitled by virtue of s 31 of the Partnership Act”. The parties misconceived the effect of s 31, thinking that it applied to the assignment of portion of a partner’s interest. However, the deed should be given the same effect it would have had if it had made no mention of future profits — the assignment of portion of the respondent’s share would have carried the right to future income referable to the portion. This is certainly what the parties intended. [page 1004] The consequence in the present case is that because the respondent assigned present property, a chose in action, being a share of his interest in the partnership which carried with it the right to a proportionate share of future income attributable to his interest, the assignment became effective at once and conferred on his wife an immediate equitable entitlement as against the respondent and the other partners to such income referable to the share assigned as might subsequently be derived. This case is to be distinguished from Kelly and other cases in which there have been assignments of future income dissociated from the property or proprietary right to which that income is attributable. Their Honours then discussed whether the income paid to the assignee was ‘net income of the trust estate’ for purposes of ITAA36 s 95 and concluded that it was. Their Honours then referred to an argument that a purported assignment of partnership income would not be effective for tax purposes on the basis that this was income from personal exertion. Their Honours then responded to this argument (at CLR 454): The respondent’s entitlement under the partnership agreement was to a proportionate share of the partnership profits as disclosed by the partnership accounts. The relevant proportion of the partnership profits was payable to the respondent because he was a partner and the owner of a share in the partnership. The respondent was entitled before the assignment to his proportionate share of

the partnership profits, however much or however little energy he devoted to the practice, so long as the partnership remained on foot. Accordingly, it is a misnomer to speak of the respondent’s share of the income as having been gained by his personal exertion. Even if it were accurate to so describe it, we cannot think that this in itself would constitute a reason for saying that an assignment of a share in the respondent’s interest carrying with it the right to a proportionate part of the partnership profits would not be immediately effective to vest the right to future income in his wife for tax purposes. Murphy J dissented.

14.52 Note that FCT v Everett (1980) 143 CLR 440 concerned the question of whether the assignor partner derived income attributable to the assigned portion of his interest in the partnership that accrued to the partnership after the date of assignment. You will recall, however, from 14.24 that in FCT v Galland (1987) [page 1005] 162 CLR 408, the High Court considered whether the assignor partner derived the partnership income attributable to the assigned portion that accrued from the commencement of the tax year up to the date of the assignment. There, the High Court pointed out that the interest in the partnership carried with it the income attributable to that share, and that there was no derivation of partnership income until the partnership accounts were taken. Thus, the income attributable to the assigned share for the whole of the year of income was derived by the assignee and not by the assignor partner.

1. 2.

Why, in the view of the majority in FCT v Everett (1980) 143 CLR 440, was there no derivation by the assignor partner of the income for the year ending 30 June 1973? Through what mechanism would the assignee in Everett have derived her share of the partnership income for the year ending 30 June 1973?

3.

4. 5.

For what reasons did the majority in Everett conclude that a share of the net income of a partnership was not ‘income from personal exertion’? Do you agree with their reasons? In what respects, if any, did the terms of the assignment in FCT v Galland (1987) 162 CLR 408 differ from the terms of the assignment in Everett? What would have been the position in Everett if the case had concerned the issue of whether there was a derivation of income attributable to the assigned share for the period from 1 July 1969 to the date of the assignment?

14.53 As a partner’s interest in a partnership is a chose in action, it will be a CGT asset. The CGT consequences of an assignment of a partner’s interest in a partnership are discussed in 14.85.

Anti-avoidance provisions relevant to partnerships 14.54 ITAA36 s 94 is an anti-avoidance provision directed specifically at partnerships. It tries to prevent income splitting through partnerships by the use of nominal partners who do not have real and effective control and disposal of their share (or of part of that share) of the net income of the partnership. Where s 94 applies, the partner who does not have real and effective control and disposal of his or her share of the net income of the partnership pays additional tax on uncontrolled income. In calculating the uncontrolled income subject to the additional tax, business [page 1006] deductions exclusively related to that income are deducted as is the appropriate portion of other business deductions not exclusively related to that income. The rate of additional tax will usually be 47% reduced by the taxpayer’s average rate of ordinary tax.10 Special treatment, in accordance with ITAA36 s 94(10B), is given to primary producers who are subject to the income averaging system.

14.55 The key issue in the application of ITAA36 s 94 is whether or not the partner has ‘real and effective control and disposal’ of his or her share of the net income of the partnership. This question was considered in the High Court decision in Robert Coldstream Partnership v FCT (1943) 68 CLR 391.

Robert Coldstream Partnership v FCT Facts: A business was carried on in partnership by Robert Coldstream, his wife and his two daughters. The partnership deed vested sole management and control of the partnership in Robert Coldstream. The profits and losses of the partnership were to be shared equally between the partners. Robert Coldstream was permitted by the deed to withdraw his share of profits at any time. However, the deed required that 70% of the other partners’ shares of profits be credited to their capital accounts and only to be withdrawn with the consent of all other partners. The remaining 30% of these partners’ shares of profits was to be credited to their drawing accounts. The deed further provided, however, that these partners were prohibited from withdrawing from their drawing accounts without the agreement of Robert Coldstream. Robert Coldstream was given power under the deed to dispose of all the partnership assets but was required to hold the proceeds of any such disposal on certain trusts. Issues: Did the wife and the two daughters have real and effective control and disposal of their shares of the net income of the partnership or did Robert Coldstream have real and effective control and disposal of their shares? ITAA36 s 94, as it then stood, did not expressly refer to ‘part of a share’ and empowered the Commissioner to assess the partner on an additional amount of tax that would have been payable if the income had been received by either: (a) the partner who had real and effective control of that share; or (b) had been divided between partners who had real and effective control of that share in proportion to their real and effective control. Held: His Honour Latham CJ observed that s 94, as it then stood, required that the presence or absence of real and effective control of [page 1007] the share had to be in relation to the whole as distinct from a part of the partner’s share in the net income of the partnership. His Honour then continued (at CLR 394): Further, I am of the opinion that the section also deals with the whole control in both its positive and its negative conditions — the whole control as distinct from the whole share. When it is inquired whether a partner has not the real and

effective control and disposal, if the answer is that he has some control and disposal but not all, it could not be held, in my opinion, that he had real and effective control and disposal. In the same way, referring to the provision in para (a) of the section, it could not be held that another partner had real and effective control of the share until he had the whole control of that share. The phrase is “the real and effective control” and not “a real and effective control” or “some real and effective control”. Further, in my opinion the section relates to the control and disposal of a share only in the net income of the partnership, and therefore relates to the partnership as a going concern. I do not think that the section has any reference to powers of control or disposal of partnership assets upon a dissolution of a partnership. Argument has been addressed to the court upon a possible distinction between “control” and “disposal” … These words cannot, in my opinion, be regarded as mutually exclusive. A power of disposal certainly appears to me to involve a right of control, and control over a share of income would ordinarily be exercised by disposal. But in the view which I take of this case it is not necessary for me to decide whether there can be control with no power of disposal. I observe that a share of income may be so disposed of in accordance with the partnership agreement or by action of a partner that it is no longer to be regarded as a share of income. It may change its character. Latham CJ went on to find that: (i) the other partners did not have real and effective control and disposal of their shares of the net income of the partnership; but (ii) Robert Coldstream did not have real and effective control of those shares either. Hence, under s 94 as it then stood the other partners could not be assessed on the income as if it had been derived by the partner who had the real and effective control and disposal. Robert Coldstream did not have the real and effective control and disposal over the other partners’ shares as he did not have the whole control over the whole of those shares. [page 1008] He did not have complete control over the other partners’ drawing accounts but only a power to prevent them making withdrawals from those accounts. He did not have complete control over their capital accounts as the agreement of all partners was required before moneys could be withdrawn from those accounts.

What do you think the result would be if the facts in Robert Coldstream Partnership v FCT occurred again today? Hint: Consider how s 94 in its present form differs from the form that it took in 1943.

Anne is a consulting engineer with an income of $200,000 from professional fees. She complains to you about the high marginal rate of tax which she has to pay. She asks whether she could legitimately minimise her tax by taking her sons Sam (aged 19), Stuart (aged 15) and Norman (aged 12) into partnership with her. Anne is also concerned, however, that her sons would be likely to spend any partnership income they received on riotous living. She asks you whether it would be possible to draw the partnership agreement so as to limit her sons’ ability to withdraw their shares of partnership income. Examine the possible operation of ITAA36 s 94 in relation to this proposed partnership. A suggested solution can be found in Study help.

Partnerships and dividend imputation The 2004 amendments 14.56 The dividend imputation system was discussed in Chapter 12 (from the company’s perspective) and Chapter 13 (from the shareholder’s perspective). We shall now explain how the dividend imputation system works when a partnership is a shareholder in a company that pays franked dividends. In 2004, the Commonwealth [page 1009] Parliament enacted the Tax Laws Amendment (2004 Measures No 2) Act 2004 (Cth) (the 2004 Amendment Act). The 2004 Amendment Act modified the operation of ITAA97 Div 207 as it applied to franked distributions received through certain partnerships or to a trustee of a trust that was not a corporate tax entity or a complying superannuation fund. The changes brought about in the 2004 Amendment Act were intended to overcome technical defects in the previous Div 207 as it

dealt with franked distributions made indirectly through trusts or partnerships following the introduction of new concepts of ‘nonassessable non-exempt income’ brought in by the Taxation Laws Amendment Act (No 4) 2003 (Cth).

Franking credits and partnership income 14.57 ITAA97 s 207-35(1) includes the ‘franking credit on the distribution’ in the ‘assessable income of a partnership or trust’ where a ‘franked distribution’ is made to a partnership or to the trustee of a trust (that is not a corporate tax entity or a complying superannuation fund). Although, technically, neither a partnership nor a trust has an ‘assessable income’, it is clear that s 207-35(1) is intended to interact with ITAA36 Pt III Divs 5 and 6. Section 207-35(2) itself states that the s 207-35(1) inclusion is in addition to any other amount included in the assessable income of the partnership or trust in relation to the distribution. The other so-called inclusion in assessable income would be through the combined operation of ITAA36 s 90 or s 95 (as the case may be) and s 44(1).

Franked distributions flow indirectly to an entity 14.58 A central feature of the 2004 amendments was to overcome the deficiency in the previous ITAA97 Div 207 when the concepts of ‘non-assessable non-exempt’ income were introduced by the Taxation Laws Amendment Act (No 4) 2003 (Cth). Section 207-35 now allows a franked distribution to flow indirectly to an entity where the distribution, or part of the distribution, represents exempt income or, alternatively, non-assessable non-exempt income in the hands of the recipient entity. According to the Explanatory Memorandum (EM) accompanying the Tax Laws Amendment (2004 Measures No 2) Bill 2004 (Cth), s 207-35 intended that a franked distribution that flows indirectly to a partner of a partnership or beneficiary under a trust would occur where the distribution is made to a partnership or trustee of a trust or flows indirectly to the partnership or to the trustee or

beneficiary of the trust as a partner or beneficiary, and one of the following conditions is satisfied: the partner has an individual interest in the partnership’s net income or is allowed a deduction for a partnership loss under ITAA36 s 92(1) and (2); the beneficiary has a share of the trust’s net income under ITAA36 s 97(1)(a) or an individual interest in the trust’s net income; the trustee is liable to be assessed on a share of the trust’s net income in respect of a beneficiary under ITAA36 s 98 or assessed on all or part of the trust’s net income for that year; or the entity’s share of the franked distribution, calculated under ITAA97 s 207-55 is a positive amount. [page 1010]

Tax offset and franked distributions 14.59 The 2004 amendments introduced ITAA97 s 207-45, which allows a tax offset for a recipient of a franked distribution. Under s 207-45, an entity is an individual, a corporate tax entity, a trustee assessed under ITAA36 s 98, s 99 or s 99A, or a trustee of an eligible entity.

A partnership receives a franked distribution of $70,000 with a $30,000 franking credit. The partnership has three partners. The partnership has made a profit of $50,000 from its operating activities and, therefore, has an overall net income of $150,000. Each individual partner receives $50,000. Under ITAA97 s 207-55, each individual partner is entitled to a franking credit of $10,000 on the basis that the franked distribution flowed indirectly to the partners as the franked distribution was first taken into account in determining the partnership’s net income.

The entity’s share of a franked distribution 14.60 Under ITAA97 s 207-55, an entity’s share of a franked distribution is deemed to be a notional share because neither the entity, nor the beneficiary, may actually receive the franking credit. The typical situation arises when the partnership or trust entity makes a loss and at the same time receives a franked distribution which is less than the entity’s deductions. As explained in 14.59 above, under s 207-45, the ultimate beneficiary (partner in a partnership or beneficiary in a trust) is entitled to a tax offset which is equal to the entity’s ‘share of the franking credit on the distribution’. See Example 14.6 below.

A partnership receives a franked distribution of $70,000 with a $30,000 franking credit. The partnership has three partners. The partnership has deductions amounting to $145,000 from its operating activities. The net loss of the partnership is $45,000. The partnership’s losses are distributed to each partner ($15,000). Under s 207-55, each individual partner is entitled to a franking credit of $10,000, notwithstanding that the partners will not receive the actual amount of the franked distribution because the partnership’s deductions exceed the amount of the franked distribution. Under s 207-45, each partner is entitled to a tax offset of $10,000 which is equal to the entity’s share of the franking credit on the distribution.

[page 1011]

Denial of tax offset deductions 14.61 ITAA97 s 207-95(1) denies partners, beneficiaries and trustees tax offsets on franked distributions that flow indirectly to them where their share of the distribution (whether or not they actually receive it) would either be exempt income or non-assessable non-exempt income to them. The provision also denies tax offsets to other entities where the

franked distribution flows through the recipient partner/trustee entity to another entity. Section 207-95(2)–(4) allows the entity a deduction where the whole of the franked distribution would have been exempt income or nonassessable non-exempt income to the recipient entity. Section 207-95(2) deals with the situation where the recipient entity is a partner. Section 207-95(2) provides that, where a franked distribution flows indirectly to a partner under s 207-50(2), the partner can deduct an amount equal to its share of the franking credit on the distribution. Deductions are allowed for beneficiaries under s 207-95(3). Section 207-95(4) provides for a similar deduction where a franked distribution flows indirectly to a trustee. Section 207-95(5) uses a formula to apply subss (2), (3) and (4) as appropriate where part of the distribution would in the hands of the entity be exempt income, or non-assessable non-exempt income. Section 207-95(6) provides that, where the distribution would otherwise flow indirectly through the entity, its share of the distribution (other than for s 207-95(2), (3) or (4)) is reduced by the relevant part mentioned in s 207-95(5). In this situation, the entity will be entitled to a tax offset on the non-exempt part of the distribution in accordance with the formula set out in s 207-95(6). Subdivision 207-E provides exceptions in relation to the denial of tax offsets in Subdiv 207-D (which includes s 207-95). The exceptions apply to certain tax-exempt institutions, trusts and life insurance companies.

CGT and partnerships Background under ITAA36 14.62 The capital gains tax (CGT) provisions in ITAA36, as originally enacted, did not contain any provisions that specifically dealt with the question of how CGT should apply to partnerships. In the application of CGT to partnerships, it is necessary to distinguish between several distinct, if related, issues:

What are the CGT consequences if a partnership CGT asset is disposed of to a third party? 2. What are the CGT consequences of a change in the composition of a partnership? 3. What are the CGT consequences of an assignment of an interest in a partnership? 4. What are the CGT consequences of a dissolution of a partnership? In the case of all but the first issue, it has always been clear that capital gains and losses arising from relevant CGT events were to be accounted for at the partner level. Commentators were originally divided on the first issue. One view, known as the ‘partnership entity’ approach, was that net capital gains should be taken into account 1.

[page 1012] via the ITAA36 Pt III Div 5 mechanism in calculating the net income of the partnership or the partnership loss. The other view, known as the ‘partner interest’ approach, was that, for CGT purposes, disposals of partnership assets were accounted for at the individual partner level. 14.63 Commentators were also somewhat divided over what the CGT consequences of a change in the composition of a partnership were. One view was that, in the absence of a specific provision in the partnership agreement varying the general law, each time there was a change in the composition of a partnership, the old partnership was dissolved and a new partnership was formed. This meant that there was a disposal of all the partnership assets by the old partners as collective owners to themselves as individuals according to their proportionate entitlements. It was argued that each of these disposals would have CGT consequences. An alternative view was that on a change in the composition of a partnership there were only acquisitions and disposals in relation to the proportion of the partnership assets that related to the interest in the partnership being acquired by a new partner or being disposed of by a deceased or retiring partner. While there were

compliance difficulties associated with both approaches, most commentators favoured the latter approach on the grounds of simplicity. 14.64 The Commissioner issued Taxation Ruling IT 2540 on 22 June 1989. In relation to disposals of partnership assets to third parties, IT 2540 adopted the partner interest approach. In relation to changes in the composition of a partnership, IT 2540 took the view that there were only acquisitions and disposals in relation to the proportion of the partnership assets that related to the interest in the partnership being acquired by a new partner or being disposed of by a deceased or retiring partner. 14.65 By adopting the partner interest approach, IT 2540 produced problems of potential double taxation and double deduction/capital losses. This was because the CGT consequences of a disposal of a partnership asset were accounted for at the individual partner level while other tax consequences (for example, in relation to depreciation) were accounted for at the partnership level. The reconciling mechanisms in ITAA36, ss 160ZA(4) and 160ZK, did not appear to be able to eliminate double taxation and double deductions/capital losses in these circumstances. This was because ss 160ZA(4) and 160ZK were aimed at eliminating double taxation and double deduction/capital losses arising under CGT and under another part of the ITAA36 for the same taxpayer. The reconciliation that appeared to be necessary when capital gains and losses were derived and incurred by partners was between the partner, as the person accounting for the capital gains and losses, and the partnership as the tax accounting entity recognising the inclusions in income and the deductions under other parts of the ITAA36.

The 1991 amendments 14.66 In 1991, several amendments relevant to CGT and partnerships were made to the CGT provisions in the ITAA36. These amendments gave express recognition to the partner interest approach (ITAA36 ss 160C(3) and 160A(d), (e)) and removed language that was inconsistent with the partner interest approach. They also attempted to prevent problems of double taxation and double deduction/capital loss

[page 1013] on disposals of partnership assets to third parties (ITAA36 ss 160ZA(5), (6) and 160ZK(3)), and attempted to prevent the same gain from being taxed twice when funds from a disposal of a partnership asset were retained in the partnership and a partner subsequently disposed of his or her interest in the partnership (s 160A(e)). 14.67 Some commentators argued that the 1991 amendments did not do all that was necessary to ensure that the partner interest approach applied when a partnership asset was disposed of to a third party. These commentators took the view that although s 160A(d) deemed the interest that each partner had in each partnership asset to be a CGT asset, it did not: deem the interest to be proportionate to each partner’s capital entitlement; or deem the disposal of a partnership asset to be a disposal of the s 160A(d) interest of each partner in each partnership asset.11 These criticisms also were relevant to ss 160ZK(3) and 160ZA(5) and (6).12 14.68 ITAA36 s 160ZA(5) and (6) were criticised as being technically deficient in that s 160ZA used the end products of the Pt III Div 5 calculation, rather than the constituent elements of that calculation, as the mechanism for reconciling the CGT provisions with inclusions in income under another part of the ITAA36. It was argued that this meant that proper reconciliation did not occur where the ITAA36 s 90 calculation produced either a partnership loss or a partnership net income of zero, or where the net income of the partnership was less than the amount included under another part of the ITAA36 in calculating that net income.13 14.69 Criticisms were also levelled at the insertion of s 160A(e), which was an attempt to ensure that double taxation did not occur when funds from the disposal of a partnership asset were retained in the partnership and the partner subsequently disposed of his or her interest

in the partnership. Commentators pointed to difficulties involved in valuing the s 160A(e) interest separately from the s 160A(d) interest and in apportioning consideration between the s 160A(d) and (e) interests. Potential problems in the operation of s 160A(e) in the context of disposals of professional work in progress were also noted. Commentators also questioned whether s 160A(e) would successfully prevent double taxation from arising on the disposal of an interest in a partnership.14 [page 1014]

ITAA97 provisions dealing with CGT and partnerships The application of CGT to partnerships under the ITAA97 14.70 ITAA97 s 106-5(1) and (2) and the accompanying examples give express statutory recognition to the partner interest approach. Sections 106-5(1) and (2) and the accompanying examples state as follows. 106-5 Partnerships (1) [Capital gain or loss made by partners individually] Any capital gain or capital loss from a CGT event happening in relation to a partnership or one of its CGT assets is made by the partners individually. Each partner’s gain or loss is calculated by reference to the partnership agreement, or partnership law if there is no agreement. Example 1: A partnership creates contractual rights in another entity (CGT event D1). Each partner’s capital gain or loss is calculated by allocating an appropriate share of the capital proceeds from the event and the incidental costs that relate to the event (according to the partnership agreement, or partnership law if there is no agreement). Example 2: Helen and Clare set up a business in partnership. Helen contributes a block of land to the partnership capital. Their partnership agreement recognises that Helen has a 75% interest in the land and Clare 25%. The agreement is silent as to their interests in other assets and profit sharing. When the land is sold, Helen’s capital gain or loss will be determined on the basis of her

75% interest. For other partnership assets, Helen’s gain or loss will be determined on the basis of her 50% interest (under the relevant Partnership Act). (2) [Separate cost base] Each partner has a separate cost base and reduced cost base for the partner’s interest in each CGT asset of the partnership.

Note that s 106-5, in contrast to ITAA36 s 160C(3), explicitly states that any capital gain or loss from a CGT event happening in relation to a partnership is made by the partners individually. Note also that each partner’s gain or loss is calculated by reference to the partnership agreement or, if there is no agreement, by partnership law. What if there is a partnership agreement but it does not expressly deal with the proportionate interests of partners in respect of particular assets? Example 2 above makes it clear that, in these circumstances, partnership law will apply and the parties will be equally entitled to the assets. Under s 106-5(2), each partner will have a [page 1015] separate cost base and reduced cost base in respect of the interest that the partner is regarded as having in each partnership asset. 14.71 Although the partner interest approach may sometimes impose a heavy compliance burden on partners, it does confer major CGT advantages when compared with the current treatment of companies and with the treatment of trusts that was proposed under the unified entity regime. These are: that capital losses can be utilised at the partner level to be offset against non-partnership capital gains made by a partner; and that CGT preferences, such as indexation for inflation and the non-recognition of gains on pre-CGT assets, are also available at the partner level. In the case of companies, capital losses are locked in at the company level and CGT preferences granted at the company level are ‘washed

out’ by the dividend imputation system when tax-preferred income is distributed to shareholders. In the case of trusts, the current position is that capital losses are locked in at the trust level but CGT preferences pass through to beneficiaries although distributions of tax-preferred income write down the cost base of the beneficiary’s interest in the trust.

Partner’s interest divided into two assets for CGT purposes 14.72 As was the case under the 1991 amendments to the CGT provisions relating to partnerships in the ITAA36, a partner’s interest in a partnership is divided into two assets for CGT purposes in ITAA97. Under ITAA97 s 108-5(2)(c), an interest in an asset of a partnership is deemed to be a CGT asset. Section 108-5(2)(d) then deems an interest in a partnership that is not covered by s 108-5(2)(c) to be a CGT asset. The Supplementary Explanatory Memorandum to the Taxation Laws Amendment Bill (No 1) 1991 (Cth), which inserted ITAA36 s 160A(d) and (e) (the ITAA36 equivalents to ITAA97 s 108-5(c) and (d) respectively), stated that s 160A(e) was inserted to prevent a partner being exposed to double taxation on the same gains. The thought was that double taxation would be prevented only by treating a partner’s interest in a partnership as a separate asset to the extent that its value does not relate to a partner’s interests in individual partnership assets which are themselves separate assets for CGT purposes. 14.73 Some commentators argue that s 108-5(2)(d) will only prevent double taxation if a partner’s interest in the proceeds, including Australian currency, of the disposal of partnership assets is itself regarded as a s 108-5(2)(c) asset to the partner.15 The proceeds will have been accounted for at the partner level on the disposal of the partner’s s 108-5(2)(c) asset. Unless the partner’s interest in the proceeds is a s 108-5(2)(c) asset, it will form part of the partner’s s 1085(2)(d) asset. If so, then the value of the partner’s s 108-5(2)(d) asset will have increased when the proceeds of a sale of a partnership asset are retained in the partnership. When this increase in value is realised, the partner will be taxed again on the same gain. The argument is that the practice of not taxing the partner in these circumstances is

consistent with the view that a partner’s interest in the proceeds of the disposal of a partnership asset is itself a s 108-5(2)(c) asset to the partner. [page 1016] 14.74 Note that, under the ITAA36, the fact that certain cars were excluded from the definition of ‘asset’ for CGT purposes meant that a partner’s interest in a car owned by the partnership was not a s 160A(d) asset to the partner but formed part of the partner’s s 160A(e) interest. This meant that, in theory, partners could be subject to CGT on gains on the disposal of their s 160A(e) interest where the gain was attributable to a purchase of partnership cars after the partner joined the partnership. This was so, in theory, even though the cars themselves were CGT-exempt assets. Under the ITAA97, cars are not excluded from the definition of CGT asset but s 118-5(a) states that a capital gain or loss you make from a car, motorcycle or similar vehicle is disregarded. Thus, under the ITAA97, a partner’s interest in a partnership car is one of the partner’s s 108-5(2)(c) assets. This means that the partner’s interest in the partnership car does not form part of the partner’s s 108-5(2)(d) interest in the partnership. This means that no capital gain or loss on a disposal of a partner’s s 108-5(2)(d) interest should be attributable to a purchase of partnership cars after the partner joined the partnership. 14.75 There are several unresolved problems in relation to ITAA97 s 108-5(2)(d). The s 108-5(2)(d) interest has no actual separate existence as a matter of general law. The majority judges in the High Court in FCT v Everett (1980) 143 CLR 440 at 450 said that a partner’s interest in a partnership could not be divided so that the right to participate in profits or the right to share in the surplus on dissolution could be hived off from the rest of it. As the s 108-5(2)(d) asset has no separate existence, apportioning the cost base and capital proceeds between a partner’s s 108-5(2)(c) and (d) assets will be necessary. Difficulties associated with such apportionment have been noted by commentators.

If, as seems likely, the s 108-5(2)(d) interest is limited to a partner’s obligations and certain unassignable rights, such as the right to participate in management, then it may be that little or no cost base or capital proceeds should be apportioned to the s 108-5(2)(d) interest. It is likely to be difficult to value an asset which cannot be separately assigned. 14.76 Despite the difficulties associated with its operation, ITAA97 s 108-5(2)(d) aims to serve an important function — preventing double taxation in situations where the whole or part of a partner’s interest in a partnership is disposed of. Its operation in the context of assignments of a partner’s interest in a partnership and in the context of a dissolution of a partnership will be examined at 14.85–14.86 respectively.

CGT effects of disposals of partnership assets 14.77 As a matter of partnership law, there is a strong argument that a partner does not have an individual interest in each partnership asset proportionate to his or her entitlements under the partnership agreement or under partnership law. The extent of a partner’s interest in partnership assets can only be definitively ascertained when the partnership liabilities are discharged on the dissolution of the partnership and, until then, remains a non-specific interest in the partnership assets generally. Because of the nature of a partner’s interest in a partnership, an argument can also be made that, as a matter of partnership law, a disposal of a partnership asset does not amount to a disposal of each partner’s non-specific interest in the partnership asset. The proceeds of the disposal of a partnership asset will themselves normally be [page 1017] partnership property and each partner’s interest will now simply relate to a different set of partnership assets. 14.78

Note that ITAA97 s 106-5(1) does not in terms deem a partner

to have an individual interest in partnership assets proportionate to his or her entitlement to a share of the net asset of the partnership on dissolution. Nor does it deem the disposal of a partnership asset to be a disposal of any interest that each partner is regarded as having in each asset. However, Example 2 in s 106-5(1), and subsequent examples in s 106-5 extracted below at 14.80, make it clear that the legislative intent is that each partner is to be regarded as having a fractional interest in each partnership asset. It also is reasonably clear that the legislative intent is that the fractional interest of each partner is determined by reference to that partner’s proportionate entitlement to the net assets of the partnership on dissolution as determined by reference to the partnership agreement or by partnership law where the partnership agreement is silent on the point. The examples also make it clear that a disposal of a partnership asset will be regarded as a disposal of the fractional interest that each partner is regarded as having in that asset.

CGT effects of changes in composition of a partnership 14.79 As a matter of general law, as noted at 14.30, a partnership at will can be dissolved by notice or, in the absence of a provision in the partnership agreement to the contrary, by the death or bankruptcy of one of the partners. As noted at 14.30, on a dissolution of a partnership there will normally be a taking of accounts and a derivation of any net income, with the incurring of any partnership loss shown by those accounts. 14.80 The CGT consequences of a change in the composition of a partnership are dealt with in ITAA97 s 106-5(3) and (4). 106-5 Partnerships (3) [Partner leaves] If a partner leaves a partnership, a remaining partner acquires a separate CGT asset to the extent that the remaining partner acquires a share of the departing partner’s interest in a partnership asset. Note: the remaining partners will not be affected if the departing partner sells its interests to an entity that was not a partner. Example: (Indexation is ignored for the purpose of this example.)

John, Wil and Patricia form a partnership (in equal shares). John contributes a building (which is a pre-20 September 1985 asset) having a market value of $200,000. Wil and Patricia contribute $200,000 each in cash. The partnership buys another asset for $400,000. John is taken to have disposed of 2/3 of his interest in the building (1/3 to Wil and 1/3 to Patricia). His remaining 1/3 share in the building remains a pre-CGT asset. The 1/3 shares that Wil and Patricia acquire are post-CGT assets. [page 1018] Wil retires from the partnership when the partnership assets have a market value of $1,200,000 ($500,000 for the building and $700,000 for the other asset). John and Patricia pay Wil $400,000 for his interest in the partnership. Wil has a capital gain of $100,000 on the building and $100,000 on the other asset. John and Patricia each acquire an additional 1/6 interest in the partnership assets. These additional interests are separate assets and post-CGT assets. (4) [New partner admitted] If a new partner is admitted to a partnership: (a) the new partner acquires a share (according to the partnership agreement, or partnership law if there is no agreement) of each partnership asset; and (b) the existing partners are treated as having disposed of part of their interest in each partnership asset to the extent that the new partner has acquired it. Example: (Indexation is ignored for the purpose of this example.) Lyn and Barry form a partnership, each contributing $15,000 to its capital. The partnership buys land for $30,000. The land increases in value to $300,000. Andrew is admitted as an equal partner, paying Lyn and Barry $50,000 each to acquire a 1/3 share in the land. His cost base is $100,000. Lyn and Barry have each disposed of 1/3 of their interest in the land. Each has a cost base for that interest of $5000, and capital proceeds of $50,000, leaving them with a capital gain of $45,000 each on Andrew’s admission to the partnership. The land is sold for its market value. Andrew has no capital gain on the land. Lyn and Barry have disposed of their remaining 2/3 original interest in the land for capital proceeds of $100,000, leaving each of them with a capital gain of: $100,000 − ($15,000 − $5000) = $90,000

Draw a diagram illustrating the operation of the examples in s 106-5(3) and (4).

[page 1019]

1.

2.

3.

4.

How, if at all, does the treatment of CGT assets on a change in the composition of a partnership differ from the treatment of trading stock on a change in the composition of a partnership? Refer to the discussion of the effect of changes in composition for the trading stock provisions in Chapter 11 and 14.48. On a change in the composition of a partnership, how, if at all, does the treatment of partnership depreciated property for capital allowance purposes differ from its treatment for CGT purposes? Refer to the discussion of the effect of changes in composition for the depreciation provisions in Chapter 10 and 14.44–14.49. The example in s 106-5(4) assumes that on admission of a new partner payment is made to the existing partners. What would the position be if the payment were made into the partnership account and the agreement was that each partner would be equally entitled to the net assets of the partnership? Should the legislation deal separately with this situation? What happens to a partner’s s 108-5(2)(d) interest on a change in the composition of the partnership? Does CGT event A1 arise and, if so, how would the consideration paid and received be apportioned between the s 108-5(2)(c) and (d) interests?

CGT implications for foreign company as a partner 14.81 On 13 August 2008, the Commissioner issued Taxation Determination TD 2008/23. This was later revised on 10 September 2008. In TD 2008/23, the Commissioner considered whether the active assets of a partnership in which a foreign company is a partner are not active foreign business assets of the foreign company for the purposes of the CGT participation exemptions contained in ITAA97 Subdiv 768-G. According to the Commissioner’s ruling, the CGT exemptions contained in Subdiv 768-G do not apply to the active assets of a partnership in which a foreign company is a partner.

The Commissioner is of the view that, where a foreign company is a partner in a partnership, the partnership’s assets themselves are not included in the foreign company’s total assets. This is because the foreign company does not have absolute ownership in each of the partnership’s assets: TD 2008/23 para 13. Since each partner has only an equitable or beneficial interest and not absolute ownership in the partnership’s assets, a foreign company which is a partner in a partnership does not include the partnership’s assets in the foreign company’s balance sheet. In support of this view, the Commissioner relied on the High Court decision of Canny Gabriel Castle Jackson Advertising Pty Ltd v Volume Sales (Finance) Pty [page 1020] Ltd (1974) 131 CLR 321 (Canny Gabriel). In Canny Gabriel, the High Court described the legal nature of a partner’s interests in partnership assets as follows (at 327–8): The partner’s share in the partnership is not a title to specific property but a right to his proportion of the surplus after the realization of assets and the payment of debts and liabilities. However, it has always been accepted that a partner has an interest in every asset of the partnership and this interest has been universally described as a “beneficial interest”, notwithstanding its peculiar character. The assets of a partnership, individually and collectively, are described as partnership property. … This description acknowledges that they belong to the partnership, that is, to the members of the partnership.

The Commissioner considered alternative arguments that CGT participation exemptions contained in Subdiv 768-G do apply to a foreign company’s interest in a partnership. According to the Commissioner in para 27 of TD 2008/23, Subdiv 768-G was: … intended to ensure that capital gains attributable to the disposal of certain foreign active assets were treated consistently. That is, a capital gain would not be subject to Australian tax regardless of whether the asset were disposed of by a foreign company and the gain repatriated back to an Australian resident company as a dividend: section 23AJ ITAA 1936; or the gain was realised by the Australian resident company by way of sale of shares in the foreign company: Subdiv 768-G ITAA 1997.

Reconciliation with taxation under other Parts of the ITAA97

14.82 ITAA97 s 118-20, discussed in 6.133–6.136, contains specific provisions aimed at ensuring that a profit on a realisation of partnership property included in calculating the net income or partnership loss of a partnership is not also taxed at the individual partner level as a capital gain. Under s 118-20(1)(b), a capital gain that you make from a CGT event will be reduced if, because of the event, another part of the ITAA97 includes an amount in the assessable income or exempt income of a partnership in which you are a partner. The capital gain is reduced to zero by s 118-20(2) if it does not exceed your share of the amount included in the assessable income or exempt income of the partnership. Your share of this amount is calculated according to your entitlement to share in the partnership net income or in the partnership loss. Under s 118-20(3), the capital gain is reduced by the amount included under the other part of the ITAA97, or by the amount of the partner’s share of that amount, where the capital gain exceeds the amount included under another part of the ITAA97. In contrast to the equivalent provisions in ITAA36 (s 160ZA(5) and (6)), ITAA97 s 118-20 uses the constituent elements in a partnership’s ITAA36 s 90 calculation as its mechanism for reconciling the CGT provisions with inclusions in the partner’s income via ITAA36 Pt III Div 5. This means that proper reconciliation will occur where the partnership’s ITAA36 s 90 calculation produces either a partnership loss or a partnership net income of zero. This should be contrasted with the position under the ITAA36 discussed in 14.68. The operation of the reductions in capital gains via ITAA97 s 118-20 is illustrated below in Example 14.7. [page 1021]

Dominic and Marcus formed a partnership together in 1990. Under the terms of the partnership agreement, they each have a 50% entitlement to partnership profits and losses. They both contributed $200,000 to the partnership.

The partnership purchases some land as part of a profit-making scheme. The partnership sells the land in 1999 and makes a profit of $40,000. Via the combined operation of ITAA97 s 6-5 and ITAA36 s 90, the profit is included in calculating the net income of the partnership or any partnership loss. For purposes of ITAA97 s 118-20(2), the $40,000 s 65 amount is ‘the amount included in the assessable income … of the partnership’. Each partner’s share of this amount for s 118-20(2) purposes will be $20,000. Assume that, in 1999, the partnership has ITAA97 s 8-1 deductions of $20,000. This will mean that the net income of the partnership is $20,000. Assume that the prima facie capital gain that each partner makes on the sale of the land is $20,000. The combined operation of ITAA97 s 118-20(1) and (2) will reduce the capital gain to zero as the prima facie capital gain that each partner makes, that is, $20,000, does not exceed that partner’s share, namely $20,000, of the ITAA97 s 6-5 amount of $40,000 that was included in the assessable income of the partnership via the ITAA36 s 90 calculation.

14.83 Note that s 118-20(1A) will reduce a partner’s capital gains where an amount is included in the assessable income or exempt income of the partnership in relation to a CGT asset rather than because of a CGT event.

1.

2.

What would the effect of the operation of ITAA97 s 118-20 have been in Example 14.7 if, because of a difference in costs for CGT and s 6-5 purposes, the capital gain that each partner made on the disposal of the land was $30,000? What would the effect of the operation of s 118-20 have been in Example 14.7 if the s 8-1 deductions allowable to the partnership had been $60,000?

The ITAA97 prevents an amount being taken into account as a deduction in a partnership’s ITAA36 s 90 calculation and giving rise to a capital loss at the partner level. ITAA97 s 110-60(2) does this by excluding from the reduced cost base of [page 1022]

a partner’s interest in a CGT asset of a partnership expenditure to the extent that the partnership has deducted, or could have deducted it apart from ITAA97 s 43-70(2)(h), in the partnership’s ITAA36 s 90 calculation. In addition, ITAA97 s 110-60(7) will prevent the one CGT event from giving rise to a revenue loss at the partnership level and a capital loss at the partner level. It does this by reducing the reduced cost base of a partner’s interest in a CGT asset by the partner’s share of the amount that the partnership deducted or could have deducted in respect of the revenue loss.

CGT effects of assignment of a partner’s interest in a partnership 14.84 We saw at 14.72 that ITAA97 s 108-5(2)(d) deems an interest in a partnership that is not covered by s 108-5(2)(c) to be a CGT asset. An assignment of a partner’s interest in a partnership will trigger CGT event A1 in relation to the part of the interest that is disposed of and acquired. Capital gains and losses will be calculated by comparing the capital proceeds from the disposal of the s 108-5(2)(d) interest with the cost base that is attributable to that interest. As noted at 14.75, it might be difficult to separately value a partner’s s 108-5(2)(d) interest in a partnership. An assignment will also trigger CGT event A1 in relation to the partner’s s 108-5(2)(c) interests in the partnership assets. To the extent that partnership assets, other than Australian currency, have increased in value since the date that the assignor partner joined the partnership, the assignor partner will (subject to indexation, if applicable) make a capital gain. Note, as mentioned at 14.73, some commentators take the view that s 108-5(2)(d) will only prevent the same gain being taxed as a prior disposal of a s 108-5(2)(c) interest and as a disposal of the s 108-5(2)(d) interest if Australian currency is regarded as an asset for CGT purposes. In IT 2540, the Commissioner states that, as the parties to an Everett assignment (FCT v Everett (1980) 143 CLR 440: see 14.51) would not usually be dealing at arm’s length, the market value substitution rule will determine the capital proceeds for the disposal of part of the partner’s interests in the partnership. IT 2540 states that the market value of the partner’s

interest should be determined by asking what a hypothetical buyer would pay for the interest having regard to the value of the right to the future income of the partnership which attached to it. Note, however, that IT 2540 was issued before a partner’s interest in a partnership was divided in two by ITAA36 s 160A(d) and (e) and subsequently by ITAA97 s 108-5(2)(c) and (d).

CGT effects of a dissolution of a partnership 14.85 On the dissolution of a partnership, its property is applied to discharge its liabilities. Partners are then entitled to a distribution, in proportion to their capital entitlements, of any surplus of assets over liabilities. Prior to distributions made in winding up, partners enjoy collective ownership of the partnership assets and have a special and non-specific equitable interest in relation to them. In the process of winding up, partnership assets are usually converted into cash by sale. Following a distribution in winding up, partners then have individual title to each of the assets that are distributed to them. Consistently with the High Court decision in Rose v FCT (1951) 84 CLR 118, such a rearrangement of interests from collective to individual ownership might not amount to a ‘disposal’ in the ordinary sense of the word. If ITAA97 s 108-5(2)(c) is [page 1023] regarded as effectively deeming a partner to have an undivided interest in each asset of the partnership, then all that happens is a conversion from an undivided interest to a divided interest. This, even more clearly, would not be a disposal in the ordinary sense of the word. Hence, the distribution on winding up might not trigger CGT event A1 in relation to each partner’s s 108-5(2)(c) and (d) interests. However, as the partnership ceases to exist, the distribution in winding up is by way of discharge or satisfaction of each partner’s s 108-5(2)(c) and (d) interests and, hence, should trigger CGT event C2. If Australian currency is regarded as an asset, then a cash distribution

should be regarded as the capital proceeds for the discharge or satisfaction of each partner’s s 108-5(2)(c) interest in the partnership assets. If so, then no capital gain or loss will be made by the partner in respect of the CGT event C2 in relation to the s 108-5(2)(c) interests as the cost base of Australian currency should normally equal its face value. Although no capital proceeds will be attributable to the CGT event C2 that takes place in relation to each partner’s s 108-5(2)(d) interest, the better view is that no capital loss should arise when this event happens. The reason is that, because the capital proceeds of zero will be less than the market value of the s 108-5(2)(d) interest (note market value here will be determined under s 116-30(3A) as if the CGT event had not occurred and was never proposed to occur), the market value substitution rule in s 116-30(2)(b)(ii) will deem the capital proceeds to be the market value of the s 108-5(2)(d) interest. This will mean that a capital loss cannot arise when the CGT event C2 takes place in relation to the s 108-5(2)(d) interest. There is some possibility that a capital gain could arise on the s 108-5(2)(d) interest,16 but it is believed that the Commissioner would not tax a capital gain on the s 108-5(2)(d) interest in these circumstances. 14.86 Any realisation of partnership assets in the process of dissolution might give rise to capital gains or losses at the partner level in relation to each partner’s s 108-5(2)(c) interests in those assets. If the proceeds of realisation are regarded as CGT assets, then their value should not be included in the proportion of the distribution on winding up that is characterised as the capital proceeds for CGT event C2 taking place in relation to each partner’s s 108-5(2)(d) interest. This will mean that the capital gain recognised on realisation of the partnership assets will not be taxed again when a distribution in winding up is made. If in specie distributions of assets are made on dissolution, the distributions should be seen as being in satisfaction of each partner’s s 108-5(2)(c) interests in those assets. This will trigger CGT event C2 for each partner. Each partner will enjoy CGT preferences such as indexation and discounts in relation to each asset. This is to be contrasted with the position in relation to liquidator’s distributions by companies discussed at 13.62–13.86. In an in specie distribution, the

actual capital proceeds in relation to each partner’s s 108-5(2)(d) interest should again be zero. The market value substitution rule should operate in these circumstances in the manner discussed above. [page 1024]

Review the discussion in 14.35–14.43. 1. What would be the position if a partnership were dissolved and, as part of the process of dissolution, the work in progress was assigned (with the consent of clients) to an entirely different firm? 2. Will the partners from the dissolved partnership derive any part of the amount received by the dissolved partnership for the work in progress? 3. Will the derivation be via ITAA97 s 6-5 or ITAA36 Pt III Div 5? 4. Would the reconciliation mechanism in ITAA97 s 118-20 work properly in these circumstances? In answering, consider whether an interest in work in progress falls into a partner’s ITAA97 s 108-5(2)(c) interest or into the partner’s s 108-5(2) (d) interest. Does this analysis suggest that any aspects of the decision in Coughlan v FCT (1991) 22 ATR 109 could be reconsidered?

Taxation of limited partnerships Nature of a limited partnership 14.87 As a matter of partnership law, partners in a general law partnership have unlimited liability to outsiders. In Australian states, however, statutes provide for the creation of ‘limited partnerships’. In these partnerships, there are two categories of partners: ‘limited partners’ and ‘general partners’. Limited partners are obliged to contribute a definite sum towards the partnership capital. This contribution cannot be withdrawn prior to the dissolution of the partnership. On dissolution, the limited partners are not liable for the

debts or obligations of the partnership in excess of these capital contributions. Limited partners cannot bind the firm in transactions with outsiders and are not permitted to take part in the management of the partnership. They may, however, inspect the partnership books and make certain inquiries about the financial position of the partnership. The position of general partners in a limited partnership is essentially the same as the position of partners in an ordinary general law partnership.

Tax treatment of limited partnerships Limited partnership treated as a company for tax purposes 14.88 ITAA36 Pt III Div 5A taxes most limited partnerships17 as if they were companies. A limited partnership that is taxed in this manner is deemed by ITAA97 s 960-115 to be a ‘corporate tax entity’ for the purposes of the ITAA97, and is [page 1025] referred to as a ‘corporate limited partnership’ in both the ITAA36 and ITAA97. Corporate limited partnerships are not regarded as private companies for tax purposes. A resident corporate limited partnership will be taxed on its ordinary and statutory income from all sources both within and outside Australia. A non-resident corporate limited partnership will be taxed on its ordinary and statutory income from sources within Australia. Payments of tax by corporate limited partnerships give rise to franking credits and corporate limited partnerships are obliged to maintain franking accounts. For CGT purposes, the corporate limited partnership is treated as owning CGT assets, and capital gains and losses are calculated at the limited partnership level. Net capital gains accruing to a corporate limited partnership form part of its assessable income.

Partners in limited partnership taxed like shareholders

14.89 ITAA36 Pt III Div 5A treats partners in a corporate limited partnership like shareholders in a company: see ITAA36 s 94Q. Distributions to partners and the payment or crediting of amounts to partners out of the profits or anticipated profits of the partnership are treated, by ITAA36 ss 94L and 94M respectively, as being dividends paid by the partnership out of profits. Under ITAA97 s 960-120 item 2 in the table, a distribution made by a corporate limited partnership to a partner as well as something that is taken to be a dividend by the partners under the ITAA97 are within the definition of ‘distribution’ for purposes of the ITAA97. This, in turn, means that a distribution by a corporate limited partnership can be franked under ITAA97 s 202-40. A natural person resident partner/shareholder includes the deemed dividend in assessable income under ITAA36 s 44(1) and is allowed a ITAA97 s 207-20 gross-up and tax offset. A partner’s interest in a limited partnership is treated by ITAA36 s 94P as a share. Thus, for CGT purposes, a disposal of a partner’s interest in a limited partnership will be regarded only as a disposal of the partner’s share and not as a disposal of the partner’s interest in the assets of the limited partnership.

Foreign hybrids 14.90 In 2004, the Taxation Laws Amendment Act (No 1) 2004 (Cth) was passed by the Commonwealth Parliament. This amendment Act included provisions to the effect that foreign hybrids18 that are limited partnerships will be treated as ordinary partnerships in the future. The legislation will apply to limited partnerships formed in a foreign country and which are treated as a partnership in that country. Typically, a foreign hybrid partnership is taxed as a partnership (ie, tax is levied on the partner’s assessable income) in the foreign country but taxed as a company under Australian taxation laws. This created a problem with the application of the controlled foreign company (CFC) rules and the foreign investment fund (FIF) rules to foreign hybrids because the CFC and FIF rules required the entity to be subject to foreign tax. Under FIF rules, the foreign entity was required to pay the foreign tax. However, these

[page 1026] requirements were unable to be met because in the overseas jurisdiction the hybrid entity was not assessed and did not pay tax. Instead, tax is levied on the partner of the foreign hybrid which has led to the risk of double taxation being levied with no relief. The Taxation Laws Amendment Act (No 1) 2004 (Cth) introduced changes to the law to allow limited liability foreign partnerships to be treated as partnerships for income tax purposes and subject to ITAA36 Pt III Div 5.19 Accordingly, US and UK limited liability companies that satisfy the definition of ‘foreign hybrid company’ (ITAA97 s 830-15) will be treated as a partnership for income tax purposes. A foreign hybrid limited partnership is defined in ITAA97 s 830-10. To satisfy the definition of ‘foreign hybrid’, the partnership must meet the following five conditions: 1. It was formed in a foreign country. 2. Foreign income tax is imposed on the partners of the limited partnership under the law of the foreign country. 3. At no time during the year of income is the limited partnership, for the purposes of the tax law of any foreign country, treated as a resident of that country. 4. The limited partnership must not be an Australian resident at any time. 5. The limited liability partnership must be a CFC with at least one taxpayer having an attribution percentage greater than nil.20 US limited liability companies (LLC) also pose similar problems to foreign tax hybrids. US LLCs are companies under Australian tax law but can also qualify for treatment as a foreign hybrid company provided that the following four conditions exist for a US LLC: 1. It must not be treated as a resident of any foreign country. 2. It cannot be an Australian resident. 3. It must qualify as a CFC with an Australian taxpayer having an attribution percentage greater than nil.

4. It must be treated as a partnership for US income tax purposes.21 As a result of the amendments introduced by the Taxation Laws Amendment Act (No 1) 2004 (Cth), a foreign hybrid limited partnership will be treated as a partnership under ITAA36 Pt III Div 5. Since a foreign hybrid partnership will no longer be treated as a company, neither the CFC rules nor the FIF rules will apply to the entity. In ATO ID 2011/35, the Commissioner held the view that a taxpayer’s share of income, which is derived through a US permanent establishment of a US LLC that is treated as a foreign hybrid for Australian income tax purposes, is non-assessable non-exempt income under ITAA36 s 23AH. [page 1027]

Tax treatment of a foreign hybrid Calculating a shareholder’s/partner’s interest in net income of an LLC 14.91 A shareholder’s interest in a US LLC will determine their individual interest in the net income or loss of the partnership: ITAA97 s 830-30. The following example provided in the Explanatory Memorandum to the Taxation Laws Amendment Bill (No 7) 2003 (Cth) illustrates the individual interest of a partner/shareholder in the net income of the LLC.22

A and B (both Australian resident companies) are each members of a US LLC. Under the operating agreement of the US LLC, A has a preferential interest in the first $10,000 of the profits of the US LLC, and both A and B have a right to 50% of any further profits. In the 2014–15 income year, the US LLC has a profit of $50,000, after tax. If all of the profits for that year were distributed at year end, A would receive $30,000 ($10,000 and 50% of the remaining $40,000), and B would receive $30,000 ($10,000

and 50% of the remaining $40,000), and B would receive $20,000 under the operating agreement. Applying ITAA97 s 830-30, A’s individual interest in the net income of the US LLC would be 60% (calculated as the $30,000 share of the $50,000 total distributable profits), and B’s would be 40%.

Tax loss limitation rules 14.92 The Taxation Laws Amendment Act (No 1) 2004 (Cth) also introduced new rules limiting tax losses that can be claimed as deductions by partners of foreign hybrids. The partner’s tax losses must be calculated in accordance with ITAA97 s 830-60(1). Under s 83060(1), the partner’s liability for loss is calculated by deducting from any contributions that the partner has made to the foreign hybrid the following loss items: all limited recourse debts owed by the partner to external lenders to the extent that the debts are secured by the partner’s interest in the foreign hybrid; the total of all deductions allowed to the partner for partnership losses allowed in previous years; and the total of all net foreign hybrid capital losses allowed in previous years. [page 1028]

No longer a foreign hybrid 14.93 ITAA97 Subdiv 830-D introduces new provisions for when an entity ceases to be a foreign hybrid. When this occurs, the entity will be treated as if it were a company under Australian income tax laws and not as a partnership. Tax losses incurred in earlier years cannot be transferred to a foreign hybrid for the purposes of calculating the entity’s net income: s 830-115(1). However, the loss may qualify as a deduction under ITAA97 Div 36: s 830-115(2).

Non-commercial losses 14.94 On 14 December 2009, amendments came into effect concerning the taxation treatment of non-commercial losses. The amendments were contained in the Tax Laws Amendment (Budget Measures No 2) Act 2009 (Cth). The amendments to noncommercial losses were introduced as a result of budget measures announced in the 2009 Federal Budget. Schedule 2 of the Act introduced amendments to the ITAA97 to tighten the application of the non-commercial losses rules in relation to individuals with an adjusted taxable income of $250,000 or more. These amendments were designed to prevent highincome individuals (including individuals who operate in the form of partnerships) from offsetting deductions from non-commercial business activities against their salary, wage or other income.

Closely held corporate limited partnerships 14.95 The Tax Laws Amendment (2010 Measures No 2) Act 2010 (Cth) was introduced into parliament on 17 March 2010 and received the Royal Assent on 28 June 2010. The Act makes amendments to the application of ITAA36 Pt III Div 7A to corporate limited partnerships. Prior to this amendment, it was considered that Div 7A did not apply to corporate limited partnerships due to the operation of s 94N. Section 94N provided that a reference to a private company in relation to the year of income did not include a reference to a corporate limited partnership. The Tax Laws Amendment (2010 Measures No 2) Act 2010 (Cth) introduced amendments so that corporate limited partnerships that satisfy the requirements under ITAA36 s 109BB will be now subject to the operation of Div 7A. According to s 109BB, a corporate limited partnership will be considered to be closely held for the purposes of Div 7A where the partnership has fewer than 50 members or an entity has, directly or indirectly, and for the entity’s own benefit, an entitlement to a 75% or greater share of the income or capital of the partnership.

Australian Taxation Office interpretative decisions

14.96 Following the amendments made to the tax treatment of foreign hybrids, the Australian Taxation Office (ATO) issued a number of interpretative decisions concerning the tax treatment of foreign hybrid limited liability partnerships. See, for example: ATO ID 2006/18 ‘Foreign Hybrid Rules: Treatment of Foreign Hybrid Company as a Partnership’; ATO ID 2006/334 ‘Classification of a United Kingdom Limited Partnership for Australian Income Tax Purposes’; ATO ID 2007/47 ‘Classification of a German Kommanditgesellschaft for Australian Income Tax Purposes’; and ATO ID [page 1029] 2008/24 ‘Foreign Hybrid Limited Partnership: UK Limited Partnership’, which was withdrawn on 21 January 2009 and replaced by TD 2009/2 (discussed in 14.97).

Taxation Determination TD 2009/2 14.97 On 21 January 2009, the Commissioner issued TD 2009/2, which deals with the foreign hybrid rules contained in ITAA97 Div 830 and their application to partners of a foreign limited partnership. Under Div 830, an entity that satisfies the conditions set out in Div 830 will be treated as a partnership instead of as a company. These conditions include the requirement that ‘foreign income tax … is imposed under the law of the foreign country on the partners, not the limited partnership, in respect of the income or profits of the partnership for the income year’: s 830-10(1)(b). According to the Commissioner’s determination, the condition cannot be satisfied where the ‘foreign country does not impose an income or profits tax, nor where such a tax does not apply to the partners of a particular type of entity’. Hence, ‘the policy intent is that partners are the relevant taxpayers in relation to their share of the partnership income or profit derived by a limited partnership formed in that country’: TD 2009/2 para 46.

Interpretative Decision ATO ID 2010/77 14.98 In ATO ID 2010/77, the Commissioner decided that a singlemember LLC that was formed in the United States of America would be characterised as foreign hybrid company under ITAA97 Div 830. The effect of the Commissioner’s decision in ATO ID 2010/77 means that an LLC incorporated in the United States will be treated as a partnership for income tax purposes. In its interpretative decision, the Commissioner relied on s 830-15(2) and found that it is possible for a single-member LLC to satisfy the partnership requirement under s 83015(2)(b)(ii). Section 830-15(2) states: 830-15 (2) For the purposes of paragraph (1)(a), the partnership treatment requirements are satisfied if: (a) the company was formed in the United States of America; and (b) for the purposes of the law of that country relating to foreign income tax (except credit absorption tax or unitary tax) imposed by that country, the company is a limited liability company that: (i) is treated as a partnership; or (ii) is an eligible entity that is disregarded as an entity separate from its owner.

1.

2.

3.

4.

Partnership Acts exist in all states and territories. See generally: Partnership Act 1963 (ACT); Partnership Act 1892 (NSW); Partnership Act 1997 (NT); Partnership Act 1891 (Qld); Partnership Act 1891 (SA); Partnership Act 1891 (Tas); Partnership Act 1958 (Vic); Partnership Act 1895 (WA). From now on in this chapter, the Partnership Acts of the states and territories will be referred to as ‘the Partnership Acts’. A ‘fiduciary relationship’ is one where a person stands in such a relationship to another person that the law will regard him or her as having obligations of utmost good faith. Such relationships will usually arise where one person is in a position of being able to deal with another’s property. Examples of fiduciary relationships include trustee and beneficiary, agent and principal, company director and the company, and a partner and his or her fellow partners. See also the High Court’s decision in Hospital Products Ltd v United States Surgical Corporation (1984) 156 CLR 41 where Mason J stated, obiter, that new categories involving a fiduciary relationship may exist. In Hughes v Fripp (1922) 30 CLR 508, the High Court held that, when a partner’s death dissolved a partnership, the deceased partner’s share of the partnership profits that would have been disclosed by an account taken as at the date of the partner’s death accrued when the account should have been taken and became part of the corpus of the deceased partner’s estate. Hughes v Fripp is discussed in more detail in 14.31. Case S75 85 ATC 544; 28 CTBR (NS) Case 81; Case T69 (1968) 18 TBRD 353.

5. 6.

7.

8.

9. 10. 11.

12. 13. 14. 15. 16.

17.

18.

See the discussion in K L Fletcher, Higgins and Fletcher: The Law of Partnership in Australia and New Zealand, 6th ed, Law Book Company Ltd, Sydney, 1991, pp 207–24. In Single v FCT (1964) 110 CLR 177, Kitto J dissented by holding that ITAA36 s 101A did not apply to the receipts. The basis of Kitto J’s reasoning was that s 101A did not apply as: (i) the receipts were income under ordinary concepts and s 101A could not apply to amounts that were otherwise income receipts; and (ii) that the amounts were not receivable as at the date of death of the deceased and s 101A could only apply to amounts which the deceased had a right to receive as at the date of death. Of the two majority judges, only Owen J considered whether the payments would have been income or capital in the absence of s 101A and neither majority judge expressed a view that s 101A could not apply to receipts that would otherwise be income under ordinary concepts. Although it is not expressly stated in the case, it would appear that the retirement of the partner did not dissolve the partnership and that the payment was made by the continuing partners outside the partnership accounts. The language used in ITAA97 s 40-345 makes it unclear whether, once a choice has been made for roll-over, the transferee is required to use the same method and effective life as the transferor was using or merely is permitted to use the same method and effective life. Additional consequences that arise for the purposes of ITAA97 Div 45 are set out in s 40350. For these purposes, the calculation of the taxpayer’s average rate of ordinary tax disregards rebates and credits and Family Tax Benefit adjustments to the tax-free threshold. See, for example, C J Taylor, ‘Part IIIA: Pickles for Partnerships’ (1992) 26 Taxation in Australia 542; B Cannon, ‘CGT and Partnerships’, Continuing Legal Education, University of Sydney, Faculty of Law, Committee for Postgraduate Studies in the Department of Law, 1991; C J Taylor, Capital Gains Tax: Business Assets and Entities, Law Book Co, Sydney, 1994, [10.17]–[10.18]; M J Cashmere, ‘Partnerships’ in Capital Gains Tax Triple Trifecta Seminar, ATAX, University of New South Wales, 1995. See Taylor, ‘Part IIIA: Pickles for Partnerships’; Taylor, Capital Gains Tax: Business Assets and Entities, [10.22] and [10.25]. See Taylor, ‘Part IIIA: Pickles for Partnerships’; Taylor, Capital Gains Tax: Business Assets and Entities, [10.24]–[10.28]. See Taylor, ‘Part IIIA: Pickles for Partnerships’; Cannon, ‘CGT and Partnerships’; Taylor, Capital Gains Tax: Business Assets and Entities, [10.18], [10.47], [10.56] and [10.58]. See Taylor, Capital Gains Tax: Business Assets and Entities, [10.58]. This would happen where the market value of the ITAA97 s 108-5(2)(d) interest has increased since the partner joined the firm. If the valuation of the partner’s s 108-5(2)(d) interest has been based on the earnings of the firm, an increase in earnings between the date on which a partner joined the firm and the date of dissolution would produce an increase in the market value of the partner’s s 108-5(2)(d) interest. Importantly, though, limited partnerships used as a vehicle for investment in Australian venture capital are treated like ordinary partnerships for tax purposes. A discussion of the tax treatment of venture capital vehicles is contained in Study help. The meaning of ‘foreign hybrid’ is contained in ITAA97 Subdiv 830-A s 830-5, and means: (a) a foreign hybrid limited partnership; or (b) a foreign hybrid company.

19. See Explanatory Memorandum to the Taxation Laws Amendment Bill (No 7) 2003 (Cth) (the EM), Sch 10 para 9.12. 20. According to the EM, this requirement will be satisfied where there is at least one Australian taxpayer who has a direct or indirect interest of at least 10% in the limited liability partnership. 21. See ITAA97 s 830-15(1)(a)–(d). 22. See the Explanatory Memorandum to the Taxation Laws Amendment Bill (No 7) 2003 (Cth), Sch 10 para 9.43 Example 9.1.

[page 1031]

CHAPTER

15

Taxation of Trusts Learning objectives After studying this chapter, you should be able to: draw a diagram explaining the scheme of Income Tax Assessment Act 1936 (ITAA36) Pt III Div 6; calculate the net income of a trust estate; identify when a beneficiary is presently entitled to a share of income of a trust estate; describe circumstances in which ITAA36 s 95A(2) can apply; explain the difference between the ‘amounts’ and ‘proportions’ views of ITAA 36 Pt III Div 6; calculate the imputation rebate for a presently entitled beneficiary in a trust that receives franked dividends; list the major capital gains tax (CGT) events that can apply in relation to trust estates; explain how ITAA36 s 101A operates; identify a ‘public trading trust’; apply the ‘pattern of distributions’ test for trust losses.

Introduction

What is a trust? 15.1 One of the distinctive features of the English legal system is the notion that one person may hold legal title to property while another person has beneficial interests in the property.1 At 12.4, we briefly surveyed some of the descriptions and definitions of trusts offered by text writers. We shall now examine some of the elements in these descriptions and definitions in more detail. 15.2

Meagher and Gummow describe a trust in the following terms:2

A trust exists when the holder of a legal or equitable interest in certain property is bound by an equitable obligation to hold his interest in that property not for his own

[page 1032] exclusive benefit, but for the benefit, as to the whole or part of such interest, of another person or persons or for some object or purpose permitted by law.

15.3 As Meagher and Gummow rightly observe, this description is not a definition and it is easier to describe a trust than it is to define its juristic nature.3 After noting that a trust has been variously defined as an obligation owed by the trustee to the beneficiary,4 as the relationship between the trustee and the beneficiary,5 and as the interest of the beneficiary, they then state:6 If definition is demanded, then it seems more appropriate to define the trust as the whole relationship which arises between the parties in respect of the property the subject of the trust, and to regard the obligation of the trustee to the beneficiary and the interest of the beneficiary in the property as results flowing from the existence of that relationship.

Reading Meagher and Gummow’s definition subject to their description quoted above produces a sufficiently comprehensive definition of a trust. The definition would more clearly express Meagher and Gummow’s intention if it referred to the ‘fiduciary relationship’ rather than merely to the ‘relationship’. With this adjustment, Meagher and Gummow’s definition and description of a trust taken together enable a trust to be distinguished from other relationships, interests or obligations which share some but not all of the necessary features of a trust.

1.

The relationship between a director and a company is a fiduciary relationship. How does this relationship differ from the relationship between a trustee and a beneficiary? 2. An agency relationship is an example of a fiduciary relationship. How does an agency relationship differ from a trust? 3. We saw in Chapter 14 that partners are regarded as having an interest in partnership property and as owing fiduciary relationships to each other. How then does a partnership differ from a trust? Suggested responses can be found in Study help.

Some features of trusts 15.4 The following features of trusts, which are implicit in but not necessarily apparent from Meagher and Gummow’s description and definition, are worth stressing. [page 1033]

How a trust is created Trusts may be created in any of three basic methods. These are: by testamentary disposition; by declaration or settlement inter vivos; or by implication of law. A trust is created by inter vivos declaration when a person declares that he or she holds particular property on trust for another person or persons or for a particular purpose or purposes. A trust is created by inter vivos settlement when a person (the settlor) settles property on another person (the trustee) to be held by that person on trust for another living person or persons (beneficiaries) or for a particular 15.5

purpose or purposes. After a trust has been established, persons other than the settlor may make capital contributions to it.

Who may be a beneficiary or object of a trust? 15.6 Meagher and Gummow’s description and definition of a trust require that the trustee hold trust property for the benefit of other persons or objects. One consequence of this is that, although a trustee may be a beneficiary of the trust, a trustee may not be the sole beneficiary of the trust. 15.7 For the trust to be valid, the object must be sufficiently certain and, where the trust is for a purpose, must be for a charitable purpose or purpose for which a statute expressly authorises the establishment of trusts. A trust in which the object is a person or persons is often called a ‘private trust’. A trust for a charitable purpose is called a ‘charitable trust’. In addition, another category of trusts, ‘purpose trusts’, can be identified, although as we shall see these trusts are truly anomalous.

Charitable trusts 15.8 Where a trust obligation is, for example, to apply the income of the trust for a charitable purpose, there is no individual or set of individuals to whom the trust obligation is owed. In these circumstances, it may be somewhat misleading to describe the charitable purposes as ‘the beneficiary’ although some writers,7 do just that. It is less confusing to say that there must either be a person or persons (the beneficiary or the beneficiaries) to whom the trust obligation is owed, or the trust obligation must be to devote the trust property to a charitable purpose. 15.9 It is necessary to explain what a charitable purpose is under Australian law. When we use the word ‘charity’ in ordinary usage, we probably think of organisations which provide support for the poor and needy or for the victims of famine. A trust which required the income from its property to be used for the purposes of one of these organisations is very likely to be a charitable trust. However, some organisations which we may regard as charities in popular usage may not be charities for purposes of trust law. On the other hand, some

organisations are charities for the purposes of trust law, although they may not be what we would describe as charities in everyday usage. The case law on what is a charitable trust was [page 1034] summarised by Lord Macnaghten in Commissioners for Special Purposes of Income Tax v Pemsel [1891] AC 531 at 583: “Charity” in its legal sense comprises four principal divisions: trusts for the relief of poverty; trusts for the advancement of education; trusts for the advancement of religion; and trusts for other purposes beneficial to the community not falling under any of the preceding heads.

15.10 Trusts for purposes which are not charitable do not have a beneficiary to enforce them and cannot be enforced by the AttorneyGeneral. The trusts will be valid if the trustee decides to carry them out. In that circumstance, other persons interested in the trust property after the expiration of the purpose trust may apply to the court to have the terms of the trust carried out. Examples of purpose trusts include trusts for animals, trusts for the erection of graves and monuments and trusts for the purposes of unincorporated associations which are not charitable associations.

Who may be a trustee? 15.11 A natural person who has the legal capacity to hold property may be a trustee. As the holding of property subject to obligations is an essential element of a trust, a person who is legally incapable of holding property cannot be a trustee.8 Also, as a trustee is required to exercise those discretions that belong to the office of trustee, a person, such as a person of unsound mind, who is incapable of exercising those discretions cannot be a trustee. Note that all states other than South Australia and Tasmania limit to four the number of persons who can be trustees of a particular trust at any particular time. 15.12 A company may be a trustee provided its constitution does not contain restrictions on its powers such that it would not be able to

perform the active duties of a trustee. Under the Corporations Act 2001 (Cth), a company will have all the powers of a natural person unless its constitution limits its powers. Thus, normally, a company incorporated under the Corporations Act 2001 (Cth) can be a trustee. A foreign corporation that can hold property in Australia can be a trustee. It is important to recognise that, although a natural person trustee cannot be the sole beneficiary of a trust, a natural person who is the sole beneficiary of a trust can also be the sole shareholder and director in a company that is the trustee of the trust. The use of corporate trustees controlled by shareholder/directors who happen to be beneficiaries of the trust is an important element in the use of trusts as tax-planning structures in Australia. This is because this structure means that the beneficiaries can be certain that the trust will be administered in accordance with their interests, including their tax interests. In the case of deceased estates, however, the use of companies as trustees is limited by the rule that, subject to the exception mentioned in 15.13, companies cannot be legal personal representatives of deceased persons. [page 1035] 15.13 Other persons who may be trustees include the Crown, statutory trustee companies, and the public trustee in each state. Statutory trustee companies are an exception to the general rule that companies cannot be legal personal representatives.

Relationship between the trustee and the trust assets 15.14 Another important point to note is that the trust assets constitute a separate fund and are not part of the trustee’s own estate. At the same time, even though the trust assets are separate from the trustee’s personal assets, a trust is not a separate legal entity. Thus, the trustee is personally liable for their actions as trustee but, in some circumstances, will have a right of indemnity against the trust assets. In certain circumstances, the trustee may also have a right of indemnity against the beneficiaries of the trust. A third party suing the trust may

be subrogated to the trustee’s rights of indemnity against the trust assets and the beneficiaries.

When does a trust terminate? 15.15 A trust is not immortal. In most Australian jurisdictions (but not South Australia), there is a rule against perpetuities, which requires, in the case of private trusts, that the trust property vest in interest in the beneficiaries within reasonably lengthy periods which vary between state jurisdictions. When a trust is established by a will or by inter vivos instrument, the trust instrument will normally clearly specify the date on which the trust assets are required to vest in the beneficiaries. 15.16 Because a charitable trust is a trust for purposes not for persons, it is meaningless to say that a charitable trust must be vested, if it is to vest at all, in the object within the relevant perpetuity period. When the rule against perpetuities is applied in the context of charitable trusts, the question becomes: will the trust property be devoted to the charitable purpose within the relevant perpetuity period? If we are able to say that the property will or will not be devoted to charitable purposes within the relevant perpetuity period, the trust is valid. It does not matter that actual distributions for the charitable purpose may not take place within the perpetuity period. However, the rule will be infringed if devoting the trust property is subject to contingencies which may not be satisfied within the relevant perpetuity period.

Types of trust Classification according to function 15.17 Throughout history, trusts have been found to be useful and flexible and a variety of forms of express trusts have developed. As we have already noted, one of the ways of classifying express trusts is by the manner in which they were created, that is, by testamentary or inter vivos disposition. Another way in which express trusts may be classified is according to the functions which they perform. Using this method of classification, the types of trusts that can be identified9 include:

[page 1036] family trusts; trusts for the limitation of successive interests; trusts to protect the interests of possibly improvident beneficiaries; trusts for employees; trusts to facilitate public investment; private trading trusts; trusts to reconcile the public need for marketability of property with the private desire to create fragmented ownership; claimant priority trusts; trusts for unincorporated associations; and trusts for charitable purposes. Trusts created for the purpose of minimising income tax are a notable omission from this list, but no tax planner, of course, will admit that such a purpose was dominant in the creation of the trust.

Classification according to beneficiaries’ entitlements 15.18 Another way in which trusts may be classified is according to the entitlements of their beneficiaries. Using this classification, two types of trust may be identified: fixed trusts and discretionary trusts.

Fixed trusts and discretionary trusts 15.19 In a ‘fixed’ trust, the entitlements of beneficiaries are just that: fixed by the instrument which created the trust. In a ‘discretionary’ trust, there are strictly no beneficiaries until the trustee exercises a discretion, given by the trust instrument, to make a disposition of trust property in favour of one or more of the objects of that discretion which are nominated in the trust instrument. Alternatively, the trustee of a discretionary trust may be given power to appoint objects of the discretion. A distinction is drawn between exhaustive and nonexhaustive discretionary trusts. In the case of an exhaustive discretionary trust, the trustee is obliged to allocate the income or

capital of the trusts among the objects. In a non-exhaustive discretionary trust, the trustee may allocate income or capital among objects of the discretion but is not obliged to do so. In relation to the one estate, there may be both fixed and discretionary trusts. For example, the entitlements of beneficiaries may be fixed in relation to the capital of a trust while there may be a discretionary trust in respect of the income of the trust. Such trusts are commonly referred to as ‘hybrid’ trusts.

Unit trusts 15.20 The final type of trust which should be mentioned is the ‘unit trust’. A unit trust is really a particular type of fixed trust. The distinctive feature of a unit trust is that the totality of the beneficial interests in the trust property is divided into units which may be transferred or redeemed. Some unit trusts are listed on the Australian Securities Exchange to facilitate the transfer of units. We shall see at 15.136–15.144 that for tax purposes some unit trusts are effectively taxed like companies. For [page 1037] capital gains tax (CGT) purposes, as we shall see at 15.120–15.123, units in unit trusts are treated in a very similar way to shares in companies.

Classifications based on the nature of the duties imposed on the trustee 15.21 The distinction which can be made under this heading relates to whether or not the trustee has active duties to perform. If the trustee’s duties are limited to conveying the trust property to nominated people on request, then the trust is usually called a ‘bare trust’. Trusts of this nature are also known as ‘simple trusts’. Where the trustee has active duties to perform under the trust, such as the investment of trust

funds on the stock exchange, for example, the trust is known as a ‘special trust’. 15.22 The distinction between bare trusts and special trusts is significant for Australian taxation purposes. For CGT purposes, a specific provision, Income Tax Assessment Act 1997 (Cth) (ITAA97) s 106-50 (discussed in 15.96–15.99), is directed at the situation where a person is the trustee of a bare trust. Moreover, CGT event E5 (discussed in 15.105–15.106) is arguably concerned with the situation where a trust which was previously a special trust becomes a bare trust.

Scope of the tax provisions dealing with trusts Who is a trustee for tax purposes? 15.23 The ITAA36 does not define what a trust is for tax purposes. A ‘trustee’ is defined in ITAA36 s 6(1) as: … in addition to every person appointed or constituted trustee by act of parties, by order, or declaration of a court, or by operation of law, includes: (a) an executor or administrator, guardian, committee, receiver, or liquidator; and (b) every person having or taking upon himself the administration or control of income affected by any express or implied trust, or acting in any fiduciary capacity, or having the possession, control or management of the income of a person under any legal or other disability.

It should be noted that the definition is inclusive and that it is clear that anyone who is a trustee under the definition discussed at 15.1–15.3 and 15.11–15.13 will also be a trustee for tax purposes. The outer limits of the definition are not so clear. Taken literally, it would include all fiduciaries such as agents or partners. The existence of specific provisions in the ITAA36 dealing with the taxation of partnerships, discussed in Chapter 14, suggests that the definition of ‘trustee’ in ITAA36 s 6(1) cannot be taken completely literally.

Who is a beneficiary for tax purposes? 15.24 The ITAA36 does not contain a definition of the term ‘beneficiary’. In Totledge Pty Ltd v FCT 80 ATC 4432, Rogers J stated that the expression ‘beneficiary’ when [page 1038] used in ITAA36 Pt III Div 6 enjoyed no extended meaning. There is, however, merit in the suggestion that, to the extent that the s 6(1) definition of ‘trustee’ includes persons who are not trustees in the ordinary equitable sense, then the concept of a ‘beneficiary’ must necessarily extend beyond its meaning for trust law purposes.10

What is a trust estate for tax purposes? 15.25 ITAA36 Pt III Div 6 makes frequent mention of a ‘trust estate’. This phrase is not defined in the ITAA36. The phrase clearly includes what equity would describe as trust property.11 Trust property in the usual sense would not embrace rights (such as those of a discretionary beneficiary who, in turn, is trustee of a sub-trust) which are traditionally regarded as trust estates for purposes of Div 6. This has led some commentators to suggest that the expression ‘trust estate’ has a wider meaning than the equitable concept of trust property, and that ‘trust estate’ includes rights in the nature of property, and merely requires that there be some relationship between a person answering the description of a trustee and the relevant rights by virtue of which income arises.12

Fundamentals of the taxation of trusts 15.26 When framing the taxation rules governing the treatment of trusts, a fundamental issue that must be addressed is whether the trustee should be recognised as a separate entity from the beneficiaries and/or

whether the trustee is treated as a mere conduit for trust income passing into the hands of trust beneficiaries. The entity approach would entail treating the profits of a trust estate in a similar way to the current Australian treatment of corporate profits. By contrast, the conduit approach would treat profits of a trust estate in a similar manner to the treatment of partnership profits under ITAA36 s 92. As described below, depending on the circumstances, the Australian taxation rules adopt one or the other of these approaches in treating the net income of a trust estate. For example: the core trust taxation rule in ITAA36 s 97 adopts a conduit approach by allocating a proportion of trust income to a particular beneficiary, regardless of whether that trust income has actually been paid to the beneficiary; and in cases where s 97 does not apply or is specifically overridden by an anti-avoidance rule such as ITAA36 ss 98, 99 and 99A, the trustee is recognised as the appropriate taxation entity. In some cases, such as where s 99A applies, disadvantageous tax outcomes will arise because the trust income to which that provision applies is taxed at a penal rate of tax. The basic provisions in the ITAA36 which deal with the taxation of trusts are contained in Pt III Div 6. The following diagram summarises (in basic form) the way [page 1039] that trusts are taxed under the ITAA36. Note that the diagram assumes that the trust is a resident trust estate and assumes that the beneficiary is a resident, is not under a legal disability (see 15.78) and is ‘presently entitled’ (see 15.64ff) to a share of the income of the trust estate as a matter of general law.

Figure 15.1:

Basic tax treatment of trusts

Scheme of ITAA36 Pt III Div 6 Trustee lodges return and calculates ‘net income of the trust estate’ 15.27 As can be seen from Figure 15.1 in 15.26, the basic scheme of ITAA36 Pt III Div 6 involves calculating the ‘net income’ of the trust estate and then taxing the trustee and/or one or more of the beneficiaries on all, or a share, of that net income. The trustee is obliged to lodge a return disclosing the ‘net income of the trust estate’. ‘Net income’ in relation to a trust estate is defined in ITAA36 s 95 as meaning: … the total assessable income of the trust estate calculated under this Act as if the trustee were a taxpayer in respect of that income and were a resident, less all allowable deductions, except deductions under Division 393 of the Income Tax Assessment Act 1997 (Farm management deposits) and except also, in respect of any beneficiary who has no beneficial interest in the corpus of the trust estate, or in respect of any life tenant, the

deductions allowable under Division 36 of the Income Tax Assessment Act 1997 in respect of such of the tax losses of previous years as are required to be met out of corpus.

A trust may be required to work out its net income in a special way by Div 266 or Div 267 of ITAA36 Sch 2F, which limit the deductibility of certain amounts such as losses and bad debts. [page 1040] 15.28 The ‘net income’ of a trust estate for income tax purposes will not necessarily correspond with the income of the trust estate for the purposes of the trust instrument. Certain items, for example, net capital gains or ITAA97 s 207-35 franking credits, which form part of assessable income for tax purposes may frequently not form part of the income of the trust for purposes of the trust instrument. Alternatively, certain amounts, such as ITAA97 Div 43 capital works allowances, may be deductible for tax purposes but are not taken into account in determining the income of the trust under the trust instrument. Problems which emerge when there are disparities between the net income of a trust for tax purposes and the income calculated in accordance with the trust instrument are discussed in 15.80–15.85.

Trustee is not assessable as trustee outside Div 6 15.29 ITAA36 s 96 ensures that a trustee will not be taxed under the Act in the capacity of trustee other than as is provided in Pt III Div 6. This is consistent with the general principle of income tax law; an amount is not derived as income if it is not derived beneficially.13

Provisions allocating tax liabilities between trustee and beneficiaries 15.30 The operative provisions of ITAA36 Pt III Div 6 allocate tax liabilities in respect of particular parts of the net income of the trust. The different taxing provisions will now be outlined and the terms used in those provisions will then be discussed.

Section 97(1) liability 15.31 ITAA36 s 97(1) deals with the situation where a beneficiary is presently entitled (either at general law or under s 101, discussed at 15.77) to a share of the income of the trust estate, is not under a legal disability and is a resident at the end of the income year. Under s 97(1) (a), the assessable income of the beneficiary includes: (i)

so much of that share of the net income of the trust estate as is attributable to a period when the beneficiary was a resident; and (ii) so much of that share of the net income of the trust estate as is attributable to a period when the beneficiary was not a resident and is also attributable to sources in Australia.

With effect from 1 July 2011, capital gains to which a beneficiary is specifically entitled are included in the beneficiary’s assessable income under ITAA97 Subdiv115-C and excluded from the operation of Div 6 by ITAA36 Pt III Div 6E. An overview of the combined operation of Divs 6 and 115 is provided in ITAA36 s 95AAA. [page 1041] 15.32 Note that because of ITAA36 s 97(2)(a), a natural person resident beneficiary who is deemed to be presently entitled by s 95A(2) (discussed at 15.75–15.76) generally is not regarded as being presently entitled for the purposes of s 97(1). Further, under s 97(2)(b), a beneficiary who is a non-resident at the end of the year of income is not regarded as a beneficiary who is presently entitled for the purposes of s 97(1).

Section 98(3) and (4) liability 15.33 ITAA36 s 98(3) and (4) deals with the situation where the beneficiary is presently entitled, either at general law or under s 101 (discussed at 15.77), to a share of the income of the trust estate, is not

under a legal disability, but is a nonresident at the end of the year of income. ITAA36 s 98(3) deals with the situation where the beneficiary is a company and is not a beneficiary as trustee of another trust. ITAA36 s 98(4) deals with the situation where the beneficiary is not a company and is not a beneficiary as trustee of another trust. Under both subsections, the trustee is assessed and liable to pay tax on: so much of that share of the net income of the trust estate as is attributable to a period when the beneficiary was a resident; and so much of that share of the net income of the trust estate as is attributable to a period when the beneficiary was a non-resident and is attributable to sources in Australia.

Section 98A(1) liability 15.34 ITAA36 s 98A(1) deals with the situation where the trustee has been assessed under either s 98(3) or (4). In those circumstances, s 98A(1) includes in the assessable income of the beneficiary: (a) so much of the individual interest of the beneficiary in the net income of the trust estate as is attributable to a period when the beneficiary was a resident; and (b) so much of the individual interest of the beneficiary in the net income of the trust estate as is attributable to a period when the beneficiary was not a resident and is also attributable to sources in Australia.

Note that s 98A(1) will apply only where the beneficiary is a nonresident on the last day of the year of income. 15.35 Where an amount is included in the assessable income of a beneficiary under s 98A(1), then the trustee will have been assessed and will be liable to pay tax under either s 98(3) or (4). Under s 98A(2), any tax paid by the trustee pursuant to either s 98(3) or (4) in respect of the interest of the beneficiary in the net income of the trust estate is deducted from the tax assessed against the beneficiary under s 98A(1). If the tax paid by the trustee is greater than the amount assessed against the beneficiary, then the beneficiary is entitled to a refund of the excess.

[page 1042]

Section 98(1) liability 15.36 ITAA36 s 98(1) deals with the situation where a beneficiary is presently entitled, either at general law or under s 101 (discussed at 15.77), to a share of the income of the trust estate and is under a legal disability. Under s 98(1), the trustee is assessed and liable to pay tax on: (a) so much of that share of the net income of the trust estate as is attributable to a period when the beneficiary was a resident; and (b) so much of that share of the net income of the trust estate as is attributable to a period when the beneficiary was not a resident and is also attributable to sources in Australia.

Note that, in contrast to ITAA36 ss 97(1) and 98(3) and (4), the residential status of the beneficiary at the end of the year of income does not affect the applicability of s 98(1). 15.37 It is not clear whether s 98(1) taxes the trustee in the situation where a beneficiary is deemed to be presently entitled by ITAA36 s 95A(2) and is under a legal disability. Arguably, the better view is that because of the presence of s 97(2)(a) (discussed at 15.32), and in the absence of an equivalent provision in s 98, the term ‘presently entitled’ in s 98(1) does include a s 95A(2) deemed present entitlement. If this is the case, then the trustee is assessed and liable to pay tax under s 98(1). Another view is that s 98(2) implies that a s 95A(2) deemed present entitlement does not attract the operation of s 98(1). According to this view, the trustee is assessed under either s 99 or s 99A. Note that, in any event, s 97(2) prevents the beneficiary being assessed under s 97(1) in this situation.

Section 98(2) liability 15.38 ITAA36 s 98(2) deals with the situation where the beneficiary is a natural person, is deemed under s 95A(2) to be presently entitled to a share of the net income of the trust estate, and is not under a legal

disability. In this situation, the trustee is assessed and liable to pay tax under s 98(2) on: (d) so much of … the net income of the trust estate as is attributable to a period when the beneficiary was a resident; and (e) so much of … the net income of the trust estate as is attributable to a period when the beneficiary was not a resident and is also attributable to sources in Australia.

Note that, as is the case with s 98(1), the residential status of the beneficiary at the end of the year of income does not affect the liability of the trustee under s 98(2). [page 1043]

Section 100(1) liability 15.39 ITAA36 s 100(1) applies where a beneficiary is either under a legal disability or is deemed to be presently entitled to any of the income of the trust under s 95A(2), and is a beneficiary in more than one trust or derives income from a source other than the trust. In these circumstances, s 100(1) includes in the assessable income of the beneficiary: (c) so much of the individual interest of the beneficiary in the net income of the trust estate or each of the trust estates as is attributable to a period when the beneficiary was a resident; and (d) so much of the individual interest of the beneficiary in the net income of the trust estate or each of the trust estates as is attributable to a period when the beneficiary was not a resident and is also attributable to sources in Australia.

15.40 ITAA36 s 100(2) provides that the tax paid or payable by the trustee in respect of that beneficiary’s interest in the net income of the trust shall be deducted from the tax assessed against the beneficiary.

Sections 99 and 99A liability

15.41 ITAA36 ss 99 and 99A apply where there is no part of the net income of a trust estate that is included in the assessable income of a beneficiary under ITAA36 s 97 or on which the trustee is assessed and liable to pay tax under ITAA36 s 98. A shorthand way of describing the occasions which give rise to s 99 or s 99A liability is that these sections apply where no beneficiary is presently entitled. 15.42 Where the trust is a resident trust estate, the prerequisites for the operation of s 99 or s 99A are as follows. There is at least a part of the net income of the trust: which is not included in the assessable income of a beneficiary under s 97; on which the trustee is not assessed and liable to pay tax under s 98; or which is not income to which a beneficiary is presently entitled that is attributable to a period when the beneficiary was not a resident and is also attributable to sources outside Australia. 15.43 Where the conditions set out in 15.42 are satisfied, the trustee is assessed and liable to pay tax on that portion of the net income of the trust, either under s 99, as if it were the income of a resident individual and were not subject to any deductions, or under s 99A at the rate declared by parliament. Note that the first two prerequisites are present to ensure that ss 99 and 99A do not tax the trustee on an amount which has otherwise been taxed. The third prerequisite is necessary as such amounts derived from foreign sources and attributable to a period when the beneficiary was not a resident would not be taxed under either s 97 or s 98 and, hence, would not be excluded from ss 99 and 99A by the first two prerequisites. The combined effect of the three prerequisites is that if no beneficiary is presently entitled to any part of the [page 1044] net income of the trust, then the trustee will be assessed under s 99 or s 99A even if the income is foreign source income. In this respect, the tax

treatment of a resident trust approximates the tax treatment of a resident individual. 15.44 Where a part of the net income of a resident trust estate meets all three of the prerequisites discussed at 15.42, then the trustee will be assessed and liable to pay tax on that part, either under s 99 or under s 99A, as if it were the income of a resident individual and were not subject to any deductions, at the rate declared by parliament. The combined effect of the three prerequisites is that, where no beneficiary is presently entitled to a part of the net income of the trust, then s 99 or s 99A will tax the beneficiary even if that part comprises foreign source income. The tax treatment of trusts in this respect approximates the tax treatment of individuals. 15.45 Where the trust estate is not a resident trust estate, the prerequisites for the operation of ss 99 and 99A are as follows. There is at least a part of the net income of the trust: that is included in the assessable income of a beneficiary under s 97; in respect of which the trustee is not assessed and liable to pay tax under s 98; or, that is attributable to sources in Australia. 15.46 Where the conditions set out in 15.45 are satisfied, then the trustee is assessed and liable to pay tax on the net income of the trust estate, either under s 99 or under s 99A, as if it were the income of a resident individual and were not subject to any deductions, at the rate declared by parliament. The combined effect of the three prerequisites in this situation is that, where no beneficiary is presently entitled to the net income of the trust, then the trustee will be assessed and liable to pay tax under either s 99 or s 99A only on so much of that net income as has an Australian source. Here, the income tax treatment of nonresident trusts approximates the tax treatment of non-resident individuals. Where the beneficiary is a non-resident and is presently entitled, and the income of the trust is foreign source income, then the beneficiary will not have been assessed under s 97 or s 98A and the trustee will not have been assessed under s 98. Nor will the trustee be

assessed under s 99 or s 99A as the whole of the third prerequisite will not have been met. Again, in this respect, the tax treatment of the trust with the nonresident beneficiary approximates the tax treatment of nonresident individuals. If the beneficiary is a non-resident at the end of the year of income and the income is not foreign source income, then the trustee will be assessed under s 98(3) or (4) and hence ss 99 and 99A will not be applicable. 15.47 Where part of the net income of a trust estate that is not a resident trust estate meets all three of the prerequisites discussed at 15.45, then the trustee is assessed and liable to pay tax on that part of the net income of the trust estate, either under s 99 or under s 99A, as if it were the income of an individual and were not subject to any deductions, at the rate declared by parliament. The combined effect of these three prerequisites is that where there is a part of the net income of the trust estate to which no beneficiary is presently entitled, the trustee is only liable to pay tax on so much of that part as is attributable to Australian sources. Again, the tax [page 1045] treatment of non-resident trusts in this respect corresponds with the tax treatment of non-resident individuals. Where a beneficiary in the trust is a non-resident who is presently entitled to a part of the net income which is attributable to a period when the beneficiary was a nonresident, and which is attributable to sources outside Australia, then the beneficiary will not have been assessed under s 97(1) or s 98A(1) and the trustee will not have been assessed under s 98. Nor will the trustee be assessed under s 99 or s 99A in respect of that part of the net income, as that part will have a foreign source. If that part of the income does not have a foreign source or is attributable to a period when the beneficiary was a resident, then the trustee will be assessed under s 98, with the result that ss 99 and 99A will not be applicable. 15.48

In the case of a testamentary trust, s 101A may deem some of

the income of the trust to be income to which no beneficiary is presently entitled. This will mean that this income is taxed under either s 99 or s 99A. Section 101A is a fairly straightforward provision which has the effect of deeming amounts received by a trustee of a deceased estate (which would have been assessable income if received by the deceased during his or her lifetime) to be included in the assessable income of the trust estate and to be income to which no beneficiary is presently entitled. Section 101A(2) and (3) ensures that s 101A(1) does not apply to amounts received in lieu of annual leave or long service leave or to eligible termination payments. Section 101A is discussed in more detail in 15.129–15.131. 15.49 Section 99 will apply only if s 99A does not apply. The difference between the two sections is that s 99A taxes the trustee at a flat rate, of 45%. Section 99A applies to all trust estates except where the trust estate is one of the types mentioned in s 99A(2), and the Commissioner is of the opinion that it would be unreasonable for s 99A to apply to that trust estate in that year of income. The trust estates listed in s 99A(2) are trust estates: (a) that resulted from: (i) a will, a codicil or an order of a court that varied or modified the provisions of a will or a codicil; or, (ii) an intestacy or an order of a court that varied or modified the application, in relation to the estate of a deceased person, of the provisions of the law relating to the distribution of the estates of persons who die intestate; (b) that consists of the property of a person who has become bankrupt, being property that has vested in the Official Receiver in Bankruptcy, or in a registered trustee, under the Bankruptcy Act 1966; (c) that is administered under Part XI of the Bankruptcy Act 1966; or (d) that consists of property of the kind referred to in paragraph 102AG(2)(c) [s 102AG(2)(c) refers to income derived by a trust from the investment of property transferred to the trust in satisfaction of certain claims for personal injury, under a policy of life insurance, or pursuant to a law relating to workers compensation and so on];. …

[page 1046]

15.50 Section 99A(3) contains a non-exhaustive list of factors which the Commissioner is required to have regard to in exercising discretion under s 99A(2). 15.51 While the Commissioner’s discretion under s 99A(2) clearly is very wide, the High Court in Giris Pty Ltd v FCT (1969) 119 CLR 365; 69 ATC 4015, pointed out that it was not unchallengeable. That decision is authority that the Commissioner must hold the opinion, must hold it bona fide, must not have formed it arbitrarily or fancifully, and must not have based it on irrelevant considerations: at ATC 4018 per Barwick CJ.14 Windeyer J pointed out that the purpose of the discretion in s 99A(2) is to enable the Commissioner to use s 99A as a means of combating tax avoidance by the use of trusts or not to use it when no tax avoidance was present. In the view of Windeyer J, for the exercise of the Commissioner’s discretion to be bona fide, it had to be for the purpose for which it was conferred: at ATC 4024.

Section 99B liability 15.52 ITAA36 s 99B applies in the situation where property of a trust estate is paid to, or applied for the benefit of, a resident beneficiary and s 99B(2) does not apply to the payment. If these conditions are satisfied, then s 99B includes the amount of the payment in the assessable income of the beneficiary. ITAA36 s 99B(2) excludes the following from the amount which is included in the assessable income of the beneficiary under s 99B(1): (a) corpus of the trust estate (except to the extent to which it is attributable to amounts derived by the trust estate that, if they had been derived by a taxpayer being a resident, would have been included in the assessable income of that taxpayer of a year of income); (b) an amount that, if it had been derived by a taxpayer being a resident, would not have been included in the assessable income of that taxpayer of a year of income; (ba) an amount that is non-assessable non-exempt income of the beneficiary because of section 802-17 of the Income Tax Assessment Act 1997; (c) an amount: (i) that is or has been included in the assessable income of the beneficiary in pursuance of section 97; or (ii) in respect of which the trustee of the trust estate is or has been assessed and

liable to pay tax in pursuance of section 98, 99 or 99A; (iii) that is reasonably attributable to a part of the net income of another trust estate in respect of which the trustee of the other trust estate is assessed and is liable to pay tax under subsection 98(4); [page 1047] (d) an amount that is or has been included in the assessable income of any taxpayer (other than a company) under section 102AAZD; or (e) if the beneficiary is a company—an amount that is or has been included in the assessable income of the beneficiary under section 102AAZD. [Note: Section 102AAZD attributes certain foreign source income to attributable taxpayers in relation to a trust estate.]

15.53 Section 99B was enacted to tax distributions to Australian resident beneficiaries of foreign source income. Three situations in which s 99B will clearly apply are: 1. where foreign source income of a trust is attributable to a period in which the beneficiary who was presently entitled to it was not an Australian resident but that beneficiary was a resident at any time during the year of income when that foreign source income was paid to him or her or applied for his or her benefit; 2. where a non-resident trust estate has foreign source income to which no beneficiary is presently entitled and which is subsequently paid to or applied for the benefit of a beneficiary who was a resident at any time in the year of payment or application; and 3. where foreign source income was derived by a trust estate prior to 30 June 1978 and distributed to a beneficiary who was a resident in the year of income ending 30 June 1979 or a subsequent year of income.15 Note that if the exception in s 99B(2)(b) applied in any of the situations mentioned above, s 99B would not apply. As the ITAA36 s 23(q) exemption was current in the years prior to 30 June 1978, it would seem that s 99B(2)(b) would always apply to the third situation identified above where the income in question was not exempt in the

country of source. In the first and second situations, there would appear to be a prospect of s 99B(2)(b) applying only where the income was derived prior to the repeal of s 23(q) (effective from the year of income commencing on 1 July 1987), or was otherwise exempt from tax or not taxable. 15.54 On a literal reading, s 99B(1) applies to other distributions of trust income which have not previously been taxed. It should be noted that the Commissioner has always confined the operation of s 99B to situations involving trusts with foreign source income. That this is correct is borne out by the obiter dicta remarks of Hill J in Traknew Holdings Pty Ltd v FCT (1991) 21 ATR 1478; 91 ATC 4272 at 4284. When discussing ITAA36 s 99B, brief mention should also be made of ITAA36 s 99C, which ensures that s 99B extends to indirect applications and distributions of trust income. [page 1048]

Anti-avoidance and anti-splitting provisions Anti-avoidance provisions 15.55 In addition to the basic taxing provisions discussed above, ITAA36 Pt III Div 6 contains anti-avoidance provisions. These are ITAA36 s 100A (dealing with the situation where present entitlement arises from a reimbursement agreement), and ITAA36 s 102 (which deals with revocable trusts). 15.56 ITAA36 s 100A is directed at preventing certain trust-stripping arrangements. Traditional trust-stripping arrangements took the form of trust distributions which were paid to a low- or no-tax beneficiary (such as a tax-exempt entity or to a trust with accumulated tax losses) who then reimbursed them to the real beneficiary as a capital receipt. This could be done, for example, by a loan of moneys with no intention that the loan be repaid. Section 100A, enacted in 1979, attacked this form of trust stripping by deeming a beneficiary, whose present

entitlement was connected with a reimbursement agreement, not to be presently entitled. This meant that the trustee was assessed on the distribution under ITAA36 s 99A on both the Australian source and any foreign source income of the trust. In Raftland Pty Ltd v FCT (2008) 68 ATR 170; [2008] HCA 21, the High Court held that the purported appointment of trust income to a loss trust was a sham because it was never intended that the loss trust would receive the economic benefit of the appointment of trust income. Further, in the absence of a valid appointment of trust income, s 100A applied to deny the present entitlement of the default beneficiaries to the trust income. Thus, the trustee of the Raftland trust was assessed under ITAA36 s 99A.16 15.57 A new generation of trust-stripping arrangements evolved following the enactment of ITAA97 s 100A. These schemes involve a tax-exempt entity (charity) being given a vested and indefeasible interest in the income of a discretionary trust, but postponing the charity’s enjoyment of the income. The idea is that the charity would then be deemed to be presently entitled to the trust income under s 95A thus eliminating tax on the net income of the trust. During the period in which the charity’s enjoyment of the income was postponed, family beneficiaries in the trust had access to the income of the trust. The Trust Recoupment Tax Assessment Act 1985 (Cth) counteracted these schemes by providing that either the trustee pay tax on the amount allocated to the tax-exempt entity at the top marginal rate or, providing that the beneficiaries so elect, tax on the allocation would be paid by non-exempt beneficiaries as if they had derived it. The persons who benefit from the trust-stripping arrangement pay tax on the allocation if the trust no longer exists, or the trust is unable to pay the tax and the beneficiaries do not elect to have the allocation included in assessable income. 15.58 Sections 100AA and 100AB were inserted to overcome tax avoidance arising from the appointment of trust income to a tax-exempt trust beneficiary

[page 1049] which would then be attributed with a greater amount of trust net income as a result of the proportionate interpretation of s 97. Section 100AA deems that a tax-exempt beneficiary is not presently entitled to trust income unless the beneficiary has been notified of that entitlement or paid the amount within two months of the end of the relevant income year. Section 100AB provides a further safeguard for the revenue by prescribing a formula which prevents the excessive allocation of trust income to a tax-exempt entity for tax purposes. 15.59 ITAA36 s 102 deals with the situation where the settlor either has power to revoke the trust or where income under the trust is payable to or accumulated for children of the settlor who are under 18 years old. The effect of ITAA36 s 102 is to impose the settlor’s marginal tax rate on income derived through trusts of this type. Tax planners fairly quickly found that s 102 could be circumvented by having a third party as settlor and by giving the parent of the children power to revoke the trust. The settlor would settle a nominal sum and then the parent would ‘feed’ the trust by giving larger amounts to it. In Truesdale v FCT (1969) 120 CLR 353, such an arrangement was held to fall outside the provisions of s 102 as the parent was the donor of funds to the trust but was not its ‘creator’ as required by s 102. Now the potential application of the general anti-avoidance provisions of Pt IVA (discussed in Chapter 17) would have to be considered in relation to such arrangements.

Anti-splitting provisions 15.60 The provisions of ITAA36 Pt III Div 6AA may be described as ‘anti-splitting’ measures. In the absence of provisions like Div 6AA, taxpayers could take advantage of the progressive rate scale to split income among family members who were unmarried minors. The basic strategy of Div 6AA is to combat this planning by imposing the top marginal rate of 45% on the unearned income of such minors after the first $416. The applicable rates are set out in ss 13 and 15 (and Schs 11

and 12) of the Income Tax Rates Act 1986 (Cth). In the case of a resident minor, a rate of 66% applies to income between $417 and $1307. (The effect of the 66% rate is to recapture the $416 tax-free threshold.) For income over $1307, the rate of 45% applies on the entire amount. Where the minor is a non-resident, 29% is payable between $0 and $416, a 66% rate applies between $417 and $732, and the top marginal rate of 45% on the entire amount applies above $732. Division 6AA applies to persons who were less than 18 years of age on the last day of the year of income and were not an ‘excepted person’. An ‘excepted person’ is defined in ITAA36 s 102AC, and includes a person: engaged in a full-time occupation on the last day of the year of income; disabled or incapacitated; a double orphan unless wholly or substantially dependent for support on a relative; permanently disabled unless wholly or substantially dependent for support on a relative. The low income rebate does not apply with respect to income to which Div 6AA applies. [page 1050] 15.61 Where Div 6AA applies to a minor, then the whole of the minor’s income is taxed at the special Div 6AA rates unless that income is ‘excepted assessable income’ (see ITAA36 s 102AE(2)): (a) employment income; (b) business income, provided the Commissioner considers that the business income and salary and wages are ‘fair and reasonable’; (c) income derived by the minor from the investment of property transferred to the minor in satisfaction of a claim for damages for personal injury, pursuant to a law relating to workers compensation, pursuant to a decree or order of dissolution or

annulment of marriage and so on; (d) income derived by a minor from the investment of property which devolved on the minor from a deceased estate, or was transferred to the minor by another person from property which devolved on that other person in a deceased estate and the transfer takes place within three years of the date of death, or acquired by the minor as a lottery prize; (e) so much of the minor’s interest in partnership income as in the opinion of the Commissioner is attributable to what would have been within the other exceptions if derived directly by the minor; (f) amounts included in the assessable income of the minor pursuant to s 97(1) or s 100 to the extent to which these amounts are ‘excepted trust income’; (g) amounts derived by the minor from the investment of any property that represents accumulations of the above types of income. 15.62 The direct application of Div 6AA to trusts comes in ITAA36 s 102AG(1). Where a beneficiary in a trust estate is a minor to whom Div 6AA applies, so much of the minor’s share of the net income of the trust estate as in the opinion of the Commissioner is attributable to assessable income other than ‘excepted trust income’ is subject to Div 6AA. The definition of ‘excepted trust income’ is contained in ITAA36 s 102AG(2). The broad effect of this definition is that ‘excepted trust income’ is so much of the income of the trust as represents income of the types referred to in paras (a), (c), (d) and (g) in 15.61.

Review of the scheme of ITAA36 Pt III Div 6 15.63 Review 15.27–15.62 before completing Activity 15.1 and Activity 15.2.

Refer to Figure 15.1 in 15.26. Note that the diagram is confined to the situation where

the beneficiary is a resident and not under a legal disability. Now draw some charts which explain how Div 6 of ITAA36 Pt III operates: (a) where the beneficiary is under a legal disability; and (b) where the beneficiary is a non-resident.

[page 1051]

Joseph is trustee of the Conrad Family Trust, which is a resident discretionary trust. The beneficiaries of the Conrad Family Trust are Marlow, a resident sui juris natural person; Jim, a non-resident sui juris natural person; and Antonia, a resident minor. In Y1, the income of the trust estate is $100,000 and the net income of the trust estate is also $100,000. There are no capital gains. Joseph distributes $30,000 of trust income to each of Marlow, Jim and Antonia but retains $10,000. Note that, in these circumstances, ITAA36 s 101 (discussed at 15.77) will deem Marlow, Jim and Antonia to be presently entitled to the share of the trust income that is distributed to them. Explain how the net income of the trust estate will be taxed under ITAA36 Pt III Div 6. A suggested solution can be found in Study help.

The meaning of the terms used in ITAA36 Pt III Div 6 Presently entitled 15.64 The phrase ‘presently entitled’ is a central concept in those sections in ITAA36 Pt III Div 6 which impose a liability to tax. The initial question that determines how net income of a trust estate (ie, income for tax purposes) is taxed via Pt III Div 6 is whether a beneficiary is presently entitled to a share of the income of the trust estate (ie, the income for trust purposes). Note also that it is possible for a beneficiary to be presently entitled to a share of income even though

that income has not been distributed to the beneficiary. What is critical is entitlement to a distribution — not the actual distribution itself. 15.65 The meaning of the phrase ‘presently entitled’ has been considered in a number of High Court and Federal Court decisions. Those decisions have not attempted to give a comprehensive definition of what it means to be ‘presently entitled’. In these cases, the courts have preferred merely to ask whether the beneficiary was presently entitled in the particular circumstances in question. In Harmer v FCT (1991) 173 CLR 264; 22 ATR 726; 91 ATC 5000, the parties agreed that the cases established that a beneficiary is ‘presently entitled’ to a share of the income of a trust estate if, but only if: (a) the beneficiary has an interest in the income which is both vested in interest and vested in possession; and (b) the beneficiary has a present legal right to demand and receive payment of the income, whether or not the precise entitlement can be ascertained before the end of the relevant year of income and whether or not the trustee has the funds available for immediate payment. [page 1052] 15.66 To understand the definition of ‘presently entitled’ agreed to by the parties in Harmer, it is necessary to explain what is meant by an interest in income being ‘vested in interest’ and what is meant by an interest in income being ‘vested in possession’. For the estate of a beneficiary to ‘vest in interest’, the following conditions must be satisfied: the beneficiary must be ascertained and in existence; and all contingencies must be satisfied so as to enable the interest to come into possession at once, subject to the determination at any time of any prior estates or interests. Thus, a beneficiary with an estate in remainder is vested in interest as the beneficiary is ascertained and in existence and will take his or her

estate when the life tenant dies. The death of the life tenant will be a determination of the prior life estate. 15.67 In Gartside v IRC [1968] AC 553 at 607; [1968] 1 All ER 121 at 128, Lord Reid said that vest in possession means ‘that your interest enables you to claim now whatever may be the subject of the interest’. Thus, a life tenant has an estate that is vested in interest and is vested in possession in that the life tenant has a present right to enjoyment of the property and its income. Note that, for an estate to vest in interest, all contingencies, other than the determination of prior estates or interests, must have been satisfied. Thus, if a will had specified that the remainderman would have an estate in remainder only if he or she married, his or her interest would be contingent until the person married. If this were the case, then once the life tenant married, his or her interest would cease to be contingent and would become vested. It is also useful to explain what is a ‘defeasible’ interest. A defeasible interest is one that can be brought to an end if a subsequent event occurs. Thus, in George Eliot’s Middlemarch, the interest that Mr Casaubon gives to his widow Dorothea in his will is a defeasible interest as it will come to an end if she remarries. Note that, until Dorothea remarries, her interest is vested rather than contingent but it is defeasible because it will come to an end if she remarries. 15.68 A further conclusion that can be drawn from the cases is that, for a beneficiary to be presently entitled to a share of the net income of a trust estate, the beneficiary must be able to require a distribution of that share or must be able to direct the trustee to deal with it on behalf of the beneficiary or would, but for the presence of a legal disability, be so able: see Walsh Bay Developments v FCT (1995) 31 ATR 15; 130 ALR 415, extracted at 15.73 below. Often this will amount to nothing more than another way of saying that the beneficiary must, subject to the rule in Saunders v Vautier (1841) 4 Beav 115; 49 ER 282, have a vested interest in possession. Thus, a widower with an equitable life estate in the income of a deceased estate would clearly appear to be presently entitled to the income of the estate for the purposes of Pt III Div 6, on the basis that the widower can call for a distribution of the income. It would not seem

to logically follow that the interest needs to be indefeasible. That is, the addition of a qualification that the widower would be entitled to the income of the estate during his life until he remarried would not appear to affect his present entitlement to the income of the estate prior to his remarriage. [page 1053] The Commissioner’s practice is to regard beneficiaries who are entitled to call for a distribution under the rule in Saunders v Vautier as being presently entitled, even though they do not strictly have a vested interest in possession. It should also be noted that, where there are several beneficiaries, the Commissioner’s practice is inconsistent with the decision in Walsh Bay Developments. In Pearson v FCT (2006) 64 ATR 109; [2006] FCAFC 111, the Full Federal Court held that the High Court decision in CPT Custodian Pty Ltd v Commissioner of State Revenue (2005) 60 ATR 371 means that the beneficiaries of a fixed trust, such as unit holders in a unit trust, will not necessarily be presently entitled to the net income of the trust for a particular accounting period. Although the meaning of ‘presently entitled’ was not an issue considered by the High Court in CPT Custodian, the High Court concluded that the unit holders in a unit trust were not the only entities with an interest in the trust fund in that case. Thus, it could not be said that the unit holders were absolutely entitled to the assets of the trust. In arriving at this conclusion, the High Court observed that the decision in Saunders v Vautier did not consider the significance of the trustee’s right of exoneration against the trust fund. This means that the unit holders of a unit trust will not necessarily be presently entitled to the income of the trust for any particular accounting period, because the unit holders may not be entitled to call for immediate payment of that sum. The decision in Pearson means that careful consideration of the terms of the relevant trust deed is necessary in determining whether or not the particular beneficiary is presently

entitled to income of the fixed trust. For discretionary trusts, the application of ITAA36 s 101 ought to be considered. 15.69 That the beneficiary must be able to require a distribution of the share of income was established in FCT v Whiting (1943) 68 CLR 199; 2 AITR 421; 7 ATD 179.

FCT v Whiting Facts: The respondents were executors and trustees of RS Whiting who died in 1929. Under the terms of the deceased’s will, after the payment of the deceased’s debts, funeral and testamentary expenses, certain pecuniary legacies and an annuity were payable, and the income from the residue of the deceased’s estate was to be divided (in unequal shares) among his wife and four children. Although the value of the estate assets as at the date of death exceeded the debts of the estate, they were insufficient to satisfy the annuity and the pecuniary legacies. Rather than realise the estate assets in the Depression and later wartime conditions, the executors carried on business in partnership with the trustees of the estate of the deceased former partner. Wartime conditions, the fact that one of the beneficiaries had died, and legal technicalities then relevant to the property of married women meant that certain beneficiaries could not consent to waive their rights under the will. [page 1054] While the assets of the estate remained unsold, it was not certain that the estate would be able to meet the estate debts in full or to provide for the annuity or to pay the legacies in full. The executors, with the consent of the beneficiaries, purported, for tax purposes, to allocate the net income of the trust estate to the annuitant and to the residuary beneficiaries in the proportions stated in the deceased’s will. In fact, the income from the estate had been applied to pay income tax and to reduce the balance on the partnership’s overdraft. Issue: Was the Commissioner correct in assessing the executors on the whole of the net income of the trust estate under ITAA36 s 99 or should he have assessed all or part of the net income to the beneficiaries under ITAA36 s 97 on the basis that the beneficiaries were presently entitled to all or some of the income? Held: No beneficiary was presently entitled to the income in the years in question and the Commissioner was correct in assessing the executors under ITAA36 s 99. Latham CJ and Williams J, after noting that no ultimate residue could emerge until all

prior obligations, including interest on interest-bearing debts and on the legacies, had been met, continued (at CLR 214): Rich J considered that the words “presently entitled” appearing in the sections quoted referred to a vested interest in possession as opposed to an interest in future. On the other hand it is contended that a beneficiary is presently entitled within the meaning of the sections only when he is entitled to immediate payment of a share of the income of the trust estate … Their Honours referred to ss 98 and 101 in support of the latter view then continued (at CLR 215): The words “presently entitled to a share of income” refer to a right to income “present” existing, that is, a right of such a kind that a beneficiary may demand payment from the trustee, or that, within the meaning of s 19 of the Act [ITAA36] the trustee may properly reinvest, accumulate, capitalise, carry to any reserve sinking fund or insurance fund, however designated, or otherwise deal with it as he directs on his behalf. A beneficiary who has a vested right to income (as in this case), but who may never receive any payment by reason of such right, is entitled to income, but cannot be said to be “presently entitled” as distinct from merely “entitled”. Indeed, it is difficult to see how he can be entitled at all to income which must be properly applied in satisfaction of some prior claim … Thus, in order to ascertain whether such a present right exists, it is necessary to look to the state of administration of the trust estate. [page 1055] Numerous authorities … have established that until an estate has been fully administered by payment of funeral and testamentary expenses, death duties, debts, annuities and legacies and the amount of residue thereby ascertained, the income of the residuary estate is the income of the executors and not of the residuary beneficiaries … The crucial question is at what moment of time, having regard to these general principles and the provisions of the trust instrument, can it be said that a beneficiary has become presently entitled to a share in the income of the trust estate. A beneficiary under a will may become entitled to a share of such income as an annuitant legatee or as a residuary beneficiary. His right to a share in such income would be determined by the trusts in the will … The only part of an estate which can be made available to satisfy the claims of the beneficiaries is that part which remains after the funeral and testamentary expenses, death duties and debts have been paid or provided for, if necessary out of the whole estate, including any income earned by the estate during the period of realisation. Entries made in the books of the estate to adjust the rights of the beneficiaries in the income and capital of the estate can only operate subject to the satisfaction of the claims of and cannot affect the rights of the creditors … The evidence shows that, in the year of income, the administration of the estate had only reached the initial stage during which the whole of the available net

income could only properly be applied (as it was, in fact, applied) in reduction of debts. The second stage will be reached when it will become proper for the executors to apply the estate or some part of it in satisfaction of the annuity and in payment of interest on or of the capital of the legacies. The annuitant and the legatees may then become presently entitled to an immediate share in the income of the trust estate within the meaning of s 97 [ITAA36], but it will only be at the third stage when the debts, the annuity and the legacies have been paid or provided for in full, that there will be any income to which the residuary beneficiaries, as such, will be presently entitled. The allocation of the net income of the estate amongst the residuary beneficiaries in the books of the executors for the year ending 30 June 1940 was, therefore, erroneous … the whole income of the estate in the relevant year was in fact and in law income to which no beneficiary was presently entitled, so that the Commissioner was right in assessing it as to the executors under s 99 [ITAA36]. Starke J delivered a separate concurring judgment.

[page 1056] 15.70 It is worth noting that the circumstances in Whiting were exceptional. The Depression and then wartime conditions, the death of one of the beneficiaries and the then law relating to the property of married women when combined meant that the relevant debts could not be provided for, let alone paid. In more normal circumstances, beneficiaries will be presently entitled in a year of income if the legal personal representatives have provided for debts without actually paying them even though the precise quantum of the beneficiaries’ entitlement has not been determined in that year: see (1951) 1 CTBR (NS) 386 Case 89.

1.

Note that in FCT v Whiting (1943) 68 CLR 199; 2 AITR 421; 7 ATD 179, the issue was whether the trustee should be assessed under ITAA36 s 99 at ordinary rates or whether each beneficiary should be separately assessed under ITAA36 s 97(1) at ordinary rates. Since both assessments would have been at ordinary rates why would the beneficiaries have preferred assessment under s 97(1)?

2.

Under the test of ‘present entitlement’ applied by Kitto J in Taylor v FCT (1970) 119 CLR 444; 1 ATR 582 (see 15.78), would each son have been presently entitled if the fourth trust had been in favour of a stranger?

15.71 In Whiting, the Full High Court held that the residuary beneficiaries were not presently entitled as the debts, annuities and pecuniary legacies in the estate had neither been paid nor provided for. Although the residuary beneficiaries may have been described as having an interest in the gross income of the trust estate, and hence as being entitled to income, they would be presently entitled only when they could call for a distribution. Note that at that time what would be distributed to them would not be the gross income of the estate but a share of the surplus that remained after the debts, annuities and legacies had been paid. In FCT v Totledge Pty Ltd (1982) 12 ATR 830; 82 ATC 4168, the Full Federal Court pursued some of the implications of the decision in Whiting. 15.72 In Totledge, the Full Federal Court held that the phrase ‘presently entitled to a share of the income of the trust estate’ requires consideration of whether a beneficiary has a present vested right to demand and receive immediate payment of the whole or the part of what has been received by the trustee as income, which amount retained its character in the hands of the trustee and is legally available for distribution. Thus, Totledge indicates that the beneficiaries entitled to receive a trust’s ‘distributable’ or ‘surplus’ income will be taken to be entitled to receive the entire ‘income of the trust estate’. In FCT v Bamford (2010) 240 CLR 481; [2010] HCA 10, the Full High Court unanimously held that trust law principles determine the meaning of ‘the income of the trust estate’, and that, accordingly, that phrase can be defined by a trust deed: see also 15.80. [page 1057]

1.

2.

What was the reason given by the Full Federal Court in FCT v Totledge Pty Ltd (1982) 12 ATR 830; 82 ATC 4168 for not holding that the words ‘presently entitled’ to a ‘share of the income’ in ITAA36 s 97(1) were not to be construed as meaning entitled to call for an immediate transfer of a share of gross income as defined? A beneficiary may be presently entitled to an amount that is available for distribution regardless of whether the accounts necessary for its precise ascertainment have been completed and/or whether it was actually held in a form ready for immediate payment. Discuss whether this statement is consistent with the decisions in FCT v Whiting (1943) 68 CLR 199; 2 AITR 421; 7 ATD 179; Taylor v FCT (1970) 119 CLR 444; FCT v Totledge Pty Ltd (1982) 12 ATR 830; 82 ATC 4168; see also Case 57 (1950) 1 TBRD 209 and Registrar Accident Compensation Tribunal (Vic) v FCT (1993) 178 CLR 145; 93 ATC 4835.

15.73 A beneficiary who has only a contingent interest will not be presently entitled to the income of the trust estate. As noted at 15.66–15.67, for an interest to no longer be contingent, all events, other than the termination of prior estates or interests, which are required to happen, must have happened before the beneficiary is entitled to possession of the fund. Walsh Bay Developments Pty Ltd v FCT (1995) 31 ATR 15; 130 ALR 415 illustrates circumstances in which a court will find that the interests of beneficiaries in a trust fund are still contingent.

Walsh Bay Developments v FCT Facts: Under a development agreement entered into with the Maritime Services Board (MSB), Walsh Bay Developments Pty Ltd (Walsh Bay) paid $74,566,000 to MSB. MSB invested the $74,566,000 in the parties’ joint names ‘on trust’. Interest earned on the investment was capitalised into the account. If notice was given that development approvals had been obtained, the whole of the fund, including interest, was to be paid to MSB. If the project could not proceed, the whole of the fund, including interest, except

for a share of interest not to exceed $1m, was to be paid to Walsh Bay. If the agreement was terminated as a result of Walsh Bay’s breach, the whole of the fund, except for a ‘retention sum’ of $10m, was to be returned to Walsh Bay. The retention sum was to be held in trust pending resolution of any dispute between the parties. [page 1058] The Commissioner assessed the parties on the interest on the fund as trustees under ITAA36 s 99A, on the basis that no beneficiary was presently entitled to the interest. Issues: 1. Was the interest income of a trust estate? 2. Should the income have been assessed under ITAA36 s 99A? Held: 1. The interest was income of a trust estate. The deed establishing the fund showed that the parties intended to create a trust. All the elements of a trust were present. It did not matter that the interests that were subject to the trust were at all relevant times contingent. 2. Neither Walsh Bay nor MSB had a vested interest in the income earned from the fund during the relevant period. Each party’s entitlement to income from the fund was dependent on future events which might not occur. 3. It could not be said that Walsh Bay and MSB were jointly entitled on the basis of the rule in Saunders v Vautier (1841) 4 Beav 115; 49 ER 282, as no consent by both parties to the termination of the trust had been given in the relevant period. 4. Dwight v FCT (1992) 37 FCR 237; 20 ATR 1461 was distinguishable as there the party paying in the money had a vested and indefeasible interest in the fund subject to a charge in favour of the other party to the litigation to secure reimbursement out of the fund should an order for costs be made in its favour. Here, as was the case in FCT v Harmer (1991) 173 CLR 264, neither party had a vested interest in the fund, and the fund was not held as security but subject to the beneficial interests which would begin when the contingencies were satisfied.

15.74 What if the events that establish the beneficiary’s interest in the income have happened but the beneficiary does not yet know that they have happened? Will the beneficiary be presently entitled to the income? In Vegners v FCT (1991) 21 ATR 1347; 91 ATC 4213, the Full Federal Court held that a beneficiary, who did not disclaim her interest in the trust, was presently entitled under s 101 (discussed in 15.77) to distributions of trust income that she received notwithstanding that she had no prior knowledge of the trust. This was because a trust is valid even though the beneficiary has no prior knowledge of it. In FCT v

Ramsden (2005) 58 ATR 485; [2005] FCAFC 39, the Full Federal Court held that a purported disclaimer of an interest in an appointment of trust income was ineffective where the disclaimer was made between two and a half and three years after the beneficiary was aware of the appointment. [page 1059]

Deeming provisions in relation to present entitlement 15.75 There are a number of deeming provisions which are relevant to the issue of whether a beneficiary is presently entitled. The first of these is an extension of the general law concept discussed above. ITAA36 s 95A(2) deems a beneficiary to be presently entitled where the beneficiary has a vested and indefeasible interest in any of the income of the trust estate but is not presently entitled to that income. Note that what is required is merely a vested and indefeasible interest not a vested interest in possession. The circumstances where a beneficiary will have a vested and indefeasible interest in the income of a trust estate but is not otherwise presently entitled to that income would appear to be limited.17 The following case, Dwight v FCT (1992) 37 FCR 178; 23 ATR 236; 92 ATC 4192, is an example of a situation where a beneficiary was found to be presently entitled under s 95A(2).

Dwight v FCT Facts: The applicant was the solicitor for United States Surgical Corp (United States Surgical), a US resident company engaged in Federal Court litigation against Hospital Products Pty Ltd and other defendants. Pursuant to a Federal Court order, United States Surgical paid sums of money as security for costs into bank accounts in the joint names of the solicitors of the parties to the litigation. The Commissioner assessed the applicant under ITAA36 s 99A on the basis that the interest from the investment of the moneys

deposited was income of a trust estate to which no beneficiary was presently entitled. The applicant appealed to the Federal Court. Issues: Among the issues considered in the case were: 1. Was the applicant a trustee for the purposes of ITAA36 Pt III Div 6? 2. Was any beneficiary presently entitled to the income of the trust estate? Held: The applicant and/or the other solicitors were trustees in the ordinary sense of the word of the moneys that had been invested. United States Surgical had a vested and indefeasible interest in the income of the trust and, hence, was deemed to be presently entitled to it under ITAA36 s 95A if it were not presently entitled in the ordinary sense. [page 1060] Hill J held (at ATR 243): Where the security takes the form of an order that moneys be deposited in the names of the solicitors of the parties, the moneys will be held, at least until the time a cost order is made (and perhaps until a bill of costs has been prepared and taxed, in default of agreement between the parties as to the quantum of costs), in trust for the plaintiff who has deposited them with the trustees. However, the trustees will be affected by, and bound to have regard to, the equitable rights of the defendant, which rights are co-extensive with his rights to have the fund held pending the determination of the proceedings and the making of a cost order, and if that order be in his favour, pending his having recourse to the fund to the extent of the costs taxed or agreed. In other words, the defendant has rights in the nature of a lien over the fund to secure reimbursement to himself, if an order of costs be made in his favour, out of the security fund … The trust in Harmer was, as the judgment of the High Court noted (at ATR 732; ALJR 93), analogous to a “trust for statutory purposes”, that is to say the persons claiming entitlement to the moneys invested were not beneficiaries in the proper sense, but, like the contributors in Fouche v Superannuation Fund Board (1952) 88 CLR 609 at 640, to which the judgment of the High Court in Harmer referred by analogy, had “… an interest in the trust fund which would probably give them standing in a court of equity, but they have not such a beneficial interest in the fund as has an ordinary cestui que trust.” So it may be said that here the defendants in the three proceedings, in respect of which security was ordered, are in a like sense not beneficiaries in the security fund, albeit that by reason of the charge or lien over the fund for their benefit they have standing in a court of equity, should, for example, the trustees of the fund seek to appropriate the trust assets. The same can not, however, be said of United States Surgical. The moneys in the fund are its moneys, although they are subject to a charge or lien in favour of the defendants creating an equitable interest co-extensive with the rights which that charge carries with it. On this basis, therefore, the question becomes whether the existence of that

charge or lien brings about the result that there is no present entitlement or deemed present entitlement. [page 1061] Hill J then noted that there were two possible answers to this question. The first was that the right to demand payment, of which the courts speak in cases like Whiting, is to be considered without reference to security interests of this kind. The second was to concede that ‘present entitlement’ in the ordinary sense does not apply, but to then look to whether there is a deemed present entitlement arising under s 95A(2). As Hill J considered that the applicant was entitled to succeed on the second basis, it was unnecessary for him to examine whether the applicant was presently entitled in the ordinary sense of the phrase: In my opinion, the present is a case where United States Surgical had, in the relevant years of income, a vested and indefeasible interest in the income from the security account. For the reasons given in Harmer, the defendants had no such interest and indeed were not beneficiaries. But here, United States Surgical was a beneficiary, indeed the only beneficiary, and the moneys in the fund and the income to be generated from it belonged to that company, subject only to a charge or lien upon it in favour of the defendants to secure future cost orders. In the result, United States Surgical was presently entitled to the whole of the income of the security fund.

15.76 The decision of Hill J in Dwight is to be contrasted with the earlier High Court decision in Harmer v FCT (1991) 173 CLR 264; 22 ATR 726; 91 ATC 5000. In Harmer, a company unsure of to whom it was obliged to pay money commenced interpleader proceedings and paid the money into court. The court ordered that this money be held by solicitors on trust for the party that would ultimately be successful in the litigation. The High Court held that no beneficiary was presently entitled to the income of the trust pending the outcome of the litigation. Once the litigation ended, the identity of the party presently entitled to the income and the quantum of that entitlement could be determined but, until that time, the interest of any party in the income was contingent. In Dwight, Hill J distinguished Harmer on two grounds. First, in Harmer, there was no suggestion that the income from the money paid into court remained the property of the party paying in. Rather, it was argued that the party that would ultimately be successful in the litigation would be presently entitled to the income when the

litigation was determined. Second, in Harmer, the moneys were not held as security for costs but to be dealt with in accordance with orders that the court ultimately made in its determination of the conflicting claims to the moneys. 15.77 Another provision which deems beneficiaries to be presently entitled is ITAA36 s 101. Section 101 deems a beneficiary in whose favour or for whose benefit a trustee exercises a discretion to pay or apply trust income to be presently entitled to the income so paid or applied. This provision will extend the meaning of the general law notion of present entitlement to cover the interest of a beneficiary in a [page 1062] discretionary trust who would otherwise not have a vested interest in possession in income of the trust prior to its distribution. The Commissioner allows trustees of discretionary trusts a period of two months grace after the end of the relevant income period in which they may make appointments of trust income for the relevant period. There is no statutory basis for this and, in any case, it is usual practice for appointments of trust income to be made prior to the end of the relevant accounting period. This might also be dictated by the terms of the particular trust deed, which might stipulate the time by which any express appointment of trust income by the trustee must be made. Further, trust deeds of discretionary trusts often incorporate a default vesting clause, which provides that, in the absence of the exercise of the trustee’s discretion by the stipulated time, and with respect to any amount of trust net income, nominated ‘default objects’ will be absolutely entitled to that net income in specified shares (if there is more than one default object). In BRK (Bris) Pty Ltd v FCT (2001) 46 ATR 347, Cooper J concluded that such a default vesting clause did not achieve the settlor’s desired outcome because the default provision operated after the end of the relevant income period and, therefore, was ineffective to confer

present entitlement upon a particular trust object prior to the end of the relevant income year. As such, penalty taxation under ITAA36 s 99A applied. However, the contrary view regarding the operation of a default vesting provision was adopted in Ramsden v FCT (2004) 56 ATR 42; [2004] FCA 632 (Spender J) and in FCT v Marbray Nominees Pty Ltd 85 ATC 4750, such that the default clause conferred present entitlement upon a beneficiary within the relevant income year. In Union Fidelity Trustee Co of Australia Ltd v FCT (1969) 119 CLR 177, Barwick CJ expressed the view that, if trust income derived by a trust estate during a year of income is distributed to a beneficiary entitled to it, the beneficiary could not thereafter be presently entitled to that income. Subsequently, ITAA36 s 95A(1) was enacted to combat this possibility. Section 95A(1) deems a beneficiary who is presently entitled to income continues to be presently entitled to that income notwithstanding that the income is paid to, or applied for the benefit of, the beneficiary.

Legal disability 15.78 A person is under a legal disability when the person lacks the capacity to give a good discharge in respect of a payment received (ie, to provide the trustee with a legally recognised acknowledgment that payment has been received and, hence, that the trustee’s obligation to the beneficiary with respect to that sum has been discharged). Examples of persons who are under a legal disability are minors, persons of unsound mind and undischarged bankrupts. Under ITAA36 s 95B, a beneficiary who is presently entitled to a share of income of a trust estate in the capacity of a trustee of another trust estate is deemed, in respect of his or her present entitlement to that share, not to be under a legal disability. As a matter of general law, a person under a legal disability cannot require a trustee to distribute income to him or her as he or she is incapable of giving the trustee a good receipt. Note, however, that ITAA36 s 98(1) speaks of a beneficiary

[page 1063] who is presently entitled to a share of the income of the trust estate but is under a legal disability. If a person who is under a legal disability cannot require the trustee to make a distribution of trust income, then how can that person be presently entitled to a share of the income of the trust estate? This was the issue that the court confronted in Taylor v FCT (1970) 119 CLR 444; 1 ATR 582; 70 ATC 4026.

Taylor v FCT Facts: The appellants were trustees of separate trusts for each of the three infant sons of LN Taylor. Until each beneficiary attained the age of 21 years (what was then the age of majority), income from each trust was to be applied: 1. as to the whole or such part (if any) as the trustees in their absolute discretion thought fit — for the maintenance, education or advancement, support or benefit of that beneficiary; 2. to accumulate the balance but so that it should continue to be available for distribution under the first trust and should otherwise go according to the third trust; 3. if the beneficiary attained the age of 21 years, to hold the accumulated and future income for him absolutely; and 4. if the beneficiary died before attaining the age of 21, to hold the accumulated and future income on trust for his personal representative absolutely to the intent that it should form part of his estate. In the relevant year, the sons were all under the age of 21. The trustees did not pay any income in exercise of their discretion under the first trust. The income was accumulated as the beneficiaries, being minors, had no right to receive it. The Commissioner assessed the trustees of each trust on the accumulated income under ITAA36 s 99A on the basis that no beneficiary was presently entitled to the income. Issues: Was the principal beneficiary of each trust presently entitled to the whole of the income of that trust in the relevant year of income with the effect that either the beneficiary should be assessed under ITAA36 s 97(1) or, in the alternative, under ITAA36 s 98(1)? Held: The principal beneficiary of each trust was presently entitled to the whole of the income of the trust estate. As each beneficiary was under a legal disability, the trustees should be assessed under ITAA36 s 98(1). Kitto J held (at CLR 447):

The trusts declared to take effect in the alternative events of the son’s attaining 21 or dying before attaining that age are both [ie, the fourth trust in the summary above], in form, contingent. [page 1064] If the second of them had been in favour of a stranger, their combined effect would have been that notwithstanding the contingent form of the first the son would have taken a vested interest liable to be divested by the event of his dying under 21, and the stranger would have taken an interest, contingent upon that event … but since the second of the trusts is in favour of the son’s personal representatives, that is to say his executors and administrators in their representative capacities … the question that arises is whether the whole of the words declaring the two trusts should not be read as creating a trust of the income for the son, postponed as to enjoyment but indefeasibly vested in interest, by the method of describing the two possible ways in which such a trust may take effect in possession. Kitto J reviewed the authorities and concluded that the latter construction was appropriate: In my opinion, immediately upon the making of the settlement in the present case the son became absolutely entitled to the income arising during his minority though his personal enjoyment of it was postponed. But that is not enough to require the conclusion that the son was “presently entitled” to the income during the relevant year. He was not in fact entitled to receive any part of it in that year, because he was not legally competent to break the trust for accumulation and demand immediate payment. If it is so held that nevertheless he was “presently entitled” to the income, two propositions must be sustained: (1) that the quoted expression is to be so construed that a beneficiary is “presently entitled” if he is either entitled to immediate payment of it to himself (s 97 [ITAA36]), or would be entitled to do so were it not for the legal disability that he is under (s 98 [ITAA36]), and (2) that in the present case the son’s disability (infancy) was all that in the relevant year stood between him and a right to require the trustees to pay the income to him. Kitto J noted that under the rule in Saunders v Vautier (1841) 4 Beav 115; 49 ER 282, each son, but for the disability of infancy, could have required the trustees to disregard the trust for accumulation and pay the income in the relevant year to him. Kitto J then considered an argument by the Commissioner that on the basis of FCT v Whiting (1943) 68 CLR 199 each son was not presently entitled to a share of income as, because of their legal disabilities, they had no right to immediate payment from the trustee. Kitto J noted that ITAA36 s 98(1) ‘plainly acknowledges’ that a beneficiary [page 1065]

may be presently entitled to income notwithstanding that he is under a legal disability. Kitto J then continued: When their Honours (in the Full High Court in Whiting) spoke of the beneficiary having a right to obtain immediate payment, they could not have been referring to his legal capacity to give a discharge for the payment … I think it is clear that they were holding only that an admittedly vested interest in possession in the income of an estate does not make the beneficiary “presently entitled” to any income which is not distributable, and so is not yet specifically caught by the beneficiary’s interest … I think “presently entitled” refers to an interest in possession in an amount of income that is legally ready for distribution so that the beneficiary would have a right to obtain payment of it if he were not under a disability.

Resident trust estate 15.79 A ‘resident trust estate’ in relation to a year of income is defined in ITAA36 s 95(2) as one where: (a) a trustee of the trust estate was a resident at any time during the year of income; or, (b) the central management and control of the trust estate was in Australia at any time during the year of income.

The concepts of ‘residence’ and ‘central management and control’ are discussed in Chapter 18.

Problems where trust income and tax income differ 15.80 The net income of a trust estate for tax purposes and the income of the trust calculated according to the trust instrument will not necessarily be the same. Indeed, in the absence of provisions in the trust instrument which deem the trust income to be calculated in the same way as the tax net income, it will be almost an accident for the two amounts to be identical. The tax income can exceed the trust income for one of two reasons: either tax law recognises as income items which the trust instrument does not recognise; or the trust instrument allows

greater deductions than does the tax law. Conversely, the trust income will exceed tax income where either: the trust instrument recognises as income an item which tax law does not; or tax law allows greater deductions than the trust instrument does. As discussed below, where these disparities exist, problems in the operation of ITAA36 Pt III Div 6 emerge. [page 1066] One way that lawyers have sought to overcome these problems is by defining ‘income of the trust’ for the purposes of the trust deed as being identical to the ‘net income of the trust’ as defined in ITAA36 s 95. Another, similar, path is to allow the trustee a power to determine the nature of receipts and outgoings for the purpose of determining the income of the trust: see the clause extracted in Cajkusic v FCT (2006) 64 ATR 676 at [19]. In FCT v Bamford (2010) 240 CLR 481; [2010] HCA 10, the Full High Court unanimously held that such terms were effective in determining the meaning of ‘the income of the trust estate’. For the Commissioner’s view of Bamford, see Practice Statement Law Administration PS LA 2010/1. The Commonwealth is reviewing the scheme of Pt III Div 6. As an interim response to Bamford, the Tax Laws Amendment (2011 Measures No 5) Act 2011 (Cth) was passed to carve out capital gains received by trusts (see now ITAA97 Subdiv 115-C), carve out the treatment of franked dividend distributions (see ITAA97 Subdiv 207-C), and also prevent tax avoidance arising from appointments of trust income to tax-exempt beneficiaries (see ITAA36 ss 100AA and 100AB).

Where tax income exceeds trust income 15.81 In this situation, the problem which arises is ascertaining whether a beneficiary is presently entitled to the excess of the tax income over the trust income. As that excess may not be recognised for

trust purposes, depending on the terms of the trust and their efficacy (see the discussion in the preceding paragraph), it cannot be distributed to beneficiaries. 15.82 Here, one view, commonly known as the ‘proportions view’, is that the correct approach is to calculate the proportions in which the beneficiaries are presently entitled to the trust income and then to use those proportions in ascertaining the present entitlement of the beneficiaries to the net income of the trust estate for tax purposes. The main difficulty with this view is that it means that amounts are included in the assessable income of beneficiaries even though the beneficiaries do not receive those amounts. Despite the unfairness that may result from an application of the ‘proportions’ approach in some circumstances, it was adopted unanimously by the Full High Court in FCT v Bamford (2010) 240 CLR 481; [2010] HCA 10. 15.83 The alternative view, commonly known as the ‘amounts view’ or the ‘quantum view’, was that the correct approach is that beneficiaries are regarded as being presently entitled to the amounts which are distributed to them or applied for their benefit, while the balance of the tax income is regarded as income to which no beneficiary is presently entitled and as income on which the trustee is assessed and liable to pay tax pursuant to either ITAA36 s 99 or s 99A.

Where trust income exceeds tax income 15.84 In this situation, the problem is whether the beneficiaries will be assessed on a distribution of the excess of the trust income over the tax income. It is clear that this excess cannot be assessed under any of the provisions of ITAA36 Pt III Div 6. The excess is by definition not a share of the net income of the trust estate for tax purposes. [page 1067] 15.85 Where distributions of an excess of trust income over the net income of the trust estate are made under what the Commissioner

regards as ‘financing unit trust arrangements’, being trust arrangements that seek to treat what would have been payments of interest as trust distributions to a beneficiary. The Commissioner’s view is that the distributions are assessable to the unit holder under ITAA97 s 6-5. In Taxation Ruling IT 2512, the Commissioner identified what he regarded as two types of ‘financing unit trusts’.

Assume the facts in Activity 15.2 with the variation that the income of the trust estate is $90,000 but the net income of the trust estate is $100,000 and that $30,000 is distributed to each beneficiary. Explain how the trustee and beneficiaries would be taxed: (a) under the ‘proportions view’; and (b) under the ‘amounts view’. A suggested solution can be found in Study help.

Trusts and dividend imputation: Receipt of franked dividends 15.86 A trustee may hold shares as part of the trust property. This has implications for the operation of the imputation system where franked dividends are received by a trustee. The rules in ITAA97 Subdiv 207-B are similar to those applying to the flow of imputation credits through partnerships discussed at 14.56ff.

CGT and trusts 15.87 Except where a beneficiary is absolutely entitled to a trust asset as against the trustee, capital gains and losses that arise on the disposal of trust assets are excluded from the trust’s ITAA36 Pt III Div 6 calculation by Div 6E and the beneficiary’s share of any trust capital

gain is included in the beneficiary’s assessable income. Where a beneficiary is absolutely entitled to a trust asset, ITAA97 s 106-50 will mean that the acts of the trustee are regarded as the acts of the beneficiary. Where s 106-50 applies, its effect will be that capital gains and losses in relation to disposals of trust assets will be accounted for only at the beneficiary level. Section 106-50 is discussed at 15.96–15.99. 15.88 Where a trustee triggers capital gains events with respect to trust assets, the effect of ITAA97 Subdiv 115-C is that a beneficiary’s share of any capital gains forming part of the trust net capital gain (and, hence, part of the trust’s net income) is included in the beneficiary’s assessable income (after being grossed up to take account of any general CGT discount and/or small business 50% concession allowed to the trustee with respect to capital gains triggered by the trustee). The [page 1068] beneficiary then offsets any capital losses or unapplied net capital losses that it has against the capital gain component in the distribution. The beneficiary then applies the appropriate discount percentage (50% if the gain is made by an individual and 33⅓% if the gain is made by a complying superannuation fund) to the net capital gain thus ascertained. 15.89 Where trust assets are acquired after 21 September 1999 and disposed of after 12 months, then, provided the other prerequisites for the Div 115 discount are met, the trustee will be entitled to the 50% discount on capital gains. The trustee will not, however, be entitled to indexation of the cost of assets acquired after 21 September 1999. The gross-up procedures discussed in 15.91 apply to the beneficiary’s distributable amount.

CGT consequences of formation of a trust 15.90

A series of CGT events are potentially relevant when a trust is

created. These are: CGT event E1 — creating a trust over a CGT asset (ITAA97 s 104-55: see 15.91); CGT event E2 — transferring a CGT asset to a trust (ITAA97 s 104-60: see 15.92); and CGT event E3 — converting a trust to a unit trust (ITAA97 s 10465: see 15.93). In the case of each of these CGT events, a capital gain or loss that would otherwise be made is disregarded if the relevant CGT asset was acquired pre-CGT. Each of these CGT events will now be discussed in more detail.

CGT event E1 15.91 One way that a trust is created is by a person declaring that he or she holds particular assets subject to a particular trust. This method of creation is known as a declaration of trust. Another method for creating a trust is by what is known as a settlement. A person, the settlor, transfers property to a trustee upon certain trusts declared in the instrument that creates the trust. In most circumstances, where a trust is created by declaration or settlement, the creator of the trust will no longer have the entire beneficial interest in the trust property. In these situations, as there has been a change in the beneficial interests in the trust property, the creation of the trust is regarded as an appropriate occasion for triggering CGT consequences. CGT event E1 is the relevant CGT event. CGT event E1 will apply where you create a trust over a CGT asset by declaration or settlement: see, for example, Taras Nominees Pty Ltd v FCT [2015] FCAFC 4. However, CGT event E1 will not apply where you are the sole beneficiary of the trust, you are absolutely entitled to the asset as against the trustee (disregarding any disability) and the trust is not a unit trust. Where CGT event E1 applies, the creator of the trust makes a capital

gain if the capital proceeds from the creation are more than the asset’s cost base. [page 1069] A capital loss is made if the capital proceeds are less than the asset’s reduced cost base.18 The cost base of the asset to the trustee is deemed by ITAA97 s 10455(4) to be its market value at the time the trust was created. This rule does not apply where a beneficiary is absolutely entitled to the asset as against the trustee. In these circumstances, ITAA97 s 106-50 will apply: see 15.96.

CGT event E2 15.92 Often, when a trust is created by settlement, the practice is for the initial settlement of trust property only to be fairly small. The trust is then fed by making gifts of other property to the trust. CGT event E2 is relevant in this situation. CGT event E2 will apply where you transfer a CGT asset to an existing trust. However, CGT event E2 will not apply where you are the sole beneficiary of the trust, you are absolutely entitled to the asset as against the trustee (disregarding any disability) and the trust is not a unit trust. Where CGT event E2 applies, the transferor of the trust asset makes a capital gain if the capital proceeds from the creation are more than the asset’s cost base. A capital loss is made if the capital proceeds are less than the asset’s reduced cost base. The cost base of the asset to the trustee is deemed by ITAA97 s 104-60(4) to be its market value at the time the asset is transferred. This rule does not apply where a beneficiary is absolutely entitled to the asset as against the trustee. On a textualist interpretation of s 104-60, any transfer of an asset to a trustee will trigger the application of CGT event E2. CGT event E2 differs from CGT event A1 with respect to the time of the CGT event

and also with respect to the trustee’s cost base. The unique rules under CGT event E2 may be appropriate where the transferor and the trustee are associates, for example, where the transferor is a beneficiary of the family trust that receives the property. However, where the transferor and the trustee are not associates, it would be an odd result if CGT event E2 were to apply rather than CGT event A1. In ATO ID 2003/559, the Commissioner states that CGT event A1 applies if the parties are dealing at arm’s length. In Healey v FCT, the 2012 ATC 20309 CGT event E2 was held to apply in circumstances where the parties were not at arm’s length. While discussing CGT event E2, it is worth noting that a mere change of the trustee of a trust will not trigger a CGT event. In particular, note that because of s 104-10(2)(b), a disposal of a CGT asset on a change of trustee will not trigger CGT event A1.

CGT event E3 15.93 In 15.20, we noted that a unit trust is a particular form of fixed trust in which the totality of beneficial interests in the trust property is divided into units which may be transferred or redeemed. CGT event E3 is concerned with the [page 1070] situation where an existing trust is converted into a unit trust. Note that all that takes place in this situation is the conversion of the trust from one type of fixed trust to another type. This would normally be done by making alterations to the trust deed. The process of conversion would not normally involve any transfers of assets. Hence, CGT event E2 would not normally apply when the trust is converted. Note also that the process of conversion does not involve the creation of a new trust but merely a change of rights and duties in an existing trust. Hence, CGT event E1 would not normally apply when the trust is converted. The conversion of a trust into a unit trust is unlikely to involve any change in the beneficiaries of the trust. Why then should the conversion

be the occasion for a CGT event? The reason is that conversion to a unit trust, in a practical sense, greatly increases the ability to create new beneficial interests in the trust. As is the case with a share issue by a company, an issue of units by a trustee of a unit trust does not trigger CGT event D1: see ITAA97 s 104-35(5)(d). This means that, in the absence of CGT event E3, it would be possible to convert a trust to a unit trust and then, without triggering CGT consequences, effectively change the beneficial ownership of trust assets by issuing new units to other parties. CGT event E3 will apply: where a trust (that is not a unit trust) over a CGT asset is converted into a unit trust; where just before the conversion a beneficiary under the trust was (disregarding any legal disability) absolutely entitled to the asset as against the trustee. Where CGT event E3 applies, the beneficiary makes a capital gain if the market value of the asset at the time of conversion is more than the asset’s cost base. A capital loss is made if the market value is less than the asset’s reduced cost base.

CGT event E9 15.94 CGT event E9 happens if you agree for consideration that when property comes into existence you will hold it on trust provided that, at the time of the agreement, no potential beneficiary under the trust has a beneficial interest in the rights created by the agreement. You make a capital gain if the market value that the property would have had, if in existence at the time of the agreement, is more than any incidental costs incurred related to CGT event E9. If the costs are more than the market value of the property, you make a capital loss. You will recall from 14.50 that when part of a partner’s interest in a partnership is assigned, the assigning partner holds that part of his or her interest on trust for the assignee. When future partnership income comes into existence, the assigning partner holds it subject to the trust created by the assignment. Thus, an assignment of a partner’s interest in

a partnership might be an example of a situation where CGT event E9 would operate. It may be, however, that the operation of CGT event E9 in these circumstances is excluded by ITAA97 s 104-105(1)(b). [page 1071]

CGT consequences of operation of a trust 15.95 The CGT provisions relevant to the operation of a trust may be divided into four broad categories. The first is provisions relevant to all trusts. The second is provisions relating to CGT events E5–E8 that do not apply to unit trusts or to trusts of deceased estates to which ITAA97 Div 128 applies. The third category is the provisions in Div 128 that apply to trusts of deceased estates. The fourth category is the provisions that apply to unit trusts but not to other trusts.

Provisions relevant to all trusts Where beneficiary absolutely entitled as against the trustee: s 106-50 15.96 Under ITAA97 s 106-50, where a beneficiary is absolutely entitled to a trust asset as against the trustee, the CGT provisions in the ITAA97 apply to an act done by the trustee in relation to the asset as if the act were done by the beneficiary. The effect of this provision is that capital gains and losses arising from CGT events that take place in relation to trust assets during the operation of the trust are accounted for at the beneficiary level. Where s 106-50 applies, the net capital gains on trust assets are not included in calculating the net income of the trust estate under ITAA36 Pt III Div 6. 15.97 The phrase ‘absolutely entitled as against the trustee’ is not defined in the ITAA97. The same phrase is used in the UK CGT provisions and there is some case law on its meaning in that context.

The core meaning of the phrase ‘absolutely entitled to the asset as against the trustee’ that emerges from the UK cases is clear enough. The beneficiary must be able to direct the trustee as to how to deal with the asset including a direction to transfer the asset to the beneficiary. More technically, the interest must be: vested (not contingent); indefeasible (not a successive interest which can be defeated by the death of the beneficiary before the termination of a prior interest); and one which enables the beneficiary to direct the trustee to convey the asset to the beneficiary or otherwise. In Kafataris v FCT [2011] FCA 1454, the Federal Court held that absolute entitlement of a beneficiary to an asset of a trust estate would arise when the beneficiary had a vested, indefeasible interest in that trust asset such that the beneficiary is able to direct the trustee as to the disposition of that asset. 15.98 Note that s 106-50 expressly states that any disability of the beneficiary is disregarded in determining whether or not the beneficiary is absolutely entitled as against the trustee. The meaning of legal disability was discussed in 15.78. As discussed in 15.78, a person under a legal disability cannot direct the trustee as to how to deal with the trust property and cannot give a good receipt to the trustee. United Kingdom authority on the use of a similar phrase in the equivalent UK provision holds that it extends the meaning of the phrase ‘absolutely entitled as against the trustee’ to persons who, but for their disability, would have been entitled [page 1072] to direct the trustee as to how to deal with the trust property.19 However, where a beneficiary’s entitlement is contingent on the beneficiary attaining a particular age, the better view is that the beneficiary is not absolutely entitled as against the trustee. This is

because it is not merely the beneficiary’s legal disability that would otherwise prevent the beneficiary from being absolutely entitled. Rather, the beneficiary would not be absolutely entitled because the beneficiary had not satisfied the contingency to which the interest was subject.20 15.99 Note that there are several differences between ITAA97 s 10650 and the equivalent UK provision.21 These differences mean that it is unclear whether the following types of beneficiaries will be absolutely entitled to an asset as against the trustee: one of several beneficiaries of a trust which has assets (such as land) that are not readily divisible; and a beneficiary of a trust where the trustee has a charge, lien or other right against the trust assets. If all concurrent beneficiaries in a trust join together in requiring the trustee to distribute assets to them, from that point onwards each beneficiary would appear to be absolutely entitled to the trust assets as against the trustee.22 The better view is that, prior to a joint direction to the trustee, one of several concurrent beneficiaries in a trust should not be regarded as being absolutely entitled to a trust asset as against the trustee.23 In TD 2000/32, the Commissioner states that a unit holder in a unit trust is not capable of being absolutely entitled to a trust asset as against the trustee for the purposes of ITAA97 s 106-50. A beneficiary who has no interest in the trust assets cannot be absolutely entitled as against the trustee. Residuary beneficiaries in an incompletely administered estate clearly fall into this category. On one view, objects in a discretionary trust do also. [page 1073]

Capital payment for trust interest: CGT event E4 15.100 CGT event E4 takes place when a trustee makes a payment to you in respect of a unit or interest in a trust. Where CGT event E4 takes place, the cost base and reduced cost base of the beneficiary’s unit or

interest in the trust is reduced by the amount of the non-assessable parts of the payment. If the non-assessable part of the payment exceeds the cost base, the excess is a capital gain. If CGT event E4 produces a capital gain, the cost base and reduced cost base of the beneficiary’s unit or interest is reduced to nil. A beneficiary cannot make a capital loss from the operation of CGT event E4. The effect of CGT event E4 is that, although distributions of an excess of trust income over the tax income of the trust are not assessed to beneficiaries under ITAA36 Pt III Div 6, they will, in most cases, ultimately give rise to capital gains that are taxable to the beneficiary. Where you did not incur expenditure to acquire the interest in the trust, the market value substitution rule will mean that the cost base of your interest is its market value at the time you acquired it. 15.101 CGT event E4 does not apply where the payment amounts to CGT event A1, C2, E1, E2, E6 or E7 happening in relation to the trust asset. Further, from 21 March 2005, CGT event E4 generally does not apply where a payment is made to a non-resident beneficiary where the payment is reasonably attributable to non-Australian source income: see ITAA97 s 104-70(9). CGT event E4 will happen only if some or all of the payment, the ‘non-assessable’ part, is not included in your assessable income. Distributions of amounts that have been assessed to the trustee under ITAA36 Pt III Div 6 are disregarded in calculating the nonassessable part. Distributions of amounts that represent the excess of the income of the trust estate over its net income for tax purposes can trigger CGT event E4. The calculation of the non-assessable part is discussed in more detail in 15.104. 15.102 CGT event E4 takes place just before the end of the income year in which the payment is made, unless another CGT event takes place in relation to the unit or interest between the date of the payment and the end of the income year. Thus, if there are several payments throughout the year, adjustments to the cost base and reduced cost base of the units or interest will only take place at the end of the income year in which the payments were made. The way in which CGT event E4 reduces the cost base is explained at 15.100.

15.103 In TD 2003/28, the Commissioner states that CGT event E4 will not happen where a non-assessable distribution is made to a mere object or to a default beneficiary in a discretionary trust unless the default beneficiary acquired the interest by way of assignment for consideration. It is arguable that CGT event E4 cannot take place in relation to a distribution if ITAA97 s 106-50 (discussed at 15.96–15.99) has previously applied to the trust. The basis of the argument would be that, as s 106-50 deems the trustee’s actions to be the actions of the beneficiary, a distribution following the operation of s 106-50 cannot be regarded as a payment for the purposes of CGT event E4 — you cannot, in the absence of an express provision to the contrary, make a payment to yourself. 15.104 ITAA97 s 104-71 explains how the non-assessable part is calculated for s 104-70 purposes. Various specific amounts are excluded from the non-assessable part. These include: [page 1074] non-assessable non-exempt income; income that has been assessable to the trustee; amounts within the small business 15-year CGT exemption. Adjustments are also made under the table in s 104-71(4) to reduce the non-assessable part of a trust distribution so that it reflects the amount of general or small business concession that a trust beneficiary actually receives after grossing up the trust gain, offsetting capital losses and claiming the relevant discounts.

Provisions relevant only to trusts other than unit trusts and trusts of deceased estates Beneficiary becoming entitled to trust asset: CGT event E5 15.105 CGT event E5 takes place when a beneficiary in a trust becomes absolutely entitled to a CGT asset of the trust as against the

trustee. Any legal disability that the beneficiary is under is disregarded in determining whether the beneficiary is absolutely entitled to a trust asset as against the trustee. The meaning of the phrase ‘absolutely entitled as against the trustee’ was discussed in 15.96–15.99. CGT event E5 does not apply to either unit trusts or to trusts to which ITAA97 Div 128 (discussed in 15.132–15.135) applies. Further, given the meaning of the phrase ‘absolutely entitled as against the trustee’, it is likely that CGT event E5 will not apply to trusts, such as discretionary trusts and trusts of incompletely administered estates, where the beneficiary, arguably, does not have an interest in the trust assets prior to the distribution: see AAT Case 9451 (1994) 28 ATR 1105. 15.106 CGT event E5 may produce either a capital gain or a capital loss for the trustee. Further, subject to some important exceptions, CGT event E5 may produce a capital gain or loss for the beneficiary. It is important to note that, because of ITAA97 s 104-75(6), CGT event E5 will not produce capital gains or losses where the beneficiary acquired the interest (except by way of assignment from another) for no expenditure. In most trusts, other than unit trusts, the beneficiary will not have paid any consideration for his or her interest in the trust capital.

Disposal to beneficiary to end income right: CGT event E6 15.107 CGT event E6 (ITAA97 s 104-80) takes place when a trustee disposes of a CGT asset of the trust to a beneficiary in satisfaction of the beneficiary’s right, or part of it, to receive ordinary or statutory income from the trust. CGT event E6 does not take place in relation to unit trusts or in relation to trusts to which ITAA97 Div 128 (discussed in 15.132–15.135) applies. 15.108 The expression ‘right to receive ordinary income or statutory income from the trust’ which appears in ITAA97 s 104-80 is not defined. At its broadest, the expression could mean the right that an income beneficiary has to receive income once the trust comes into existence but before the income is distributed. This would include rights

that an income object in a discretionary trust has once a discretion to distribute has been exercised but before the actual distribution has been made. A narrower view of the meaning of the expression is that the right referred to is a right to income that exists independently of any right that might crystallise in [page 1075] relation to a particular year of income.24 Under the CGT provisions in the ITAA97, the broader meaning appears to be preferable as a distribution would not normally be in satisfaction of the narrower right in the absence of express agreement between the trustee and the beneficiary. The arguments in favour of the narrower view are not as strong under the ITAA97 as they were under the ITAA36.25 CGT event E6 may produce a capital gain or loss for the trustee. The trustee makes a capital gain if the market value of the asset is more than its cost base. It makes a capital loss if the market value of the asset is less than its reduced cost base. 15.109 CGT event E6 may produce a capital gain or loss for the beneficiary. The beneficiary makes a capital gain if the market value of the asset is more than the cost base of the right or part of the right to income. The beneficiary makes a capital loss if the market value of the asset is less than the reduced cost base of the right or part of the right to income. The market value substitution rule will not apply where the beneficiary did not pay anything for the right. Hence, in this situation, the cost base of the beneficiary’s right to income will be zero. In the usual situation where the beneficiary did not pay anything for the right, CGT event E6 will mean that the amount distributed to the beneficiary in satisfaction of the right to income will be all capital gain to the beneficiary. Note that nothing in ITAA97 s 104-80 (which sets out the details of CGT event E6) expressly excludes amounts that have been taxed to the trustee or the beneficiary under ITAA36 Pt III Div 6. It is likely that ITAA97 s 118-20(1A) (discussed at 6.134–6.137) should prevent double taxation in circumstances where the beneficiary is taxed,

for example, under ITAA36 s 97(1). However, s 118-20 will not eliminate the capital gain that accrues to the beneficiary via CGT event E6 where the trustee has been taxed previously under ITAA36 s 98 on the amount distributed. This is because for ITAA97 s 118-20 to operate an amount has to be included in the beneficiary’s assessable income.26 15.110 It is arguable that CGT event E6 cannot take place where ITAA97 s 106-50 (discussed in 15.96–15.99) has previously applied to the trust. The basis [page 1076] of the argument would be that, as s 106-50 deems the trustee’s actions to be the actions of the beneficiary, a distribution by following the operation of s 106-50 cannot be regarded as a disposal of a trust asset for the purposes of CGT event E6, as you cannot make a disposal, in the ordinary sense of the word, to yourself. If this argument is sound, then the circumstances in which CGT event E6 can operate will be limited. The event would be confined to disposals of a CGT asset in total or partial satisfaction of a right to income in circumstances where the beneficiary is not absolutely entitled to the asset as against the trustee. One circumstance where such a distribution might be able to be made as a matter of trust law would be where the trust instrument gives the trustee power to apply the income of the trust for the purposes of education and maintenance of minor beneficiaries. Another situation where CGT event E6 could take place would be where an income distribution is made to a life tenant or to an income beneficiary in a discretionary trust. Note that either of these distributions could be of an amount that was income for trust law purposes but was not income for tax purposes. Note, however, that where CGT event E6 applies to a distribution, CGT event E4 does not apply.

Disposal to beneficiary to end capital interest: CGT event E7 15.111

CGT event E7 (ITAA97 s 104-85) happens if a trustee of a

trust disposes of a CGT asset of the trust to a beneficiary in satisfaction of the beneficiary’s interest, or part of it, in the trust capital. CGT event E7 does not take place in relation to unit trusts or in relation to trusts to which ITAA97 Div 128 (discussed in 15.132–15.135) applies. 15.112 It is possible that CGT event E7 is confined to in specie distributions. Whether CGT event E7 is so confined appears to depend, in part, on whether or not Australian currency is an asset for CGT purposes. It is also possible that even if Australian currency is generally an asset for CGT purposes, it might not be an asset for the purposes of CGT event E7. Taxation Determination TD 2002/25 takes the view that Australian currency is not an asset for CGT purposes. 15.113 For CGT event E7 to apply, the disposal to the beneficiary must be in satisfaction of the beneficiary’s interest in the capital of the trust estate. Hence, CGT event E7 will not apply to distributions to beneficiaries, such as income objects of a discretionary trust or life tenants, who have no interest in the trust capital. Whether capital objects of a discretionary trust and default objects have an interest (in the relevant sense) in the trust capital cannot be regarded as a settled question. Arguably, the better view is that they do not. See the discussion of the authorities on the question of whether discretionary objects have an interest in the trust assets in 15.99. 15.114 It is arguable that CGT event E7 cannot take place where ITAA97 s 106-50 (discussed in 15.96–15.99) has previously applied to the trust. The basis of the argument would be that, as s 106-50 deems the trustee’s actions to be the actions of the beneficiary, a distribution by following the operation of s 106-50 cannot be regarded as a disposal of a trust asset for the purposes of CGT event E7, as you cannot make a disposal, in the ordinary sense of the word, to yourself. A further argument in favour of this view is that CGT event E5 may have applied to tax the [page 1077]

trustee or the beneficiary on a capital gain when the beneficiary became absolutely entitled to the asset as against the trustee. If CGT event E7 can apply to a subsequent distribution of a trust asset in satisfaction of the beneficiary’s interest in the corpus, then it too could give rise to capital gains for the trustee or the beneficiary. As the triggers for the two CGT events differ they both could potentially apply, with the result that the trustee and the beneficiary are taxed twice on the same gain. If these arguments are sound, then the circumstances in which CGT event E7 can operate will be limited. One circumstance where CGT event E7 could apply would be where a trustee, pursuant to a power in the trust instrument, appropriates capital of the trust estate for the maintenance or advancement of a minor beneficiary. As a matter of trust law, such an appropriation would be in partial satisfaction of the beneficiary’s interest in the trust capital. Another circumstance would be where a trustee pursuant to a power in the trust instrument appropriates an asset to one of several sui juris beneficiaries in satisfaction of the beneficiary’s interest in the trust capital.27 15.115 Although a distribution which triggers CGT event E7 might represent an excess of trust income over the net income of the trust estate, CGT event E4 (discussed in 15.100–15.104) will not be triggered by the distribution. This is because CGT event E4 does not happen where CGT event E7 is triggered. 15.116 The operation of CGT event E7 can give rise to capital gains or losses for the trustee. The trustee makes a capital gain where the market value of the asset is greater than its cost base. The trustee makes a capital loss where the market value of the asset is less than its reduced cost base. 15.117 CGT event E7 can produce capital gains or losses for the beneficiary. The beneficiary makes a capital gain where the market value of the asset is greater than the cost base of the interest, or the part of it, being satisfied. The beneficiary makes a capital loss where the market value of the asset is less than the reduced cost base of the interest being satisfied. ITAA97 s 104-85 does not expressly exclude distributions which are assessable to the beneficiary under ITAA36 Pt

III Div 6. ITAA97 s 118-20 would have to be relied on to prevent double taxation. A capital gain or loss that the beneficiary makes is disregarded if the beneficiary’s interest in the trust capital is a pre-CGT asset. Any capital gain or loss is also disregarded if, as would normally be the case with trusts of this type, the beneficiary did not give any money or property to acquire the interest in the trust capital.

Disposal by beneficiary of capital interest: CGT event E8 15.118 CGT event E8 (ITAA97 s 104-90) takes place when a beneficiary disposes of his or her interest in the trust, or part of the interest, otherwise than to the trustee. CGT event E8 does not take place in relation to unit trusts or in relation to trusts to which ITAA97 Div 128 (discussed at 15.132–15.135) applies.

Provisions relevant to trusts of deceased estates 15.119 The CGT treatment of trusts of deceased estates during the operation of the trust is discussed in 15.132–15.135. [page 1078]

Provisions relevant to unit trusts 15.120 In Taxation Determination TD 2000/32, the Commissioner expresses the view that the scheme of the ITAA97 is to treat units in a unit trust as the relevant asset for CGT purposes rather than any interest a unit holder might have in the underlying property of the unit trust. This means that the issue and redemption of units in a unit trust will not involve fractional disposals and acquisitions by other unit holders. Rather, for CGT purposes, a unit in a unit trust is treated like a share in a company which does not give the shareholder any interest in the assets of the company. One consequence of this approach is that many of the CGT provisions specifically relevant to units in a unit trust parallel, or are the same as, provisions specifically relevant to shares in

a company. The following paragraphs will discuss the more important of the CGT provisions specifically relevant to units in unit trusts. 15.121 As is the case with company-issued shares, CGT event D1 (discussed in 6.34–6.39) does not apply where the trustee of a unit trust issues units in the trust: see ITAA97 s 104-35(5)(d). Nor does CGT event D2 (discussed at 6.40–6.42) apply to an option granted, renewed or extended by a trustee of a unit trust to acquire a CGT asset that is units in the unit trust or debentures of the unit trust: see ITAA97 s 10440(6). Under item 6 in the table set out in ITAA97 s 112-20(3), the market value substitution rule does not apply where a unit in a unit trust was issued to you by the trustee and you did not pay or give anything for it. Hence, in these circumstances, the cost base of the unit in the unit trust will be zero. 15.122 Provisions set out in ITAA97 Subdiv 130-A, parallel to those relevant to bonus shares, govern the CGT consequences of an issue of bonus units.28 Provisions relating to the acquisition and exercise of unit trust-issued rights and options are set out in ITAA97 Subdiv 130-B. These provisions are identical to the provisions relevant to companyissued rights and options. Subdiv 130-B was discussed in 13.112–13.115. The provisions in ITAA97 Subdiv 130-C, which relates to convertible interests, apply to interests that convert to units in a unit trust in the same way as they apply to interests that convert to shares. Subdivision 130-C was discussed in 13.116–13.117. ITAA97 Div 134, dealing with options other than those to which Subdiv 130-B applies, is relevant to options to acquire units in a unit trust. Division 134 was discussed in 6.43–6.44. Certain CGT roll-over provisions are specifically relevant to units in a unit trust. These are: ITAA97 Subdiv 124-E ‘Exchange of shares or units’; ITAA97 Subdiv 124-N ‘Disposal of assets by a trust to a company’; ITAA97 Subdiv 615-A ‘Choosing to obtain roll-overs’.

15.123 ITAA97 s 106-50 (discussed at 15.96–15.99) does not expressly state that it cannot apply to unit trusts. The Commissioner has expressed the view in [page 1079] TD 2000/32 that a unit holder in a unit trust is not capable of being absolutely entitled to a CGT asset forming part of the underlying property of the trust for the purposes of s 106-50.

Disposal of pre-CGT trust interest where 75% of net assets of the trust are post-CGT: CGT event K6 15.124 CGT event K6 was discussed in the context of shares or interests in a company in 13.123–13.128. The prerequisites that must be satisfied before CGT event K6 will occur in relation to a person who has an interest in a trust are the same as those discussed in 13.124 with two exceptions: 1. that the references to shares in a company in that paragraph should be to ‘an interest in a trust’; and 2. that under ITAA97 s 104-230(9)(b), CGT event K6 does not apply to units in a unit trust where some of its units were listed on an Australian or foreign stock exchange or were ordinarily available to the public for subscription or purchase at any time in the five-year period before the relevant CGT event took place. The comments made in 13.125–13.128 about the operation of CGT event K6 in relation to shares are equally applicable to its operation in relation to interests in trusts.

Consequences of change in majority underlying interests in trust assets: ITAA97 Div 149 15.125 The operation of ITAA97 Div 149 when changes occur in the majority underlying beneficial interests in a company which has pre-

CGT assets was discussed in 12.139–12.142. Division 149 will also apply where a change takes place in the majority underlying beneficial interests in a trust which owns pre-CGT assets. The Division will apply only where the beneficiaries of the trust have either beneficial interests in the trust assets (as defined in s 149-15(4)) or have beneficial interests in the ordinary income of the trust (as defined in s 149-15(5)). Prior to the exercise of the trustee’s discretion, rights that objects of a discretionary trust have in relation to the trustee would appear not to satisfy the definition of beneficial interests in a CGT asset of another entity set out in s 149-15(4) as, prior to the exercise of the trustee’s discretion, it cannot be said that the object would receive any of the capital of the trust. Similarly, an object of a discretionary trust would not appear to have a beneficial interest in the ordinary income of the trust as defined in s 149-15(5) as, prior to the exercise of the trustee’s discretion, it cannot be said that the object would receive any of the ordinary income of the trust. The tests, however, would appear to be satisfied once the trustee has exercised the discretion but before a distribution is actually made. In Taxation Ruling IT 2340, the Commissioner expresses the view that former ITAA36 s 160ZZS (the ITAA36 equivalent to ITAA97 Div 149) applies to discretionary trusts. The ruling states that, where a trustee continues to administer a trust for the benefit of a particular family, it would be reasonable to assume that, for all practical purposes, the majority underlying interests in the trust assets have not changed. Where, by the exercise of [page 1080] the trustee’s discretionary powers to appoint beneficiaries or by amendment of the trust deed, there is, in practical effect, a change of 50% or more in the underlying interests in trust assets, the Commissioner states that former ITAA36 s 160ZZS would apply. Examples of such a change which appear in the ruling are where the members of a new family are substituted as recipients of distributions in

place of the former objects. In Taxation Ruling TR 2004/7, the Commissioner states that the same principles as those expressed in IT 2340 will apply where another entity needs to trace the underlying interests in its pre-CGT assets and a family discretionary trust has shares, units or other interests in that other entity. The effects of an application of Div 149 on a change in the majority underlying interests of a trust other than a publicly traded trust are as set out in 12.140. A ‘publicly traded trust’ is defined in s 149-50(2) as a unit trust the units in which are listed on an Australian or foreign stock exchange or are ordinarily available for subscription or purchase by the public. The rules for applying Div 149 to publicly traded trusts and the effects of its application are explained in 12.141.

CGT consequences of termination of a trust 15.126 In 15.15–15.16, we noted that in most Australian states and territories trusts are subject to the rule against perpetuities which puts an upper limit on the number of years that a trust may continue in existence before the trust assets vest in the capital beneficiaries of the trust. When the vesting time in relation to a trust is reached, one possibility is that the trustee might distribute trust assets to the beneficiaries.29 What are the CGT effects if such a distribution is made? The answer appears to vary according to the type of trust and, unfortunately, has not been conclusively determined. Table 15.1 summarises the likely CGT effects of different types of distributions in different types of trusts. Bear in mind, when reading through the table, that the CGT effects of a termination of a trust are contentious and different commentators take different views. Table 15.1: CGT consequences of terminations of trusts Category 1

Characteristics

CGT Treatment

Trusts where beneficiaries have had no interest in the trust assets up to the point of vesting

Arguably, up to the point of distribution, the beneficiaries do not have an interest in the trust. Hence, arguably, CGT events E5 to E8 cannot take place on distribution. Once the discretion is exercised in a discretionary trust, the object beneficiary has a right to a distribution in accordance with the exercise

of the discretion. Arguably, however, this is not a capital interest in the trust and is not a right to receive income. If this is so, then CGT events E6 and E7 do not apply.

[page 1081] Table 15.1: CGT consequences of terminations of trusts (cont’d) Category

Characteristics

1 (cont’d)

CGT Treatment If CGT events E6 and E7 do not apply, the distribution would not appear to have CGT consequences as, arguably, there has been no change in the beneficial ownership of the trust assets. In the case of trusts to which ITAA97 Div 128 applies, CGT events E6 and E7 cannot apply. Arguably, there are no CGT consequences as, consistently with Commissioner of Stamp Duties (Qld) v Livingston [1965] AC 694, there has been no change in the beneficial ownership of the trust assets. Where CGT events E6 and E7 apply, capital gains or losses may arise at the trustee level but not in the case of a cash distribution. See the discussion at 15.107 and 15.111. If CGT events E6 and E7 apply, they may produce capital gains or losses at the beneficiary level but not where the beneficiary acquired the interest in the trust for no consideration.

2

Trusts where beneficiaries had an interest in the trust asset but were not absolutely entitled as against the trustee until the point of vesting

Arguably, the beneficiaries become absolutely entitled immediately prior to the distribution. Thereafter, ITAA97 s 106-50 should apply. For trusts to which CGT events E5 to E8 can apply, the position thereafter should be as stated at category 5. For trusts to which CGT events E5 to E8 cannot apply, the position should be as stated at category 4.

3

Trusts, other than unit trusts and trusts to which Div 128 applies, where the beneficiary has an interest in the trust asset and has been absolutely entitled to the trust asset as

Via ITAA97 s 106-50, CGT provisions apply as if acts of

against the trustee the trustee were acts of the beneficiary. That is, CGT is from the inception of accounted for at the beneficiary level and not via the the trust ITAA36 Pt III Div 6 mechanism. Arguably, s 106-50 means that CGT events E6 and E7 cannot apply to distributions from the trust: see the discussion at 15.14. That is, there cannot be a disposal by the trustee to the beneficiary as the acts of the trustee are regarded as the acts of the beneficiary.

[page 1082] Table 15.1: CGT consequences of terminations of trusts (cont’d) Category

Characteristics

3 (cont’d)

CGT Treatment Assuming the beneficiary has an interest in the trust following the operation of s 106-50 and assuming the distribution is a CGT non-event, the termination of the trust will arguably be a disposal of the beneficiary’s interest at its then market value. This will trigger CGT event A1 and could produce capital gains or losses at the beneficiary level.

4

Trusts to which CGT events E5 to E8 do not apply where the beneficiary has an interest in the trust asset and has either been absolutely entitled as against the trustee either from the inception of the trust or subsequently became absolutely entitled as against the trustee

Once the beneficiary becomes absolutely entitled as against the trustee, ITAA97 s 106-50 applies as if the acts of the trustee were the acts of the beneficiary. That is, thereafter CGT is accounted for at the beneficiary level and not via the ITAA36 Pt III Div 6 mechanism. Arguably, a subsequent distribution cannot take place for CGT purposes as the acts of the trustee are regarded as the acts of the beneficiary. If units are still regarded as existing for CGT purposes following the operation of s 106-50, and assuming that the distribution is a CGT non-event, then redemption will arguably be a disposal of units at their market value. This will trigger CGT event C2 and could produce capital gains or losses at the unitholder level. As noted at 15.99, the Commissioner’s view is that s 106-50 cannot apply to a unit in a unit trust and a redemption will simply be treated as being the capital proceeds for CGT event C2 taking place in relation to the unit.

5

Trusts to which CGT

CGT event E5 happens when the beneficiary becomes

events E5 to E8 apply where the beneficiary has an interest in the trust asset but was not absolutely entitled to the trust asset as against the trustee from the inception of the trust but subsequently became so entitled

absolutely entitled. This may produce capital gains or losses for the trustee: see the discussion at 15.105. It may also produce capital gains and losses for the beneficiary but not where the beneficiary acquired the interest in the trust estate for no consideration: see the discussion at 15.106. Thereafter, ITAA97 s 106-50 should apply with the consequences described in category 3 above.

[page 1083]

Trusts of deceased estates 15.127 The legal personal representative of a deceased estate will be a trustee under the ITAA36 definition of trustee: see the discussion of the ITAA36 definition at 15.23. Once a grant of probate or, in the case of an intestate estate, letters of administration, is made, the property of a deceased estate vests in the executor or administrator of the estate retrospectively from the date of death. There follows a period of administration in which the executor or administrator is required to ascertain the assets in the estate; pay the debts, funeral and testamentary expenses of the deceased; and apply the balance of the assets of the deceased to the beneficiaries in accordance with a particular statutory order as varied by the deceased’s will. While the process of administration is still being completed, the legal personal representative has full ownership of the deceased’s property subject to control by the courts in carrying out his or her duties. See the advice of the Privy Council in Commissioner of Stamp Duties (Qld) v Livingston [1965] AC 694 at 699. Under the decision in FCT v Whiting (1943) 68 CLR 199; 2 AITR 421; 7 ATD 179, discussed at 15.69–15.71, until the debts, funeral and testamentary expenses and claims of prior beneficiaries in the statutory order have been paid or provided for, a beneficiary in a deceased estate

will not be presently entitled to the income of the estate. Once the period of administration is complete, the legal personal representative of a deceased estate may then hold some or all of the remaining assets of the estate under trusts established by the will. This is common, for example, in situations where there are minor beneficiaries in the will. Here the important point to note is that when a legal personal representative continues to hold assets subject to trusts declared in the will after the process of administration is complete, he or she does so as trustee, not as legal personal representative. That is, the legal personal representative will no longer hold the assets as full owner but will hold a legal interest as trustee while the beneficiaries have beneficial interests in relation to each asset.30 15.128 The scheme of ITAA36 Pt III Div 6 will apply to legal personal representatives and trustees of deceased estates in the same manner that it applies to trust estates generally. See the discussion at 15.26–15.63.

Income received after death 15.129 Under ITAA36 s 101A, income received by the trustee of a deceased estate that would have been assessable income if received by the deceased person during his or her lifetime is included in the assessable income of the deceased estate. Furthermore, the income is deemed to be income to which no beneficiary is presently entitled. The deeming does not extend to amounts received in lieu of annual leave or long service leave but, under s 101A(3), does relate to eligible termination payments. 15.130 ITAA36 s 101A was introduced following the High Court decision in FCT v Lawford (1937) 1 AITR; 4 ATD 253, where it was held that fees received by the [page 1084] legal personal representative of the estate of a deceased partner in a firm

of solicitors for accounts rendered as at the date of his death for prior services were not derived as income either by the deceased or by the legal personal representative. As the deceased was a cash basis taxpayer, there was no derivation by the deceased as he had not received payment. Rather, the moneys received were capital receipts to the legal personal representative. 15.131 In Single v FCT (1964) 110 CLR 177, a majority of the High Court held that ITAA36 s 101A included in the assessable income of the trust estate amounts received by the executor of the estate of a deceased solicitor. The amounts represented the deceased’s entitlement to fees for work which was incomplete and unbilled as at the date of his death but which was subsequently completed by the firm. This was so even though the deceased could not have derived the amounts as income during his lifetime as the work remained incomplete. This was because all that s 101A required was that the character of the receipt be determined on the hypothetical assumption made that the amount had been received by the deceased during his lifetime.

CGT aspects of deceased estates 15.132 ITAA97 Div 128 deals with the CGT consequences of death. As CGT is not meant to be a death duty, s 128-10 states that when you die a capital gain or loss that results for a CGT asset you owned just before dying is disregarded. Under s 128-15(2), the deceased’s legal personal representative (in this context, the executor or administrator of the deceased’s estate) is taken to have acquired any of the deceased’s CGT assets on the day the deceased died. Thus, even though the asset might have been a pre-CGT asset to the deceased, s 128-15(2) will mean that there is a deemed acquisition by the legal personal representative as at the date of the deceased’s death. Hence, what were pre-CGT assets to the deceased will become post-CGT assets to the legal personal representative. The cost base and reduced cost base of the deceased’s CGT assets in the hands of the legal personal representative are set out in the Table 15.2, which is in s 128-15(4):

Table 15.2: Modifications to cost base and reduced cost base Item

For this kind of CGT asset:

The first element of the asset’s cost base is:

The first element of the asset’s reduced cost base is:

1

One you acquired on or after 20 September 1985, except one covered by item 2, 3 or 3A

the cost base of the asset on the day you died

the reduced cost base of the asset on the day you died

2

One that was trading stock in your hands just before you died

the amount worked out under section 70-105

the amount worked out under section 70-105

[page 1085] Table 15.2: Modifications to cost base and reduced cost base (cont’d) Item

For this kind of CGT asset:

The first element of the asset’s cost base is:

The first element of the asset’s reduced cost base is:

3

A dwelling that was your the market value of the main residence just before dwelling on the day you you died, and was not died then being used for the purpose of producing assessable income

the market value of the dwelling on the day you died

3A

If you were a foreign resident just before you died — an asset that was not taxable Australian property just before you died, except one covered by item 2

the market value of the asset on the day you died

the market value of the asset on the day you died

4

One you acquired before 20 September 1985

the market value of the asset on the day you died

the market value of the asset on the day you died

Note 1: Section 70-105 has a general rule that the person on whom the trading stock devolves is taken to have bought it for its market value. There are some exceptions though. Note 2: Subdivision 118-B contains other rules about dwellings acquired through deceased estates. Note 3: The rule in item 3 in the table does not apply to a dwelling that devolved to your legal personal representative, or passed to a beneficiary in your estate, on or before 7.30 pm

on 20 August 1996: see section 128-15 of the Income Tax (Transitional Provisions) Act 1997.

15.133 Where an estate asset passes from the legal personal representative to a beneficiary, ITAA97 s 128-15(3) indicates that any capital gain or loss that the legal personal representative makes is disregarded. Under s 128-15(2), the beneficiary is taken to have acquired the asset on the day the deceased died. The cost base and reduced cost base of the asset to the beneficiary will be determined under the rules set out in the table extracted in 15.132. Under s 12815(5), expenditure incurred by the legal personal representative on the asset is included in the beneficiary’s cost base and reduced cost base if the legal personal representative would have been able to include it. Section 128-20(1) states that an asset passes to a beneficiary for the purposes of s 128-15, when the beneficiary becomes its owner: under the deceased’s will; by operation of an intestacy law; because it is appropriated to the beneficiary by the legal personal representative in satisfaction of a pecuniary legacy or some other interest that the beneficiary had in the deceased’s estate; or under a deed of arrangement that the beneficiary entered into to settle a claim to participate in the deceased’s estate provided the consideration given by the beneficiary consisted only of a variation or waiver of a claim to one or more assets in the deceased’s estate. [page 1086] It is important to note that ITAA97 s 128-20(2) provides that an asset does not pass to a beneficiary if the legal personal representative transfers it to the beneficiary under a power of sale. This means that where a legal personal representative sells an asset to a beneficiary that sale may trigger capital gains or losses for the legal personal representative. Section 128-20(2) also means that, in a sale situation, the cost base of the asset to the beneficiary will be determined under the

ordinary cost base rules rather than under the rules set out in the table in s 128-15(4). 15.134 Where an asset is owned by joint tenants, on the death of one joint tenant the asset will pass to the surviving joint tenant and not to the deceased’s legal personal representative. Under ITAA97 s 128-50(2), the surviving joint tenant is taken to have acquired the asset as at the date of the deceased’s death. Where there are two or more survivors, they are taken to have acquired the deceased’s interest in equal shares. Where the deceased’s interest was acquired post-CGT, the cost base of the interest acquired by each survivor is the cost base of the interest to the deceased as at the date of death apportioned equally between the survivors. The reduced cost base to the survivors is determined similarly. Where the deceased’s interest was acquired pre-CGT, the cost base and reduced cost base of the interest acquired by the survivors is the market value of the deceased’s interest as at the date of death apportioned equally between the survivors. 15.135 Remember that, in our discussion of the CGT consequences of the operation and termination of trusts, we noted that CGT events E5–E8 do not apply to trusts to which ITAA97 Div 128 applies. This, together with s 128-15(3), means that, where an asset passes from the executor or administrator to a beneficiary as part of the process of administration of the estate (as discussed in 15.127), there will be no CGT consequences for the executor or administrator and the cost base of the asset to the beneficiary will be determined via the table in s 12815(4). However, it appears that the position is different once the process of administration is complete and the executor or administrator holds the asset as a trustee of trusts established by the will. Here, it would appear that CGT events E5–E8 may occur, in the manner described in 15.105–15.123, during the operation and termination of the trust.31

Unit trusts which are taxed as companies

Background to ITAA36 Pt III Div 6B 15.136 Prior to the introduction of the dividend imputation system, the primary advantage of a trust over a company as a business structure was that the income of a trust was taxed in the hands of either the trustee or the beneficiary but not both, while the income of a company was taxed at the company level and that income was again taxed in the hands of shareholders when distributed as dividends. [page 1087] 15.137 The then government’s response to these company reorganisations was the enactment of ITAA36 Pt III Div 6B, which, broadly, has the effect of taxing what the Division defines as ‘corporate unit trusts’ as if they were companies. 15.138 Division 6B applies to those unit trusts which fall within the definition of ‘corporate unit trust’ in ITAA36 s 102J. It is important to remember that many unit trusts that would commonly be described as corporate trusts by the unit trust industry do not, in fact, fall within the s 102J definition. 15.139 It should be noted that the tax treatment of corporate unit trusts does not exactly parallel the tax treatment of companies. The deductibility of losses and the carry forward of current year losses are governed by the trust loss rules (see 15.145–15.146) rather than by the rules applicable to companies (see 12.90–12.104). Nonetheless, corporate unit trusts are treated as corporate tax entities and are permitted to choose the order in which they deduct their prior year losses in determining their taxable income for a particular year. This aspect is discussed in more detail at 13.92.

Background to ITAA36 Pt III Div 6C 15.140 ITAA36 Pt III Div 6B has a somewhat narrow operation. It was soon realised that Div 6B would not apply where, instead of a unit

trust acquiring a trading business from a company, the unit trust founded a new business. The government apparently saw the establishment of these types of trust as threatening a loss of revenue. The government’s response was to introduce ITAA36 Pt III Div 6C.

Treatment of ‘public trading trusts’ in ITAA36 Pt III Div 6C 15.141 The operative provisions in ITAA36 Pt III Div 6C apply to those unit trusts which fall within the definition of ‘public trading trust’ in ITAA36 s 102R. The main consequence of a unit trust being a ‘public trading trust’ as defined in Div 6C is that its income is taxed under ITAA36 s 102S, which reads as follows: 102S Taxation of net income of public trading trust The trustee of a unit trust that is a public trading trust in relation to a relevant year of income shall be assessed and is liable to pay tax on the net income of the public trading trust of the relevant year of income at the rate declared by the Parliament for the purposes of this section.

The tax rate applicable to a s 102S assessment is 27.5% if the trust is a ‘base rate entity’ or, in any other case, 30%. Thus, the tax treatment of the income of a public trading trust corresponds with the tax treatment of a Div 6B corporate trading trust. Likewise, Div 6C contains a provision, ITAA36 s 102T, which corresponds with ITAA36 s 102L in Div 6B. Section 102T has the effect of deeming public unit trusts and their unit holders to be entitled to s 46 rebates in terms which mirror s 102L. The application of the Simplified Imputation System to public trading trusts is discussed at 15.143–15.144. [page 1088] 15.142 It should also be noted that the tax treatment of Div 6C public trading trusts differs from the tax treatment of companies in the

same way as the tax treatment of Div 6B corporate unit trusts differs from the tax treatment of companies.

Application of the Simplified Imputation System to corporate unit trusts and public trading trusts 15.143 The parallel between the tax treatment of corporate unit trusts and public trading trusts and companies is carried through into the dividend imputation system. Corporate unit trusts and public trading trusts are within the definition of ‘corporate tax entity’ in ITAA97 s 960-115. Hence, provided relevant residency requirements are satisfied, corporate unit trusts and public trading trusts are obliged to maintain franking accounts, can allocate franking credits to distributions, and are entitled to gross-ups and tax offsets in respect of franking credits attached to distributions received. Further, the provisions relating to the conversion of excess franking credit tax offsets into loss carry forwards apply to corporate unit trusts and to public trading trusts. The application of the Simplified Imputation System to companies is discussed in 12.34–12.62 and in 13.42–13.56. 15.144 The trustee of a corporate unit trust or of a public trading trust is not treated as a trustee for purposes of the Simplified Imputation System. Hence, the provisions relating to franking credits flowing indirectly through a trust, discussed at 15.86, do not apply to franking credits that flow through corporate unit trusts or through public trading trusts.

Trust loss provisions 15.145 The trust loss provisions, found in ITAA36 Sch 2F, are measures designed to:32 restrict the recoupment of prior year and current year losses and debt deductions of trusts in order to prevent the transfer of the tax benefit of those losses or deductions; and transfer the benefit of losses when a person who did not bear the

economic loss at the time obtains a benefit from the trust being able to deduct the loss. Schedule 2F, in contrast to the general law concept, treats all trusts as entities. Schedule 2F applies if there has been a change in ownership or control of a trust after 9 May 1995. If this occurs, no deduction is available for: revenue losses incurred in a previous year or in the current year; or bad debts written off and losses incurred on debt/equity swaps33 (the losses being incurred after 7.30 pm AEST on 20 August 1996). Treating trusts as entities means that they can then be classified according to the risk of, or potential for, change in ownership and control. Classification determines the tests that a trust must satisfy if it wants to continue claiming tax deductions for its income losses. [page 1089]

Classification of trusts and the tests that must be satisfied 15.146 ITAA36 Sch 2F basically classifies trusts into three categories: that is, fixed trusts, non-fixed trusts and excepted trusts. For each category of trusts, discrete tests must be satisfied before a trust’s losses can be carried forward. The categories of excepted trusts are family trusts (as defined), complying superannuation funds, trusts of deceased estates (subject to certain time limits) and unit trusts where unit holders whose income is exempt under ITAA36 s 23 or under ITAA97 Div 50 are entitled to all the income or capital of the trust, subject to certain time limits.34 Where an interest in a trust is, in any way, discretionary, the trust is non-fixed. Table 15.3 summarises the classification of trusts and the particular tests that each class of trust must satisfy.35 A number of terms have been defined and relevant provisions noted.

Table 15.3: Classification of trusts for trust loss provisions Type of trust

More than 50% stake testa

Same business testb

Pattern of distributions testc

Control testd

Scheme assessable income teste

Closely held fixedf

(1)

(3)

Unlisted widely heldg

(3)

(3)

Listed widely heldh

(3)

Unlisted very widely heldi

(3)

(3)

Wholesale widely heldj

(3)

(3)

Non-fixedk

(3)

Familyl

(2)

(3)

(4), (5)

(3)

(3) (6)

Other excepted trustsm (1) As an alternative, the non-fixed trust stake test is available if the trust is 50% or more held by non-fixed trusts (meaning the more than 50% stake test cannot apply).n (2) Can be used if the more than 50% stake test is failed. (3) The test is not applicable if no individuals ever hold fixed entitlements. (4) Does not apply for current-year loss or current-year debt deduction purposes. (5) The test does not apply if no distributions from the trust are ever made. (6) Does not apply to an income injection from within the family group.

[page 1090] a. b. c. d. e. f.

g. h.

Sch 2F ss 269-50 and 269-55. Sch 2F s 269-100. Sch 2F ss 269-60–269-85. Sch 2F s 269-95. Sch 2F ss 270-5–270-25. A trust is closely held if no individuals, or up to 20 individuals, have between them direct or indirect fixed entitlements to 75% or more of the income or capital of the trust: Sch 2F s 272-105(2) and (2A). A widely held unit trust is not a closely held fixed unit trust: Sch 2F s 272-105(1). A listed widely held unit trust is a widely held unit trust listed for quotation in the official list of an approved stock exchange: Sch 2F s 272-115.

i.

An unlisted, very widely held unit trust includes, for example, an unlisted widely held unit trust that engages only in arm’s length investment activities and has 1000 or more unit holders. Each unit must have equal entitlements and, if the units are redeemable, the redemption price must reflect the trust’s net asset value: Sch 2F s 272-120. j. A wholesale widely held trust is an unlisted widely held unit trust that has less than 1000 members and 75% or more of its units, all carrying the same rights, are held by certain bodies (eg, listed widely held trusts). The initial subscription to units must amount to $500,000 and if the units are redeemable, the redemption price must reflect the trust’s net asset value: Sch 2F s 272-125. k. A non-fixed trust is simply not a fixed trust: Sch 2F s 272-70. l. A fixed or non-fixed trust is a ‘family trust’ after having made a family trust election: Sch 2F ss 272-75 and 272-80. m. Excepted trusts include family trusts, complying superannuation funds and income tax exempt funds: Sch 2F s 272-100. n. Sch 2F s 266-45.

Measures to curtail avoidance through chains of trusts Obligation to report trustee beneficiary of closely held trusts 15.147 A trustee of a closely held trust must disclose the identity of any beneficiaries acting in a trustee capacity where those beneficiaries obtain distributions of ‘untaxed amounts’: see ITAA36 Pt III Div 6D. These rules were revised in 2007, the most significant change being that a trustee need only identify a trustee beneficiary to whom an untaxed amount (ie, an amount on which tax has not been paid and from which no amount of tax has been withheld) is distributed, rather than identifying the ultimate beneficiary of any trust distribution (which entailed considerable compliance costs where the trust distribution might pass through a chain of entities before reaching the hands of the ultimate beneficiary). 15.148 A closely held trust is either: a trust where no more than 20 (unrelated) individuals have a fixed entitlement to a 75% or greater share of the income or capital of the trust; or a discretionary trust that is not a fixed trust for the purposes of

the family trust loss rules. The disclosure must be made to the Australian Taxation Office by the due date for lodgment of the trust return. If, by that time, the trustee fails to lodge the notification [page 1091] identifying the trustee beneficiaries (and the relevant amount), the trustee will be taxed on the net income at the top marginal rate (inclusive of the Medicare levy). The result of these provisions is that the streaming of distributions through chains of closely held trusts and other ‘interposed entities’36 might become less attractive to trustees.

Trusts and consolidated groups 15.149 A resident trust can be a member of a consolidated group but cannot be the head entity in a consolidated group. The consolidation regime is discussed at 12.111–12.130.

Trusts and demerger relief 15.150 The demerger relief provisions can apply to the restructuring of trust groups. The demerger relief provisions are discussed at 13.158–13.162. 1.

2. 3. 4.

For an overview of the historical development of trusts, see H A J Ford and W A Lee, Principles of the Law of Trusts, 2nd ed, Law Book Co Ltd, Sydney, 1990; R P Meagher and W M C Gummow, Jacobs’ Law of Trusts in Australia, 5th ed, Butterworths, Sydney, 1986. Meagher and Gummow, Jacobs’ Law of Trusts in Australia, p 7. Meagher and Gummow, Jacobs’ Law of Trusts in Australia, p 7. For example, in D J Hayton, Underhill and Hayton: Law Relating to Trusts and Trustees,

5. 6. 7. 8.

9. 10.

11. 12. 13. 14. 15. 16.

17.

18. 19.

20.

21.

14th ed, London, Butterworths, 1987, p 3; and Ford and Lee, Principles of the Law of Trusts, p 3. See, for example, G W Keeton, The Law of Trusts, 4th ed, Pitman, London, 1947, p 3. Meagher and Gummow, Jacobs’ Law of Trusts in Australia, p 8. See, for example, Meagher and Gummow, Jacobs’ Law of Trusts in Australia, p 9. For example, in New South Wales, s 151A of the Conveyancing Act 1919 (NSW) and s 10(1)(b) of the Minors (Property and Contracts) Act 1970 (NSW) prohibit a person under the age of 18 years from being a trustee. This list is based largely on Ford and Lee, Principles of the Law of Trusts, [102]–[102.11]. B Marks, Taxation of Trusts, CCH Australia Ltd, Sydney, 1980, p 37. See also G W Fisher, ‘Domestic Aspects of Trusts’ in Intensive Seminar on Trusts, North Wollongong, 1–3 November 1984, Taxation Institute of Australia, pp 23–4. See the authorities cited in Marks, Taxation of Trusts, p 37. See the discussion in Fisher, ‘Domestic Aspects of Trusts’, pp 19–22. See R W Parsons, Income Taxation in Australia, Law Book Co, Sydney, 1985, [2.41], citing Countess of Bective v FCT (1932) 47 CLR 417 at 423 per Dixon J. See also Duggan and Ryall v FCT (1972) 129 CLR 365; 72 ATC 4239 at 4243 per Stephen J. Marks, Taxation of Trusts, pp 295–6. For analysis of this decision, see J Glover, ‘Shams, Reimbursement Agreements … and the Return of Economic Equivalence?’ (2008) 43 Taxation in Australia 21; M Burton, ‘The High Court Decision in Raftland — Rewriting the Concept of “Sham”?’ (2008) Issue 23, CCH Tax Week, 13 June 2008. More generally, see M Kirby, ‘Of “Sham” and Other Lessons for Australian Revenue Law’ (2009) 32 Melbourne University Law Review 868. It would seem that a remainderman would be presently entitled under s 95A(2), if the interest of the remainderman is indefeasible. It would be unusual for the interest of a remainderman to be indefeasible; the death of the remainderman prior to the determination of the interest of the life tenant would normally defeat the interest of the remainderman in the absence of provisions which will have the effect of making the gift form part of the remainderman’s estate in those circumstances. For the Commissioner’s views upon the application of CGT event E1 in relation to the creation of life estates and remainder interests, see Taxation Ruling TR 2006/14. See Tomlinson v Glyns Executor & Trustee Co [1970] Ch 112; (1968) 45 TC 600 (Cross J; affirmed on appeal to the English Court of Appeal [1969] 3 WLR 310). See the discussion in C J Taylor, Capital Gains Tax: Business Assets and Entities, Law Book Co, Sydney, 1994, [11.8]. In the Court of Appeal in Tomlinson v Glyns Executor & Trustee Co [1969] 3 WLR 310, Lord Denning MR and Sachs LJ agreed with the suggestion of counsel that the UK provision applied only where the beneficiary had a vested and indefeasible interest in possession. See also the discussion in G S Cooper (assisted by L R Wolfers), Cooper’s TLIP Capital Gains Tax, ATP, Sydney, 1998, [14–770]. See the discussion of differences between ITAA36 s 160V(1) (the equivalent of ITAA97 s 106-50) and s 60 of the Taxation of Chargeable Gains Act 1992 (UK) and its predecessor, s 46 of the Capital Gains Tax Act 1979 (UK), in Taylor, Capital Gains Tax: Business Assets and Entities, [11.8]–[11.9].

22. See the discussion in Taylor, Capital Gains Tax: Business Assets and Entities, [11.42] and [11.111]. 23. See the discussion in Taylor at [11.42]. This approach is consistent with the practice in relation to unit trusts where generally ITAA97 s 106-50 is not regarded as applying during the operation of the trust. 24. These meanings are suggested as possibilities in CCH Tax Editors, Australian Capital Gains Tax: Principles and Practice, CCH Australia Ltd, Sydney, 1992, [1407]. 25. It was argued (see CCH Tax Editors, Australian Capital Gains Tax: Principles and Practice, [1407]) in relation to the ITAA36 provisions that such a construction of the phrase ‘right to receive income’ in ITAA36 s 160ZYA (the ITAA36 equivalent of ITAA97 s 104-80) would mean that the same amounts could be taxed twice — as capital gains and also under ITAA36 Pt III Div 6. The basis of this argument was that the ITAA36 antidouble counting provision s 160ZA(4) would not prevent double taxation as the Div 6 inclusion was not ‘as a result of’ the subsequent s 160ZYA disposal. This problem will no longer arise under the ITAA97 as s 118-20(1A) (discussed at 6.135) reduces capital gains where an amount is included in your assessable income in relation to a CGT asset. This language appears to be broad enough to cover an amount that is included in income prior to the CGT event taking place. ITAA97 s 118-20 still suffers from the technical inadequacy that it cannot reconcile the beneficiary’s capital gain arising under CGT event E6 with an amount on which the trustee is assessed and liable to pay tax under ITAA36 s 98. 26. A similar point was made in relation to ITAA36 ss 160ZYA and 160ZA(4) (the ITAA36 equivalents of ss 104-80 and 118-20) by Parsons, note 13 above, p 80. 27. This is assuming that one of several sui juris beneficiaries cannot, without joining with others to request a trust distribution, be absolutely entitled to a trust asset as against the trustee. 28. Note that these provisions do not apply to corporate unit trusts as defined in ITAA36 s 102J nor to public trading trusts as defined in ITAA36 s 102R. See ITAA97 s 130-20(4). 29. Depending on the terms of the trust deed, another possibility is that the trustee might resettle the trust property upon another trust. This possibility is not discussed in detail in this book. 30. For the Commissioner’s views, see Taxation Ruling IT 2622. 31. Under ITAA36, the Commissioner regarded ‘a trust of the estate of a deceased person’ for the purposes of former ITAA36 s 160ZX(1) in contrast to a ‘trust that arose upon or resulted from the death of a person’ as being limited to the estate of a deceased person while it was being administered by the executor or administrator. Such a trust was not regarded as including a testamentary trust which may have arisen after the administration of the estate was completed. See TD 93/35. 32. Explanatory Memorandum to Taxation Laws Amendment (Trust Loss and Other Deductions) Bill 1997 (Cth), para 1.4. 33. Otherwise deductible under ITAA36 ss 63 and 63E respectively. 34. ITAA36 Sch 2F s 272-100. 35. Based on Table 2 of the Appendix to the Explanatory Memorandum to Taxation Laws Amendment (Trust Loss and Other Deductions) Bill 1997 (Cth). 36. ITAA36 Sch 2F s 272-85.

[page 1093]

CHAPTER

16

Tax Administration Learning objectives After studying this chapter, you should be able to: recognise the importance of tax administration in the Australian tax system; describe the different modes of assessment and explain when each is appropriate; identify who must file a return and what is necessary to fulfil their obligations; describe the role and legal status of rulings in the Australian tax system; list what information the tax administration requires of taxpayers and understand the powers held by the tax administration to enforce those requirements; define what actions by the tax administrator are reviewable and who may seek review; state what review mechanisms are available and the reasons why one may be preferable to another; describe the penalty structures under the Australian tax system; describe the main tax collection mechanisms that operate in the Australian tax system; advise what enforcement mechanisms are available to the revenue

authorities.

Introduction 16.1 This chapter looks at the key features of tax administration in Australia. The key elements of tax administration to be studied are: Taxpayer representation and tax advice: In Australia, a very high percentage (around 75% of individuals) of taxpayers use tax advisers in the preparation of their taxes. Clearly, an accurate and trustworthy system of advice for taxpayers should exist. Interpretative devices: With a growing trend of self-assessment and as tax laws become more complex, revenue authorities around the world have tended towards issuing documents to explain tax laws. There should be a predictable system of explanation which allows taxpayers to easily find, use and rely on government explanations. Tax returns: The tax return is the method by which taxpayers describe their financial affairs to revenue authorities. Some form of return is needed to provide a consistent format for the financial descriptions in a user-friendly format. [page 1094] Assessment: Tax assessment is the process by which the amount of tax to be paid is determined either by the tax authority or by the taxpayer on the authority’s behalf. This requires a predictable non-arbitrary system. Collection of information: At its core, the tax administration is an information-processing system. There should be rules to govern the type and the amount of information that should be provided to the government, as well as the mechanisms that may be used to obtain information from taxpayers or from others. Review and appeal: Within any system, where decisions are made,

there should be a process for resolving disputes and reviewing decisions in an impartial and efficient manner. Tax collection: The final stage of the tax system is the voluntary payment of taxes by the taxpayer to the revenue authority. Where the voluntary payment does not take place, the tax administration should have the means by which it can compel taxpayers to meet their legal obligations. It should also have the means to collect interest owed on balances outstanding to the tax administration. Penalties: An important goal of tax administration is the maintenance of high levels of compliance with the tax law. The threat of penalties and the actual imposition of penalties are the key means of gaining and maintaining compliance. In modern times, other forms of encouragement with compliance, such as compliance information and amnesties, are also relied upon.

Legislative overview and the Commissioner’s powers of administration 16.2 There are seven main pieces of income tax legislation that affect taxpayers in the context of tax administration. They are the: 1. Income Tax Assessment Act 1936 (Cth) (ITAA36); 2. Income Tax Regulations 1936 (Cth); 3. Taxation Administration Act 1953 (Cth) (TAA); 4. Taxation Administration Regulations 1976 (Cth); 5 Income Tax Rates Act 1986 (Cth); 6 Income Tax Assessment Act 1997 (Cth) (ITAA97); 7. Income Tax Regulations 1997 (Cth). It is within this legislative context that the Commissioner administers the tax laws. ITAA36 s 8 states that ‘[t]he Commissioner shall have the general administration of this Act’. Similarly, TAA s 3A provides that the Commissioner is responsible for general administration of the TAA.

Under the TAA, the Commissioner also has the power to delegate his powers. Of specific interest to us later will be the Commissioner’s power to delegate his information-gathering powers. We might also be interested in the Commissioner’s power of administration in the context of any judicial review of the exercise of those powers under the Judiciary Act 1903 (Cth), the Australian Constitution or the Administrative Decisions (Judicial Review) Act 1977 (Cth) (AD(JR)A). [page 1095]

The self-assessment system 16.3 As is the case in many countries, Australia’s income tax system is described as a self-assessment system. The appropriateness of ‘selfassessment’ has sometimes been questioned, especially as some taxpayers perceive it as a ‘self-regulation’ system. The two are different concepts and the meaning of the term ‘assessment’ has been addressed frequently and thoroughly by the courts. There is a definition of ‘assessment’ in ITAA36 s 6(1). It is clear from the cases that an assessment is the end result of a process of ascertaining a taxpayer’s taxable income and calculating the tax payable on that income. This was made clear in the decision of Isaacs J in R v DCT; Ex parte Hooper (1926) 37 CLR 368. The notice of assessment is the final part of the assessment process. Thus, it is important to bear in mind that a notice of assessment is not itself an assessment. This should make it clear that self-assessment does not mean that taxpayers themselves finally determine their own tax liabilities (which would be self-regulation). The Australian Taxation Office (ATO) has the right to review what taxpayers put on their tax returns, subject to the length of time that the legislation specifies for it to do so. The normal process for individual taxpayers is to complete a form (paper or online) providing all the items of information that the ATO has asked of them after which the form is ‘processed’ by the ATO to determine how much tax is owed, if any. The processing includes a

superficial check of the return (but not the information provided) and the issuing of a notice of assessment, which is then sent to the taxpayer who should pay the amount owing, if any. For superannuation funds and companies, the process is different: the form compiled by the company and superannuation fund is itself deemed to be a notice of assessment once it is completed. This means that companies and superannuation funds are required to provide their information and calculate the amount of tax they owe. They are also required to pay the tax that they owe when they submit the form.

Taxpayer support 16.4 For taxpayers to properly self-assess their income tax liability, they need a supportive administrative and legislative environment. The ATO has introduced the myTax electronic lodgment service designed to provide individual taxpayers with information and even pre-populated sections to help them in completing their tax returns: see the ‘Lodging your tax return’ part of the ‘Individuals’ section on the ATO website. Also provided to support taxpayers is a system of: public rulings (the ATO’s interpretation of the law) that bind the ATO; legally binding private rulings; a period within which taxpayers can seek an amendment to their notice of assessment; and a system of penalties recognising that a lower penalty should apply to taxpayers who have used reasonable care in completing their tax returns but, nonetheless, made an error. In addition, taxpayers have remedies through the TAA for review of assessments and decisions made by the ATO, and they have remedies under other legislation to [page 1096] control what they might perceive as an abuse of power by the tax

administration. These will be discussed further below. The ATO also operates under what is termed the Taxpayers’ Charter. The ATO sees this as a major tool for the effective working of the self-assessment system and for improving relations between the ATO and taxpayers. The Charter was introduced in 1997 under the recommendation of the then Joint Committee of Public Accounts of Parliament (made in 1993). It was intended to address the joint committee’s perception of an imbalance of power between the ATO and taxpayers. The Taxpayers’ Charter describes taxpayers’ legal rights and obligations and indicates more broadly how taxpayers can expect the ATO to treat them. Much of its content is, therefore, not legally binding on the ATO, but it nevertheless constitutes an indication of the respectful environment in which taxpayers can expect their affairs to be handled. Go to the ATO webpage and see the Taxpayers’ Charter at , search for ‘Taxpayers’ Charter’, then click in turn on ‘Your Rights’ and ‘Your Obligations’ (accessed 26 September 2017).

From your reading of the Taxpayers’ Charter, list your rights as a taxpayer. Once you have listed these, consider which of them seems to you to be the most important and overriding right. An answer to this is provided in Study help.

The ATO compliance model 16.5 The ATO compliance model provides an important perspective on the ATO’s approach to administering the self-assessment system. The model is an example of the way the ATO has been redesigning its compliance strategies with the introduction of self-assessment. The compliance model takes the form of a narrow pyramid which combines the risk to the tax collector of loss of revenue and the attitude of the taxpayer. Only the small group of taxpayers near the top of the pyramid require vigorous enforcement for them to meet their tax obligations. The mass of taxpayers at the broader base of the pyramid

require no more than support because they are willing and able to meet their tax obligations. The use of the model is intended to offset the impression, which some might have, that all taxpayers are noncompliant and unwilling to pay their tax.

Self-assessment and full self-assessment taxpayers 16.6 A general definition of full self-assessment taxpayers is provided in ITAA36 s 6(1). Essentially, these taxpayers include: a company or an entity treated like a company for tax (such as the trustee of a public trading trust or a limited partnership); a superannuation fund; an approved deposit fund; or a pooled superannuation trust. [page 1097] Under ITAA36 s 161AA, such taxpayers are required to specify in their tax returns not only their taxable income but also the amount of tax payable, or the refund that might be due to them on that income. Unless a taxpayer is a full self-assessment taxpayer there is no requirement to work out the amount of tax payable. Instead, ordinary taxpayers are required only to provide the Commissioner of Taxation with the information that the ATO needs to determine the amount of their taxable income. Anomalously, although the term ‘full selfassessment taxpayer’ is defined in the ITAA36, there is no definition of a ‘self-assessment taxpayer’. Similarly, the term ‘self-assessment’ is not defined. There is a definition of ‘self-assessment’ in the TAA but this definition is not one of general application.

Income tax returns 16.7

ITAA36 s 161 contains the legislative provisions relating to the

lodgment of annual income tax returns. Section 161(1) specifies that: Every person must, if required by the Commissioner by notice published in the Gazette, give to the Commissioner a return for a year of income within the period specified in the notice.

The definition of a ‘person’ here includes a full self-assessment taxpayer. Section 161(1A) reinforces the discretionary power given to the Commissioner under s 161(1). It does so by giving the Commissioner the power to issue a notice in the Gazette exempting such persons or classes of persons as the Commonwealth sees fit from liability to furnish returns. The Commissioner also has the power to defer the time a taxpayer has for submitting a return: TAA Sch 1 s 38855. This power is used to allow registered tax agents to spread the lodgment of their clients’ returns over a longer period of time than would otherwise be the case.

Further returns and information 16.8 ITAA36 s 162 is the primary method by which the Commissioner can seek to enforce compliance with the gazetted notice to lodge an annual tax return. However, the scope of s 162 is broader than this. The broader scope reflects the fact that the ATO will often find that it needs more information than is provided in the current annual tax return. The section makes it clear that taxpayers who argue that self-assessment was intended to limit the amount of information that the ATO can obtain from taxpayers are incorrect. Although s 162 is very broad, there have been few cases concerning its exercise by the Commissioner. In 2004, in DPP (Cth) v Buckett [2005] 1 Qd R 20; [2004] QCA 206 (Queensland Court of Appeal), two taxpayers successfully argued that they should not be penalised for noncompliance with some aspects of s 162 following their failure to lodge income tax returns over a 10-year period. Their success was because the ATO had been unable to prove that the Commissioner had actually approved forms for the years prior to 1 July 2000.

[page 1098] The definition of ‘approved form’ for tax law purposes is found in TAA Sch 1 s 388-50. Section 162 should be read jointly with s 166, which is an important assessment provision and requires the Commissioner to make an assessment from the ‘returns’ and any other information in his possession about a taxpayer’s taxable income. Finally, note that s 162 information-gathering powers are separate from information-gathering powers under ITAA36 ss 263 and 264, which we will discuss later. Section 162 is supported by the broadly framed ITAA36 s 163, which requires any person, not necessarily a taxpayer, to furnish any return required by the Commissioner for the purposes of the Act. This means that special returns can be obtained from persons other than taxpayers. The only restriction on this appears to be that there would need to be an ‘approved form’.

Assessments Original assessments 16.9 We have noted above at 16.3 that there are critical aspects of the definition of an assessment and these are: an assessment is the end result of a process of ascertaining the taxpayer’s taxable income and calculating the tax payable on that income (ITAA36 s 6(1)); and a notice of assessment becomes final once the statutory period for review (and possible amendment) has expired (ITAA36 s 170(1)). What this demonstrates is that the assessment process involves both an original assessment and the possibility that the original assessment might be amended before it becomes final. So, the term ‘an assessment’ generally includes both original and amended assessments. The ITAA36 contains provisions relating to the time in which an assessment may be amended, and there is a fairly consistent time limit in which original

assessments can be re-opened and amended before they are regarded as final and not subject to any amendment.

Ordinary and deemed assessments 16.10 ITAA36 s 166 is a key provision in that it specifies in broad terms the information the Commissioner is required to take into account when first assessing a taxpayer’s tax liability, that is, when making the original assessment. This section appears to apply equally to self-assessment and full self-assessment taxpayers. The Commissioner has been given considerable discretion in making assessments under s 166. The manner in which full self-assessment taxpayers are assessed is governed by ITAA36 s 166A. This section deems the Commissioner to have made an original assessment of their taxable or net income and of the tax payable on that income as reported in their own tax returns. This means that the Commissioner is not required to issue a notice of assessment to full self-assessment taxpayers. These taxpayers are obliged to indicate in their annual tax returns the amounts of tax they think they owe for that income year net of any tax that has already been paid. There is [page 1099] no obligation on the Commissioner to accept the stated amount as correct if the Commissioner has information to the contrary. This means that s 166A operates as a supplement to s 166.

Default, special and other assessments 16.11 Default assessments are covered by ITAA36 s 167. Section 167 may apply to anyone who does not provide a tax return or provides one with which the Commissioner is not satisfied. In such cases, the Commissioner may make an assessment ‘of the amount upon which in

his judgment income tax ought to be levied, and that amount shall be the taxable income of that person for the purpose of section 166.’ A default assessment can be issued either as an original assessment or an amended assessment. This may occur following an audit where the taxpayer has not been cooperative in furnishing required information. In such cases, as with any assessment, the taxpayer has the onerous burden of proving the default assessment is incorrect. Such a provision is potentially oppressive and the courts have taken particular interest in how the s 167 power is used — such as in Favaro v FCT (1997) 36 ATR 55; 97 ATC 4442. It is interesting to note that the courts have indicated that the failure by the Commissioner to seek information from a taxpayer before issuing a default notice would not invalidate the default assessment if the history of dealings with the taxpayer indicated that this taxpayer would be unlikely to cooperate. In addition, the courts have also, on occasion, determined that the Commissioner is not obliged to ascertain and deduct on the taxpayer’s behalf allowable deductions when making a default assessment.1 You will note from the discussion above that taxpayers who have been subjected to a default assessment will find it difficult to prove that it is excessive. Some taxpayers have, however, been successful and an example of this may be found in Kimche v FCT (2004) 57 ATR 28; [2004] FCA 1108. Section 167 is a powerful weapon available to the Commissioner in recovering tax from recalcitrant taxpayers. If you care to read an example of the issue of default assessments and the way in which the Commissioner estimates the amount of income not disclosed, you will find one in the case of Re Armirthalingam and Commissioner of Taxation [2012] AATA 449. The Commissioner’s powers to make original assessments are made complete by two other provisions. ITAA36 ss 168 and 169 apply to all taxpayers. Section 168 principally allows assessment for part of an income tax year to be made at any time. Such a power is necessary to cover events such as a taxpayer leaving the country, a taxpayer becoming bankrupt, etc. Section 168 has also, on occasion, been used to issue two assessments covering different parts of the same income year.

Section 169 enables the Commissioner to raise assessments of tax liabilities arising from sources other than taxable income. This section is necessary because ss 166–168 cover assessments relating to taxable income only. [page 1100]

Amended assessments 16.12 An important feature of the assessment system is the ability, subject to certain limitations, for the Commissioner and even the taxpayer to amend original assessments. Taxpayer self-amendment is permitted via s 169A(1). This enables the Commissioner (but does not require him) to accept a statement made by a taxpayer, in a return or otherwise, as to the assessable income or allowable deductions of the taxpayer for the purposes of making an assessment. This section does not actually distinguish between original and amended assessments. What the section does is permit the Commissioner to amend an assessment based on taxpayer statements without having to verify the information that the taxpayer has provided. There seems to be no requirement for a taxpayer to use an approved form when seeking an amendment. ITAA36 s 170 contains detailed provisions setting out the Commissioner’s power to amend original, and to amend further assessments that have already been amended. It gives the Commissioner the discretion, although not an obligation, to amend any assessment at any time subject to various limitations set out in the subsections to s 170. The main limit on the Commissioner’s power to amend (or further amend) assessments is the amount of time that is afforded. Examples of what may determine this amount of time include: that the Federal Court considers the Commissioner needs more time; that amendment is required to give effect to the outcome of a court decision or an Administrative Appeals Tribunal decision;

that the taxpayer has complied with the Commissioner’s exercise of his powers under TAA Div 353; that the Commissioner is of the opinion that there has been fraud or evasion. The current statutory time limits during which the Commissioner has the power to amend an assessment are: individuals — within two years of the notice of assessment; taxpayers that are a small business entity — within two years of the notice of assessment; and other taxpayers — within four years of the notice of assessment. You should look at the detailed provisions of s 170. They are set out via a link in Study help. An assessment disclosing no liability to tax is included in the meaning of an assessment to which these rules apply; thus making nil assessments eligible for the same amendment period as other assessments. An amended assessment is an assessment for all purposes of the income tax law unless the law provides otherwise, which means that the Commissioner is able to amend that amended assessment. However, the amended assessment provisions ensure that, when the Commissioner amends an assessment, a fresh amendment period only arises for the particular item that was amended. The balance of the assessment is limited by the normal time limits. [page 1101]

Valid and conclusive assessments 16.13 Both ordinary and deemed assessments qualify as assessments for the purposes of the ITAA36. The following discussion concerns what amounts to a valid and conclusive assessment. Although the Commissioner must act within the limits of his statutory powers (which will be discussed later), ITAA36 s 175 specifies that:

The validity of any assessment shall not be affected by reason that any of the provisions of this Act have not been complied with.

Section 175 is further supported by TAA Sch 1 s 350-10(1), which states (at item 2) that the effect of: The production of a notice of assessment … under [the] taxation law … is conclusive evidence that … (a) the assessment or declaration was properly made, or the notice was properly given; and (b) except in proceedings under Part IVC of this Act on a review or appeal relating to the assessment, declaration or notice — the amounts and particulars of the assessment, declaration or notice are correct.

The proceedings under TAA Pt IVC referred to in the extract above are the objection and appeal provisions that require a taxpayer to have a decision reviewed via the Administrative Appeals Tribunal (AAT) and/or the Federal Court. These will be discussed later. They constitute a formal review and appeal mechanism constrained by statute and set out in the income tax legislation. The effect of ITAA36 s 175 and TAA Sch 1 s 350-10(1) is that a taxpayer can do little to question the Commissioner’s actions in raising an assessment other than by means of the formal review and appeals rights under TAA Pt IVC. There have, on occasion, however, been important court cases which have emphasised the point that the Commissioner must act in good faith when exercising his various powers. Notwithstanding the limitations set out in ITAA36 s 175 and TAA Sch 1 s 350-10(1) (more particularly its predecessor, ITAA36 s 177(1)), the courts have been prepared to subject the Commissioner’s actions to judicial review. Judicial review by the High Court or Federal Court is a different action from the kind of merit review made available via the formal review and appeal process. The powers of the High Court and Federal Court to review the administrative actions of the Commissioner (and other Commonwealth officers) were considered by the High Court in FCT v Futuris Corp Ltd (2008) 237 CLR 146; [2008] HCA 32 (Futuris). In

Futuris, the High Court held that s 175 does not protect assessments based on deliberate failure to administer the law in accordance with its terms and reiterated [page 1102] that individuals may seek an injunction against an official in cases involving fraud, bribery, dishonesty, or other improper purpose (it also made the point that this is very rare). The High Court engaged in a lengthy discussion of the relationship between ITAA36 s 175 and the predecessor of TAA Sch 1 s 350-10(1), making the point that there is no inconsistency between these two and that s 350-10(1) simply gives evidentiary effect to s 175. It is difficult for a taxpayer to challenge an assessment on the basis that the Commissioner has done something wrong. Some recent cases demonstrate this. In FCT v Donoghue [2015] FCAFC 183, the use of legally privileged information (usually kept confidential between a taxpayer and their lawyer; see 16.26) was permitted as a partial basis for a default assessment because although there was a suspicion on the part of a tax officer that it was privileged and should not be used, the officer did not know for certain that it was privileged. So the assessment could not be voided on those grounds. In Denlay v FCT [2011] FCAFC 63, an assessment based on documents that had been stolen and that then fell into the hands of the ATO was upheld. The illegality of their original acquisition did not displace the Commissioner’s obligation to make an assessment on the information available.

Taxpayer advice 16.14 The ATO provides a wide range of advice and instructions to taxpayers to assist them in meeting their obligations. We have noted the need for the Commissioner to publish his tax return instructions in the Government Gazette and also to provide taxpayers with approved tax

return forms. The ATO also provides a substantial amount of advice and instructions that are more discretionary in nature than the items mentioned above and which are not legally binding on either itself or taxpayers. There is discretionary material which, once published, becomes legally binding on the Commissioner but not on the taxpayer. The main examples of this are public rulings. A good overview of the different types of advice that the ATO provides may be found in the ATO’s Practice Statement Law Administration PS LA 2008/3.

Rulings 16.15 There are three general types of rulings which are legally binding on the ATO. They are public, private and oral rulings. They remain legally binding until they are withdrawn or replaced. The public ruling system is a very important part of the Australian self-assessment tax system. It sets out how the ATO interprets the tax laws and what taxpayers must do when having their self-assessments challenged and amended. The public ruling system relieves self-assessing taxpayers of a considerable degree of uncertainty and risk. The rulings system covers a wide range of taxes including income tax, withholding tax, Medicare levy, fringe benefits tax, franking deficit tax, GST, etc. The Commissioner is bound by a ruling if the ruling applies to the taxpayer and the taxpayer relies on it. A ruling applies to a taxpayer if the taxpayer is a member of the class to which the ruling applies or, if it is given in response to an application (in the case of a private or oral ruling), and the facts, assumptions or conditions set out [page 1103] in the ruling are met. A taxpayer is said to rely on a ruling when the taxpayer acts or deliberately omits to act in accordance with the ruling. A taxpayer does not actually need to know of the existence of a public ruling in order to be said to have relied on it. A public ruling is a binding written advice published by the Commissioner for the

information of taxpayers in general covering the way in which, in the opinion of the Commissioner, a provision of a tax law would apply. A public ruling may deal with anything involved in the application of a provision of the Act including issues relating to liability, administration, procedure, collection and ultimate conclusions of fact. The Commissioner must publish notice of the making of a public ruling in the Gazette. From the time it is published, a public ruling binds the Commissioner unless the ruling states that it binds the Commissioner from some other time. The Commissioner withdraws a public ruling either fully or in part by publishing a notice in the Gazette. The withdrawal is effective from the time specified in the notice but cannot be retrospective. Where a public ruling is withdrawn, that ruling continues to apply to transactions or schemes to which it applied if they had commenced before the withdrawal but it does not apply to schemes that commence after the withdrawal. Go to the ATO homepage at and search for ‘ATO advice and guidance’ where you will find links to a variety of sources of information (accessed 29 September 2017); note how many published rulings are available. The Commissioner may choose to tailor some public rulings to cover a particular class of entities or limit the scope of the ruling to a particular transaction entered into by a number of entities. These types of public rulings fall into the category of product (transaction based) or class (entity based) rulings. A class of entities may be defined by reference to certain characteristics such as being an employee or a shareholder of a company or the member of an association. A product ruling may relate only to a particular financial product and the tax outcome for taxpayers who participate in that product. For an example of a product ruling, go to the ATO website at and look at Product Ruling PR 2009/40 ‘Income Tax: Film Investment — “Hell for Leather”’ (locate by searching for ‘PR 2009/40’) (accessed 29 September 2017). To understand class rulings, go to the same ATO website and look at Class Ruling CR 2001/1 (locate by searching for ‘CR 2001/1’) (accessed 29 September 2017).

Private rulings 16.16 A private ruling is a written expression of the Commissioner’s opinion on the way in which the Commissioner considers a relevant provision applies or would apply to a taxpayer who has sought an opinion. A private ruling may deal with anything involved in the application of a relevant provision including issues concerning liability, administration, procedure and collection, and ultimate conclusions of fact. The Commissioner is bound by the ruling if the ruling applies to the taxpayer and the taxpayer relies on it. The essential difference between a private ruling and a public ruling is that a private ruling deals with a specific course of action by a particular person whereas a public ruling is provided for the information of taxpayers generally or a class of taxpayers. Any taxpayer or their agent or legal representative may apply for a private ruling. [page 1104] The Commissioner may seek information about matters that are not in a private ruling application in order to make the private ruling. The Commissioner would do this by asking the applicant to provide additional material or the applicant may volunteer additional information after the application is made, or the Commissioner may rely on information provided by an entity other than the applicant (provided the applicant is aware of that information and has an opportunity to comment on it). The Commissioner may also make an assumption that he considers most appropriate in the circumstances (provided that the applicant is informed of this assumption and is given a reasonable opportunity to respond). The private ruling is recorded in writing by the Commissioner and a copy of it is given to the applicant either on paper or electronically. A private ruling should state any assumptions the Commissioner has made in making the ruling and should state additional information from any other entity that the Commissioner has relied on. The private ruling

may specify the time it begins to apply and the time it ceases to apply, but cannot retrospectively replace another ruling to the taxpayer’s detriment. There are circumstances in which the Commissioner may decline to make a private ruling. These would be where: the Commissioner considers that making the ruling would prejudice or unduly restrict the administration of a tax law; the matter sought to be ruled on is already being, or has been, considered by the Commissioner; the matter sought to be ruled on is how the Commissioner would exercise a power under a relevant provision and the Commissioner decides to exercise the power (or not to); the Commissioner has asked the taxpayer to give further information under TAA Sch 1 s 357-105 and the taxpayer does not provide it in a reasonable time; the Commissioner considers the ruling application to be frivolous; there is no point because the transaction has occurred and the amendment period has passed; or an applicant does not agree to pay the amount charged by the Commissioner for a valuation or a review of an applicant’s valuation pertinent to the ruling. If a private ruling has been given by the Commissioner, a person may object to a private ruling that applies to that person. If the Commissioner simply fails to give a ruling, then the person may give the Commissioner notice to make a ruling and then object to the Commissioner’s failure to make the ruling after the delivery of such a notice. For purposes of transparency, many private rulings are stripped of the detail that would enable the public to identify who has asked for the ruling and are published as anonymous ATO interpretative decisions. There is a register of private rulings also made available (and stripped of identifying material). A link to the register of private binding rulings may be found at .

Oral rulings and other forms of taxpayer advice

16.17 Oral rulings are dealt with under TAA Sch 1 Div 360. They are a third type of advice available to taxpayers and are legally binding on the Commissioner. [page 1105] They are available only to individual taxpayers with simple tax affairs. They are a type of private binding ruling except that neither the ATO nor the taxpayer provides anything in writing. Oral rulings cannot be appealed. Very few oral rulings have been made over the years. In addition to the rulings system, there are a number of other forms of taxpayer advice available. Policy guidelines are major ATO documents which provide both tax officers and taxpayers with a wide range of information about how the ATO intends to administer the laws, including how the Commissioner’s powers are intended to be exercised; many of these have been moved to Law Administration Practice Statements (LAPS) in recent times. An example is the ATO Receivables Policy. 16.18 As is noted above, the ATO publishes practice statements. These are administratively binding and they indicate what the ATO approach will be when administering particular aspects of tax laws. They articulate the ATO policy in particular areas but their scope is actually narrower than the policy guideline documents. Good examples of practice statements that you may care to look at are as follows: Practice Statement PS LA 2013/3 — provides information on the mediation of disputes between the ATO and taxpayers, showing the ATO prefers an Alternative Dispute Resolution (ADR) approach; Practice Statement PS LA 2011/14 — sets out the ATO’s general debt collection powers and principles; Practice Statement PS LA 2009/9 — provides details on the way in which the ATO will conduct litigation and other dispute resolution;

Practice Statement PS LA 2002/8 — provides details on the application of penalties and penalty remissions for particular situations. As mentioned, the ATO also publishes indicative (and, therefore, not administratively binding) interpretations (ATO IDs) of particular narrow aspects of tax law. These would usually cover areas in which there is not yet a public ruling. Taxpayers who rely on an ATO ID will not be subject to penalties if the ATO’s interpretation of the law subsequently changes. Many ATO IDs are subsequently withdrawn. This gives you an idea of how tentative and preliminary they are as opinions of the ATO. Another form of non-binding advice which is intended to inform taxpayers about tax-planning issues and arrangements that are of concern to the ATO are Taxpayer Alerts. For a full understanding of Taxpayer Alerts, read Practice Statement PS LA 2008/15.

Record-keeping obligations of taxpayers 16.19 Taxpayers need adequate records to ensure their tax returns are correct and so that they can be verified subsequently by the ATO if the need arises. (There is even a Practice Statement Law Administration on this topic — see PS LA 2008/14, which deals with the computer software records tax officers can expect taxpayers to keep.) Sometimes the ATO will need access to a taxpayer’s records to avoid having to use the Commissioner’s power to issue a default assessment under ITAA36 s 167. [page 1106] ITAA36 s 262A specifies what records business taxpayers are obliged to keep. There is no equivalent general provision applicable to nonbusiness individual taxpayers but all taxpayers must be aware that failure to keep adequate documentation to support claims may mean

that they are unable to discharge the burden they bear under TAA s 14ZZK or s 14ZZO to prove their entitlement to deductions or to challenge the inclusion of additional amounts in their assessable income. A number of provisions describe the substantiation required for particular categories of tax deductions. These provisions are located in ITAA97 Div 900. The major categories are: Subdivision 900-B for employees’ work expenses; Subdivision 900-C for car expenses; Subdivision 900-D for business travel expenses. Written evidence of work-related expenses is not required at all where the total of all work expenses claimed is $300 or less. Subdivision 900-E specifies the general nature of the written evidence taxpayers normally need to keep, where substantiation is required. This written evidence usually has to be retained for five years following lodgment of the taxpayer’s return. There are penalties for failure to keep records. TAA Sch 1 s 288-25(1) gives the Commissioner power to impose an administrative penalty for non-compliance with s 262A by businesses. The maximum value of the 20 penalty units is currently equivalent to $4200: see s 4AA of the Crimes Act 1914 (Cth). If this seems a modest penalty for failure to keep records, some breaches may also attract criminal prosecution that might result in imprisonment: see TAA s 8R. Examples include TAA ss 8L, 8Q and 8T.

Commissioner’s information-gathering powers 16.20 As has been shown, information and verification of information are key aspects of the self-assessment system. Business taxpayers are required under ITAA36 s 262A to keep records and may be subject to penalties for failure. The Commissioner has certain powers under TAA Sch 1 Div 353 to gain access to such records as may have been kept. These sections have been subject to many court cases. The

Commissioner also has separate powers in relation to search warrants unrelated to these tax law powers. Search warrants under the federal laws are beyond the scope of this chapter. 16.21 TAA Sch 1 s 353-15 applies to the situation where tax officers in search of information — usually during the course of an audit — physically visit the premises of either a taxpayer, or a third party, such as a bank or professional adviser, who is able to provide information about that taxpayer. Section 353-15 has three subsections and reads as follows. 353-15 Access to premises, documents etc (1) For the purposes of a taxation law, the Commissioner, or an individual authorised by the Commissioner for the purposes of this section: [page 1107] (a) may at all reasonable times enter and remain on any land, premises or place; and (b) is entitled to full and free access at all reasonable times to any documents, goods or other property; and (c) may inspect, examine, make copies of, or take extracts from, any documents; and (d) may inspect, examine, count, measure, weigh, gauge, test or analyse any goods or other property and, to that end, take samples. (2) An individual authorised by the Commissioner for the purposes of this section is not entitled to enter or remain on any land, premises or place if, after having been requested by the occupier to produce proof of his or her authority, the individual does not produce an authority signed by the Commissioner stating that the individual is authorised to exercise powers under this section. (3) You commit an offence if: (a) you are the occupier of land, premises or a place; and (b) an individual enters, or proposes to enter, the land, premises or place under this section; and (c) the individual is the Commissioner or authorised by the Commissioner for the purposes of this section; and (d) you do not provide the individual with all reasonable facilities and assistance for the effective exercise of powers under this section. Penalty: 30 penalty units.

Each of these subsections is worthy of more discussion. 16.22 Under TAA Sch 1 s 353-15(1)(b), the phrase ‘full and free access’ for ‘the purposes of a taxation law’ gives the Commissioner (actually his staff) very wide powers to seek information. The Acts Interpretation Act 1901 (Cth) provides that ‘documents’ include computer records. Officers are able to make copies of documents when using TAA Sch 1 s 353-15 powers, but this does not mean they are entitled to keep the original documents. Court findings in relation to the predecessor s 263(1) of the ITAA36 suggest that the wide power is constrained only by the need to give the taxpayer a reasonable opportunity to claim legal professional privilege for any of the documents sought by the ATO. Otherwise, the only other limitation is that the Commissioner is acting in good faith. The Commissioner is not obliged to give notice of his intention to use the TAA Sch 1 s 353-15 powers but will often do so where legal professional privilege is likely to be an issue. It would be counterproductive to give prior notice of an intention to ‘raid’ for information. It has been accepted by the courts that the ITAA36 s 263(1) power included ‘fishing expeditions’ as part of random audits and TAA Sch 1 s 353-15 is not intended to change the law. The powers can be used even when there is no expectation that the particular taxpayer has particular records of interest to the ATO. The information sought can relate to other [page 1108] persons and the ATO will sometimes use its access powers to seek information from third parties. The Commissioner cannot use access powers once court proceedings have commenced but may do so where AAT proceedings are involved. 16.23 With regard to TAA Sch 1 s 353-15(2), the authorisation given to an officer to exercise TAA Sch 1 s 353-15 powers seemingly does not have to specify the premises or the documents involved. Under TAA Sch 1 s 353-15(3), it is the occupant who is obliged to provide the

assistance. There might be some uncertainty about the meaning of this term but, in effect, at present it means any responsible person on the premises at the time, which may include relatively low-level staff. The requirement that all reasonable facilities be provided has been interpreted under the predecessor provision to include power and lighting, indications where documents are located, unlocking cabinets, operating computers, etc. In the absence of this assistance being provided, tax officers are entitled to use reasonable force to access documents.

Power to obtain information and evidence: TAA Sch 1 s 353-10 16.24 In contrast to the exercise of TAA Sch 1 s 353-15 powers where the Commissioner or officers may visit premises to access documents, TAA Sch 1 s 353-10 powers require a person either to attend a meeting with ATO officers or otherwise provide the ATO with information that it has requested. Section 353-10 provides: 353-10 Commissioner’s power (1) The Commissioner may by notice in writing require you to do all or any of the following: (a) to give the Commissioner any information that the Commissioner requires for the purpose of the administration or operation of a* taxation law; (b) to attend and give evidence before the Commissioner, or an individual authorised by the Commissioner, for the purpose of the administration or operation of a taxation law; (c) to produce to the Commissioner any documents in your custody or under your control for the purpose of the administration or operation of a taxation law. Note: Failing to comply with a requirement can be an offence under section 8C or 8D. (2) The Commissioner may require the information or evidence: (a) to be given on oath or affirmation; and (b) to be given orally or in writing. For that purpose, the Commissioner or the officer may administer an oath or affirmation. (3) The regulations may prescribe scales of expenses to be allowed to entities required to attend before the Commissioner or the officer.

[page 1109] Based on decisions concerning the predecessor provision ITAA36 s 264, these powers can also be used by the Commissioner engaged in a random audit, even if this might be branded a ‘fishing expedition’. 16.25 TAA Sch 1 Div 353 is further supplemented by ITAA36 s 264A. It is obvious that the practical reach of TAA Sch 1 Div 353 is inhibited where the information is held, at least partly, outside Australia. ITAA36 s 264A complements the powers by permitting the Commissioner to issue an ‘offshore information notice’ to a person subject to Australian income tax. Unlike the situation for TAA Sch 1 Div 353, it is not an offence under ITAA36 s 264A to fail to provide information. However, the taxpayer cannot rely on such information at a subsequent AAT or court hearing, except where the Commissioner consents to its admission or where a tax penalty is involved.

Legal professional privilege 16.26 In the previous discussion, it has been mentioned that the privilege of secret communications between a taxpayer and his or her legal adviser is a privilege that may limit the Commissioner’s powers under TAA Sch 1 ss 353-10 and 353-15. Legal professional privilege is a right to privacy of communications between a person and his or her legal representative in certain circumstances. It is for the taxpayer to claim legal professional privilege for documents. It is not something that can be claimed by the legal representative, but representatives of the taxpayer’s interests have a responsibility to advise the ATO that the taxpayer may wish to claim legal professional privilege for documents. It is then up to the courts to decide whether a claim made by the taxpayer is valid. While that decision is being made, the ATO is not permitted to see the documents. 16.27 Legal professional privilege is a common law privilege whose purpose is to keep information provided by persons to their legally qualified advisers confidential. The privilege is available only where the

‘dominant purpose’ of a confidential communication from the legal adviser to the client involves either: legal advice about some matter; or pending or anticipated litigation. 16.28 This privilege is lost where a communication has ceased to be confidential between the client and the legal adviser and thus the inclusion of third parties in the information may result in the loss of the privilege. Legal professional privilege is not available to clients for communications with their accountants and other non-legal professional advisers. The ATO has set out guidelines for access to information that it will observe in the context of dealings with accountants. These guidelines closely resemble legal professional privilege, but they are not, in fact, legal professional privilege. The government may extend the legal professional privilege to accountants. The privilege is not available for source documents that record a transaction or arrangement entered into by the client. It is available only for advice. A privilege does not apply where the client has deliberately committed a crime or a fraud, or where the communication represents a step in the direction of a crime or a fraud, but it may well apply in cases of tax avoidance which do not amount to a crime or fraud. [page 1110] For an outline of the manner in which the ATO uses its information powers, read the ATO’s Our Approach to Information Gathering manual, available from , enter Our Approach to Information Gathering in the search area on the ATO website (accessed 29 September 2017).

Disputes with the Taxation Office 16.29 The ATO constantly makes decisions: assessments, decisions to investigate, and decisions to take some action (apply a penalty or an

interest charge) or refrain from taking an action. Many such decisions may be unsatisfactory to the persons affected by them. The following discussion covers the principal means by which a taxpayer may challenge a decision reached by the ATO affecting that taxpayer. The major categories of review of complaints are administrative or judicial. Administrative review comprises dispute resolution processes within the tax administration (‘internal administrative review’) as well as adjudication by administrative review bodies independent of the tax administration (‘external administrative review’). Judicial review comprises the review and appeal procedures in the court system. The ATO has an active policy in place to try to resolve disputes before they end up in the courts or a review tribunal outside the ATO. Paragraphs 16.30 and 16.31 below apply where this internal process has failed. 16.30 The principal legal method of disputing an assessment is by means of the appeal and review process provided in TAA Pt IVC. This provides access by taxpayers to the Administrative Appeals Tribunal (AAT). Aspects of the functioning of the AAT are covered by the Administrative Appeals Tribunal Act 1975 (Cth). TAA s 14ZZA specifies that, subject to certain limitations, the Administrative Appeals Tribunal Act 1975 (Cth) applies in relation to: (a) the review of reviewable objection decisions; and (b) the review of extension of time refusal decisions; and (c) AAT extension applications; …

16.31 The Federal Court has jurisdiction in relation to appeals regarding appealable objection decisions: TAA s 14ZZO. Thus, taxpayers may be engaged in an appeal against an objection decision via the Federal Court and in a review of an objection decision by the AAT. At a later point, we will discuss taxpayers’ remedies to have an action of a Commonwealth officer subject to a review by a higher court using the Constitution, the Judiciary Act 1903 (Cth) or the Administrative Decisions (Judicial Review) Act 1977 (Cth). When speaking of a

taxpayer seeking a review of an ATO objection decision by the AAT, this is referred to as an ‘external administrative review’. (It is certainly not a judicial review because the AAT is not a court.) [page 1111]

Objections, reviews and appeals Objections (‘internal administrative review’) 16.32 Generally, when a person is affected by a decision of the ATO with which he or she does not agree, the least expensive and most expeditious means of resolving the dispute is first to seek redress directly from the ATO. The ATO has been changing aspects of its problem resolution service in order to prevent disputes arising and in order to resolve them as soon as possible when they do arise. It therefore has ‘dispute management principles, strategies and techniques to avoid, minimise and resolve disputes as early, cooperatively and collaboratively as possible’: ATO, Our Dispute Resolution Strategies, , search for Our Dispute Resolution Strategies on the ATO website (accessed 29 September 2017). It commenced an independent review service in 2013, which is used to clear up disputes arising from large taxpayer audits. The purpose of this review is to resolve areas of disagreement before an assessment is issued. It uses an independent internal reviewer who is not influenced by having been involved in the audit. For disagreements that are not resolved in this way, the ATO has been developing a code of settlement to encourage settlement before disputes go to a tribunal or court hearing. For disputes that escalate, the ATO also uses private Alternative Dispute Resolution (ADR) using private experts to negotiate a resolution between the ATO and the taxpayer without the full cost and delay of an inevitable court hearing. Less complex disputes are being resolved by means of an in-house facilitation service which was launched in 2014 with considerable

success. Only once these various processes have failed should a dispute go on to more formal resolution as discussed below.2 16.33 The trigger for embarking on a dispute resolution process is a ‘taxation decision’. A taxation decision is the assessment, determination, notice or decision against which a ‘taxation objection’ is made: TAA ss 14ZQ and 14ZL. Not all decisions made by the tax administration are ‘taxation decisions’. TAA Pt IVC effectively states that where the taxation law does not provide that the affected person may object to a particular decision, assessment or determination, that decision will not be categorised as a ‘taxation decision’. If the decision is not a taxation decision, an aggrieved taxpayer may not make an objection. For the rules of appeal and review in the TAA to operate, it is necessary for a provision, for example, in the ITAAs, to state that the particular decision is capable of objection. There are many examples of decisions that do not specifically state this. For example, TAA Sch 1 s 353-10 authorises the Commissioner to write a notice requiring a person to attend before him with documents and records, but does not mention that it is open to objection by the person who is so ordered (to attend) and so the objection procedures in the TAA would not apply. Any review of such a decision [page 1112] would have to be made under some other authority, such as the Administrative Decisions (Judicial Review) Act 1977 (Cth). For actions taken that are not taxation decisions, external administrative review is the usual form of redress (where any internal dispute resolution, such as those described above, has failed). These instances are typically ones where review under administrative law (not taxation law) may be sought. An example of this would be a decision to use the TAA Sch 1 s 353-15 investigation power. 16.34

So when a taxpayer is dissatisfied with a tax decision, he or she

may lodge an objection. The objection must be in writing (TAA s 14ZU(a)) and lodged with the Commissioner. Section 14ZU(c) specifies that the objection must state ‘fully and in detail’ the grounds on which the objection is based. It is not sufficient for the objection to state baldly that the assessment was ‘wrong’ or ‘excessive’ (see HR Lancey Shipping Co Pty Ltd v FCT [1951] ALR 507; (1951) 5 AITR 135); more detail is necessary. The time limit for lodging objections to original (as opposed to amended) assessments is, in most instances, four years (TAA s 14ZW(1)) and, in the case of non-business individuals and small businesses, two years (TAA s 14ZW read with ITAA36 s 170(1)).

Simple, a taxpayer with simple tax affairs, disagrees with the Commissioner’s assessment of his liability to tax, believing that an amount has been incorrectly included in his taxable income. How much time does he have in which to lodge an objection? Joe’s sister Georgia runs a successful medium-sized information technology consultancy in partnership with three other consultants. The Commissioner has failed in the notice of assessment to allow her to deduct certain expenses which she considers to be business related and deductible. How much time does she have in which to lodge an objection? The Managing Director of Tramp Enterprises Pty Ltd is informed by the company’s accountant that the Commissioner has refused to allow the company’s claimed rate of deduction for depreciation of plant and equipment under the capital allowances scheme. How much time does the company have in which to lodge an objection? A suggested solution can be found in Study help.

16.35 An objection may in some instances be lodged after the time limit has expired. Such an objection must be accompanied by a written request to the Commissioner that it be dealt with as if it had been lodged within the required period: TAA s 14ZW(2). If an extension is requested, the Commissioner is obliged to give written notice of whether the extension will be granted or not: TAA s 14ZX(2).

[page 1113] If the request for extension is denied, the applicant may apply to the Administrative Appeals Tribunal for review of that decision: TAA s 14ZX(4). The Commissioner is obliged to serve written notice of his decision on the person who objected. If no objection decision is forthcoming within 60 days, here TAA 14ZYA(2) provides that the taxpayer may request in writing that the Commissioner provide an objection decision within a further 60 days. If the Commissioner does not deliver an objection decision within 60 days of being served with the written request, TAA 14ZYA(3) deems that the Commissioner has disallowed the objection in its entirety. Requiring the Commissioner to make an objection decision, even if it is an unfavourable one, is important since, without the objection decision, the aggrieved taxpayer is unable to take the case to the next stage of the dispute resolution process.

1.

If the Commissioner has been served with notice to give a decision, and fails to do so within the time limit, can the taxpayer go to the next stage even if TAA s 14ZY(3) (about the service of notice of the Commissioner’s decision) has not been complied with? 2. What alternative can be used to encourage timely response by the ATO to objections? Suggested solutions can be found in Study help.

Choice of court or AAT 16.36 Review or appeal can commence only where the taxpayer is ‘dissatisfied’ with the objection decision. An objection decision may be reviewable, appealable, or both reviewable and appealable. If the

decision is reviewable only, the only redress is review by the AAT: TAA s 14ZZ(b). If the matter is appealable only, the aggrieved taxpayer may take the matter on appeal to the Federal Court: TAA s 14ZZ(c). If the issue is both reviewable and appealable, the taxpayer may seek redress from either the AAT or the Federal Court: TAA s 14ZZ(a). All objection decisions that do not fall within one of the limited legislative exceptions will be both reviewable and appealable. A ‘reviewable objection decision’ is defined as any objection decision that is not an ineligible income tax remission decision. TAA s 14ZQ defines an ‘appealable objection decision’ as any objection decision other than a decision made under certain specific statutory provisions. In effect, virtually all objection decisions are both appealable and reviewable. 16.37 Where the decision is reviewable and appealable, the aggrieved individual will have to choose whether to seek review at the AAT or appeal to the Federal Court. If the decision is one that falls within the exceptions, the individual does not have a choice of review mechanisms and must follow the route available. Whether a taxpayer seeks the review or appeal of the objection decision by the AAT or Federal Court could depend on a number of factors including the nature of [page 1114] the matter at issue and the remedy sought. The AAT has a much broader power to provide remedies. It may exercise any discretion which the decision-maker under review could exercise. The Federal Court is limited to legal remedies and is forbidden by the constitutional doctrine of separation of powers to act in an administrative manner. Other important considerations include the cost of litigation, privacy (hearings at the AAT — except when it is sitting in its small claims capacity — are in camera whereas cases before the Federal Court are held in public and the litigants named and the decisions reported), speed

of result, complexity of the case and the sophistication of the taxpayer and access to further appeal.

Figure 16.1:

The tax objection and appeal path

[page 1115] 16.38 Whether an objection decision is being reviewed before the AAT or appealed to the Federal Court, the taxpayer has the same burden of proof. The burden of proof typically rests on the taxpayer making the objection (the ‘objector’) but what must be proven before the adjudicator depends on the tax decision that triggered the objection. If the tax decision is an assessment, the objector must prove to the AAT (TAA s 14ZZK (b)) or the court (TAA s 14ZZO(b)) that the assessment was excessive. The High Court decided in FCT v Dalco (1990) 168 CLR 614; 90 ALR 341; 90 ATC 4088 that it is not sufficient for the objector to show that the assessment was merely wrong. If the taxation decision was anything other than an assessment, the objector must prove that the decision should not have been made or should have been made differently. In Trautwein v FCT (No 1) (1936) 56 CLR 63; [1936] ALR 425, the High Court held that the objector must show in what way the decision was wrong, how that error created an excessive assessment and how it should be rectified. 16.39 On further appeals from the AAT to the Federal Court or from the Federal Court to the Full Federal Court, the burden remains with the original objector. The High Court provided in McCormack v FCT (1979) 143 CLR 284; 23 ALR 583 that the taxpayer’s burden of proof applied both at the Taxation Board of Review (the AAT’s predecessor) and on appeal. This means that, even where the Commissioner is appealing from a decision of the AAT or the Federal Court, the burden of proof remains with the taxpayer. In a number of cases (such as Jacob v FCT (1971) 2 ATR 608; 71 ATC 4192, McCormack v FCT (1979) 143 CLR 284 per Gibbs J at 300–2 and Macmine Pty Ltd v FCT (1979) 24 ALR 217; 9 ATR 638; 79 ATC 4133), the courts have found that the taxpayer must prove his or her case on the balance of probabilities. The balance of probabilities is the general standard of proof in civil matters. This is contrasted with the standard in criminal matters that requires proof beyond reasonable doubt. This means that, when the court weighs the strengths of the

cases of the parties, if the balance tips away from the centre and in the direction of the taxpayer to any degree, the taxpayer should succeed.

Why should the burden of proof lie with the taxpayer in a review matter? A suggested solution can be found in Study help.

16.40 Taxes must still be paid notwithstanding review being sought. TAA ss 14ZZM and 14ZZR provide that proceeding with a review or appeal of a tax decision does not suspend the implementation of the challenged tax decision. The Federal Court may grant a stay of proceedings when a tax decision is being appealed to that court. The practice of the Commissioner is not to proceed with implementing a decision while the matter is pending review. However, even though there may have been a suspension of proceedings, if the taxpayer loses the review or appeal, late penalties and interest charges that have accrued during the entire period will be charged to the taxpayer. [page 1116]

External administrative review 16.41 If the result of the internal review is unsatisfactory to the party seeking the review, there are three choices that the party can make: 1. not to pursue the matter further; 2. to seek review through an administrative adjudicator (‘external administrative review’); or 3. to appeal the matter in the courts (‘judicial appeal’). The following section looks at the legislative mechanisms for external administrative review.

Administrative Appeals Tribunal (AAT) 16.42 TAA s 14ZZ(a)(i) and (b) provides for an application for administrative review of an objection decision to be made directly to the AAT. TAA s 14ZZC sets out the requirements for the application, which must be in writing, in accordance with the prescribed form, and must set out the reasons for the application. The application must be lodged with the AAT within 60 days of the objector having been served with notice of the objection decision. An important feature of the process of review by the AAT is the preliminary hearing but even before this it seems that the serious engagement of the parties leads to settlement of cases: see Inspector General of Taxation, Review into the Australian Taxation Office’s Use of Early and Alternative Dispute Resolution, Commonwealth of Australia, May 2012, p v — 90% of matters are resolved prior to a full hearing. It is this that has encouraged the ATO to adopt new internal resolution processes so as to engage the parties sooner than was the case before. Within the formal AAT process, a preliminary hearing provides an opportunity for the parties to clarify the issues in dispute as well as delineating the legal positions of the parties to expedite the hearing. The preliminary hearing has taken on the increasingly important role of diverting disputes from full hearings by seeking to resolve them informally. As with all ADR processes, the fact that the parties are directly involved in this informal resolution attempt is important. When the parties are directly involved, they feel that they have a greater stake in ensuring the success of the resolution process.

How does ADR assist tax administration? A suggested solution can be found in Study help.

16.43

When there has been an application made before the AAT for

review of a decision of the Commissioner, the Administrative Appeals Tribunal Act 1975 (Cth) (AATA) s 37(1) as modified by TAA s 14ZZF(1)(a) obliges the Commissioner to provide the AAT with information regarding the decision that is the subject of the review. The Commissioner must provide copies of a statement of reasons for the decision; the taxation objection; notice of the objection decision; and any [page 1117] other document in the possession or under the control of the Commissioner which the Commissioner considers necessary for the review of the objection decision. If the AAT is not satisfied with the statement provided by the Commissioner, AATA s 38 as modified by TAA s 14ZZG enables the AAT to order a further and better statement. In its adjudication of a dispute, the AAT looks beyond the legality to the merits of the decision. The AAT must be satisfied that the decision of the Commissioner was the correct one or not. To do this, AATA s 43(1) enables the AAT to exercise all of the powers and discretions of the Commissioner. The role of the AAT in reviewing the decision of the Commissioner goes beyond the Federal Court role of determining whether the Commissioner made an error in law. In dealing with a review, the AAT has an extremely broad range of actions open to it. It may affirm the decision, vary it or set it aside. If the decision is set aside, AATA s 43(1) allows the AAT to make a substitute decision or remit the matter to the Commissioner to reconsider it in accordance with any directions or recommendations of the AAT. AATA s 45(1) enables the AAT, on request of a party, or on its own motion, to refer a question of law to the Federal Court. The AAT will not decide a case in which there is a pending decision on a question of law but, under AATA s 45(3), will await the decision of the Federal Court before deciding the case in question.

How does the role of the AAT in dispute resolution differ from that of the Federal Court? A suggested solution can be found in Study help.

Small Taxation Claims Tribunal 16.44 Within the AAT, there used to be an additional dispute resolution mechanism: the Small Taxation Claims Tribunal (STCT). The STCT has been closed from 1 July 2015. The concept of a separate tribunal was abandoned and matters of the same character as STCT matters (tax in dispute under $5000) can now be dealt with in the Taxation and Commercial Division of the AAT.

Is the AAT a court? Why/Why not? Is this a problem? A suggested solution can be found in Study help.

16.45 Matters that used to be dealt with by the STCT still benefit from a lower fee than AAT matters. The fee for filing a case with the STCT used to be $87, [page 1118] as compared to the normal filing fee at the AAT of $884. Currently a lower fee of $100 is available to applicants to the AAT when: applicants state in writing that the amount of tax in dispute is less

than $5000; the ATO has refused a request to be released from paying a tax debt (regardless of the amount involved); and the ATO has refused to extend the time for the applicant to lodge a taxation objection.

Do you think the access to a lower application fee for a low amount of tax (under $5000) is a useful thing? A suggested solution can be found in Study help.

Judicial review 16.46 The last avenue of review is having the dispute considered by the court system. Judicial review may take the form of an appeal against a decision by the administrative adjudicator or an ATO objection decision (a judicial appeal), or, alternatively, the matter may reach the court directly (a judicial review). In Australia, where the choice is available, there may be a number of reasons why an objector may decide to proceed with an appeal to the Federal Court rather than request a review by the AAT. In court, the objector will have the certainty that is associated with being able to rely on the doctrine of precedent. In contrast, the AAT, being an administrative rather than a judicial body, is not bound by its own previous decisions, although members of the AAT often follow earlier decisions. The objector may feel that due to the legal complexity of the subject matter it would be preferable for it to be adjudicated by the Federal Court because of a perceived higher level of competence in dealing with technical legal issues. The nature and scope of subsequent appeals is another factor that may lead a taxpayer to have his or her objection adjudicated by the Federal Court rather than the AAT. Section 24(1)(a) of the Federal Court of Australia Act 1976 (FCAA)

provides that if the Federal Court hears the matter there is an appeal, as of right, to the Full Federal Court. If the AAT hears the matter, appeal from its decision is only on questions of law. An absolute right of appeal may be an attraction. Furthermore, the scope of appeal from a single judge of the Federal Court to the Full Federal Court under FCAA s 24 is much broader than the appeal from the AAT to the Federal Court under AATA s 44(1). 16.47 A judicial appeal is commenced by filing a notice of appeal at the district registry of the Federal Court and paying the appropriate filing fee ($9335 for a company, and $4325 for others). The notice of appeal will outline the question of law at issue, the order sought and the grounds asserted in support of the order. The Federal Court Rules govern the appeal procedure. [page 1119] A single judge of the Federal Court will hear the appeal unless the AAT case was heard by one or more AAT members who are also members of the Federal Court. In such instances, the appeal will go directly to the Full Federal Court. In addition, if the AAT feels that there is an appropriate question of law to be heard by the Full Court, and the President of the AAT or a Presidential Member agrees, the case may also go directly to the Full Federal Court: AATA s 45(2). The AAT is the final arbiter of questions of fact. If there is no question of law at issue, there can be no appeal to the Federal Court. Furthermore, the Full Federal Court found in FCT v Brixius (1987) 16 FCR 359; 14 ALD 470; 87 ATC 4963 that the sole issue on appeal to the Federal Court will be the AAT’s treatment of the question of law. Further, in FCT v Sahhar (1984) 15 ATR 400; 84 ATC 4167, the court found that this question of law must be a real one, not one contrived by the parties so as to get a Federal Court appeal. In Haritos v FCT [2015] FCAFC 92, the Full Federal Court said that this does not preclude the court reviewing the AAT’s fact-finding process; it simply cannot be the final arbiter of fact.

It is a legal requirement (see the Civil Dispute Resolution Act 2011 (Cth)) that all proceedings instituted in the federal courts (with the exception of some judicial review matters) be preceded by the taking of genuine steps to resolve the dispute before there can be any court hearing. The steps taken and their outcome must be documented and a statement outlining these steps must be provided to the court. The requirement is still quite new and there is little experience of its precise application in tax matters. Its intention seems to be to force the parties to make a genuine effort to resolve disputes before placing them before the courts.

1.

Is there any sense in a general rule that the first court, the one in which the evidence is heard, is the court which makes the final decision on questions of fact? 2. What is a question of law as distinct from a question of fact? Suggested solutions can be found in Study help.

16.48 In dealing with cases on appeal from the AAT, the Federal Court may act in a number of ways. The Federal Court may decide to affirm or set aside the decision under appeal or remit the matter back to the AAT with directions. The AAT hearing the remitted case may be constituted with the same or different members. The Federal Court may or may not specify a preference on this point. At the Federal Court, the remitted matter may be heard with or without the taking of further evidence: AATA s 44(6).

Why is the Federal Court so limited in its relief? A suggested solution can be found in Study help.

[page 1120] 16.49 The relevant constitutional provisions are ss 61 and 71 of the Commonwealth of Australia Constitution Act: 61 Executive power The executive power of the Commonwealth is vested in the Queen and is exercisable by the Governor-General as the Queen’s representative, and extends to the execution and maintenance of this Constitution, and of the laws of the Commonwealth. … 71 Judicial power and Courts The judicial power of the Commonwealth shall be vested in a Federal Supreme Court, to be called the High Court of Australia, and in such other federal courts as the Parliament creates, and in such other courts as it invests with federal jurisdiction. The High Court shall consist of a Chief Justice, and so many other Justices, not less than two, as the Parliament prescribes.

A detailed discussion of the concept of the separation of powers is beyond the scope of this text. Suffice to say, it has long been perceived by theorists, especially in societies established in the English tradition, that some separation of the powers of law-making (legislative powers), applying the law (executive/administrative powers) and interpreting the law (judicial power) is essential to ensure that the subjects of nations do not face bodies which can do all of: make the law; interpret it; and apply it to the subjects; without their having recourse to some other body which will scrutinise these actions. Australia has incorporated the separation of powers into its Constitution and this separation is observed, more or less, in the way the organs of government operate. The greatest separation is usually seen in the separation of the federal courts from the executive and legislative branches of government. FCAA ss 24 and 25 provide that the decision of a single judge of the Federal Court about a decision of the AAT may be appealed to the Full Federal Court. However, s 25 stipulates that the appeal may only be made with leave of the Full Federal Court. Where the taxpayer has the choice and eschews the AAT to go directly to the Federal Court, FCAA

s 24(1)(a) allows an appeal as of right from a single judge of the Federal Court to the Full Federal Court. Under FCAA s 33, the decision of the Full Federal Court may be appealed, by special leave, to the High Court of Australia. The High Court Rules 2004 (Cth) r 41.02 specify that an application for leave to appeal shall be filed within 28 days of the pronouncement of the judgment of the Full Federal Court. Leave to appeal to the High Court is not readily granted in taxation cases. The High Court has taken the view, in FCT v Westfield Ltd (1991) 22 ATR 400 per Mason CJ at 402, that only questions of fundamental importance will be granted leave by the court. Furthermore, as shown in FCT v David Jones Finance & Investments Pty Ltd (1991) 22 ATR 397 at 399; 91 ATC 4635, per Mason CJ, again, at 4636, the High Court will grant leave only where there is an active dispute between the parties. [page 1121]

Methods to improve compliance: Penalties 16.50 Methods for maintaining compliance are a critical component of the organisational strategy of the ATO. Penalties are a key means of ensuring taxpayer compliance and they will be the central focus of this section. Penalties are of particular importance in a self-assessment system. Self-assessment of taxes places the main burden of compliance (ie, reporting income honestly and fully) on the taxpayer. Penalties provide a means of deterring taxpayers from choosing not to comply with their obligations. In addition to penalties, there are other methods that the ATO might use to encourage compliance. These methods include: taxpayer identification systems; taxpayer amnesties — where the government decides that for a finite period penalties will not be applied against taxpayers who

have violated the law, if they make a full disclosure to the tax authorities of their transgressions; and various withholding regimes — where taxes are deducted from payments before they reach the recipient. 16.51 A penalty is defined as a punishment related to the breach of a statute. Penalties in a tax system may be administrative or judicial. Administrative penalties, which generally take the form of additional or penalty tax, are provided under the tax laws. These penalties are imposed directly by the tax administration. Judicial penalties are those provided under the same law or other laws and are imposed after a conviction at trial. The courts administer the application and imposition of judicial penalties. The form of the penalty may involve the payment of a sum of money or the imposition of a term of imprisonment or a combination of the two. Tax-related offences may also be dealt with under the criminal law, either in specific taxation crimes legislation or in the general criminal code of the jurisdiction. Procedures under these laws are like any other criminal process with the more onerous standard of proof as well as procedural safeguards not present in non-criminal proceedings. The following section will examine the administrative and judicial penalty provisions in relation to non-filing or late filing of returns, late payment of tax and understatement of tax.

Non-filing and late filing penalties 16.52 ‘Non-filing’ occurs when a (should be) taxpayer fails to file a tax return. The late filing of returns is a subset of the non-filing problem. A ‘non-filer’ who is found out or voluntarily decides to comply after the filing date is a ‘late filer’. These two offences will be discussed together since they are so closely related. Non-filing of returns is a critical problem for the ATO since non-filers are persons who may not be known at all to the administration. The fact that there are people who should be reporting income and transactions to the ATO but who fail to do so is of concern. Assessable income is not being reported and, therefore, revenue that would otherwise be available to fund

government services, such as health and education, is not being collected. This may be indicative of considerable economic activity about which the tax administration has no knowledge, involving additional persons who are also [page 1122] not within the tax system information net. This is the problem of the underground economy and the choice made by some people to evade the income tax system. The lack of information and the failure to collect tax, combined with the knock-on effect on social attitudes regarding the efficacy of the tax system, can seriously undermine the operation of the tax system. 16.53 The ATO employs a number of strategies designed to maximise the number of taxpayers who file returns. Penalties are a specific means of punishing people who do not meet their legal obligation to file a return and of recouping the lost revenue. The imposition of penalties also has a general deterrent effect on those who might consider non-filing as an option. TAA Sch 1 s 286-75 provides that individual taxpayers are liable to pay a late filing penalty if they file returns later than the date specified by the Commissioner’s notice in the Gazette. The penalty is a base amount of one penalty unit up to a maximum of five per 28 days late. In addition, interest on the penalty is charged under what is termed the ‘general interest charge’ (GIC) and is worked out in accordance with TAA s 8AAG. It is a rate of the published Treasury Note yield rate plus 7%. The outstanding tax is usually added to a running balance account (RBA) established for the taxpayer under TAA s 8AAZC(1) and which the Commissioner may, under s 8AAZC(4), use to pool payments by the taxpayer in relation to all tax debts and credits owed by and to the taxpayer. TAA ss 8AAZH(1) and 8AAZF(1) describe how the GIC is calculated on the daily debit balance on the RBA. This means that a

taxpayer’s other debts are accumulated and interest is charged on all of them. In addition, any credits due to the taxpayer on other tax matters are not refunded to the taxpayer but used to offset these debts.

1. 2.

Is there a problem with basing the quantum of tax penalty on the net tax payable? Is there a problem with using tax refunds due to the taxpayer to offset the taxpayer’s other tax debts? Suggested solutions can be found in Study help.

Late payment penalties 16.54 In the normal course of events, an assessment is made and tax is due to be paid by a certain date. Late payment occurs where the taxpayer has failed to pay some or all of the tax owed by the date specified. There is a uniform penalties regime coupled with the GIC described above at 16.53. This system has the advantage of applying uniformly to all tax debts owed under Commonwealth tax laws whereas, before 1 July 1999, different penalty rules applied to different Commonwealth taxes. [page 1123] In discussing late payments, two issues need to be considered. First, the due date for payment of taxes: a date must be imposed so that a determination of lateness can be made. Second, the punishment itself: how is it calculated? In most instances, the date on which taxes are due is provided for in the Australian income tax law. As a general provision, ITAA97 s 5-5(5) provides that the due date will be the date 21 days after the date on

which you must lodge your tax return. The general provision does not apply to taxpayers subject to full self-assessment. Section 5-5(4) specifies that the due date for these taxpayers is 1 December if they have a tax year ending on 30 June, or six months after the end of their tax year. Late payment of taxes results in the GIC being imposed. The GIC has the dual effect of imposing a penalty and charging interest. 16.55 In addition to the GIC described above, other administrative penalties may apply. The GIC applies principally to late payment and underpayment of income tax, which falls within the RBA deficit as specified by TAA s 8AAZF(1). The uniform penalty regime is the principal penalty system for late payments and inadequate payments. There are yet other types of actions, such as fraud or other misconduct, which it is necessary for the tax authority (and courts) to penalise. The Commissioner has some limited discretion to remit all or part of the GIC or a penalty. The ATO website at (search for ‘About penalties and interest charges’) sets out some of the principles involved in whether a penalty will be remitted and Practice Statement PS LA 2012/5 explains the remission of penalties for false or misleading information.

Tax shortfall penalties 16.56 One of the most significant problems faced by the ATO is the underpayment of taxes. Underpayment of taxes may take the form of under-reporting of assessable income or over-reporting of allowable expenses, or a combination of the two. In any event, the result is that less tax is paid than should have properly been due. This is referred to as a ‘tax shortfall’. TAA Sch 1 s 284-80 shows how a tax shortfall can generally be defined as the gap between the amount of tax which should have been paid had the taxpayer fully complied with the tax law and the amount the taxpayer actually paid or was credited with in the RBA. The tax shortfall is a key focus of penalty provisions in the tax law. TAA Sch 1 s 284-75 sets out the uniform penalties which apply to tax shortfalls

arising from statements made to the Commissioner or some other entity (like an entity required to withhold tax from a payment to a taxpayer) administering or applying the tax law. 16.57 There are certain circumstances under the Australian law where the taxpayer will not be subject to a penalty even when there is a tax shortfall. TAA Sch 1 s 284-224 allows that no penalty will be due if there is a tax shortfall resulting from the taxpayer relying on a position taken by, or administrative action of, the ATO. A tax shortfall will also be ignored for penalty purposes if the tax shortfall resulted from advice given by a taxation officer or as a result of the application of the general administrative practice of the ATO. [page 1124] TAA Sch 1 s 284-75(1) imposes penalties for false or misleading statements. Where the entity has taken reasonable care to comply with their tax obligations, no administrative penalty will be imposed under TAA Sch 1 s 284-75(1). The reasonable care standard asks whether an ordinary person in all of the circumstances would have foreseen as a reasonable likelihood that his or her act or failure to act would result in a tax shortfall. If a reasonable person would not have foreseen the tax shortfall, then that person will be considered to have taken reasonable care. The standard ignores what the actual intention of the taxpayer was or what the taxpayer may have actually foreseen or not foreseen. 16.58 If there has been a determination that the taxpayer has not exercised reasonable care, the circumstances surrounding the tax shortfall and the culpability of the behaviour will determine the level of penalty. If the taxpayer, or the agent of the taxpayer, intentionally disregarded the income tax law or regulations, TAA Sch 1 s 284-90(1) makes that party subject to a penalty tax equal to 75% of the tax shortfall. This is in addition to the liability to pay the tax shortfall itself and the GIC related to its lateness. If the shortfall is caused by recklessness of the taxpayer or agent, the same section sets the

applicable penalty at 50% of the tax shortfall. If the shortfall is related to certain anti-avoidance provisions, the penalty is also 50% of the shortfall as specified in TAA Sch 1 s 284-160(a). If the taxpayer disregards a private ruling, TAA Sch 1 s 284-90(1) makes him or her subject to a penalty of 25% of the tax shortfall. Most other situations where there is a shortfall and the taxpayer did not exercise reasonable care are covered by TAA Sch 1 s 284-90(1), which sets the penalty at 25% of the tax shortfall. TAA Sch 1 s 284-15(1) says that a position is ‘reasonably arguable … if it would be concluded in the circumstances, having regard to relevant authorities, that what is argued for is about as likely to be correct as incorrect, or is more likely to be correct than incorrect’. TAA Sch 1 s 284-15(3) specifies that ‘authority’ includes the income tax law; ‘extrinsic material’— a decision of an Australian or foreign court, the Administrative Appeals Tribunal or Board of Review; or a public ruling under the income tax law. The definition of ‘authority’ is not exhaustive.

What is the problem with the ‘reasonably arguable’ and ‘reasonable care’ standards? A suggested solution can be found in Study help.

Under TAA Sch 1 s 298-25, the GIC applies to tax penalties as it does to outstanding tax. Written notice to pay the penalty must be given (TAA Sch 1 s 298-10) and, once given, TAA Sch 1 s 298-15 read with s 298-25 means that the GIC will apply to parts of the penalty unpaid after the due date given in the notice. [page 1125]

Does the power of the Commissioner to remit penalties under TAA Sch 1 s 298-20 mean that the complex penalty regime is, in effect, meaningless? A suggested solution can be found in Study help.

Collection of taxes 16.59 The mainstay of Australia’s tax collection system since 1944 has been the Pay-As-You-Earn (PAYE) system of withholding tax from wages and allied payments. This has been expanded into a Pay-As-YouGo (PAYG) system. The A New Tax System (Pay-As-You-Go) Act 1999 (Cth) collects all income tax as well as other obligations arising, such as those under Medicare or the Higher Education Contribution Scheme (HECS). This brings the collection mechanisms together under the Taxation Administration Act 1953 under two systems: 1. TAA Sch 1 Pt 2-5: a withholding tax system with the objective of ‘the efficient collection of’ income tax, the Medicare levy and other obligations specified in s 11-1, such as the remittance of interest, dividends and royalties to non-residents; and 2. TAA Sch 1 Pt 2-10: a tax instalment system. An important element in the system is the monthly or quarterly reporting of instalment income via the Business Activity Statement (BAS) or Instalment Activity Statement (IAS) and the ‘running balance account’ (RBA). Under the system, withholding or instalment amounts are remitted to the Commissioner and credited against the taxpayer’s tax debts. Excess credits are refunded and any deficit is payable.

PAYG — withholding 16.60

Under the PAYG withholding system, the entity that makes

prescribed payments (called ‘withholding payments’) is required to withhold tax (at appropriate rates) and remit the amount to the Commissioner within a specified time frame. If a non-cash benefit is provided rather than a payment, the provider must first pay to the Commissioner the amount that would have been withheld from the payment. A payment includes dealing with the amount on the recipient’s behalf or as directed. General exceptions are limited to payments of exempt income, such as a living away from home allowance fringe benefit (LAFHA). Depending on the size of the withholder, payments must be remitted to the ATO within a week of the withholding (for amounts greater than $1m pa), monthly ($25,000– $1m), or quarterly (less than $25,000). Failure to withhold or failure to remit amounts attracts penalties. The Commissioner has powers similar to those under TAA Sch 1 s 353(10) to require information, documents or evidence. Withholding payments are summarised in TAA Sch 1 Pt 25 s 10-5. TAA Sch 1 Subdivs 12-B–12-H address 11 categories of withholding payments: 1. Subdivision 12-B ‘Payments for work and services’; [page 1126] 2.

3. 4. 5. 6. 7. 8. 9.

Subdivision 12-C ‘Payments for retirement or because of termination of employment’ (retirement payments, eligible termination payments and annuities); Subdivision 12-D ‘Benefit and compensation payments’; Subdivision 12-E ‘Payments where a [tax file number] TFN or [Australian Business Number] ABN not quoted’; Subdivision 12-F ‘Dividend, interest and royalty payments’; Subdivision 12-FA ‘Departing Australia superannuation payments’; Subdivision 12-FAA ‘Excess untaxed roll-over amount’; Subdivision 12-FB ‘Payments to foreign residents etc’; Subdivision 12-FC ‘Seasonal Labour Mobility Program’;

10. Subdivision 12-G ‘Payments in respect of mining on Aboriginal land, and natural resources’; 11. Subdivision 12-H ‘Distributions of managed investment trust income’.

Payments for work and services 16.61 The principal category under this heading is payments to employees but it also covers payments to company directors, office holders, payments made under voluntary agreements to withhold and payments made under labour hire arrangements. Amounts withheld may be prescribed by the regulations or by schedules determined by the Commissioner having regard to Medicare and obligations such as HECS. They also accommodate tax offsets such as dependant and low income rebates: see Taxation Administration Regulations 1976 (Cth) regs 24 and 25. For payments where no TFN or ABN is quoted, the rate at time of writing is 46.5% (the top tax rate plus Medicare levy) — check the current rate at .

Employees 16.62 Under TAA Sch 1 s 12-35, an entity must withhold an amount from salary, wages, commission, bonuses or allowances it pays to an individual as an employee (whether of that or another entity). Whether a person is an employee as opposed to a contractor is a vexed question and for PAYG purposes, the meaning of ‘employee’ derives from common law and the ‘master–servant’ relationship, between a contract of service (employee) and a contract for services (independent contractor) that characterised the former PAYE system. The difference is to be determined by examining the contract and its express and implied terms, the result of the contract, power to delegate, risk and remedying of defects. For more information on this, see Taxation Rulings TR 2000/14 and TR 2005/16 (note, however, that the Superannuation Guarantee rules are referred to in the rulings but are not a focus of this chapter).

Other payments

16.63 TAA Sch 1 Subdiv 12-B also covers rules applicable to labour hire arrangements, voluntary withholding arrangements, payments to directors, return to work payments (assessable under ITAA97 s 15-3) and payments to office holders [page 1127] (such as public servants). TAA Sch 1 Subdiv 12-C covers retirement payments, eligible termination payments and annuities; TAA Sch 1 Subdiv 12-D covers benefit and compensation payments. As mentioned, a payer making a payment to an entity for a supply provided in the course of carrying on an enterprise in Australia must withhold tax at 46.5% (under rates at time of writing — check current rates at ) unless an ABN is quoted or some limited exceptions apply. TAA Sch 1 Subdiv 12-E applies to payments where a TFN or ABN is not quoted. A ‘supply’ takes its meaning from the goods and services tax (GST) legislation. Exceptions include private and domestic arrangements or payments that are not ‘in the course or furtherance of an enterprise’, payments less than $50, etc. In the case of investments, an ABN or TFN must be quoted or 46.5% (under rates at time of writing — check current rates at ) will be withheld. Dividend, interest and royalty withholding requirements are covered in TAA Sch 1 Subdiv 12-F. The Subdivision interacts with ITAA36 s 128B, which deals with withholding tax liability: see Chapter 18. A resident Australian company that pays a dividend to a shareholder or an entity that makes a payment of interest or a royalty to recipients with an address outside Australia must withhold appropriate amounts.

PAYG — instalments 16.64 TAA Sch 1 Pt 2-10 provides a tax instalment system that bases payment obligations on the current year’s income — ‘instalment income’ — and interacts critically with the reporting requirements of

the BAS and IAS. The PAYG instalment system and the PAYG withholding system are mutually exclusive. The instalment system applies to individuals, companies and other entities listed in ITAA97 s 9-1. However, TAA Sch 1 s 45-15 provides that the liability to pay an instalment arises only if the Commissioner gives an entity an instalment rate. Usually the instalments will be quarterly on the 21st day of October, January, April and July. Reduced to its essentials, the system operates as shown below:

Figure 16.2:

PAYG instalment system

Taxpayers liable to pay an instalment must advise the Commissioner before the instalment is due (via a BAS or IAS). [page 1128]

Quarterly instalments 16.65 A formula in TAA Sch 1 s 45-110 specifies an instalment of tax as: Applicable instalment rate × Your instalment income for that quarter The ‘applicable instalment rate’ is defined in s 45-110(2) as the most recent calculated by the Commissioner or a rate chosen by the entity (and communicated to the Commissioner). In the normal case, ‘instalment income’ will be ‘ordinary income’ as defined in ITAA97 s 995-1. That is, ‘ordinary income’ in terms of

ITAA97 s 6-5 which, in the general case, will be a gross amount and which by definition does not include exempt income and is exclusive of statutory income. Under TAA Sch 1 s 45-125, individual taxpayers can choose instead to pay their quarterly instalments of what is called their ‘GDP-adjusted notional tax’. This will be the taxpayer’s most recent notional tax multiplied by an uplift factor determined by the Commissioner.

Running balance accounts (RBAs) 16.66 RBAs record tax liabilities arising under the PAYG, fringe benefits tax (FBT), GST and other obligations (such as the wine equalisation or the luxury car tax). The RBA reflects a single debit or credit balance for all tax obligations. Debits are payments due to the Commissioner and credits reflect payments of tax. A credit balance may be refunded and a debit balance is payable. The system is underpinned by the BAS reporting requirements. Entities with a turnover exceeding $20m pa are required to lodge a monthly BAS. Other taxpayers are required to make quarterly lodgments.

Mechanisms for enforced collection 16.67 Where the taxpayer voluntarily pays taxes owed, the tax system need not operate further. Where, however, there is no voluntary payment, the tax system must take additional steps to ensure receipt of tax owed. The previous section looked at the penalties which were applicable if a taxpayer failed to pay taxes in a timely manner. The imposition of penalties is not necessarily the end of the story. The taxpayer, notwithstanding additional penalties, may still not be forthcoming in paying the taxes owed. Since the collection of taxes is the primary goal of the tax administration and the tax system, there must be mechanisms in place to ensure the recovery of taxes. This section considers what mechanisms are available to the tax administration if the taxpayer still does not pay taxes owed. Essentially, there needs to be some sort of enforced collection of taxes.

Pursuing a tax debt through the courts 16.68 The tax debt is the amount not paid by the taxpayer within the required time frame and sought to be collected by the ATO. At issue is what is included in the definition of tax debt. When are taxes due and can the due date be postponed? Is there a limitation period beyond which the ATO cannot pursue the delinquent taxpayer? [page 1129] 16.69 In Australia, unpaid taxes may be recovered through the courts as an ordinary debt owed to the Commonwealth. TAA Sch 1 s 255-5 provides that the Commissioner or Deputy Commissioner may sue in a court of competent jurisdiction for tax-related liabilities owed. The definition of ‘tax-related liability’ in TAA Sch 1 s 255-1 includes the GIC and penalty tax. Taxes may be recovered, under TAA ss 14ZZM and 14ZZR, even though the taxpayer may have commenced review or appeal proceedings. Superior courts do, however, retain an overriding power to grant a stay of collection proceedings. Where the taxpayer disputes the amount of tax assessed, provision in TAA Sch 1 s 255-10 provides that the Commissioner may agree to permit the taxpayer to defer the payment of the tax in dispute. An alternative to judicial process is to pursue a number of administrative remedies. These administrative remedies are internal tax office procedures and are often considerably cheaper, easier and faster to pursue than bringing a civil suit.

Indirect collection 16.70 Normally, taxes are collected directly from the taxpayer. Should a taxpayer be reluctant to cooperate with requests for payment, it is possible for the tax administration to recover payment indirectly. Collection may be made against persons who owe money to the

defaulting taxpayer, or who are likely to owe money to the taxpayer in the foreseeable future, or who hold money on behalf of the taxpayer. In any event, it is actually the taxpayer’s money which is being collected. The third party may also include some person having authority from some other person to pay money to the taxpayer now or in the future. TAA Sch 1 s 260-5 empowers the Commissioner to order a third party to pay the amount owed by the taxpayer in taxes, or the amount owed by the third party in relation to the taxpayer, whichever is less. This form of collection is in effect a ‘garnishee order’ but the garnishment is from a person other than the tax debtor. The Commissioner may seek payment of unpaid taxes from third parties that owe money to the defaulting taxpayer. These provisions are purely a tax collection aid: see Edelsten v Wilcox and FCT (1988) 15 ALD 546; 88 ATC 4484. 16.71 Where a third party makes a requested payment to the Commissioner, that party is deemed to have made the payment under the authority of the taxpayer: TAA Sch 1 s 260-15. Furthermore, Sch 1 s 260-15 provides that the third party will be indemnified in respect of that payment against the tax defaulter. This ensures that the third party cannot later be successfully sued by the defaulting taxpayer because the payment to the Commissioner constituted a breach of some other legal duty held in relation to the taxpayer or some other person. A person who refuses to comply with the garnishee notice is guilty of an offence and subject to a maximum penalty of 20 penalty units (currently $3600) under TAA Sch 1 s 260-20. A court may also order that the third party itself become liable for the tax amount if it fails to follow the Commissioner’s instruction. This is a strong incentive. [page 1130]

Is the garnishee order something that should require court intervention or approval? A suggested solution can be found in Study help.

Collecting taxes from fleeing taxpayers 16.72 When taxpayers are in default in relation to their taxes and not cooperating with the tax administration, the defaulter may be tempted to leave the country and thus make the problem ‘go away’, or at least go away from the problem! Australia, like most other countries, has laws to deal with fleeing taxpayers. The Commissioner may issue an order prohibiting a person from leaving Australia. TAA s 14S(1) empowers the Commissioner to issue a departure prohibition order where that person has a tax liability and the Commissioner reasonably believes that the tax debtor may leave the country without making arrangements for the discharge of his or her tax liability. The issue of the departure prohibition order (commonly called a ‘DPO’) is an internal act of the tax administration and does not require a court to authorise it. There is no requirement of prior notice to be given to the taxpayer. However, as soon as possible after the DPO is issued, the Commissioner is obliged under TAA s 14S(4) to notify the taxpayer that the order has been made. The Commissioner must also give a copy of the order, along with any information which will assist in identifying the person, to the Secretary of the Department of Immigration and Border Protection and any other persons whom the Commissioner thinks it would be appropriate to notify. Where the defaulting taxpayer is an Australian citizen, the Commissioner has the option, under s 14S(5), of not notifying the Secretary of the Department of Immigration and Border Protection, unless the Commissioner is of the view that it would be desirable to do so. 16.73 The DPO has a narrow scope. It may only be used for the purpose of stopping someone leaving Australia when that person’s departure will likely have an adverse effect on the revenue. Where the departure of the defaulting taxpayer would not alter the likelihood of

collection, a DPO may not be issued because it does not fulfil the legislative prerequisites. This was highlighted by the Full Federal Court in Skase v FCT (1992) 32 FCR 206; 105 ALR 506; 92 ATC 4001, when the late Christopher Skase successfully challenged the issue of a DPO on the basis that he had no funds and could not discharge his tax debt whether he was in Australia or not. The taxpayer successfully argued that the DPO should be set aside since prohibiting him from leaving Australia would not protect the revenue, it would only punish him.

Considering the policy rationale for departure prohibition orders, does the court ruling in Skase v FCT (1992) 32 FCR 206; 105 ALR 506; 92 ATC 4001 make sense? [page 1131] Are there other circumstances in which a departure prohibition order might be made? Suggested solutions can be found in Study help.

A person who has had a DPO issued against them may appeal against its issue to a single judge of either the Federal Court of Australia or the Supreme Court of that person’s state or territory under TAA s 14V(1). If the appeal is made initially to the state or territory Supreme Court, there is a right of appeal to the Federal Court and to a further appeal from the Federal Court, with special leave, to the High Court of Australia provided by TAA s 14W. 16.74 Where a DPO is in force, the Commissioner may, under TAA s 14Z(1), authorise officers of the ATO to take such steps as are reasonably necessary to prevent the departure of the subject person. This power includes removing that person from a vessel or aircraft if the authorised officer believes on reasonable grounds that person is about to leave Australia. Authorised officers may also question persons or

require persons to produce documents to ascertain whether a DPO applies to them and, if so, whether their departure is permitted under a departure authorisation certificate. Once issued, the DPO remains in force until it is revoked by the Commissioner (TAA s 14T) or set aside by a court (TAA s 14S(2)). TAA s 14T describes the conditions that must be met for the revocation of an order. If these conditions are present, the order will be revoked after an application is made by the affected person or may be revoked by the Commissioner on his own initiative. The Commissioner will revoke the DPO where: the tax liabilities of the person have been wholly discharged; arrangements have been made which the Commissioner is satisfied will ultimately result in the liability being wholly discharged; or the Commissioner is satisfied that the liabilities are completely unrecoverable.

Settlement arrangements and compromise of debt 16.75 There may be circumstances where the taxpayer has defaulted on his or her tax obligations and it is appropriate that some flexibility be shown by the tax administration. This may be appropriate if the taxpayer has fallen into default due to no fault of his or her own, or where making some alternative arrangements for payment may increase the likelihood of recovery of more money from the defaulting taxpayer. TAA s 340-5 allows a taxpayer to make an application for a partial or complete release from the payment of tax. Applications for relief may be granted where collecting the full tax would constitute a serious hardship for the taxpayer. Serious hardship is not defined in law, but it would include circumstances such as when payment of the tax liability would result in the taxpayer being left unable to make reasonable acquisitions of food, accommodation, clothing, medical supplies and education for their children. For more information on this, see Practice Statement PS LA 2011/17 on debt relief.

1.

2.

For an understanding of the ATO approach to these issues, you should review Practice Statement Law Administration PS LA 2011/21. This explains what tax credits the Commissioner must take into account and which ones he has a discretion to ignore when collecting outstanding tax liabilities. For more information, see ATO, Options for Resolving Disputes, Including Alternative Dispute Resolution (ADR), Litigation and Settlement, , click on ‘Dispute or object to an ATO decision’ (accessed 29 September 2017).

[page 1133]

CHAPTER

17

Anti-Tax Avoidance Measures Learning objectives After studying this chapter, you should be able to: appreciate the problematic nature of the concept of ‘tax avoidance’, and the difficulty which this creates for the application of the general anti-avoidance rules within the Income Tax Assessment Act 1936 (Cth) (ITAA36) Pt IVA; describe the various avenues open to the Commissioner of Taxation in challenging a tax avoidance arrangement; distinguish between the terms ‘tax evasion’ and ‘tax avoidance’; discuss the provisions of ITAA36 Pt IVA and the case law surrounding its operation; apply the provisions of ITAA36 Pt IVA to factual situations; employ the specific anti-tax avoidance rules that apply to expenses incurred under certain tax avoidance schemes; understand the basic operation of Income Tax Assessment Act 1997 (Cth) (ITAA97) Pt 2-42 concerning the alienation of personal services income.

Introduction 17.1

Perhaps in a perfect world, an income tax system would

accurately identify the appropriate taxpayer and subject all forms of economic income to income tax, irrespective of the legal form through which that income was generated. In such a world, each taxpayer would have no option but to pay the one ‘right’ amount of tax determined under the legislation. The concept of tax avoidance would not be significant because there would be a clear line between compliant and non-compliant behaviour. However, in the real world tax legislation is not that simple. Tax legislation must construct the tax base and the other aspects of the relevant tax. In doing so, trade-offs between competing public policy imperatives (including equity, efficiency, simplicity, revenue sustainability) and public policy influences (institutional elements such as international obligations) must be made. The resulting complexity of tax legislation is conducive to tax avoidance.1 [page 1134]

Defining tax avoidance 17.2 It is usual to define ‘tax avoidance’ by distinguishing it from ‘tax evasion’ and ‘tax planning’. The common element of all three is that a taxpayer pays less tax than they might otherwise have paid. However, the distinguishing element, which is not clearly conveyed by the ‘evasion/avoidance/planning’ nomenclature, is whether the tax reduction achieved by a particular transaction is sanctioned by the legislation or the Commissioner of Taxation. In 1975, the Full Report of the Commonwealth Taxation Review Committee chaired by Justice Asprey (Asprey Committee) provided the following definition of ‘tax evasion’: The phrase ‘tax evasion’ describes an act in contravention of the law whereby a person who derives a taxable income either pays no tax or pays less tax than he would otherwise be bound to pay.

Although not mentioned in this definition, tax evasion generally connotes a deliberate attempt to break the law, as opposed to an ‘honest error’ made by a taxpayer. Tax evasion triggers the operation of

various criminal provisions both under the taxation law (ie, the Taxation Administration Act 1953 (Cth) (TAA) s 8K) and under other Commonwealth legislation, such as the Crimes Act 1914 (Cth). Tax evasion can, for example, arise where a taxpayer: fails to lodge a tax return; omits assessable income; over-claims deductions; and/or falsely claims rebates, credits or exemptions. The ordinary meaning of tax avoidance, on the other hand, is more difficult to define. The Asprey Committee (para 11.1) defined ‘tax avoidance’ as follows: [It] usually connotes an act within the law whereby income, which otherwise would be taxed at a rate applicable to the taxpayer who but for that act would have derived it, is distributed to another person or between a number of other persons who do not provide a bona fide and fully adequate consideration; in the result the total tax payable in respect of that income is less than it would have been had no part of the income been distributed and the whole been taxed as the income of that taxpayer.

Therefore, like tax evasion, tax avoidance results in less tax being paid but, unlike tax evasion, it is achieved by means that are ‘within the law’. When elaborating on the meaning of ‘within the law’, commentators often suggest that a tax avoidance arrangement is within the letter of the law but not within the spirit or purpose of the law. In an era of statutory construction purportedly founded on a preference for purposive construction of legislation, it is a moot point whether the perceived dichotomy between the letter of the law and the purpose of the law is relevant. Tax planning is generally understood in terms of a reduction in tax otherwise payable, which complies with the law and is not challenged by the Commissioner. Example 17.1 specifically illustrates the difference between the three concepts. [page 1135]

Distinction between tax evasion, tax avoidance and tax planning Assume that on 1 July 2012, William Shakespeare commenced employment with Gogol Publishing Pty Ltd (Gogol). At that time, William entered into a prospective salary sacrifice agreement by which the employer agreed to pay one half of William’s total remuneration to a complying superannuation fund on behalf of William (see Chapter 7). For the 2012–13 income year, William prepares his own tax return and claims deductions for $500 with respect to donations to charities that William knows he has not actually incurred. On 1 July 2013, William terminates his employment with Gogol and commences employment with a company in which he owns all of the shares, Tolstoy Pty Ltd (.olstoy). Tolstoy enters into a service agreement with Gogol, under which Tolstoy agrees to provide services to be performed by William. Leaving to one side minor expenses, assume that the payments to Tolstoy from Gogol, with respect to the services performed by William, comprise Tolstoy’s net profits. These profits are withheld by Tolstoy and are subject to the corporate tax rate (assume that William’s marginal rate of tax is 46.5%, including the Medicare levy, because he receives other income). In this case, the deliberate overclaiming of deductions by William is tax evasion. The prospective salary sacrifice agreement between William and Gogol is tax planning (see Taxation Ruling TR 2001/10) because it is sanctioned by the Commissioner of Taxation. The alienation of income from William to Tolstoy is, according to many, ‘tax avoidance’ in the ordinary sense because it is contrary to the spirit of the income tax that an individual can alienate income in this way. The effectiveness of such a tax avoidance arrangement, however, will depend on the application of ITAA97 Pt 2-42 and also ITAA36 Pt IVA. It may be the case, for example, that Tolstoy is conducting a ‘personal services business’ (see 17.23) and that Pt IVA does not apply for reasons indicated in Ryan v FCT (2004) 56 ATR 1122; 2004 ATC 2181. If neither of these anti-avoidance rules applies, the interposition of Tolstoy would constitute ‘tax planning’ rather than ‘tax avoidance’ because, presumably, the legislative spirit allows such alienation.

Relevance of the ordinary meaning of ‘tax avoidance’ 17.3 In theory, the definition of the ordinary meaning of ‘tax avoidance’ is irrelevant to the elaboration of the statutory meaning of the phrase embodied in Australian income tax law. However, in

practice, and as we will see in this chapter, the statutory definition of tax avoidance embodies ‘leeways of choice’: see, for example, the [page 1136] consideration of the meaning of ‘scheme’ in FCT v Peabody (1994) 181 CLR 359; 28 ATR 344; 94 ATC 4663 and FCT v Hart (2004) 217 CLR 216; 55 ATR 712; 2004 ATC 4599, discussed at 17.8. If one accepts that there is interpretative discretion with regard to the operation of the statutory anti-avoidance rules, it is arguable that the decision-maker’s understanding of the ordinary concept of tax avoidance will influence (but not necessarily determine) that decisionmaker’s interpretation and application of the statutory anti-avoidance rules. For the reasons outlined in the following paragraphs, different people will reasonably disagree about the ordinary meaning of tax avoidance. As was noted in 17.2, one definition of ‘tax avoidance’ states that it entails compliance with the letter of the law but not the spirit of the law. However, the existence of a discernible ‘spirit’ of the taxation law is open to question. One reason for this is that the public finance literature does not offer a universally accepted definition of basic concepts such as income.2 Another reason to question the existence of an underlying spirit is that tax legislation is built on ad hoc political compromises.3 For no obvious reason, the income tax favours some categories of taxpayers, or different forms of the same substantive transaction, over others. For example, as we saw in Chapter 7, careful attention to employee remuneration packaging can reduce the total tax payable by shifting remuneration from ‘salary’ to ‘fringe benefits’. Likewise, the washout of corporate tax preferences, where profits reflecting the benefit of those preferences are distributed as assessable dividends (see ITAA36 s 44), means that a discretionary trading trust affords a better path to preserving tax preferences into the hands of the trust beneficiaries: see ITAA36 s 97.

A third factor undermining the existence of a spirit of the income taxation law is that legislation is inevitably unclear given the vagaries of legislative language. Many believe that these vagaries can be resolved by the rules of statutory construction such that a ‘right answer’ can be discovered. However, the validity of this ‘right answers’ thesis is hotly contested in the academic literature dealing with the interpretation of legislation. This discussion suggests that the line between ‘tax minimisation’ and ‘tax avoidance’ is blurred because it can be difficult to identify exactly which tax-minimising behaviour crosses the line into the realm of tax minimisation that contravenes the (indiscernible) spirit of the law and, hence, is tax avoidance.

Rules that may override a tax avoidance arrangement 17.4 There are a number of avenues open to the Commissioner in challenging an arrangement that he considers to be tax avoidance. In structuring a transaction, [page 1137] advisers will consider several questions with a view to assessing the risk that the Commissioner will challenge the validity of an arrangement: 1. Is the arrangement legally effective? For example, the purported appointment of trust income to beneficiaries of the trust will not be legally effective if, under the terms of the trust deed, the ‘beneficiaries’ could not be beneficiaries: see BRK (Bris) Pty Ltd v FCT (2001) 46 ATR 347; 2001 ATC 4111. 2. Is the arrangement a sham? The High Court noted in Equuscorp Pty Ltd v Glengallan Investments Pty Ltd (2004) 218 CLR 471 at 486 that the concept of ‘sham’ is somewhat vague. In Raftland Pty Ltd v FCT (2008) 246 ALR 406; [2008] HCA 21, the High Court unanimously held that an appointment of trust income to a beneficiary was a sham because it was never intended that the

beneficiary would actually benefit from the appointed income. All of the judgments in the High Court accepted that a key element of a sham arrangement is that the legal description of the arrangement adopted by the parties does not accurately describe the intended effect of the arrangement. However, the joint judgment of Gleeson CJ, Gummow and Crennan JJ seemed to accept that a sham will arise even if the parties to the arrangement do not necessarily intend to deceive third parties: compare the judgments of Heydon J at [173] and Kirby J at [145]; see also Lockhart J in Sharrment Pty Ltd v Official Trustee in Bankruptcy (1988) 18 FCR 449 at 454. 3. Is the arrangement ineffective in achieving its tax-reducing purpose because of the operation of ‘core taxation rules’ such as ITAA97 s 8-1? Decisions such as Ure v FCT (1981) 11 ATR 484 and Fletcher v FCT (1991) 22 ATR 613; 92 ATC 4611 are authority for the proposition that a loss or outgoing incurred for the purpose of minimising tax will not be allowable under ITAA97 s 8-1. Further, Howland-Rose v FCT (2002) 49 ATR 206; 2002 ATC 4200 indicates that a taxpayer’s efforts to avoid tax may falter because an essential element of the core taxing rules is not satisfied (ie, because a business has not commenced and so expenditure will not be deductible). 4. Do specific anti-avoidance rules negate the tax avoidance arrangement? For example, specific anti-tax avoidance rules have been enacted in the areas of allowable deductions (ITAA36 ss 82KJ, 82KK and 82KL), trusts (ITAA36 s 100A), transfer pricing (ITAA36 Pt III Div 13) and the alienation of personal services income (ITAA97 Pt 2-42). 5. Do the general anti-avoidance rules in ITAA36 Pt IVA allow the Commissioner to negate the tax avoidance arrangement by applying the power conferred upon him under ITAA36 s 177F? It should be noted that this list does not include any judge-made antiavoidance doctrine, such as the ‘fiscal nullity doctrine’ adopted in the United Kingdom in the decisions of the House of Lords in WT Ramsay v CIR [1982] AC 300, CIR v Burmah Oil Co Ltd (1981) 54 TC 200

and Furniss v Dawson [1984] AC 474. Lord Brightman stated the doctrine succinctly in Furniss v Dawson at 527, as follows: First, there must be a pre-ordained series of transactions: or, if one likes, one single composite transaction. This composite transaction may or may not include the achievement of a legitimate commercial (ie business) end … Secondly, there must be steps inserted which have no commercial (business) purpose apart from the

[page 1138] avoidance of a liability to tax — not “no business effect”. If those two ingredients exist, the inserted steps are to be disregarded for fiscal purposes. The court must then look at the end result. Precisely how the end result will be taxed will depend on the terms of the taxing statute sought to be applied.

The fiscal nullity doctrine, therefore, voids a scheme which has no commercial purpose apart from the avoidance of tax. However, this doctrine was developed in the United Kingdom where there was no general anti-avoidance rule such as that found within ITAA36 Pt IVA. The High Court of Australia has held that the fiscal nullity doctrine has no application in Australia: FCT v Patcorp Investments Ltd (1976) 140 CLR 247; 6 ATR 420; 76 ATC 4225; John v FCT (1989) 166 CLR 417; 89 ATC 4101.

General anti-avoidance measures Introduction 17.5 The general anti-avoidance measures for all taxpayers are found in ITAA36 Pt IVA. Within Pt IVA, there are rules dealing with: schemes that limit a taxable presence in Australia (ITAA36 s 177DA); a diverted profits tax (ITAA36 ss 177H–177R); dividend-stripping arrangements (ITAA36 s 177E); dividend-streaming arrangements (ITAA36 s 177EA); schemes which are intended to achieve a transfer of franking

credits to a head company on consolidation of a corporate group (ITAA36 s 177EB); and general tax avoidance arrangements. This chapter will focus on the last category of rules within Pt IVA as these rules are of general application. In determining whether the general anti-avoidance rules within Pt IVA apply to any given factual situation, the following four questions need to be asked in accordance with ITAA36 s 177D: 1. Is there a scheme? 2. Was the scheme entered into after 27 May 1981? 3. Was there a tax benefit in connection with the scheme? 4. Was the scheme entered into or carried out with the sole or dominant purpose of obtaining a tax benefit for a taxpayer? If the answers to all of the above four questions are ‘yes’, ITAA36 s 177F will apply to the taxpayer’s arrangements and the Commissioner is allowed under the tax legislation to: cancel any tax benefit so obtained; and impose additional tax. Each of these four questions is considered below (see 17.8–17.14) in order for us to understand how Pt IVA can be applied by the Commissioner to any given factual situation of the taxpayer. [page 1139]

Reconciliation of Pt IVA with other income tax legislation 17.6 Prior to the introduction of ITAA36 Pt IVA, the scope of the general anti-avoidance rule in ITAA36 s 260 had been narrowed on the basis of a general, rebuttable rule of statutory construction. That rule states that if two rules within the one Act of Parliament deal with the same case, in the absence of a contrary intention, the more specific rule should prevail over the more general of the two rules.4 As s 260 was expressed in general terms, and as there was no express statement of a

contrary intention, the Australian courts gave more weight to specific statutory rules which seemed to sanction various forms of tax minimisation. Thus, for example, in Mullens Investments Pty Ltd v FCT (1977) 135 CLR 290; 6 ATR 504, the High Court held that the taxpayer’s manipulation of his circumstances to take advantage of a specific provision which allowed a tax deduction for capital payments did not breach s 260, on the basis that the specific provision was intended to allow such tax minimisation. In an effort to prevent the scope of Pt IVA being narrowed by the application of the same rule of statutory construction, the legislature expressly stated in s 177B(1) that: Subject to subsection (2), nothing in the provisions of this Act other than this Part or in the International Tax Agreements Act 1953 or in the Petroleum (Timor Sea Treaty) Act 2003 shall be taken to limit the operation of this Part.

Part IVA is, therefore, accorded primary status within the income tax legislative scheme. Notwithstanding s 177B(1), the Commissioner states that Pt IVA is applied as a measure of last resort.5 Subsections 177B(2)–(4) preserves the priority of specific antiavoidance rules which operate with respect to tax deductions.

‘Taxpayer’ 17.7 Part IVA applies to ‘taxpayers’. ITAA36 s 6(1) states that ‘taxpayer means a person deriving income or deriving profits or gains of a capital nature’. ITAA36 s 177A(1) states that ‘taxpayer includes a taxpayer in the capacity of a trustee’. In Grollo Nominees Pty Ltd v FCT (1997) 36 ATR 424; 97 ATC 4585, the taxpayer argued that the trustee in that case could not be a ‘taxpayer’ for the purposes of Pt IVA because it was not a ‘taxpayer’ as defined in ITAA36 s 6(1). This argument was based on the fact that, in general, the trustee of a trust estate does not derive income under the ordinary meaning of the term because the trustee is not the beneficial owner of

[page 1140] trust income. Notwithstanding the technical merit of this argument, the Full Federal Court held that Pt IVA could apply to the trustee in that case.6

Is there a ‘scheme’? 17.8

A ‘scheme’ is defined in ITAA36 s 177A as follows.

177A Interpretation (1) … scheme means: (a) any agreement, arrangement, understanding, promise or undertaking, whether express or implied and whether or not enforceable, or intended to be enforceable, by legal proceedings; and (b) any scheme, plan, proposal, action, course of action or course of conduct.

Section 177A (3) expands this definition by stating that ‘a unilateral scheme, plan, proposal, action, course of action or course of conduct’ may also constitute a scheme. The breadth of this definition means that it is extremely difficult to envisage behaviour that will not fall within one of the categories of ‘scheme’ identified in s 177A. Entering into a contract, depositing money in a bank account and selling property are all instances of behaviour that will fall within the definition. When examining the behaviour of a particular taxpayer, then, a multitude of possible schemes will be discernible. However, as discussed below, the operation of Pt IVA hinges on the exact ascertainment of when a scheme commences and also when it finishes. This is because the counterfactual question embodied within the definition of ‘tax benefit’ (in ITAA36 s 177C), and also the dominant-purpose test embodied in ITAA36 s 177D, requires the precise ascertainment of the particular scheme in question. Only with the scheme precisely defined is it possible to

determine whether a tax benefit exists and also what the dominant purpose of that scheme was. The central questions that have arisen in this regard are: 1. whether the Commissioner is restricted to identifying just one scheme when issuing amended assessments on the basis of a determination made under ITAA36 s 177F. If this were the case, the Commissioner would only be allowed to identify one possible scheme and his amendment of assessments would stand or fall on whether that identified scheme was accepted by the courts; and 2. whether the Commissioner can identify as a scheme an action that forms part of a broader course of conduct, or whether the Commissioner is constrained to define a scheme as comprising all behaviour of relevant parties that is logically or temporally connected. [page 1141] On the first question, the High Court decision in Peabody v FCT (1994) 181 CLR 359; 28 ATR 344; 94 ATC 4663 confirms that the Commissioner is entitled to identify other possible schemes rather than being locked into identifying just one scheme. On the second question, there is some tension within the relevant case authorities. The decision in Peabody stands for the proposition that the Commissioner can identify part of a broader arrangement as the relevant scheme, provided that the part identified is capable of standing on its own and is not robbed of all practical meaning. The High Court did not elaborate on the statutory foundation for this limitation and nor did it elaborate on the meaning of the terms within the proviso. For example, it is not clear when a part of a broader arrangement will have ‘some practical meaning’ such that it can be identified as a scheme. The authority of Peabody with respect to the meaning of scheme was criticised by Gummow and Hayne JJ in FCT v Hart (2004) 217 CLR 216; 55 ATR 712; 2004 ATC 4599. In that case, the taxpayers entered

into a loan arrangement to finance the acquisition of a principal residence and also to refinance the balance of an existing loan with respect to their former residence (which was to be leased out). The loan arrangement allowed the Harts the option of splitting the total loan balance between the amounts respectively attributable to each property. Further, they could elect in writing for all of their repayments to be allocated to reducing the loan principal attributable to their new residence, while interest on the rental property was to be capitalised. The Full Federal Court had held that ITAA36 Pt IVA did not apply to this arrangement on the basis that the relevant scheme was obtaining finance and all that followed (including the written election for repayments to be allocated to one side of the split loan facility). The High Court unanimously decided that Pt IVA did apply. In deciding that the written election alone could be a ‘scheme’ for the purposes of Pt IVA, Gummow and Hayne JJ strongly criticised the Peabody decision on the basis that it had no statutory foundation. Their Honours observed that making a written election fell within the literal meaning of ‘action’ and therefore was a scheme. Gleeson CJ and McHugh J apparently adopted the Peabody approach to the definition of ‘scheme’, and applied Pt IVA having regard to the entire arrangement. Nevertheless, their Honours concluded that the broader scheme exhibited the requisite dominant purpose for Pt IVA to apply. Callinan J did not clearly accept or reject the Peabody doctrine. Notwithstanding the tension regarding the meaning of ‘scheme’ evident in the Peabody and Hart decisions, it is clear that even the Peabody doctrine allows the Commissioner to focus on part of a broader arrangement in identifying a scheme. Thus: In Peabody, it was the conversion of the Kleinschmidt shares to worthless ‘Z’ class shares that comprised the scheme, notwithstanding that these transactions were part of a broader arrangement. In FCTv Spotless Services Ltd (1996) 186 CLR 404; 96 ATC 5201; 34 ATR 183, it was depositing money with a bank in the Cook Islands and the associated

[page 1142] transactions (guarantee, receipt of interest) which comprised the scheme. The equity raising undertaken prior to depositing the money was ignored, despite the fact that the source of the deposit was the equity raising. In Consolidated Press Holdings v FCT (2001) 207 CLR 235; 47 ATR 229; 2001 ATC 4343, it was the insertion of an Australian resident corporate entity (Murray Leisure Group Pty Ltd) as a participant within a chain of payments which constituted the scheme.

Was the scheme entered into after 27 May 1981? 17.9 The time the scheme was entered into or carried out is important for three reasons: 1. For ITAA36 Pt IVA to apply, the scheme must be entered into or carried out after 27 May 1981. 2. Carrying out a scheme will create a tax benefit for a particular income year(s). The Commissioner is subject to time limits with respect to amendment of assessments (see ITAA36 s 170) and, generally, the application of Pt IVA is subject to those time limits: see 17.16. 3. ITAA36 s 177D requires consideration of the purpose of relevant persons at the time a scheme is entered into or carried out. The purpose of those involved in entering into the scheme, as determined under s 177D, at the time the scheme commences is, therefore, a significant fact.

Was there a tax benefit in connection with the scheme? 17.10 Before ITAA36 Pt IVA can apply, the taxpayer must have actually received a ‘tax benefit in connection with a scheme’. Given the broad definition of ‘scheme’ accepted by the High Court in Peabody, the requirement of a tax benefit serves to exclude many ‘schemes’ from

the operation of Pt IVA. For example, the action of getting out of bed is a ‘scheme’, but it is difficult to see how such a scheme could create a ‘tax benefit in connection with that scheme’. ITAA36 s 177C defines the phrase ‘obtaining a tax benefit in connection with a scheme’. 177C Tax benefits (1) Subject to this section, a reference in this Part to the obtaining by a taxpayer of a tax benefit in connection with a scheme shall be read as a reference to: (a) an amount not being included in the assessable income of the taxpayer of a year of income where that amount would have been included, or might reasonably be expected to have been included, in the assessable income of the taxpayer of that year of income if the scheme had not been entered into or carried out; or [page 1143] (b) a deduction being allowable to the taxpayer in relation to a year of income where the whole or a part of that deduction would not have been allowable, or might reasonably be expected not to have been allowable, to the taxpayer in relation to that year of income if the scheme had not been entered into or carried out; … and, for the purposes of this Part, the amount of the tax benefit shall be taken to be: (c) in a case to which paragraph (a) applies — the amount referred to in that paragraph; and (d) in a case to which paragraph (b) applies — the amount of the whole of the deduction or of the part of the deduction, as the case may be, referred to in that paragraph;

Aside from the categories of tax benefit included in paras (a) and (b) in the extract above, ITAA36 s 177C(1) also includes the following types of tax benefit: a capital loss being incurred by the taxpayer where the whole or a part of that capital loss would not have been incurred, or might reasonably be expected not to have been incurred, had the scheme not been entered into or carried out; and a foreign income tax offset being allowable to the taxpayer where the whole or a part of that offset would not have been allowable,

or might reasonably be expected not to have been allowable, had the scheme not been entered into or carried out. Section 177C(1) therefore requires a counterfactual inquiry: one must identify the relevant scheme and then ask: ‘What would have happened, or what might reasonably be expected to have happened, in the absence of that scheme?’ 17.11 The application of this counterfactual inquiry posed several challenges, prompting the inclusion of s 177CB in the ITAA36: see Tax Laws Amendment (Countering Tax Avoidance and International Profit Shifting) Act 2013 (Cth). To understand the purpose of s 177CB it is necessary to understand the nature of the difficulties confronted by the Commissioner in the earlier cases. In FCT v Peabody (1994) 181 CLR 359; 28 ATR 344; 94 ATC 4663, the High Court decided that there was no tax benefit because the taxpayer’s use of redeemable preference share financing meant that a corporate entity was an essential element of any counterfactual scheme, and it was not possible to predict with sufficient certainty where the corporate entity’s profits would flow.

FCT v Peabody Facts: In this case, the taxpayer, Mrs Peabody, was a beneficiary of a discretionary family trust known as the ‘Peabody Family Trust’. [page 1144] TEP Holdings Pty Ltd was the corporate trustee of the trust. It owned 62% of the Pozzolanic group of companies, while a Mr Kleinschmidt owned the remaining 38% of the group. Mrs Peabody’s husband was one of the directors of TEP Holdings who originally established the business. In 1985, Mr Peabody formulated a plan whereby TEP Holdings would acquire Mr Kleinschmidt’s interest in the Pozzolanic Group, publicly float 50% of the group and retain control of the remaining 50%. Mr Kleinschmidt did not want the price of his

shares, worth some $8.6m, to be publicly disclosed, and Mr Peabody agreed to his request. There was an expectation that the public float would be capitalised at a value well in excess of the $24m, which was the basis of the price agreed for the purchase of the Kleinschmidt shares. It was anticipated that difficulties could arise if it became necessary to disclose in the prospectus for the public float that the shares acquired by the Peabody interests from Mr Kleinschmidt had been acquired a short time before at an amount substantially less than that to be offered to the public. Discussion between Mr Peabody and his advisers revealed the possibility of the Peabody interests acquiring the Kleinschmidt shares and converting them into a different class of shares with restricted rights that would render them almost worthless. The result of this would be that the shares held by TEP Holdings would increase in value by the amount shed by the Kleinschmidt shares. Mr Peabody’s adviser suggested that TEP Holdings could then sell its shares to a public company formed for the purpose of the float for a price that reflected the increased value so as to avoid the application of ITAA36 s 26AAA, which at the time included as assessable income any profit arising from the sale of property acquired within 12 months of purchase. There was also some discussion concerning the method of financing the purchase of the Kleinschmidt shares. It became evident that there was an advantage if the financier used redeemable preference shares to fund the purchase, instead of using borrowed funds. By this method, the cost of the finance would be greatly reduced. The financier would receive dividends on the preference shares equal to the interest it would have received on the loan, but less the tax that it would have paid on that interest. Moreover, the financier would receive, under ITAA36 s 46, a rebate of 100% of the tax in respect of the dividends. Hence, the financier would effectively receive a tax-free dividend equal to the after-tax interest. Thereafter, once the dividend had been declared, the preference shares would be redeemed so that the financier would receive back an amount that would be equivalent to the principal amount of a loan. [page 1145] It was decided that TEP Holdings would acquire a shelf company called Loftway Pty Ltd to purchase Mr Kleinschmidt’s shares in the Pozzolanic Group. Westpac Banking Corporation (Westpac) became the financier to the arrangement. Loftway purchased the Kleinschmidt shares for the sum of $8,656,177. Westpac provided the funds to acquire the Kleinschmidt shares by subscribing for redeemable preference shares in Loftway. After the Kleinschmidt shares had been acquired by Loftway, the companies which formed part of the Pozzolanic Group each declared dividends that were subsequently paid to Loftway. With these funds, Loftway declared and paid the appropriate dividend on its redeemable preference shares to Westpac. With the consent of Loftway, each of the companies represented in the Pozzolanic Group passed special resolutions converting the shares which Loftway had purchased in them into ‘Z’-class preference shares, which carried restricted rights reducing their value from some $8.6m to something less than $500. As a consequence, the shares in the Pozzolanic Group held by TEP Holdings, which previously represented only 62% of the value in the group, came to approximately 100% of that value. Consequently, TEP Holdings agreed to sell all of the ordinary shares in the

Pozzolanic Group to a public company that eventually became Pozzolanic Industries Ltd for $30m. The purchase price was payable partly in cash and partly in shares in Pozzolanic Industries. This resulted in TEP Holdings having 50% of the shares in Pozzolanic Industries. The remaining 50% of the shares in Pozzolanic Industries were issued to the public by way of prospectus. No mention was made in the prospectus of Pozzolanic Industries concerning the price paid for the purchase of the Kleinschmidt shares. Finally, with the funds raised by the sale, TEP Holdings lent an amount to Loftway, which enabled it to redeem the preference shares held by Westpac. Moreover, it seems that Loftway eventually transferred the Z-class shares in the Pozzolanic Group to TEP Holdings, which then transferred them to Pozzolanic Industries either by way of gift or at par value. TEP Holdings then forgave the debt owed by Loftway. The Commissioner considered that Mrs Peabody obtained a tax benefit in connection with a scheme within the meaning of ITAA36 Pt IVA. He then made a determination under ITAA36 s 177F that the sum of $888,005 should be included in Mrs Peabody’s assessable income for the year ended 30 June 1986. This amount represented one-third of the profit for the purposes of ITAA36 s 26AAA, which the Commissioner claimed TEP Holdings would have realised if it had bought the Kleinschmidt shares and sold them within 12 months of their acquisition. The Commissioner subsequently disallowed the taxpayer’s objection and the matter was then referred to the Federal [page 1146] Court. The Federal Court (O’Loughlin J) upheld the Commissioner’s objection decision and found that the dominant purpose of the scheme was to avoid the application of ITAA36 s 26AAA and obtain a tax benefit. Mrs Peabody subsequently appealed to the Full Federal Court: Peabody v FCT (1993) 40 FCR 531; 93 ATC 4104. In relation to the operation of ITAA36 Pt IVA, the court must consider the scheme that is identified by the Commissioner. The court cannot substitute some other scheme for the scheme on which the Commissioner exercised his discretion under ITAA36 s 177F: at ATC 4116. In the present case, the scheme identified by the Commissioner included 10 steps, beginning with the acquisition of the Kleinschmidt shares by Loftway, including the finance transaction with Westpac, and ending with the transfer of the ‘Z’-class shares by Loftway to TEP Holdings and Pozzolanic Industries. It was this scheme which was considered by the Full Federal Court at ATC 4116. Held: Scheme? The High Court (FCT v Peabody (1994) 181 CLR 359; 28 ATR 344; 94 ATC 4663) found that, based on the facts of the case, there was a scheme within the meaning of ITAA36 s 177A. In fact, the High Court (at ATC 4670) found that the Commissioner might rely on a narrower definition of ‘scheme’ as meeting the conditions of Pt IVA, but only where the circumstances are able to stand on their own, without being robbed of all practical meaning. Was a tax benefit received? It was on the ‘reasonable expectation’ issue that Mrs Peabody won the case.

The High Court disagreed with the Commissioner that Mrs Peabody had obtained a benefit under the arrangement. The High Court said that it was not a ‘reasonable expectation’ as opposed to merely a ‘possibility’ that some amount might have but for the scheme been included in Mrs Peabody’s assessable income during the relevant year of income. The High Court (Mason CJ, Brennan, Deane, Dawson, Toohey, Gaudron and McHugh JJ) said (at ATC 4671) that a ‘reasonable expectation’: … require[s] more than a possibility. It involves a prediction as to events which would have taken place if the relevant scheme had not been entered into or carried out and the prediction must be sufficiently reliable for it to be regarded as reasonable. [page 1147] In conclusion, the High Court found (at ATC 4672) that: … it cannot be said that the amount which the Commissioner included in Mrs Peabody’s assessable income … was an amount which would have been included or might reasonably be expected to have been included in her assessable income for that year … Mrs Peabody did not, therefore, obtain a tax benefit in connection with a Pt IVA scheme and, accordingly, the appeal must be dismissed.

Thus, in Peabody, the High Court did not accept that it was reasonable to predict that Loftway would have paid a dividend to the trustee of the Peabody Family Trust. The decision in Peabody suggested that, at least in some cases, the formal legal complexity of an arrangement may act as a barrier to the identification of a tax benefit, such that ITAA36 Pt IVA will not apply. This outcome appears to be counterintuitive, as one might have expected that Pt IVA should pierce the legal form of a particular transaction by focusing on what might be conceived as the substance of the transaction. Thus, for example, in Peabody the substance of the transaction was that value shifted to the Peabody group from Mr Kleinschmidt, and the Peabody group realised an economic gain by disposing of a part of their total interest in the Pozzolanic group of companies. A substance approach might have led to the conclusion that a part of this gain was attributable to the recently acquired Kleinschmidt shares, despite the fact that the legal form of the transaction indicated that all of the gain was attributable to the shares held by the Peabody interests for at least 12 months.

In response to this problem identified in Peabody and subsequent cases, the Commissioner sought to interpret the counterfactual element of ITAA36 s 177C as requiring the lesser requirement of a reasonable alternative, rather than an alternative that would or might reasonably be expected to have happened. This approach was rejected by the Full Federal Court: see, for example, RCI Pty Ltd v FCT 2011 ATC 20-275; [2011] FCAFC 104. In response to these difficulties regarding the counterfactual inquiry, s 177CB was inserted into the ITAA36. 177CB The bases for identifying tax benefits (1) This section applies to deciding, under section 177C, whether any of the following (tax effects) would have occurred, or might reasonably be expected to have occurred, if a scheme had not been entered into or carried out: (a) an amount being included in the assessable income of the taxpayer; (b) the whole or a part of a deduction not being allowable to the taxpayer; [page 1148] (c) the whole or a part of a capital loss not being incurred by the taxpayer; (ca) the whole or a part of a loss carry back tax offset not being allowable to the taxpayer; (d) the whole or a part of a foreign income tax offset not being allowable to the taxpayer; (e) the taxpayer being liable to pay withholding tax on an amount. (2) A decision that a tax effect would have occurred if the scheme had not been entered into or carried out must be based on a postulate that comprises only the events or circumstances that actually happened or existed (other than those that form part of the scheme). (3) A decision that a tax effect might reasonably be expected to have occurred if the scheme had not been entered into or carried out must be based on a postulate that is a reasonable alternative to entering into or carrying out the scheme. (4) In determining for the purposes of subsection (3) whether a postulate is such a reasonable alternative: (a) have particular regard to: (i) the substance of the scheme; and (ii) any result or consequence for the taxpayer that is or would be achieved by the scheme (other than a result in relation to the operation of this Act); but (b) disregard any result in relation to the operation of this Act that would be achieved by the postulate for any person (whether or not a party to the scheme).

In determining whether a tax benefit would have arisen under the alternative postulate, s 177CB (2) makes it clear that only real, as opposed to speculative, possibilities can be taken into account. In Hart, for example, the possibility that the taxpayers might have obtained a dedicated interest-free loan in refinancing the loan on the Jerrabomberra property, instead of actually taking the Wealth Optimiser package, was ignored by the courts on the basis that the taxpayers had not seriously contemplated the interest-free loan as an option. This suggests that it may be in the interests of taxpayers to carefully document the range of options open to them before entering into a particular arrangement. Such careful documentation may negate the existence of a tax benefit if it is accepted that the other possible ‘scheme’ (which was not infected with a dominant tax avoidance purpose) would have given rise to the same (or lower tax) outcome as arose under the impugned scheme. Section 177CB (3) was the legislative response to the decision in RCI. This provision makes clear that the relevant postulate need not be one actually contemplated by a person (ie, taxpayer, adviser) in order for that postulate to be the foundation for identifying a tax effect. Section 177CB (4) must be followed in applying s 177CB(3). Section 177CB (4) provides an inclusive list of factors to be considered in applying [page 1149] s 177CB(3), but directs that particular attention be given to the specifically enumerated factors. The purpose of those specific factors is to allow the Commissioner to identify a reasonable alternative postulate by considering the substantive effect of the actual scheme, ignoring the tax aspects of that substantive effect. It remains to be seen whether the insertion of s 177CB will resolve the difficulties encountered by the Commissioner. For example, in Commissioner of Taxation v Sleight [2004] FCAFC 94 at [81], Hill J

suggested that the substantive effect of an agricultural management investment scheme could be described in different ways: There is a difference between the form and the substance of the present scheme. In form there is an option whether to farm alone or to employ the management company. There is a management agreement and financing and interest payments. The form involving pre-payment of management fee and interest is, it may be concluded readily, designed to increase the taxation deductions available to an investor. The substance is, however, quite different. As senior counsel for the Commissioner put it, in substance the investor is a mere passive investor in what, once the tax features are removed, is a managed fund where no deduction would be available, or perhaps an alternative characterisation of the substance of the scheme is an investment in shares in the land company which at the expiration of 15 years is to own the tea tree plantation.

In determining whether a tax benefit exists, the taxpayer bears the onus of proving that the scheme challenged by the Commissioner did not produce a tax advantage by comparison to the counterfactual scheme posited by the taxpayer: Futuris Corporation Ltd v FCT [2009] FCA 600; BC200904882. 17.12 ITAA36 s 177C(2) sets out specific exclusions from the definition of ‘tax benefit’ in s 177C(1). In general, where taxpayers avail themselves of an expressly allowed declaration, election, selection or choice available under the income tax legislation, no tax benefit will arise. For example, in calculating the decline in value of a depreciating asset, taxpayers are allowed the choice of depreciation formula (see ITAA97 s 40-65) and this choice will affect the amount of the allowable deduction. The exercise of this choice will not give rise to a tax benefit. The requirement that the choice be expressly allowed under the income tax legislation is intended to prevent taxpayers from availing themselves of the extended ‘choice doctrine’ which had been developed by the High Court with respect to the former ITAA36 s 260. In its latter stages of development, that doctrine held that s 260 could not apply where taxpayers availed themselves of a choice implicitly allowed under the legislation: see WP Keighery Pty Ltd v FCT (1957) 100 CLR 66. Thus, for example, a decision of a company to withhold profits or make a payment of a dividend is one which is implicitly recognised for the purposes of the income tax legislation because ITAA36 s 44 includes only dividends paid to shareholders: compare ITAA36 Pt X. Where a company withholds profits (perhaps for the purpose of sheltering those

profits at the corporate tax rate), that decision may be a scheme which gives rise to a tax benefit. The withholding of profits is not a choice expressly allowed under the income tax legislation. Where the relevant scheme was entered into or carried out for the purpose of creating the circumstances which gave rise to an express choice under the income tax legislation, s 177C(2) states that a tax benefit in connection with the scheme may arise. [page 1150]

Was the scheme entered into or carried out with the sole or dominant purpose of obtaining a tax benefit for a taxpayer? 17.13 The third major element that must be satisfied before Pt IVA can apply to a taxpayer’s factual situation is that a person involved in entering into or carrying out the scheme had the sole or dominant purpose of obtaining a tax benefit for the taxpayer: ITAA36 ss 177A(5) and 177D. Many ‘schemes’ which give rise to a ‘tax benefit’ will fall outside Pt IVA because of this purpose element. For example, a donation to a charity is a ‘scheme’ (ie, the action of making payment) that often will give rise to a tax benefit (in the absence of the scheme, there would not have been an allowable deduction because the taxpayer would not have incurred deductible expenditure). However, it will generally be found that the dominant purpose of making the donation was to advance the charitable cause rather than obtaining the tax benefit. 17.14 ITAA36 s 177D(2) lists eight factors to be considered in the course of determining whether the requisite purpose existed. The subjective purpose of those involved in the scheme is not listed and it is therefore impermissible to have regard to this purpose: see FCT v Hart (2004) 217 CLR 216; 55 ATR 712; 2004 ATC 4599 at [64] per Gummow and Hayne JJ. The purpose of the inquiry to be undertaken under s 177D is an inquiry into the ‘objective purpose’ of those involved

in the scheme. That is, having regard to the eight listed objective factors, it must be determined whether it can be inferred that a person had a dominant subjective purpose of obtaining a tax benefit for the taxpayer. However, it is possible that a taxpayer’s subjective purpose will be manifested in objective ways. Thus, in FCT v News Australia Holdings Pty Ltd [2010] FCAFC 78; BC201004442, the Full Federal Court concluded (at [33]) that the taxpayer’s ‘no tax, no tax risk’ position in undertaking a global corporate restructure ‘had objectively demonstrable consequences for both the manner in which the scheme was entered into and carried out and its form and substance’. The manner in which the scheme was entered into or carried out comprises the circumstances in which the scheme was implemented. In Eastern Nitrogen Ltd v FCT (2001) 46 ATR 474 at 492; 2001 ATC 4164 at 4179, Carr J (Lee and Sundberg JJ concurring) observed: As the appellant pointed out in its written submissions, there was a lengthy process of deliberation, on the part of the appellant’s Finance Managers and Board before the Instalment Purchase Agreement and the Agreement for Lease were entered into. The proposal was exhaustively researched and the benefits, costs and risks involved were examined at length. Advice was taken on legal, accounting, taxation and financial implications. That, in summary, was the manner in which the scheme was entered into.

Consideration of the form and substance of the scheme entails consideration of the non-tax objectives sought to be achieved and the extent to which the formal structuring of the scheme was manipulated to generate tax benefits. In FCT v Sleight (2004) 55 ATR 555; 2004 ATC 4477 at [82], Hill J (Hely J agreeing; Carr J dissenting on this point) drew a contrast between the form and substance of the agribusiness investment scheme considered in that case: It is not correct to say that form and substance are the same. Rather the particular shape the investment took was clearly fashioned in a way that would maximise the

[page 1151] tax deductions. They were geared up by the loan agreement with up-front interest payments. But for the tax deductions the form the investment might be expected to take would clearly relate more to the substance of what happened. Rather than a loan with prepaid interest where the loan was to be repaid out of the investor’s profit share without

recourse (achieved through the indemnity agreement) the substance is that the investor was to receive only a lesser share of profit over the term of the loan agreement. The loan allowed, also, the prepayment of the management fee and the deduction which emanated from that.

Consideration of the time at which the scheme was entered into and the length of the period during which the scheme was carried out has been referred to in a number of decisions where the scheme has been implemented in a ‘flurry of activity’ shortly before the end of the income year: Sleight; Pridecraft v FCT (2005) 58 ATR 210; 2005 ATC 4001. Such year-end tax planning may support the inference that one purpose of the scheme was to secure tax benefits for the income year before the income year ends. However, it may also be the case that the scheme had been contemplated for some time and it was merely convenient to enter into the scheme shortly before the end of a particular income year: Cooke v FCT (2004) 55 ATR 183; 2004 ATC 4268. Section 177D(2)(d) requires consideration of ‘the result in relation to the operation of this Act’ that, but for the operation of ITAA36 Pt IVA, would have been achieved by the scheme and directs attention to the tax benefit that would have been achieved under the scheme. This factor is clearly relevant to a consideration of the inferred purpose(s) of those involved in entering into or carrying out the scheme. Section 177D(2)(e) directs consideration of any change in the financial position of the relevant taxpayer that has resulted, will result, or may reasonably be expected to result from the scheme. Similarly, s 177D(2)(f) directs consideration of any change in the financial position of any person connected with the taxpayer that might arise from the scheme. Section 177D(2)(g) directs attention to any other (ie, nonfinancial) consequence that might result from the scheme for the taxpayer or any person connected with the taxpayer. Finally, s 177D(2) (h) directs consideration of the nature of the relationship of the relevant person referred to in s 177D(2)(f)–(g) to the taxpayer. The factors identified in the latter subparagraphs of s 177D(2) entail consideration of the non-tax consequences of the scheme. Thus, for example, the substantial commercial success of the taxpayer’s investment in FCT v Lenzo (2008) 247 ALR 242; 71 ATR 511; 2008 ATC 20-014; [2008] FCAFC 50 was clearly relevant to a determination

of the taxpayer’s objective purpose in accordance with s 177D. Likewise, the nature of the relationship of the taxpayer and a person connected with the taxpayer will be relevant to the purpose of the scheme where, for example, one aspect of the scheme is financial advantage to the associate. For example, a declaration of a trust over a taxpayer’s property where the trust beneficiaries include the taxpayer’s family might be explicable on non-tax grounds. Such non-tax considerations are clearly relevant to a determination on the objective purpose(s) of the scheme. In relation to the application of the eight matters appearing in ITAA36 s 177D(2), it should be remembered that, even though all of them must be taken into account, it is not essential that they be unpackaged from a universal consideration of ‘purpose’ and mechanically ticked off by the Commissioner. [page 1152] Further, s 177D directs attention to the purpose of any person who entered into or carried out the scheme or any part of the scheme. It is therefore clear that the purpose of an adviser is significant, even where the taxpayer is ignorant of the tax aspects of the arrangement: Consolidated Press Holdings v FCT (2001) 47 ATR 229 at 247; 2001 ATC 4343 at 4360. The requirement that there be a dominant purpose of obtaining a tax benefit in connection with the scheme means that the relevant purpose must be the ‘ruling, prevailing or most influential purpose’ of the scheme. The process by which the weight to be accorded to each purpose is determined is not governed by any statutory rule within Pt IVA. Rather, the decision-maker considers the basket of eight factors listed in s 177D and ultimately makes a subjective decision regarding the relative weight to be accorded to each purpose. In this matter, reasonable people may reasonably disagree and arguably this is one reason why there is frequent disagreement regarding the dominantpurpose inquiry.

However, in many cases, the scope of the particular scheme adopted by the Commissioner will make identification of the requisite dominant purpose far easier, as may be seen in FCT v Spotless Services Ltd (1996) 186 CLR 404; 34 ATR 183; 96 ATC 5201.

FCT v Spotless Services Ltd Facts: As a result of a successful capital raising, the two taxpayer companies, Spotless Services Ltd and Spotless Finance Pty Ltd (Spotless), had surplus funds of $40m and decided to place them in a short-term investment. The taxpayers received an information memorandum and other documents from an investment adviser concerning the investment of the excess funds with a bank situated in the Cook Islands. By a telex dated 5 December 1986, Spotless received an offer from that bank for the investment of the $40m, indicating that the offer could be accepted by delivery of a bank cheque for $40m to the bank in the Cook Islands on 10 December 1986. In accordance with the offer, the taxpayer sent an officer of the company to the Cook Islands with a power of attorney to draw and deliver a cheque for $40m to the bank. The officer was also empowered to secure the certificate of deposit and receive the principal amount together with the interest (less Cook Islands withholding tax) on maturity. On 23 June 1987, the taxpayers received the $40m and the interest of $2.96m less Cook Islands withholding tax. In their tax returns for the 1986–87 income tax year, the taxpayers claimed that the interest income received on their Cook Islands investment was exempt from Australian tax under ITAA36 s 23(q), [page 1153] which was in existence at the time. Section 23(q) provided exemption for a resident Australian taxpayer for foreign source income that was taxed in the source country. The Commissioner amended the taxpayer assessments, arguing that the interest was derived from a source within Australia or, alternatively, that Pt IVA applied to the arrangement. The taxpayers appealed to the Federal Court. At first instance, the Federal Court (Lockhart J) allowed the taxpayer’s appeal. Lockhart J found that the investment contract was entered into in the Cook Islands and was subsequently concluded on delivery of the $40m cheque to the Cook Islands and the receipt of the certificate of deposit. Moreover, the bank situated in the Cook Islands was incorporated and carried on business there and not in Australia. Finally, the deposit was repaid, together with the interest (less Cook Islands withholding tax) in the Cook Islands, thus the income was exempt under ITAA36 s 23(q).

On the Commissioner’s alternative argument concerning Pt IVA, Lockhart J held that Pt IVA did not apply to the investment arrangement because the scheme, which the Commissioner cited, was too narrowly defined. Rather, his Honour found that the offer and acceptance of that offer, along with all the other acts carried out by the parties to the arrangement, comprised the appropriate commercial transaction and the scheme. Furthermore, the Commissioner had only selected some of those steps and not recognised the whole scheme as he was obligated to do under Pt IVA. On appeal to the Full Federal Court, the Commissioner relied on the High Court decision in FCT v Peabody (1994) 181 CLR 359; 28 ATR 344; 94 ATC 4663 to base his argument on alternative (broad and narrow) formulations of the taxpayer’s scheme. Issues: In determining whether Pt IVA applies to any given factual situation, the following questions need to be asked: Is there a scheme? Was the scheme entered into after 27 May 1981? Was a tax benefit received? Was the scheme entered into or carried out with the sole or dominant purpose of obtaining a tax benefit? Held: The High Court allowed the appeal. The main judgment (Brennan CJ, Dawson, Toohey, Gaudron, Gummow and Kirby JJ) concentrated mainly on answering the last two questions above in a determining whether Pt IVA applied. Was the scheme entered into or carried out with the sole or dominant purpose of obtaining a tax benefit? The majority of the High Court (Brennan CJ, Dawson, Toohey, Gaudron, Gummow and Kirby JJ) looked at whether the sole or dominant purpose of the taxpayer in entering the scheme was to obtain a tax benefit. It found that a taxpayer’s particular course of [page 1154] action might be both tax-driven and bear the character of a rational commercial decision. However, the presence of a commercial purpose did not preclude the operation of Pt IVA. Rather, much turned on the identification of what purpose is dominant. In its ordinary meaning, dominant indicates the purpose which was the ruling, prevailing or most influential purpose. They found (at ATC 5210) that: In those circumstances, a reasonable person would conclude that the taxpayers in entering into and carrying out the particular scheme had, as their most influential and prevailing or ruling purpose, and thus their dominant purpose, the obtaining thereby of a tax benefit, in the statutory sense. The scheme was the particular means adopted by the taxpayers to obtain the maximum return on the money invested after payment of all applicable costs, including tax. The dominant purpose in the adoption of the particular scheme was the obtaining of a tax benefit. In reaching the contrary conclusion, or, rather, placing the matter on a different footing, the majority of the Full Court fell into error … viewed objectively, it was the obtaining of the tax benefit which directed the taxpayers in taking steps they otherwise would not have taken by entering into the scheme. Wos o tox benefit received? In answering the final question concerning the operation of Pt IVA, the majority of the High Court found that the taxpayers did, in fact, receive a tax benefit within the meaning of ITAA36 s 177C. The tax benefit consisted of an amount equal to the interest less the

Cook Islands withholding tax, which the taxpayers received from their investment of $40m (at ATC 5211): The taxpayers were determined to place the $40 million in short-term investment for the balance of the then current financial year. The reasonable expectation is that, in the absence of any other acceptable alternative proposal for “off-shore” investment at interest, the taxpayers would have invested the funds, for the balance of the financial year, in Australia. The amount derived from that investment then would have been included in the assessable income of the taxpayers. The interest rate in the Cook Islands was 4.5% below applicable bank rates in Australia. It reasonably could be concluded that the amount the taxpayers would have received on the Australian investment would have been not less than the amount of interest in fact received from the investment with EPBCL [European Pacific Banking Co Ltd]. Accordingly, there is no error adverse to the taxpayers in identifying the amount of the “tax benefit” as an amount equal to the interest less the Cook Islands withholding tax.

[page 1155] 17.15 An important case that discussed the eight matters referred to in ITAA36 s 177D(b) (the predecessor to s 177D(2)) was WD & HO Wills (Australia) v FCT (1996) 65 FCR 298; 32 ATR 168; 96 ATC 4223.

WD & HO Wills (Australia) v FCT Facts: In this case, the taxpayer set up a subsidiary company in Singapore to act as the insurer against the health risks associated with its tobacco products for which third-party insurance cover was not available at acceptable rates. The Commissioner relied on ITAA36 Pt IVA to deny the taxpayer’s claims for deductions paid for premiums paid to the subsidiary. The taxpayer subsequently appealed to the Federal Court. Held: The appeal was allowed. The Federal Court found that Pt IVA could not apply to the taxpayer’s arrangements. Even if the taxpayer had obtained a ‘tax benefit’ in relation to the scheme, it could not be said, having regard to the criteria in s 177D(2)(b) ‘the form and substance of the scheme’, that the scheme was entered into with the dominant purpose of allowing the taxpayer to obtain a tax benefit. The principal objective in

establishing the captive insurer was commercial and any tax advantages were incidental to these objectives. Sackville J said (at ATC 4254): … the scheme identified by the Commissioner had two principal commercial purposes. First, the scheme enabled Wills to obtain indemnity against health risks that otherwise was not available to it. Secondly, the scheme provided the Amatil Group with a number of commercial advantages. These included more effective risk management and claims handling, better chances of gaining access to the reinsurance market and the opportunity to retain the underwriting profits that might have flowed (and in fact did flow) from a somewhat speculative underwriting venture.

The Commissioner’s red flags of tax avoidance 17.16 In Practice Statement Law Administration PS LA 2005/24, the Commissioner identifies factors that, in his view, indicate a stronger likelihood that ITAA36 Pt IVA will apply. These factors include: the arrangement (or any part of it) is out of step with achieving ordinary family dealings of the sort ordinarily used to achieve the relevant commercial objective; the arrangement includes a degree of artificiality, such as the interposition of an entity for no family/commercial purpose other than obtaining a tax benefit; [page 1156] the tax outcome is at odds with the commercial outcome, as where a tax loss arises notwithstanding that the transaction generates a commercial profit; the arrangement results in little or no risk where risk would normally be expected, such as where the arrangement includes non-recourse loans (a loan where the debtor’s exposure to the creditor is restricted, often to the assets acquired with the financing); non-arm’s length dealings between the parties to the arrangement,

as where prices of goods are not within the range of market values; and arrangements where the substance is not consistent with the form of the arrangement, as where a series of offsetting transactions produce no economic outcome but produce a tax benefit.

Cancellation of tax benefits 17.17 Once the four conditions in ITAA36 Pt IVA have been appropriately satisfied according to the facts of the taxpayer’s case, the Commissioner is allowed to make a determination under ITAA36 s 177F(1) to cancel any tax benefits so obtained by the taxpayer, as follows. 177F Cancellation of tax benefits etc (1) Where a tax benefit has been obtained, or would but for this section be obtained, by a taxpayer in connection with a scheme to which this Part applies, the Commissioner may: (a) in the case of a tax benefit that is referable to an amount not being included in the assessable income of the taxpayer of a year of income — determine that the whole or a part of that amount shall be included in the assessable income of the taxpayer of that year of income; or (b) in the case of a tax benefit that is referable to a deduction or a part of a deduction being allowable to the taxpayer in relation to a year of income — determine that the whole or a part of the deduction or of the part of the deduction, as the case may be, shall not be allowable to the taxpayer in relation to that year of income; … and, where the Commissioner makes such a determination, he shall take such action as he considers necessary to give effect to that determination.

Generally, the Commissioner’s power to amend assessments under s 177F is restricted by the time limits imposed by ITAA36 s 170. However, where the Commissioner amends assessments under s 177F and increases the tax payable for one taxpayer, it may be appropriate for the Commissioner to amend the assessments for other taxpayers by reducing their respective tax liabilities: see ITAA36 s 177F(3).

[page 1157] Section 177F(3) may operate, for example, where a scheme has procured the diversion of income from one (often high-tax) entity to another (low-tax) entity. Section 177G states that s 170 does not apply to any amended assessments issued under s 177F(3).

Tax avoidance penalties 17.18 In addition to the cancellation of the taxpayer’s benefits under Pt IVA, the Commissioner also has the power to impose penalty tax. From 1 July 2000, an administrative penalty can be imposed by the Commissioner under TAA ss 284-140–284-160 in relation to tax avoidance schemes as follows: 50% of the scheme shortfall amount (ie, basically the tax sought to be avoided); or 25% of the scheme shortfall amount if it is reasonably arguable that Pt IVA does not apply. The Commissioner also has the power under TAA Sch 1 s 284-215 to remit the penalties for tax avoidance in appropriate circumstances. See 16.50–16.58 for a broad discussion of the tax penalty system.

Helen Peters was an employee of Computer Services Pty Ltd in Adelaide. She was not satisfied with her employer, so she moved to Sydney to work for another company called Fastnet Pty Ltd. Her new ‘employer’ insisted on engaging her as an independent contractor rather than as an employee. To satisfy this demand, Helen incorporated a company called Peters Solutions Pty Ltd (Peters Solutions), which then entered into a consultancy contract with Fastnet Pty Ltd. Peters Solutions engaged Helen as an employee. Peters Solutions also acted as corporate trustee of a family discretionary trust, the beneficiaries of which were Helen and members of her immediate family. During the current income tax year, the consultancy fees received by Peters Solutions exceeded the salary paid to Helen, with the excess being distributed to family members through the trust structure.

Required: Advise Helen Peters whether ITAA36 Pt IVA will apply to the above arrangements. Assume that ITAA97 Pt 2-42 does not apply to Peters Solutions (eg, because its income is not personal services income or because it is conducting a personal services business): see the discussion of Pt 2-42 (Divs 84–87) at 9.82–9.89.

Specific anti-tax avoidance measures Introduction 17.19 There are many specific anti-tax avoidance measures spread throughout the ITAA36 and ITAA97, dealing with different taxation issues. Many of these specific [page 1158] anti-tax avoidance rules have been already discussed at length in other chapters. Therefore, in this chapter, we will look briefly only at specific tax legislation that deals with the taxation treatment of expenses incurred under certain statutory tax avoidance schemes and at specific provisions dealing with the alienation of personal services income.

Expenses incurred under certain tax avoidance schemes 17.20 In some cases, deductions for otherwise allowable expenses can be deferred or even denied entirely under the ITAA36 where the expenses have been incurred in relation to particular types of tax avoidance schemes. The tax legislation in this area is contained in ITAA36 Pt III Div 3 Subdiv D, comprising: s 82KJ, which does not allow a deduction in respect of certain pre-paid expenses — ‘prepayment schemes’; s 82KK, which delays a deduction for expenses designed to postpone a taxpayer’s tax liability — ‘tax deferral schemes’; and s 82KL, which does not allow a tax benefit in respect of certain

recouped expenditure — ‘expenditure recoupment schemes’. 17.21 ITAA36 s 82KJ deals with expense prepayment schemes. No deduction is allowable under ITAA36 s 82KJ where a taxpayer prepays expenses (eg, interest or rent) with the idea of reducing the amount payable for the acquisition of property by the taxpayer or an associate of the taxpayer. However, s 82KJ may not operate if the amount of the taxpayer’s expenses in question was no more than what might reasonably be expected to have been paid under an arm’s length transaction. 17.22 ITAA36 s 82KK deals with tax deferral schemes. These schemes encompass dealings among associated parties to defer tax liabilities. The legislation has two important facets: 1. it postpones the deduction until the payment has been made in relation to the goods or services in question (s 82KK(2)); and 2. it denies the taxpayer a deduction for goods or services until the income year in which they have been provided (s 82KK(3) and (4)). 17.23 ITAA36 s 82KL deals with expenditure recoupment schemes. Where a taxpayer incurs an otherwise deductible expense, yet receives a compensating benefit which, along with the expected tax saving, functionally recoups the expense for the taxpayer such that no real deductible expense is suffered, a deduction is not allowed for the expense at all under s 82KL.

Alienation of personal services income 17.24 Several features of the Australian income tax system can make the diversion of income through an interposed entity (such as a company or a trust) attractive from a tax-planning viewpoint for high marginal rate taxpayers. For example, income diverted through a company can be retained and taxed at the corporate rate (currently 30%) rather than at the top marginal rate of 46.5% (including Medicare levy). Alternatively, where other family members are

shareholders of a company or beneficiaries of a trust, income derived through a company or a trust can be split [page 1159] between them, therefore taking advantage of the progressive income tax rate scale. Additionally, some deductions (such as salaries paid to the personal services income provider/shareholder/employee) are only or more easily obtained when the services are provided through a business conducted by an interposed entity rather than in an employment relationship. Other aims in alienating personal services income to interposed entities include obtaining certain forms of income-tested government support, and avoiding other levies, such as the Medicare levy surcharge, or even child-support obligations. At various points in this book, we have noted that specific provisions in the ITAA36 were designed to prevent income-splitting through the use of interposed entities: see 14.54–14.55 and 15.55–15.62. These provisions had a narrow application and, in some cases, were easily circumvented by the taxpayer. In a series of rulings, the Commissioner indicated that the general anti-avoidance provisions of ITAA36 Pt IVA would apply in some circumstances where personal services are performed through an interposed entity: see Taxation Rulings IT 2330, IT 2503 and IT 2639. Whether or not Pt IVA applied would depend on the circumstances of the particular case. This involved a lot of uncertainty for taxpayers and an administrative burden for the ATO, which had to make determinations as to the applicability or otherwise of Pt IVA on a case-by-case basis. 17.25 In April 2001, a new set of specific anti-avoidance provisions (ITAA97 Pt 2-42 Divs 84–87) was introduced in relation to the alienation of personal services income via interposed entities. The provisions apply as from 1 July 2001. For consideration of the operation of these rules, see 9.82–9.89. It should be noted that in cases involving the alienation of personal services income to a personal services entity, the Commissioner is authorised to apply ITAA36 Pt IVA

notwithstanding that the personal services entity is conducting a ‘personal services business’ within the meaning of ITAA97 Div 87.7.7 1.

2.

3. 4. 5.

6. 7.

For a critical review of the Australian income tax framework and the sources of tax complexity, see R Krever, ‘Taming Complexity in Australian Income Tax’ (2003) 25 Sydney Law Review 46. Boris Bittker, ‘A Comprehensive Tax Base as a Goal of Income Tax Reform’ (1967) 80 Harvard Law Review 925. Bittker’s article prompted a flurry of academic papers regarding the integrity of the concept of economic income: see, for example, R Musgrave, ‘In Defense of an Income Concept’ (1967) 81 Harvard Law Review 44. Although somewhat dated, the argument was cogently put by Ross Parsons in ‘Income Tax — An Institution in Decay?’ (1986) 12 Monash University Law Review 77. See D Pearce and R Geddes, Statutory Interpretation in Australia, 4th ed, Butterworths, Sydney, 1996, [4.24]. See, for example, Michael D’Ascenzo, ‘Part IVA — The Steward’s Inquiry — A Fair Tax System’, speech delivered at the 37th West Australian State Convention, Taxation Institute of Australia, 2 May 2003. For discussion of this decision, see M Burton, ‘The Rhetoric of Taxation Interpretation and the Definition of “Taxpayer” for the Purposes of Part IVA’ (2006) Revenue Law Journal 4. See ITAA36 s 177B(1), and also the note to ITAA97 s 86-10.

[page 1161]

CHAPTER

18

International Aspects Learning objectives After studying this chapter, you should be able to: identify when some foreign source income can be exempt income or non-assessable non-exempt income; calculate a foreign income tax offset for resident taxpayers; determine how the accruals tax system applies in relation to controlled foreign companies (CFCs); calculate the withholding tax liability for foreign resident taxpayers; be aware of the thin capitalisation rules; outline recent changes to Australia’s transfer pricing rules; determine briefly how Australia’s double tax agreements (DTAs) operate; outline the basic action items in the OECD BEPS Action Plan and Australia’s proposed responses.

Introduction Background 18.1

International taxation is an important issue given the

globalisation of world trade and financial markets. Globalisation of business has resulted from developments in information technology, the removal of exchange controls in many countries and the widespread use of free trade agreements. Australian enterprises are no longer constrained by their distance from major world markets. Cross-border commerce has become a reality even for small business taxpayers.

The OECD BEPS project 18.2 After the global financial crisis and the recessions that followed in several OECD and G20 countries, international tax issues became even more prominent. Falling revenues from corporate tax and widespread publicity given to the apparently low effective tax rates paid by major multinational enterprises (MNEs) led the G20 to charge the OECD with the Base Erosion and Profit Shifting (BEPS) project. The OECD produced an initial report on BEPS in 2013 followed by an Action Plan which identified the following 15 Action Items:1 [page 1162] Action Item 1: Action Item 2:

Address the tax challenges of the digital economy Neutralise the effect of hybrid mismatch arrangements Action Item 3: Strengthen CFC rules Action Item 4: Limit base erosion via interest deductions and other financial payments Action Item 5: Counter harmful tax practices more effectively, taking into account transparency and substance Action Item 6: Prevent treaty abuse Action Item 7: Prevent artificial avoidance of PE status Action Items 8– Ensure that transfer pricing outcomes are in line 10: with value creation

Action Item 11: Establish methodologies to collect and analyse data on BEPS and the actions to address it Action Item 12: Require taxpayers to disclose their aggressive tax planning arrangements Action Item 13: Re-examine transfer pricing documentation Action Item 14: Make dispute resolution mechanisms more effective Action Item 15: Develop a multilateral instrument. In October 2015, the OECD released its Final Reports on the 15 BEPS Action Items. Further work isongoing in relation to some of the Action Items while others require implementation by G20 and OECD member states (such as Australia). The Executive Summary to the Final Reports identifies the following different levels of political commitment required of member states to the Actions in the Reports: New minimum standard (all states are required to implement a new rule, but in some cases there are alternative options); Revision of a standard which already exists (while this is binding in principle the Final Report noted that ‘not all BEPS participants have endorsed the revisions’); Common approach facilitating convergence; and Best practice (these merely have the status of optional recommendations for states).

Organisation of chapter 18.3 The basic jurisdictional rules applying to Australian income taxation were discussed in Chapter 2. This chapter builds on that discussion as follows. First, we consider how Australian resident taxpayers are treated in accordance with the international taxation rules appearing in the Income Tax Assessment Act 1936 (Cth) (ITAA36) and the Income Tax Assessment Act 1997 (Cth) (ITAA97). This will include a review of: (i) provisions which mean that certain types of foreign source income are either exempt or are non-assessable non-exempt

income; (ii) provisions which reduce certain capital gains on shares in foreign companies; (iii) the foreign income tax [page 1163] offset system; and (iv) the accruals tax systems contained in the controlled foreign corporations (CFCs) rules. Second, we will look at how foreign resident taxpayers are affected by Australia’s taxation regime. Afer recapping our discussion of Australian taxation of foreign source income of foreign residents on an assessment basis we will then review the withholding tax provisions, the thin capitalisation legislation2 and the transfer pricing rules. The chapter goes on to a brief introduction to Australia’s double taxation agreements and then discusses the 2015 amendments to ITAA36 Pt IVA, commonly referred to as the Multinational Anti-Avoidance Law (or MAL) and the 2017 Diverted Profits Tax. Throughout the chapter, in those areas where Australia has existing legislation dealing with an issue dealt with in the OECD BEPS Final Reports the Australian response to the Final Reports will be noted. Under the heading ‘Other aspects of Australia’s response to the BEPS Final Reports and recent developments’ comment will be made on Australia’s response to those issues dealt with in the OECD BEPS Final Reports on which Australia does not, as yet, have directly relevant legislation and will note other recent developments which have not yet been legislated.

Taxation of residents General rule for Australian taxation of residents and exceptions and qualifications to that rule 18.4 We saw in Chapter 2 that, as a general rule, Australia taxes residents on their worldwide income but, in general, only taxes foreign residents on their Australian-source income. The concepts of ‘resident’ and of ‘source’ were discussed at 2.37–2.49. Under the basic rule,

consistently with the general Australian approach to taxing income, residents are taxed on foreign source income on a realisation basis when it is derived. There are, however, several exceptions or qualifications to these basic rules. These include: provisions which mean that certain types of foreign source income are either exempt income or are non-assessable non-exempt income; provisions which, within limits, allow foreign tax paid on certain types of foreign source income to be offset against a taxpayer’s Australian tax liability on that income; the foreign accruals tax regime contained in the controlled foreign company (CFC) rules, which can tax residents on certain types of foreign source income that would not otherwise be regarded as being derived by the resident. There are two policy rationales behind the first set of provisions. First, they are a means of preventing international double taxation that would otherwise arise where the source country taxed the income on the basis that it was sourced within that country while Australia taxed its residents on their worldwide income. Second, insofar as these provisions extend to offshore business investment, they are a means [page 1164] of promoting what is known as ‘capital import neutrality’. One of the rationales behind this policy is that Australian businesses should be able to compete in foreign jurisdictions on the same terms as local businesses. To achieve that objective, it is argued that the only tax payable by an Australian business on the foreign income should be the foreign tax. Similarly, there are two policy rationales behind the second set of provisions. Again, these provisions are a means of preventing international double taxation that would otherwise arise. In addition, these provisions are an attempt at achieving what is known as ‘capital

export neutrality’. This policy aims to produce the same after-tax result for an investor who invests offshore as is produced for one who invests in Australia. Where the offshore investment is made in a lower-taxed jurisdiction, this will mean that Australian tax will be payable on the income from that investment but, in broad terms, the Australian tax will be limited to the difference between the foreign tax paid and the Australian tax otherwise payable. The third set of provisions are really international anti-avoidance provisions aimed at counteracting planning, such as the diversion of income to controlled companies incorporated in low-tax jurisdictions. Each of these exceptions and/or qualifications to the basic rule will now be discussed in turn.

Exempt and non-assessable non-exempt foreign source income 18.5 Under this heading, there are three main categories of provisions which either exempt certain types of foreign source income from tax in Australia or classify certain types of foreign source income as nonassessable non-exempt income. These are: 1. the exemption, in limited circumstances, for foreign employment income (ITAA36 s 23AG); 2. the categorisation of certain foreign branch profits derived by an Australian company as non-assessable non-exempt income (ITAA36 s 23AH); and 3. the categorisation of certain non-portfolio dividends as nonassessable non-exempt income (ITAA97 Subdiv 768-A). We shall now consider each of these provisions in more detail.

Foreign employment income exemption 18.6 Prior to 1 July 2009, in broad terms, under ITAA36 s 23AG, foreign earnings derived by an Australian resident from 91 days continuous foreign service were exempt from Australian tax. As from 1 July 2009, the exemption will only apply where the continuous period of foreign service is directly attributable to: (a) the delivery of

Australian official development assistance by the individual’s employer (effectively the overseas aid program administered by AusAID or DFAT); (b) the activities of the individual’s employer in operating a developing country relief fund or a public disaster relief fund in a developed country; (c) the activities of the individual’s employer, if the employer is a registered charity (or, before 3 December 2012, a prescribed religious or charitable institution) located or pursuing objectives outside Australia which is exempt from Australian income tax under item 1.1 or [page 1165] former item 1.2 of s 50-5 of ITAA 1997; (d) the person’s deployment outside of Australia as a member of a disciplined force by the Commonwealth, a state or a territory (or an authority of any of these); or (e) an activity of a kind specified in the regulations. As from 1 July 2009, taxpayers receiving other income from foreign service (other than foreign source income from an approved overseas project which is exempt under ITAA36 s 23AF) will receive a foreign income tax offset in respect of any foreign income tax paid on the foreign source income. The foreign income tax offset provisions are discussed at 18.14–18.20.

Non-assessable non-exempt foreign branch profits 18.7 Under ITAA36 s 23AH, where an Australian company derives income from carrying on business through a permanent establishment3 (eg, a branch)4 in a foreign country, that income is non-assessable nonexempt income where the permanent establishment passes an active income test or where the foreign source income is active income.5 Note that a permanent establishment would not normally be a separate legal entity from the Australian company and, in the absence of s 23AH, the general Australian rule would be that the profits of the foreign permanent establishment would be included in the assessable income of the Australian company as they were derived. In addition, s 23AH

provides that capital gains (other than those made on tainted assets in the case of unlisted countries or on tainted assets where the gain is eligible designated concession income in the case of a listed country) made by a resident company in disposing of non-tainted assets used in deriving foreign branch income are non-assessable non-exempt income to the company.6 Our discussion here will be limited to the application of s 23AH to foreign branch income other than capital gains. The operative provisions relevant in determining whether foreign branch income is non-assessable non-exempt income to an Australian resident company are s 23AH(2), (5), (7) and (9), which are as follows. [page 1166]

23AH Foreign branch income of Australian companies not assessable (2) Subject to this section, foreign income derived by a company, at a time when the company is a resident in carrying on a business, at or through a PE of the company in a listed country or unlisted country is not assessable income, and is not exempt income, of the company. … (5) Subsection (2) does not apply to foreign income derived by the company if: (a) the PE is in a listed country; and (b) the PE does not pass the active income test (see subsection (12)); and (c) the foreign income is both: (i) adjusted tainted income (see subsection (13)); and (ii) eligible designated concession income in relation to a listed country. … (7) Subsection (2) does not apply to foreign income derived by the company if: (a) the PE is in an unlisted country; and (b) the PE does not pass the active income test (see subsection (12)); and (c) the foreign income is adjusted tainted income (see subsection (13)). … (9) This section applies to foreign income derived by an entity in the course of disposing, in whole or part, of a business carried on in a listed country or unlisted country at or through a PE of the entity in the listed country or unlisted country as if the foreign income had been derived in carrying on that business.

18.8 Note that the income of a permanent establishment in a listed country that is both adjusted tainted income and eligible designed concession income will not be non-assessable non-exempt income under ITAA36 s 23AH if the permanent establishment does not pass an active income test. Where the foreign branch is in an unlisted country, its adjusted tainted income will not be non-assessable non-exempt income if permanent establishment does not pass the active income test. The active income test for s 23AH purposes is set out in s 23AH(12). Section 23AH(12) applies the active income test for CFC purposes (discussed at 18.28) with certain modifications. We will see that the essential requirement of the CFC active income test is that the ratio of the CFC’s ‘gross tainted turnover’ to its ‘gross turnover’ is less [page 1167] than 0.05. Importantly, for the purposes of applying the test, s 23AH(14)(c) in effect treats the company and the permanent establishment as if they were separate legal entities dealing wholly independently with each other and as if any income derived by the Australian company were disregarded. Listed countries for s 23AH purposes are the countries listed in the Income Tax Regulations 1936 (Cth) as comparably taxed countries for CFC purposes. Currently, the listed countries are the United Kingdom, the United States of America, New Zealand, Germany, Canada, France and Japan. Currently, all other countries in the world are unlisted countries. Subject to certain modifications, ‘adjusted tainted income’ for s 23AH purposes has the same meaning as it has for CFC purposes. Again, importantly for these purposes, s 23AH(14)(c) in effect treats the company and the permanent establishment as if they were separate legal entities dealing wholly independently with each other and as if any income derived by the Australian company were disregarded. In broad terms, ‘adjusted tainted income’ will be passive income and tainted sales and services income. ‘Eligible designated concession income’ has the same meaning for s 23AH purposes as it has for CFC purposes. In

broad terms, it will be income or profits of certain kinds specified in the Regulations where either foreign tax is not payable because of a specific feature of foreign law or, where foreign tax is payable, there is a specific feature of foreign law of a kind specified in the Regulations. These concepts are discussed in more detail at 18.23–18.33. To summarise, s 23AH will mean that foreign income derived by a company from carrying on business through a permanent establishment (such as a branch) in the foreign country is non-assessable non-exempt income unless: where the branch is in a listed country, the branch fails the active income test and the income is adjusted tainted income that is eligible designated concession income; or where the branch is in an unlisted country, the branch fails the active income test and the income is adjusted tainted income.

Non-assessable non-exempt non-portfolio dividends 18.9 ITAA97 s 768-5(1) provides that a ‘foreign equity distribution’ made to an Australian resident ‘corporate tax entity’, not received in the capacity of a trustee (other than as a trustee of a corporate unit trust or a public trading trust), which satisfies the ‘participation test’ in s 768-15 in relation to the paying company, is non-assessable non-exempt income to the Australian resident company. Section 76-85(2) extends treatment of the distribution as non-assessable non-exempt income to distributions that are received by an Australian resident corporate tax entity which flow to that entity from a foreign company via one or more interposed partnerships or trusts. A ‘corporate tax entity’ is defined in ITAA97 s 960-115 at a particular time as: (a) a company (see the discussion at 12.26); (b) a corporate limited partnership (see the discussion at 14.88); (c) a corporate unit trust (see the discussion at 15.136–15.139); or (d) a public trading trust (see the discussion at 15.140–15.142). 18.10 ITAA97 Subdiv 768-A appears to be deceptively simple. When reading it, however, you need to bear in mind that prior to an actual dividend being paid by

[page 1168] the foreign company, the profits from which it was paid may have been attributed to the Australian company under Australia’s foreign accruals tax regimes. Where this has happened, then, in broad terms to the extent that the dividend represents a distribution of previously attributed income, ITAA36 s 23AI or s 23AK will deem it to be nonassessable non-exempt income. Australia’s accruals tax regimes are discussed at 18.21–18.34. It is important to note that ITAA97 s 25-90 provides that debt deductions (such as interest) are allowable to an Australian resident company where the company incurred the debt deductions in deriving income that is non-assessable non-exempt income under ITAA36 s 23AI or s 23AK and ITAA97 Subdiv 768-A. Such interest would not be deductible under ITAA97 s 8-1 as it would not meet the requirements of the so-called positive limbs of s 8-1. To understand the scope of ITAA97 Subdiv 768-A, we need to explain what a ‘foreign equity distribution’ and the ‘participation test’ is. 18.11 A ‘foreign equity distribution’ is defined in ITAA97 s 768-10 as a ‘distribution’ or ‘non-share dividend’ made by a company that is a foreign resident in respect of an ‘equity interest’ in that company. The terms ‘distribution’, ‘non-share dividend’ and ‘equity interest’ were discussed at 12.25. 18.12 The ‘participation test’ in ITAA97 s 768-15 is satisfied if the ‘direct participation interest’7 and ‘indirect participation interest’8 that the Australian resident corporate tax entity has in the foreign company is at least 10%. In applying these tests, rights on winding up are disregarded and, in determining the ‘indirect participation interest’, only the interests of intermediate entities other than corporate tax entities are taken into account in the calculation. Hence, dividend income received by Australian resident companies from foreign companies will be non-portfolio dividends where the shareholding is greater than, or equal to, 10%. However, for holdings

less than 10%, dividends received are included in the shareholder’s assessable income, but international double taxation is relieved unilaterally through Australian’s foreign income tax offset rules as discussed at 18.15–18.20.

Reduction in capital gains on non-portfolio shareholdings in foreign companies with active business operations 18.13 We saw earlier that capital gains from the disposal of assets of a branch, other than certain tainted (largely passive) assets, are nonassessable non-exempt income under ITAA36 s 23AH. You may also recall from 6.54 that foreign assets [page 1169] of a foreign resident company are not taxable Australian property for capital gains tax (CGT) purposes. If a foreign company that is owned by an Australian company sells its underlying foreign assets used in active business operations and then remits the profit to Australia as a dividend, then any capital gain made on the sale by the foreign company will not be subject to Australian tax and the dividend will be non-assessable non-exempt income to the Australian company under ITAA97 Subdiv 768-A. ITAA97 Subdiv 768-G is designed to produce equivalent results for Australian companies where they sell or otherwise dispose of their non-portfolio shareholdings in foreign companies that conduct active business operations. Under Subdiv 768-G, capital gains arising from any of CGT events A1, B1, C2, E1, E2, G3, J1, K4, K6, K10 and K11 happening to a non-portfolio shareholding that an Australian company or a controlled foreign company (CFC) has held in a foreign company for a minimum prescribed period, is reduced to the extent that the underlying business activities of the foreign company are active. The minimum period for which the shares must be held is 12 months in the two years preceding the relevant CGT event. The gain is reduced by the percentage that the value of the foreign company’s active

business assets represents of the total assets of the foreign company. Capital losses are also disregarded to the same extent. The Australian company, or the CFC as the case may be, can choose to value the assets of the foreign company on either a market value or a book value basis but if no choice is made the default method is that all capital gains made on the shares are fully taxable and capital losses on the shares are reduced to zero.

Foreign income tax offset system Generally 18.14 If Australia exercised in full its right to tax residents on their worldwide income, international double taxation would arise in the case of foreign source income where the source country exercised its right to tax that income on the basis that it was sourced within its jurisdiction. Since its inception in 1915, Australian Commonwealth income tax legislation has always contained some unilateral provisions that sought to prevent this type of international double taxation. Between 1915 and 1930, Australia, in general, taxed only income that had an Australian source and did not tax foreign source income at all. Between 1930 and 1987, Australia nominally taxed residents on their worldwide income but, subject to some exceptions, exempted foreign source income from Australian tax where that income had been subject to tax in the foreign country. Australia introduced a foreign tax credit for dividend income in 1947 and also allowed Australian resident companies an inter-corporate dividend rebate in respect of both foreign source and domestic source dividends. Australia introduced a general foreign tax credit system in 1987 but the operation of this system was soon modified by earlier iterations of the provisions discussed at 18.5–18.12. The previous foreign tax credit system was replaced in 2007 with the current foreign income tax offset system, which applies from 1 July 2008. The provisions allowing a foreign income tax offset are contained in ITAA97 Div 770. When considering the operation of the foreign income

tax offset system, we should keep in mind that, as discussed previously, certain types of foreign income are [page 1170] either exempt from tax in Australia or are non-assessable non-exempt income. You will recall that these include: from 1 July 2009 onwards, foreign employment income of individuals fitting into the categories specified at 18.5 (ITAA36 ss 23AG and 23AF);9 foreign branch profits derived by an Australian company (ITAA36 s 23AH); and non-portfolio dividends (ITAA97 Subdiv 768-A). Where foreign income is either exempt from tax in Australia through the operation of these provisions or is non-assessable non-exempt income, no foreign income tax offset is allowed. In other words, in general, there is no foreign income tax offset unless the foreign income is assessable income in Australia. We shall see, however, that an exception to this general rule applies where income which has previously been attributed under one of Australia’s foreign accruals tax regimes is repatriated non-assessable non-exempt income under either ITAA36 s 23AI or s 23AK.10 In these circumstances, the recipient of the income is entitled to a foreign income tax offset in relation to any foreign withholding tax that was payable on the dividend. It is important to note, as discussed in more detail below, that when income is attributed under Australia’s foreign accruals tax regimes the Australian resident to whom the income is attributed may, in certain circumstances, be entitled to a foreign income tax offset in respect of foreign corporate tax paid by, for example, a CFC.

Operation of the foreign income tax offset system 18.15 Basically, the operation of Australia’s foreign income tax offset system involves the following issues:

whether the resident Australian taxpayer qualifies for foreign income tax offset relief; and if ‘yes’, the calculation of the amount of offset allowed. In answering the first issue, the starting point is ITAA97 s 770-10, which states as follows. [page 1171]

770-10 Entitlement to foreign income tax offset (1) You are entitled to a tax offset for an income year for foreign income tax. An amount of foreign income tax counts towards the tax offset for the year if you paid it in respect of an amount that is all or part of an amount included in your assessable income for the year. Note 1: The offset is for the income year in which your assessable income included an amount in respect of which you paid foreign income tax — even if you paid the foreign income tax in another income year. Note 2: If the foreign income tax has been paid on an amount that is part non-assessable non-exempt income and part assessable income for you for the income year, only a proportionate share of the foreign income tax (the share that corresponds to the part that is assessable income) will count towards the tax offset (excluding the operation of subsection (2)). Note 3: [relates to offshore banking units and has been omitted from this extract.] Taxes paid on section 23AI or 23AK amounts (2) An amount of foreign income tax counts towards the tax offset for you for the year if you paid it in respect of an amount that is your nonassessable non-exempt income under either section 23AI or 23AK of the Income Tax Assessment Act 1936 for the year. Note 1: Sections 23AI and 23AK of the Income Tax Assessment Act 1936 provide that amounts paid out of income previously attributed from a controlled foreign company or a foreign investment fund are nonassessable non-exempt income. Note 2: Foreign income taxes covered by this subsection are direct taxes (for example, a withholding tax on a dividend payment) and not underlying taxes, only some of which are covered by section 770-135. Exception for certain residence-based foreign income taxes (3) An amount of foreign income tax you paid does not count towards the tax offset for the year if you paid it: (a) to a foreign country because you are a resident of that country for the purposes of a law relating to the foreign income tax; and (b) in respect of an amount derived from a source outside that country. Exception for previously complying funds and previously foreign funds

(4) [Subsection 4 relates to certain foreign income tax paid by a superannuation provider in relation to a superannuation fund and has been omitted from this extract.] [page 1172] Exception for credit absorption tax and unitary tax (5) An amount of credit absorption tax or unitary tax you paid does not count towards the tax offset for the year.

18.16 Note that to obtain a foreign income tax offset you must have paid foreign income tax. ITAA97 770-130 contains rules about when foreign income tax is paid, which will mean that a payment can be regarded as being made even though it was paid by someone other than you either under an arrangement or under a requirement of foreign law. Section 770-130 states as follows. 770-130 When foreign income tax is considered paid — taxes paid by someone else (1) This Act applies to you as if you had paid an amount of foreign income tax in respect of an amount (a taxed amount) that is all or part of an amount included in your ordinary income or statutory income if you are covered by subsection (2) or (3) for an amount of foreign income tax paid in respect of the taxed amount. (2) You are covered by this subsection for an amount of foreign income tax paid in respect of a taxed amount if that foreign income tax has been paid in respect of the taxed amount by another entity under an arrangement with you or under the law relating to the foreign income tax. Example: You are a partner in a partnership and the partnership pays foreign income tax on the partnership income. (3) [Subsection 3 relates to amounts of foreign tax that are regarded because of the operation of ITAA36 s 6B to be attributable to another amount of income of a particular kind or source. Subsection 3 and the accompanying notes have been omitted from this extract.]

18.17 The most common situation likely to be covered by s 770130(2) would be where the law of the foreign country imposes an obligation on a payer of dividends, interest or royalties to withhold tax when making a payment to a non-resident of that jurisdiction. In these circumstances, the combined operation of s 770-130(1) and (2) would

be that the recipient of the dividend, interest or royalty would be regarded as having paid the foreign withholding tax. In addition, s 770-140 contains rules deeming foreign income tax not to be paid where you, or any other entity, become entitled to a refund of the foreign income tax or to any other benefit (other than a reduction in the amount of the foreign income tax) determined by reference to the amount of the foreign income tax. [page 1173] There are also rules set out in s 770-135 which apply in relation to foreign income tax paid, for example, by CFCs, on income which has been attributed to Australian residents. These rules, as they apply to CFCs, are discussed at 18.31. 18.18 ITAA97 s 770-15 contains definitions that are relevant to determining whether a tax is creditable for foreign income tax offset purposes. The meaning of ‘foreign income tax’ is defined in s 770-15(1) as meaning a tax that: (a) is imposed by a law other than an Australian law; and (b) is: (i) tax on income; or (ii) tax on profits or gains, whether of an income or capital nature; or (iii) any other tax, being a tax that is subject to [one of Australia’s double taxation agreements].

A note to s 770-15(1) explains that: Foreign income tax includes only that which has been correctly imposed in accordance with the relevant foreign law or, where the foreign jurisdiction has a tax treaty with Australia (having the force of law under the International Tax Agreements Act 1953), has been correctly imposed in accordance with that tax treaty.

Note that while there is a requirement that the tax be imposed by a law other than an Australian law, there is no requirement that the tax be imposed by a national, as opposed to state or provincial, government of a foreign country. Hence, income taxes imposed by states of the United States of America or by provinces of Canada are creditable taxes for purposes of ITAA97 Div 770. Examples of taxes that might not be considered income taxes or taxes on profits or gains that are subject to an Australian double taxation agreement (DTA) can be found in Australia’s DTA with Norway. The Norwegian taxes covered under that agreement, in addition to the taxes on general income and on personal income, include: (a) the special tax on petroleum income; (b) the resource rent tax on income from the production of hydro-electric power; (c) the withholding tax on dividends; and (d) the tax on remuneration to non-resident artists. Some of these taxes might possibly be regarded as taxes on income or as taxes on profits or gains, but, as they are taxes covered under the agreement with Norway, it is unnecessary to determine if they are taxes on income or taxes on profits or gains. The fact that they are taxes covered under the agreement with Norway is enough to make them creditable taxes for purposes of Div 770. [page 1174] You may have noted from s 770-10(5) that neither a ‘credit absorption tax’ nor a ‘unitary tax’ counts towards your tax offset for the year. A credit absorption tax is defined in s 770-15(2) as being a tax imposed by a law of a foreign country, or any part of, or place in, a foreign country to the extent that the tax would not have been payable if the entity concerned, or another entity, had not been entitled to an offset in respect of tax under Div 770. In other words, a credit absorption tax is one where the foreign country only levies the tax if the taxpayer is entitled to a foreign tax offset in respect of the tax. If Australia allowed foreign income tax offsets for credit absorption taxes,

it would mean that Australia was, in effect, bearing the foreign tax rather than the taxpayer. A ‘unitary tax’ is defined in s 770-15(3) as follows. 770-15 Meaning of … unitary tax (3) Unitary tax means a tax imposed by a law of a foreign country, or of any part of, or place in, a foreign country, being a law which, for the purposes of taxing income, profits or gains of a company derived from sources within that country, takes into account, or is entitled to take into account, income, losses, outgoings or assets of the company (or of a company that for the purposes of that law is treated as being associated with the company) derived, incurred or situated outside that country, but does not include tax imposed by that law if that law only takes those matters into account: (a) if such an associated company is resident of the foreign country for the purposes of the law of the foreign country; or (b) for the purposes of granting any form of relief in relation to tax imposed on dividends received by one company from another company.

Typical examples of unitary taxes are taxes imposed by several states of the United States on the income of multinational enterprises. While the details of these taxes vary from state to state, in general they determine the amount of the multinational’s income derived from sources within the state by applying a formula (which takes into account items such as sales and payroll within the state) to the global profits of the multinational. This process can produce a state tax base which differs significantly from what Australian tax law would regard as income sourced within that state. This appears to be the reason why unitary taxes are not creditable for foreign income tax offset purposes. 18.19 Under ITAA97 s 770-70, the amount of the foreign income tax offset is the sum of the foreign income tax that you paid that counts towards the tax offset for the year. If there were no limit on a foreign income tax offset, then payments of foreign tax at rates greater than the relevant Australian rate would generate [page 1175]

excess offsets which, depending on the purposes for which offsets could be used and whether or not they were refundable, could reduce an Australian resident’s tax liability on Australian source income or could produce tax refunds for the Australian residents. If this were the case, then, in effect, Australia would be funding another country’s tax system. For this reason, the Australian foreign income tax offset system (in common with most foreign tax credit systems used throughout the world) contains upper limits on the amount of the tax offset. The limits of the offset are set out in s 770-75, which reads as follows. 770-75 Foreign income tax offset limit (1) There is a limit (the offset limit) on the amount of your tax offset for a year. If your tax offset exceeds the offset limit, reduce the offset by the amount of the excess. (2) Your offset limit is the greater of: (a) $1000; and (b) this amount: (i) the amount of income tax payable by you for the income year; less (ii) the amount of income tax that would be payable by you for the income year if the assumptions in subsection (4) were made. Note 1: If you do not intend to claim a foreign income tax offset of more than $1000 for the year, you do not need to work out the amount under paragraph (b). Note 2: The amount of the offset limit might be increased under section 770-80. (3) For the purposes of paragraph (2)(b), work out the amount of income tax payable by you, or that would be payable by you, disregarding any tax offsets. (4) Assume that: (a) your assessable income did not include: (i) so much of any amount included in your assessable income as represents an amount in respect of which you paid foreign income tax that counts towards the tax offset for the year; and (ii) any other amounts of ordinary income or statutory income from a source other than an Australian source; and (b) you were not entitled to any deductions that: (i) are debt deductions that are attributable to an overseas permanent establishment of yours; or (ii) are deductions (other than debt deductions) that are reasonably related to amounts covered by paragraph (a) for that year. [page 1176]

Note: You must also assume you were not entitled to any deductions for certain converted foreign losses: see section 770-35 of the Income Tax (Transitional Provisions) Act 1997. Example: If an entity has paid foreign income tax on a capital gain that comprises part of its net capital gain, only that capital gain on which foreign income tax has been paid is disregarded.

Note that your tax offset is reduced by the amount by which it exceeds the tax offset limit. This means that excess offsets cannot be refunded and cannot be carried forward. The combined effect of ITAA97 s 770-75(2) and (4) is that the limit will be the greater of $1000 or the Australian tax payable on non-Australian source assessable income less deductions that are debt deductions (typically interest) attributable to an overseas permanent establishment and less other deductions that are reasonably related to your non-Australian source income. Because this result is achieved by first calculating Australian tax payable on your worldwide income and then subtracting the Australian tax payable on your Australian-sourced income, it means the credit allowed on your foreign source income is effectively calculated using your highest marginal rate. Special provisions, discussed at 18.31, increase the tax offset limit where dividends are received that are non-assessable non-exempt income under either ITAA36 s 23AK or s 23AI. 18.20 A foreign income tax offset is incorporated into the general tax offset system. Foreign income tax will normally have been paid in a foreign currency. Note that in calculating a foreign income tax offset, you will be required by ITAA97 s 960-50 to convert the payment of foreign tax into Australian dollars. Item 6 in the table in s 960-50(6) requires the conversion of amounts of ordinary income at the rate applicable at the earlier of the date of derivation or the date of receipt. Under Regulations issued in 2005, you are permitted to elect to use average exchange rates for periods up to 12 months provided the rate is reasonable. The basic operation of a foreign income tax offset is illustrated in Example 18.1.

Grant Andrews is an Australian resident individual with no dependants. He carries on an Internet web design business as a sole trader. During the current year of income, he has provided the following information. Gross amount

Tax

A$/Foreign exchange rate

Income: Gross income from trading in Australia

A$100,000

[page 1177] Gross amount Gross income from trading in New Zealand

Tax

A$/Foreign exchange rate

NZ$20,000

NZ$7500

1 20* 1 18***

Dividend income US$10,000 derived on US shares

US$1500

0.62**, 0.65***

Expenses: Cost of goods sold in Australia

A$30,000

Cost of goods sold in New Zealand

NZ$5000

Marketing expenses

A$15,000

Administration expenses

A$10,000

1.20*

*

Average exchange rate during time of trading. Deductions relating to foreign trading income are converted at the same exchange rate as that used to convert the trading income.

**

Exchange rate at date of remittance. This is also the rate used to convert the tax.

*** Exchange rate at the time tax was paid. Note that these are hypothetical exchange rates used for the purposes of illustration and do not reflect actual rates. Grant’s foreign income tax offset would be calculated as follows:

Step 1

Convert the foreign income and foreign taxes into Australian dollars: New Zealand trading income and cost of goods sold are both converted at the average exchange rate of 1.20 (NZ$20,000/1.20 and NZ$5000/1.20), while the tax is converted at the exchange rate prevailing at the time the tax was paid, being 1.18 (NZ$7500/1.18); and US dividend income and the withholding tax are both converted at the exchange rate at the time the dividend income was remitted to Australia, being 0.62 (US$10,000/0.62 and US$1500/0.62). [page 1178] Hence, the foreign amounts are converted as follows: New Zealand trading income A$16,667 New Zealand cost of goods sold A$4167 New Zealand tax on net trading income A$6356 US dividend income A$16,129 US withholding tax on dividend income A$2419

2

Calculate the Australian tax payable for the income year on worldwide income Assessable income Australian-sourced taxable income

$100,000

New Zealand trading income

$16,666.67

United States-sourced dividend

$16,129.03

Less deductions Cost of goods sold in Australia Cost of goods sold in New Zealand

$30,000 $4,166.67

Marketing

$15,000

Administration

$10,000

Taxable income

$73,629.03

Australian tax payable at 2012–13 rates

$15,476.34

Medicare levy is not income tax and hence is not included in calculating the credit limit. 3

Calculate the Australian tax payable on Australian-sourced income for the income year Australian-sourced assessable income Australian trading income Less deductions not relevant to foreign-sourced income

$100,000

Cost of goods sold in Australia

$30,000

*

Proportion of marketing expenses

*

Proportion of administration expenses

83.33% × $15,000 = $12,499.50 83.33% × $10,000 = $8333

Australian-sourced taxable income

$49,167.50

Australian tax payable on Australian-sourced taxable income at 2012–13 rates 4

$7,526.44

Subtract result of Step 3 from result of Step 2 to calculate limit of foreign income tax offset $15,476.34 – $7526.44 = $7949.90 As the foreign tax paid of $8775 is greater than the foreign income tax offset limit of $7949.90, the offset is reduced by the amount of the excess and becomes $7949.90. [page 1179]

5

Calculate net Australian tax payable Hence, Grant’s Australian tax payable plus Medicare levy (assuming that Grant has an adequate level of private health insurance) will be: Tax on taxable income

$15,476.34

Medicare levy

$1,104.44

Less

*

Foreign income tax offset

$7,949.90

Net tax and Medicare levy payable

$8,630.88

The marketing and administration expenses have been apportioned between the Australian and New Zealand trading operations according to the percentage that turnover from each operation represents of total turnover.

Olympic Ltd is an Australian resident company which, during the current year of income, derived the following income and paid the following tax: Source country

Income*

Tax

Type of income

Australia

$200,000

On assessment

Trading income

France

$100,000

$55,000

Trading income

Hong Kong

$50,000

$7,500

Trading income

* Net of tax. Note that the trading income from France was attributable to a permanent establishment that Olympic Ltd conducted in France. Olympic Ltd does not have a permanent establishment in Hong Kong. Required: 1. Calculate Olympic’s taxable income and gross tax payable. 2. Calculate Olympic’s net tax payable, after taking into account foreign income tax offsets. 3. What difference would it make if the French income consisted of dividends from public companies, on which the only French tax payable was withholding tax of $15,000?

[page 1180]

Australian accruals tax regimes Generally 18.21 Between the introduction of the general foreign tax credit system in 1987 and 1 July 1990, Australian taxpayers were usually taxed on foreign income only when that income was remitted or distributed back to Australia. This presented a tax planning opportunity for the accumulation of income offshore and the ability thereby to defer the liability to Australian income taxation until the point of remittance. This is shown in Example 18.2.

Elle, an Australian resident taxpayer, has A$3m invested in Model Plc, a company resident in Monaco, which is a tax-free haven. She allows the income derived from Model Plc to accumulate in Monaco and never remits it back to Australia. Model Plc is a separate legal entity from Elle. Hence, in the absence of a foreign accruals tax regime, the Commissioner does not have the power to tax Elle on the income derived on her investments in Monaco. This would occur only when Model Plc distributes the income to Elle, for example, by paying a dividend.

18.22 Australia now has a very complex system for the attribution of income derived by certain offshore entities.11 The ‘controlled foreign company’ (CFC) provisions apply from 1 July 1990, and essentially target those overseas companies controlled by Australian resident taxpayers. The relevant legislation is contained in ITAA36 Pt X ss 316– 468. The broad objective of the CFC legislation is to tax Australian resident shareholders on their portion of a CFC’s tainted income12 as that income is derived13 by the entity, unless the income is comparatively taxed offshore, or the CFC derives its income almost solely from active business activities.14 The CFC legislation is very complex, so the discussion in this chapter concentrates only on its key features. Australia introduced foreign investment fund (FIF) rules with effect from 1 January 1993. Following recommendations by the Board of Taxation, the FIF rules were repealed with effect from 14 July 2010. As an integrity measure, the Gillard Government had released exposure draft legislation dealing with foreign accumulation funds (FAFs). In the 2013–14 Federal Budget, the Gillard Government announced that it would reconsider these proposals once the Organisation of [page 1181] Economic Co-operation and Development (OECD) had completed its examination of tax base erosion and profit shifting. The Gillard Government had released an exposure draft for new CFC legislation. In the 2013–14 Federal Budget, the Gillard Government announced that it would reconsider the proposed changes to the CFC legislation once the OECD completed its examination of tax base erosion and profit shifting (BEPS). By a media release dated 14 December 2013, the then Assistant Treasurer, Senator Sinodinos, announced that the Abbott Government would not proceed with the review of the foreign source income antitax-deferral (attribution) regimes. It is understood that the

announcement in the media release will also mean that the proposed FAF provisions will not proceed. The Treasurer’s Media Release of 6 October 2015, following the release of the OECD’s Final BEPS Reports, indicated that ‘Australia’s CFC rules meet OECD best practice guidance’. Hence it is not anticipated that significant changes will be made to Australia’s CFC rules in response to the OECD’s Final BEPS Reports.

Controlled foreign companies Generally 18.23 The starting point for examining the CFC legislation is ITAA36 s 456, which includes in an attributable taxpayer’s assessable income the taxpayer’s attribution percentage in a CFC’s attributable income. 456 Assessability in respect of CFC’s attributable income (1) Subject to subsection (2), where a CFC has attributable income for a statutory accounting period in respect of an attributable taxpayer, the taxpayer’s attribution percentage of the attributable income is included in the assessable income of the taxpayer of the year of income in which the end of the statutory accounting period occurs. …

18.24 Therefore, for ITAA36 s 456 to apply, the following three conditions must be satisfied: 1. there must be a CFC (defined in ITAA36 s 340); 2. there must be an ‘attributable taxpayer’ (defined in ITAA36 s 361); and 3. there must be ‘attributable income’ (defined in ITAA36 Pt X Div 7). If these three conditions are satisfied, then the taxpayer’s ‘attribution percentage’15 is included in the taxpayer’s assessable income for the year of income in which the CFC’s statutory accounting period ends.

[page 1182]

Controlled foreign company (CFC) 18.25 Attribution will occur only in relation to an entity that is a CFC as defined in ITAA36 s 340. There are three essential elements to the definition: 1. the entity must be a company; and 2. the entity must be foreign; and 3. the entity must be controlled in the relevant sense. To be a CFC, the entity must first be a company as defined in ITAA36 s 6(1) and ITAA97 s 995-1(1). The definition of ‘company’ for Australian income tax purposes was discussed at 12.26–12.27. The company must also be ‘foreign’. That is, it must be a resident of either a listed country or an unlisted country. Under ITAA36 s 320, a listed country means a foreign country, or a part of a foreign country, that is declared by the Regulations to be a listed country for the purposes of the CFC provisions.16 Also, if only part of a country is a listed country, then the remainder of the country is an unlisted country. The effect of s 332 is that a company will be deemed to be a resident of a listed country where it is treated as a resident of that country for the purposes of its tax law and it is not a ITAA36 Pt X Australian resident. In essence, a company will be a Pt X Australian resident where it is an Australian resident under the s 6(1) definition except where a tiebreaker article in one of Australia’s double taxation agreements deems it to be a foreign resident. The effect of s 333 is that a company that is not a Pt X Australian resident will be a resident of an unlisted country if that country regards it as a resident for purposes of its tax law. A company that is not a Pt X Australian resident is also deemed by s 333 to be a resident of an unlisted country if no particular listed or unlisted country regards it as a resident for the purposes of its tax law. Thus, residency in an unlisted country is the default option under the CFC legislation. Finally the company must be controlled in the relevant sense. Under s 340, this means that either:

there is a group of five or fewer Australian 1% entities who have an aggregate associate inclusive control interest of 50% or greater (the ‘strict control’ test); or 2. there is a single Australian entity with an associate inclusive control interest in the company of 40% or greater at a time when the company is not actually controlled by a group of other entities (the ‘assumed control’ test); or 3. the company is actually controlled by a group of five or fewer Australian entities either alone or together with associates (whether or not the associate is also an Australian entity) (the ‘de facto control’ test). Note that under the third test of control, there is no requirement that the actual controller(s) have any voting power or other rights in the company. Where the third test of control is established, then each Australian entity in the group is deemed by s 350(6) to have a direct control interest in the CFC of 100%. Note also that for purposes of these tests, a ‘group’ is defined by s 317 as including a single entity and any number of entities not in any way associated or acting together. 1.

[page 1183] Establishing control under the first two tests depends on finding particular levels of ‘associate inclusive control interest’ held by resident taxpayers. Under s 349, an entity’s associate inclusive control interest in a foreign company will be the aggregate of the direct and indirect control interests that the entity and the entity’s associates hold in the company. An entity has a direct control interest in a company equal to the greatest of its shareholding percentage, its voting rights percentage and its percentage rights to distributions of capital or profits both on and outside a winding up. An entity will have an indirect interest in a foreign company where another CFC is interposed between the entity and the foreign company. Where the interposed entity is a ‘controlled foreign entity’ (ie, a CFC, a controlled foreign partnership or a

controlled foreign trust), the Australian entity’s interest in the foreign company may be traced through the interposed entity. In these circumstances, the indirect interest of the Australian entity will be the entity’s ‘control tracing interest’ in the interposed entity multiplied by the interposed entity’s ‘control tracing interest’ in the foreign company. Normally, the Australian entity’s control tracing interest in the interposed entity will be its direct control interest in that entity, and the interposed entity’s control tracing interest in the foreign company will be the interposed entity’s direct control interest in the foreign company. In some circumstances, however, an entity that has sufficient control over an interposed entity will be deemed by s 353(2) to have a control tracing interest in the entity of 100%. The circumstances where this deeming is made are: (a) where an entity and its associates hold direct control interests in the interposed entity of 50% or more; (b) the entity and its associates hold direct control interests in the interposed entity of 40% or more and no other group of entities controls the interposed entity; or (c) the entity, either alone or together with associates, controls the interposed entity. Note that (b) and (c) correspond exactly with the ‘assumed control’ and ‘de facto control’ tests in s 340. The requirement under (a) above, however, differs from the ‘strict control’ test in s 340 in that under (a) only direct control interests held by associates of the entity are aggregated with those held by the entity whereas in the strict control test in s 340 direct control interests of an unconnected group of Australian entities may be taken into account. The same method for computing the indirect control interests of entities continues throughout a chain of entities. Example 18.3 illustrates the operation of these rules.

Macbeth, Macduff, Banquo and Hamish are all Australian residents who are not associates for purposes of the CFC rules. They each own 25% of Highland Plc, a company incorporated in Scotland. Highland Plc in turn owns 50% of Island Pty Ltd, a company incorporated in Vanuatu. Island Pty Ltd in turn owns 40% of Resort Pty Ltd, a company also incorporated in Vanuatu. No other entities have actual control of any of Highland Plc, Island Pty Ltd or Resort Pty Ltd. [page 1184] Highland Plc will be a CFC because of the strict control test as a group of five or fewer Australian 1% entities between them owns more than 50% of the shares in Highland Plc. As Highland Plc is a CFC, each of Macbeth, Macduff, Banquo and Hamish will have a control tracing interest in Highland Plc of 25% each. As Macbeth, Macduff, Banquo and Hamish are not associates, their individual control tracing interests will not be deemed to be 100%. As Highland Plc has a 50% interest in Island Pty Ltd, it will be deemed to have a control tracing interest in Island Pty Ltd of 100%. This will mean that Island Pty Ltd is a CFC under the strict control test as each of Macbeth, Macduff, Banquo and Hamish will have an indirect control interest in Island Pty Ltd of 25% × 100%. The aggregate of these indirect interests will be greater than 50% and will in fact be 100%. As Island Pty Ltd is a CFC, it can be traced through to determine if Resort Pty Ltd is a CFC. As Island Pty Ltd has a direct control interest in Resort Pty Ltd of 40%, and as no other entity actually controls Resort Pty Ltd, Island Pty Ltd will be deemed to have a control tracing interest in Resort Pty Ltd of 100%. This will mean that Resort Pty Ltd is a CFC under the strict control test as each of Macbeth, Macduff, Banquo and Hamish will have an indirect control interest in Resort Pty Ltd of 25% × 100% × 100% = 25%. The aggregate of these indirect control interests in Resort Pty Ltd will be greater than 50% and will, in fact, be 100%.

Attributable income 18.26 ‘Attributable income’ is exhaustively defined in ITAA36 Pt X Div 7. For our purposes, attributable income represents the taxable income of a CFC with certain modifications relating to depreciation, trading stock and capital gains. Attributable income: generally excludes active income derived by a CFC in any country;17 includes adjusted tainted income18 derived by a CFC resident in unlisted countries (ULC), unless the CFC passes the active income test;19

[page 1185] includes adjusted tainted income, derived by a CFC resident in a listed country, which is eligible designated concession income20 unless the CFC passes the active income test or where the de minimis exemption21 applies; and includes income, or other amounts derived by a CFC resident in a listed country that are not eligible designated concession income, are not derived from sources in the listed country and that are either: — adjusted tainted income not taxed in the listed country; or — not taxed in a listed country, unless the CFC passes the active income test or the de minimis exemption applies. Attributable income of a CFC is computed at the end of the statutory accounting period of the CFC (ITAA36 s 319) and is calculated separately for each attributable taxpayer (ITAA36 s 381).

Listed countries and unlisted countries 18.27 The application of the CFC rules differs according to whether the CFC is resident in a listed or an unlisted country. In summary, the differences in treatment are as follows: Listed countries are countries whose tax systems are highly comparable to Australia’s that are listed in the Income Tax Assessment (1936 Act) Regulation 2015 (Cth) Pt 8 item 19. Income from entities set up in these countries is generally attributed only if it is tainted income (broadly, if it is passive income or related party sales or services income) and has benefited from some preferential tax treatment in those countries. Income which benefits from such treatment is known as ‘eligible designation concession income’. If a country is not a listed country, then it is an unlisted country. Where the CFC fails the active income test, then the passive income and certain related party sales and services income derived by the unlisted country CFC will generally be attributed.

Under ITAA36 s 320, a CFC is a resident of a listed country if it is a resident of a foreign country that is declared by the regulations to be a listed country for the purposes of ITAA36 Pt X s 320. Currently the listed countries are the United Kingdom, the United States of America, New Zealand, Canada, France, Germany and Japan. [page 1186]

Active income exemption 18.28 Where a CFC passes the active income test in ITAA36 s 432, income that would otherwise be attributed under some provisions is exempt from the accruals legislation. The active income exemption applies only if certain conditions are satisfied. The main conditions are that: the CFC was in existence at the end of its statutory accounting period and was a resident of a listed or unlisted country at all times during the accounting period when the CFC was in existence; the CFC had at all times carried on business through a permanent establishment in its country of residence; and the CFC has a limited amount of ‘tainted’ income (passive income and certain related party sales and services income). To pass the active income test, the CFC’s ‘gross tainted turnover’ must be less than 5% of the CFC’s gross turnover. Hence, if the trading enterprise has too much passive income, it loses the active income exemption. It is important to note, however, that even if the CFC fails the active income test then, generally, where it is resident in an unlisted country only its adjusted tainted income will be attributable, and only so much of its adjusted tainted income that is eligible designated concession income will be attributable where it is resident in a listed country. In other words, even if the CFC fails the active income test, then generally its active income will not be attributable.

Attributable taxpayer 18.29 An attributable taxpayer is a taxpayer who has a minimum 10% ‘associate inclusive control interest’ in a CFC, or, where the taxpayer is one of five or fewer Australian entities that controls the CFC under the ‘de facto control’ test, has a minimum 1% associate inclusive control interest in the CFC: ITAA36 s 361. The definition ensures that if a taxpayer spreads his or her holdings to others over whom that taxpayer has control, those other interests are taken into account.

Attribution percentage 18.30 Once a determination has been made that a company is a CFC, that it has attributable income, and that there are attributable taxpayers in relation to it, the next step in the case of each attributable taxpayer is to determine the taxpayer’s attribution percentage — as the taxpayer’s attribution percentage will be the amount that is included in the taxpayer’s assessable income under ITAA36 s 456. Under s 362, an attributable taxpayer’s attribution percentage will be the sum of the taxpayer’s direct attribution interests and the taxpayer’s indirect attribution interests, in the CFC. The taxpayer’s direct attribution interests will be the greatest of the taxpayer’s percentage interest in the paid-up share capital of the CFC, percentage voting rights in relation to the CFC, and percentage rights to a distribution of profits of the CFC both within and outside a winding up. [page 1187] The taxpayer’s indirect attribution interest in the CFC will be the taxpayer’s tracing interest in an interposed entity (such as another company, partnership or trust) multiplied by the tracing interest that the interposed entity has in either the CFC or in another interposed entity. It is important to note that a taxpayer’s attribution percentage will not necessarily be the same as that taxpayer’s associate inclusive control

interest in a CFC. This is because the provisions (discussed at 18.25), which deem there to be a control tracing interest of 100% in certain circumstances, do not apply when determining a taxpayer’s attribution percentage. The calculation of the attribution percentage of a taxpayer is illustrated by Example 18.4.

Assume the facts in Example 18.3. The attribution percentage of each of Macbeth, Macduff, Banquo and Hamish in Highland Plc would be 25%. As Highland Plc owns 50% of Island Pty Ltd, the attribution percentage of each of Macbeth, Macduff, Banquo and Hamish in Island Pty Ltd will be: 25% × 50% = 12.5% As Island Pty Ltd owns 40% of Resort Pty Ltd, the attribution percentage of each of Macbeth, Macduff, Banquo and Hamish in Resort Pty Ltd will be: 25% × 50% × 40% = 5%

Relief from international double taxation 18.31 At the time that income of a CFC is attributed to Australian resident attributable taxpayers, it would not normally have been distributed as a dividend to shareholders in the CFC. Hence, it is unlikely that at the time of attribution dividend withholding tax would have been paid in respect of the amount included in the attributable taxpayer’s assessable income under the CFC rules. It is possible, however, that at, or prior to, the time of attribution the CFC might have paid foreign corporate tax on the attributable income. Where the attributable taxpayer is an Australian resident company with an attribution percentage of 10% or more, then ITAA97 s 770-135(1) treats the Australian company as having paid an amount of foreign corporate tax equal to the foreign income tax paid by the CFC in the relevant period multiplied by the Australian company’s attribution percentage. As a consequence, the Australian company will receive a foreign income tax credit in relation to the amount of foreign corporate

tax that it is deemed to have paid. The limits discussed at 18.19 will apply in calculating the amount of the foreign income tax offset. If an amount that has previously been attributed to attributable taxpayers under the CFC rules is subsequently distributed to them as a dividend, then foreign withholding tax might be payable on the dividend. Where the dividend is paid by the CFC to Australian resident attributable taxpayers, the dividend will be non-assessable [page 1188] non-exempt income under ITAA36 s 23AI. Notwithstanding, ITAA97 s 770-10(2) provides that foreign income tax paid in respect of income that is non-assessable non-exempt income under ITAA36 s 23AI counts towards your foreign income tax offset. You will recall that, under ITAA97 s 770-130, you are treated as having paid foreign income tax where withholding tax has been payable under foreign law by another entity.22 Under ITAA97 s 770-80, the foreign income tax offset limit is increased by the amount of foreign tax that counts towards the offset because of s 770-10(2). In other words, in this situation the offset limit is increased by the amount of foreign withholding tax paid on the dividend.

Summary of the main attribution rules 18.32 Figure 18.1 summarises the key steps in the main attribution rules under the CFC legislation.

Figure 18.1:

CFCs — Summary of common attribution rules

[page 1189] 18.33 Example 18.5 is a simple example of the effect of the operation of the CFC rules:

Sebastian is a resident Australian taxpayer and owns 75% of the shares in Pay Less Tax Plc, a company resident in the Cook Islands (an unlisted country). During the current tax year, the company derived A$250,000 interest income. No dividends have been paid to Sebastian during the year. Sebastian’s taxable income is $187,500 (75%* × $250,000). If a dividend of $187,500 less 15% dividend withholding tax were subsequently paid to Sebastian, then the dividend itself would be non-assessable non-exempt income but Sebastian would be entitled to a foreign income tax offset for the 15% withholding tax and his foreign income tax offset limit would be increased by the amount of the 15% foreign withholding tax. If Pay Less Tax Plc derived the income from carrying on a genuine business in the Cook Islands, Sebastian’s taxable income would be zero. This income will only be taxed if and when the dividend is remitted as this situation falls under the active income exemption. * This is Sebastian’s attribution percentage: ITAA36 s 362.

Foreign investment funds Generally 18.34 The Foreign Investment Fund (FIF) measures applied from 1 January 1993 and were contained in ITAA36 Pt XI ss 469–624. They were introduced by the Commonwealth Government as a means of stopping any tax avoidance opportunities that remained after the introduction of the CFC measures.23 The FIF legislation could be activated where a foreign company or trust, despite not being controlled by Australian residents, allowed for the accumulation of income offshore in low-tax or tax-free haven countries, thereby allowing the investor to minimise or defer the payment of Australian tax. The FIF legislation was broad in scope and included in assessable income any increase in the value of the Australian resident taxpayer’s interest in a FIF during the tax year even though no income had been remitted back to the taxpayer during the year: ITAA36 former s 469(3). The legislation contained three possible methods for determining the amount of deemed income in relation to an interest in an FIF

[page 1190] (ie, ‘FIF income’) — the market value method, the deemed rate of return method, and the calculation method: see ITAA36 former s 469(6). Finally, as the FIF rules could potentially catch all offshore interests, the legislation contained an extended list of exemptions to ensure that only certain types of income were brought to account in the FIF regime. Note that, unlike the CFC legislation, the FIF legislation did not depend on finding that Australian residents controlled the FIF in any sense. The intention of the FIF legislation was to tax Australian residents on an accruals basis on certain realised and unrealised gains of the FIF. Also, unlike the CFC legislation, the income attributed under the FIF legislation was not in terms confined to ‘tainted income’. The otherwise extensive scope of the FIF legislation was circumscribed by a lengthy list of exemptions. Following recommendations made by the Board of Taxation, the FIF rules were repealed with effect from 14 July 2010. The Gillard Government released exposure draft legislation of integrity measures which would have applied to certain noncontrolling interests in foreign accumulation funds. It appears from the media release dated 14 December 2013 by the then Assistant Treasurer, Senator Sinodinos, discussed at 18.22, that the proposed FAF provisions will not proceed.

Taxation of foreign residents Taxation of Australian source income of foreign residents on assessment basis 18.35 We saw at 2.32 and 2.41 that the general Australian jurisdictional rule is that foreign residents are only taxed on their Australian source income. The traditional Australian source rules for different types of income were discussed at 2.42–2.49. We shall see at 18.38–18.50 that tax on some types of income is levied via withholding taxes which impose obligations on payers to deduct and remit tax when

making payments to foreign residents. The effect of ITAA36 s 128D is that if income derived by a foreign resident is subject to withholding tax, then it will not be taxed on an assessment basis. However, certain types of Australian source income derived by foreign residents are taxed on an assessment basis rather than on a withholding basis. Australian source business profits of foreign residents are taxed on an assessment basis. As discussed at 18.82, Australia’s bilateral double taxation treaties (DTAs) restrict Australian source country taxation of business profits of a foreign resident to those profits which are attributable to an Australian permanent establishment of the foreign resident. No such restriction applies, however, where the profits are Australian source and the foreign resident resides in a country with which Australia does not have a DTA. Another significant type of Australian source income derived by foreign residents is income from services. In the absence of a DTA, Australia asserts the right to tax foreign residents on an assessment basis on their Australian source income from services. As noted at 18.82, Australia’s DTAs limit Australian taxation of Australian source income from services derived by foreign residents. [page 1191] 18.36 A foreign resident who derives dividend income that is attributable to an Australian permanent establishment24 of the foreign resident is also taxed on an assessment basis on that dividend income. As noted at 13.43, in these circumstances, the foreign resident satisfies the residency requirement for Australian dividend imputation purposes and is thus entitled to have any franking credit on the dividend included in assessable income and is entitled to a tax offset equal to the franking credit. In these circumstances, however, the offset is not refundable. ITAA97 s 67-25(1DA) provides that tax offsets received by foreign resident shareholders in these circumstances are not subject to the refundable tax offset rules. As discussed at 13.53 and 18.40, dividends paid to a foreign resident in these circumstances are exempt from dividend withholding tax. Where the foreign resident is a ‘corporate tax

entity’ as defined in ITAA97 s 960-115 then ITAA97 s 67-25(1C) will also mean that the refundable tax offset rules do not apply to it. In these circumstances, however, ITAA97 s 36-55 will mean that, as discussed at 13.91 and 13.92, the corporate tax entity’s excess tax offset may be converted into a tax loss. 18.37 As discussed at 2.33, capital gains and losses derived by foreign residents are disregarded where the relevant CGT event happens in relation to a CGT asset that is not ‘taxable Australian property’. In the 2013–14 Federal Budget, the Gillard Government announced that two changes would be made to the ‘principal asset test’ aspects of the definition of ‘taxable Australian property’. The first change proposed was that inter-company dealings between entities in the same consolidated group would not be taken into account in principal asset test calculations. The second change proposed was that intangible assets connected with mining, prospecting or quarrying rights would be treated as part of those rights for determining the value of the ‘taxable Australian real property’ of the foreign resident. Amendments relating to but broader than the first change previously proposed were introduced by the Tax and Superannuation Laws Amendment (2014 Measures No 4) Act (Cth), which received the Royal Assent on 16 October 2014. The Explanatory Memorandum to the Tax and Superannuation Laws Amendment (2014 Measures No 4) Bill 2014 (Cth) contains the following comments on the scope of the amendments: 3.27

Part 1 of Schedule 3 amends the law to prevent the double counting of certain non-taxable Australian real property] TARP assets that can distort the application of the Principal Asset Test.

[page 1192] 3.28 Where the assets of two or more entities are included in the Principal Asset Test, the market value of new non-TARP assets arising from certain arrangements between those entities will be disregarded for the purposes of the Principal Asset Test. 3.29 If the group has consolidated financial accounts, the asset would not be recognised because it would be offset by the existence of the liability in the other entity. The

amendments are necessary because the corresponding liability is not included in the Principal Asset Test calculations. 3.30 These amendments are broader than those announced by the previous government. In particular, the scope of the amendments is not restricted to entities that are members of the same consolidated group or [multiple entry consolidated] MEC group.

The Tax Laws Amendment (2013 Measures No 2) Act 2013 (Cth), which gave effect to a government announcement in the 2012–13 Federal Budget, received the Royal Assent on 29 June 2013. The effect of the Act is to: remove the CGT discount for capital gains accruing to foreign residents and temporary residents after 8 May 2012; preserve the CGT discount for capital gains which accrued to foreign residents and temporary residents prior to 9 May 2012; and apportion the CGT discount in situations where an individual has been a foreign resident and a foreign or temporary resident at some time during a period after 8 May 2012. In the 2013–14 Federal Budget, the Gillard Government also announced that a non-final withholding tax obligation of 10% would be imposed on foreign purchasers of certain taxable Australian property. On 8 July 2015, the Abbott Government released the Exposure Draft Tax and Superannuation Laws Amendment (2015 Measures No 5) Bill 2015: Foreign Resident Capital Gains Withholding Payments, which proposed the introduction of a non-final withholding tax in these situations. The withholding obligation became law with effect from 1 July 2016 by the Tax and Superannuation Laws Amendment (2015 Measures No 6) Act 2015 by amending the Tax Administration Act (Cth). Subject to certain exceptions, the amendments required purchasers who acquire TARP or an indirect interest in TARP or an option to acquire TARP or an indirect interest in TARP from a relevant foreign resident to pay 10% of the first element of cost base of the asset acquired to the Commissioner on or before the date of settlement. The Treasury Laws Amendment (Foreign Resident Capital Gains Withholding Payments) Act 2017 increased the

withholding rate to 12.5% and reduced the withholding threshold from $2 million to $750,000.

Withholding tax Generally 18.38 When a foreign resident taxpayer is not present in Australia’s jurisdiction, Australia cannot enforce obligations that the foreign resident has to meet his or her income tax liabilities under ITAA97 ss 65(3) and 6-10(5) or ITAA36 s 44(1)(b) without the cooperation of the foreign jurisdiction in which the taxpayer is present. [page 1193] For this reason, dividend, interest and royalty withholding tax provisions have been enacted: ITAA36 Pt III Div 11A ss 128AAA– 128R. Australia’s withholding tax legislation is similar to provisions adopted by many OECD countries. Withholding taxes typically impose obligations on payers to deduct and remit tax when making a payment to a non-resident. In addition, because of difficulties associated with auditing deduction claims made by non-residents, withholding taxes are generally levied on a gross basis. That is, no deductions are allowed in calculating the withholding tax liability. For this reason, withholding tax rates, particularly under double taxation treaties, tend to be lower than ordinary marginal rates. 18.39

Figure 18.2 outlines the essential scheme of the legislation:

Figure 18.2:

Withholding tax legislation

Where Australian source dividend, interest and/or royalty income is paid in certain circumstances to foreign resident taxpayers, the person liable to pay it is required under the legislation to withhold an amount representing the tax payable at source. The person then remits the withholding tax to the Australian Taxation Office (ATO) and the ‘net’ amount is distributed to the foreign resident taxpayer. Dividend, interest and royalty withholding taxes represent the final tax liability for that income in Australia. Under ITAA36 s 128D, dividend, interest and royalty income on which withholding tax has either been payable, or would but for certain specified exemptions have been payable, is non-assessable non-exempt income to the non-resident payee. [page 1194]

Dividends 18.40 In the case of dividends, a final withholding tax liability is imposed on dividends paid by a resident company to non-resident taxpayers under ITAA36 s 128B(1). However, withholding tax does not apply to the franked part of a dividend (or to certain dividends franked with exempting credits) unless the Commissioner determines that the paying company has streamed the dividends25 or a franking credit trading or streaming scheme has occurred: ITAA36 s 128B(3)(ga). Under ITAA97 s 976-1, the franked part of a distribution is the franking credit on the distribution multiplied by the applicable gross-up rate. The ‘applicable gross-up rate’ is the ‘corporate tax gross-up rate’ of the entity making the distribution for the income year in which the distribution is made. For the 2017–18 year of income, the corporate tax gross-up rate for companies with an aggregated turnover of less than $10m will be 72.5/27.5. For companies with an aggregated turnover of $10m or greater, the corporate tax gross-up rate will be 70/30. Hence, if a company on the 30% corporate tax rate paid a dividend of $170 with $30 of franking credits attached, the franked part of the dividend would be $30 × 70/30 = $70. In addition, under ITAA97 s 802-15, so much of the unfranked part of a frankable dividend as an Australian company declares in its distribution statement to be ‘conduit foreign income’ is non-assessable non-exempt income of a foreign resident and is an amount to which the dividend withholding tax provisions in ITAA36 s 128B do not apply. If an Australian resident company receives a dividend from another Australian resident company that is declared to be conduit foreign income and redistributes that dividend to a foreign shareholder, then all or a part of the unfranked portion of the dividend received is nonassessable non-exempt income to the recipient Australian resident company. The amount that is non-assessable non-exempt income to the recipient company in these circumstances increases to the extent that the recipient company redistributes the dividend and declares it to be conduit foreign income. Hence, the whole of the unfranked portion of a dividend received will be non-assessable non-exempt income to the recipient company where it is wholly conduit foreign income and the

whole of the dividend is redistributed as conduit foreign income. In broad terms, conduit foreign income is income of an Australian resident company that: has benefited from either the ITAA36 s 23AH or ITAA97 Subdiv 768-A exemptions discussed earlier; has previously been attributed to the company under the foreign accruals systems; has effectively been freed from tax by the Australian foreign income tax offset rules; represents capital gains that have been reduced under the participation exemption discussed earlier in this chapter; is a distribution of conduit foreign income from another Australian company. [page 1195] The basic aim of the conduit foreign income provisions is to reduce tax barriers to the holding of non-Australian investments by foreign residents indirectly through Australian companies. As from 26 June 2005, ITAA36 s 128B(3E) exempts dividends from withholding tax where: the dividend is paid to a non-resident carrying on business in Australia at or through a permanent establishment; the dividend is attributable to the permanent establishment; and the dividend is not paid to the non-resident in that person’s capacity as a trustee. Note that dividends that are exempt from withholding tax under ITAA36 s 128B(3E) are not listed in the amounts that are deemed to be non-assessable non-exempt income under ITAA36 s 128D. Hence, a dividend paid by a resident company to the Australian permanent establishment of a non-resident will be taxed on an assessment basis and subject to the relevant tax rate applicable to nonresidents. As noted at 18.36, in these circumstances, to the extent that the dividend is

franked the foreign resident shareholder will be entitled to imputation gross up and tax offset. The tax offset will not refundable, but where the foreign resident is a corporate tax entity foreign resident will, in some circumstances, be able to convert excess tax offset into a tax loss.

an be the an

18.41 A person who derives dividend income, to which the withholding tax provisions in ITAA36 s 128B apply, is liable to pay income tax on that income at the rate declared by parliament: ITAA36 s 128B(4). The withholding tax rates as set by s 7(a) of the Income Tax (Dividends, Interest and Royalties Withholding Tax) Act 1974 (Cth) and the various Schedules of the International Tax Agreements Act 1953 (Cth) are: on the unfranked part of a dividend paid to non-resident taxpayers of countries with which Australia has a double taxation treaty (DTA), the rate varies from treaty to treaty. In most of Australia’s older treaties, the rate is 15% on all dividends. In Australia’s more recent treaties, the rate is 15% on portfolio dividends and 5% on non-portfolio (generally, shareholdings of 10% or more are regarded as ‘non-portfolio’) dividends. In some of Australia’s important DTAs, such as the US and UK treaties, the rate of withholding tax is zero on dividends paid to corporate shareholders owning 80% or more of the shares in the paying company; on the unfranked part of dividends paid to non-resident taxpayers of countries with which Australia does not have a tax treaty, a flat rate of 30% of the gross amount; and nil on the franked part of dividends.

Interest 18.42 In relation to interest under ITAA36 s 128B(2), a final tax liability is imposed on interest derived by a non-resident taxpayer, whether directly or indirectly, where the interest is paid by: [page 1196]

a resident taxpayer (except where the interest is wholly incurred by the resident as an expense of carrying on a business overseas at or through a permanent establishment); or a non-resident taxpayer and the interest is an expense wholly or partly incurred by the non-resident taxpayer in carrying on a business in Australia at or through a permanent establishment in Australia. 18.43 A person who derives interest income, to which the withholding tax provisions in ITAA36 s 128B apply, is liable to pay income tax on that income at the rate declared by parliament: ITAA36 s 128B(5). The withholding tax rates as set by s 7(b) of the Income Tax (Dividends, Interest and Royalties Withholding Tax) Act 1974 (Cth) is a flat rate of 10% of the gross amount. This rate was generally unaffected by Australia’s older DTAs but, in some of Australia’s more recent treaties (such as the treaty with France), subject to certain conditions, a zero rate can apply to interest paid to financial institutions. 18.44 ‘Interest’ for the purpose of the withholding tax legislation is defined to include an amount ‘in the nature of interest’: ITAA36 s 128A(1AB). Therefore, ‘interest’ in this section of the ITAA36 has its ordinary meaning: ‘Interest postulates the making of a loan and then runs from day to day until repayment of the loan, its total depending on the length of the loan’.26 Furthermore, an amount ‘in the nature of interest’ can extend beyond the ordinary meaning of ‘interest’. Generally, to be an amount ‘in the nature of interest’, there should be a debtor–creditor relationship between the parties. The amount payable by the debtor to the creditor is normally calculated by reference to the quantum of the amount outstanding and the time for which it was outstanding. Therefore, a discount fee on a bill of exchange is not interest according to ordinary concepts. However, where the acceptor to the bill provides finance to the drawer/payee — an ‘accommodation bill’ — then such an amount arguably may be in the nature of interest and subject to withholding tax under ITAA36 s 128AD. The ITAA36 s 128A(1AB) definition of interest also includes an amount: to the extent that it could reasonably be regarded as having been

converted into a form that is ‘in substitution for interest’; to the extent that it could be regarded as having been received in exchange for interest in connection with a ‘washing arrangement’; that is a dividend paid in respect of a non-equity share (non-equity shares are discussed at 12.25); paid on ‘upper tier 2 capital instruments’ issued after 21 March 2005 that are prescribed under the Regulations as debt instruments. Therefore, where a lump sum payment is made in substitution of a series of interest payments, it will, nevertheless, represent ‘interest’ for the purposes of the withholding tax provisions of the ITAA36. A ‘washing arrangement’ is a scheme under which title to a security is transferred to an Australian resident just prior to an interest payment being made where the sole or dominant purpose of the scheme is to decrease the amount of withholding tax payable by a person. [page 1197] 18.45 ITAA36 s 128B(3)(h), subject to certain exceptions that will not be discussed here, exempts from withholding tax interest derived by a non-resident taxpayer carrying on business in Australia at or through a permanent establishment. In such circumstances, the interest is liable to Australian tax under the normal assessment process if it is sourced in Australia. 18.46 Furthermore, ITAA36 s 128F provides an exemption for certain widely distributed debentures27 from withholding tax. Generally, where resident taxpayers raise funds from an overseas source, foreign lenders may pass on their Australian withholding tax liability to the resident in the form of a higher interest rate. For this reason, ITAA36 s 128F provides that no interest withholding tax is payable where the following conditions have been satisfied: the borrower company must either have been a resident both at the time of issuing the debentures and at the time the interest was

paid or, if it was a nonresident at the time of payment, the issue must have been made through a permanent establishment of the company in Australia; and the issuing of the debentures satisfies the ‘public offer test’ detailed in ITAA36 s 128F(3) or (4).

Royalties 18.47 Under ITAA36 s 128B(2B), a withholding tax liability is also extended to royalties28 derived by non-resident taxpayers during the 1993–94 or a subsequent year of income. Generally speaking, royalties derived by a non-resident taxpayer are subject to withholding tax where the royalties are: paid by a resident taxpayer (except where they are wholly incurred by the payer as an outgoing in carrying on a business outside Australia at or through a permanent establishment); or paid by a non-resident taxpayer and are expenses wholly or partly incurred by the payer in carrying on a business in Australia at or through a permanent establishment in Australia. 18.48 To curtail evasion of withholding tax on royalty income, ITAA36 s 128B(2C) ensures that, where royalties are derived by a resident carrying on a business through an overseas branch after 7.30 pm Australian Capital Territory time on 20 August 1996, they are subject to withholding tax if they are paid by: another resident and they are not wholly incurred by the payer in carrying on a business in a foreign country through a permanent establishment in that country; or a non-resident and they are wholly or partly incurred by the nonresident in carrying on a business in Australia through a permanent establishment. [page 1198] 18.49

Section 7(c) of the Income Tax (Dividends, Interest and

Royalties Withholding Tax) Act 1974 (Cth) sets the rate of withholding tax on royalties at 30% of the gross amount. However, where royalties flow to a resident of a country with which Australia has a comprehensive DTA, the rate of royalty withholding tax in the past has generally been limited to 10% of the gross amount of the royalties, but under some of Australia’s more recent treaties, such as the 2003 treaty with the United Kingdom and the 2009 treaty with New Zealand, lower rates, 5% in both of those treaties, apply.

Richmond Ltd is an Australian resident company. The following are payments by Richmond to foreign residents. See the comprehensive list of Australia’s double tax agreements (DTAs) in Study help. Payee

Type of income

Amount ($)

US resident

Unfranked non-portfolio dividend — shareholder with 20% shareholding

1000

US resident

Fully franked dividend

2000

Resident of Hong Kong

Unfranked dividend

3000

Resident of Hong Kong

Interest

4000

Resident of Hong Kong

Royalty

2000

Resident of Singapore

Royalty

5000

Resident of Singapore

Unfranked dividend

1000

The payer is required to deduct the following amounts of withholding tax: US resident, unfranked dividend — withholding tax at 5% ($1000 × 0.05 = $50) nonportfolio dividend rate under US treaty; US resident, franked dividend — no withholding tax (ITAA36 s 128B(3)(ga)); Hong Kong resident, unfranked dividend — non-tax treaty country, withholding tax at 30% ($3000 × 0.30 = $900); Hong Kong resident, interest — non-tax treaty country, withholding tax at 10% ($4000 × 0.10 = $400); [page 1199]

Hong Kong resident, royalty income — non-tax treaty country, withholding tax at 30% ($2000 × 0.30 = $600); Singapore resident, royalty income—DTA country—withholding tax at 10% ($5000 × 0.10 = $500); and Singapore resident, unfranked dividend — older DTA — withholding tax at 15% ($1000 × 0.15 = $150).

Administration 18.50 Withholding tax on payments to non-residents is administered through the Pay-As-You-Go (PAYG) withholding system in the Taxation Administration Act 1953 (Cth) (TAA) Sch 1 Subdiv 12-F. These provisions require an Australian resident company (in the case of dividends) or an entity (in the case of interest or royalties) to withhold an amount from a dividend, interest or a royalty that is either: paid to an entity with an address outside Australia; or authorised or directed to be paid at a place outside Australia. In addition, the withholding obligation applies where an entity in Australia (or an Australian government agency) receives dividends, interest or royalties which a foreign resident is or becomes entitled to receive or to have the resident entity credit it with or otherwise deal with as it directs. Under ITAA97 s 26-25, no deduction is allowable for interest or royalty payments where the withholding obligations have not been met. Under s 12-300 of TAA Sch 1, the amount withheld is not required to exceed the withholding tax payable on the payment. TAA Sch 1 Subdiv 12-F requires an Australian resident entity deriving interest through an overseas permanent establishment to notify the payer of those facts and then must immediately notify the Commissioner of the particulars of the transaction. There is no obligation to withhold where no withholding tax is payable under ITAA36 Pt III Div 11A. (The situations where no withholding tax is payable under Div 11A were discussed at 18.38–18.49.)

Star Investments Ltd, an Australian resident corporation, has declared an unfranked dividend of 50c per share for the 2013–14 tax year. It has the following shareholders: Shareholder

Country of residence

Number of shares held

William J Clinton

United States

80,000

Hamid Karzai

Afghanistan

5000

Hui Jin Tao

China

5000 [page 1200]

In addition, the company has issued a series of five-year $1000 7% debentures with annual interest payments. Mr Pierre Trudeau, a Canadian resident, holds 150 of these debentures. Note that Australia has DTAs with the United States and China but does not have a DTA with Afghanistan. The rate of dividend withholding tax in the Australia–China DTA is 15%. Required: 1. Compute the withholding tax liability (if any) for each shareholder of Star Investments Ltd. 2. Calculate the withholding tax liability (if any) for the annual interest payments.

Thin capitalisation Generally 18.51 Where multinational corporations are considering cross-border investment, the choice of the mix between debt and equity in the capital structure of the new overseas enterprise becomes a fundamental taxplanning issue. The term ‘thin capitalisation’ refers to those corporations that are financed by multinational corporations primarily by debt capital (as opposed to equity capital) in their capital structure. The tax benefits that arise from injecting debt capital instead of equity capital into an Australian corporation’s capital structure can be

illustrated by Example 18.7 (assuming that no thin capitalisation legislation exists):

Basis Gross income

Direct equity investment ($) 100

Interest paid

Direct debt investment ($) 100 (100)

Taxable income

100

Australian company tax

30

Dividend/interest distributed

70

100

Australian withholding tax

N/A*

(10)

Cash received by foreign investor

70

90

Effective Australian tax rate

30%

10% [page 1201]

*

Fully franked dividends are exempt from withholding tax: ITAA36 s 128BB(3)(ga). For companies with a turnover under A$2m, the corporate rate has been reduced to 28.5% as from 1 July 2015. For other companies, the corporate rate remains at 30%. In this and the following examples in this chapter, the corporate rate applied is 30%.

18.52 This example shows that without any specific thin capitalisation rules, there is a bias towards including as much debt as possible in the capital structure of the subsidiary corporation. That is, the effective Australian tax rate (10%) on the gross income for direct debt investment by the multinational corporation is much less than the effective Australian tax rate for direct equity investment (30%)that applies to companies with an aggregated turnover of $10m or more. By adopting a high debt-to-equity ratio, a corporation is able to pay out a large proportion of its operating profits, in effect, as tax deductible interest rather than as dividends. This treatment provides taxpayers

with an incentive to gear their foreign operations highly, leading to a loss of national tax revenue for the country involved and a distortion in the way in which investment is financed. Taxation authorities throughout the world, including the ATO, have become increasingly aware of the prospect of multinational corporations minimising their exposure to national taxes by applying thin capitalisation strategies and, as a consequence, have acted by introducing specific anti-tax avoidance rules. Note, that Australia’s dividend imputation system means that generally there is no bias in favour of debt over equity in the case of investments by Australian residents in Australian companies. The existence of the bias when there is investment by foreign residents in Australian companies is largely the product of the fact that Australia does not extend refundable franking credits to foreign resident shareholders. 18.53 Prior to the BEPS project, the OECD29 had emphasised two approaches (or a combination of the two) which were commonly utilised to reduce the benefits attached to thin capitalisation: 1. the ‘arm’s length’ approach (under which analysis is made of all the surrounding facts and circumstances, in order to determine the inherent nature of the provision of debt or equity funds. In essence, the question is whether or not an unrelated party would have advanced debt funds on the same basis as the related party loan arrangement. If not, the arrangement may be deemed to be a disguised equity contribution); or 2. the ‘fixed ratio’ approach (under this approach, if a specified debtto-equity ratio is exceeded, the excess interest expense may be disallowed). At present, Australia has adopted a combination of the two OECD approaches as its taxation policy to combat thin capitalisation in practice. [page 1202]

Australia’s response to the OECD BEPS Reports on interest deductibility 18.54 The OECD’s BEPS Final Reports indicated a preference for an earnings stripping rule under which an entity’s net actual interest expense deduction would be capped at between 10 to 30% of its Earnings Before Interest Tax Depreciation and Amortisation (EBITDA) but allowed for the use of a debt to assets ratio in certain circumstances.30 The BEPS Final Reports also acknowledged the appropriateness of a worldwide gearing safe harbour and of the need to have targeted anti-abuse rules. The Treasurer’s Media Release of 6 October 2015, which stated that Australia had already tightened its thin capitalisation rules, appears to indicate that the government does not intend to amend the thin capitalisation rules in response to the BEPS Final Recommendations.

Which of the two OECD approaches aimed at reducing the benefits attached to thin capitalisation is the fairest and most objective approach? Which approach is likely to be the most administratively feasible? Critically discuss.

The current Australian legislation 18.55 Australia’s current thin capitalisation regime contained in ITAA97 Div 820 has three significant distinctive features: 1. it applies to the Australian operations of both inbound and outbound investors; and 2. it limits the deductions relating to the total debt of the Australian operations of those investors, instead of the foreign debt only; and 3. it takes into account total debt not just related party debt.

Main elements of the legislation

18.56 There are four main elements of ITAA97 Div 820 that help to guide an entity in deciding whether the thin capitalisation rules apply and, if so, which particular rules apply. The four main elements are: 1. the de minimis rule; 2. whether the entity is an Australian or foreign multinational; 3. whether the entity is an authorised deposit-taking institution (ADI) or a non-ADI; and 4. whether the entity is a general entity or a financial entity. [page 1203]

The de minimis rule? 18.57 The thin capitalisation de minimis rule is intended to eliminate the need for particular entities to act in accordance with ITAA97 Div 820. Up to 30 June 2014, all entities (regardless of their nature or business) that either alone or together with associate entities claim no more than $250,000 in debt deductions per income year are not subject to the thin capitalisation regime: ITAA97 s 820-35.31 As from 1 July 2014, the de minimis threshold has been increased to $2m of debt deductions to reduce compliance costs for small business.

Australian or foreign multinational entity? 18.58 Subject to the de minimis exception in ITAA97 s 820-35, Australian entities that are either foreign controlled, or are themselves controllers of foreign entities, their associate entities and foreign entities with operations or investments in Australia are subject to Australia’s thin capitalisation regime. Entities are classified as being either inward investing entities or outward investing entities: an inward investing entity is a foreign-controlled Australian resident entity, and any foreign entity that carries on business at or through an Australian permanent establishment, or has direct investments within Australia; and an outward investing entity is an Australian resident entity that

controls any foreign entity or carries on business at or through an overseas permanent establishment, and an Australian associate entity of another outward investor. If an entity is neither an inward investing entity nor an outward investing entity, it will not be subject to ITAA97 Div 820. Wide-ranging control rules, based on the control rules in the CFC provisions of the ITAA36, decide if an Australian entity is an outward investor or not. Generally, this will be the case where the entity is an Australian controller or an Australian associate entity of an Australian controller. The same rules also determine whether an Australian entity is foreign controlled or not.

ADI or non-ADI? 18.59 After determining that an entity is either an inward investing entity or an outward investing entity, and therefore subject to ITAA97 Div 820, it is also necessary to find out if that entity is an Australian deposit-taking institution (ADI). An ADI entity is subject to a minimum capital requirement similar to capital requirements imposed by regulatory agencies, such as the Australian Prudential Regulation Authority. If an entity is a non-ADI entity, it will be subject to a maximum amount of debt based on a safe harbour gearing ratio, an arm’s length debt amount, or, in the case of outward investing entities only, a worldwide gearing debt test. [page 1204]

General entity or a financial entity? 18.60 A non-ADI entity is further classified as being either a financial entity or a general entity. A general entity is any entity that is neither a financial entity nor an ADI. This classification is required because special rules apply to financial entities. These rules recognise that financial entities have unique requirements for debt funding. 18.61

We will now briefly consider the operation of the thin

capitalisation regime as it applies to both outward and inward investing non-ADI entities.

Thin capitalisation regime for outward investing entities (non-ADIs) 18.62 The thin capitalisation rules in ITAA97 Subdiv 820-B for outward investing non-ADI entities are intended to prevent excessive debt deductions being claimed by Australian investors. The maximum allowable debt amount is calculated on the basis of the greatest of three amounts determined according to one of the following tests: Safe harbour debt test: Up to 30 June 2014, the maximum ‘safe harbour’ debt-to-assets ratio allowed under the rules was 3:1. As financial entities onlend substantial amounts of debt in the normal course of business, they were allowed a debt-to-assets ratio of up to 20:1 under the rules. Moreover, in certain circumstances, a ratio above 20:1 could be permitted for non-bank financial entities where they hold a specific class of assets. As from 1 July 2014, the safe harbour debt ratio for general entities has been reduced to 1.5:1; and for non-bank financial entities, the ratio has been reduced to 15:1. Arm’s length debt test: The arm’s length debt amount is determined by carrying out a study, based on factors and assumptions specified in the legislation, of the entity’s funding and other activities to ascertain a notional debt amount that signifies what would reasonably be expected to have been the entity’s maximum debt funding during the period. Worldwide gearing debt test: Up to 30 June 2014, this test allowed an Australian entity with foreign investments to fund its Australian investments with gearing up to 120% of the gearing of the worldwide group that it controls. But this test is not available if the Australian entity is itself controlled by foreign entities. As from 1 July 2014, the gearing ratio has been reduced to 100% but the worldwide gearing test would be extended to inward investing entities.

Where the Australian entity is found to have an excess of debt over and above the maximum allowable debt calculated on the basis of the three above-mentioned tests, there is a proportionate reduction in the amount of interest expense that can be claimed as a tax deduction against any of the Australian entity’s assessable income. ITAA97 s 25-90 allows an Australian entity to deduct interest incurred in deriving foreign source from its assessable income notwithstanding that the foreign source income is non-assessable nonexempt income because of the operation of ITAA36 s 23AK or s 23AI and ITAA97 Subdiv 768-A. 18.63 An example of the operation of ITAA97 Subdiv 820-B for outward investing non-ADI entities follows. Example 18.8 demonstrates the complexity of the thin capitalisation rules for Australian business entities. [page 1205]

Aussie Wool Manufacturers Ltd is an Australian resident company that has a wholly owned subsidiary in England called Aussie Wool Knits UK Ltd. Aussie Wool Manufacturers’ balance sheet (expressed in Australian dollars) as at 30 June 2017 is as follows: Assets

$m

Liabilities/equity

$m

Investment in Aussie Wool Knits UK Ltd

2.0

Issued capital

1.8

Land and buildings

3.0

Bank loan (@ 12% pa)

2.8

Other Australian assets

1.0

Other liabilities (non-debt)

1.4

Total assets

6.0

Total liabilities/equity

6.0

Regarding Aussie Wool Knits UK Ltd, it has an A$1m of bank debt represented in its own balance sheet. Aussie Wool Manufacturers needs to determine whether it will be denied all or a portion of its debt deduction as a consequence of the application of the thin capitalisation rules under ITAA97 Subdiv 820 B for the 2016–17 tax year.

Introductory steps: Aussie Wool Manufacturers has debt deductions, being interest payable at 12% pa on the bank loan. This is calculated as $336,000. Aussie Wool Manufacturers falls within the ITAA97 Subdiv 820-B thin capitalisation rules as it represents an Australian controller of an Australian controlled foreign entity (ie, Aussie Wool Knits UK Ltd) for the whole tax year, and it is not a financial entity or an authorised deposit-taking institution for all of the tax year. Final steps: Calculate Aussie Wool Manufacturers’ adjusted average debt for the 2016–17 tax year in accordance with the s 820-85(3) method statement. If Aussie Wool Manufacturers’ loan of $2.8m was stable during the 2016–17 tax year, its adjusted average debt for this period would just be $2.8m. This seems to be the case as Aussie Wool Manufacturers does not have any controlled foreign entity debt as Aussie Wool Knits UK Ltd does not have any intercompany debt due and payable to Aussie Wool Manufacturers. Calculate Aussie Wool Manufacturers’ safe harbour debt for the 2016–17 tax year in accordance with the ITAA97 s 820-95 method statement. [page 1206] This will be $1.56m (ie, $6m – $2m – $1.4m = $2.6m × 60%). Calculate Aussie Wool Manufacturers’ arm’s length debt for the 2016–17 tax year in accordance with ITAA97 s 820-105. This signifies the maximum amount of taxdeductible debt that Aussie Wool Manufacturers could reasonably be expected to have borrowed from commercial lending institutions, paying attention to particular assumptions and factors. Most likely, this should be less than $1.95m on an asset base of $6m. Thus, assume Aussie Wool Manufacturers’ arm’s length debt is $1.4m after applying ITAA97 s 820-105. Calculate Aussie Wool Manufacturers’ worldwide gearing debt for the 2016–17 tax year on the basis of the ITAA97 s 820-110(1) method statement. This will be $1.864m (ie, $3.8m/$1.8m = $2.11m). Then, $2.11m × 100% = $2.11m + $1m = $3.11m. Then, $2.112m/$3.11m = 0.6784565. Then, 0.6784565 × $2.6m (ie, step 6 in s 820-95 method statement) = $1.7640m). As Aussie Wool Manufacturers’ safe harbour debt is greater than its worldwide gearing debt, its safe harbour debt will be its maximum allowable debt. Compare Aussie Wool Manufacturers’ adjusted average debt (ie, $2.8m) with its maximum allowable debt (ie, $1.56m). If the adjusted average debt exceeds the maximum allowable debt, the excess will be disallowed: ITAA97 s 820-115. Calculate the disallowed amount of debt for the 2016–17 tax year in accordance with ITAA97 s 820-115. The amount of Aussie Wool Manufacturers’ interest expense that is disallowed is calculated according to the following formula: Debt deduction × (Excess debt/Average debt)

Hence, $336,000 × ($1,240,000/$2,800,000) = $148,799.99 Accordingly, after applying the thin capitalisation rules in ITAA97 Subdiv 820-B to Aussie Wool Manufacturers’ balance sheet for the 2016–17 tax year, the taxpayer will be allowed an interest deduction of only $187,200 (ie, $336,000 – $148,799.99).

Thin capitalisation regime for inward investing entities (non-ADIs) 18.64 The thin capitalisation rules in ITAA97 Subdiv 820-C for inward investing non-ADI entities are intended to prevent excessive debt deductions being claimed by foreign investors. These particular rules function in a similar manner to those discussed above in relation to outward investing non-ADI entities. Specifically, for [page 1207] foreign entities investing in Australia, the maximum amount of debt will be the greater amount determined under the: safe harbour debt test; or arm’s length debt test. Up to 30 June 2014, amount of debt used to finance the Australian investments was treated as being excessive when it was greater than that which is permitted by the safe harbour gearing limit of 3:1. As from 1 July 2014, the ratio for general entities has been reduced to 1.5:1. For financial entities, the safe harbour gearing ratio of 3:1 applied to their non-lending business up to 30 June 2014. An on-lending rule operates to eliminate from the calculations any debt that is on-lent to third parties or that is used for comparable financing activities. The application of this on-lending rule was limited by a further safe harbour gearing ratio of 20:1, which related to the financial entity’s total business. As from 1 July 2014, the ratio for financial entities has been reduced to 1.5:1. There are also special rules that result in higher

allowable gearing ratios for financial entities that have assets which are allowed to be fully debt funded. The arm’s length debt amount is determined by conducting an analysis of the entity’s funding and activities to determine a notional amount that represents what would reasonably be expected to have been the entity’s maximum debt funding of its Australian business during the period. In order to do this, it is assumed that the entity’s Australian operations are independent from any other operations that the entity or its associates had during the period, and that they had been financed on arm’s length terms. As from 1 July 2014, the worldwide gearing test has been extended to inward investing entities but the gearing ratio has been reduced to 100%. Where the foreign entity is found to have an excess of debt over and above the maximum allowable debt computed on the basis of the two above-mentioned tests on its Australian investments, then there is a balanced reduction in the amount of interest expense that can be claimed as a tax deduction against any of the Australian investments’ assessable income.

Wang Electronics Ltd is a Hong Kong incorporated company that has a wholly owned subsidiary carrying on business in Australia called Wang Electronics (Australia) Pty Ltd. Wang Electronics (Australia) Pty Ltd’s balance sheet (expressed in Australian dollars) as at 30 June 2017 is as follows: Assets

$m

Liabilities/equity

$m

Current assets

4.0

Issued capital

1.0

Land and buildings

5.0

Bank loan (@ 10% pa)

7.0

Other non-current assets

1.0

Other liabilities (non-debt)

2.0

Total assets

10.0

Total liabilities/equity

10.0 [page 1208]

Regarding Wang Electronics Ltd, it has no bank debt represented in its own balance

sheet. Required: Determine whether Wang Electronics (Australia) Pty Ltd will be denied all or a portion of its debt deduction as a consequence of the application of the thin capitalisation rules under ITAA97 Subdiv 820-C for the 2016–17 tax year.

Relevance of debt/equity rules to the thin capitalisation regime 18.65 Finally, in order for the thin capitalisation regime appearing in ITAA97 Div 820 to function effectively in practice, an appropriate distinction must be made between debt and equity. For this purpose, debt and equity are described under ITAA97 Div 974 as follows: Debt interests are those where there is an effectively noncontingent obligation on the part of the issuing company to return an amount at least equal to the issue price. If the term of the interest is 10 years or less, this issue price must be measured in nominal value terms; if not, it is measured in present value terms. Equity includes shares, interests that provide returns contingent upon the performance of a company and interests that may well convert to such interests or shares. If something is a debt interest, it is not treated as equity.

Why do you think that it is important to be able to make the distinction between debt and equity for thin capitalisation purposes?

Transfer pricing Generally 18.66

Transfer pricing encompasses the flow of goods or services

between a subsidiary of a multinational corporation in one country and the parent company in another country. It can also occur between an unincorporated branch office in one country and the head office in another. If the parent corporation provides goods or services to the subsidiary corporation at an inflated price, the price represents a notional payment from the subsidiary to the parent to the extent of the difference. On the other hand, if goods or services are sold to the subsidiary at a fallaciously low price, the transaction will represent a notional payment from the parent to the subsidiary. The price paid for the goods or services is a deductible expense for the purchaser and part of the assessable income of the vendor. [page 1209] Therefore, in the absence of any anti-avoidance legislation, transfer pricing could be used by multinational corporations as a means of tax avoidance by siphoning off profits from a subsidiary corporation in high-tax countries to other members of the corporate group in low-tax countries. 18.67 Another form which transfer pricing may take is the giving of low-interest or interest-free loans by one member of a multinational group to another located in a different country. To the extent to which the interest paid is less (more) than the commercial (ie, arm’s length) rate that would be offered to a borrower which is not a member of the group, the interest represents a payment from the lender (borrower) to the borrower (lender).

ABC Ltd is an Australian corporation and it has a taxable income (before interest expense)

of $5m. It has a subsidiary in the Bahamas, which has lent it $5m. What rate of interest should the subsidiary charge? If it charges 10% interest ($500,000), what is the effect on taxable income? Taxable income reduces to $4.5m. What if it charges 100% interest ($5m)? Taxable income is reduced to zero. The consequence? Withholding tax is payable at 10% on the $5m interest paid. Instead of paying $1.5m company tax ($5m × 30%), the group pays $0.5m withholding tax ($5m × 10%), a saving of $1m ($1.5m – $0.5m). Why not cut out all Australian tax? This can be achieved by pricing some other service which does not attract withholding tax. Why not charge $5m for insurance, management fees, marketing services, or research and development?

What is meant by the term ‘transfer pricing’ and how can it be used to avoid tax? Give some examples in your answer.

[page 1210]

The current Australian legislation 18.68 In 1982, Australia introduced legislation dealing with transfer pricing into the ITAA36. Specifically, ITAA36 Pt III Div 13 ss 136AA– 136AF required related party international transactions to be valued at arm’s length prices. Australia’s transfer pricing rules were then amended following the decision of the Full Federal Court in SNF (Australia) 2011 ATC 20-265 (discussed at 18.72). 18.69 As an interim measure, the Tax Laws Amendment (CrossBorder Transfer Pricing) Act (No 1) 2012 (Cth) introduced new Subdiv 815-A into the ITAA97, which operated concurrently with ITAA 1936

Div 13 where an entity received a transfer pricing benefit, and an international tax agreement (ie, a bilateral taxation treaty between Australia and another country) that contains an associated enterprises article or a business profits article (as the case may be) applies to the entity. 18.70 New provisions on transfer pricing were introduced into the ITAA97 by the Tax Laws Amendment (Countering Tax Avoidance and Multinational Profit Shifting) Act 2013 (Cth). Division 13 was repealed and Subdiv 815-A ceased to have effect.32 Currently, ITAA97 Subdivs 815-B (transfer pricing between separate entities) and 815-C (transfer pricing between a permanent establishment and the rest of a single entity) are the relevant transfer pricing provisions in Australian domestic law that apply in both treaty and non-treaty situations. These rules apply from the year commencing 1 July 2013. Under ITAA97 s 815-115(1),33 if an entity obtains a ‘transfer pricing benefit’ from conditions that operate between the entity and another entity in connection with their commercial or financial relations, then, instead of those conditions operating, ‘arm’s length conditions’ are taken to operate for the purposes of s 815-115(2). Under s 815-120(1), an entity is regarded as obtaining a ‘transfer pricing benefit’ from so operating where: (a) the conditions differ from arm’s length conditions; (b) the actual conditions satisfy the ‘cross border test’; and (c) if arm’s length conditions had operated instead of the actual conditions, then either: (i)

the amount of the entity’s taxable income would be greater;

(ii) the amount of the entity’s loss of a particular sort for an income year would be less; (iii) the amount of the entity’s tax offsets for an income year would be less; or (iv) the amount of the withholding tax payable in respect of interest or royalties by the entity would be greater.

18.71 A table in s 815-120(3) explains when the actual conditions satisfy the ‘cross border’ test. Examples of conditions which appear to be regarded as ‘cross border conditions’ include: (a) an Australian entity selling to a foreign resident entity which does not have an Australian permanent establishment;

[page 1211] (b) an Australian resident entity purchasing from a foreign entity which does not have an Australian permanent establishment; (c) an Australian resident entity selling through its foreign permanent establishment to an Australian resident entity; (d) an Australian resident entity purchasing through its foreign permanent establishment from an Australian resident entity; (e) an Australian resident entity selling through its foreign permanent establishment to a foreign resident entity which does not have an Australian permanent establishment; (f) an Australian resident entity purchasing through its foreign permanent establishment from a foreign resident entity which does not have an Australian permanent establishment; (g) a foreign resident entity without an Australian permanent establishment selling to a foreign resident entity which has an Australian permanent establishment; (h) a foreign resident entity without an Australian permanent establishment selling to a foreign resident entity which does not have an Australian permanent establishment. In situations such as (g) and (h), which only involve foreign entities, there will only be transfer pricing benefit if there is some connection with Australia. For example, if it is alleged in situation (g) that there is a transfer pricing benefit because under arm’s length conditions the selling entity’s price would have been higher, there will only be a transfer pricing benefit if the profit on the sale would have had an Australian source.

Meaning of arm’s length conditions 18.72 ITAA97 s 815-125(1) provides that arm’s length conditions are the conditions that might be expected to operate between independent entities dealing wholly independently with each other in comparable circumstances. As the hypothetical parties must be independent entities

and deal with each other ‘wholly independently’, it would seem that if there is a relationship between the parties in the actual circumstances, that relationship cannot be a feature of the ‘comparable circumstances’. In identifying comparable circumstances, s 815-125(3) requires that all relevant factors, including the following, must be taken into account: (a) (b) (c) (d) (e)

the functions performed, assets used and risks borne by the entity; the characteristics of any property or services transferred; the terms of any relevant contracts between the parties; the economic circumstances; the business strategies of the entities.

[page 1212] Circumstances will still be regarded as comparable if differences from actual circumstances either do not materially affect a condition (eg, a price) or if a reasonably accurate estimate can be made to eliminate the effect of the difference on a condition that is relevant to the method for determining arm’s length conditions. The biggest practical problem associated with applying transfer pricing rules is determining appropriate arm’s length conditions, such as price. In identifying arm’s length conditions, s 815-125(2) requires the use of the method, or the combination of methods, that is the most appropriate and reliable having regard to all relevant factors. The subsection states that the factors to be taken into account are to include: (a) the respective strengths and weaknesses of possible methods when applied to the actual conditions; (b) the circumstances, functions performed, assets used, and risks borne by the entities; (c) the availability of reliable information needed to apply a particular method; (d) the degree of comparability between the actual circumstances and the comparable circumstances including the reliability of adjustments to eliminate material differences.

The identification of arm’s length is required by s 815-130 to be based on the commercial and financial relations in which the actual conditions (such as price) operate having regard to both the substance and form of those relations. Where the form of relations is inconsistent with their substance, the form is to be disregarded. Section 815-135 provides that the identification of arm’s length conditions (such as price) should be done in a way which best achieves consistency with: (a) the OECD Transfer Pricing Guidelines (except those that are expressly excluded by the Regulations); and (b) a document or part of a document prescribed by the Regulations. The Treasury Laws Amendment (Combating Multinational Tax Avoidance) Act 2017 added the requirement that the identification of arm’s length conditions should be done in a way that best achieves consistency with: (aa) the Aligning Transfer Pricing Outcomes with Value Creation, Actions 8-10 – 2015 Final Reports, of the Organisation for Economic Cooperation and Development, published on 5 October 2015. The Commissioner issued a number of lengthy and detailed public rulings in relation to ascertaining arm’s length price under the former Div 13 of ITAA36.34 The rulings discussed appropriate pricing methodologies [page 1213] based on the concept of comparability, which is consistent with the OECD Transfer Pricing Guidelines.35 Acceptable transfer pricing methodologies identified in these rulings are as follows, in Table 18.1. Table 18.1: Transfer pricing methodologies Method Comparable uncontrolled price method*

Description of method This method compares the price for property or services transferred in a controlled transaction to the price charged for property or services transferred in a comparable uncontrolled transaction in comparable circumstances. Put simply, it compares prices charged in an open market with the prices charged within a multinational group.

Resale price method*

This method attempts to test the price paid by the taxpayer for property or services supplied by a related party which is subsequently on-sold to an independent entity by deducting from the sales price an appropriate gross margin.

Cost plus method*

This method determines the arm’s length price of a related party transaction by adding an appropriate gross margin to the costs incurred by the seller. This method is most appropriate for the sale of immediate products within a multinational group and the provision of services.

Profit split method**

This method ensures that the profits are split between the related parties based on the value contributed by each party. The profit that is split may be either the ‘combined profit’ of the enterprise or the ‘residual profit’ (which is represented as the combined profit less the amount of profit that can be readily attributed to either of the parties).

Transactional net margin method**

This method applies the resale price method and the cost plus method by using the net margin instead of the gross margin. It examines the net profit margin relative to an appropriate base (eg, costs, sales and assets) that a taxpayer realises from a controlled transaction or from transactions it is appropriate to combine.

* Traditional transaction-based method. ** Non-traditional profit-based method.

[page 1214] The Full Federal Court in FCT v SNF (Australia) Pty Ltd 2011 ATC 20-265; [2011] FCAFC 74; BC201103571 rejected the Commissioner’s submission that one of the independent parties referred to in the ITAA36 s 136AA(3)(d) definition of arm’s length consideration was required to be the taxpayer in question. Rather, what was required, as the trial judge Middleton J had found (SNF (Australia) Pty Ltd v FCT [2010] FCA 635; BC201004320 at [44]), was: … to find truly comparable transactions involving the acquisition of the same or sufficiently similar products in the same or sufficiently similar circumstances, where those transactions are undertaken at arm’s length, or if not taken at arm’s length, where suitable adjustments can be made to determine the arm’s length consideration that would have taken place if the acquisition was at arm’s length.

1. 2.

Why do you think the OECD chooses arm’s length pricing as a means of combating tax avoidance practices? FCT v SNF (Australia) Pty Ltd was decided under ITAA36 Pt III Div 13. Discuss whether the point made by Middleton J in the passage quoted above would still have been appropriate under ITAA97 Div 815.

Modifications for thin capitalisation 18.73 Where Australia’s thin capitalisation rules (discussed at 18.51–18.65) apply to an entity and arm’s length conditions affect interest deductions of the entity, then ITAA97 s 815-140 provides that the arm’s length interest rate as determined under Div 815 is used for thin capitalisation purposes but is applied to the actual borrowing.

Consequential adjustments 18.74 Where ITAA97 s 815-115 (discussed at 18.70) means that arm’s length conditions (such as price) are taken to operate, the Commissioner may make consequential adjustments in favour of disadvantaged entities that can: reduce their taxable income; increase their losses of a particular sort; increase their tax offsets; or reduce their withholding tax payable in respect of interest or royalties.

Documentation requirements 18.75 Under Sch 1 Subdiv 284-E of the Taxation Administration Act 1953 (Cth) (TAA), if an entity does not meet the documentation requirements which support the particular way in which it has applied the transfer pricing provision in the ITAA97, then TAA Sch 1 Div 284 applies to the entity as if the matter was not reasonably arguable. This will affect the penalty provisions that apply to the entity if it is subsequently found that the way the entity has applied the transfer

pricing provisions has not complied with a relevant subdivision in ITAA97 Div 815. [page 1215]

1. 2.

Can you think of any non-tax reasons why a company may engage in transfer pricing? Do you think it is appropriate for penalty provisions to apply in these situations?

Tax avoidance penalties 18.76 The Commissioner may decide to impose an administrative penalty where the entity is liable for additional tax as a result of an amended assessment under the transfer pricing provisions: TAA Sch 1 s 284-160. The rate of administrative penalty where the taxpayer has a dominant tax avoidance purpose is as follows (s 284-160(a)): 50% of the tax avoided; or 25% if the taxpayer has a ‘reasonably arguable’ position. Of course, the rate of penalty tax is reduced where the taxpayer does not have a dominant tax avoidance purpose. Specifically, in this situation the penalty is 25% of the tax avoided, which is reduced to 10% where the taxpayer has a reasonably arguable position: TAA Sch 1 s 284-160(b).

Advance pricing arrangements 18.77 To provide taxpayers with some semblance of legal certainty with regards to transfer pricing, they can apply for an advance pricing arrangement (APA) on the issue. An APA represents an agreement between the Commissioner and the

taxpayer (and a foreign tax authority, where appropriate), which sets out approved transfer pricing methodologies that can be used to determine arm’s length prices. Of course, the APA should conform to the arm’s length principles discussed at 18.68–18.72, the various income public rulings on the matter and, finally, Australia’s DTAs.

Australia’s responses to the OECD BEPS actions on transfer pricing 18.78 Part of the Final Reports on the OECD’s BEPS Action Plan on Actions 8 to 10 (the actions relevant to transfer pricing) involve changes to the OECD’s Transfer Pricing Guidelines. Significant changes have been made to the Guidelines in relation to intangibles, low-value intragroup services, and cost contributions arrangements. The changes to the Guidelines are aimed at ensuring that the result of transfer pricing analysis reflects economic substance. The Treasurer’s Media Release of 7 October 2015 stated that there would be ‘No fundamental change to Australia’s transfer pricing rules, but enhanced guidance to help ATO’s administration’. In the 2016 Budget [page 1216] papers, the government announced that Australian regulations would be amended to give effect to the changes to the Guidelines.36 As noted at 18.72, the Treasury Laws Amendment (Combating Multinational Tax Avoidance) Act 2017 added the requirement that the identification of arm’s length conditions should be done in a way that best achieves consistency with: (aa) the Aligning Transfer Pricing Outcomes with Value Creation, Actions 8-10 – 2015 Final Reports, of the Organisation for Economic Cooperation and Development, published on 5 October 2015.

18.79 In response to OECD BEPS Action 13, the Tax Laws Amendment (Combating Multinational Tax Avoidance) Act2015 (Cth) inserted ITAA97 Div 815-E, which imposes ‘country by country’ reporting requirements on ‘significant global entities’. Division 815-E requires Australian resident entities and foreign entities with an Australian permanent establishment with annual global revenue of A$1bn or greater to provide the Commissioner of Taxation with: (a) a master file providing an overview of the multinational group’s business; (b) a local file containing information about transactions between the reporting entity and its associated enterprises in other countries; and (c) a country-by-country (CbC) report containing information concerning the global allocation of the multinational enterprise’s income and taxes paid along with information concerning the location of economic activity within the multinational group.

Double taxation agreements Generally 18.80 A double taxation agreement (DTA) or treaty represents an arrangement between Australia and a foreign country relating to the taxation treatment of certain income or gains flowing between the two countries. Traditionally, the dual aims of DTAs have been expressed in their preambles as follows: the avoidance of double taxation; and the prevention of fiscal evasion. The 2015 OECD Final Report on Action 6 Preventing the Granting of Treaty Benefits in Inappropriate Circumstances changed the preamble to the OECD Model to read: (State A) and (State B), Desiring to further develop their economic relationship and to enhance their cooperation in tax matters, Intending to conclude a Convention for the elimination of double taxation with respect to taxes on income and on capital without creating opportunities for non-taxation or reduced taxation through tax evasion or avoidance (including through treaty-shopping arrangements aimed at obtaining reliefs provided in this Convention for the indirect benefit of residents of third States).37

Virtually identical language was used in the preamble to Australia’s most recent DTA signed with Germany in November 2015 and it is likely that the preamble to future Australian DTAs will contain similar language. [page 1217] International juridical double taxation arises where two countries tax the same taxpayer on the same income. There are three common causes of international juridical double taxation. These are: 1. Residence–source conflicts: These occur where the residence country taxes its residents on their worldwide income while the source country taxes a non-resident on the same income on the basis that it was sourced within its jurisdiction. 2. Conflicts of source rules: These occur where both countries regard income as being sourced within their jurisdiction and tax the same non-resident on the same income on that basis. 3. Dual residence: This is where each country regards a taxpayer as being a resident of that country and taxes the resident on his or her worldwide income on that basis. We have seen earlier in this chapter that Australian tax legislation contains unilateral measures (provisions that deem certain income to be non-assessable non-exempt income and the foreign income tax offset system) which prevent some forms of international juridical double taxation. The tax systems of many countries around the world also contain provisions which unilaterally prevent at least some forms of international juridical double taxation. Given this fact, you might wonder whether DTAs are really necessary to prevent international double taxation and why countries continue to enter into them. Part of the reason is that the international double taxation that arises due to dual residence can be prevented only through DTAs. Also, the international juridical double taxation that arises through a conflict of source rules is not prevented by unilateral measures similar to those that Australia uses as they depend on concluding that the income was not

Australian sourced before they give relief. In addition, entering into a DTA with another country is the only way that Australia can ensure that the other country’s unilateral measures for relieving international juridical double taxation will remain in place at least for the duration of the treaty. There are other reasons why a country like Australia enters into DTAs. A major reason is often to provide a more favourable taxation environment for inbound investors into Australia. We have seen already in this chapter that one thing that DTAs do is reduce withholding taxes imposed by the source country on dividends, interest and royalties. Such reductions can benefit a foreign investor into a country provided the foreign investor’s home country either uses an exemption system to prevent international juridical double taxation or, where the home country uses a foreign tax credit system, if the foreign investor already has excess foreign tax credits in the investor’s home country. The means that DTAs adopt to resolve the various types of international juridical double taxation are as follows: Residence–source conflicts: DTAs resolve these conflicts by what amounts to an element of sacrifice by both parties in that they typically limit the taxing rights of the source country and, at the same time, require that the residence country relieve international double taxation through either a foreign tax credit or by exempting foreign source income. Here, it should be noted that all of [page 1218] Australia’s DTAs require Australia to give a foreign tax credit for income that has been taxed in the source country. Notwithstanding these requirements, the ATO regards Australia’s current mix of unilateral measures (discussed earlier in this chapter) as fulfilling these treaty requirements and being consistent with international practice. Conflict of source rules: DTAs may give one jurisdiction the

exclusive right to tax certain types of income or may contain source rules that, for purposes of the treaty, deem certain types of income to be sourced in one only of the countries. Dual residence: DTAs often (but not always) contain ‘tiebreaker’ provisions that aim to ensure that a taxpayer is regarded as a resident of one only of the countries for purposes of the treaty. DTAs promote the prevention of fiscal evasion by establishing exchange of information and, more recently, by assistance in collection arrangements between the ATO and overseas taxation authorities.38 18.81 Australia has concluded over 40 comprehensive DTAs with developed and developing nations, including Canada, China, France, Germany, Japan, Malaysia, New Zealand, Switzerland, the United Kingdom, the United States and Vietnam. These are usually largely based on the OECD Model Tax Convention.39 The influence of the United Nations’ Model Double Taxation Convention between Developed and Developing Countries, which generally gives greater taxing rights to a capital importing source state, can be seen in DTAs that Australia has entered into with developing countries. Countries with which Australia has concluded a DTA appear in Study help. Australia’s DTAs are given the force of law in Australia by the International Tax Agreements Act 1953 (Cth) (the Agreements Act). An important provision of the Agreements Act is s 4. In essence, this section provides that ‘the Assessment Act is incorporated and shall be read as one’ with the Agreements Act and that, in the case of any inconsistency, the Agreements Act is to prevail.40 Nevertheless, it should be remembered that the DTAs do not normally extend Australia’s taxing rights in relation to certain types of income but, rather, usually set the outer limits for it. For example, we have seen that Australian domestic law imposes a 10% withholding tax on interest. In some of the DTAs that Australia has entered into in the past, each treaty partner has a right to impose withholding tax on interest at a rate higher than 10%. However, for Australia to impose a withholding tax on interest paid to a resident of one of these treaty partners at a rate higher than 10%, Australia would need to amend its domestic law. It is more common for the dividend, interest and

[page 1219] royalty articles in Australia’s DTAs to reduce the rates at which Australia would otherwise be able to impose withholding tax on these types of income. Note The provisions in a DTA prevail over inconsistent Australian domestic law other than ITAA36 Pt IVA and FBTAA 1986 s 67.

18.82 The origins of DTAs can be traced back at least to treaties entered into by continental European states in the 19th century. Major work was done by the League of Nations in the 1920s and 1930s on the development of model DTAs. At the time, continental European countries tended to use schedular and impersonal taxes on different types of income. Countries such as the United States and the United Kingdom, which used more global approaches to taxing income, did not enter into DTAs until relatively late. For example, the United Kingdom’s first comprehensive DTA was its treaty with the United States in 1945. A consequence of the relative lack of involvement of these two major capital exporters in the early development of DTAs was that, by the time these two countries started entering into DTAs, common structural features of DTAs had already evolved in international practice. Understandably, this structure resembled the structure of tax systems of continental European countries in that it was schedular having different rules for different types of income. Hence, when you read through a DTA, you will note that, typically, there are separate articles dealing with, for example, the taxation of business profits, the taxation of dividends, the taxation of interest, the taxation of royalties, and so on. A DTA typically includes articles dealing with the following:41 Taxes covered: Usually from Australia’s perspective, the taxes covered will be the income tax (including capital gains tax), but some of Australia’s treaties (such as the treaty with New Zealand

or the 2003 treaty with the United Kingdom) extend to fringe benefits tax. Definitional matters: These usually include a definition of ‘resident’ for the purposes of the treaty. Most of Australia’s treaties include a dual residence tiebreaker. In the case of companies, the most common dual residence tiebreaker in Australia’s treaties is ‘place of effective management’. Importantly, the Australia–United States treaty does not contain a corporate dual residence tiebreaker. Another important term that is defined in each treaty is ‘permanent establishment’. In many of Australia’s treaties, the definition of ‘permanent establishment’ tends to be wider than the OECD norm. Tax treatment of business profits: All of Australia’s treaties restrict source country taxation of business profits to those attributable to a permanent establishment carried on in the source country. Hence, Australia’s wider definition of ‘permanent establishment’ tends to mean that there is greater [page 1220] scope for source taxation of business profits under Australia’s treaties than would be the case under the OECD model. Tax treatment of income from services: In the case of income from independent services, Australia’s treaties generally limit source country taxation to cases where the income is attributable to a fixed base in Australia. In line with the current OECD model, some of Australia’s more recent treaties (eg, the 2003 treaty with the United Kingdom) do not have a distinct provision dealing with independent services but deal with such services under the business profits article. In the case of dependent services or income from employment generally, such income is taxable only in the state of the recipient’s residence except where the income relates to services performed in the source state by a recipient who has been present in the source state for 183 days or less in the

relevant tax year and the payment is made by the recipient’s foreign employer and was not deductible to the employer in determining the profits of permanent establishment of the employer in the source state. Tax treatment of investment income (with separate articles dealing with each of dividends, interest and royalties): For many years, Australia’s treaties lowered the rate of dividend withholding tax to 15%. In some of Australia’s more recent treaties (importantly including the 2003 United Kingdom treaty and the 2002 protocol to the treaty with the United States), the rates of tax on dividends are lowered further still. For example, currently under Australia’s treaties with the United Kingdom and the United States, the source tax rate on non-portfolio dividends (representing shareholdings of 10% or more) is lowered to 5%. Where the shareholding is 80% or more, there is zero source tax on dividends under these treaties. Most of Australia’s treaties retain the statutory rate of withholding tax on interest of 10%, although some treaties, such as the Australia–United States treaty, exempt certain interest payments to the government of either state (or its political or administrative subdivisions) and to financial institutions from source tax. It is more difficult to generalise about the treatment of source taxation of royalties tax under Australia’s treaties. In recent years, several Australian treaties reduce source taxation of royalties tax to 5%. Tax treatment of other specific types of income: This includes, for example, separate articles will deal with shipping/air transport, pensions/annuities, alimony/child support and income of diplomatic/consular officers. Tax treatment of income not expressly mentioned: The relevant article in Australian treaties differs from the OECD model as it gives the source country the right to tax income, sourced in that country, that is not otherwise dealt with. A double tax relief mechanism in the form of a foreign tax credit or an exemption for foreign source income. Other matters: These include, for example, non-discrimination,

limitation of benefits, exchange of information and a dispute resolution mechanism called the ‘mutual agreement procedure’. For many years, Australia refused to agree to a non-discrimination article in its treaties. The United States–Australia treaty of 1982 contained a non-discrimination article but this article was not given the force of law in Australia and therefore its status was only as an agreement [page 1221] between governments. The UK treaty of 2003 contained a nondiscrimination article. This triggered ‘most favoured nation’ provisions in several of Australia’s other treaties and, as a result, several, but not all, subsequent Australian treaties have contained a non-discrimination article. Anti-abuse measures: The OECD Final Report on Action 6 Preventing the Granting of Treaty Benefits in Inappropriate Circumstances introduced a detailed ‘limitation of benefits’ provision into the OECD Model.42 However, the Report allowed members of the BEPS project flexibility in the approach that they took to anti-abuse measures, particularly where a state had antiabuse measures as part of its domestic law. The Final Report also included a ‘principal purpose’ test in the OECD Model.43 Australia’s 2015 DTA with Germany includes a ‘principal purpose’ test similar to the test in the OECD Final Report on Action 6 and it is likely that future Australian DTAs will include a principal purpose test rather than a ‘limitation of benefits’ article.

How would your answer to Question 1 in Activity 18.2 differ if the United States resident shareholder, instead of being William J Clinton, was a company WJC Inc incorporated in Delaware and a United States resident for tax purposes?

The Multilateral Instrument 18.83 As part of the BEPS project a multilateral instrument was developed with the aim of more rapidly modifying existing tax treaties in line with the Final BEPS recommendations. Australia signed the Multilateral Instrument on 7 June 201744 and lodged a list of notifications and reservations at the time of signature.45 Australia stated that it wished for 43 of its existing bi-lateral tax treaties to be covered by the Convention. Australia’s 2015 Tax Treaty with Germany was not on the list, apparently because it already contained many of the BEPS Tax Treaty measures that Australia adopted under the Multilateral Instrument. In general, it may be observed that Australia, where possible, in choosing options under the Multilateral Instrument, chose those that were most consistent with prior Australian tax treaty practice. Australia also chose not to apply multilateral articles to existing tax treaties that contained provisions having equivalent effects to the multilateral articles. [page 1222]

Amendments to Pt IVA in response to BEPS 18.84 In an apparent following of the lead of the United Kingdom, Australia responded to BEPS by amending the general anti-avoidance provision in ITAA36 Pt IVA. First, the Tax Laws Amendment (Combating Multinational Tax Avoidance) Act 2015 (Cth) included a provision in ITAA36 Pt IVA (the general anti-avoidance provision), which applies to schemes involving entities with a global revenue of A$1bn or greater under which the entity derives ordinary or statutory income from supplies to Australian residents and some or all of that

income is not attributable to an Australian permanent establishment of the foreign entity. In addition, for the amendment to apply, activities in connection with the supply must be undertaken in Australia by another Australian entity or an Australian permanent establishment of another foreign entity which is an associate of, or commercially dependent on, the entity making the supply. Where these conditions are met, Pt IVA will apply where a principal purpose of a person (or one of the persons) who entered into or carried out the scheme was to enable a taxpayer (or a taxpayer and one or more other taxpayers) to obtain a tax benefit, or to obtain a tax benefit and reduce foreign tax or Australian tax other than income tax. The consequences of the application of Pt IVA to schemes generally were discussed in Chapter 17. 18.85 The second amendment to Pt IVA in an apparent response to BEPS was the Treasury Laws Amendment (Combating Multinational Tax Avoidance) Act 2107 introduced further amendments to ITAA36 Pt IVA which triggered a new tax liability imposed under the Diverted Profits Tax Act 2017. Like the Multinational Anti-avoidance Law, the Diverted Profits Tax will only apply to ‘significant global entities’46 and the test of purpose used to trigger it is also a ‘principal purpose’ test. Subject to further requirements (discussed below) the Diverted Profits Tax will apply at a rate of 40% where the relevant taxpayer obtains a tax benefit in connection with a scheme where it would be concluded that a person or persons entered into or carried out the scheme for a principal purpose of enabling the relevant taxpayer to obtain a tax benefit or to obtain a tax benefit and reduce one or more of the relevant taxpayer’s liabilities to tax under foreign law. For Diverted Profits Tax to apply, a foreign entity associate of the relevant taxpayer must either be the person or persons who entered into the scheme or be otherwise connected with the scheme. Furthermore, Diverted Profits Tax will not apply where any of the following tests are passed: the Equal To Or Less Than $AUD25 Million test; the Sufficient Foreign Tax test; and the Sufficient Economic Substance test.47 In addition to the factors [page 1223]

normally taken into account in determining purpose in Pt IVA, the following are relevant in the Diverted Profits Tax for determining principal purpose: (a) any quantifiable non-tax financial benefits (disregarding tax results under the ITAA36, ITAA97 or foreign tax law) that have resulted, will result, or may reasonably be expected to result from the scheme; (b) the result in relation to foreign tax law relating to taxation that would be achieved by the scheme; and (c) the amount of the tax benefit involved. Where the Diverted Profits Tax is triggered, the relevant taxpayer is liable to pay Diverted Profits Tax at the rate of 40% 21 days after the Commissioner gives the relevant taxpayer a notice of assessment of the amount of the tax. The relevant taxpayer then has the opportunity during a review period (usually of 12 months) to provide the Commissioner with information supporting a submission that the assessment should be reduced partially or wholly. If at the end of the review period the relevant taxpayer is dissatisfied with the assessment or any amended assessment it has 60 days to appeal to the Federal Court.

Other aspects of Australia’s response to the BEPS Reports and recent developments 18.86 The OECD Final Report on Action 2 Eliminating Hybrid Mismatch Arrangements made several recommendations for rules to be developed to combat cross border mismatches in relation to both hybrid entities and hybrid instruments. In the 2016–17 Federal Budget, the government announced that it would implement these recommendations taking into account recommendations by the Board of Taxation on how the OECD rules could best be implemented in Australia. The government released the Board of Taxation’s report on the issue on 3 May 2016. The Board recommended that the OECD rules be implemented but with some variations. For example, the Board recommended that the OECD rules not apply to hybrid mismatches on financial instruments with terms of less than three years where the

mismatch is due to timing. The Board also recommended that grandfathering provisions would be appropriate for some arrangements, and that a de minimis rule should be considered, along with changes to Australia’s thin capitalisation rules that might be necessary on implementation of the hybrid mismatch rules. The Board also recommended that a post implementation review of the hybrid mismatch rules be undertaken. At the time of writing, draft legislation implementing the 2016–17 Budget announcement had not been released. 1. 2.

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8.

9.

OECD, Action Plan on Base Erosion and Profit Shifting, Paris, 2013. As a result of the introduction of the new thin capitalisation legislation in ITAA97 Div 820, outward investing Australian entities are now covered by the thin capitalisation regime with effect from 1 July 2001. This issue will be discussed in more detail below: see 18.62–18.63. ITAA36 s 23AH also extends to indirect interests that the Australian company has through interposed partnerships or trusts in income that the partnership or trust derives from carrying on business through a foreign permanent establishment: see s 23AH(10). Under ITAA36 s 23AH(15), ‘permanent establishment’ or ‘PE’ is defined as: (a) where Australia has a DTA with another country, the same meaning as in the DTA; or (b) otherwise the meaning given by ITAA36 s 6(1). More technically, the foreign income will be non-assessable non-exempt income where it is not: (a) adjusted tainted income; and (b) not eligible designated concession income in relation to a listed country. The concepts of ‘adjusted tainted income’ and ‘eligible designated concession income’ for these purposes are discussed at 18.8. ITAA36 s 23AH also applies to indirect interests that the Australian company has through interposed partnerships or trusts in a capital gain or capital loss made in relation to a partnership asset or made by the trustee in carrying on business through a foreign permanent establishment: see s 23AH(11). ‘Direct participation interest’ is defined in ITAA97 s 960-190. The definition incorporates the test of ‘direct control interest’ for purposes of the controlled foreign companies legislation discussed at 18.25. ‘Indirect participation interest’ is defined in ITAA97 s 960-185 as the holding entity’s ‘direct participation interest’ in the ‘intermediate entity’ multiplied by the intermediate entity’s direct or indirect participation interest (if any) in the test entity. Where there is more than one intermediate entity, the holding entity’s indirect participation interest in the test entity is the sum of the interests calculated in relation to each of the intermediate entities. As discussed at 18.6, prior to 1 July 2009 under ITAA36 s 23AG, in broad terms, foreign earnings derived by an Australian resident from 91 days or more continuous foreign service were exempt from Australian tax. Under the current s 23AG, the exemption applies only to income that fits into the categories discussed at 18.6.

10. In broad terms, ITAA36 s 23AI deems distributions of income which have previously been attributed to Australian residents under the CFC regime to be non-assessable non-exempt income to the recipient. New ITAA36 s 23AK (introduced following the repeal of the FIF regime), in broad terms, deems distributions of income which had been attributed under the former FIF regime to be non-assessable non-exempt income to the recipient. 11. In addition to the rules discussed in more detail in this chapter mention should be made of the ‘transferor trust’ rules in ITAA36 Div 6AAA, which can include the net income of nonresident trust estate in the assessable income of a resident who directly or indirectly transferred value (defined broadly to include both property and services) to the nonresident trust. 12. This is basically investment income: dividends, interest, royalties, or amounts flowing from related party transactions. See ITAA36 s 446. 13. That is, as the income accrues rather than when it is remitted. 14. This is essentially trading income of a business: ITAA36 s 432. 15. Defined in ITAA36 s 362 as essentially the percentage of the attributable income of the CFC that will be attributed to the taxpayer on the basis of the taxpayer’s interests in the CFC. 16. See 18.27 for a discussion of listed and unlisted countries. 17. Attribution can still take place where a CFC passes the active income test, for example, under ITAA36 s 384(2)(c) (amounts included in notional assessable income of a CFC resident in an unlisted country via ITAA36 Pt III Div 6 as modified by ITAA36 Pt X Div 3 Subdivs B and C) or under s 385(2)(c) (amounts included in notional assessable income of a CFC resident in a listed country via Pt III Div 6 as modified by Pt X Div 3 Subdivs B and C). 18. ITAA36 s 386 defines ‘adjusted tainted income’ as passive income, tainted sales income or tainted services income: all defined in ITAA36 Pt X Div 8. 19. The CFC must derive more than 95% of its income from active business activities: ITAA36 s 432. 20. This is income that is either not taxed at all or is taxed at reduced rates to attract particular forms of business or financial activity: ITAA36 s 317. 21. The de minimis exemption applies where the sum of: (a) eligible designated concession income; (b) income from sources outside the listed country that is either not taxed in a listed country or is tainted income not taxed in a listed country; and (c) FIF (explained below) income, does not exceed certain levels. Such income is not included in the attributable income of a CFC of a listed country. For a CFC in a listed country with a gross turnover of less than A$1m, the exemption applies where the sum of the three amounts does not exceed 5% of the gross turnover. Where a CFC of a listed country has a gross turnover of more than A$1m, it applies where the sum of the three amounts does not exceed A$50,000: ITAA36 s 385. 22. It does appear, however, that this deeming will extend only to withholding tax paid by the CFC that actually paid the dividend to Australian resident attributable taxpayers. Where withholding tax is payable on an earlier dividend in a chain of dividends passing through a chain of CFCs, it appears that the only attributable taxpayers who are entitled to a foreign income tax offset on those payments are companies with an attribution percentage of 10%

23.

24.

25. 26. 27. 28.

29. 30.

31.

32. 33.

34. 35.

or more. In those circumstances, the provisions of ITAA97 s 770-135, as discussed above, will apply. In addition, ‘transferor trust measures’ were also introduced: ITAA36 Pt III Div 6AAA ss 102AAA–102AAZG. These measures apply accrual taxation to the income of non-resident trusts to which resident Australian entities have transferred property or provided services. These rules are not discussed in this chapter. The government announced that these rules will be amended with an aim to making them more effective and to enhance their integrity. The definition of ‘permanent establishment’ for these purposes was amended by Tax and Superannuation Laws Amendment (2014 Measures No 4) Act 2014 (Cth). The effect of the amendment is that, for the purposes of determining whether an asset is taxable Australian property on the basis that it is attributable to an Australian permanent establishment, the term ‘permanent establishment’ will have the meaning that it has within the definition of ‘permanent establishment’ in a relevant Australian double-taxation treaty or under ITAA97 s 995-1 and ITAA36 s 6(1). The proposed amendment is aimed at dealing with the technical difficulty that the previous referent (ITAA36 s 23AH) was viewing a permanent establishment from an outbound perspective which strictly was not applicable in relation to inbound investment by foreign residents. For a discussion of ‘dividend streaming’, see Chapter 12. Chow Yoong Hong v Choong Fah Rubber Manufactory [1962] AC 209 at 217. The exception also extends to certain other debt interests such as non-equity shares, stapled securities and syndicated loans issued by a company. It should be noted here that, for withholding tax purposes, the extended definition of ‘royalty’ in ITAA36 s 6(1) applies, and not the ordinary meaning of ‘royalty’ that is relevant in ITAA97 s 15-20. The extended definition of ‘royalty’ as defined in ITAA36 s 6(1) is reproduced in Study help. OECD, Issues in International Taxation No 2: Thin Capitalization; Taxation of Entertainers, Artists and Sportsmen, OECD, Paris, 1987. OECD/G20, Base Erosion and Profit Shifting Project, Limiting Base Erosion Involving Interest Deductions and Other Financial Payments, Action 4, Final Report, OECD, Paris, 2015. Chapter 2 outlines the OECD recommendations for a best practice approach. A more specific de minimis rule applies to outward investing entities: where at least 90% of the assets of such entities represent Australian assets, they are also excluded from the thin capitalisation regime: ITAA97 s 820-37. This is the effect of ss 815-1(2) and 815-15 of the Income Tax (Transitional Provisions) Act 1997. The discussion in this chapter will focus on ITAA97 Subdiv 815-B. A separate subdivision, Subdiv 815-C, dealing with transfer pricing involving permanent establishments, is not discussed in this chapter. See, for example, Taxation Rulings TR 94/14 and TR 97/20, and Draft Taxation Ruling TR 95/D22. These tax rulings can be accessed at the ATO website: . OECD, Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, OECD, Paris, 1995. Note, however, that in FCT v SNF (Australia) Pty Ltd 2011 ATC 20-265; [2011] FCAFC 74; BC201103571, the Full Federal Court held that the OECD Transfer Pricing Guidelines could only be referred to in interpreting art 9(1) of the OECD Model Tax Convention (see 18.72) if there was evidence that Australia and the

36. 37.

38. 39. 40.

41.

42.

43.

44. 45. 46.

47.

relevant treaty partner in question had adopted the practice of applying the guidelines in any circumstances in which art 9 of the OECD Model might obtain in their jurisdictions. As the guidelines were not a legitimate aid in construing the relevant DTAs, the Commissioner failed in this argument that the guidelines could be referred to in interpreting ITAA36 Div 13 on the basis that the meaning of DTAs could illuminate Div 13. As discussed in the text, ITAA97 Div 815 now requires, both where tax treaties apply and where they do not, that determination of arm’s length conditions is done in the way which best achieves consistency with the OECD Transfer Pricing Guidelines. 2016 Budget Paper No 2, p 35. OECD/G20 Base Erosion and Profit Shifting Project, Preventing the Granting of Treaty Benefit in Inappropriate Circumstances, Final Report Action 6, OECD, Paris, 2015, para 72. These aspects of double taxation treaties are not discussed in detail in this chapter. OECD, Model Convention with Respect to Taxes on Income and on Capital (OECD Model Tax Convention), OECD, Paris, looseleaf. Other than the general anti-avoidance provisions of ITAA36 Pt IVA. Section 4AA of the International Tax Agreements Act 1953 (Cth) states that the Fringe Benefits Tax Assessment Act 1986 (Cth) (FBTAA) is also incorporated and is to be read as one with the Agreements Act and that the provisions of the Agreements Act have effect in spite of anything inconsistent with those provisions contained in the FBTAA. For a more comprehensive account of the form that DTAs might take, see the OECD Model Convention with Respect to Taxes on Income and on Capital, which can be accessed at . OECD/G20 Base Erosion and Profit Shifting Project, Preventing the Granting of Treaty Benefit in Inappropriate Circumstances, Final Report Action 6, OECD, Paris, 2015, para 25. OECD/G20 Base Erosion and Profit Shifting Project, Preventing the Granting of Treaty Benefit in Inappropriate Circumstances, Final Report Action 6, OECD, Paris, 2015, para 26. . The list may be accessed at . However, the Diverted Profits Tax will not apply to the following entities even if they are significant global entities: (i) managed investment trusts; (ii) foreign collective investment vehicles with wide membership; (iii) foreign entities owned by a foreign government; (iv) complying superannuation entities; (v) foreign pension funds. Details of these tests are discussed in the Revised Explanatory Memorandum to the Treasury Laws Amendment (Combating Multinational Tax Avoidance) Act 2017 (Cth).

[page 1225]

CHAPTER

19

Goods and Services Tax Learning objectives After studying this chapter you should be able to: explain why we have a goods and services tax (GST) in Australia; identify a ‘taxable supply’, ‘taxable importation’, ‘creditable acquisition’ and ‘creditable importation’; explain what is meant by the term ‘supply’ and what it means to ‘carry on an enterprise’; calculate an input tax credit and explain how input tax credits work; distinguish between taxable supplies, input taxed supplies and GST-free supplies, and cite examples of each; advise on the importance and consequences of registration for GST and the thresholds applicable; understand and describe the principal ‘exemptions’ from GST; identify the needs for and effect of the GST general anti-avoidance rule.

Background 19.1 The goods and services tax (GST) has been in place in Australia for over 15 years. Not all of the problems with its rules have yet been

litigated or otherwise solved. On 1 July 2000, Australia introduced the GST to replace the wholesale sales tax (WST) and a number of other state taxes. The introduction of the GST was intended to address a number of issues: a small and (relatively) shrinking tax base; the inequitable incidence of the WST; the ‘cascading’ effect of the WST (and resulting economic inefficiency); and certain constitutional and political problems regarding state taxation and Commonwealth/state fiscal relations. 19.2 The WST, because it applied only to goods, held little prospect of raising sufficient revenue to adequately contribute to meeting Australia’s needs at the time or in the future. The GST, as its name suggests, includes services, which are becoming an increasingly large component of the modern Australian (and world) economy. Because the WST applied only to goods, together with the exemptions (eg, farmers paid no WST on farm inputs) and the myriad rates, this meant the WST was [page 1226] inherently unfair. The burden fell most heavily on some manufacturing businesses, less heavily on others, while businesses selling services paid no WST at all. The GST, with two rates (0% and 10%) and fewer exemptions (at least, as originally proposed) is arguably more equitable. Another problem was that WST became ‘embedded’ in the price of goods. This had a ‘cascading’ effect through the supply chain — with WST being charged on ‘embedded’ WST — pushing up prices to the consumer, and therefore, distorting economic decisions resulting in inefficient allocations of resources. Among other concerns expressed by politicians at the time was the detrimental impact this was having on Australia’s export competitiveness (making Australian exports more expensive than those of its competitors). Although exports are GST-free

(or ‘zero-rated’; this term is explained later), any improvement in competitiveness is most likely to have been short-lived as the exchange rate adjusted to take account of the change in tax law. The GST does provide a more transparent and easy to audit system, taxing the value added at each step in the supply chain. A wider constitutional problem with Australia’s indirect tax system is that under s 90 of the Commonwealth of Australia Constitution Act (the Constitution), the states are not permitted to levy excise on goods.1 This leaves the states with few options for taxing at a sufficient level to meet their revenue needs, especially as the states have practically, if not in a strict legal sense, handed their power to collect income tax over to the Commonwealth Government while retaining the responsibility to deliver expensive services like health and education. The proceeds of the GST, now it has been introduced, are distributed to the states (with adjustments for the benefit of the less-populous states). The GST is a form of value added tax (VAT), which is widely used around the world. The features of such a tax are that: it is quite broad based; it taxes consumption; it is paid at every level through the supply chain; [page 1227] where a supplier takes taxed goods and services and uses them in the creation of another supply, the supplier is entitled to a credit for the GST that has been paid on these ‘inputs’; the GST is collected from the supplier but because of the input credit system it is borne by the consumer; and GST is not charged on exports. These features of a GST rely on an intricate web of definitions and interdependent statutory provisions. The GST is, in many senses, ‘a lawyers’ tax’ because of its reliance on important definitional boundaries established under the relevant statutes.

The GST was imposed by means of a number of Acts of Parliament, a list of which may be found at the Australian Taxation Office (ATO) website at in the ‘Legislation and supporting material’ database. The principal GST legislation is to be found in A New Tax System (Goods and Services Tax) Act 1999 (Cth) (the GST Act), but other important legislation relating to GST is in at least three other Acts2 and a myriad of amendments introduced in following years to address emerging issues. There are also a number of relevant Regulations, principally A New Tax System (Goods and Services Tax) Regulations 1999 (Cth) (GST Regulations), all of which can be found on the ATO legislation database (see above). The Australian experience of GST has also been complex and, at times, attracted considerable media and business attention. The result is that staff in the ATO have found it necessary to explain the impact and operation of the GST in particular circumstances by means of a number of GST rulings. The GST rulings (published as a GST set in which each ruling is identified by a number in the form ‘GST/year/ruling number’) are made to assist taxpayers in their understanding of the GST law and, although not strictly speaking ‘law’, a taxpayer may rely on them even when to do so would be advantageous to the taxpayer.

The basics of GST 19.3 It has been mentioned that a business making taxable supplies under GST does not bear the cost of the GST. This is achieved through the system of refunding (usually in the form of credits) the GST that it has paid on its inputs to the business. An understanding of this system of credits is the key to understanding GST and its strengths, compared to other forms of sales tax. However, it is worth noting that, while the business does not ultimately bear the cost of the GST, it does bear the costs of collecting the tax and complying with the rules (compliance costs). The high cost to businesses of compliance is seen as one of the weaknesses of value-added taxes like the Australian GST.

[page 1228]

A manufacturer of wooden mandolins3 makes taxable supplies of the mandolins and so charges its customers 10% GST on the supplies of instruments made to them. The mandolin maker will have been charged GST on the goods and services (wood, strings, varnish, steamer, plane and other machinery, rent, electricity, etc) purchased in the course of making the instruments. The GST on the supplies into the business is called ‘input tax’. Every quarter, the mandolin maker pays the ATO the difference between the amount collected from customers and the input tax paid to suppliers.

This example assumes that the mandolin maker collects more tax on the musical instruments sold than the input tax that the mandolin maker has paid on materials and other costs of manufacture. In those circumstances, the requirement is that an amount be forwarded to the ATO. In a case where the amount of input tax paid exceeds the amount of GST collected, the ATO is required to make a refund to the mandolin maker. The collection process (or refund claim process) is achieved by means of the (usually) quarterly business activity statement (BAS). You can find a simple guide to the GST for businesses on the ATO website at .3

GST is borne by the final consumer 19.4 Final consumers are not required to remit GST to the ATO. They also are usually unable to claim back the GST that they pay through input credits.4 The party who sold them the goods or services has collected their GST and is required to remit it to the ATO. As final consumers are themselves not making taxable supplies, there is no GST to remit on supplies they have made to others and there is no input tax to be credited against that GST. This means that the GST is a prime example of an indirect tax. It is a tax paid to the revenue authorities by

one party (the supplier of goods and/or services) but is actually borne by another party (the final consumer). For a good summary overview (with an excellent diagram), look at Ch 1 ‘Executive Summary’ of the Explanatory Memorandum to A New Tax System (Goods and Services Tax) Bill 1998 (Cth) (GST Bill) on the ATO website or on Austlii.5 [page 1229]

Special treatment of ‘exempt supplies’ 19.5 There is a departure from the normal rules of collection and credit (payment or refund) of GST in the case of certain supplies that are special in their nature. The two types of supplies affected in this way are: ‘input taxed’ supplies; and ‘GST-free’ supplies.

Input taxed supplies 19.6 Input taxed supplies are supplies made by a business on which no GST is charged but in respect of which no input tax credits are available. Input taxed supplies will be examined in more detail later: see 19.41. At this stage, it is important to understand that a business making an input taxed supply is not liable for any GST on that supply and, therefore, may not charge any to its customers. The way the rules work means that a supplier of an input taxed supply is not liable to remit GST to the ATO on any input taxed supplies made and cannot claim any credit on acquisitions made in connection with those supplies. For a business supplying a mixture of taxable and input taxed supplies, the matching of input taxes to actual supplies makes for some complex apportionment processes. (Examples of this type of business would include a business that supplies both commercial rental property and residential property, or a business making some financial supplies and

some associated supplies that do not fall within the financial supply definition.) Note: Australian terminology differs from conventional VAT terminology in relation to input taxed supplies. In most versions of VAT, input taxed supplies are termed ‘exempt supplies’. The Australian term is possibly more accurate because the supply is exempted from tax only from the perspective of the final consumer.

GST-free supplies 19.7 Just as for input taxed supplies, a business making GST-free supplies should not charge GST in its price on supplies to its customers because it is not liable for GST on those supplies. However, the business making GST-free supplies may claim input tax credits for tax paid on goods and services acquired for the purposes of making those supplies. This has the consequence that the customer of the business pays no GST to the business for the supply of goods and services and that the business itself incurs no GST on the acquisitions it makes in order to make GST-free supplies, because it claims a credit on those inputs. A business making only GST-free supplies will, in all likelihood, be able to claim a refund from the ATO at the end of each GST accounting period. The term ‘GST-free’ makes sense: it accurately conveys that there is no component of the price paid for the GST-free supply that includes any GST. Businesses that make both taxable supplies and GST-free supplies face a considerable degree of complexity in their processes at point of sale. The predicament is probably most acutely felt by mixed businesses, such as grocers (who make supplies of ‘food’, which is GST-free, and other items, which are not GST-free, all at the same point of sale) and pharmacists (who supply medicines, which are GST-free, and cosmetics and other general items, which are not). [page 1230] Note: Australia’s terminology differs from normal VAT terminology in

relation to GST-free supplies. What is termed ‘GST-free’ in Australia is termed a ‘zero-rated’ supply in most VAT systems. The making of GSTfree supplies is discussed further later: see 19.32. The Australian term is possibly more accurate — but is a departure from the international norm.

Timing of GST returns 19.8 GST returns are required to be filed periodically by taxpayers. As a general rule, these periods are quarterly (the quarterly periods ending on 31 March, 30 June, 30 September and 31 December): see GST Act s 27-5. Taxpayers with a history of failing to pay GST, with an enterprise that will not continue for longer than three months, or with a tax period turnover threshold of $20m or more, may be required by the Commissioner to comply with one-month tax periods: GST Act s 27-15. Taxpayers may also elect to comply with one-month tax periods if they wish to do so: GST Act s 27-10. GST returns are actually made as part of the enterprise’s BAS. The BAS was introduced at the same time as the GST in an attempt to reduce the costs of tax compliance, and includes several business taxes on one return.

Central provisions of GST 19.9 The central provisions of the GST are set out in Div 7 of the GST Act. Section 7-1 of the Act reads as follows. 7-1 GST and input tax credits (1) GST is payable on taxable supplies and taxable importations. (2) Entitlements to input tax credits arise on creditable acquisitions and creditable importations.

This section of the Act means that GST is payable on taxable supplies made in Australia (see 19.10) and taxable importations into Australia (see 19.29), and that input tax credits can be claimed on creditable acquisitions and creditable importations made by registered businesses.

Furthermore, GST and input tax credits are offset to produce a net amount for a tax period, which must be remitted via a registered taxpayer to the ATO or, in the case of a negative amount, may be refunded to the registered taxpayer by the ATO.

Taxable supplies 19.10 The following diagram from para 3.12 of the Explanatory Memorandum to the GST Bill summarises the central concepts of GST on supplies under s 9-5. [page 1231]

Figure 19.1:

19.11

New Tax System (Goods and Services Tax) Bill 1998 (Cth)

Section 9-5 of the GST Act reads as follows.

9-5 Taxable supplies You make a taxable supply if: (a) you make the supply for *consideration; and (b) the supply is made in the course or furtherance of an *enterprise that you *carry on; and (c) the supply is *connected with the indirect tax zone; and (d) you are *registered, or *required to be registered. However, the supply is not a *taxable supply to the extent that it is *GST-free or *input taxed.

By reason of the use of the word ‘and’ between each paragraph of s 95, you will note that each of the components must be in place for the supply to be a taxable supply. This means that a taxable supply must be made for consideration, in the course or furtherance of an enterprise carried on, it must be connected with the Australian ‘indirect tax zone’, and the supplier must either be registered, or at least be required to be registered, for GST. The final explanation in the section takes supplies that are GST-free or input taxed out of the scope of the definition of ‘taxable supply’. This is because, as has been explained above, these receive special treatment. Many of the terms within the section are identified as defined terms by means of an asterisk. Such defined terms can usually be found in Div 195 ‘Dictionary’ of the GST Act. [page 1232]

Supply 19.12 A term not signified by an asterisk (indicating its definition in the Act) in s 9-5 but, nevertheless, defined in s 9-10 of the GST Act is the term ‘supply’. Section 9-10 gives the meaning of ‘supply’ as follows. 9-10 Meaning of supply (1) A supply is any form of supply whatsoever. (2) Without limiting subsection (1), supply includes any of these: (a) a supply of goods;

(b) (c) (d) (e) (f) (g)

a supply of services; a provision of advice or information; a grant, assignment or surrender of real property; a creation, grant, transfer, assignment or surrender of any right; a financial supply; an entry into, or release from, an obligation: (i) to do anything; or (ii) to refrain from an act; or (iii) to tolerate an act or situation; (h) any combination of any 2 or more of the matters referred to in paragraphs (a) to (g). (3) It does not matter whether it is lawful to do, to refrain from doing or to tolerate the act or situation constituting the supply. (3A) …

It will be evident from this extremely broad definition that just about anything imaginable would constitute a supply. It does not matter whether making the supply is lawful or not. In addition, the terminology used in the Act is such that the list given in s 9-10(2) is not exhaustive of all things that might constitute a supply and, although the definition is as wide as possible, it may well be that something else also constitutes a supply. There have been several cases on the meaning of ‘supply’ that have added further nuances to this otherwise very broad definition (eg, FCT v Qantas Airways Ltd (2012) 291 ALR 653; 83 ATR 1; [2012] HCA 41, discussed at 19.17 below). In case it occurs to you that this definition is so wide as to make the payment for a supply a supply in itself, note that s 9-10(4) removes some of the risk of this circularity.

The meaning of ‘goods’ 19.13 Section 195-1 of the GST Act defines ‘goods’ as ‘any form of tangible personal property’. There is no definition of ‘services’. [page 1233]

The meaning of ‘consideration’ 19.14

The term ‘consideration’ is defined in s 9-15 of the GST Act.

9-15 Consideration (1) Consideration includes: (a) any payment, or any act or forbearance, in connection with a supply of anything; and (b) any payment, or any act or forbearance, in response to or for the inducement of a supply of anything. (2) it does not matter whether the payment, act or forbearance was voluntary, or whether it was by the recipient of the supply. (2A) …

This definition of ‘consideration’ is also very broad and further subsections within s 9-15 make it even broader because they include consideration made, for example, by order of a court or other body; and consideration paid by a supplier to a recipient where both are members of the same entity. Other subsections operate so as to limit the very broad meaning of consideration. Thus, s 9-17 of the GST Act removes some payments from the meaning of the term ‘consideration’. 9-17 Certain payments and other things not consideration (1) If a right or option to acquire a thing is granted, then: (a) the consideration for the supply of the thing on the exercise of the right or option is limited to any additional consideration provided either for the supply or in connection with the exercise of the right or option; or (b) if there is no such additional consideration — there is no consideration for the supply. (2) Making a gift to a nonprofit body is not the provision of consideration. (3) A payment is not the provision of consideration if: (a) the payment is made by a *government related entity to another government related entity for making a supply; and (b) the payment is: (i) covered by an appropriation under an *Australian law; or [page 1234]

(ii) made under the National Health Reform Agreement agreed to by the Council of Australian Governments on 2 August 2011, as amended from time to time; or (iii) made under another agreement entered into to implement the National Health Reform Agreement; and (c) the payment is calculated on the basis that the sum of: (i) the payment (including the amounts of any other such payments) relating to the supply; and (ii) anything (including any payment for any act or forbearance) that the other government related entity receives from another entity in connection with, or in response to, or for the inducement of, the supply, or for any other related supply; does not exceed the supplier’s anticipated or actual costs of making those supplies. (4) A payment is not the provision of consideration if the payment is made by a *government related entity to another government related entity and the payment is of a kind specified in regulations made for the purposes of this subsection. (5) This section applies despite section 9-15.

Because the definition of ‘consideration’ is, like many of the other definitions, very broad, it could cover any exchange, including ones to which it was not intended that GST should apply. Hence, the need to narrow the definition by subsections such as those quoted above. A GST ruling has been issued concerning when consideration has been received by a supplier or provided by a recipient under various types of transactions. In GST Ruling GSTR 2003/12, the ATO expresses the view that: in the case of cash, consideration is normally provided and received when the cash is tendered; for cheques, consideration is provided when the cheque is handed in or posted, and is received when it is actually received rather than when it is banked or when the funds are cleared; post-dated cheques constitute consideration on the date written on their face, except when they are received after that date, in which case the consideration is attributed to the date of receipt; for credit cards — if a payment is made in person, the consideration is received and is provided at the time of signature

by the cardholder on the docket authorising the transaction; for telephone and online transactions, consideration is when the cardholder gives the requisite details; and [page 1235] for EFTPOS,6 consideration is provided and received when the transaction is accepted by the EFTPOS system. GSTR 2003/12 also deals with a number of relatively novel forms of payment, such as digital cash, vouchers, store value cards and barter transactions. The ruling may be viewed at the ATO website at . Example 19.2 and Example 19.3 provide some examples of the application of the ruling’s provisions:

Jess telephones eTicket on 31 August and buys two tickets to the ‘One Direction’ concert in November in Melbourne using her credit card. Each ticket costs $88 including GST. She gives the operator her card number, expiry date and verification code number as well as her name and contact phone number. As it is a credit card transaction over the telephone, consideration is deemed to be provided and received when the details are given. GST is $16 ($8 per ticket) and eTicket should remit this in its September quarter return.

On the same day (31 August), Kim writes a cheque in favour of Shifty Office Agents for $1100 for rent on new business premises. As agreed, the cheque is post-dated to 31 October, the week before the business is due to occupy the new premises. She also writes a cheque for $550 for a batch of new business cards received from Very-Fast Printing Pty

Ltd (VFP). As she submits the BAS each month, she includes $50, being the GST on the business cards (1/11 fraction of $550), as an input tax credit in her return for the month of August. She knows that VFP will probably receive the cheque in the first few days of September and so will only include the GST in its September return, but understands that this has no impact on her claim for the input tax credit. She makes a note that the $100 input tax credit on the rent deposit (1/11 fraction of $1100) should be claimed in the October return.

It will have been noted that s 9-17(1) of the GST Act makes special reference to consideration paid for an option. This has the effect that where a supply occurs as a consequence of the exercise of a right or an option to take (and presumably make) the supply, the consideration for the supply is no more than the additional [page 1236] consideration which is provided. This has the effect that the grant of the option and the supply on exercise of the option, are treated as two separate supplies. Several similar refinements to the consideration definition are to be found in the Act. Section 9-17(3) of the GST Act disregards as consideration payments that are appropriations between governmentrelated entities. This means that government appropriations between government-related entities are not subject to GST. If this were not so, the effect would be that 1/11 of such appropriations would have to be paid to the ATO. The definition of ‘consideration’, aside from the exclusions and refinements that are to be found in Div 19 of the GST Act, also leads to problems elsewhere, and special rules are in place to deal with those problems. Some of those special rules are discussed below.

Security deposits 19.15

Under s 99-5 of the GST Act, the taking of a deposit as

security for the performance of an obligation is not treated as consideration for a supply, unless the deposit is forfeited or applied as consideration for the supply. This has the effect of ensuring that a liability to pay GST on the consideration for the entire sale does not arise simply because a security deposit has been paid. Were this provision not in place, the liability to GST would be triggered immediately on payment of the security deposit, because s 29-5 of the GST Act says that GST is payable on a taxable supply in the tax period in which any of the consideration for the supply is received. The exclusion in s 99-5 applies only to a security deposit and so care must be taken to ensure that the deposit concerned is precisely that, a security deposit. Most ordinary deposits will be part consideration and will trigger GST obligations at the time of the deposit. An example of a security deposit is a fee paid as security for the return of something when hiring it, such as a deposit paid on hiring a bicycle at the park or adventure centre. A security deposit is thus something that is forfeited on failure to perform your obligations under the contract — rather than an advance payment to offset future costs.

In December 2015, Mrs Short makes a booking from New York to rent a fully serviced holiday house in Noosa for her family’s summer holiday for the months of June, July and August 2016 (the US summer), and secures that booking by paying two weeks’ rent in advance. If she cancels her rental, but not within the agreed cancellation period, her deposit will be forfeited. If she takes the house, the deposit is offset against the rent for the full rental period. The agent will charge GST on the deposit and is obliged to remit that in the December tax period. [page 1237] When the Shorts arrive, they are required to pay a $1000 ‘key’ deposit, which will be returned to them if they return the keys leaving the house in the condition in which they found it. The agent will not remit GST in the June tax period when the ‘key’ deposit is lodged, or at all, if the Shorts take good care of the property and return all the keys. In the event that the Shorts’ sons run riot, smashing the bunk beds and leaving holes in the

bedroom door and plaster on the bedroom walls, the ‘key’ deposit would be forfeited and the agent would remit 1/11 as GST on the deposit in the September tax period.

Buyer Ltd (Buyer) wanted to purchase a block of land owned by Seller Ltd (Seller). Seller agreed to sell the land but was doubtful as to Buyer’s ability to raise sufficient funds to pay the $5m purchase price of the land. They entered into a sale contract under which Buyer provided a deposit of $500,000 as security against its performance under the contract of sale. According to the contract, if, after six months from the date of entering into the purchase contract, Seller gave Buyer notice that the balance of the purchase price was due, Buyer was required to pay that price in full within three weeks. If Buyer failed to pay the balance of the purchase price within that time, the contract was cancelled and Seller was entitled to retain the deposit forfeited by Buyer. Six months passed. Seller Ltd gave notice to Buyer, which failed to pay the purchase price after three weeks. The deposit was forfeited by Buyer and retained by Seller. Should Seller pay GST on the $500,000? What is the supply made by Seller on which GST should be collected? See Study help for a suggested analysis.

Vouchers 19.16 Another interesting area where refinements have had to be made to the Act is in relation to vouchers. GST Ruling GSTR 2003/12 states that if payment is made using a voucher, which falls within Div 100 of the GST Act and entitles the holder to receive supplies up to a stated value, the consideration is both paid and received on the redemption (note — not the purchase) of the voucher. This is called a ‘face value voucher’. If more consideration were required than the value of the face value voucher, then the manner of the ‘top-up’ payment, whether by cheque, cash etc, would determine when that part of the consideration is provided and received. [page 1238]

Division 100 was specifically included in order to deal with vouchers. This Division provides that vouchers like gift vouchers are not subject to GST. Such vouchers are not treated as taxable supplies at the time when they are purchased. The time of the supply is the time when the things for which the voucher is redeemed are supplied. Vouchers that do not fall within Div 100 (‘non-face value vouchers’) and the supply of such non-face value vouchers is a taxable supply in itself at the time of acquisition.

Cancelled lay-by sales 19.17 Division 102 is another Division included in the GST Act in order to deal with relatively unusual circumstances. Section 102-1 of the GST Act states that if a lay-by sale is cancelled, any amount retained or recovered by the supplier falls within the GST system. Section 102-5 of the GST Act reads as follows. 102-5 Cancelled lay-by sales (1) If a supply by way of lay-by sale is cancelled: (a) any amount already paid by the recipient that the supplier retains because of the cancellation; and (b) any amount the supplier recovers from the recipient because of the cancellation; is treated as consideration for a supply made by the supplier and as consideration for an acquisition made by the recipient. (2) This section has effect despite section 9-15 (which is about what is consideration).

Section 102-5 is a graphic example of the need that has been found to depart from the general rules in order to deal with specific situations if the correct outcome, in a GST sense, is to be achieved. The cancelled sale has resulted in an ultimate supply of nothing to the recipient — but, because the funds have been retained, or extra funds are recovered, by the supplier, they must be made subject to GST. In FCT v Qantas Airways Ltd (2012) 291 ALR 653; 83 ATR 1; [2012] HCA 41, the High Court held that, in a case where a passenger pays for a flight and then does not take it and has no right to a refund (as distinct from forfeiting a deposit which is what is discussed above), a

supply of a service is nevertheless made although the passenger appears to receive nothing. Thus, Qantas was required to pay GST to the ATO. The High Court reasoned that what the passenger received was a promise by the airline to make its best effort to carry the passenger and baggage. This was a ‘taxable supply’ for which the consideration was received.

Enterprise 19.18 Another of the defined terms that must be discussed is the term ‘enterprise’. For a supply to be taxable, it must be made ‘in the course or furtherance of an [page 1239] enterprise that you carry on’: GST Act s 9-5. The definition of ‘enterprise’ is very broad. Section 9-20 of the GST Act reads as follows. 9-20 Enterprises (1) An enterprise is an activity, or series of activities, done: (a) in the form of a business; or (b) in the form of an adventure or concern in the nature of trade; or (c) on a regular or continuous basis, in the form of a lease, licence or other grant of an interest in property; or (d) by the trustee of a fund that is covered by, or by an authority or institution that is covered by, Subdivision 30-B of the ITAA 1997 and to which deductible gifts can be made; or (da) by a trustee of a complying superannuation fund or, if there is no trustee of the fund, by a person who manages the fund; or (e) by a charitable institution or by a trustee of a charitable fund; or (f) by a religious institution; or (g) by the Commonwealth, a State or a Territory, or by a body corporate, or corporation sole, established for a public purpose by or under a law of the Commonwealth, a State or a Territory; or (h) by a trustee of a fund covered by item 2 of the table in section 30-15 of the ITAA 1997 or of a fund that would be covered by that item if it had an ABN.

The breadth of the term ‘enterprise’ is very clear from this definition in that it includes not only business ventures, but ventures that are merely regular or continuous, and it includes the activities of charitable and religious institutions as well as governments and public bodies. Just as you have noticed in other cases where the definition has been broad, it is necessary to know what is excluded in certain instances, and s 9-20(2) sets out some of the exclusions that do not constitute enterprises. The activities excluded from the meaning of enterprise encompass activities such as those of employees, or those earning income similar to employees, who are taxed by a withholding tax system such as Pay-As-You-Go (PAYG): see 16.62. Also excluded as enterprises are private or recreational pursuits or hobbies and the activities of individuals or partnerships made up of individuals where there is no reasonable expectation of profitable gain.

List some income tax cases that may be relevant in deciding whether an entity is carrying on an enterprise for GST purposes. See Study help for suggestions.

[page 1240]

Josh is a university student who is an active and advanced player in the multi-player Internet game, World of Warcraft. He has developed a very advanced warrior, Hakai, who has many powers and is a formidable adversary in battles in World of Warcraft. Now that university has started and he has no time to play computer games, Josh sells his World of Warcraft account and all his rights to Hakai via an Internet site for $1500. Will Josh have to pay GST on the sale he has made?

Josh’s friends, Guy and Sandy, are at college part-time and work part-time. They also love computer games and have worked out that they can make money for themselves either by developing their computer avatars through battle games for hours on end and then selling the avatars when they are more advanced — or by operating other players’ avatars in return for money. They set up a website and offer their services in developing (‘grinding’) computer avatars and make a steady income from their activity, which is all run from the kitchen table of their shared apartment. Will Guy and Sandy have to pay GST on the sale of computer game avatars and their services provided to other computer game participants? See Study help for suggested solutions.

Carrying on 19.19 The enterprise in question must be ‘carried on’ by you. The definition of ‘carry on’ is, perversely, not to be found in the GST Act, but there is a definition of ‘carrying on’ in Div 195 of the Act. This definition states that: carrying on an enterprise includes doing anything in the course of the commencement or termination of the enterprise.

This means that even if an enterprise is, for example, being wound down because it is about to be terminated, it, nevertheless, continues to be an enterprise being carried on, and, thus, taxable supplies made in the course of that process will be subject to GST and entitle recipients of those supplies to input tax credits where appropriate. [page 1241] The implications of these definitions are that even isolated activities

can constitute an enterprise where the criteria in s 9-20 of the GST Act are met. Thus, the lease or licence of an interest in property, although an isolated activity, will, nevertheless, satisfy the requirement that it is ‘carried on’ if it is undertaken on a regular and continuous basis in accordance with s 9-20(1)(c). This may prompt further debate as to what is meant by ‘regular’ or ‘continuous’. Another issue is whether an activity constitutes a ‘business’ for the purposes of the definition. The Dictionary in s 19-51 of the GST Act defines ‘business’ to include any profession, trade, employment, vocation or calling, but does not include occupation as an employee. Once again, the definition appears to be broad, and deliberately so.

A retired naval officer who purchases a property outside Yass in New South Wales and allows his farming neighbour to run his sheep on the 50 ha pastures in return for having the farmer maintain his fences each year may be ‘carrying on’ an enterprise.

A winemaker who saws his old wine barrels in half and sells them to a local plant nursery may be carrying on an enterprise.

A schoolteacher who makes wooden carvings and artefacts and sells them through the lobby shop of a local tourist hotel is carrying on an enterprise.

The requirements in the definition of taxable supply in s 9-5 include that the supply must be connected with the indirect tax zone (which is a concept essentially meaning Australia). Section 9-25 of the GST Act sets out in some detail the connection with Australia that certain supplies have.

Connected with Australia 19.20 Section 9-25 of the GST Act states that, in the case of goods that are wholly within the indirect tax zone, a supply of goods is connected with Australia if the goods in question are delivered, or made available in the indirect tax zone, to the recipient of the supply: s 925(1). In the case of supplies of goods from the indirect tax zone, which involve the goods being removed from Australia, this supply is also regarded as connected with the indirect tax zone: s 9-25(2). [page 1242] A supply of goods that involves the goods being brought to the indirect tax zone is regarded, pursuant to s 9-25(3), as connected with the indirect tax zone if the supplier either: (a) imports the goods into the indirect tax zone; or (b) installs or assembles the goods in the indirect tax zone.

A supply of real property (such as land or a building) is connected with the indirect tax zone when the land is in the indirect tax zone: s 925(4). In relation to anything else, s 9-25(5) states that a supply of anything other than goods or real property is connected with the indirect tax zone if the thing is done in the indirect tax zone or the supplier makes the supply through an enterprise that the supplier carries on in the indirect tax zone. This suggests that something that is done outside the indirect tax zone, provided it is supplied through an enterprise carried on in the indirect tax zone, may well fall within the GST net. This possibility should prompt some reflection on the types of transactions that might be affected.

In this regard, an enterprise is carried on in the indirect tax zone if it is carried on through a permanent establishment in the indirect tax zone (‘permanent establishment’ is defined in ITAA36 s 6(1)) or is carried on through a place that would be a permanent establishment if paras (e), (f) or (g) of the s 6(1) definition did not apply: GST Act s 9-25(6). If the definition in s 9-25 of ‘connected with the indirect tax zone’ is not enough, there is also a ruling on the subject (GST Ruling GSTR 2000/31) that deals with GST supplies connected with the indirect tax zone (called ‘Australia’ at the time) and provides a full coverage of this issue. As a result of a 2016 amendment, the concept of ‘connected with the ITZ’ was widened. The Act now reads as follows — note the new para (d): (5) A supply of anything other than goods or * real property is connected with the indirect tax zone if: (a) the thing is done in the indirect tax zone; or (b) the supplier makes the supply through an * enterprise that the supplier * carries on in the indirect tax zone; or (c) all of the following apply: (i) neither paragraph (a) nor (b) applies in respect of the thing; (ii) the thing is a right or option to acquire another thing; (iii) the supply of the other thing would be connected with the indirect tax zone; or (d) the * recipient of the supply is an * Australian consumer. Example: A holiday package for a trip to Queensland that is supplied by a travel operator in Japan will be connected with the indirect tax zone under paragraph (5)(c).

[page 1243] Whereas before the insertion of the new paragraph the connection with the Australian indirect tax zone was established by something being done within the zone or the carrying on of an enterprise within the zone, now a supply might be subject to GST if the recipient of the supply is an ‘Australian consumer’, the meaning of which is defined in s 9-25(7) and includes any entity that is not registered for GST or that

acquires the thing (whether registered or not) other than for a creditable purpose. The effect of this change is that there is an obligation imposed on a supplier who is overseas (provided they meet a certain test as to their turnover threshold relating to Australian sales) to pay GST on supplies made to Australian recipients consuming the intangible supply for nonbusiness consumption (or for a business below the GST registration threshold). This might be illustrated by some examples:

Jack and Jill invite some friends over on Friday night to watch a new Henry Putter movie which they have downloaded on ‘Nutflix’ an overseas based supplier of digital entertainment content. They pay for the download on the account they have with ‘Nutflix’. In this case, as Jack and Jill are not a GST registered business, the account holder of them is an Australian consumer as defined and GST should be paid by Nutflix to the Australian Tax Office.

Alex has a limousine service which is registered for GST. Alex uses accounting software supplied by ‘Eezi Books’, an overseas supplier, to run the business. Alex downloads the software from Eezi Books’ website in Singapore and pays for it via the website. As the limousine service is registered for GST and Alex can supply Eezi Books proof of this at the time of purchase, the downloaded software can be treated as not being supplied to an Australian consumer and no GST should arise.

Registration 19.21 The final requirement in s 9-5 of the GST Act is that, in order for the supply to be a taxable supply, the supplier must be registered, or

required to be registered, for GST. This was mentioned in the reference to s 9-5(d), above at 19.11. Registration is not only important for the purposes of when a supply is a taxable supply. It can also be important because input tax credits are only available if the taxpayer is registered or required to be registered, and because returns for the GST under the BAS must be lodged by a taxpayer who is registered or required to be [page 1244] registered. Section 23-1 of the GST Act gives a useful overview of the registration provisions in the GST Act. The overview asks the question: ‘Are you carrying on an enterprise?’ If the answer to that question is ‘no’, then you cannot be registered. If the answer to that question is ‘yes’, then a further question must be answered, namely: ‘Does your [annual] GST turnover meet the registration turnover threshold?’ If the answer to this threshold question is ‘no’, then you may register if you wish, but you do not have to register. If the answer is ‘yes’, then you must be registered — there is no choice in the matter. This requirement to register was extended in the 2016 amendments discussed at 19.20 so even non-residents whose sales into Australia exceed the threshold are expected to register. Enforcement of this rule may prove to be a problem. The registration process is set out in the various provisions in Div 23 of the GST Act. Thus, a person who is not carrying on an enterprise cannot register for GST, but a person who is carrying on an enterprise may register for GST if their annual turnover falls below the threshold and must register for GST if their annual turnover exceeds the statutory threshold. In addition, a person not carrying on an enterprise who intends to carry on an enterprise from a particular date in the future may choose to register in advance of that: GST Act s 23-10(2).

Registration turnover threshold

19.22 Note from the discussion above that a key aspect of the GST registration process is the taxpayer’s actual or expected annual (GST) turnover, and the question that arises is whether their turnover falls above or below the registration turnover threshold. If a taxpayer’s enterprise has a turnover which exceeds the registration turnover threshold, then the taxpayer must register for GST. If their turnover falls below the threshold, then registration is optional — they have the choice of registering or not. The registration turnover threshold is set out in s 23-15 of the GST Act, which sets out threshold amounts ‘or such higher amount[s]’ as the Regulations specify. Accordingly, if you are not a non-profit body, your registration turnover threshold is $75,000: A New Tax System (Goods and Services Tax) Regulations 1999 (Cth) reg 23-15.01. According to reg 23-15.02, if you are a non-profit body, your registration turnover threshold is $150,000. Both of these threshold amounts can be increased under appropriate Regulations at some date in the future. There are special amendments to these rules regarding registration that apply to particular types of entities. The amendments in place can be read in s 23-99 of the GST Act and they apply to government entities, non-profit sub-entities, representatives of incapacitated entities, agents resident in Australia acting for non-residents, and to taxi businesses. Each of these provisions is intended to deal with each of these categories in a special fashion. For example, under Div 144 of the GST Act, taxis are required to be registered for GST whether or not they meet the registration turnover threshold.

GST turnover 19.23 Under s 188-10 of the GST Act, a taxpayer’s GST turnover meets the registration turnover threshold if its ‘current GST turnover’ is $75,000 or more, [page 1245]

except where the Commissioner is satisfied that the ‘projected GST turnover’ is below $75,000. Alternatively, it meets the GST turnover threshold if it has a ‘projected GST turnover’ of $75,000 or more. A taxpayer’s ‘current GST turnover’ is measured over the 12-month period ending at the end of the current month: GST Act s 188-15. A taxpayer’s ‘projected GST turnover’ is measured over the 12-month period starting at the beginning of the current month: GST Act s 18820. The rules for calculating the annual turnover amounts are set out in ss 188-15 and 188-20 of the GST Act. Several GST rulings also deal with turnover, including GSTR 2000/13 and GSTR 2001/7. The latter, in particular, deals with the meaning of ‘GST turnover’. The difficulty this poses for some types of small business is considerable. For example, accurately projecting annual income may be a difficult task for any small business whose income is vulnerable to climate variation, like farming, or manufacturing and selling specialty ice cream. Businesses whose annual incomes can fluctuate significantly around the threshold may prefer to establish the systems needed and elect to be registered rather than run the risk that in one out of three years their projected or actual annual income will exceed the threshold. Some small businesses may be in the fortunate position where they can choose to be registered or not. Businesses will often choose to be registered because access to input tax credits effectively reduces their costs — although being registered means they have compliance costs in collecting and remitting GST. Businesses may choose not to be registered because that means they do not have to pay GST (and thus can give the appearance of a lower price to customers) and do not have to trouble themselves with GST compliance and the associated costs.

Consider the following two problems (based on GST Ruling GSTR 2001/7 paras 48–57). For answers, go to Study help.

Graham, a drought-affected grazier, aged 65, decides to retire from his sheep farm. He holds a clearing sale and sells all his livestock, machinery and implements to various buyers. He receives $100,000 from the sale, which will be included in his current GST turnover. He is not registered for GST, as his GST turnover from selling livestock is usually around $55,000. Does Graham have to register for GST? Go to Study help to check your answer.

[page 1246]

Beth, a retiree, owns three shops in a row in a small regional shopping centre. Each shop is rented to tenants whose weekly tenancies are to terminate on 14 December 2017. The rent payable for each of the three shops is $200 per week. The local council is planning an expansion of the shopping centre and Westfield gets approval to develop the area. Beth sells the shops to the Westfield company for $200,000. Beth’s only enterprise is renting the shops. She is not registered for GST and does not intend to carry on any other enterprise in the next 12 months. Settlement is to take place on 20 December 2017. Beth’s current GST turnover as calculated in December 2017 is the sum of the values of all the supplies that she has made or is likely to make during the 12 months ending on 31 December 2017. She has no supplies that are excluded under the GST Act. (Sections 18815 and 188-20 of the GST Act deal with excluded supplies such as input taxed supplies. These concepts will be dealt with later in the chapter.) Does Beth have to register for GST? See Study help for a suggested solution.

Registration and cancellation 19.24 When an enterprise meets one of the turnover threshold tests, it has 21 days in which to apply to be registered: GST Act s 25-1. Applications must be received on the approved form and the

Commissioner must register the entity if satisfied that it is carrying on an enterprise, or will do so from a particular date, or where the Commissioner is satisfied that it is required to be registered: GST Act s 25-5. Should a registered taxpayer cease its enterprise, it must apply for cancellation of its registration, again on the approved form, within 21 days: GST Act s 25-50. The Commissioner must cancel the taxpayer’s registration if satisfied that the taxpayer is not carrying on an enterprise and that it is not likely to do so for at least 12 months — this seems to apply whether or not the taxpayer has applied for cancellation: GST Act s 25-55.

Exceptions to the general registration rules 19.25 The general registration rules are, like many other aspects GST, subject to exceptions. These exceptions have been put in place order to deal with unusual situations so as to achieve the best result terms of the impact of GST. Some of these exceptions are discussed the paragraphs below.

of in in in

Branches 19.26 Division 54 of the GST Act deals with branches. Although they are part of a larger entity, branches may themselves apply for registration. This enables the branch to lodge separate GST returns and to make separate GST payments as well as [page 1247] receive separate GST refunds, independently of the parent entity. It may well be that, for practical reasons, or reasons of financial control or geography, this is desirable.

Agents for non-residents 19.27

Division 57 of the GST Act deals with residents who are acting

as agents for non-residents. In cases where the non-resident is registered, or required to be registered, their agent must also be registered.

Taxis 19.28 Division 144 of the GST Act requires a person who is carrying on an enterprise supplying taxi travel to be registered. This registration requirement is independent of the enterprise’s annual turnover. This policy is apparently in the interests of simplicity and reducing both adverse impacts on the industry and tax avoidance.7 An argument over whether an Uber car is a taxi was recently resolved in favour of the Commissioner in relation to whether the services provided by Uber drivers are covered by these rules. See Uber B.V. v CT [2017] FCA 110.

Taxable importations 19.29 Section 7-1 of the GST Act imposes GST on both ‘taxable supplies’ and ‘taxable importations’. The preceding discussion has focused on taxable supplies and the related definitions arising from the definition of ‘taxable supply’. ‘Taxable importations’ are defined in the GST Act. Division 13 deals with the general rules applicable to taxable importations and Div 114 deals with certain special rules relating to importations. According to s 13-5 of the GST Act, a ‘taxable importation’ is made if goods are imported and they are brought into the country for what is termed ‘home consumption’. The latter does not mean consumption within the domestic environment of the taxpayer but is a special term used in the Customs Act 1901 (Cth). It means that they are used, applied or consumed within Australia. The approach in the rules is that any importations of goods into Australia are taxable importations save to the extent that the rules define them as non-taxable importations: s 13-5(1). The non-taxable importations mentioned in the Act are found in s 13-10 of the GST Act, which provides that an importation will be a non-taxable importation if it is specifically stated to be a non-taxable importation by Div 42 of the Act, or if it would have been a supply that was GST-free or input taxed if it had originated in Australia. Division

42 cross-refers to certain goods covered by customs legislation and is discussed at 19.46. [page 1248] Where a taxable importation has been made, the importer is usually liable to pay the tax on it. This solves the difficult administrative problem of ensuring that GST is collected on an importation when the supplier, being outside Australia, is neither subject to the GST Act nor can be practically compelled to comply with the GST Act. There is a new exception to this in the case of cross border supplies by an electronic platform or similar supplier, which are now treated the same as cross border digital supplies. The new rules applicable to cross border digital supplies extend the meaning of ‘connected with the indirect tax zone’ so as include supplies of intangibles to an ‘Australian consumer’: see 19.20. If the recipient of a digital product (eg, music, apps, games, movies, etc) or an intangible, such as professional services, is an ‘Australian consumer’, the supply is connected to the indirect tax zone and GST should be remitted by the supplier. This will apply if the recipient is not registered for GST and but makes the acquisition for carrying on their enterprise, or if the consumption is private and domestic. If a supplier has taken reasonable steps to ascertain that the recipient is not an ‘Australian consumer’ and believes this to be so, it need not remit the GST. Some are calling this a ‘Netflix’ tax. Whereas there is a rule that registered consumers that receive supplies for private purposes are required to pay GST that was not paid by the supplier, there seems to be no rule that makes unregistered domestic consumers of imported intangibles liable to pay GST if the supplier did not. From July 2018, similar rules apply also to goods supplied in this manner and it is expected that the supplier will collect the GST and remit it to the ATO in respect of supplies of goods to Australian consumers.

Liability for GST 19.30 Liability for GST falls on the party which makes the taxable supply or the taxable importation. It is noticeable that, although the ultimate consumer effectively pays the GST, it is the supplier who is liable to pay it to the ATO. There is no right that is established under statute law to recover GST from customers. The right to recover GST, if such a right is to exist, must be included in the agreement reached between the parties. As a general rule, this is done by means of setting the sale price of the goods. A supplier who forgets to charge GST at a time when they are registered (or required to be registered) will be required to remit to the ATO 10% (ie, 1/11th) of whatever they received from their customers. The amount of the GST is established by s 9-70 of the GST Act, which stipulates the amount of GST on a taxable supply is 10% of the value of the taxable supply. ‘Value’ is a defined term in s 9-75 of the GST Act, which provides that the ‘value’ is the ‘price’ of the goods multiplied by the fraction of 10/11th. The ‘price’ for these purposes is the amount of money payable on supply, that is, the consideration for the supply or, where the consideration is not expressed in terms of money, it is the GST-inclusive market value of that consideration. The practical effect is that if an agreement for a taxable supply is silent as to whether the recipient must pay GST to the supplier in addition to the contract price, [page 1249] the supplier will be liable for GST of 1/11th of the contract price — whether or not the supplier has built GST into the contract price. Relating it to the sections, the contract price will be taken to be the ‘price’ (the consideration); the ‘value’ is 10/11th of the contract price (GST Act s 9-75); and the GST is 10% of the ‘value’ (GST Act s 9-70) — that is, 1/11th of the contract price. The recipient, if registered for

GST, may be entitled to claim an input tax credit of 1/11th of the contract price, even though GST was not built into the price they paid. If the agreement specifies that the recipient must pay to the supplier an additional 10% of the contract price, being the GST, the ‘price’ of the supply will be the contract price plus the GST (the consideration) and the ‘value’ of the supply will be 1/11th of that amount — that is, the contract price.

GST-free supplies Introduction 19.31 A policy decision was made that certain supplies should not be subject to GST. In traditional VAT models, this is achieved by designating the supplies either as subject to a GST rate of 0% (‘GSTfree’ or ‘zero-rated’ supplies) or, by means of an exemption system, not subject to GST (‘input taxed’ or ‘exempt’). The key difference is that, in the case of GST-free supplies, GST is not borne by any part of the supply chain, whereas, in the case of an exemption system, the supplier immediately prior to the final consumer bears the GST. This follows because, as detailed previously, the supplier of a ‘GST-free’ supply is entitled to claim a refund of the input taxes paid on goods and services purchased in the course of making the supply. And, as you might expect, the supplier of an ‘input taxed’ supply is unable to claim a refund of input taxes paid and probably eventually passes this cost on to final consumers in higher prices. The earlier discussion about the basics of GST (see 19.3) mentioned the potential for confusion arising from the different terms used in different countries. For present purposes, it is sufficient to bear in mind that in Australia both types of supply are loosely termed ‘exemptions’ and that, in other systems, ‘GST-free’ supplies are known as ‘zero-rated supplies’ while ‘input taxed supplies’ are known as ‘exempt supplies’.

Types of GST-free supplies and the reasons for them

19.32 The supplies that are GST-free are set out in Div 38 of the GST Act. The list of supplies treated as GST-free under that Division is: Subdivision 38-A ‘Food’; Subdivision 38-B ‘Health’; Subdivision 38-C ‘Education’; Subdivision 38-D ‘Child care’; Subdivision 38-E ‘Exports and other supplies that are for consumption outside Australia’; Subdivision 38-F ‘Religious services’; Subdivision 38-G ‘Activities of charitable institutions etc’; [page 1250] Subdivision 38-I ‘Water, sewerage and drainage’; Subdivision 38-J ‘Supplies of going concerns’; Subdivision 38-K ‘Transport and related matters’; Subdivision 38-L ‘Precious metals’; Subdivision 38-M ‘Supplies through inwards duty free shops’; Subdivision 38-N ‘Grants of land by governments’; Subdivision 38-O ‘Farm land’; Subdivision 38-P ‘Cars for use by disabled people’; Subdivision 38-Q ‘International mail’; Subdivision 38-R ‘Telecommunications supplies made under arrangements for global roaming in Australia’; Subdivision 38-S ‘Eligible emissions units’; and Subdivision 38-T ‘Inbound intangible supplies’. It will be noted from this long list that there are many categories of GST-free supplies — and supplies may be on the list for a variety of reasons. There may be economic reasons, such as ensuring that Australia is competitive in relation to its trading rivals. This reason applies to exports (Subdiv 38-E) and, as a consequence, to international

mail (Subdiv 38-Q) — if there is to be no GST on exports there should be no GST on postage stamps, which pay for the exporting of the item. Another economic reason is to minimise the extent to which the tax impacts on economic efficiency by influencing decision-making through unnecessary administration or compliance costs. This applies to the supplies of going concerns and of farmland: Subdiv 38-O. As land prices are likely to be amounts such that paying the GST would necessitate raising a significant amount of money, the inclusion of GST in the price could inhibit sales. Since sales are most likely to occur between GST-registered persons, the purchaser will (through input tax credits) eventually receive a refund of the GST paid in the sale price. Thus, making the supply of farmland GST-free removes a potential distortion without affecting the amount of revenue raised. Other items are on the list for social or political reasons. For example, a society might decide that non-commercial charitable activities, fundraising activities of certain charitable institutions, health, childcare, education and other similar services should not be taxable for reasons of equity. Any indirect tax is, almost by definition, regressive and a broad-based consumption tax like GST or VAT is no exception. This means that its impact on less wealthy consumers is relatively heavier than its impact on the rich because it takes no account of the ability of an individual consumer to pay. (An indirect tax, like GST, is unlike a direct tax, such as income tax, in this respect because income tax is related to personal circumstances with different rates at different income levels and allowances for taxpayers in particular family, social or other personal circumstances.) One way of ensuring that the impact of this regressivity is minimised is to set the rate at zero. Subdivision 38P also falls into this category. As part of the political compromises that had to be made in order for GST to be introduced in Australia, Subdiv 38-A was introduced. This was done in order to ensure that a subset of foods is not subject to GST and was to address regressivity. [page 1251]

In this chapter, we deal with a limited number of the GST-free supplies. It is important to remember that the GST-free supplies dealt with here are not the only GST-free supplies available. Before moving to the specific GST-free supplies discussed below, it is important to remember that the effect of a supply being GST-free is that no GST is required to be paid on the supply of that good or service, but all input tax that has been paid in relation to the making of that supply is, nevertheless, claimable as a credit by the supplier. This means that the cost of the supply to the recipient contains no element of GST and it can truly be termed a ‘GST-free supply’.

Food 19.33 Section 38-2 of the GST Act states that ‘a supply of *food is GST-free’. Thus, the meaning of the word ‘food’ is critically important for the operation of this exemption. The aim of the definition of food, found in s 38-4 of the GST Act, is to ensure that ‘basic’ food for human consumption is free from GST. The full text of s 38-4 is too long to repeat here. The section contains 10 paragraphs that explain what is and what is not ‘food’. The intent of these paragraphs is to make it clear that, for GST purposes, ‘food’ includes food that is intended for human consumption, whether or not it requires any further processing or treatment prior to being ready for consumption. This extends to the ingredients used in making food for human consumption; to beverages, and their ingredients, for consumption by humans; and to any goods that might be mixed or added to food, including such things as spices and seasonings as well as fats and oils that are consumed by humans. Express exclusions from the definitions of food are (sometimes surprisingly and sometimes not so surprisingly) such things as live animals other than shellfish, unprocessed cow’s milk, raw cereals, grains and sugar that has not been subjected to any process or treatment resulting in an alteration of its form. From the latter, one can conclude that sugar is food, but that sugar cane prior to its being milled is not. Also excluded are plants under cultivation that can be consumed without being subject to further processing or treatment as food for human consumption, notwithstanding that they can be consumed

without further treatment — they are, nevertheless, not food for GST purposes. These inclusions and exclusions have particular implications for primary producers like farmers or market gardeners. The statutory exclusions indicate that, generally, items will not be food for the purposes of the Act until they are processed or treated in some way as to make them fit for human consumption. Thus, sales by farmers of primary products for further processing would be subject to GST.8 The picture of what food is GST-free and the implications of that picture are incomplete until consideration is given to the definition of food that is not GST-free. Food that is not GST-free is defined in s 38-3 of the GST Act. This definition is, once [page 1252] again, too lengthy to repeat here, but, broadly speaking, it has the effect of making prepared food subject to GST. Section 38-3(1) states that a supply is not GST-free if it is: a supply of food for consumption on the premises where it is supplied; hot food for consumption away from those premises (take-away food); a specified type of food set out in Sch 1 to the GST Act, or a combination of those special types of food; a beverage set out in a Schedule to the GST Act (GST Act Sch 2); or food specified in regulations as not being GST-free. The effect of this exclusion from the meaning of ‘food’ is that food and drinks supplied, for example, for consumption in a restaurant, and hot food for consumption after being taken away from those premises, are not GST-free. The Act goes further and defines what is meant by ‘premises’ from which food is supplied. This definition in s 38-5 of the GST Act includes

within its meaning the grounds surrounding the food supplier, although it does not generally include a public thoroughfare unless it is an area designated for use in connection with the food outlet, such as the area of a pavement café. This means that any food or drink supplied at, for example, a sports venue or a recreation park will be subject to GST regardless of whether it is consumed in the food outlet or not, because, under the definition, the grounds of a football ground, for example, are specifically included within the ‘premises’ used in supplying food: s 385(c). Reference has been made above to Schedules of the Act that specify further categories of food that are not GST-free. Schedule 1 to the GST Act sets out 32 categories of food that are not GST-free and five sets of explanations in relation to some of those categories. These categories range from ‘prepared food’, such as pizzas, quiches, hot dogs, etc, through confectionery, savoury snacks, bakery products and biscuits and on to ice cream and similar frozen confectionery. This means that take-away food which has not been heated and is therefore not ‘hot food for consumption away from those premises’ as stipulated in s 383(1)(b) may, nevertheless, fall into the category of food that is not GSTfree by reason of it being ‘prepared food’ within Sch 1 to the Act: see GST Act Sch 1 item 4. The categories set out in the Schedule and Div 38 are not without anomalies. For example, it may seem that the intention behind the legislation is to include complete meals as ‘prepared food’. However, cl 3 of Sch 1 to the GST Act indicates that the Sch 1 item 4 ‘food marketed as a prepared meal, but not including soup’ applies only to food that requires refrigeration or freezing for its storage. It would seem that food that does not require refrigeration or freezing for storage, for example, food that comes in a tin or vacuum pack, will be GST-free even if it appears to be a prepared meal. A full appreciation of the complexities of the inclusions and exclusions from food that is GST-free will be best obtained by a review of Sch 1 of the GST Act. The Act can be found on the ATO website in the Legal Database area. At the same site, you can see GST Determination GSTD 2000/5, which deals with the question, ‘When is a

supply of food in terms of para 38-3(1)(a) of the GST Act a supply “for consumption on the premises from which it is supplied”?’ [page 1253]

Packaging of food 19.34 The GST status of the food also has implications for the GST status of the packaging in which it is supplied. Section 38-6 of the GST Act states that a supply of packaging in which food is supplied is GSTfree if the supply of food is GST-free. This is limited, however, by s 386(2) which states that the supply of the packaging is GST-free only to the extent that the packaging is necessary for the supply of the food and is packaging of a kind that is normally supplied. This suggests that the supply of a cardboard container for an item of food that is GST-free, for example, a quantity of strawberries, would also be GST-free. If, however, the packaging supplied is of an unusual kind or is unnecessary for the supply of the food then the supply would not be GST-free. Thus, the supply of honey in a glass jar, or even a glass jug, may be GST-free. The supply of that honey in a lead-crystal container would clearly not be GST-free. What rule do you think should apply to a supply of honey in a miniature glass beer-mug?

The Sandcastle family (mother, father, and two children) visit a suburban beach on their summer holidays. They decide to picnic at the beach, and while Mr Sandcastle stays on the beach to play with the children Mrs Sandcastle goes up the beach to the High Street to buy them a picnic lunch. She returns with the following: a ham and salad roll for the father; three bread rolls purchased from the baker for herself and the children and an avocado to put in the three rolls (the father does not like avocado, his family do not like ham — they have a suitable knife in their beach set to cut the rolls and avocado); four oranges purchased from the greengrocer along with the avocado;

four tubs of ice cream for dessert, and five drinks — one carton of milk, one can of cola, one large bottle of water, one plastic container of freshly squeezed carrot juice and one bottle of plain orange juice. Which parts of the picnic lunch are GST-free and which are not? See Study help for a suggested solution.

Health 19.35 Subdivision 38-B of the GST Act deals with medical and other health services, hospital treatment, medical aids, drugs and health insurance. According to s 38-7 of the Act, a supply of a medical service is GST-free. A ‘medical service’ is defined in s 195-1 of the GST Act to mean a service supplied by or on behalf [page 1254] of a medical practitioner, or an approved pathology practitioner, that is generally accepted in the medical profession as being necessary for the appropriate treatment of the recipient of the supply. A ‘medical practitioner’ is defined under the Health Insurance Act 1973 (Cth) as a medical person licensed or registered as a medical practitioner under the law of a state or territory. Generally speaking, medical services are not GST-free where they are not covered by Medicare: this includes services listed in the Health Insurance Regulations 1975 (Cth) under the Health Insurance Act 1973 (Cth) (s 38-7(2)(a)) and services provided for cosmetic reasons (s 38-7(2)(b)). Some of these exclusions from Medicare (and which are, therefore, not GST-free) are surprising; for example, professional services rendered in relation to the use of hyperbaric oxygen therapy in treating multiple sclerosis. Others are not so surprising, such as services rendered for the removal of tattoos: see reg 14 of the Health Insurance Regulations 1975 (Cth), excluding regs 14(2)(ea), (f) and (g). There is also a list of health services provided by recognised professionals, whether government funded or not, which are GST-free.

These are additional to the medical services referred to above. These health services are listed in a table in s 38-10(1) of the GST Act. Such supplies include items such as acupuncture, chiropody, dental services, supplies of herbal medicine, physiotherapy and so on. Pharmacy services are also GST-free but only if they fall within the criteria set in s 38-50 of the Act. These include where drugs are supplied to an individual for private or domestic use by humans and they: are supplied only by prescription; or are supplied by a person permitted under law to supply them but only if they could not be supplied by anyone else; or fall within the government’s Pharmaceutical Benefits Scheme (ie, the application of Medicare to pharmaceutical supplies). This section also provides that certain painkillers approved by the Minister for Health may be GST-free.

Hospital treatment 19.36 Under s 38-20 of the GST Act, the supply of hospital treatment is GST-free to the extent that it involves a ‘professional service’ that is GST-free. A ‘professional service’, according to s 3(1) of the Health Insurance Act 1973 (Cth), means: (a) a service (other than a diagnostic imaging service) to which an item relates, being a clinically relevant service that is rendered by or on behalf of a medical practitioner; or (b) a prescribed medical service to which an item relates, being a clinically relevant service that is rendered by a dental practitioner approved by the Minister in writing for the purposes of this definition; …

‘Hospital treatment’ is also a defined term encompassing accommodation and nursing care and the provision of relevant health services to, or facilities at a hospital [page 1255]

for, a patient of the hospital: GST Act s 195-1, which refers to the Private Health Insurance Act 2007 (Cth).

Medical aids and appliances 19.37 Schedule 3 of the GST Act and Sch 3 of the GST Regulations together list a number of medical aids and appliances designed for people with illness or a disease, which can be supplied GST-free under s 38-45(1) of the GST Act. There are 158 of these items in Sch 3 of the Act, and a further 20 items in Sch 3 of the Regulations. Not only is the type of supply important, but the place at which it is supplied can be important too. Thus, under s 38-7(3) of the GST Act, a supply of goods (not particularly medical goods) is GST-free if it is made to an individual in the course of supplying to the individual a medical service which is GST-free and is made at the premises at which the medical service is supplied. A supply of ‘health goods’ may also be GST-free by virtue of a determination made by the Health Minister: GST Act s 38-47(1). Such goods include items such as sunscreen, condoms, folate tablets, etc. It is open to the supplier and the recipient not to treat these goods as GSTfree if that would be more convenient for them.

Education 19.38 Education is dealt with under Subdiv 38-C of the GST Act, and ‘education courses’, ‘course materials’ and the administrative services directly related to them and which are supplied by the same supplier are all GST-free. ‘Education course’ is defined in s 195-1 of the GST Act along with a list of terms that are further defined in that section. Thus, ‘education course’ means: a pre-school course; a primary course; a secondary course; a tertiary course; a masters or doctoral course;

a special education course; an adult and community education course; an English language course for overseas students; a first-aid or lifesaving course; a professional or trade course; a tertiary residential college course. Because each of these items is further defined within the Act, it cannot be assumed that a course will necessarily be GST-free. Thus, for example, the mere fact that a course is a tertiary course will not necessarily mean that it is GST-free. The definition of ‘tertiary course’ in s 195-1 includes courses determined by the Federal Education Minister under the Student Assistance Act 1973 (Cth). These courses will be GST-free, together with any other courses the Minister determines to be GST-free or that have been specifically included in the Act. Currently, this excludes hobby courses. [page 1256] Another important distinction is the difference between courses that are undertaken to obtain qualifications and those undertaken to maintain qualifications. Courses taken to maintain qualifications will only be GST-free if they satisfy the conditions outlined in a definition of ‘adult and community education courses’. This would exclude typical community education courses held in the evenings and covering topics such as music, pottery, picture-framing, etc. The sections of the Act dealing with GST-free supplies of education are also not without anomalies, and to address the room for confusion there have been a number of rulings on the subject.9 For example, accommodation in a boarding school or in a hostel providing accommodation for students from rural or remote locations will be GST-free under s 38-105 of the GST Act. This, however, applies only to students undertaking a primary course, or a secondary course, or special education. It does not apply to tertiary courses. Thus, accommodation

provided in a hostel dormitory at boarding school is GST-free, but accommodation provided in a university college is not.

Exports 19.39 The GST-free nature of exports is justified by reason of the desire to ensure that Australia is competitive as an exporter. If tax is included as part of the cost of goods that Australia exports, Australia might be at a disadvantage vis-à-vis its competitors on world markets. Accordingly, Subdiv 38-E of the GST Act sets out a list of supplies for consumption outside Australia that are GST-free.10 The main one is the export of general goods that are considered to be GST-free if the supplier exports them from the indirect tax zone within 60 days of the earlier of the day on which the supplier receives any consideration for the supply or the date that the supplier gives an invoice for the supply. There are also provisions within s 38-185 of the GST Act that deal with the export of goods paid for by instalments. In the latter case, the export is GST-free provided it takes place within 60 days of the earlier of the day on which the supplier receives the final instalment of the consideration for the supply or the day on which the supplier gives an invoice for that final instalment. Goods exported as the accompanied baggage of a traveller are included in the list of GST-free exports (s 38-185 item 7), as is a supply of goods in the course of repairing, renovating, modifying or treating other goods whose destination is outside the indirect tax zone. The latter supply is subject to the condition that the goods become attached to, or part of, the other goods, or that they become incapable of further separate use, as a direct result of being used to repair, modify, etc the other goods (s 38-185 item 6). Goods that have already been exported from the indirect tax zone will not continue to be GST-free when they are re-imported. The rationale of export competitiveness will have fallen away by reason of the re-importation. [page 1257]

In the case of supplies of things other than goods for consumption outside the indirect tax zone, s 38-190(1) of the GST Act contains a detailed table of the rules that will apply. Under this section, the following five types of supplies are GST-free:11 1. a supply of a thing that is ‘directly connected with goods or real property situated outside the indirect tax zone’, irrespective of where the recipient is; 2. a supply that is made to a non-resident who is not in the indirect tax zone when the supply is made.12 This is provided that the supply is not a supply of work physically performed on goods inside the indirect tax zone when the work is done, nor a supply that is connected with real property in the indirect tax zone. Alternatively, a supply that is made to a non-resident who is not in the indirect tax zone at the time of supply and where the nonresident acquires the thing in carrying on an enterprise and is not registered or required to be registered in Australia is GST-free. This latter requirement means that if the non-resident would get an input tax credit for the supply then there is no need for it to be made GST-free; 3. supplies used or enjoyed outside the indirect tax zone where they are made to a recipient who is not in the indirect tax zone at the time of the supply and where they are for the effective use or enjoyment of that recipient, which takes place outside the indirect tax zone;13 4. a supply that is made in relation to rights if the rights are for use outside the indirect tax zone, or the supply is to an entity that is not an Australian resident and is outside the indirect tax zone when the supply is made; and 5. a supply that takes the form of a repair, renovation, modification or treatment of goods from outside the indirect tax zone whose destination is outside the indirect tax zone. Some of these might be illustrated by example. The work of an architect in relation to a building in New Zealand would be GST-free on the grounds that it is a supply connected with property outside the indirect tax zone. The provision of legal advice to a Singapore resident

concerning a transaction, perhaps concerning the Australian GST rules, would be a supply made to a recipient who is not in the indirect tax zone when the thing supplied is done and for the effective use or enjoyment of that thing outside the indirect tax zone. Thus, this supply would be GST-free.

Going concerns 19.40 Included in the long list of things that are GST-free is the supply of a going concern. Section 38-325 (Subdiv 38-J) of the GST Act provides that a supply of a going concern is GST-free if it is for consideration, the recipient is registered or required to be registered, and the supplier and the recipient have agreed in writing that the supply is a supply of a going concern. At the time of writing, the amendment of the going concern rules is under consideration but no legislation has been drafted. [page 1258] Obviously, what is meant by a ‘going concern’ is important. Accordingly, s 38-325(2) states that: (2) A supply of a going concern is a supply under an arrangement under which: (a) the supplier supplies to the recipient all of the things that are necessary for the continued operation of an enterprise; and (b) the supplier carries on, or will carry on, the enterprise until the day of the supply (whether or not as a part of a larger enterprise carried on by the supplier).

The rationale for this GST-free supply is that if the supply of a going concern were not GST-free, the seller of a business would be required to charge GST on the price of the business. The acquirer of the business would have to pay that GST but, in the next accounting period, would be entitled to an input tax credit for the amount of GST that has been paid. The exemption has been established in order to avoid this, and to

avoid the extra burden of the acquirer having to finance the GST amount for the short period (also known as the ‘cash flow cost’ of financing the GST for a short time). There may often be a question whether the supply has taken the form of a going concern and, indeed, whether the recipient has provided ‘all of the things that are necessary for the continued operation of an enterprise’. It is worth noting that the enterprise that is continued by the acquirer does not have to be the same enterprise as the one that is handed over. In addition, it seems that there is no requirement that the recipient actually carry on that enterprise — the requirement under this section is merely that all things that are necessary for the continued operation of an enterprise are transferred. Of course, were the recipient not to continue an enterprise, it may well be required to pay the GST on the closure of its enterprise. Other important considerations are that the supplier must continue to carry on the enterprise until the day of supply and, most importantly, both the supplier and the recipient must agree in writing that the supply is one of a going concern. This latter condition avoids the problem of one party claiming that the supply was of a going concern and no GST needs to be paid to the ATO, and the other party claiming that the supply was not of a going concern but that they paid GST in the purchase price and that they now require a refund from the ATO.14 Note: The government has announced that it will replace the current going concern exemption with a ‘reverse charge’ rule under which the sale of a wider set of assets in going concern situations will be subject to GST but the purchaser will have to remit the GST and simultaneously claim a refund — on the same BAS — on the grounds that it is a going concern acquisition. At the time of writing, the law has not yet been changed. [page 1259] Consider Problem 19.7, and the suggested solution in Study help in order to learn more about the going concern exemption.

Black Panther Printing and Copying (Black Panther) is a large business with printing and copying outlets all across Australia. It is fiercely competitive and competes aggressively with businesses that it sees as competitors for clients. Crackle Printers opens up a few streets away from Black Panther’s main outlet in Melbourne’s CBD. After a few years of price wars and advertising campaigns, the owners of Crackle Printers agree to sell their business to Black Panther. As Crackle Printers is a family run business, the owners have no staff but have well-maintained printing facilities, a long lease and a large clientele on their books. They agree to sell Crackle Printers as a going concern to Black Panther and to leave the printing and copying business in that district for at least three years. They operate the business until the date of change of ownership, having assisted Black Panther in taking over their lease. Immediately after the sale, Black Panther (whose purpose was to remove all competition) closes Crackle Printers and invites all its customers to Black Panther’s store a few streets away. Having no use for the printing and copying equipment, Black Panther sells it. Would this sale qualify as the sale of a going concern? See Study help for a suggested solution.

Input taxed supplies 19.41 It will be recalled that GST-free supplies are those that contain no component of GST because the supplier does not charge GST on supply of the thing and is entitled to input tax credits on the items consumed by the enterprise in making that supply. Input taxed supplies are different. Input taxed supplies are those which are not subject to a charge of GST when supplied, but in respect of which the supplier is not entitled to any input tax credits for items consumed in making the supply. Thus, the supplier bears the GST and will most probably pass on the cost, along with the other cost elements that make up their price. In cases where a particular supply might be regarded as both GSTfree and input taxed, the GST-free status overrides the input taxed status of that supply. A supply is regarded as input taxed if it is used solely in connection with supplies that are input taxed (with the exception of financial

supplies). In cases where the value of the taxable supplies are partly input taxed, s 9-80 of the GST Act applies so as to apportion the value of the supply between the taxable part and the input taxed part. A similar system operates in relation to partly GST-free supplies. [page 1260]

Financial supplies 19.42 One of the most important types of input taxed supplies is a financial supply. A full discussion of the complicated rules applicable to financial supplies is beyond the scope of this chapter, but it is important to be aware of the general principles applicable. ‘Financial supply’ is a term that covers a variety of financial facilities supplied to customers, based on activities involved in supplying financial services. The list of items that are financial supplies is contained in a table in reg 40-5.09 of the GST Regulations. Such things as a debit or credit arrangement, a letter of credit, a charge or mortgage over property, an annuity and a derivative are all ‘financial supplies’. Regulation 40-5.12 sets out the supplies that are not financial supplies. These include things such as debt collection services, broking services, a payment system, trustee services and so on. In addition to the limited list of items that are financial supplies (which has the effect of not exposing the whole of the Australian financial sector to the burden of an input tax regime), Australia has introduced a system of reduced input tax credits, which system is available to those who make financial supplies: see GST Act Div 70 and Regulations Div 70. Once a financial service provider has passed through the ‘gateway’ of Subdiv 40-A of the Regulations, and is the appropriate type of financial service provider, making the appropriate type of supply, it may be entitled to an input tax credit of 75% (reg 705.03) of the input tax credit that would be available if the supply to which it is attributable were regarded as a taxable supply under the ordinary rules. Thus, instead of these financial suppliers having to bear

the full cost of the input taxes they have paid, without the opportunity to offset them against GST collected from their customers, they are allowed an arbitrary percentage of the input tax credits that they would have been entitled to were they not making input taxed financial supplies. The rules are complex, and the government has simplified them a little by: increasing the financial acquisitions threshold in Subdiv 40-A of the GST Act, making it applicable to fewer suppliers (moving the relevant dollar amount of input tax credits in the test from $50,000 to $150,000); allowing small businesses that account on a cash basis to access full input tax credits upfront when they enter hire-purchase arrangements; and excluding bank deposit accounts from the current special rules for borrowings.15 However, the government also complicated the rules by lowering the Reduced Input Tax Credit (RITC) rate on certain services acquired by trusts (including superannuation funds) from 75% to 55%. The intention of these unique financial supply rules is to limit the extent to which the financial sector is unduly disadvantaged by the input taxing of financial services, and the intention of the changes seems to be to limit the extent to which small business is unduly disadvantaged by the financial supply rules. [page 1261]

Residential rents 19.43 An important example of an input taxed supply is the provision of residential premises for rent under Subdiv 40-B of the GST Act. According to s 40-35, a supply of premises that is by way of lease, hire or licence is input taxed if it is a supply of residential premises (other than commercial residential premises). This supply is input taxed

in an attempt to ensure comparable treatment for renters and owneroccupiers. Again, to preserve equity, the supply of a berth at a marina by way of lease, hire or licence is also input taxed in certain circumstances: GST Act s 40-35(1A). ‘Residential premises’ means land or a building occupied, or intended to be occupied as a residence and includes a floating home. The important exception to this is ‘commercial residential premises’. This is defined broadly and includes hotels, inns, boarding houses and the like, school accommodation premises, certain ships, camping grounds and similar residential premises. Supplies of commercial residential premises are generally taxable. This exception means that part of the commercial sector providing hotel accommodation and similar services is not subjected to the added cost of the input tax regime. However, in the case of long-term accommodation in such premises, special provisions may apply under Div 87 of the GST Act, which discounts by 50% the value on which the GST payable is calculated. Again, this is an attempt to achieve comparable treatment for different types of renters and to reduce the potential competitive disadvantage faced by the service provider. Note that a supplier of commercial accommodation of a long-term nature may elect to ‘opt-out’ of Div 87 so that the supplies are input taxed. To summarise, normal residential letting of a home will be input taxed (neither tenant nor owner–occupier pays GST) but a stay in, for example, holiday accommodation will not be. There could be a financial advantage in renting a private home for an extended period, rather than staying in, for example, a boarding house. In order to reduce the competitive disadvantage at which this would place suppliers of long-term accommodation in commercial residential premises, Div 87 provides some relief. Specifically, where accommodation is provided for a continuous period of 28 days or more in the same commercial residential premises (GST Act s 87-20), the GST amount payable for that accommodation is reduced by 50% (ss 87-5 and 87-10). The effect of this is to ensure that commercial accommodation used for relatively lengthy periods of time is not made less attractive than other rental

accommodation by reason of the fact that rented residential premises are input taxed and accommodation in commercial accommodation is subject to GST.

Residential premises 19.44 Subdivision 40-C of the GST Act deals with the input taxing of the supply of residential premises as distinct from the supply of accommodation in residential premises. The supply of residential premises is input taxed unless the residential premises concerned are newly constructed properties or the type of ‘commercial residential premises’ already discussed. This is provided for in s 40-65 of the GST Act. ‘New residential premises’ means residential premises that have not been previously sold as residential premises and that have not previously been the subject [page 1262] of a long-term lease. A sale or long-term lease of new residential premises is taxable. This means that the vendor of the new residential premises is able to claim input tax credits arising from the construction (or substantial renovation of them if that is the case) of the premises in question. Similarly, the builder of a hotel, inn, etc is able to claim input tax credits on the construction of the building. In all other cases, the supply of residential premises is input taxed. Thus, when a taxpayer sells the home that they have been living in, the supplier is input taxed and the taxpayer is not required to charge GST on the price and is unable to claim any input tax credits in respect of the supply of the residential premises. This keeps the ordinary person outside the GST system unless they are carrying on a business of selling new residential premises. There have now been a number of cases that clarify what is meant by ‘residential premises’, ‘new residential premises’, and ‘commercial accommodation’ in residential premises.

Fundraising events 19.45 Section 40-160 (Subdiv 40-F) of the GST Act specifies that supplies made at fundraising events are input taxed if the supplier is a charitable institution, a trustee of a charitable fund, or similar, and the supply is made in connection with a fundraising event and the supplier chooses to have all supplies that it makes in connection with the event treated as input taxed. In addition, the supplier’s records must show that the event is treated as input taxed. The effect of this is to relieve the charitable sector from the burden of GST compliance whenever it engages in fund-raising events which it believes it can run more efficiently and more cost effectively on the basis that they are input taxed. The concession is quite limited by reason of the definition of ‘fundraising event’. The events listed must not be conducted as part of a series or regular run of similar events. The listed events are to be found in s 40-165(1) of the GST Act and include a fete, a ball, a gala show, a dinner, a performance or similar event. Also included is an event comprising a sale of goods if each sale is for a consideration less than $20 and if the selling of such goods is not a normal part of the business of the supplier. In addition, a supplier may apply in writing to the Commissioner to have a particular event designated a fundraising event.

Non-taxable importations 19.46 In earlier consideration of taxable importations, we briefly mentioned non-taxable importations. These are non-taxable imported goods made not taxable for GST purposes because they are duty-free under customs law or would have been GST-free or input taxed if they were supplies rather than importations. This is, therefore, a category of importation of property which is neither GST-free nor input taxed — it is simply ‘non-taxable’. Division 42 of the GST Act lists non-taxable importations and crossrefers to Sch 4 of the Customs Tariff Act 1995 (Cth). These goods can

be summarised as mainly repair and warranty-related importations; goods of insubstantial value and [page 1263] other goods (such as donations or goods bequeathed by non-residents or trophies, etc from outside Australia).

Anti-avoidance 19.47 GST is a complex tax and the lists of exceptions, inclusions, modifications, etc may provide opportunities for a taxpayer to gain the maximum advantage from these exceptions, etc, in circumstances not intended by the legislature. In order to prevent large-scale tax avoidance, the GST Act includes both specific anti-avoidance provisions, and a general anti-avoidance provision. The general antiavoidance provision is contained in Div 165 of the Act. This general anti-avoidance provision is similar to, but wider than, the general antiavoidance provision in ITAA36 Pt IVA. If it can be concluded that the relevant elements of Div 165 have been met, then the Commissioner may make a declaration that has the effect of negating the GST benefit that the avoider received, or might receive, from the avoidance: GST Act s 165-40. In addition, the Commissioner may reduce another entity’s net amount of GST, to redress any disadvantage contingent on the avoider’s GST benefit: GST Act s 16545. Thus, any advantage caused to an entity or disadvantage caused to another entity by an avoidance scheme may be reversed by the Commissioner. The essential elements that determine whether Div 165 applies are that: there must be or must have been a scheme; an entity must obtain or must have obtained a benefit from a scheme; and

it must be reasonable to conclude that the sole or dominant purpose or the principal effect of the scheme must be or must have been to obtain a GST benefit. A scheme is defined in s 165-10(2) of the GST Act, and is very broad so as to include any arrangement, agreement, understanding, promise or undertaking, whether express or implied, and whether legally enforceable or not. It will include a plan, a proposal, an action or course of conduct, even if it is unilateral. The GST benefit that an entity gets from a scheme is determined from s 165-10(1), which defines such a benefit to cover: a reduction of the GST payable; an increase in a refund; a delayed payment of GST; and an accelerated refund of GST. The Act deems that a GST benefit can arise from a scheme even if there was no economic alternative to the scheme that would produce the same economic result without a tax benefit. This again is very broad and would cover any situation where an entity reduces its GST bill or increases its refund or simply influences the timing of its GST or refund to its benefit. These elements of ‘scheme’ and ‘benefit’ are subject to a purpose or effect test before the anti-avoidance provisions will actually apply. Thus, if a scheme existed and the GST benefit arose as a result, it must be reasonable to conclude that the sole [page 1264] or dominant purpose for entering the scheme, or the principal effect of the scheme, must have been to receive the benefit. The ‘sole or dominant purpose’ is understood to be the ruling, prevailing or most influential purpose: GST Act s 165-5. Section 165-15 of the GST Act lists the matters to be taken into account in considering an entity’s purpose in entering or carrying out a

scheme from which the ‘avoider’ received a GST benefit, and the effect of the scheme. Such matters include: ‘the manner in which the scheme was entered into or carried out’; ‘the form and substance of the scheme, including: (i) the legal rights and obligations involved’; and ‘(ii) the economic and commercial substance’; the ‘purpose or object’ of the GST Act; ‘the timing of the scheme’; ‘the period over which the scheme was entered into’; the effect that the GST Act ‘would have in relation to the scheme apart from’ Div 165; ‘any change in the avoider’s financial position [resulting] from the scheme’; any change in the financial position of an entity that ‘has … a connection or dealing with the avoider’ whether or not of a family business or other nature; ‘any other consequence for the avoider or the connected entity because of participation in the scheme’; ‘the nature of the connection between the avoider and a connected entity, including the question whether the dealing is or was at arm’s length’; ‘the circumstances surrounding the scheme’; and ‘any other relevant circumstances’. It can thus be concluded that the matters to be considered in determining the purpose or effect of the scheme are very wide indeed. They are wider than the matters set out in ITAA36 Pt IVA, which, for example, does not have a category of ‘any other relevant circumstances’. Some of the specific anti-avoidance measures have been covered earlier in this chapter where relevant. For example, the requirement that supplier and recipient have agreed in writing that the supply is of a going concern: GST Act s 38-325(1)(c). More detailed discussion is beyond the scope of this chapter.

Conclusion 19.48 It is clear from this chapter that the GST in Australia, although ostensibly simple, is, in fact, rather complex. It is one of the later GST systems to be introduced in the world and has attempted to benefit by learning from the mistakes of other tax systems and other jurisdictions. It was born of a political compromise. The result is a GST system that is conceptually simple but complex in operation, with many exceptions, ‘carve-outs’ and allowances made for different transactions and different industry sectors. 1.

2.

3. 4.

5.

See Ha v New South Wales; Walter Hammond & Associates Pty Ltd v New South Wales (1997) 189 CLR 465; 36 ATR 319. In this High Court case, the plaintiffs sought the refund of certain fees (imposed by the Business Franchise Licences (Tobacco) Act 1987 (NSW)) that they were required to pay to the state of New South Wales for statutory licences to sell tobacco products in their duty-free stores. The licence fees were required to be paid monthly, and were based on a specified percentage of the value of tobacco sold in a prior month. The plaintiffs had, in fact, sold the products without licences and had subsequently been assessed for fees of approximately $23m for the sales they had made. The plaintiffs sought a declaration by the High Court to the effect that the fees were invalid because they were ‘duties of excise’. Under s 90 of the Constitution, the power to impose duties of customs and of excise, and to grant bounties on the production or export of goods, is preserved exclusively for the Commonwealth Government. The plaintiffs were successful in their action — resulting in acute damage to the power of the states to raise their own revenues by charging such fees. The Commonwealth immediately introduced legislation under which it imposed such fees, and then passed these on to the states; however, the case exposed the fragility and limited scope of the tax base available to the states. A New Tax System (Goods and Services Tax Transition) Act 1999 (Cth); A New Tax System (Goods and Services Tax Imposition — Customs) Act 1999 (Cth); A New Tax System (Goods and Services Tax — General) Act 1999 (Cth). A mandolin is a type of stringed musical instrument like a ukulele or small guitar, usually used (these days) to play folk music. There are some exceptions. One example is that retail customers departing Australia with certain purchases may be able to claim a refund of the GST that they have paid by completion of a formal process at their port of departure (such as an international airport). However, this relates more to the change in nature of the goods as they become ‘exports’: see discussion of ‘GST-free’ supplies at 19.7. If the goods are re-imported, GST is again payable. Go to , click on ‘Legislation and supporting material’, ‘Extrinsic Material’, ‘Explanatory Memorandum and SRS’, then ‘1999’, and locate the Act title (accessed 29 September 2017).

6. 7.

8.

9. 10. 11.

12. 13. 14.

15.

Electronic Funds Transfer at Point of Sale (EFTPOS). It is apparently an attempt to learn from international experience. It seems when Canada introduced its VAT years ago, it was found that some taxi drivers touted for business with lower prices because they were not registered for VAT. This caused competition in the industry. In addition, some taxi drivers limited their activities as taxi drivers in such a way as to stay below the registration threshold, thus causing a shortage of taxis at particular times of the year (presumably winter!). This is in contrast to the originally stated intention behind the classification of food as GST-free or not, which is (see the Further Supplementary Explanatory Memorandum to the GST Bill at para 1.15) that food that is GST-free is to be GST-free ‘throughout the supply chain’. This means, apparently, that if the final consumption of the food is not GST-free then it is only at that point that tax will be charged; at all previous points in the supply chain, it will be treated as GST-free. Relevant rulings are GST Rulings GSTR 2000/27, GSTR 2000/30, GSTR 2001/1 and GSTR 2002/1. The main operative subsection is s 38-185(1) of the GST Act, which lists the supply of goods that will be GST-free. Note that these principles may be affected by the announced change to the concept of ‘connection with the indirect tax zone’ for supplies of intangibles to a recipient that is an ‘Australian consumer’: see 19.20. The Act uses the term ‘… when the thing supplied is done’: GST Act 38-190(1) item 2. But see note 11 above. GST Ruling GSTR 2002/5 explains the Commissioner’s views on what is meant by a ‘going concern’ and when a supply of a going concern will be regarded as GST-free under Subdiv 38-J of the GST Act. See Exposure Draft to Tax Laws Amendment (2011 Miscellaneous Measures) Bill (No 1) 2011 (Cth) (GST financial supply provisions), available at (accessed 14 September 2017).

References are to paragraph numbers

Index A Accounting accrual basis …. 3.33, 4.4–4.21 cash (receipts) basis …. 3.34, 4.5–4.13 change of method …. 4.8, 4.9 derivation of income see Derivation of income partnership accounts see Partnerships Accruals taxation system advance payments …. 4.15–4.19 change from cash basis to …. 4.8, 4.9 controlled foreign companies …. 18.22 derivation of income …. 3.34, 4.4–4.21 advance payments …. 4.15–4.19 change from cash to …. 4.8, 4.9 income derived …. 4.11 instalment payments …. 4.20, 4.21, 4.44 refinements …. 4.14–4.21 when appropriate …. 4.7 foreign source income …. 18.21 income derived …. 4.11 instalment payments …. 4.20, 4.21 when appropriate …. 4.7

Accrued leave payments assessability …. 5.35–5.37 deductibility …. 9.34, 9.36 unused annual leave …. 5.36 unused long service leave …. 5.37 Accrued leave transfer payments assessable income …. 5.3, 5.6 deductibility …. 9.36 definition …. 9.36 derivation …. 5.3 Acquisition costs see Cost base Acquisition rules …. 6.81 Administrative Appeals Tribunal (AAT) access to …. 16.30 appeal to Federal Court from …. 16.37, 16.39, 16.48 application requirements …. 16.42 burden of proof …. 16.38 choice of court or …. 16.36, 16.37 jurisdiction …. 16.37 power to provide remedies …. 16.37 preliminary hearing …. 16.42 procedure …. 16.42 review by …. 16.30, 16.42 application for …. 16.42 objection decision …. 16.35 reviewable decisions …. 16.36 substitute decision …. 16.43 Advance pricing arrangements see Transfer pricing

Airline transport fringe benefit …. 7.27, 7.41 Alienation of income see Personal services income Allowances …. 5.4 Alternative Dispute Resolution Scheme CGT exemption …. 6.129 A New Tax System (ANTS) …. 1.18 Animals definition …. 1.32 live stock trading stock, as …. 1.32, 11.3 Annual leave payments see Accrued leave payments Annuities assessability …. 3.62, 5.43 definition …. 3.65 exclusion from ETP definition …. 5.28 income …. 1.4, 3.62, 3.65 non-superannuation annuities …. 5.43 purchased annuities …. 3.65 superannuation income streams …. 3.65 Anti-tax-avoidance measures see Tax avoidance Appeals see Disputes Apportionment rule capital proceeds …. 6.95 cost base of CGT assets …. 6.116 depreciating assets …. 10.38

Asprey Committee …. 1.16, 10.94, 17.2 Assessable income …. 2.2, 2.4 accrued leave payment in lieu …. 5.35–5.37 transfer payments …. 5.3, 5.6 Australian law …. 1.4, 1.13, 1.14 capital gains included in …. 6.5 central provisions …. 5.1 compensation for loss of …. 3.68–3.70 construction of Div 6 …. 5.2 deemed dividends …. 13.17, 13.23, 13.29 derivation see Derivation of income Div 6, identified in …. 2.2 Div 15 provisions …. 5.3–5.21 dividends see Dividends English law …. 1.4 excluded amounts …. 2.4, 2.14 financial spread betting …. 3.28 GST excluded …. 4.46 income, concept of see Income insurance or indemnity for loss of …. 5.3, 5.16 jurisdictional limits of Div 15 …. 5.3 ordinary income …. 1.23, 2.1, 2.2, 2.4, 2.9–2.13, 3.1 profit as …. 4.22–4.31 recoupments …. 5.22–5.25 relevant provisions …. 2.3 return to work payments …. 5.3, 5.5 statutory income …. 1.23, 2.2, 2.4, 5.1 subsidies …. 5.3, 5.7

Assessment …. 16.1, 16.9 amendment …. 4.30, 16.11, 16.12 tax avoidance …. 17.17 time limits …. 4.30, 16.12, 17.17 challenges based on fault of the Commissioner …. 16.13 Commissioner’s powers …. 16.20–16.28 access to records …. 16.20–16.23 obtaining information and evidence …. 16.24–16.25 conclusive …. 16.13 deemed …. 16.10, 16.13 default …. 16.11 definition …. 16.3 disputing see Disputes due date …. 16.54 nil liability to tax …. 16.12 notice of …. 16.3, 16.9 ordinary …. 16.10, 16.13 original …. 16.9, 16.11 review of …. 16.1 self-amendment …. 16.12 self-assessment …. 16.3 ATO compliance model …. 16.5 companies …. 12.17 full self-assessment taxpayers …. 16.6, 16.10 penalties for non-compliance see Penalties self-assessment taxpayers …. 16.6 taxpayer advice …. 16.1, 16.14–16.18 taxpayer support …. 16.4 special …. 16.11 valid …. 16.13

Asset cost setting see Consolidated groups Associate deemed dividend excessive payment to …. 13.18–13.20 loan to …. 13.17, 13.22 definition …. 13.19 Associations see also Clubs deduction for membership payments …. 8.5, 9.28 demutualisation …. 3.32 exempt entities …. 2.21, 2.22 member subscriptions deductibility …. 8.5, 9.28 distribution …. 3.32 income, whether …. 3.30, 3.31 mutual receipts …. 3.30–3.3 payments for services …. 3.30 surplus funds at wind-up …. 3.32 unincorporated associations …. 3.30 partnerships distinguished …. 14.8, 14.13 Assumption of liability rule …. 6.98, 6.117 ATO practice statements …. 16.18 ATO rulings …. 1.22 Attributed foreign income exemption income …. 2.24 Audits evidence …. 16.24, 16.25 legal professional privilege …. 16.22, 16.26–16.28

limitations …. 16.22 offshore information notice …. 16.25 power to access records …. 16.20–16.23 power to obtain information …. 16.24–16.25 search warrants …. 16.20 Australian Business Number (ABN) …. 1.18 Australian carbon units CGT exemption …. 6.128 Australian Constitution basis of taxation …. 1.8–1.12 discrimination between states prohibited …. 1.11 High Court jurisdiction …. 16.49 laws imposing taxation …. 1.10 one subject only …. 1.10 states and taxation …. 1.12, 19.2 taxation power …. 1.9 Australian currency amounts to be in …. 3.7, 4.2 convertibility of income into …. 3.7 exchange rate gain or loss …. 3.21, 5.53 Australian tax law A New Tax System (ANTS) …. 1.18 case law …. 1.24, 1.25 constitutional basis …. 1.8–1.12 discrimination between states prohibited …. 1.11 Federal Government Tax Reform Plan …. 1.15

federal legislation …. 1.13, 16.2 Green Paper …. 6.1 Henry Review …. 1.20 historical development …. 1.5–1.17 Income Tax Assessment Act 1936 see Income Tax Assessment Act 1936 Income Tax Assessment Act 1997 see Income Tax Assessment Act 1997 interpretation see Statutory interpretation Jones v Leeming, effect of decision in …. 1.14 laws imposing tax …. 1.10 overview …. 2.1 practice statements …. 16.18 Ralph Report …. 1.19 Re:Think Initiative …. 1.21, 6.1 reform process …. 1.16–1.21 rejection of UK scheme …. 1.5, 1.6 restructuring …. 2.1 Review of Australia’s Future Tax System (2009) see Henry Review rewritten provisions …. 2.1 rulings …. 1.26, 16.15–16.18 sources …. 1.22–1.25 state laws …. 1.12 statute law …. 1.23 statutory interpretation see Statutory interpretation Tax Law Improvement Project (TLIP) …. 1.17, 2.1, 6.1 uniform taxation …. 1.15 Australian Taxation Office (ATO) compliance model …. 16.5 disputes with see Disputes

guidelines on choice of accounting method …. 4.35 indicative interpretations (ATO IDS) …. 16.18 practice statements …. 16.18 problem resolution service …. 16.32 rulings …. 1.22, 1.26, 16.15–16.18 taxpayer alerts …. 16.18 website …. 2.2B

B Bad debts assessable recoupments …. 5.23, 9.24 change in corporate ownership …. 12.107–12.111 alternative continuity of ownership test …. 12.110 business continuity test …. 12.107, 12.111 continuity of ownership test …. 12.107–12.110 current year, debt incurred in …. 12.109 first continuity period …. 12.108, 12.109 previous year, debt incurred in …. 12.108 second continuity period …. 12.108, 12.109 death or bankruptcy of debtor …. 9.22 deductibility …. 4.36, 8.5, 9.1, 9.2, 9.20–9.24 change in corporate ownership …. 12.107–12.111 existence of debt …. 9.21 formerly counted as assessable income …. 9.24 irrecoverable debt …. 9.22 written off during income year …. 9.23 purchased debt …. 9.24 question of fact …. 9.22 reasonable expectation of non-payment …. 9.22

subsequently recovered …. 9.24 Balancing adjustments adjustable value …. 10.44 after balancing adjustment …. 10.57 termination value less than …. 10.56 termination value more than …. 10.55 assessable amount …. 10.55 balancing adjustment event …. 10.55, 10.58 ceasing to hold asset …. 10.58 cost of asset, affecting …. 10.33 deductions following …. 10.56 depreciating asset becoming trading stock …. 10.58, 10.62 low-value asset pool …. 10.76 partnership …. 10.58, 14.44–14.47 receipt only partially in respect of …. 10.61 roll-over relief …. 10.67–10.69 termination value …. 10.59–10.61 capital allowance regime …. 10.5 cars …. 10.63, 10.64 CGT event K7 …. 10.65, 10.66 partnership asset …. 10.66 depreciating assets …. 10.5, 10.54–10.66 adjustable value …. 10.44, 10.57 cost of …. 10.33 low-value asset pool …. 10.76 split or merged …. 10.58 taxable purpose, use partially for …. 10.65 termination value …. 10.59, 10.60 GST taxable supply …. 10.60 non-deductible expenses …. 10.37, 10.60

partnership change in composition …. 14.44–14.47 cost rule …. 14.45 formation or dissolution …. 10.58 partner’s personal property …. 14.45 roll-over …. 14.46, 14.47 time limits …. 14.46 roll-over relief …. 10.67–10.69 automatic …. 10.68 choice as to …. 10.69 notice to transferee …. 10.68 partnership …. 14.46, 14.47 sale of Div 43 capital works …. 10.109 sum of reductions …. 10.65 termination value …. 10.59–10.61 cars …. 10.63 greater than cost …. 10.65 GST taxable supply …. 10.60 less than adjustable value …. 10.56 more than adjustable value …. 10.55 non-deductible expenses part of …. 10.37, 10.60 total decline …. 10.65 Bank/banking business income …. 3.53–3.56 waiver of bank fees as fringe benefit …. 7.10 Bankrupt partner …. 14.30, 14.33 paying debt, CGT event K2 …. 6.24 tax losses not deductible …. 9.69

trustee in bankruptcy CGT asset vested in …. 6.57 Barter transaction …. 3.7 Base Erosion and Profit Shifting Project (BEPS) …. 18.2, 18.3, 18.80, 18.84 Australian response …. 18.3, 18.54, 18.78, 18.84 Benchmark franking percentage see Dividend imputation system Benefit, definition …. 5.4 BEPS Action Plan see Organisation for Economic Co-operation and Development (OECD) ‘Black hole’ expenditure capital allowances for …. 10.82–10.88 deductions over five years …. 10.87 TR 2008/5 …. 10.88 project pools …. 10.84–10.88 Review of Business Taxation recommendations …. 10.83 Board fringe benefits …. 7.42 Boats deductibility of expenses …. 6.124, 9.41 reduced cost base, exclusion from …. 6.124 Bonuses assessable income …. 5.4 derivation …. 4.42 essential characteristic …. 7.57 salary or wages, whether included in …. 7.57 Borrowing expenses

amortisation …. 9.18 deductibility …. 9.2, 9.18 foreign resident …. 9.18 meaning …. 9.18 Bounties assessable income …. 5.3, 5.7 derivation …. 5.3 Bribes to public official denial of deduction …. 6.124 reduced cost base, exclusion from …. 6.124 Buildings see also Plant capital works see Capital works plant, whether …. 10.11, 10.13, 10.94 separate assets from land …. 6.84 Business badges of …. 3.46–3.51 business-related costs see Business-related costs definition …. 3.45, 8.8, 8.57 expenditure denied deduction see ‘Black hole’ expenditure forms of organisation …. 12.1–12.5 corporate tax entities …. 12.7 legal difference between …. 12.2–12.5 tax treatment …. 12.5, 12.6 hobby distinguished …. 3.40, 3.44–3.50, 8.18 income see Business income losses or outgoings in carrying on see Deductions travel see Business travel expenses Business activity statement (BAS) …. 16.59, 16.64

GST returns …. 19.3, 19.8 running balance account (RBA) and …. 16.66 Business income assignment of right to interest …. 3.57, 3.58 banking and insurance cases …. 3.53–3.56 California Copper principle …. 3.11, 3.44, 3.56, 3.58 capital/income distinction …. 3.44, 3.59, 3.61 carrying on business, proceeds of …. 2.15, 2.17, 3.44, 3.56 commercial transactions …. 3.45, 3.59 Cooling decision …. 2.17, 3.55, 3.60, 3.61 definition of business …. 3.45 existence of business …. 3.44–3.51 commencement …. 3.51 company, use of …. 3.51 indicia of …. 3.46–3.51 organisation and system …. 3.49 profit-making purpose …. 3.47, 3.59 repetition and regularity …. 3.48 size and scale of operations …. 3.50 type and quantity of good traded …. 3.51 hobbies distinguished …. 3.40, 3.45–3.51 illegal activities …. 3.51 investments, realisation of …. 3.53–3.56 isolated transactions …. 2.17, 3.11, 3.56, 3.57, 3.59 lease incentives …. 3.60, 3.61 mere realisation of property …. 3.56 Montgomery’s case …. 3.61 Myer Emporium decision …. 3.57, 3.58, 3.59 nature of business …. 3.52–3.55 ordinary income …. 2.15, 2.17, 3.44

particular transaction within business …. 3.56–3.58 profit-making purpose …. 3.47, 3.59 Business-related costs deducting undeducted expenditure …. 10.89 deduction of capital expenditure …. 10.89–10.91 asset for principle purpose …. 10.91 ‘proposed to be’, meaning …. 10.90 Business travel expenses deduction …. 9.73 record-keeping requirements …. 9.74, 16.19 substantiation …. 9.73, 9.74 travel diary …. 9.74 Buy-backs see Share buy-backs

C Capital income distinguished see Income/capital dichotomy losses and outgoings …. 3.8, 4.24, 8.61–8.69 not deductible …. 3.8, 8.4, 8.19, 8.27, 8.61–8.69 receipts …. 3.2, 3.8 sale of capital asset …. 3.2 Capital allowances assessable recoupments …. 5.23 background …. 10.2, 10.3 ‘black hole’ expenditure …. 10.82–10.88 deductions over five years …. 10.87 project pools …. 10.84–10.88

Review of Business Taxation recommendations …. 10.83 TR 2008/5 …. 10.88 building works see Capital works business-related costs …. 10.89–10.91 asset for principle purpose …. 10.91 ‘proposed to be’, meaning …. 10.90 core provisions …. 10.3 deductions over five years …. 10.87, 10.90 depreciation see Depreciating assets; Depreciation key features of Div 40 regime …. 10.5 mining and quarrying …. 10.4 overview …. 10.1 primary production …. 10.4 project pools …. 10.84–10.88 share issue in exchange for assets …. 10.88 uniform capital allowance regime …. 10.2, 10.3 capital works exclusion …. 10.8 exclusions …. 10.15 proposed changes …. 10.111 Capital assets acquisition …. 8.68 Capital benefits streaming advantaged shareholder …. 12.86 anti-streaming rules …. 12.84, 13.31 avoiding franking debits …. 12.88 bonus shares …. 12.84 deemed dividends …. 13.17, 13.31 definition of capital benefit …. 12.87 determination by Commissioner …. 12.88

franking credit tax offset not available …. 13.103 minimally franked dividends …. 12.85 non-share equity …. 12.84 provision of capital benefits, meaning …. 12.86 unfrankable distributions …. 12.85, 12.88, 13.103 Capital expenditure revenue expenditure distinguished …. 3.16 Capital gains and losses acquisition rules …. 6.81 assessable income, inclusion in …. 6.5 averaging provisions …. 6.22 companies …. 12.132 bunching …. 6.22 calculation of …. 6.6–6.21 capital gain …. 6.6–6.12 capital loss …. 6.7, 6.15–6.21 CGT see Capital gains tax (CGT) CGT events see also CGT events capital proceeds from …. 6.9, 6.12, 6.89–6.98 not giving rise to capital loss …. 6.18 companies see Companies discount capital gain …. 6.11 foreign source …. 18.7, 18.13 neither gain nor loss …. 6.19 net capital gain …. 6.6 assessable income, inclusion in …. 6.5 calculation of …. 6.6–6.12 capital losses reducing …. 6.13 capital proceeds from CGT event …. 6.9, 6.12

CGT event occurring …. 6.8 cost base for CGT assets …. 6.10 discount percentage …. 6.10 exemptions, whether applicable …. 6.8 net capital loss …. 6.13 applying …. 6.21 calculation of …. 6.15–6.18, 6.20 capital gain reduced by …. 6.13 capital proceeds compared with reduced cost base …. 6.17 carried forward …. 6.12 collectables, on …. 6.14, 6.18 not deductible from assessable income …. 6.21 personal use assets …. 6.18 plant …. 6.16 recouped expenditure …. 6.15 reduced cost base …. 6.15, 6.16, 6.121 partnerships see Partnerships and CGT pre-13 May 1997 assets …. 6.10 pre-21 September 1999 assets …. 6.10, 6.13, 6.22 separate gain for each CGT event …. 6.12 trusts see Trusts and CGT Capital gains tax (CGT) acquisition rules …. 6.81 calculating capital gain or loss see Capital gains and losses capital proceeds see Capital proceeds CGT events see CGT events change in residency …. 2.33, 2.34 commonwealth approaches …. 6.2 companies see Companies continental approaches …. 6.2

cost base of assets see Cost base; Reduced cost base date of acquisition …. 6.11 asset passing on death …. 6.11 roll-overs …. 6.11 direct value shift …. 13.137 discount …. 6.11 companies, not applicable to …. 12.132 foreign and temporary residents …. 18.37 percentage …. 6.10 trusts …. 15.88, 15.89 entity making gain or loss …. 6.57 exemptions see CGT exemptions foreign residents …. 2.33, 18.37 taxable Australian property …. 2.33, 6.54, 18.37 forex realisation events …. 5.54 fundamental principles …. 6.4–6.22 global approach …. 6.2 Henry Review recommendations …. 6.1 history …. 6.1 introduction of general tax …. 6.1 ITAA97 provisions …. 6.5 jurisdictional limits …. 2.33–2.35 liquidator’s distributions see Liquidator’s distributions main residence exemption see Main residence CGT exemption OECD countries, approaches in …. 6.2 overview …. 6.3 partnerships see Partnerships and CGT pre-CGT assets …. 6.126 companies …. 12.140–12.143 residents …. 2.33 rights and options …. 13.112–13.115

savings income discount, recommendation …. 6.1 securities, gains on disposal of …. 5.45 shareholders see Shareholders simplification, recommendation …. 6.1 small business concessions see Small business CGT concessions taxable Australian property …. 2.33, 6.54, 18.37 trusts see Trusts and CGT unit trusts see Unit trusts Capital proceeds actual payment or obligation to pay …. 6.89 apportionment rule …. 6.95 assumption of liability rule …. 6.98 capital gain, calculating …. 6.9, 6.12 CGT events, from …. 6.9, 6.12, 6.89–6.98 creation of contractual rights …. 6.37 definition …. 6.89 earn-out arrangements …. 6.89, 6.99, 6.118 entitlement to subsequent receipts …. 6.91 general rules …. 6.89 ‘in respect of’ CGT event …. 6.92 instalment payments …. 6.91 look-through approach …. 6.89 market value substitution rule …. 6.93, 6.94, 13.111 modifications to general rules …. 6.93–6.98 non-monetary consideration …. 6.92 non-receipt rule …. 6.96 receipt of money or property …. 6.90 repaid rule …. 6.97 separate asset approach …. 6.89

Capital works application of Div 43 …. 10.8, 10.97 background …. 10.94 buildings …. 10.13, 10.94, 10.96, 10.97 construction expenditure …. 10.100 definition …. 10.100 pool of …. 10.104 construction expenditure area …. 10.101–10.103 extensions …. 10.101 purchaser from speculative builder …. 10.103 date of commencement …. 10.99 deductions …. 10.94–10.96 basic conditions …. 10.95 calculation of …. 10.107 rates …. 10.108 disposal …. 10.109, 10.110 consequences …. 10.109, 10.110 no balancing adjustment …. 10.109 fixtures …. 10.13 key elements of Div 43 …. 10.97–10.106 overview of Div 43 …. 10.94 plant Div 43 not applicable …. 10.8 whether building or structure is …. 10.11, 10.13, 10.94 pool of construction expenditure …. 10.104 preliminary work …. 10.99 quasi-owner …. 10.102, 10.110 relationship between Divs 40 and 43 …. 10.8 sale of …. 10.109, 10.110 structural improvements …. 10.13, 10.94, 10.96, 10.97 undeducted construction expenditure …. 10.106

uniform capital allowance regime, excluded from …. 10.8 use for producing assessable income …. 10.8, 10.102 use in required manner …. 10.98 use of term …. 10.96 what are …. 10.97 your area, meaning …. 10.105 your construction expenditure …. 10.105, 10.106 Car expenses cents-per-kilometre method …. 9.71 depreciation deductions not allowed …. 10.15, 10.64 deductions …. 9.71 depreciation …. 10.15 personal services entity …. 9.88 substantiation …. 9.70, 9.71 fringe benefits …. 5.21 log-book method …. 9.71 depreciation deductions …. 10.15, 10.64 methods of calculating …. 9.71 one-third of expenses method …. 9.71 depreciation deductions …. 10.15, 10.64 record-keeping requirements …. 9.74, 16.19 reimbursements …. 5.21 assessable income …. 5.3, 5.21 derivation …. 5.3 substantiation …. 9.70, 9.71 12% of cost method …. 9.71 depreciation deductions not allowed …. 10.15, 10.64 Car fringe benefits base value of car …. 7.31

car, definition …. 7.29 definition …. 7.29 exempt benefit …. 7.30 motorcycle excluded …. 7.29 parking …. 7.45, 7.46 private use available for …. 7.30 definition …. 7.29 recipient’s payment …. 7.31 taxable value …. 7.31 valuation rules …. 7.31 operating cost basis …. 7.31, 7.32 statutory formula …. 7.31, 7.32 Car parking deduction of expenses …. 9.80 fringe benefits …. 7.45 conditions …. 7.45 valuation methods …. 7.46 Carbon tax …. 1.2 Carer payments exempt income …. 2.31 Cars CGT exemption …. 6.127, 14.74 definition …. 6.127 depreciation see also Depreciation balancing adjustment event …. 10.63 calculation method …. 10.15, 10.64 cost of asset …. 10.42

deductions …. 10.15 disabled people, for transporting …. 10.42 discount, acquired at …. 10.42 luxury leased car …. 10.20, 10.34 expenses see Car expenses fringe benefits see Car fringe benefits parking deduction …. 9.80 fringe benefits …. 7.45, 7.46 partnership, owned by …. 14.74 sale of formerly leased car …. 5.24, 5.25 Case law …. 1.24, 1.25 context …. 1.25 establishing legal principles …. 1.25 facts …. 1.25 ratio decidendi …. 1.24 stare decisis …. 1.24 CGT assets acquisition …. 6.79–6.83 application of correct rule …. 6.81 buildings separate from land …. 6.84 CGT events see CGT events cost base see Cost base definition …. 6.62–6.74 financial accounting …. 6.63 ITAA97 …. 6.64 goodwill …. 6.74 human rights …. 6.71, 6.72 improvements separate from land …. 6.84

joint tenancy …. 6.84 liquidator, vested in …. 6.57 partnership see Partnerships and CGT property, meaning …. 6.65, 6.66 proprietary rights …. 6.67–6.69 rights …. 6.70–6.73 legal or equitable …. 6.70 security holder, vested in …. 6.57 separate CGT assets …. 6.84 taxable Australian property …. 2.33, 6.54, 18.37 tenants in common …. 6.84 trustee in bankruptcy, vested in …. 6.57 CGT discount …. 6.11 companies, not applicable to …. 12.132 foreign and temporary residents …. 18.37 percentage …. 6.10 trusts …. 15.88, 15.89 CGT events balancing adjustment for depreciating assets (K7) …. 10.65 partnership asset …. 10.66 roll-over relief …. 10.67–10.69 bankrupt pays debt (K2) …. 6.24 calculating capital gain …. 6.9 cancellation etc of CGT asset (C2) …. 6.28–6.33 discharge of contractual obligation …. 6.29 exceptions …. 6.30 expiry of asset owned by taxpayer …. 6.31 liquidator’s distribution …. 13.56, 13.79, 13.80, 13.83, 13.86 market value substitution rule …. 6.31–6.33, 13.111

no capital proceeds …. 6.31 non-portfolio shareholding in foreign company …. 18.13 return of capital with cancellation …. 13.56 share buy-back …. 13.56 statutory licence …. 6.31 capital payment for shares (CGT event G1) …. 13.118–13.121 liquidator’s distribution …. 13.56, 13.82, 13.86, 13.120 capital proceeds from see Capital proceeds change of residence …. 2.33, 6.54 individual or company (I1) …. 2.34, 6.54 trust (I2) …. 2.35, 6.54 collectables …. 6.77, 6.78 exclusion from D2 …. 6.41 losses (K5) …. 6.24 special rules …. 6.77, 6.78 companies …. 12.23, 12.133–12.139 ceasing to be member of group (J1) …. 12.23, 12.139 changing residence (I1) …. 2.34, 6.54 convertible interests, issue of (D1) …. 12.138 debentures, issue of (D1) …. 12.137 end of option (C3) …. 12.136 issue or allotment of shares (D1) …. 12.133 non-portfolio shareholding in foreign company …. 18.13 options, issue of (D2) …. 12.135, 13.115 rights, creation of (D1) …. 12.134 concept …. 6.23 consolidation events (L2 to L8) …. 12.130 creation of contractual rights (D1) …. 6.24, 6.34–6.39 company issuing convertible interest …. 12.138, 13.116 company issuing debentures …. 12.137 company issuing rights …. 12.134

company issuing shares …. 12.133 disposal of asset not required …. 6.36 identifying capital proceeds …. 6.37 interaction with other CGT events …. 6.38, 6.39 ITAA36 provisions …. 6.34, 6.35 partnership …. 14.70 unit trust, exclusion …. 15.93, 15.121 discharge of contractual obligation (C2) …. 6.29 dissolution of partnership …. 14.85, 14.86 disposal of CGT asset (A1) …. 6.25, 6.58–6.69 acquisition as element of …. 6.79–6.83 another entity, to …. 6.85–6.88 case study …. 6.58–6.70 CGT assets, definition …. 6.62–6.70 change in ownership …. 6.85, 6.88 compulsory acquisition …. 6.60 constituent elements …. 6.60, 6.61 contract, under …. 6.87 disposal, meaning …. 6.85–6.88 disregarding capital gain or loss …. 6.60 identical asset disposed of and acquired …. 6.86 non-portfolio shareholding in foreign company …. 18.13 non-property rights …. 6.88 time of event …. 6.87 foreign hybrid loss (K12) …. 6.24 forex realisation events …. 5.54 forfeiture of deposit (H1) …. 6.46, 6.47 importance of concept …. 6.56 ITAA97 model …. 6.23 leases, in relation to …. 6.45

grant, renewal or extension …. 6.45 surrender of …. 6.51 variation or waiver of term, payment for …. 6.45 limited range of expenditure …. 6.23 liquidator’s distributions see Liquidator’s distributions loss or destruction of CGT asset (C1) …. 6.26 compensation for …. 6.26, 6.27 non-portfolio shareholdings in foreign companies …. 18.13 not giving rise to capital loss …. 6.18 option call options …. 6.43, 13.115 company issuing …. 12.135, 13.112–13.115 end of (C3) …. 12.136 grant, renewal or extension (D2) …. 6.40–6.45, 13.115 put options …. 6.44, 13.115 unit trust issuing …. 15.121 overview …. 6.23–6.56 partnerships see Partnerships and CGT personal use assets debt arising from CGT event …. 6.75 exclusion from D2 …. 6.41 special rules …. 6.75, 6.76 pre-CGT assets …. 6.126 pre-CGT shares (K6) …. 12.33, 13.123–13.128 cash as underlying property …. 13.128 company with post-CGT assets …. 13.123 market value of post-CGT underlying property …. 13.127 net value of entity …. 13.125 non-portfolio shareholding in foreign company …. 18.13 other CGT event occurring …. 13.124, 13.126 prerequisites …. 13.124

trust interests …. 15.124 receipt for event relating to CGT asset (H2) …. 6.24, 6.48–6.53 capital gain/loss disregarded …. 6.52, 6.53 deemed disposal …. 6.48–6.50 former s 160M(7) …. 6.48–6.51 grant of put options …. 6.53, 13.115 ownership of asset …. 6.51 restrictive covenant …. 6.48, 6.49 surrender of lease …. 6.51 same facts giving rise to more than one event …. 6.24 shares capital payment for (G1) …. 13.86, 13.118–13.121 liquidator declaring worthless (G3) …. 6.160, 13.56, 13.84, 13.122 non-portfolio shareholding in foreign company …. 18.13 pre-CGT shares (K6) …. 12.33, 13.123–13.128 small business roll-over …. 6.159, 6.160 change in replaced asset (CGT event J2) …. 6.159, 6.160 failure to acquire replacement asset (J5) …. 6.159, 6.160 insufficient expenditure on replacement asset (J6) …. 6.159, 6.160 specific circumstances …. 6.24 trusts see Trusts and CGT CGT exemptions Alternative Dispute Resolution Scheme …. 6.129 anti-overlap provisions …. 6.132–6.139 amounts otherwise assessable …. 6.135–6.138 balancing adjustment event …. 6.134 balancing adjustment exception …. 6.137, 6.138 financial arrangements …. 6.139 research and development …. 6.139 trading stock …. 6.133

cars …. 6.127 categories …. 6.125 collectables …. 6.128 compensation or damages …. 3.18, 6.129, 6.130 personal wrong or injury, for …. 6.130 decoration for bravery …. 6.127 early stage innovation companies investments …. 6.161, 13.163 exempt assets …. 6.127, 6.128 exempt transactions …. 6.129 firearms surrender compensation …. 6.129 gambling winnings …. 6.129, 6.131 General Practice Rural Incentives Program …. 6.129 government scheme, payments under …. 6.129 insurance policies …. 6.148 M4/M5 Cashback Scheme …. 6.129 main residence see Main residence CGT exemption National Rent Affordability Scheme …. 6.129 non-assessable non-exempt income, assets used to produce …. 6.128 overview …. 6.125 personal use assets …. 6.128 pooled development fund, shares in …. 6.128 pre-CGT assets …. 6.126 primary production …. 6.129 prizes …. 6.129, 6.131 reimbursements …. 6.129 sugar industry exit payment …. 6.129 superannuation funds …. 6.137, 6.148 surrender of CGT asset (C2) …. 6.28–6.33 Sydney Aircraft Noise Insulation Project …. 6.129 tobacco industry exit payment …. 6.129 trading stock …. 6.133

Unlawful Termination Assistance Scheme …. 6.129 venture capital equity …. 6.148 water entitlements/infrastructure improvements …. 6.129 CGT roll-overs categories …. 6.163 choice whether provision applies …. 6.162 companies group roll-overs …. 12.159 incorporation roll-overs …. 12.151–12.157 reorganisation roll-overs …. 12.158, 13.155 transfer of assets to wholly owned company …. 12.151–12.157 compulsory …. 6.162 demerger …. 13.158–13.162 CGT event J1 not occurring …. 13.161 consequences for members of demerger group …. 13.160 cost base adjustment …. 13.158 effects of roll-over …. 13.159 reducing market value of CGT asset …. 13.162 trust …. 15.149 discount, qualification for …. 6.11 marriage breakdown …. 6.166 overview …. 6.162, 6.163 provisions …. 6.162, 6.163 replacement asset roll-over …. 6.163, 6.164 compulsorily acquired, lost or destroyed …. 6.165 exceptions to general rule …. 6.165 general rules …. 6.164 post-CGT asset …. 6.164 pre-CGT asset …. 6.164 small business …. 6.159, 6.160

restructure of company …. 12.158, 13.155 same asset roll-over …. 6.163, 6.166 scrip for scrip roll-over …. 13.152–13.156 corporate restructure …. 13.155 effect on acquiring shareholder …. 13.154 exceptions …. 13.156 ineligible part …. 13.154 integrity provisions, effect of …. 13.157 position in absence of roll-over …. 13.152 preconditions …. 13.153 transfer of cost base to acquiring company …. 13.155 small business roll-over …. 6.155, 6.159 applicable CGT events …. 6.159, 6.160 change in replaced asset (CGT event J2) …. 6.159, 6.160 failure to acquire replacement asset (CGT event J5) …. 6.159, 6.160 insufficient expenditure on replacement asset (CGT event J6) …. 6.159, 6.160 transfer of assets to wholly owned company …. 12.151 all assets rolled over …. 12.155 consequences …. 12.154, 12.155 excluded assets …. 12.152 excluded transfers …. 12.156 individual or trustee …. 12.151–12.155 limit on liabilities undertaken …. 12.153 not all assets rolled over …. 12.154 partnership …. 12.151, 12.157 pre-CGT assets …. 12.153–12.155 trigger event …. 12.151 unit trusts …. 15.122 Changes in corporate ownership

bad debt deductions …. 12.107–12.111 alternative continuity of ownership test …. 12.110 business continuity test …. 12.107, 12.111 continuity of ownership test …. 12.107–12.110 current year, debt incurred in …. 12.109 first continuity period …. 12.108, 12.109 previous year, debt incurred in …. 12.108 second continuity period …. 12.108, 12.109 business continuity test …. 12.91, 12.97, 12.103, 12.105, 12.107, 12.118–12.120 bad debt …. 12.107, 12.111 ‘similar business’ test …. 12.97, 12.103 CGT implications …. 12.23 continuity of ownership test …. 12.91–12.96 alternative test of control …. 12.95, 12.96, …. 12.110 bad debt deductions …. 12.107–12.110 beneficial ownership …. 12.93 consolidated groups …. 12.117, 12.119, 12.120 exactly same shares …. 12.94, 12.96 ownership test period …. 12.92 primary test …. 12.93, 12.94 voting power …. 12.93 current and former business, assessment of similarity …. 12.103 current year losses …. 12.105 group loss transfers …. 12.106 loss carry back …. 12.90 tax offset component …. 12.90 loss carry forward …. 12.90 business continuity test …. 12.91, 12.97, …. 12.103, 12.105 consolidated groups …. 12.117–12.122 continuity of ownership test …. 12.91–12.96

deduction conditions …. 12.91 proportion of losses deducted …. 12.104 same business test …. 12.98–12.104 notional loss …. 12.105 same business test …. 12.98–12.104 business, meaning …. 12.100, 12.101 consolidated groups …. 12.118–12.120 continuity of ownership test failed …. 12.97 new business test …. 12.98, 12.101 new transaction test …. 12.98, 12.102 positive test …. 12.98, 12.99 same, meaning …. 12.100 test time …. 12.97, 12.98 TR 1999/9 …. 12.100, 12.101, 12.102 ‘same owners’ test …. 12.92, 12.94, 12.96, 12.105, 12.145 ‘similar business’ test …. 12.97, 12.103 tax implications …. 12.89 Charitable institution exempt entity …. 2.20, 2.21 exempt fringe benefits …. 7.54 gifts to …. 9.45 registration with Australian Charities and Not-for-profits Commission (ACNC) …. 2.21 Charitable trust see Trusts Child care deductibility of expenses …. 8.77, 8.81 GST-free supplies …. 19.32 private/domestic expense …. 8.77 residual fringe benefits …. 7.50

Chose in action partner’s interest in partnership …. 14.53 trading stock, whether …. 11.5, 11.11 Closely held corporate limited partnerships …. 14.95 Clothing deductibility of expenditure on …. 8.75, 9.61 laundry expenses …. 9.72 non-compulsory uniform …. 9.61 private/domestic character …. 8.75 protective …. 8.75, 9.61 Clubs demutualisation …. 3.32 exempt entities …. 2.21, 2.22 member subscriptions deductibility …. 9.34, 9.40 distribution …. 3.32 income, whether …. 3.30, 3.31 mutual receipts …. 3.30–3.33 mutuality principle …. 3.32 partnership distinguished …. 14.8, 14.13 payments for services …. 3.30 recreational/sporting see Sporting or recreational clubs registration or incorporation surplus funds at wind-up …. 3.32 Collectables antiques …. 6.77 capital losses on …. 6.14, 6.18, 6.78 CGT events in relation to …. 6.77, 6.78

exclusion from D2 …. 6.41 losses (K5) …. 6.24 special rules …. 6.77, 6.78 CGT exemption …. 6.128 definition …. 6.77 Collection of information tax returns, and …. 16.1, 16.8, 16.20–16.25 Collection of tax …. 16.1 administrative remedies …. 16.69–16.71 business activity statement (BAS) …. 16.59, 16.64, 16.66 compromise of debt …. 16.75 court action to recover …. 16.68, 16.69 enforced collection …. 16.67–16.74 fleeing taxpayers …. 16.72–16.74 departure prohibition order …. 16.72–16.74 flexibility to tax administration …. 16.75 garnishee order …. 16.70, 16.71 HECS …. 16.59 indirect collection …. 16.70, 16.71 instalment activity statement (IAS) …. 16.59, 16.64 instalments see Pay-As-You-Go (PAYG) system Medicare levy …. 16.59 Pay-As-You-Earn (PAYE) …. 1.16, 1.18, 7.3, 16.59 Pay-As-You-Go see Pay-As-You-Go (PAYG) system release from payment …. 16.75 serious hardship …. 16.75 running balance account (RBA) …. 16.53, 16.55, 16.66 settlement arrangements …. 16.75 Commercial debt forgiveness

commercial debt, definition …. 9.92 debt, definition …. 9.92 debt forgiveness, meaning …. 9.93 deduction for creditor …. 9.91 net forgiven amount …. 9.91, 9.94 object of provisions …. 9.91 reducible amounts …. 9.91 Commissioner’s powers access to records …. 16.20–16.23 information gathering …. 16.20–16.25 remission of penalties …. 16.55 tax administration …. 16.2 Companies bad debts see Bad debts capital benefits streaming see Capital benefits streaming CGT …. 12.132–12.159 carry forward of losses …. 12.144 change of ownership with unrealised net loss …. 12.146 discount not applicable …. 12.132 loss multiplication rules …. 12.150 majority underlying interests …. 12.141, 12.143 offsetting current year losses …. 12.145 pre-CGT assets …. 12.140–12.143 roll-over see CGT roll-overs transferring losses within group …. 12.147, 12.148 CGT events …. 12.23, 12.133–12.139 ceasing to be member of group (J1) …. 12.23, 12.139 changing residence (I1) …. 2.34, 6.54 convertible interests, issue of (D1) …. 12.138, 13.116

debentures, issue of (D1) …. 12.137 end of option (C3) …. 12.136 issue or allotment of shares (D1) …. 12.133 non-portfolio shareholding in foreign company …. 18.13 options, issue of (D2) …. 12.135 rights, creation of (D1) …. 12.134 subsidiary stops being member of group (J1) …. 12.139 change in ownership see Changes in corporate ownership compensatory tax …. 12.12 consolidated groups see Consolidated groups continuity of ownership test …. 12.22 private/public company distinction …. 12.33 corporate tax entities …. 12.7, 14.88 corporate tax systems …. 12.8 debt and equity rules …. 12.25 debt interests …. 12.25 definition for tax purposes …. 12.26 partnership excluded …. 12.27 directors, payments to deduction for employer …. 9.27 dividends see Dividends imputation system see Dividend imputation system donations by …. 9.45 entity definition includes …. 12.16 equalisation tax …. 12.12 equity interests …. 12.25 flat rate of tax …. 12.19 future changes to …. 12.19 group companies see Consolidated groups; Group companies Henry Review recommendations …. 12.10 incorporation in Australia …. 2.40

instalments of tax …. 12.20 losses see Company losses non-profit companies …. 12.29 non-share capital account …. 12.25, 12.52, 13.32 partnerships distinguished …. 12.3, 12.27, 14.6 PAYG instalments …. 12.20 franking credit …. 12.41–12.43 refund, franking debit …. 12.47 payment of tax by …. 12.20 franking credit …. 12.41–12.43 refund, franking debit …. 12.47, 12.48 ‘person’ definition includes …. 12.16 private/public distinction …. 12.28–12.33 Commissioner’s discretion …. 12.31 definitions …. 12.29 significance …. 12.33 subsidiaries of public companies …. 12.29, 12.32 20 or fewer persons 75% test …. 12.30 residency …. 2.40 central management and control …. 2.40 resident, definition of …. 2.40, 12.24 Review of Business Taxation …. 12.6 self-assessment …. 12.17 separate legal entity …. 12.2, 12.16 share capital account …. 12.25 tax entity, as …. 12.15–12.24 tax rate …. 2.2, 12.19 proposed change to …. 18.51 tax return …. 12.17 taxation of …. 12.1, 12.5, 12.6

classical system …. 12.8 codes for …. 3.67 compensatory tax …. 12.12 distinctive features …. 12.18 dividend deduction system …. 12.8 dividend exemption system …. 12.8 dividend imputation system see Dividend imputation system equalisation tax …. 12.12 full integration system …. 12.8 rate …. 2.2, 12.19 shareholder relief …. 12.8 superintegration problem …. 12.11–12.13, 12.34 variable credit system …. 12.13, 12.14, 12.34 trusts compared …. 12.4 underlying beneficial ownership …. 12.22 change of …. 12.23 unified entity regime …. 12.6 Company losses capital losses …. 12.144–12.150 carry forward …. 12.144 change of ownership with unrealised net loss …. 12.146 linked group transactions …. 12.149 loss multiplication rules …. 12.150 offsetting current year losses …. 12.145 transfer within group …. 12.147, 12.148 carry back …. 12.90 conditions for …. 12.90 loss carry back tax offset component …. 12.90 carry forward …. 12.90 ‘business continuity test’ …. 12.91

capital losses …. 12.144 change in corporate ownership …. 12.90 consolidated groups …. 12.117–12.122 ‘continuity of ownership’ test …. 12.91–12.96 proportion of losses deducted …. 12.104 ‘same business’ test …. 12.98–12.104 consolidated groups …. 12.117–12.122 bundling …. 12.122 ‘business continuity’ test …. 12.118–12.120 ‘continuity of ownership’ test …. 12.117, 12.119, 12.120 joining entity …. 12.117 limits …. 12.121 loss fractions …. 12.121, 12.122 transfer to head company …. 12.117–12.122 current year losses …. 12.105 deduction of prior year losses …. 9.69 group loss transfer …. 12.106, 13.91 capital losses …. 12.147, 12.148 cost base adjustments …. 12.148 excess franking offset …. 13.91, 13.92 linked group transactions …. 12.149 reduced cost base adjustments …. 12.148 tax losses …. 9.64, 12.106 transitional provisions …. 12.112 loss multiplication rules …. 12.150 Compensation cancellation of business contract …. 3.68 CGT exemption …. 3.18, 6.129, 6.130 income/capital dichotomy cancellation of agreement …. 3.18

defamation …. 3.18 forfeiture of rights …. 3.18 personal injury …. 3.19, 3.20 loss of revenue assets …. 3.68 lost income, for …. 3.68–3.70 assessable income …. 3.67, 5.16 correspondence principle …. 3.69 statutory extensions …. 3.70 personal injury, for CGT exemption …. 6.129, 6.130 FBT exclusion …. 7.8 income/capital dichotomy …. 3.19, 3.20 interest …. 3.63 unliquidated damages …. 3.20 World War II payments …. 6.129 Compulsory acquisition CGT event A1 …. 6.60 depreciating asset …. 10.70 Consolidated groups asset cost setting …. 12.123–12.127 apportioning allocable cost amount …. 12.126 CGT events (L2 to L8) …. 12.130 determining allocable cost amount …. 12.124 modifications to basic rules …. 12.127 pre-CGT assets and membership interests …. 12.129 special provisions …. 12.127 subsidiary leaving group …. 12.128 tax cost setting amount …. 12.125 termination value …. 12.126

WIP amount asset …. 12.125 consolidatable group …. 12.113 consolidation regime …. 12.21, 12.112 formation …. 12.113 franking accounts …. 12.131 head entity …. 12.18, 12.21, 12.112 income tax treatment requirements …. 12.113 notice identifying …. 12.113 ownership requirements …. 12.113 residence requirements …. 12.113 tax paid by …. 12.112 transfer of losses to …. 12.117–12.122 trust, not to be …. 15.149 interposed shelf company …. 12.115 leaving group …. 12.112, 12.128 life insurance companies …. 12.113 losses …. 12.117–12.122 bundling …. 12.122 ‘business continuity’ test …. 12.118–12.120 continuity of ownership test …. 12.117, 12.119, 12.120 joining entity …. 12.117 limits …. 12.121 loss fractions …. 12.121, 12.122 transfer to head company …. 12.117–12.122 multiple entry consolidated (MEC) group …. 12.116 eligible tier one companies …. 12.116 head company becoming member of …. 12.113 notice …. 12.113 overview …. 12.112 single entity, treated as …. 12.112, 13.93 single tax return …. 12.112

subsidiary member …. 12.113 debt/equity rules applicable to interests in …. 12.114 income tax treatment requirements …. 12.113 leaving group …. 12.112, 12.128 notice identifying …. 12.113 ownership requirements …. 12.113 residence requirements …. 12.113 restrictions …. 12.113 wholly owned subsidiary …. 12.113 tax cost setting …. 12.112 amount …. 12.125 transitional provisions …. 12.112 trust as member of …. 15.149 wholly owned subsidiary …. 12.113 Continuity of ownership test see Changes in corporate ownership Contractors see Personal services income (PSI) Controlled foreign companies (CFCs) accruals taxation …. 18.4, 18.22 active income exemption …. 18.28 attributable income …. 18.23, 18.24, 18.26 attributable taxpayer …. 18.24, 18.29 attribution percentage …. 18.24, 18.30 attribution rules summary …. 18.32 control tests …. 18.25 definition …. 18.25 double taxation relief …. 18.31 foreign hybrids …. 14.90 group definition …. 18.25 listed countries …. 18.25, 18.27

non-portfolio shareholding in foreign company …. 18.13 operation of rules, example …. 18.33 unlisted countries …. 18.27 Convertible interests issue by company CGT event D1 …. 12.138 cost base of shares or units acquired …. 13.116 shareholder taxation …. 13.116, 13.117 Copyright collection society income derived by …. 5.14 payments to …. 5.3, 5.14 depreciating asset …. 10.6 effective life …. 10.48 film copyright exclusion …. 10.15 licence …. 3.16 sale of exclusive rights …. 3.15 Corporate limited partnerships closely held corporate limited partnerships …. 14.95 deemed dividends …. 13.26 franking of distribution …. 14.89 non-resident …. 14.88 partners taxed like shareholders …. 14.89 tax treatment …. 14.88 unincorporated association as …. 14.14 Corporate tax entities …. 12.7 Corporate unit trusts background to Div 6B …. 15.136–15.138

background to Div 6C …. 15.140 dividend imputation …. 15.143, 15.144 head entity of consolidated group …. 12.18, 12.21, 12.113 losses governed by trust loss rules …. 15.139 public trading trust …. 15.144 consequence of being …. 15.141 rate of tax …. 15.141 taxed as companies …. 12.18, 12.21, 15.137–15.144 Cost base acquisition costs …. 6.100, 6.104–6.107 Commissioner’s view …. 6.107 contingent liability to pay …. 6.105 ‘in respect of’ acquisition of asset …. 6.106 interest on money borrowed …. 6.106 money paid or property given …. 6.104, 6.107 apportionment rules …. 6.95, 6.116 assets acquired after 13 May 1997 …. 6.10, 6.101, 6.102 assets acquired before 13 May 1997 …. 6.103 assumption of liability rule …. 6.117 capital gain or loss, calculating …. 6.10, 6.15 CGT assets, of …. 6.10, 6.100–6.124 deceased estates …. 15.132, 15.133 trusts …. 15.91–15.93 changed assets …. 6.115 costs of owning asset …. 6.100, 6.109 deducted expenditure excluded …. 6.10, 6.100 elements of …. 6.100 expenditure to establish, preserve or defend title …. 6.100, 6.112 expenditure to increase or preserve asset’s value …. 6.100, 6.110, 6.111

goodwill excluded …. 6.110, 6.111 legal expenses …. 6.111 own labour excluded …. 6.110 restoration of asset …. 6.111 state or nature of asset at time …. 6.110 expenditure to install or move asset …. 6.100, 6.110 general rules …. 6.100–6.112 incidental costs …. 6.100, 6.108 giving of property …. 6.108 related to CGT event …. 6.108 indexation …. 6.10, 6.100, 6.119, 6.120 market value substitution rule …. 6.113 exceptions …. 6.114 non-arm’s length dealings …. 6.113 merged assets …. 6.115 modifications to general rules …. 6.113–6.117 options call options …. 6.43 put options …. 6.44 particular time, at …. 6.100 personal use assets …. 6.76 pre-21 September 1999 assets …. 6.10, 6.13 reduced …. 6.121–6.124 assets acquired after 13 May 1997 …. 6.102, 6.123 assets acquired before 13 May 1997 …. 6.103, 6.124 balancing adjustments …. 6.121, 6.123 capital loss, calculating …. 6.15, 6.17, 6.121 capital proceeds compared with …. 6.17 deducted capital expenditure …. 6.102 elements of …. 6.121, 6.123 exclusions …. 6.124

incidental costs …. 6.124 inflation, not indexed for …. 6.16, 6.121 ITAA36 provisions …. 6.122 net GST input tax credit …. 6.101 transfer of loss within corporate group …. 12.148 split, changed or merged assets …. 6.115 transfer of loss within corporate group …. 12.148 value shifting adjustment …. 13.131, 13.142 Court action disputes see Disputes recovery of tax …. 16.68, 16.69 Criminal offences …. 16.50 tax evasion …. 17.2 Cultural Bequests Program …. 9.52 Cultural organisations gifts to …. 9.45, 9.51 register of …. 9.51

D Datacasting transmitter licence depreciating asset …. 10.6 diminishing value method prohibited …. 10.23, 10.30 effective life …. 10.48 Death benefit termination payments …. 5.27, 5.34 Debt bad see Bad debts

definition …. 9.92 derivation rules …. 4.13, 4.36 debtors …. 4.36 legal recoverability …. 4.13, 4.14 forgiveness …. 9.93 commercial debt, definition …. 9.92 deduction for creditor …. 9.91 deemed dividend …. 13.17, 13.22, 13.27 net forgiven amount …. 9.91, 9.94 reducible amounts …. 9.91 waiver fringe benefit …. 7.33, 13.30 Debt and equity rules consolidated groups …. 12.114 dividends …. 12.25, 12.52 frankable distributions …. 12.25, 12.52 interests in company …. 12.25 consolidated group member …. 12.114 non-contingent obligation …. 12.25 thin capitalisation …. 18.65 Deceased estates beneficiary’s entitlement to income of …. 15.68 CGT aspects …. 15.132–15.135 CGT events not applicable …. 15.95, 15.105–15.118, 15.135 CGT main residence acquired from deceased estate …. 6.147 exemption …. 6.140 company trustee, limitation cannot be legal personal representative …. 15.12 income received by trustee

assessable income of trust estate …. 14.31, 15.48, 15.129 work in progress …. 14.35 minor inherits investment property …. 15.61 superannuation death benefits …. 5.39–5.42 testamentary gifts …. 9.52 testamentary trust …. 15.48 trust income …. 15.48, 15.127–15.131 income received after death …. 15.129–15.131 ITAA36 Pt III Div 6 applicable …. 15.128 present entitlement of beneficiary …. 15.127 trust legislation applicable …. 15.127–15.135 trust loss provisions …. 15.146 trusts of …. 15.127–15.135 Decorations for bravery CGT exemption …. 6.127 Deductions allowable …. 8.1, 9.1 anti-avoidance provisions …. 9.79 apportionment of composite expenditure …. 8.28–8.37 arithmetic …. 8.37 commercial reality test …. 8.33 excessive expenditure …. 8.33 identifying disallowable element …. 8.30 legal basis …. 8.30 legal rights basis …. 8.30, 8.31, 8.32 mixed purposes …. 8.35, 8.36 objective purpose …. 8.30, 8.32 purposive basis …. 8.30, 8.33–8.36 repairs …. 9.15

associations, payments to …. 9.28 bad debts see Bad debts borrowing expenses …. 9.2, 9.18 capital allowances see Capital allowances capital expenditure acquisition of capital asset …. 8.68 circulating or fixed capital …. 8.65 defending title to asset …. 8.69 exclusion …. 3.8, 8.4, 8.19, 8.27, 8.61–8.69 immunity from competition, creating …. 8.64, 8.67 income/capital dichotomy …. 8.66–8.69 ‘once and for all’ test …. 8.61 process–structure test …. 8.62, 8.63 repairs …. 9.9, 9.14, 9.15 tax-related …. 9.5 capital works see Capital works car expenses see Car expenses car parking …. 9.80 carrying on business, incurred in …. 8.6, 8.8, 8.18, 8.54, 8.57 business, definition …. 8.8, 8.57 business and living expenses distinguished …. 8.13, 8.14, 8.72 cessation of business …. 8.59 contemporaneous payments …. 8.54 degree of activity required …. 8.57 establishing, expanding or diversifying …. 8.55 hobby distinguished …. 8.18 incurred, meaning …. 8.38–8.53 nexus …. 8.1, 8.4, 8.6, 8.7, 8.11, 8.27, 8.54 preliminary expenditure …. 8.58 profit motive …. 8.57 purpose …. 8.60

same time frame as business activities …. 8.55 clothing …. 8.75 club membership fees …. 8.5, 9.40 common business expenses …. 8.1 composite expenditure apportionment of …. 8.28–8.37 dissection of …. 8.28, 8.29 concessional …. 9.1 construction of provisions …. 8.16 criteria for deductibility …. 8.6 depreciation see Depreciation director’s fees …. 8.7 dissection of composite expenditure …. 8.28, 8.29 apportionment as alternative …. 8.30 donations see Gifts double …. 8.3, 9.1 education fees …. 9.37 election expenses …. 9.29 entertainment expenses see Entertainment expenses ‘essential character’ test …. 8.9, 8.12–8.14, 8.71 estimated liability …. 8.46, 8.53 exempt income, production of …. 8.16, 8.82 expenditure, connection to income production …. 8.7 gaining or producing assessable income …. 8.54 changing employment expenses excluded …. 8.55 connection of expenditure to …. 8.7 incidental and relevant to …. 8.10–8.13, 8.71 nexus with …. 8.1, 8.4, 8.6, 8.7, 8.11, 8.27, 8.54 purpose …. 8.60 remoteness …. 8.24

temporal nexus …. 8.21–8.24, 8.54 the/such/your assessable income …. 8.56 voluntary outlay …. 8.15, 8.26 general deduction …. 8.1, 8.2, 8.4, 8.25–8.82 construction …. 8.16 development of provisions …. 8.4 elements of …. 8.25–8.81 rationale for …. 8.2 summary …. 8.83 general interest charge …. 5.17 gifts see Gifts gratuities …. 9.27 GST, effect on …. 9.75 health and medical expenditure …. 8.76 home office expenses …. 8.78 ‘incidental and relevant’ test …. 8.9–8.14, 8.71 income/capital dichotomy …. 8.66–8.69 acquisition of capital asset …. 8.68 capital expenditure excluded …. 3.8, 8.4, 8.19, 8.27, 8.61–8.69 fixed or circulating capital …. 8.65 immunity from competition, creating …. 8.64, 8.67 once and for all test …. 8.61 outgoings to defend title to asset …. 8.69 process–structure test …. 8.62, 8.63 incurred, meaning …. 8.38–8.53 accounting principles …. 8.46–8.50 amortisation of prepayments …. 8.50 estimated liability …. 8.46, 8.53 insurance payments …. 8.44, 8.45 leading authorities …. 8.40–8.45 ‘matching’ expenditure and income …. 8.40, 8.48–8.50

necessarily incurred …. 8.38, 8.52, 8.55 present liability …. 8.42, 8.43, 8.44 threatened or impending liability …. 8.43 input tax credits, effect on …. 9.75 ITAA97 Div 8, identified in …. 2.2, 8.1 ITAA97 Div 25 allowing …. 9.2–9.33 also satisfying s 8-1 …. 9.2 ITAA97 Div 26 denying …. 9.34–9.43 ITAA97 framework …. 9.76–9.81 lease document expenses …. 9.17 repair obligation under …. 9.16 termination capital expenditure …. 9.33 licence, termination capital expenditure …. 9.33 limit on …. 9.43 limited recourse debt …. 9.90 losses or outgoings …. 8.11, 8.26 composite …. 8.28–8.37 distinction …. 8.26 meaning …. 8.7, 8.26 necessarily incurred …. 8.38, 8.52, 8.55 net amount …. 8.27 private or domestic nature …. 8.20, 8.70 proper, reasonable or necessary to incur …. 8.55 tax avoidance schemes …. 9.79 ‘to the extent’ connected with income production …. 8.28, 8.29 when incurred …. 8.38–8.53 mortgage, discharge expenses …. 9.19 non-cash business benefits …. 9.81 operation of provisions …. 8.17

overdue tax charges …. 5.17 particular amounts …. 9.44–9.94 pensions …. 9.27 ‘perceived connection’ …. 8.9, 8.15 personal services income see Personal services income (PSI) political donations …. 6.124, 9.45, 9.46 post-closure expenses …. 8.23 prepaid expenses …. 9.77, 9.78 when outgoing incurred …. 8.50 private/domestic expenditure …. 8.70–8.80 business and living expenses distinguished …. 8.13, 8.14, 8.72 child minding …. 8.77 clothing …. 8.75 exclusion …. 8.20, 8.70–8.80 food …. 8.73 health and medical …. 8.76 home office …. 8.78 relevance and character …. 8.71 self-education …. 8.15, 8.80, 8.81 specific categories …. 8.73 travel …. 8.72, 8.79 profit-making undertaking or plan, loss from …. 9.25 protective clothing …. 8.75 purpose …. 8.60, 8.83 rates and taxes …. 9.30 related entity, payments to …. 9.34, 9.39 relatives payments to …. 9.34, 9.39 travel expenses …. 9.34, 9.38 relevant provisions …. 2.3 repairs …. 9.1, 9.2, 9.7–9.15

lease obligation …. 9.16 retirement payments …. 9.27 shortfall interest charge …. 5.17 specific deductions …. 8.3, 8.5, 8.83, 9.1–9.33 specific denying provisions …. 9.34–9.43 student assistance payments …. 9.37 substantiation see Substantiation summary …. 8.83 tax equation …. 2.2, 4.1, 8.1 tax expenditures …. 9.1 tax losses see Tax losses tax-related expenses …. 9.3–9.6 temporal nexus with income production …. 8.21–8.24, 8.54 term or condition of employment …. 8.9, 8.15 theft or embezzlement, loss by …. 9.2, 9.26 TOFA rules, application to …. 8.51 trade, professional or business association membership …. 8.5 travel expenses see Travel expenses two or more provisions allowing for …. 9.1 uniforms …. 8.75, 9.61 unlegislated tests of deductibility …. 8.9, 8.71 work in progress amount …. 9.31 Deemed dividends assessable income …. 13.17, 13.23, 13.29 associate definition …. 13.19 excessive payment to …. 13.18–13.20 loan to …. 13.17, 13.22 capital benefit streaming …. 13.17, 13.31 Commissioner’s discretion …. 13.25

corporate limited partnerships …. 13.26 debt forgiveness …. 13.17, 13.22, 13.27 fringe benefit, otherwise amounting to …. 13.30 distributable surplus …. 13.28 net assets …. 13.28 non-commercial loans …. 13.28 non-commercial loans, repayment …. 13.28 reduction where dividend exceeds …. 13.28 exclusions …. 13.27 failure to make minimum payment against amalgamated loan …. 13.24 fringe benefit, otherwise amounting to …. 13.30 general rules …. 13.28 ITAA36 Pt III Div 7A structure …. 13.27 proposed changes …. 13.30 liquidator’s distributions see Liquidator’s distributions loans to associates …. 13.17, 13.22 non-share dividends …. 13.27 non-share equity interests …. 13.27 payments …. 13.26 private company loan or payment …. 13.17–13.22, 13.27 associate or shareholder, to …. 13.22 distribution of profits …. 13.21, 13.29 excessive payments to associates …. 13.18–13.20 loans to associates …. 13.17, 13.22 share buy-backs …. 13.17, 13.56, 13.61 2007 amendments …. 13.23–13.25 2010 amendments …. 13.26 unfrankable distribution …. 13.18, 13.23, 13.29 unpaid trust distributions …. 13.26 withholding tax, disregarded for …. 13.29

Defence force allowances exempt income …. 2.25, 2.26 Demerger dividends …. 13.104 Demerger relief CGT event J1 not occurring …. 13.161 CGT roll-over …. 13.158–13.162 consequences for members of demerger group …. 13.160 effects …. 13.159 reducing market value of CGT asset …. 13.162 trusts …. 15.149 Demutualisation …. 3.32 Departure prohibition order …. 16.71–16.73 Depreciating assets see also Depreciation adjustable value …. 10.44 after balancing adjustment …. 10.57 merged asset …. 10.41 split asset …. 10.40 termination value less than …. 10.56 termination value more than …. 10.55 balancing adjustments see Balancing adjustments base value …. 10.43 car …. 10.15 calculating depreciation see Depreciation discount, acquired at …. 10.42 luxury leased car …. 10.20, 10.34 composite items …. 10.15 compulsory acquisition …. 10.70 co-owners …. 10.20

cost …. 10.33–10.42 apportionment …. 10.38 arrangement, held under …. 10.33 balancing adjustment …. 10.33 bringing asset to present condition …. 10.37 car …. 10.42 decline in value equal to …. 10.24 deductions other than under Div 40 …. 10.39 demolition of existing structure …. 10.36 determination of …. 10.33 excavation expenses …. 10.36 first element …. 10.33 GST adjustment …. 10.35 hired under hire–purchase agreement …. 10.33, 10.34 inherited asset …. 10.33 market value …. 10.33, 10.62 merged assets …. 10.33, 10.41 non-capital amounts …. 10.39 non-cash business benefits …. 10.34 notional transactions …. 10.34 particular asset …. 10.36 partnership asset …. 10.33 reduction by deducted amount …. 10.39 second element …. 10.37 split assets …. 10.33, 10.40 datacasting transmitter licence …. 10.6 diminishing value method prohibited …. 10.23, 10.30 effective life …. 10.48 decline in value see Depreciation definition …. 10.5, 10.6 economic ownership …. 10.16

effective life …. 10.45–10.50 determined by Commissioner …. 10.45, 10.46 determined by taxpayer …. 10.45, 10.47 intangible assets …. 10.48 recalculation …. 10.49 TR 2008/4 …. 10.50 fixtures …. 10.6, 10.13 holder of …. 10.18, 10.19 quasi-ownership right …. 10.18 hire–purchase agreement, under …. 10.33 cost …. 10.33, 10.34 hold, meaning …. 10.16–10.20 identifying holder …. 10.17–10.20 improvements …. 10.6, 10.13, 10.18 quasi-ownership right …. 10.18 indefeasible right to use (IRU) …. 10.3, 10.6 exclusions …. 10.15 in-house software …. 10.6 diminishing value method prohibited …. 10.23, 10.30 effective life …. 10.48 intangible assets …. 10.6 effective life …. 10.48 intellectual property …. 10.6 diminishing value method prohibited …. 10.23, 10.30 effective life …. 10.48 interests in …. 10.15, 10.20 involuntary disposal …. 10.70 joint ownership …. 10.20 land excluded …. 10.6 leased asset …. 10.19, 10.20

legal ownership …. 10.16 luxury leased car …. 10.20 cost …. 10.34 merged assets …. 10.41 adjustable value …. 10.41 balancing adjustment event …. 10.58 cost …. 10.33, 10.41 mining, quarrying or prospecting information …. 10.6 holder of …. 10.20 mining, quarrying or prospecting rights …. 10.6 multiple interests in same asset …. 10.20 opening adjustable value …. 10.44 input tax credits, effect on …. 10.44 partnership asset …. 10.33 balancing adjustment …. 10.58, 14.44–14.47 CGT event K7 …. 10.66 cost …. 10.33 holder of …. 10.20 patent …. 10.6 effective life …. 10.48 plant …. 10.9–10.14 research and development, used for …. 10.7, 10.14, 10.39 pooling general STS pool …. 10.93 long-life STS pool …. 10.93 low-value pools …. 10.71–10.76 project pools …. 10.84–10.88 small business entities …. 10.93 software development pools …. 10.77–10.81 quasi-ownership right …. 10.18 renewal or extension of rights …. 10.15

share issue in exchange for …. 10.88 spectrum licence …. 10.6 diminishing value method prohibited …. 10.23, 10.30 effective life …. 10.48 split assets …. 10.40 adjustable value …. 10.40 balancing adjustment event …. 10.58 cost …. 10.33, 10.40 taxable purpose …. 10.51–10.53 held in reserve …. 10.52 use or installation for purpose other than …. 10.53 telecommunications site access rights …. 10.6 effective life …. 10.48 total decline …. 10.65 trading stock balancing adjustment event …. 10.58 converted to depreciating asset …. 10.34 depreciating asset becoming …. 10.58, 10.62 exclusion …. 10.6, 10.58 useful life …. 10.5, 10.6 Depreciation see also Depreciating assets balancing adjustments see Balancing adjustments calculating …. 10.21–10.31 adjustable value …. 10.40, 10.44 associate, asset acquired from …. 10.23 base value …. 10.43 choice of method …. 10.22, 10.23 cost of asset see Depreciating assets diminishing value method …. 10.5, 10.22, …. 10.23, 10.29–10.31 former holder, method used by …. 10.23

opening adjustable value …. 10.44 prime cost method …. 10.5, 10.22, 10.23, 10.26–10.28 restrictions on choice …. 10.23, 10.30 start time …. 10.21 car …. 10.15, 10.42 balancing adjustment event …. 10.63 disabled people, for transporting …. 10.42 discount, acquired at …. 10.42 expense calculation method …. 10.15, 10.64 notional depreciation …. 5.25 decline in value of asset …. 10.5 calculating …. 10.21–10.31 deduction …. 10.5 diminishing value method …. 10.5, 10.29–10.32 adjustments to cost …. 10.31 calculation using …. 10.29 choice of …. 10.22, 10.23 days held, meaning …. 10.31 decline in value not to exceed base value …. 10.30 effective life, adjustments to …. 10.31 post-9 May 2006 assets …. 10.32 pre-9 May 2006 assets …. 10.29–10.31 restrictions on use of …. 10.23, 10.30 effective life …. 10.45–10.50 adjustments to …. 10.28, 10.31 GST adjustment …. 10.35 intangible assets …. 10.48 key features …. 10.5 low-cost assets …. 10.71 low-value asset distinguished …. 10.71 low-value asset pools …. 10.71–10.76

balancing adjustment event …. 10.76 calculating decline in value …. 10.74, 10.75 closing pool balance …. 10.75 estimate of percentage of use …. 10.73 GST input credits reducing balance …. 10.75 low-cost assets allocated to …. 10.71, 10.72 plant …. 10.2, 10.9–10.14 capital works, whether …. 10.8–10.13 definition …. 10.9–10.13 research and development, used for …. 10.7, 10.14, 10.39 prime cost method …. 10.5, 10.26–10.28 adjustments to cost …. 10.28 calculation using …. 10.26, 10.27 choice of …. 10.22, 10.23 days held, meaning …. 10.27 effective life, adjustments to …. 10.28 project pools …. 10.84–10.88 roll-over relief …. 10.67–10.69 small business entities …. 10.92, 10.93 pooling of assets …. 10.93 software development pools …. 10.77–10.81 STS provisions …. 10.92, 10.93 total decline in value …. 10.65 uniform capital allowance regime …. 10.2, 10.3 capital works excluded …. 10.8 exclusions …. 10.15 useful life …. 10.5 Derivation of income …. 4.4 accounting method, choice of …. 4.5–4.13, 4.35 accrual basis …. 3.34, 4.4–4.21

ATO guidelines …. 4.35 cash (receipts) basis …. 3.34, 4.5–4.13 change of …. 4.8, 4.9 removal of choice …. 4.9 accrual basis …. 3.34, 4.4–4.21 advance payments …. 4.15–4.19 change from cash to …. 4.8, 4.9 income derived …. 4.11 instalment payments …. 4.20, 4.21, 4.44 refinements …. 4.14–4.21 when appropriate …. 4.7 advance payments …. 4.15–4.19, 4.40 fees …. 4.15, 4.16 interest …. 4.18 long-term construction projects …. 4.31 rent or property income …. 4.18 subscriptions …. 4.17 advances on salary …. 4.42 Arthur Murray principle …. 4.15–4.20, 4.40 beneficially derived …. 3.34 Carden’s case …. 4.6–4.10 cash (receipts) basis …. 3.34, 4.5–4.13 changed earning rate of goods and services …. 4.19 chattel leasing …. 4.39 commissions and bonuses …. 4.42, 7.57 constructive receipt …. 3.36, 4.32, 4.33 interest …. 4.32 superannuation contributions …. 4.32 debt, enforceable …. 4.13, 4.14, 4.36 legal recoverability …. 4.13, 4.14 debtors …. 4.36

deemed derivation …. 4.32–4.34 directors’ fees …. 4.42 dividends …. 4.41 Firstenberg’s case …. 4.11–4.13 forfeited amounts …. 4.40 Henderson’s case …. 4.9–4.10, 4.13 instalment sales …. 4.20, 4.21, 4.44 interest …. 4.32, 4.33, 4.43 lay-by arrangements …. 4.17, 4.40 leading authorities …. 4.6–4.13 legal recoverability …. 4.13, 4.14 long-term construction projects …. 4.30 advance payments …. 4.31 estimation …. 4.30 meaning …. 4.4 measurement of income …. 4.1 non-refundable deposits …. 4.40 one-off adjustment …. 4.8, 4.9 ordinary income …. 4.3 partnership income …. 4.37, 14.21–14.26 payments received over time …. 4.20, 4.21 prepayments …. 4.15–4.19, 4.40 Arthur Murray principle …. 4.15–4.20, 4.40 debtors …. 4.36 fees …. 4.15, 4.16 interest …. 4.18 long-term construction projects …. 4.31 rent or property income …. 4.18, 4.38 subscriptions …. 4.17 professional fees …. 4.9, 4.37

profit as assessable income …. 4.22–4.31 Citibank case …. 4.28 Cyclone Scaffolding case …. 4.25 deductions irrelevant …. 4.28 less than taxable income …. 4.27 limits …. 4.27 net profit …. 4.22, 4.23, 4.28 profit emerging basis …. 4.21 specific profit assessment …. 4.23–4.27, 4.45 property rent …. 4.38 advance payment …. 4.18 refund of payment …. 4.15, 4.16, 4.18 salary …. 4.42 securities …. 4.33 discounted or deferred interest …. 4.33 eligible return …. 4.33 qualifying …. 4.33 simplified tax system (STS) (2001 to 2007) …. 4.34 small business concessions …. 4.34 sole practitioner …. 4.12 special contractual payments …. 4.29 specific profit assessment …. 4.23–4.27, 4.45 statutory income …. 4.3, 5.3 timing …. 4.1, 4.3, 4.4 wages …. 4.42 Diminishing value method see Depreciation Disability support pension exempt income …. 2.31 Disputes

Administrative Appeals Tribunal …. 16.30, 16.42, 16.43 appeal to Federal Court from …. 16.37 application requirements …. 16.42 choice of court or …. 16.36, 16.37 jurisdiction …. 16.37 power to provide remedies …. 16.37 preliminary hearing …. 16.42 procedure …. 16.42 review by …. 16.30, 16.36 reviewable decision …. 16.36 substitute decision …. 16.43 appeal …. 16.30 appealable decision …. 16.36 burden of proof …. 16.38, 16.39 choice of review or …. 16.36, 16.37 Federal Court …. 16.31, 16.37 Full Federal Court …. 16.37, 16.39, 16.49 further …. 16.37, 16.39 High Court …. 16.37, 16.39, 16.49 payment of taxes notwithstanding …. 16.40 ATO problem resolution service …. 16.32 burden of proof …. 16.38, 16.39 Civil Dispute Resolution Act 2011 …. 16.47 constitutional provisions …. 16.49 court action to recover tax …. 16.68, 16.69 external administrative review …. 16.29, 16.31, 16.41–16.49 Federal Court …. 16.31, 16.37 appealable decision …. 16.36 choice of AAT or …. 16.36, 16.37 Full Court …. 16.37, 16.39, 16.49 jurisdiction …. 16.37

High Court appeal …. 16.37, 16.39, 16.49 special leave …. 16.49 internal administrative review …. 16.29, 16.32–16.35 notice of decision …. 16.35 problem resolution service …. 16.32 time for objection …. 16.33, 16.34 judicial review …. 16.29, 16.31, 16.41, 16.46–16.49 commencing …. 16.47 constitutional provisions …. 16.49 dispute resolution prior to …. 16.47 jurisdiction …. 16.36–16.40 notice of appeal …. 16.47 objection decision …. 16.35 appealable …. 16.36, 16.37 reviewable …. 16.36, 16.37 process for …. 16.1 review of decision …. 16.30 choice of appeal or …. 16.36, 16.37 payment of taxes notwithstanding …. 16.40 Small Taxation Claims Tribunal …. 16.44, 16.45 substitute decision …. 16.43 taxation decision …. 16.33 taxation objection …. 16.33, 16.34 time limit …. 16.34, 16.35 Distributions to shareholders alternative forms …. 13.56 bonus shares …. 13.11–13.13, 13.56, 13.57 buy-backs see Share buy-backs CGT implications …. 13.56 deemed dividends see Deemed dividends

dividend reinvestment plans …. 13.58 dividends see Dividends liquidator see Liquidator’s distributions return of capital with cancellation of shares …. 13.56, 13.59 return of capital without cancellation of shares …. 13.56, 13.60 unfrankable …. 13.98 dividends see Dividends non-equity shares …. 13.99 Diverted profits tax …. 12.45, 18.85 Dividend imputation system see also Dividends advantages …. 12.9 anti-franking credit trading rules …. 12.71–12.75, 13.102, 17.5 general anti-avoidance rule …. 12.71 key features …. 12.73 proposed reform …. 12.73 anti-streaming rules see Dividend streaming benchmark franking percentage …. 12.57, 13.36, 13.41 Commissioner permitting different percentage …. 12.58 different share classes …. 12.66 differing significantly between franking periods …. 12.70 exceeding …. 12.59, 13.41 franking percentage less than …. 12.50, 12.60, 13.41 over-franking tax where exceeded …. 12.59 benchmark franking rule …. 12.57, 12.65–12.67 company taxation …. 12.8, 12.34, 12.35 corporate unit trust …. 15.143, 15.144 deemed dividends unfrankable …. 13.18, 13.23, 13.29 denial of franking credit tax offset …. 13.95–13.105 capital benefits streaming …. 13.103

demerger dividends …. 13.104 dividend streaming see Dividend streaming dividend stripping …. 13.96, 13.97 franking credit trading …. 13.102 manipulation of system …. 13.95 non-equity shares …. 13.99 non-share dividend …. 13.105 partnership …. 14.60 receiving entity not qualified person …. 13.95 redeemable preference shares …. 13.100 share capital account, dividends funded from …. 13.101 unfrankable distributions …. 13.98 disadvantages …. 12.10 distribution statement …. 12.61 amending franking credit on …. 12.62 dividend streaming see Dividend streaming excess tax offsets, refund of …. 13.50, 13.55 first franking period …. 12.57 frankable distributions …. 12.25, 12.52 debt and equity rules …. 12.25, 12.52 franking account …. 12.14, 12.34, 12.35, 12.37 consolidated groups …. 12.131 deficit …. 13.36 tracking tax paid …. 12.37, 13.42 franking credit trading …. 12.71–12.75 associated payments rule …. 12.73 denial of franking credit tax offset …. 13.102 effective ownership …. 12.75 exempting entities …. 12.74, 12.75 former exempting companies …. 12.75 45-day rule …. 12.73

general anti-avoidance rule …. 12.71 proposed reform …. 12.73 provisions to curtail …. 12.73, 13.102 franking credits …. 12.25, 12.38–12.45 allocating to distribution …. 12.53, 12.54, 13.41, 13.43–13.46 amending franking credit distribution statement …. 12.62 assessable income of receiving entity …. 13.43 distribution via partnership or trust …. 12.45 diverted profits tax payment …. 12.45 former system, accrued under …. 12.39 gross-up …. 13.43 liability to pay franking deficit tax …. 12.40, 12.45, 12.53, 13.47 maximum allocation …. 12.53, 13.44 partnership …. 14.57 PAYG instalments …. 12.41–12.43 payment of company tax …. 12.41–12.43 receipt of franked distribution …. 12.44 reconciliation at end of franking year …. 12.40 refund of excess tax offsets …. 13.50, 13.55 residency requirement …. 12.38 shareholder using as tax offset …. 13.41–13.55 trading …. 12.71–12.75 franking debits …. 12.46–12.50 anti-streaming provisions, under …. 12.50, 12.68 ceasing to be franking entity, surplus on …. 12.50 contravention of benchmark rule …. 12.50, 12.60 franking of distribution …. 12.49 market buy-back …. 12.50 refund of company tax …. 12.47, 12.48 residency requirement …. 12.46

tainting share capital account …. 12.50, 12.78 untainting share capital account …. 12.50, 12.81 franking deficit tax …. 12.55, 13.41, 13.42 amount …. 12.55 deferring franking deficit to avoid …. 12.56 franking account tracking tax paid …. 12.37, 13.42 liability giving rise to franking credit …. 12.40, 12.45, 12.53, 13.47 reduction of offset …. 12.55 franking of distributions …. 12.51 franking debit …. 12.49 less than 100% …. 13.48 franking period …. 12.57 private company …. 12.57 franking tax offset …. 2.2 grossing up dividend …. 13.45, 13.46, 13.47, 13.49 Henry Review recommendations …. 12.65 New Zealand companies …. 12.35, 12.52 non-equity share …. 12.25, 12.52 unfrankable …. 13.99 non-share dividend …. 12.25, 12.52 non-share equity …. 12.52 over-franking tax …. 12.59 overview …. 12.8, 12.36 partnerships …. 14.56–14.61 denial of tax offset deductions …. 14.61 entity’s share of franked distribution …. 14.60 franked distribution flowing indirectly …. 14.58, 14.59 franking credits …. 14.57 non-assessable non-exempt income …. 14.56, 14.58, 14.61 tax offset …. 14.59, 14.60, 14.61 2004 amendments …. 14.56

private/public company distinction …. 12.33 public trading trust …. 15.143, 15.144 redeemable preference shares franking credit tax offset not available …. 13.100 redemption or cancellation as dividend …. 13.16, 13.40, 13.56 share capital account see Share capital accounts shareholder credit account system …. 12.13, 12.14, 12.34 shareholder perspective …. 13.4 shareholder taxation …. 12.34, 12.36, 13.1–13.4, 13.33–13.55 allocating franking credits to distribution …. 12.53, 12.54, 13.41, 13.43–13.46 assessable income …. 13.2, 13.3, 13.33, 13.45 CGT …. 13.106–13.128 credit for tax paid by company …. 13.41–13.55 denial of tax offset …. 13.95–13.105 foreign residents …. 13.33, 13.53–13.55, 18.36 grossing up dividend …. 13.45, 13.46, 13.47, 13.49 intermediate entities …. 13.51, 13.52 maximum franking credit allocation …. 12.53, 13.44 refund of excess tax offsets …. 13.50, 13.55 tax exempt institutions …. 13.50 washing out corporate tax preferences …. 13.49 Simplified Imputation System …. 12.39, 12.66, 13.42, 13.47, 13.48 superintegration problem …. 12.11–12.13, 12.34, 13.42, 13.47 trusts …. 15.86 receipt of franked dividends …. 15.86 unfrankable dividends …. 12.52 capital benefits streaming …. 12.85, 12.88, 13.103 deemed dividends …. 13.18, 13.23, 13.29 demerger dividends …. 13.104 denial of tax offset …. 13.98–13.105

non-equity share …. 13.99 non-share dividend …. 13.105 share capital account, funded from …. 13.101 variable credit system …. 12.13, 12.14, 12.34 Dividend streaming advantaged shareholders, to …. 12.69 anti-streaming rules …. 12.63–12.70, 17.5 benchmark franking rule and …. 12.65–12.67 differing significantly between franking periods …. 12.70 definition …. 12.69 different classes of shares …. 12.66, 12.67 dividend selection schemes …. 12.68 examples …. 12.63, 12.64, 12.66 franking credit trading distinguished …. 12.72 Henry Review recommendations …. 12.65 imputation providing opportunity for …. 12.63 linked distribution …. 12.68 Dividend stripping anti-avoidance measures …. 13.97, 17.5 denial of tax offset …. 13.95, 13.97 meaning …. 13.96, 13.97 tax avoidance …. 13.96 Dividend withholding tax see Withholding tax Dividends alternative forms of distribution see Distributions to shareholders amount credited to shareholders …. 13.9–13.13 credited, definition …. 13.9 amount debited against share capital account …. 13.14–13.15, 13.37,

13.39 anti-streaming rules see Dividend streaming assessable income …. 1.4, 2.15, 2.19, 3.67, 13.2, 13.3, 13.33, 13.39, 13.45 bonus share issue …. 13.11–13.13 capitalisation of profits …. 13.11, 13.12 company taxation compensatory/equalisation tax …. 12.12 dividend deduction system …. 12.8 dividend exemption system …. 12.8 imputation system see Dividend imputation system profits as taxable income …. 13.2, 13.36 shareholder dividends, and …. 3.67 debt and equity rules …. 12.25 deemed see Deemed dividends definition …. 13.5–13.16 derivation of income …. 4.41 distribution made by company …. 13.6–13.8 franking credits attached …. 12.25 distribution statement …. 12.61, 12.62 double taxation, avoiding …. 13.2, 13.3 foreign equity distribution …. 18.9, 18.11 foreign resident Australian permanent establishment …. 18.36 participation test …. 18.12 shareholder …. 13.33, 13.53–13.55, 18.36 tax offset …. 13.55, 18.40 withholding tax see Withholding tax franking credits …. 12.25 imputation see Dividend imputation system in specie distribution …. 13.6

income …. 1.4, 2.15, 2.18, 3.37, 3.67, 13.2, …. 13.3, 13.33 informal appropriation of company assets …. 13.7 inter-corporate see Inter-corporate dividends intermediate entities, flowing through …. 13.51, 13.52 liquidator’s distributions see Liquidator’s distributions non-cash distribution …. 13.6 non-portfolio dividends …. 18.9–18.12 non-share dividends …. 12.25, 13.32 deemed dividends …. 13.27 definition …. 12.25, 13.32 frankable distributions …. 12.25, 12.52 non-share capital account …. 12.25, 12.52, 13.32 ordinary income …. 13.2 paid, meaning …. 13.34 passing of money or property to shareholder …. 13.8 private company payments deemed see Deemed dividends profits, paid out of …. 12.52, 13.2, 13.3, …. 13.14, 13.35–13.40 redeemable preference shares, redemption or cancellation of …. 13.16, 13.40, 13.56 reinvestment plans …. 13.58 repayment of money paid-up on share …. 13.39 returns of capital …. 13.39 share capital account …. 12.76 amount debited against …. 13.14–13.15, 13.37, 13.39 distribution from tainted account as dividend …. 12.79, 13.14, 13.38 tainting …. 12.77–12.79, 13.14 untainting …. 12.80–12.83 shareholder taxation …. 13.1–13.4, 13.33–13.55 assessable income …. 1.4, 2.15, 2.18, 3.67, 13.2, 13.3, 13.33, 13.39, 13.45

CGT …. 13.106–13.128 foreign resident …. 13.33, 13.53–13.55, 18.36 imputation system see Dividend imputation system payment of dividend, meaning …. 13.34 source …. 2.46 streaming see Dividend streaming stripping …. 13.96, 13.97 withholding tax see Withholding tax Donations see Gifts Double tax agreements (DTAs) Australian income of foreign residents …. 18.35 Australia’s DTAs …. 18.81 capital gains …. 2.33 conflict of source rules …. 18.80 contents …. 18.82 dividend withholding tax …. 13.53 dual residence …. 18.80 tiebreakers …. 18.80 force of law …. 18.81 foreign residents, taxation of …. 18.35 history …. 18.82 overview …. 18. purpose …. 18.80 residence and source jurisdiction …. 18.80 source rules …. 18.80 transfer pricing benefits …. 18.69 Drug dealing income, whether proceeds are …. 3.29

E Early payments of tax interest as assessable income …. 5.3, 5.17 Early retirement scheme payments ETP, taxation as …. 5.38 Early stage innovation companies tax incentives for investment …. 13.163 who may make …. 13.163 Earn-out arrangements …. 6.89 look through earn-out rights …. 6.89, 6.99, 6.118 Education course, definition …. 19.38 GST-free supplies …. 19.32, 19.38 Educational allowances employment contract …. 2.28 exempt income …. 2.25, 2.28 Educational institution exempt entity …. 2.20, 2.21 gifts to …. 9.45 Election expenses assessable recoupments …. 5.23, 9.29 deductibility …. 9.29 entertainment …. 9.29 Embezzlement

assessable recoupments …. 5.23 deduction of loss …. 9.2, 9.26 Employee share schemes (ESS) assessable income …. 5.46–5.51 automatic deferral of taxation point …. 5.49 cessation time …. 5.49 deferral of taxation …. 5.50, 5.51 ESS deferring tax point …. 5.51 forfeiture risk …. 5.51 salary sacrifice arrangement …. 5.51 upfront taxation compared …. 5.50, 5.51 definition …. 5.46 discount deferred vs upfront taxation …. 5.50, 5.51 taxable at point of acquisition …. 5.51 FBT exclusion …. 7.8 former ITAA36 s 26AAC …. 5.47 former ITAA36 Pt III Div 13A …. 5.48, 5.49 ITAA97 Div 83A …. 5.50 market value discount …. 5.48 qualifying rights or shares …. 5.49 reduced assessable amount …. 5.49 taxation of ESS interests …. 5.50 transitional measure …. 5.47 Employees allowances …. 5.3, 7.57 assessable income …. 5.3, 5.4 derivation …. 5.3 non-income amounts …. 5.4

reimbursements distinguished …. 5.4 salary or wages, whether included in …. 7.57 definition …. 7.11 fringe benefits see Fringe benefits PAYG withholding see Pay-As-You-Go (PAYG) system remuneration income, whether …. 3.6 non-cash benefits …. 5.4, 7.1 non-cash business benefits see Non-cash business benefits salary or wages see Salary or wages statutory scheme …. 7.1 work expenses see Work expenses Employer definition …. 7.11 fringe benefits tax see Fringe benefits tax (FBT) PAYG withholding see Pay-As-You-Go (PAYG) system Employer association exempt entity …. 2.23 Employment termination payments (ETPs) accrued leave payments assessability …. 5.35–5.37 deductibility …. 9.34, 9.36 unused annual leave …. 5.36 unused long service leave …. 5.37 assessability …. 5.26–5.43 categories …. 5.35 death benefit termination payments …. 5.27, 5.34 dependant …. 5.34 tax-free component …. 5.34

taxable component …. 5.34 definition …. 5.27 early retirement schemes …. 5.38 ETP cap amount …. 5.33 exclusions …. 5.28 FBT exclusion …. 7.8 former provisions …. 5.26 genuine redundancy payments …. 5.38 grandfathering clauses …. 5.26 income …. 2.19 invalidity segment …. 5.33 life benefit termination payments …. 5.27, 5.33 invalidity segment …. 5.33 pre-July 83 segment …. 5.33 tax-free component …. 5.33 taxable component …. 5.33 pre-July 83 segment …. 5.33 termination of employment …. 5.29 in consequence of, meaning …. 5.30–5.32 unused annual leave …. 5.36 unused long service leave …. 5.37 whole-of-income cap amount …. 5.33 Entertainment expenses advertising and promotion …. 9.59 deductibility …. 6.124, 9.54–9.60 definition of entertainment …. 9.54 employer expenses …. 9.56 entertainment industry expenses …. 9.58 gifts for employees …. 9.54 in-house dining facilities …. 5.52, 9.56

meal entertainment fringe benefits …. 7.43, 7.44, 9.55 object of provisions …. 9.54 overtime allowance …. 9.60 reduced cost base, exclusion from …. 6.124 seminar expenses …. 9.57 Environmental organisations gifts to …. 9.45, 9.48 Exchange gains/losses see Foreign exchange gains/losses Exempt entities …. 2.20–2.23 charitable institutions …. 2.21 educational and scientific institutions …. 2.21 employer associations …. 2.23 not-for-profit associations …. 2.21 religious institutions …. 2.21 sporting clubs …. 2.21, 2.22 trade unions …. 2.23 Exempt income …. 1.23, 2.14, 2.20 assessable income, excluded from …. 2.4, 2.20, 3.1 attributed foreign income …. 2.24 categories of …. 2.14 defence force allowances …. 2.25, 2.26 definition …. 2.2, 2.14, 2.20 Div 11, identified in …. 2.2 educational allowances …. 2.25, 2.28 exempt entities …. 2.20–2.23 foreign source income …. 2.25, 2.29, 2.32, 18.4, 18.5 fringe benefits …. 2.20, 2.24 losses and outgoings in deriving not deductible …. 8.16, 8.82

maintenance payments …. 2.25, 2.27 net foreign resident …. 9.66 resident …. 9.66 tax loss offset against …. 9.67 non-cash business benefits …. 2.24 partnership …. 14.17 pensions …. 2.25, 2.31 social security payments …. 2.20, 2.25, 2.31 taxation consequences …. 2.20 Expenditure capital and revenue distinguished …. 3.16 income production, connection to …. 8.7 Expense payments allowance and reimbursement distinguished …. 7.37 capital and revenue distinguished …. 3.16 fringe benefit …. 7.37, 7.38 exempt benefits …. 7.38 in-house expense payment …. 7.38 taxable value …. 7.38 Exports GST, applicability …. 19.2 GST-free supplies …. 19.32, 19.39

F Fairness in taxation …. 1.2 False or misleading statements

penalties …. 16.55, 16.57 Federal Court appeal to …. 16.31, 16.36, 16.37 AAT decision, from …. 16.37, 16.39, 16.48 burden of proof …. 16.38, 16.39 Full Court …. 16.37, 16.39, 16.49 appeal to High Court from …. 16.37, 16.39, 16.49 choice of AAT or …. 16.36, 16.37 jurisdiction …. 16.37 remitting case back to AAT …. 16.48 Financial arrangements CGT exemption and …. 6.139 definition …. 5.55 taxation of …. 5.55 timing of gains and losses …. 4.1, 8.51 TOFA rules …. 4.1, 8.51 Financial spread betting …. 3.28 Financial supplies GST …. 19.42 Fines see also Penalties non-deductibility …. 9.34, 9.35 Firearms surrender compensation CGT exemption for …. 6.129 Fixtures capital works, whether …. 10.13, 10.19 depreciating asset …. 10.6 holder of …. 10.18, 10.19

quasi-ownership right …. 10.18 Fleeing taxpayers collecting tax from …. 16.72–16.74 departure prohibition order …. 16.72–16.74 Food and drink board meal fringe benefits …. 7.42 deductibility of expenditure on …. 8.74 alcohol …. 9.54 entertainment expenses …. 6.124, 9.54–9.60 light lunches …. 9.54 morning and afternoon tea …. 9.54 exempt fringe benefits …. 7.54 GST-free supplies …. 19.32, 19.33 definition of food …. 19.33 packaging …. 19.34 premises …. 19.33 in-house dining facilities …. 5.52, 9.56 meal allowance expense, deductibility …. 9.72 meal entertainment fringe benefits …. 7.43, 7.44, 9.55 private/domestic expenditure …. 8.74 Foreign accumulation funds (FAFs) exposure draft legislation …. 18.22, Foreign employment exempt income …. 18.5, 18.6 foreign income tax offset …. 18.6 non-assessable non-exempt income …. 18.4, 18.5 Foreign exchange gains/losses assessable income …. 5.53, 5.54

Australian currency …. 5.53 deduction …. 5.53, 5.54 eligible contract, under …. 5.53 financial arrangements, rules for taxation of …. 5.55 forex realisation events …. 5.54 income/capital dichotomy …. 3.21 Foreign hybrids ATO interpretative decisions …. 14.96, 14.98 ceasing to be …. 14.93 CFC rules …. 14.90 definition …. 14.90 double taxation …. 14.90 FIF rules …. 14.90 legislation applicable …. 14.90 limited partnership …. 14.90 net income, calculating interest in …. 14.91 single-member LLC as …. 14.98 tax loss limitation rules …. 14.92 tax treatment …. 14.91 TD 2009/2 …. 14.97 US limited liability companies (LLC) …. 14.90, 14.91 Foreign income tax offset background …. 18.14 calculation …. 18.19, 18.20 entitlement to …. 18.15 foreign tax paid …. 18.16–18.18 foreign income tax, definition …. 18.18 foreign tax paid …. 18.16–18.18 credit absorption tax …. 18.18

dividend, interest or royalty withholding tax …. 18.17 foreign currency, in …. 18.20 rules deeming tax paid/not paid …. 18.17 taxes not considered income tax …. 18.18 unitary tax …. 18.18 limit …. 18.19 operation of system …. 18.15, 18.20 overview …. 18.14 provisions allowing …. 18.14 Foreign investment fund (FIF) rules foreign hybrids …. 14.90 overview …. 18.34, repeal …. 18.22, 18.34 Foreign residents Australian permanent establishment …. 18.35 dividend income attributable to …. 18.35 Australian source income …. 2.32, 18.35 borrowing expenses, deductibility …. 9.18 capital gains tax …. 2.33, 18.37 discount, removal of …. 6.10 taxable Australian property …. 2.33, 6.10, 6.54, 18.37 dividends …. 13.33, 13.53, 18.36 Australian permanent establishment …. 18.36 shareholder taxation …. 13.33, 13.53–13.55, 18.36 tax offset …. 13.55, 18.40 withholding tax see Withholding tax liability to tax in Australia …. 2.4, 2.32, 18.35 proposed changes to law …. 13.53, 18.8 source of income …. 2.41

taxable Australian property …. 2.33, 18.37 taxation of …. 2.32, 18.35 withholding tax see Withholding tax Foreign source income …. 2.29, 2.30 accruals taxation system …. 18.21, 18.22 active income test …. 2.29, 18.8 branches of Australian companies …. 2.29, 18.7 capital export neutrality …. 18.3 capital gains and losses foreign branch income …. 18.7 non-portfolio shareholdings in foreign companies …. 18.13 capital import neutrality …. 18.3 controlled foreign company see Controlled foreign companies (CFCs) currency conversion …. 3.21, 18.20 exempt income …. 2.25, 2.29, 2.30, 2.32, 18.4, 18.4 foreign branch income …. 2.29, 18.7, 18.8 active income test …. 18.7, 18.8 adjusted tainted income …. 18.8 eligible designated concession income …. 18.8 gross tainted turnover …. 18.8 listed countries …. 18.8 non-assessable non-exempt income …. 18.7, 18.8 foreign earnings …. 2.30 foreign equity distribution …. 18.9, 18.11 foreign service …. 2.30, 18.6 listed country …. 2.29, 18.8 non-assessable non-exempt income …. 18.4, 18.5 active income test …. 18.8 capital gains and losses …. 18.7, 18.13 dividends …. 18.9–18.12

foreign branch income …. 18.7, 18.8 non-portfolio dividends …. 18.8–18.12 overview …. 18.3 participation test …. 18.12 permanent establishment in foreign country …. 2.29, 18.7, 18.8 proposed changes to law …. 18.8 tax offset see Foreign income tax offset taxed in country of source …. 2.30, 2.32 unlisted country …. 2.29 Foreign tax credits see Foreign income tax offset Foreign tax relief see Foreign income tax offset Forestry agreements prepayments as assessable income …. 5.3, 5.19 Forex realisation events …. 5.54 Forfeiture of deposit CGT event H1 …. 6.46, 6.47 Franking deficit tax …. 12.55 amount …. 12.55 deferring franking deficit to avoid …. 12.56 franking account tracking tax paid …. 12.37 liability giving rise to franking credit …. 12.40, 12.45, 12.53 offset …. 12.55 reduction of offset …. 12.55 Franking of distributions see Dividend imputation system Fringe benefits see also Fringe benefits tax (FBT) airline transport …. 7.27, 7.41

ANTS proposals …. 7.16 arrangement, definition …. 7.13 bank fees, waiver of …. 7.10 benefit, definition …. 7.9 board meal …. 7.42 car …. 7.29–7.32 car parking …. 7.45, 7.46 classification …. 7.28 debt waiver …. 7.33 definition …. 7.8–7.16 employee advantage to …. 7.9, 7.25 current …. 7.11, 7.16 declaration …. 7.25 definition …. 7.11 employer advantage to …. 7.26 current …. 7.11 definition …. 7.11 former …. 7.15 future …. 7.15 provisions of benefits …. 7.15 employer’s motives irrelevant …. 7.9 exclusions …. 7.8, 7.56 salary or wages …. 7.8, 7.11, 7.56–7.58 exempt benefits …. 7.19, 7.50, 7.54 exempt income …. 2.20, 2.24 expense payment …. 7.37, 7.38 historical approaches to taxing …. 7.2 housing …. 7.39 in respect of employment …. 7.14–7.16

income tax exemption …. 2.20, 2.24 living away from home allowance …. 7.40 loan …. 7.10, 7.14, 7.34–7.36 meal entertainment …. 7.43, 7.44, 9.55 Medicare levy, inclusion in calculation of …. 7.4, 7.19 MT 2016 …. 7.16 non-assessable non-exempt income …. 7.1, 7.55 non-cash benefits …. 5.4, 7.1 overview …. 7.1 private advantage irrelevant …. 7.9 property …. 7.47–7.49 provide, meaning …. 7.10 reportable …. 7.4 residual …. 7.50, 7.51 in-house …. 7.38, 7.52 taxable value see Fringe benefits tax (FBT) two employers …. 7.10 value to taxpayer …. 5.4, 7.2 Fringe benefits tax (FBT) aggregate fringe benefits tax amount …. 7.17 airline transport fringe benefit …. 7.41 application …. 7.7 associate, definition …. 7.12 board fringe benefits …. 7.42 calculation …. 7.4, 7.7, 7.17 car fringe benefits …. 7.29 definition …. 7.29 exempt benefit …. 7.30 private use, available for …. 7.30 valuation rules …. 7.31, 7.32

car parking fringe benefits …. 7.45, 7.46 conditions …. 7.45 valuation methods …. 7.46 classification of benefits …. 7.28 concessions …. 7.27 contributions by employee …. 7.24 GST effect on …. 7.24 residual fringe benefit …. 7.53 debt waiver fringe benefit …. 7.33 Draft White Paper 1985 …. 7.3 employee’s marginal rate …. 7.61 employer definition …. 7.11 liability …. 7.7, 7.60 payable by …. 7.1, 7.4, 7.7 exempt benefits …. 7.19, 7.50, 7.54 expense payment fringe benefits …. 7.37, 7.38 allowance and reimbursement distinguished …. 7.37 exempt benefits …. 7.38 in-house expense payment …. 7.38 taxable value …. 7.38 fixed rate …. 7.3 fringe benefits taxable amount …. 7.7, 7.17 grossing up taxable value …. 7.4, 7.19, 7.31, 7.60 Henry Review recommendations …. 7.5 history …. 7.2–7.4 housing fringe benefits …. 7.39 lease or licence to occupy …. 7.39 remote area …. 7.27, 7.39 taxable value …. 7.39 income tax and …. 7.55–7.58

individual fringe benefits amount …. 7.19 excluded benefits …. 7.19 in-house fringe benefits …. 7.26, 7.27 introduction in Australia …. 7.4 living away from home allowance …. 7.40 loan fringe benefit …. 7.34 definition of loan …. 7.34 exempt benefits …. 7.35 taxable value …. 7.36 meal entertainment fringe benefits …. 7.43, 7.44, 9.55 valuation methods …. 7.44 otherwise deductible rule …. 7.25, 7.49, …. 7.53 overview …. 7.1, 7.7 property fringe benefits …. 7.47–7.49 exempt benefits …. 7.47 external …. 7.47, 7.49 in-house …. 7.47, 7.48 taxable value …. 7.47–7.49 quantifying liability …. 7.17–7.23 rate …. 7.4, 7.17 rebate for tax-exempt employers …. 7.59 remote area housing …. 7.27, 7.39 reportable fringe benefits amount …. 7.19 disclosure on group certificate …. 7.19 residual fringe benefits …. 7.38, 7.50, …. 7.51 categories …. 7.52 exempt benefits …. 7.50 external non-period …. 7.51–7.53 external period …. 7.51–7.53 in-house non-period …. 7.51–7.53

in-house period …. 7.51–7.53 taxable value …. 7.53 salary or wages excluded …. 7.8, 7.56–7.58 salary packaging and …. 7.4, 7.60, 7.61 superannuation contributions …. 7.61 taxable amount …. 7.7, 7.17 taxable value …. 7.18 benefits valued in aggregate …. 7.23 employee’s share of …. 7.20, 7.23 grossing up …. 7.4, 7.19 individual benefit in respect of one employee …. 7.21 individually taxed benefit shared by two or more employees …. 7.22 Type 1 aggregate fringe benefits amount …. 7.17, 7.18 Type 2 aggregate fringe benefits amount …. 7.17, 7.18 valuation of benefits …. 7.24–7.27 Full self-assessment taxpayers …. 16.6 assessment …. 16.10 see also Assessment

G Gambling business, whether …. 3.47, 3.49 financial spread betting differentiated …. 3.28 losses, whether deductible …. 8.27 winnings CGT exemption …. 6.129, 6.131 income, whether …. 3.25, 3.26 Garnishee order …. 16.70, 16.71

General interest charge (GIC) …. 16.53–16.55 Commissioner’s discretion to remit …. 16.55 deductibility …. 5.17 late filing penalty …. 16.53 late payment penalty …. 16.54, 16.55, 16.58 non-filing penalty …. 16.53 non-payment of penalty …. 16.58 penalty and interest …. 16.54 rate …. 16.53 running balance account (RBA) …. 16.53, 16.55 underpayment of tax …. 16.55 General Practice Rural Incentives Program CGT exemption …. 6.129 Gifts charitable donations …. 9.45 companies, by …. 9.45 Cultural Bequests Program …. 9.52 cultural organisations …. 9.45, 9.51 deductibility …. 9.45–9.53 deductible gift recipients …. 9.45 deduction not to increase tax loss …. 9.43, 9.68 definition …. 3.22, 9.46 disaster relief funds …. 9.45 environmental organisations …. 9.48 income distinguished …. 2.18, 3.22–3.24, 3.38 natural incident of employment …. 3.22 one-off payment …. 3.23, 3.43 proximity of service/employment relationship …. 3.23, 3.24 regular, recurrent, periodic payments …. 3.24, 3.37

related to income-earning activities …. 3.23, 3.38 scholarship or award …. 3.24 tip or gratuity …. 3.22, 3.39 voluntary payments …. 3.23, 3.38 ‘mere gift’ …. 3.22–3.24, 3.38 minor benefit …. 9.45 motive of donor …. 3.23, 9.46 philanthropic trusts …. 9.50 political donations …. 6.124, 9.45, 9.46 promotional give-aways …. 9.45, 11.27 public benevolent institutions …. 9.45, 9.47 recipients …. 9.45 scholarship …. 9.45 sport and recreation associations …. 9.49 tax expenditures …. 9.45 testamentary gifts …. 9.52 trading stock …. 9.45, 11.27 valuation requirements …. 9.53 voluntary transfer …. 3.23, 3.38, 9.46 Going concerns GST-free supplies …. 19.32, 19.40 Goods and services tax (GST) anti-avoidance provisions …. 19.47 Australian consumers …. 19.29 assessable income, exclusion from …. 4.46 background …. 19.1, 19.2 business activity statement (BAS) …. 19.3, 19.8 carrying on enterprise …. 19.19 central provisions …. 19.9

commercial residential premises …. 19.43 compliance costs …. 19.3 consideration …. 19.14 cancelled lay-by sales …. 19.17 definition …. 19.14 security deposits …. 19.15 vouchers …. 19.16 creditable acquisitions …. 19.9 creditable importations …. 19.9 current GST turnover …. 19.23 debate on …. 1.2 deductions, effect on …. 9.75 depreciation, effect on …. 10.35 enterprise carrying on …. 19.19 definition …. 19.18 registration …. 19.21 exports …. 19.2, 19.32, 19.39 FBT and …. 7.24 Federal Government Tax Reform Plan …. 1.15 final consumer, borne by …. 19.4 financial supplies …. 19.42 food …. 19.32, 19.33 definition …. 19.33 packaging of …. 19.34 fund-raising events …. 19.45 going concerns …. 19.32, 19.40 reverse charge rule, proposed …. 19.40 goods, definition …. 19.13 GST-free supplies …. 19.5, 19.7, 19.31, 19.32 education …. 19.32, 19.38

exports …. 19.32, 19.39 food …. 19.32, 19.33, 19.34 going concerns …. 19.32, 19.40 health services …. 19.35–19.37 international mail …. 19.32 GST turnover …. 19.23 health services …. 19.35 hospital treatment …. 19.36 medical aids …. 19.37 hobbies …. 19.18 importations non-taxable …. 19.46 taxable …. 19.9, 19.29 income and …. 4.46 indirect tax zone …. 19.11, 19.20, 19.21, 19.29, 19.39 connected with …. 19.20 overseas suppliers, obligations …. 19.20 input tax credits …. 4.46, 19.4, 19.6, 19.9 cost base reduction …. 6.101 deductions, effect on …. 9.75 depreciation, effect on …. 10.35 input taxed supplies …. 19.3, 19.5, 19.6, 19.41 financial supplies …. 19.42 fund-raising events …. 19.45 residential premises …. 19.44 residential rents …. 19.43 lay-by sale cancelled …. 19.17 liability …. 19.30 non-taxable importations …. 19.46 projected GST turnover …. 19.23

rates …. 19.2 registration …. 19.21 agents for non-residents …. 19.27 annual turnover threshold …. 19.21, 19.22, 19.23 branches …. 19.26 cancellation of …. 19.24 enterprise …. 19.21 exceptions …. 19.25–19.28 GST turnover …. 19.23 indirect tax zone and …. 19.20, 19.21 requirement …. 19.21 taxis …. 19.28 time limits …. 19.24 remitting to ATO …. 19.4 residential premises …. 19.44 residential rents …. 19.43 returns …. 19.8 reverse charge rule, proposed …. 19.40 supply connected with indirect tax zone …. 19.11, 19.20 definition …. 19.12 taxable …. 19.9–19.11, 19.30 supply of service not made …. 19.17 tax periods …. 19.8 taxable importations …. 19.9, 19.29 connected with indirect tax zone …. 19.29 home consumption …. 19.29 taxable supplies …. 19.9–19.11, 19.30 concept …. 19.10, 19.11 connected with indirect tax zone …. 19.11, 19.20 supply, meaning …. 19.12

turnover …. 19.23 upgrading assets to meet GST obligations assessable recoupments …. 5.23 value, definition …. 19.30 zero-rated supplies …. 19.2, 19.31 Goodwill CGT asset …. 6.74 expenditure to increase asset’s value, exclusion …. 6.111 property, as …. 6.74 Gratuities assessable income …. 3.22, 5.4 deduction …. 9.27 not to increase tax loss …. 9.27, 9.68 Group companies consolidation see Consolidated groups inter-corporate dividends see Intercorporate dividends loss transfers …. 12.106, 13.91 capital losses …. 12.147, 12.148 cost base adjustments …. 12.148 excess franking offset …. 13.91, 13.92 linked group transactions …. 12.149 reduced cost base adjustments …. 12.148 tax losses …. 9.64, 12.106 transitional provisions …. 12.112

H Health deductibility of expenditure …. 8.76

private/domestic character …. 8.76 gifts to hospitals …. 9.45 GST-free supplies …. 19.32, 19.35 health insurance offsets …. 2.2 hospital treatment …. 19.36 medical aids …. 19.37 HECS payments collection …. 16.59 deductibility …. 9.37 fringe benefits included in calculation of …. 7.4 Henry Review …. 1.2, 1.20 CGT recommendations …. 6.1 companies, recommendations …. 12.10 dividend imputation recommendations …. 12.65 dividend streaming recommendations …. 12.65 FBT recommendations …. 7.5 general recommendations …. 1.20 Re: Think Initiative …. 1.21 High Court appeal to …. 16.37, 16.39, 16.49 special leave …. 16.49 Hire–purchase agreement cost of depreciating asset under …. 10.33, 10.34 Hobby/business distinction deductions …. 8.18 GST …. 19.18 income …. 3.40, 3.45–3.51

Home office deductibility of expenses …. 8.78 depreciable assets …. 8.78 place of business …. 8.78 private/domestic character …. 8.78 Horizontal equity …. 1.2 Hospitals exempt fringe benefits …. 7.54 gifts to …. 9.45 treatment as GST-free supply …. 19.36 Housing fringe benefit …. 7.39 lease or licence to occupy …. 7.39 remote area …. 7.27, 7.39 taxable value …. 7.39 Hybrid business entities (foreign) see Foreign hybrids

I Illegal activities business, whether …. 3.51 deductibility of expenses …. 9.42 income, whether proceeds are …. 3.29 theft or embezzlement, deduction of loss …. 9.26 Importations and GST non-taxable importations …. 19.46 taxable importations …. 19.9, 19.29 Improvements

capital works, whether …. 10.13 depreciating asset …. 10.6, 10.18 quasi-ownership right …. 10.18 repairs distinguished …. 9.8, 9.9 separate assets from land …. 6.84 In-house dining facilities assessable income …. 5.52 Inbound intangible supplies GST-free supplies …. 19.32 Income accounting concept …. 2.6 accretion of wealth …. 2.7 annuities …. 3.37, 3.62, 3.65 assessable see Assessable income beneficially derived …. 3.34 business, derived from see Business income capital distinguished see Income/capital dichotomy character in hands of recipient …. 3.35, 3.36 classes of …. 1.4 commercial activity, from …. 2.6 compensation for lost income …. 3.68–3.70 concept of …. 2.1, 2.5–2.13, 3.1, 3.71 historical development …. 1.4–1.7, 2.10 constructive receipt …. 3.36 convertibility into money …. 3.4–3.7 Australian currency …. 3.7 barter transaction …. 3.7 non-cash business benefits …. 3.6 non-convertible amounts …. 3.5

non-money consideration …. 4.2 statutory provisions …. 3.6, 3.7 derivation of see Derivation of income dividends see Dividends earned/unearned …. 1.4 economic concept …. 2.7 employment or provision of services, derived from …. 3.38–3.43 employment termination payments see Employment termination payments (ETPs) estimation, long term projects …. 4.30 ex gratia payment …. 3.39 exempt see Exempt income financial spread betting …. 3.28 flow versus gain …. 2.8 gain …. 2.12 gambling and punting …. 3.25, 3.26 gift distinguished …. 2.18, 3.22–3.24, 3.38 natural incident of employment …. 3.22 one-off payment …. 3.23, 3.43 proximity of service/employment relationship …. 3.23, 3.24 regular, recurrent, periodic payments …. 3.24, 3.37 related to income-earning activities …. 3.23, 3.38 scholarship or award …. 3.24 tip or gratuity …. 3.22, 3.39 gross receipts …. 2.11 illegal activities, proceeds of …. 3.29 interest …. 3.63 ITAA97, under …. 2.14, 2.15 judicial concept …. 2.1, 2.8–2.13, 3.1, 3.71 lay-by arrangements …. 4.17, 4.40 measurement of …. 4.1

mutual receipts …. 3.30–3.33 net profit …. 2.6, 2.11, 2.12 non-cash business benefits …. 3.6 non-pecuniary benefits …. 2.7 one-off payment …. 3.23, 3.39 ordinary …. 1.23, 2.1, 2.4, 2.9–2.13, 2.15, 3.1–3.70, 8.1 partnerships see Partnerships personal exertion, from …. 1.4, 2.5 primary production income …. 1.4 prizes and winnings …. 3.25, 3.27 profits …. 1.4, 1.13, 1.14, 2.8, 2.11, 2.15, 2.18 net profit …. 2.6, 2.11, 2.12 property, derived from …. 1.4, 2.5, 3.62–3.67 annuities …. 3.62, 3.65 definition …. 3.62 dividends …. 3.67, 13.2, 13.3 financial instruments …. 3.62 interest …. 3.63 ordinary income …. 1.4, 2.5, 3.62 rent …. 3.64 royalties …. 3.62, 3.66 propositions …. 3.1, 3.3–3.70 quiz contestants …. 3.27 recurrence, regularity and periodicity …. 3.24, 3.37, 3.39, 3.71 remuneration for personal services …. 2.15, 2.16, 3.71 rent …. 3.64 return on investments …. 2.15, 3.71 royalties …. 3.62, 3.66 source see Source of income sports-related payments …. 3.40–3.43 statutory see Statutory income

taxable …. 1.4, 2.2, 2.14, 3.1 timing of financial arrangements …. 4.1 tip or gratuity …. 3.22, 3.39 types …. 1.4 voluntary payments …. 3.38, 3.39 windfalls …. 3.25 workers compensation payments …. 3.19, 3.37 year …. 2.2 Income/capital dichotomy …. 3.1, 3.8–3.21 application of …. 3.14–3.21 business receipts …. 3.44, 3.59 California Copper principle …. 3.11, 3.44 cancellation of agreements …. 3.18 cancellation of right to sue …. 3.20 case example …. 3.14 circulating capital …. 3.13, 8.65 compensation cancellation of agreement …. 3.18 defamation …. 3.18 forfeiture of rights …. 3.18 personal injury …. 3.19, 3.20 unliquidated damages …. 3.20 consideration, nature of …. 3.12 copyright licence …. 3.15, 3.16 criteria for distinguishing …. 3.9–3.13 deductions …. 8.66–8.69 acquisition of capital asset …. 8.68 capital expenditure excluded …. 3.8, 8.4, 8.19, 8.27, 8.61–8.69 fixed or circulating capital …. 8.65 immunity from competition, creating …. 8.64, 8.67

once and for all test …. 8.61 outgoings to defend title to asset …. 8.69 process–structure test …. 8.62, 8.63 Dixon’s criteria …. 3.10, 3.61 enhancement of value …. 3.11 exchange rate gain or loss …. 3.21 fixed capital …. 3.13, 8.65 historical development …. 1.7, 1.10 know-how payments …. 3.15, 3.16 licence payments …. 3.15, 3.16 mere realisation of asset …. 3.11 ordinary income not including capital …. 3.8 patent licence …. 3.15, 3.16 process–structure distinction …. 3.10, 3.18, 8.62, 8.63 propositions …. 3.1, 3.3 reasons for …. 3.8 restrictive covenants …. 3.17 workers compensation payments …. 3.19 Income tax Australian law see Australian tax law English law …. 1.4, 1.7 Jones v Leeming, decision in …. 1.14 rejection in Australian law …. 1.5–1.7 formula …. 2.2 components …. 2.3 fringe benefits tax and …. 7.55–7.58 history …. 1.3 income, concept of see Income jurisdictional limits …. 2.4, 2.31–2.36, 4.3 obligation to pay …. 2.2

percentage of budget …. 1.2 proportion of taxes …. 1.2 statistics …. 1.2 taxable income …. 1.4, 2.2, 2.14 Income Tax Assessment Act 1936 (ITAA36) …. 1.17, 2.1 concurrent operation with ITAA97 …. 1.17, 2.1, 2.3 definitions …. 2.1 enactment …. 1.17 income by ordinary/judicial concepts …. 3.1 rewritten provisions …. 2.1, 2.3 Income Tax Assessment Act 1997 (ITAA97) …. 1.17, 2.1 central and parallel provisions …. 5.1 concurrent operation with ITAA36 …. 1.17, 2.1, 2.3 construction of Div 6 …. 5.2 core provisions …. 2.1, 2.2, 2.3 definitions …. 1.31, 2.1 guides and examples …. 1.28 income by ordinary/judicial concepts …. 3.1 interpretation see Statutory interpretation structure …. 1.17, 2.1, 2.3 transition from ITAA36 …. 2.1, 2.3 Indefeasible right to use (IRU) depreciating asset …. 10.3, 10.6 exclusions …. 10.15 Indirect tax zone see Goods and services tax (GST) Inspector-General of Taxation …. 1.19 Instalment activity statement (IAS) …. 16.59, 16.64

Instalment sales derivation of income …. 4.20, 4.21, 4.44 Insurance or indemnity assessable recoupments …. 5.23 business income …. 3.53–3.56 CGT exemption for insurance policies …. 6.148 loss of assessable income, for …. 5.16 assessable income …. 5.3, 5.16 derivation …. 5.3 personal services entity, deduction for …. 9.89 Intellectual property copyright see Copyright depreciating asset …. 10.6 diminishing value method prohibited …. 10.23, 10.30 effective life …. 10.48 patents see Patents Inter-corporate dividends assessable income of recipient …. 13.89 deductions …. 13.90 cascading of tax …. 13.88, 13.89, 13.94 classical system of company tax …. 13.87 consolidated group as single entity …. 13.93 excess franking offset …. 13.91, 13.92 excess tax offset …. 13.90 franking credit …. 13.89 income flowing through chain of companies …. 13.87, 13.88 rebate …. 13.94, 13.100 tax losses carried forward …. 13.91

Interest assessable income …. 3.63, 5.17 compensation for personal injury …. 3.63 constructive receipt …. 4.32 deductibility …. 9.18 definition …. 3.63 derivation …. 4.33, 4.43 early payments of tax, on …. 5.3, 5.17 income …. 1.4, 3.37, 3.62, 3.63 ‘interest only’ loans …. 3.63 overpayments of tax, on …. 5.3, 5.17 source …. 2.45 what constitutes …. 3.63 withholding tax see Withholding tax International taxation BEPS Action Plan …. 18.2, 18.3, 18.80, 18.84 Australian response …. 18.3, 18.54, 18.78, 18.84 capital export neutrality …. 18.3 capital import neutrality …. 18.3 CFC rules see Controlled foreign companies (CFCs) diverted profits tax …. 18.85 double tax agreements see Double tax agreements (DTAs) FIF rules (repealed) …. 18.22, 18.34 foreign source income see Foreign source income globalisation and …. 18.1 Multinational Anti-Avoidance Law …. 18.3, 18.83 thin capitalisation see Thin capitalisation transfer pricing see Transfer pricing

J

Joint tenancy capital gains tax assets and …. 6.84 death of one tenant asset passing to other, CGT implications …. 15.134 CGT event A1 …. 6.85 Joint venture non-entity joint venture …. 12.27 partnerships distinguished …. 14.11, 14.12 Judicial income see Income Jurisdictional limits …. 2.4, 2.32–2.36 capital gains tax …. 2.33 foreign residents …. 2.4, 2.32 overview …. 2.32 residency see Residency source see Source of income

L Land see also Property building on, separate asset …. 6.84 capital allowance regime, exclusion …. 10.6 improvements, separate asset …. 6.84 subdivision, effect on CGT …. 6.115 trading stock, whether …. 11.5, 11.9 product of land …. 11.10 undeveloped land …. 11.20 Late payment of tax general interest charge …. 16.54, 16.55, 16.58

deductibility …. 5.17 Law, sources of sources of taxation …. 1.22 Lay-by arrangements derivation of income …. 4.17, 4.40 Lease CGT events in relation to …. 6.45 grant, renewal or extension …. 6.45 surrender of …. 6.51 variation or waiver of term, payment for …. 6.45 chattel leasing derivation of income …. 4.39 depreciating asset, leased asset as …. 10.19, 10.20 document expenses, deduction for …. 9.17 grant, renewal or extension CGT event F1 …. 6.45 long-term lease (CGT event F2) …. 6.45 incentives, whether income …. 3.60, 3.61 premium …. 3.64 rent distinguished …. 3.64 rental income see Rent repair obligations, receipts for assessable income …. 5.3, 5.15 deduction …. 9.16 derivation …. 5.3 termination, deduction of capital expenditure …. 9.33 variation or waiver of term, CGT events lessee receiving payment (F4) …. 6.45 lessor receiving payment (F5) …. 6.45

lessor’s expenditure (F3) …. 6.45 Leave payments accrued leave see Accrued leave payments deductibility …. 9.34, 9.36 Legal professional privilege access to information and …. 16.22, 16.26 dominant purpose …. 16.27 loss of …. 16.28 crime or fraud …. 16.28 non-legal advisers …. 16.28 taxpayer information …. 16.22, 16.26 Leisure facilities deductibility of expenses …. 9.34, 9.41 definition …. 9.41 Licence exclusive …. 3.16, 5.13 grant of, capital or income …. 3.16 ordinary …. 3.16, 5.13 royalties source …. 2.49 statutory …. 5.13 sole …. 3.16, 5.13 termination, deduction of capital expenditure …. 9.33 Life benefit termination payments …. 5.27, 5.33 Limited partnerships see also Partnerships corporate limited partnership …. 14.14, 14.88 closely held …. 14.95

deemed dividends …. 13.26 corporate tax entity …. 14.88 distributions by …. 14.89 foreign hybrids …. 14.90–14.93, 14.96–14.98 general partners …. 14.87 liability of …. 12.3 limited partners …. 14.87 liability of …. 12.3, 14.87 nature of …. 14.87 non-resident corporate limited partnership …. 14.88 partners taxed like shareholders …. 14.89 tax treatment …. 14.88 unincorporated association as …. 14.14 Limited recourse debt definition …. 9.90 purpose …. 9.90 rights of the creditor …. 9.90 Liquidation …. 13.62 Liquidator CGT asset vested in …. 6.57 declaring shares worthless (CGT event G3) …. 6.160, 13.56, 13.84, 13.122 distributions by see Liquidator’s distributions Liquidator’s distributions …. 13.62–13.86 assessable income of company …. 13.64, 13.75, 13.76 cancellation of shares (CGT event C2) …. 13.56, 13.79, 13.80, 13.83 capital loss offsets disallowed …. 13.67 capital losses disregarded …. 13.69

CGT event C2 …. 13.56, 13.79, 13.80, 13.83, 13.86 CGT event G1 (s 104-135) …. 13.82, 13.86, 13.120 CGT implications for shareholders …. 13.56, 13.78–13.86 CGT indexation …. 13.65 deemed dividend …. 13.17, 13.56, 13.62, 13.63, 13.68, 13.76 final distribution …. 13.79 frankable distribution …. 13.63 income applied to make good loss of paid up capital …. 13.70–13.73 capital receipts …. 13.73 formal application rules …. 13.72 properly applied, meaning …. 13.70, 13.71 income derived by the company …. 13.64, 13.74–13.77 interim distribution …. 13.80–13.83 company dissolved within 18 months …. 13.83 company not dissolved within 18 months …. 13.80 no cancellation of shares …. 13.81 non-assessable …. 13.56, 13.82 net capital loss offsets disallowed …. 13.66 non-assessable interim distribution …. 13.56, 13.82 non-dividend return of capital …. 13.68 non-resident company …. 13.76 order of distribution …. 13.68 ‘profit’, paid out of …. 13.62, 13.63 recipient’s assessable income …. 13.64 reduction of capital gain if otherwise assessable …. 13.85, 13.86 Living away from home allowance fringe benefit …. 7.40 Loan benchmark interest rate …. 7.36

borrowing expenses, deductibility …. 9.18 deemed dividend see Deemed dividends definition …. 7.34 fringe benefit …. 7.10, 7.14, 7.34 exempt benefits …. 7.35 taxable value …. 7.36 unpaid debt …. 7.34 unpaid interest …. 7.34 non-commercial …. 13.28 repayment …. 13.28 Long service leave payments see Accrued leave payments Losses capital see Capital gains and losses company see Company losses consolidated groups see Consolidated groups corporate unit trust …. 15.139 deductions see Deductions group companies, loss transfers see Group companies partnership …. 14.17, 14.18 capital losses …. 14.66, 14.71 deductibility …. 14.19, 14.20 non-commercial losses …. 14.94 partner’s interest in …. 14.19, 14.20, 14.22 tax losses see Tax losses trust see Trust losses Low-value asset pools balancing adjustment event …. 10.76 calculating decline in value …. 10.74, 10.75 closing pool balance …. 10.75

depreciating assets …. 10.71–10.76 estimate of percentage of use …. 10.73 GST input credits reducing balance …. 10.75 low-cost assets allocated to …. 10.71, 10.72

M M4/M5 Cashback Scheme CGT exemption …. 6.129 Main residence CGT exemption absences …. 6.145, 6.146 adjacent land …. 6.141, 6.142 separate CGT event …. 6.146 building dwelling …. 6.145 changing main residences …. 6.145 compulsorily acquired or destroyed dwelling, absence from …. 6.145 compulsory acquisition of land adjacent to main residence main residence not compulsorily acquired …. 6.145 conditions for …. 6.140 Crown lease …. 6.144 deceased estate, acquired from …. 6.147 destruction of dwelling …. 6.145 dwelling, definition …. 6.141 dwelling used to produce assessable income …. 6.146 first use …. 6.146 extension …. 6.145 garage or storeroom …. 6.142 land immediately under unit of accommodation …. 6.141 limitations …. 6.146 moving into dwelling …. 6.145

ownership interest Crown lease …. 6.144 definition …. 6.144 tenants and licensees …. 6.144 ownership period …. 6.143 definition …. 6.143 only main residence for part of …. 6.146 private and domestic purposes, used primarily for …. 6.142 relevant CGT events …. 6.140 repairing or renovating …. 6.145 spouse having different main residence …. 6.146 Maintenance payments exempt income …. 2.25, 2.27 Market value substitution rule capital proceeds …. 6.93, 6.94, 13.111 CGT event C2 …. 6.31–6.33, 13.111 concentrated ownership …. 13.111 cost base of CGT assets …. 6.113 determination of market value …. 6.93 exceptions …. 6.114 issue of shares for no consideration, not applicable …. 13.109 non-arm’s length dealings …. 6.113, 13.109 Meal entertainment definition …. 7.43 expenses see Entertainment expenses fringe benefits …. 7.43, 7.44, 9.55 valuation methods …. 7.44 Measurement of income …. 4.1

MEC groups …. 12.116 eligible tier one companies …. 12.116 head company becoming member of …. 12.113 Medical expenditure deductibility …. 8.76 GST-free supplies …. 19.32, 19.35 hospital treatment …. 19.36 medical aids …. 19.37 private/domestic character …. 8.76 Medicare levy …. 2.2 collection …. 16.59 fringe benefits included in calculation of …. 7.4, 7.19 Mineral resource rent tax …. 1.20 Mining, quarrying or prospecting capital allowances …. 10.4 Henry Review recommendations …. 1.20 information as depreciating asset …. 10.6 holder of …. 10.20 information, payments for providing …. 5.18 assessable income …. 5.3, 5.18 derivation …. 5.3 rights as depreciating assets …. 10.6 Minors tax rates …. 15.60, 15.61 trusts …. 15.59–15.62 anti-avoidance provisions …. 15.59 anti-splitting provisions …. 15.60–15.62 excepted trust income …. 15.61, 15.62

Mortgage discharge, deduction of expenses …. 9.19 Multiple entry consolidated (MEC) groups …. 12.116 eligible tier one companies …. 12.116 head company becoming member of …. 12.113 Multinational Anti-Avoidance Law (MAL) …. 18.3, 18.83 Mutual receipts club member subscriptions …. 3.30, 3.31 demutualisation …. 3.33 income, whether …. 3.30-33 mutuality principle …. 3.30, 3.32 MyTax …. 16.4

N National Disability Insurance Scheme expenditure denial of deduction …. 6.124 reduced cost base, exclusion from …. 6.124 National Rent Affordability Scheme CGT exemption …. 6.129 Net capital gains and losses see Capital gains and losses Net income partnership …. 14.17, 14.18, 14.24, 14.68 CGT reduction for amounts included in …. 14.82, 14.83 individual interest of partner in …. 14.21, 14.22 trust estate …. 15.27, 15.28, 15.80

New Zealand companies dividend imputation …. 12.35, 12.52 Non-assessable non-exempt income (NANE) call options …. 6.43, 13.115 conduit foreign income …. 18.40 foreign branch profits …. 18.7, 18.8 foreign source income …. 18.4, 18.5 fringe benefits …. 7.1, 7.55 non-portfolio dividends …. 18.9–18.12 partnership …. 14.17, 14.18 dividends …. 14.56, 14.58, 14.61 Non-cash business benefits assessable income …. 5.4, 7.55 deductibility …. 9.81 definition …. 3.6 depreciating asset, cost …. 10.34 exempt income …. 2.24 FBT exemption …. 7.55 income, whether …. 3.6 value to taxpayer …. 3.6, 5.4, 7.2 Non-commercial losses …. 9.69 Non-receipt rule capital proceeds …. 6.96 Non-residents see Foreign residents Non-share dividends …. 12.25, 13.32 deemed dividends …. 13.27 definition …. 12.25, 13.32

frankable distributions …. 12.25, 12.52 non-share capital account …. 12.25, 12.52, 13.32

O Objections see Disputes Offsets …. 2.2 Offshore information notice …. 16.25 Options call options …. 6.43, 13.115 CGT events …. 6.43 company issued …. 13.112–13.115 cost base …. 13.114, 13.115 end of (CGT event C3) …. 12.136 grant, renewal or extension (CGT event D2) …. 6.40–6.44 capital gain …. 6.42 capital loss …. 6.42 company …. 12.135, 13.113–13.115 exclusions …. 6.41 limited cost base …. 6.42 unit trust …. 15.121, 15.122 GST consequence …. 19.14 put options …. 6.44, 13.115 CGT events …. 6.44 cost base …. 13.115 grant (CGT event H2) …. 6.53, 13.115 shareholder taxation …. 13.112–13.115 unit trusts …. 15.121, 15.122

Oral rulings see Tax rulings Ordinary income see Income Organisation for Economic Cooperation and Development (OECD) Australian law reforms to align with …. 18.79 BEPS Action Plan …. 18.2, 18.3, 18.80 Australian response …. 18.3, 18.54, 18.78 CGT approaches in OECD countries …. 6.2 thin capitalisation benefit reduction …. 18.53 transfer pricing guidelines …. 18.72 Over-franking tax …. 12.59 Overpayments of tax interest as assessable income …. 5.3, 5.17

P Partnerships accounts …. 14.22 derivation of income …. 4.37 dissolution of partnership …. 14.31, 14.32 payments outside …. 14.36, 14.43 taking of …. 14.25, 14.26, 14.45, 14.47–14.49 agreement …. 14.22, 14.31–14.34 capital gains and losses …. 14.70 non-dissolution clause …. 14.33, 14.34, 14.45 anti-avoidance provisions …. 14.54, 14.55 assessable income …. 14.17, 14.29 assignment of interests …. 14.50–14.53 CGT consequences …. 14.84

general law effects …. 14.50 who derives partner’s share of net income …. 14.51, 14.52 balancing adjustments see Balancing adjustments bankruptcy of partner …. 14.30, 14.33 beneficiaries, distinguished …. 14.6, 14.10 capital allowances …. 14.44 balancing adjustment relief …. 10.58, 14.44–14.47 carrying on business …. 14.7–14.9 in common …. 14.10 view to profit …. 14.12, 14.13 CGT see Partnerships and CGT change in composition …. 14.30–14.49 anomalies arising on …. 14.49 balancing adjustment relief …. 14.44–14.47 CGT consequences …. 14.62, 14.63, 14.79, 14.80 death of partner …. 14.30, 14.31, 14.33, …. 14.34 dissolution …. 14.30–14.32 non-dissolution clause …. 14.33, 14.34, …. 14.45 not dissolving partnership …. 14.33, 14.34 partnership assets on …. 14.45 retirement of partner …. 14.36–14.42 taking of accounts …. 14.45, 14.47–14.49 trading stock on …. 14.48 work in progress payments …. 14.35–14.43 closely held corporate limited partnerships …. 14.95 co-ownership of property, distinguished …. 14.9 companies distinguished …. 12.2, 12.3, 12.27, 14.6 corporate limited see Limited partnerships deductions …. 14.15, 14.17 interest in partnership loss …. 14.19, 14.20 partner …. 14.18, 14.19

work in progress amount …. 14.42, 14.43 definition …. 12.3, 12.27, 14.1–14.6 depreciating assets balancing adjustment …. 10.58, 14.44–14.47 CGT event K7 …. 10.66 cost …. 10.33 holder of …. 10.20 derivation of income …. 4.37, 14.21–14.26, 14.33 disposal of assets see Partnerships and CGT dissolution …. 12.3, 14.30–14.32 balancing adjustment event …. 10.58, 14.44–14.47 CGT consequences …. 14.62, 14.85, 14.86 dividend imputation …. 14.56–14.61 denial of tax offset deductions …. 14.61 entity’s share of franked distribution …. 14.60 franked distribution flowing indirectly …. 14.58, 14.59 franking credits …. 14.57 non-assessable non-exempt income …. 14.56, 14.58, 14.61 tax offset …. 14.59, 14.60, 14.61 2004 amendments …. 14.56 exempt income …. 14.17 fiduciary duties …. 14.4, 14.6 foreign hybrids …. 14.90–14.93, 14.96–14.98 general law partnership …. 14.3–14.5 husband and wife …. 14.2 incidental profits …. 14.13 income derivation …. 4.37, 14.21–14.26, 14.33 exempt …. 14.17 joint receipt of …. 14.2

net income …. 14.17, 14.18, 14.24, 14.68 non-assessable non-exempt …. 14.17, 14.18 partner’s assessable income …. 14.18 partner’s individual interest in …. 14.21, 14.22 real and effective control of share …. 14.54, 14.55 splitting …. 14.50, 14.54 taxation of …. 14.15 uncontrolled …. 14.54, 14.55 interest payments …. 14.29 partner as external lender …. 14.29 interests assignment of …. 14.32, 14.50–14.53, 14.84 CGT asset …. 14.53, 14.67 disposal of …. 14.67, 14.69 joint venture, distinguished …. 14.11, 14.12 limited partnerships see Limited partnerships losses …. 14.17, 14.18 capital losses …. 14.66, 14.71 deductibility …. 14.19, 14.20 non-commercial losses …. 14.94 partner’s interest in …. 14.19, 14.20, 14.22 tax losses …. 9.63 meaning for tax purposes …. 14.1–14.13 mutual agency …. 14.4, 14.10, 14.11 net income …. 14.17, 14.18, 14.24, 14.68 CGT reduction for amounts included in …. 14.82, 14.83 individual interest of partner in …. 14.21, 14.22 real and effective control of share …. 14.54, 14.55 non-assessable non-exempt income …. 14.17, 14.18 dividends …. 14.56, 14.58, 14.61 non-commercial losses …. 14.94

non-resident partner’s income …. 14.18, 14.20 not separate legal entity …. 12.3, 14.34 obligations …. 14.4, 14.50 partner assessable income …. 14.18 assignment of interests …. 14.32, 14.50–14.53, 14.84 death or bankruptcy …. 14.30, 14.31, 14.33, 14.34 individual interest in net income …. 14.21, 14.22 interest payments …. 14.29 retirement …. 14.36–14.42 salaries …. 14.27–14.29 partnership salary agreements, 14.29 property …. 14.6 proportionate ownership …. 14.22 relationship between people …. 14.6 returns …. 14.15, 14.16 rights …. 14.4, 14.50 tax losses …. 9.63 taxation of …. 14.15 trust, distinguished …. 14.6, 14.7 uncontrolled income …. 14.54, 14.55 rate of tax …. 14.54 unincorporated associations distinguished …. 14.8, 14.13 view to profit …. 14.12, 14.13 work in progress payments …. 14.35–14.43 change in composition …. 14.35–14.43 deductions for …. 14.42, 14.43 partnership not dissolved …. 14.43 retirement of partner …. 14.36–14.42 unbilled services, 14.42

Partnerships and CGT assignment of partner’s interest …. 14.84 background …. 14.62–14.65 capital losses …. 14.66, 14.71 cars …. 14.74 CGT assets …. 14.53, 14.67 cars excluded …. 14.74 CGT events balancing adjustment (K7) …. 10.66 creation of contractual rights (D1) …. 14.70 discharge of contractual obligation (C2) …. 14.85, 14.86 change in composition …. 14.62, 14.63, 14.79, 14.80 disposal of assets …. 14.63, 14.64, 14.66, 14.67, 14.69, 14.77 partner’s individual interest in asset …. 14.78 dissolution …. 14.62, 14.85, 14.86 cash distribution of assets …. 14.85 CGT event C2 …. 14.85, 14.86 in specie distributions of assets …. 14.86 realisation of partnership assets …. 14.86 double taxation potential for …. 14.65 preventing …. 14.66, 14.69, 14.72, 14.73, 14.76, 14.82 foreign company as partner …. 14.81 interests divided into two assets …. 14.72–14.76 problems …. 14.75 purpose …. 14.76 ITAA36 …. 14.62–14.65 1991 amendments …. 14.66–14.69 ITAA97 provisions …. 14.70–14.86 reconciliation with other Parts …. 14.82, 14.83 partner interest approach …. 14.62, 14.65–14.67, 14.71

partnership entity approach …. 14.62 reduction for amounts included in net income …. 14.82, 14.83 separate cost base for each partner’s interest …. 14.70 Patents depreciating asset …. 10.6 effective life …. 10.48 licence …. 3.16 royalties, source …. 2.49 sale of exclusive rights …. 3.15 Pay-As-You-Go (PAYG) system business activity statement (BAS) …. 16.59, 16.64 collection of tax …. 16.59 companies …. 12.20 employees …. 16.62 franking credit …. 12.41–12.43 instalment activity statement (IAS) …. 16.59, 16.64 instalments …. 12.20, 16.59, 16.64, 16.65 applicable instalment rate …. 16.65 GDP-adjusted notional tax …. 16.65 instalment income …. 16.65 quarterly instalments …. 16.65 introduction of system …. 1.18, 16.59 payment categories …. 16.60–16.63 penalties for failure to withhold …. 16.60 quarterly instalments …. 16.65 running balance account (RBA) …. 16.66 withholding payments …. 16.59, 16.60 ABN not quoted …. 16.63 categories …. 16.60

employees …. 16.62 exceptions …. 16.60 other payments …. 16.63 payments for work or services …. 16.61 TFN not quoted …. 16.63 Penalties administrative …. 16.51, 16.55 Commissioner’s discretion to remit …. 16.55 compliance, enforcing …. 16.1, 16.50 definition …. 16.51 enforced collection …. 16.67–16.74 exemptions …. 16.57 failure to keep records …. 16.19 false or misleading statements …. 16.55, 16.57 fraud or misconduct …. 16.55 garnishee order, non-compliance with …. 16.71 general interest charge (GIC) …. 16.53–16.55, 16.58 judicial …. 16.51 late filing …. 16.52, 16.53 late payment …. 16.54, 16.55, 16.58 non-deductibility …. 9.34, 9.35 non-filing …. 16.52, 16.53 objectives of …. 16.1, 16.50 penalty tax …. 16.58 transfer pricing …. 18.76 reasonably arguable position …. 16.58 running balance account (RBA) …. 16.53, 16.55 tax avoidance …. 17.18 transfer pricing …. 18.76 tax shortfall …. 16.56–16.58

exemptions …. 16.57 penalty tax …. 16.58 reasonable care requirements …. 16.57, 16.58 transfer pricing …. 18.76 underpayment of tax …. 16.55 uniform penalties regime …. 16.54, 16.55 Pensions deduction for employer …. 9.27 not to increase tax loss …. 9.27, 9.43, 9.68 exclusion from ETP definition …. 5.28 exempt income …. 2.20, 2.25, 2.31 Personal services business (PSB) business premises test …. 9.85 determinations …. 9.86 80% rule …. 9.85 employment test …. 9.85 exclusion from PSI regime …. 9.82 existence of …. 9.82 results test …. 9.84 tests …. 9.82–9.85 unrelated clients test …. 9.85 Personal services income (PSI) alienation …. 9.82, 17.24, 17.25 anti-avoidance provisions …. 9.82, 17.24, 17.25 attribution …. 9.87 deductions …. 9.82, 9.88 car expenses …. 9.88 denial of …. 9.89 entity maintenance …. 9.88

limits …. 9.89 superannuation contributions …. 9.88 definition …. 9.82, 9.83 diversion of …. 17.24 entity maintenance deductions …. 9.88 income splitting …. 17.24 non-deductible expenses …. 9.89 personal services business exclusion from PSI regime …. 9.82 tests for see Personal services business Personal use assets capital gains disregarded …. 6.76, 6.128 capital losses disregarded …. 6.18, 6.76 CGT events in relation to debt arising from …. 6.75 exclusion from D2 …. 6.41 special rules …. 6.75, 6.76 CGT exemption …. 6.128 collectables see Collectables cost base …. 6.76 definition …. 6.75 option to acquire …. 6.75 set as single asset …. 6.76 Philanthropic trusts gifts to …. 9.45, 9.50 Plant see also Buildings buildings or structures, whether …. 10.11, 10.13 capital allowances …. 10.2, 10.8, 10.11 capital works, whether …. 10.8–10.13, 10.94

definition …. 10.9–10.14 depreciation see Depreciation machinery …. 10.13 research and development, used for …. 10.7, 10.14 Political donations deductibility …. 6.124, 9.45, 9.46 reduced cost base, exclusion from …. 6.124 Pooled development fund CGT exemption …. 6.128 Prepayments amortisation …. 8.50, 9.77 deduction …. 9.77, 9.78 excluded expenditure …. 9.77 small business taxpayers …. 9.77 when outgoing incurred …. 8.50 derivation of income …. 4.15–4.19, 4.40 Arthur Murray principle …. 4.15–4.20, 4.40 debtors …. 4.36 fees …. 4.15, 4.16 interest …. 4.18 long-term construction projects …. 4.30, 4.31 rent or property income …. 4.18, 4.38 subscriptions …. 4.17 expense prepayment schemes …. 17.21 forestry agreements, under …. 5.19 inflated prepayment scheme …. 9.79 tax avoidance …. 9.79, 17.21 tax shelter arrangements …. 9.78

Primary production assessable income …. 1.4 business, definition …. 11.3 capital allowances …. 10.4 CGT exemptions sugar industry exit payment …. 6.129 tobacco industry exit payment …. 6.129 livestock trading stock, as …. 11.3 uncontrolled income …. 14.54 Prime cost method see Depreciation Private rulings see Tax rulings Prizes CGT exemption …. 6.129, 6.131 income, whether …. 3.25–3.27 quiz show contestants …. 3.27 sportspersons …. 3.25, 3.40, 3.42 Product rulings …. 1.26 Profit-making undertaking or plan assessable income …. 5.3, 5.8 deduction of loss from …. 9.25 derivation …. 5.3 exclusions …. 5.8 Profits assessable income …. 4.22–4.31 capital profits …. 2.48 definition …. 1.13

derivation …. 4.23–4.26, 4.45 Citibank case …. 4.28 Cyclone Scaffolding case …. 4.25 deductions irrelevant …. 4.28 limits …. 4.27 net profit …. 4.22, 4.23, 4.28 profit emerging basis …. 4.21 dividends paid out of …. 12.52, 13.2, 13.3, 13.14, 13.35–13.40 income …. 1.4, 1.13, 1.14, 2.8, 2.11, 2.15, 2.18 income/capital distinction …. 1.7, 1.10 less than taxable income …. 4.27 net profit …. 2.6, 2.11, 2.12, 4.22, 4.23 source …. 2.48 specific profit assessment …. 4.23–4.26, 4.45 limits …. 4.27–4.31 taxable income, whether …. 13.36 Project pools assessable income …. 10.86 capital allowances …. 10.84–10.88 closing pool value …. 10.84 deductions …. 10.85, 10.87 calculation of …. 10.85 exclusions …. 10.87 DV project pool life …. 10.84 operation other than for taxable purpose …. 10.86 pool value …. 10.84 Property see also Land definition …. 6.65, 6.66 fringe benefits …. 7.47–7.49

exempt benefits …. 7.47 external …. 7.47, 7.49 in-house …. 7.47, 7.48 taxable value …. 7.47–7.49 goodwill as …. 6.74 income from …. 2.5, 3.62–3.67 annuities …. 3.62, 3.65 definition …. 3.62 dividends …. 3.67, 13.2, 13.3 financial instruments …. 3.62 interest …. 3.63 ordinary income …. 1.4, 2.5, 3.62 rent …. 3.64 royalties …. 3.62, 3.66 proprietary rights …. 6.67–6.69 trading stock …. 11.5 Public benevolent institutions definition …. 9.47 exempt fringe benefits …. 7.54 gifts to …. 9.45, 9.47 Public rulings see Tax rulings Public trading trusts see also Trusts background to ITAA36 Pt III Div 6C …. 15.140 consequence of being …. 15.141 definition …. 15.125 dividend imputation …. 15.143, 15.144 head entity of consolidated group …. 12.18, 12.21, 12.113 rate of tax …. 15.141 taxation as company …. 12.18, 12.21, 15.144

Q Quiz show winnings income, whether …. 3.27

R Ralph Report …. 1.19, 9.82 Rates and taxes assessable recoupments …. 5.23 deductibility …. 9.30 personal services entity …. 9.89 Ratio decidendi …. 1.24 Re:Think Initiative …. 1.21, 6.1 Record keeping access to books …. 16.21 audits …. 16.20–16.25 business travel expenses …. 9.74, 16.19 car expenses …. 9.74, 16.19 documentation of claims …. 16.19 obligations …. 9.74, 16.19 penalties for failure to keep …. 16.19 power to access records …. 16.20–16.23 time limits …. 16.19 work-related expenses …. 9.74, 16.19 Recoupments assessable …. 5.22–5.25 bad debts …. 5.23, 9.24

definition …. 5.23 insurance or indemnity …. 5.23 payment for disposing of right to receive …. 5.23 sale of formerly leased car …. 5.24, 5.25 Recovery of unpaid taxes administrative remedies …. 16.69 court action …. 16.68, 16.69 fleeing taxpayers …. 16.72–16.74 departure prohibition order …. 16.72–16.74 garnishee order …. 16.70, 16.71 Recreational clubs see Sporting or recreational clubs Redeemable preference shares financing schemes …. 13.100 franking credit tax offset not available …. 13.100 redemption or cancellation as dividend …. 13.16, 13.40, 13.56 Reduced cost base see also Cost base assets acquired after 13 May 1997 …. 6.102, 6.123 assets acquired before 13 May 1997 …. 6.103, 6.124 balancing adjustments …. 6.121, 6.123 capital loss, calculating …. 6.15, 6.17, 6.121 capital proceeds compared with …. 6.17 CGT event triggering revenue loss …. 6.122 deducted capital expenditure …. 6.102 elements of …. 6.121, 6.123 exclusions …. 6.124 incidental costs …. 6.124 inflation, not indexed for …. 6.16, 6.121 ITAA36 provisions …. 6.122

net GST input tax credit …. 6.101 transfer of loss within corporate group …. 12.148 Redundancy payments ETP, taxation as …. 5.38 tax-free amount …. 5.38 base amount …. 5.38 service amount …. 5.38 Registered emissions units CGT exemption …. 6.128 tax treatment …. 6.128 Reimbursements allowances distinguished …. 5.4 car expenses …. 5.21 assessable income …. 5.3, 5.21 derivation …. 5.3 Related entity deductibility of payments to …. 9.34, 9.39 definition …. 9.39 Relatives deductibility of payments to …. 9.34, 9.39 definition …. 9.38 travel expenses, deductibility …. 9.34, 9.38 Religious institutions exempt entity …. 2.20, 2.21 exempt fringe benefits …. 7.54 Rent deductibility

personal services entity …. 9.89 definition …. 3.64 derivation of income advance payment …. 4.18 chattel lease …. 4.39 property rent …. 4.38 GST …. 19.43 income …. 3.62, 3.64 lease premium distinguished …. 3.64 Repairs apportionment …. 9.15 capital expenditure …. 9.9, 9.14, 9.15 deductibility …. 9.1, 9.2, 9.7–9.15 entirety or subsidiary parts, affecting …. 9.9 improvement distinguished …. 9.8, 9.9 incidental costs of acquisition …. 9.10 income-producing assets …. 9.7 initial repairs …. 9.10, 9.11 capital nature …. 9.14 lease, receipts for obligations under assessable income …. 5.3, 5.15 deduction …. 9.16 derivation …. 5.3 main residence, effect on CGT exemption …. 6.145 meaning …. 9.8 notional repairs …. 9.13 renewal distinguished …. 9.8 routine repairs and maintenance …. 9.10 suitability doctrine …. 9.10, 9.11 temporary cessation of business, during …. 9.7

terminal repairs …. 9.12 Replacement roll-over see CGT roll-overs Research and development assessable income amounts CGT exemption and …. 6.139 plant used for …. 10.7, 10.14 cost …. 10.39 Residency capital gains tax and …. 2.33–2.35 changing residence …. 2.33, 2.34, 6.54 trusts …. 2.35 change of, CGT event …. 2.33, 2.34, 6.54 individual or company (I1) …. 2.34, 6.54 trust (I2) …. 2.35, 6.54 common law test …. 2.37 companies …. 2.40 central management and control …. 2.40 resident, definition …. 2.40, 12.24 concept of …. 2.37, 2.38, 2.39 diplomatic appointees …. 2.39 domicile test …. 2.37 dual residence double tax agreements …. 18.80 tiebreakers …. 18.80 individuals …. 2.37–2.39 183-day stay test …. 2.37 overview …. 2.36 Part X Australian resident …. 18.25 participation test …. 18.12 partnerships …. 2.37

permanent place of abode …. 2.38, 2.39 resident, definition …. 2.37, 2.38, 2.40 superannuation test …. 2.37 tax jurisdiction based on …. 2.4, 2.32 taxation of residents …. 18.4 trusts …. 2.37, 6.54 Resident individuals general tax rates 2017–18 …. 2.2 Restrictive covenants CGT event H2 …. 6.48, 6.50 income/capital dichotomy …. 3.17 sports related …. 3.41 Retirement allowance see also Employment termination payments (ETPs) deduction for employer …. 9.27 not to increase tax loss …. 9.27, 9.68 Return to work payments assessable income …. 5.3, 5.5 derivation …. 5.3 Returns see Tax returns Revenue expenditure capital expenditure distinguished …. 3.16 Review of Australia’s Future Tax System (2009) see Henry Review Reviews see Disputes Rights CGT asset, as …. 6.70–6.73

human rights …. 6.71, 6.72 legal or equitable rights …. 6.70 right to work …. 6.72 Royalties assessable income …. 3.62, 5.3, 5.9–5.13 assignment of right to …. 3.58 common law …. 3.66, 5.10–5.12 copyright see Copyright definition …. 3.66, 5.1, 5.13 derivation …. 5.3 extended …. 5.9, 5.10, 5.13 income …. 3.37, 3.62, 3.66, 5.9 licence, categories of …. 3.16, 5.13 ordinary concept …. 5.10–5.12 source …. 2.49 statutory …. 5.9, 5.13 withholding tax …. 5.13, 18.47–18.49 anti-avoidance …. 18.48 rate …. 18.49 Rulings see Tax rulings

S Salary or wages allowances in nature of …. 5.4, 7.37 fringe benefit distinguished …. 7.37, 7.57 assessable income …. 1.4, 2.5, 2.15, 2.16 bonus …. 7.57 definition …. 7.11, 7.56–7.58

derivation of income …. 4.42 eligible person, made to …. 7.58 FBT exclusion …. 7.8, 7.56–7.58 partners’ salaries …. 14.27–14.29 interest payments …. 14.29 partnership salary agreements …. 14.29 retention payments …. 7.57 salary packaging …. 7.60 FBT and …. 7.4, 7.60, 7.61 principles of …. 7.60 superannuation contributions …. 7.61 source of income …. 2.43 Salary sacrifice arrangement employee share scheme, deferred taxation …. 5.51 forfeiture of interest …. 5.51 Same business test see Changes in corporate ownership Scrip for scrip roll-over see CGT roll-overs Securities derivation of income …. 4.33 discounted or deferred interest …. 4.33 eligible return …. 4.33 gains on disposal of traditional securities …. 5.45 capital gains provisions …. 5.45 qualifying …. 4.33, 5.45 traditional …. 4.33, 5.45 income from disposal of …. 5.45 Self-assessment see Assessment

Self-education expenses deductibility …. 8.15, 8.80, 8.81 travel …. 8.80 private/domestic character …. 8.80 Seminars deductible expenses …. 9.57 Share buy-backs CGT event C2 …. 13.56 CGT implications …. 13.56 deemed dividends …. 13.17, 13.56, 13.61 franking debit …. 12.50 off-market …. 13.56 demerger distinguished …. 13.158 proposed changes …. 13.61 on-market …. 12.50, 13.56 value shifting …. 13.141 Share capital accounts distribution from tainted account as dividend …. 12.79, 13.14, 13.38 distribution not treated as dividend …. 12.76 dividend as amount debited against …. 13.14–13.15, 13.37, 13.39 dividends funded from …. 13.101 meaning …. 12.76 tainting …. 12.77–12.79 direct capitalisation of profits …. 12.77 effects …. 12.78, 12.79 franking debit …. 12.50, 12.78 indirect capitalisation of profits …. 12.77 untainting …. 12.80–12.83 applicable franking percentage …. 12.81

franking debit …. 12.50, 12.81 untainting tax applicable tax amount …. 12.82, 12.83 company with higher-taxed members …. 12.82 company with lower-taxed members …. 12.83 notional franking amount …. 12.82 tainting amount …. 12.82 Shareholders CGT …. 13.106–13.128 acquisition and disposal of equity interests …. 13.106–13.111 capital payment for shares …. 13.118–13.121 convertible interests …. 13.116, 13.117 equity acquired by issue or allotment …. 13.107 market value substitution rule …. 13.109, 13.111 partly paid equity interests …. 13.108 rights and options …. 13.112–13.115 roll-over see CGT roll-overs shares as fungible assets …. 13.110 distributions to …. 13.56 bonus share issue …. 13.11–13.13, 13.56 buy-backs see Share buy-backs deemed dividends see Deemed dividends dividends see Dividends liquidator’s distribution see Liquidator’s distributions return of capital with cancellation of shares …. 13.56, 13.59 return of capital without cancellation of shares …. 13.56, 13.60 loans or payments to associates see Deemed dividends taxation of …. 13.1–13.3 CGT …. 13.106–13.128 dividends see Dividend imputation system; Dividends

Shares bonus issues …. 13.56, 13.57 capital benefits streaming …. 12.84 CGT implications …. 13.56 dividend, whether …. 13.11–13.13, 13.56, 13.74 value shifting …. 13.140 buy-backs see Share buy-backs capital payment for …. 13.118–13.121 CGT event G1 …. 13.118–13.120 liquidator’s distribution …. 13.56, 13.82, 13.86, 13.120 non-share equity interests …. 13.33, 13.121 reduced cost base …. 13.119 CGT on acquisition and disposal of …. 13.106–13.111 debt and equity rules …. 12.25 early stage innovation companies, in …. 6.161, 13.163 fungible assets …. 13.110 liquidator declaring worthless (CGT event G3) …. 6.160, 13.56, 13.84, 13.122 non-equity shares …. 12.25 options on …. 13.112–13.115 pre-CGT shares (CGT event K6) …. 13.123–13.128 redeemable preference shares financing schemes …. 13.100 franking credit tax offset not available …. 13.100 redemption or cancellation as dividend …. 13.16, 13.40, 13.56 revenue assets, valuing shares acquired as …. 13.110 trading stock, whether …. 11.5, 11.11 value shifting see Value shifting Simplified tax system (STS) (2001–2007) depreciating assets …. 10.92, 10.93

Small business CGT concessions accounting system …. 4.34 active assets definition …. 6.151 excluded assets …. 6.152 share in Australian resident company …. 6.151 test …. 6.150 used in carrying on business …. 6.151 affiliate …. 6.150 deemed …. 6.150 aggregated turnover …. 6.150 amendments …. 6.149 basic conditions …. 6.150 CGT concession stakeholder …. 6.150, 6.153, 6.154 definition …. 6.150, 6.153 interposed entity, interest held through …. 6.154 significant individual …. 6.150, 6.153 CGT event D1 …. 6.150 CGT small business entity, definition …. 6.150 connected with another entity …. 6.150 current concessions …. 6.149 15-year exemption …. 6.155, 6.156 exempt amount …. 6.156 50% discount …. 6.155, 6.157 indexation instead …. 6.157 maximum net asset value test …. 6.150 net value of assets …. 6.150 order of application …. 6.155 overview …. 6.149 retirement exemption …. 6.155, 6.158 small business roll-over …. 6.155, 6.159

applicable CGT events …. 6.159, 6.160 change in replaced asset (CGT event J2) …. 6.159, 6.160 failure to acquire replacement asset (CGT event J5) …. 6.159, 6.160 insufficient expenditure on replacement asset (CGT event J6) …. 6.159, 6.160 replacement asset …. 6.159 turnover threshold …. 4.34 Small business entities capital allowances …. 10.92, 10.93 CGT concessions see Small business CGT concessions definition …. 6.150 depreciating assets …. 10.92, 10.93 pooling …. 10.93 prepaid expenses …. 9.77 tax concessions …. 4.34 Small business roll-over see CGT roll-overs Small Taxation Claims Tribunal closure …. 16.44 filing fee …. 16.45 Social security payments exempt income …. 2.20, 2.25, 2.31 income, whether …. 3.37 Software expenditure on development of …. 10.77 in-house software definition …. 10.78 depreciating asset …. 10.6 diminishing value method prohibited …. 10.23, 10.30

effective life …. 10.48 software development pools …. 10.77–10.81 taxable purpose …. 10.79 software development pools …. 10.77–10.81 allocation of expenditure to …. 10.78, 10.79 assessable income …. 10.81 deductions …. 10.80 Source of income …. 2.41–2.49 Australian source …. 2.41 capital profits …. 2.48 contractual payments …. 2.43 deeming provisions …. 2.50 dividends …. 2.46 double tax agreements …. 2.33 foreign residents …. 2.41 foreign source see Foreign source income geographical genesis …. 2.41 interest …. 2.45 overview …. 2.36 residents …. 2.41 royalties …. 2.49 rules …. 2.42–2.49 salary …. 2.43 sale of securities …. 2.47 tax jurisdiction based on …. 2.32, 2.36 trading income …. 2.44, 2.47 wages …. 2.43 Spectrum licence depreciating asset …. 10.6

diminishing value method prohibited …. 10.23, 10.30 effective life …. 10.48 Sporting or recreational clubs deductibility of membership fees …. 8.5, 9.40 definition …. 9.40 exempt entities …. 2.21, 2.22 gifts to …. 9.49 nature of game or sport …. 2.22 subscriptions not deductible …. 8.5 Sports-related payments grants …. 3.40 income, whether …. 3.40–3.43, 3.47 performance awards …. 3.42 prize money …. 3.25, 3.40, 3.42 professional/amateur distinction …. 3.40 signing-on payments …. 3.41 sponsorship payments …. 3.40 testimonial payments …. 3.43 Stare decisis …. 1.24 Statutory income …. 1.23, 2.2, 2.4, 2.19, 5.1 definition …. 5.1 derivation …. 4.3, 5.3 Div 15 amounts …. 5.3–5.21 employee share acquisition schemes see Employee share schemes (ESS) ETPs see Employment termination payments (ETPs) foreign exchange gains/losses …. 5.53–5.55 in-house dining facilities …. 5.52 jurisdictional limits of Div 15 …. 5.3

non-resident’s …. 5.3 overview …. 5.1 recoupments …. 5.22–5.25 traditional securities, gains on disposal of …. 5.45 Statutory interpretation …. 1.23, 1.27–1.32 definitions …. 1.31, 1.32 ‘includes’ basis …. 1.32 ejusdem generis rule …. 1.32 golden rule …. 1.27, 1.28 guides and examples in ITAA97 …. 1.28 judicial versus ordinary meaning …. 1.31 literal rule …. 1.27 purposive approach compared …. 1.28–1.30 mischief rule …. 1.27, 1.28 noscitur a sociis rule …. 1.32 purposive approach …. 1.27–1.30 tax avoidance schemes …. 1.30 technical terms …. 1.31 Subsidiaries consolidated groups see Consolidated groups interest on loan to, deduction …. 8.27 public company, of …. 12.29, 12.32 Subsidies assessable income …. 5.3, 5.7 derivation …. 5.3 Substantiation business travel expenses …. 9.73, 16.19 car expenses …. 9.71, 16.19

deductions requiring …. 9.70, 16.19 record keeping …. 9.74, 16.19 travel diary …. 9.74 work expenses …. 9.72, 16.19 exceptions …. 9.72 Substituted accounting period …. 4.2 Superannuation benefits assessability …. 5.39–5.42 components …. 5.39, 5.40 death benefits …. 5.42 exclusion from ETP definition …. 5.28 income stream …. 3.65, 5.41, 5.42 lump sum …. 5.41, 5.42 reasonable benefit limit, abolition of …. 5.39 tax-free component …. 5.39, 5.40 taxable component …. 5.39, 5.40 Superannuation contributions concessions, fringe benefits included in calculation of …. 7.4 constructive receipt …. 4.32 deduction not to increase tax loss …. 9.68 personal services entity …. 9.88 employers’ contributions, non-assessability …. 3.34 FBT exemption …. 7.8, 7.61 salary packaging …. 7.61 surcharge, fringe benefits included in calculation of …. 7.4 Superannuation funds CGT exemption and …. 6.137, 6.148

Sydney Aircraft Noise Insulation Project CGT exemption …. 6.129

T Tax administration access to books …. 16.21 assessment see Assessment collection see Collection of tax collection of information …. 16.1, 16.8, 16.20–16.25 compliance, methods to improve …. 16.50 indicative interpretations (ATO IDS) …. 16.18 interpretative devices …. 16.1 MyTax …. 16.4 penalties see Penalties powers of …. 16.2 delegation of …. 16.2 practice statements …. 16.18 returns see Tax returns rulings see Tax rulings taxpayer advice …. 16.1, 16.14–16.18 taxpayer support …. 16.1, 16.4 Taxpayers’ Charter …. 16.4 Tax avoidance anti-avoidance measures …. 9.79, 17.5 application …. 17.5 general …. 17.5–17.18 inconsistency between …. 17.6 overriding tax avoidance arrangements …. 17.4 reconciliation with other tax provisions …. 17.6

specific …. 17.6, 17.19–17.25 trusts …. 15.55–15.62 arrangements …. 17.16 cancellation of tax benefit …. 17.17 Commissioner’s red flags …. 17.16 deductions …. 9.79 associate expenses …. 9.79 inflated prepayment scheme …. 9.79 definition …. 17.2, 17.3 dividend streaming see Dividend streaming dividend stripping …. 13.96, 13.97, 17.5 expenditure recoupment schemes …. 17.23 expense prepayment schemes …. 17.21 fiscal nullity doctrine …. 17.4 GST …. 19.47 income diversion …. 17.24 income splitting …. 17.24 means ‘within the law’ …. 17.2 need for legislation to deal with …. 17.1 penalty tax …. 17.18 transfer pricing …. 18.76 personal services income alienation …. 9.82, 17.24, 17.25 prepayments …. 9.79, 17.21 rules overriding arrangements …. 17.4 ineffective because of core taxation rules …. 17.4 legally effective …. 17.4 scheme …. 17.8 change in financial position as a result of …. 17.14 definition …. 17.8 dominant purpose …. 17.14 expenses incurred under …. 17.20–17.23

non-tax objectives …. 17.14 purpose of …. 17.13–17.15 tax benefit in connection with …. 17.10, 17.13 time entered into …. 17.9, 17.14 sham arrangements …. 17.4 statutory interpretation …. 1.30 tax benefit …. 17.10 cancellation of …. 17.17 choice doctrine …. 17.12 definition …. 17.11 exclusions …. 17.12 obtaining in connection with scheme …. 17.10 types …. 17.10 tax deferral schemes …. 17.22 tax evasion, distinguished …. 17.2 tax planning, distinguished …. 17.2 taxpayer, definition …. 17.7 trusts anti-avoidance provisions …. 15.55–15.59 anti-splitting provisions …. 15.60–15.62 minors …. 15.59–15.62 trust stripping …. 15.56–15.57 withholding tax …. 17.5 royalties …. 18.48 Tax deferral schemes …. 17.22 Tax Law Improvement Project (TLIP) …. 1.17, 2.1, 6.1 Tax losses bankruptcy affecting …. 9.69 calculating …. 9.63

capital losses excluded …. 9.69 companies see Company losses consolidated groups see Consolidated groups deduction of prior year losses …. 9.62–9.69 deductions not to increase …. 9.27, 9.43, 9.68 definition …. 9.63 foreign hybrids …. 14.92 foreign losses excluded …. 9.69 investment …. 9.69 matters affecting …. 9.69 net exempt income …. 9.66 tax loss offset against …. 9.67 non-business pursuits …. 9.69 non-commercial loss provisions …. 9.69 non-deductible amounts …. 9.68 partnerships …. 9.63 primary production …. 9.69 rental activity …. 9.69 transfer agreements …. 9.65 transfer within group …. 9.64, 12.106 Tax offsets …. 2.2 early stage innovation companies …. 6.161, 13.163 excess, inter-corporate dividends …. 13.90 foreign income see Foreign income tax offset franking credits denial of tax offset …. 13.95–13.105 refund of excess tax offsets …. 13.50, 13.55 shareholder using as tax offset …. 13.41–13.55 franking tax offset …. 2.2 relevant provisions …. 2.3

Tax rates …. 2.2 company tax …. 2.2, 12.19 future changes to …. 12.19, 18.51 foreign residents …. 2.2 fringe benefits tax …. 7.4, 7.17 general rates for 2017–18 …. 2.2 Medicare levy …. 2.2 Tax-related expenses assessable recoupments …. 5.23, 9.6 capital expenditure …. 9.5 deductions …. 9.3–9.6 personal services entity …. 9.88 managing tax affairs …. 9.4 tax excluded …. 9.3 Tax returns …. 16.1, 16.7 approved form …. 16.8 Australian currency, amounts in …. 3.7, 4.2 companies …. 12.17 consolidated groups …. 12.112 full self-assessment taxpayer …. 16.7 GST returns …. 19.8 late filing penalties …. 16.53 non-money consideration …. 4.2 partnerships …. 14.15, 14.16 penalties for non-compliance see Penalties reasonable care standard …. 16.57 requirement to lodge …. 2.3, 4.2, 16.7 special returns …. 16.8 substituted accounting period …. 4.2

time limits …. 16.7 Tax rulings …. 1.26, 16.15–16.18 application of …. 16.15 class …. 16.15 indicative interpretations (ATO IDS) …. 16.18 legally binding …. 1.26, 16.4, 16.15–16.18 oral …. 1.26, 16.15, 16.17 practice statements …. 16.18 private …. 1.26, 16.4, 16.15, 16.16 product …. 1.26, 16.15 public …. 1.26, 16.4, 16.15 taxpayer alerts …. 16.18 Tax treaties see Double tax agreements (DTAs) Taxable Australian property definition …. 2.33, 6.54, 18.37 foreign residents and CGT …. 2.33, 18.37 real property …. 2.33 Taxable income …. 2.2, 2.14, 3.1 calculating …. 1.13, 2.2, 2.14, 4.1 English law …. 1.4 equation …. 2.2, 4.1, 8.1 subject of assessment …. 4.2 Taxation Australian law see Australian tax law constitutional basis …. 1.8–1.12 definition …. 1.9 discrimination between states prohibited …. 1.11 fairness …. 1.2

history of …. 1.1, 1.3 Australian law …. 1.5, 1.6 English law …. 1.4, 1.7 horizontal equity …. 1.2 income tax see Income tax laws imposing …. 1.10 one subject only …. 1.10 laws with respect to …. 1.9 nature of …. 1.1 statistics …. 1.2 vertical equity …. 1.2 Taxpayer information Commissioner’s powers …. 16.20–16.28 access to records …. 16.20–16.23 obtaining information and evidence …. 16.24–16.25 legal professional privilege …. 16.22, 16.26–16.28 Taxpayers’ Charter …. 16.4 Telecommunications site access rights depreciating asset …. 10.6 effective life …. 10.48 Tenancy in common capital gains tax assets and …. 6.84 Testamentary gifts …. 9.52 Theft assessable recoupments …. 5.23 deduction of loss …. 9.2, 9.26 illegal activity …. 9.26

Thin capitalisation ADIs …. 18.57, 18.59 anti-avoidance rules …. 18.52 application of rules …. 18.57 arm’s length debt test …. 18.53, 18.62, 18.64 Australian or foreign multinational …. 18.58 BEPS Action Plan …. 18.2, 18.3, 18.80 Australian response …. 18.3, 18.54 control rules …. 18.58 de minimis rule …. 18.57, 18.57 debt/equity rules …. 18.65 definition …. 18.51 financial entity …. 18.560 fixed ratio approach …. 18.53 general entity …. 18.560 interest deductions …. 18.62 inward investing entity …. 18.58, 18.59 non-ADIs …. 18.64 legislation …. 18.55 main elements …. 18.56 non-ADIs …. 18.59, 18.560 OECD approaches to reducing benefits …. 18.53 operation of regime …. 18.61 outward investing entity …. 18.58, 18.59 non-ADI …. 18.62, 18.63 overview …. 18.51, 18.52 safe harbour debt test …. 18.62, 18.64 transfer pricing and …. 18.72 worldwide gearing debt test …. 18.62 Timing of financial arrangements rules (TOFA)

application …. 4.1 deductions, application to …. 8.51 intent of …. 8.51 Trade, professional or business association deduction for membership …. 8.5, 9.28 Trade union exempt entity …. 2.23 Trading income sale of securities …. 2.47 source …. 2.44, 2.47 Trading stock accounting treatment …. 11.2 tax treatment compared …. 11.4–11.7, 11.23 valuation …. 11.19 ceasing to hold item as …. 11.30 CGT event K4 …. 6.133 CGT exemption …. 6.133 change in ownership interests …. 11.28 characterisation on case-by-case basis …. 11.5 choses in action …. 11.5, 11.11 consumables …. 11.6, 11.12 death of owner …. 11.29 deductions …. 11.1 gifts …. 9.45, 11.27 timing of …. 11.2, 11.16 definition …. 1.32, 11.3 depreciating asset balancing adjustment event …. 10.58

becoming trading stock …. 10.58, 10.62 excluded from definition of …. 10.6, 10.58 trading stock converted to …. 10.34 valuation …. 11.22, 11.23 disposal outside ordinary course of business …. 11.27 ceasing to hold item as trading stock …. 11.30 change in ownership interests …. 11.28 death of owner …. 11.29 market value on day of disposal …. 11.27 personal consumption …. 11.30 promotional give-aways …. 9.45, 11.27 termination of business …. 11.27 work in progress …. 11.15 eligible small business entity stocktake and valuation not required …. 11.19 gift of …. 9.45, 11.27 in transit …. 11.17 indirect materials …. 11.6 inventory compared …. 11.4–11.7, 11.12 ITAA97 Div 70 …. 11.1, 11.2 land …. 11.5, 11.9 product of …. 11.10 undeveloped …. 11.20 livestock …. 11.3 valuation …. 11.19 non-arm’s length transactions …. 11.31 non-business disposals …. 11.26–11.30 obsolete stock …. 11.19 dumping or destruction of …. 11.27 on hand …. 11.16 out of date/out of use …. 11.19

packing and wrapping materials …. 11.13 partially manufactured goods …. 11.7 partnership, change in composition …. 14.48 personal consumption of …. 11.30 property …. 11.5 provisions relating to …. 11.1 purchases not of capital nature …. 11.2 raw materials …. 11.5, 11.6 shares …. 11.5, 11.11 spare parts …. 11.12 specific items …. 11.8 stock for sale or rental …. 11.18 stock on consignment …. 11.17 stock on hand …. 11.16 stores …. 11.12 taxing scheme …. 11.2 unbilled services …. 11.14 valuation …. 11.19 actual cost …. 11.22 average cost …. 11.21 closing stock …. 11.19 cost price …. 11.21 depreciation of plant and machinery …. 11.22, 11.23 each item …. 11.20 end of income year …. 11.19 first-in-first-out (FIFO) assumption …. 11.21 manufactured stock, cost of …. 11.22 market selling value …. 11.24 overhead costs …. 11.22 replacement price …. 11.25

retail inventory …. 11.21 standard cost …. 11.21 value shifting …. 13.138 work in progress …. 11.5, 11.7, 11.14 disposal outside ordinary course of business …. 11.15 wrapping materials …. 11.13 Transfer pricing acceptable methodologies …. 18.72 advance pricing arrangements …. 18.77 arm’s length conditions …. 18.670, 18.72 meaning …. 18.71 BEPS actions, Australian response to …. 18.78 comparable uncontrolled price method …. 18.72 consequential adjustments …. 18.74 cost plus method …. 18.72 cross border test …. 18.670, 18.71 documentation requirements …. 18.75 legislation …. 18.68–18.71 loans …. 18.67 no taxation treaty, where …. 18.70 OECD Guidelines …. 18.72 overview …. 18.66 penalty tax …. 18.75 profit split method …. 18.72 resale price method …. 18.72 tax avoidance …. 18.66 penalties …. 18.75 testing international transfer prices …. 18.72 thin capitalisation modifications …. 18.73 transaction net margin method …. 18.72

transfer pricing benefit …. 18.70 Travel expenses business travel …. 9.73 substantiation …. 9.73 deductibility …. 8.12, 8.72, 8.79 between workplaces …. 9.32 relatives’ travel expenses …. 9.34, 9.38 self-education …. 8.15, 8.80 private/domestic character …. 8.72, 8.79 relatives …. 9.34, 9.38 substantiation …. 9.70 business travel …. 9.73 record-keeping requirements …. 9.74, 16.19 work expenses …. 9.72 transport expense …. 9.72 travel diary …. 9.74 work travel allowance …. 9.72 Trust income allocation between trustee and beneficiary …. 15.30–15.54 amounts not previously subject to tax …. 15.52–15.54 anti-avoidance provisions …. 15.55–15.59 anti-splitting provisions …. 15.60–15.62 assessable income of beneficiary …. 15.34, 15.35, 15.39 amounts not previously subject to tax …. 15.52–15.54 credit for tax paid by trustee …. 15.40 beneficiary presently entitled …. 15.31–15.40, 15.64–15.77 able to require distribution of share …. 15.68, 15.69, 15.72 company …. 15.33 contingent interest …. 15.73

deeming provisions …. 15.75–15.77 discretionary trust …. 15.77 exceptional circumstances …. 15.70 fixed trust …. 15.68 legal disability …. 15.36, 15.37, 15.39, 15.78 meaning …. 15.64–15.74 natural person …. 15.38 no knowledge of trust …. 15.74 non-resident at end of income year …. 15.32, 15.33, 15.34 not under legal disability …. 15.31, 15.33 reimbursement agreement, entitlement arising from …. 15.55 resident at end of income year …. 15.31 residuary beneficiaries …. 15.71 trustee assessed on behalf of beneficiary …. 15.38 vested and indefeasible interest …. 15.75 vested in interest …. 15.65, 15.67 vested in possession …. 15.65–15.68 deceased estate …. 15.48, 15.127–15.131 income received after death …. 15.129–15.131 ITAA36 Pt III Div 6 applicable …. 15.128 present entitlement of beneficiary …. 15.127 discretionary trust …. 15.77 foreign source income …. 15.46, 15.53 legal disability beneficiary under …. 15.36, 15.37, 15.39 meaning …. 15.78 minors …. 15.59–15.62 anti-avoidance provisions …. 15.59 anti-splitting provisions …. 15.60–15.62 excepted trust income …. 15.61, 15.62 tax rates …. 15.60

net income …. 15.27, 15.28, 15.80 no beneficiary presently entitled …. 15.41–15.51 Australian-sourced income …. 15.46 Commissioner’s discretion …. 15.50, 15.51 flat rate of tax …. 15.49 foreign source income …. 15.46 non-resident trust estate …. 15.45–15.47, 15.53 resident trust estate …. 15.44 special rate of tax …. 15.49–15.51 taxed as income of an individual …. 15.46 testamentary trust …. 15.48 non-resident trust estate …. 15.45–15.47, 15.53 resident trust estate …. 15.79 definition …. 15.79 no beneficiary presently entitled …. 15.41–15.44 revocable trusts …. 15.55, 15.59 tax income differing from …. 15.80–15.85 amounts view …. 15.83 distributions of excess …. 15.85 exceeding trust income …. 15.81–15.83 financing unit trust …. 15.85 income of the trust, meaning …. 15.80 less than trust income …. 15.84, 15.85 net distributable income …. 15.82 proportions view …. 15.82 quantum view …. 15.83 review of ITAA36 Pt III Div 6 …. 15.80 taxation entity …. 15.26 taxed as income of an individual …. 15.46 trust stripping …. 15.56–15.57

counter measures …. 15.58 trustee assessed on behalf of beneficiary …. 15.38 Trust losses capital losses …. 14.71 classification of trusts …. 15.145, 15.146 risk of change in ownership and control …. 15.145 corporate unit trust …. 15.139 deceased estate …. 15.146 discretionary trust …. 15.146 excepted trusts …. 15.146 family trust …. 15.146 fixed trusts …. 15.146 ITAA36 Sch 2F …. 15.145 non-fixed trusts …. 15.146 purpose of provisions …. 15.145 tests applicable to categories of trusts …. 15.146 trusts treated as entities …. 15.145 unit trust …. 15.146 Trustees allocation of tax liabilities see Trust income bankruptcy, in CGT asset vested in …. 6.57 closely held trust …. 15.148 reporting trustee beneficiary …. 15.147 company …. 12.4, 15.12 Crown …. 15.13 definition for tax purposes …. 15.23 foreign corporation …. 15.12 income received by

assessable income of trust estate …. 14.31, 15.48, 15.129 work in progress …. 14.35 indemnity, right of …. 12.4, 15.14 ITAA36 Pt III Div 6, taxation under …. 15.29 legal capacity to hold property …. 15.11 personal liability …. 15.14 public trustee …. 15.13 relationship with trust assets …. 15.14 statutory trustee company …. 15.13 who may be …. 15.11–15.13 Trusts bare …. 15.21, 15.22 beneficiary assessable income see Trust income definition …. 15.24 entitlements …. 15.18–15.20 presently entitled see Trust income trustee not to be sole …. 15.6 who may be …. 15.6–15.10 certainty of object …. 15.7 CGT see Trusts and CGT charitable …. 15.7, 15.8, 15.9 charitable purpose …. 15.8, 15.9 rule against perpetuities …. 15.16 classification beneficiaries’ entitlements …. 15.18–15.20 duties of trustee …. 15.21–15.22 function …. 15.17 loss deductions, for …. 15.145, 15.146 manner of creation …. 15.5

closely held …. 15.148 reporting trustee beneficiary …. 15.147 tax loss provisions …. 15.146 company compared …. 12.2, 12.4 consolidated group, member of …. 15.149 corporate unit trust see Corporate unit trusts creation …. 15.5 deceased estates …. 15.127–15.135 CGT …. 15.132–15.135 CGT events not applicable …. 15.95, 15.105–15.118 executor as trustee …. 15.127 income received after death …. 15.129–15.131 ITAA36 Pt III Div 6 applicable …. 15.128 present entitlement of beneficiary …. 15.127 tax loss provisions …. 15.146 definition …. 12.4, 15.2, 15.3 demerger relief …. 15.150 discretionary …. 15.19 dividend imputation …. 15.86 receipt of franked dividends …. 15.86 features …. 12.4, 15.4–15.16 fixed …. 15.19 tax loss provisions …. 15.146 hybrid …. 15.19 income see Trust income inter vivos …. 15.5, 15.15, 15.17 losses see Trust losses minors …. 15.59–15.62 non-charitable purpose …. 15.10 not separate legal entity …. 12.4 object …. 15.6, 15.7

partnership, distinguished …. 14.6, 14.7 private …. 15.7, 15.15 public trading trust see Public trading trust purpose trust …. 15.7, 15.10 residence …. 2.35, 6.54 rule against perpetuities …. 12.4, 15.15, 15.16 simple …. 15.21 special …. 15.21, 15.22 taxation of …. 15.26 allocation of income see Trust income core rule …. 15.26 ITAA36 Pt III Div 6 …. 15.27–15.63 termination …. 15.15 testamentary …. 15.5, 15.15, 15.17 trust estate …. 15.25 net income see Trust income resident …. 15.79 trust stripping …. 15.56–15.57 trustee see Trustee types …. 15.17–15.22 unified entity regime …. 12.6 unit trust see Unit trusts what is …. 15.1–15.3 Trusts and CGT beneficiaries absolutely entitled as against trustee …. 15.95, 15.96–15.99 disposal of trust assets …. 15.87 legal disability disregarded …. 15.98 meaning …. 15.97 taxation of trust …. 15.96

termination of trust …. 15.126 UK provision …. 15.99 unit trust …. 15.123 beneficiaries not yet absolutely entitled to trust asset termination of trust …. 15.126 beneficiaries with no interest in trust assets incompletely administered estate …. 15.99 no absolute entitlement as against trustee …. 15.99 termination of trust …. 15.126 CGT discount …. 15.88, 15.89 CGT events …. 6.55, 15.90–15.96, 15.100–15.118 agreement to hold property on trust (E9) …. 15.94 beneficiary becoming entitled to asset (E5) …. 15.105–15.106, 15.114 beneficiary’s assessable income …. 15.87, 15.88 capital payment for interest in (E4) …. 15.100–15.104, 15.115 change of residence (I2) …. 2.35, 6.54 conversion to unit trust (E3) …. 15.90, 15.93 creation of trust (E1) …. 15.90, 15.91 disposal of capital interest by beneficiary (E8) …. 6.24, 15.118 disposal to beneficiary to end capital interest (E7) …. 15.111–15.117 disposal to beneficiary to end income right (E6) …. 15.107–15.110 non-assessable part for purposes of E4 …. 15.104 non-portfolio shareholding in foreign company …. 18.13 pre-CGT trust interest (K6) …. 15.124 termination of trust …. 15.126 transfer of CGT assets (E2) …. 15.90, 15.92 trustee triggered …. 15.88 concurrent beneficiaries …. 15.99 deceased estates …. 15.132–15.135

asset passing from personal representative to beneficiary …. 15.133 CGT events not applicable …. 15.95, 15.105–15.118, 15.135 disregarded capital gains/losses …. 15.132 joint tenants …. 15.134 modifications to cost base …. 15.132 pre-CGT assets …. 15.132 termination of trust …. 15.135 demerger relief …. 15.150 disposal of trust assets …. 15.87 incompletely administered estates …. 15.99, 15.105 operation of trust …. 15.95 pre-CGT assets CGT event K6 …. 15.124 change in underlying interests …. 15.125 deceased estate …. 15.132 provisions relevant to all trusts …. 15.96–15.104 residence …. 2.35, 6.54 small business concession …. 15.88 special trust becoming bare trust …. 15.22 termination of trust …. 15.126 deceased estate …. 15.135 trusts to which CGT events E5E8 apply termination …. 15.126 trusts to which CGT events E5E8 do not apply termination …. 15.126 unit trusts see Unit trusts unpaid distributions, deemed dividends …. 13.26

U

Unified entity regime …. 12.6 Uniform capital allowance regime background …. 10.2 capital works exclusion …. 10.8 exclusions …. 10.15 new Div 40 …. 10.3 proposed changes …. 10.111 Uniforms deductibility …. 8.75, 9.61 non-compulsory …. 9.61 Unincorporated associations see also Associations corporate limited partnership …. 14.14 members’ contributions …. 3.30 mutual receipts …. 3.30–3.33 partnership distinguished …. 14.8, 14.13 Unit trusts CGT …. 15.120–15.123 CGT event E3 …. 15.90, 15.93 CGT events not applicable …. 15.95, 15.105–15.118 issue of units …. 15.93, 15.120 options …. 15.121, 15.122 pre-CGT trust interest (K6) …. 15.124 provisions relevant to …. 15.120–15.123 residency …. 2.35 rights and options …. 15.122 units treated as relevant asset …. 15.120 corporate unit trust see Corporate unit trusts definition …. 15.20

financing unit trust arrangements …. 15.85 public trading trust see Public trading trust taxation as company …. 15.136–15.144 background …. 15.136, 15.137, 15.140 corporate unit trust …. 15.137–15.139 dividend imputation …. 15.142, 15.143, 15.144 trust converting to (CGT event E3) …. 15.90, 15.93 trust loss provisions …. 15.146 Unlawful Termination Assistance Scheme CGT exemption …. 6.129 Unpaid taxes penalties see Penalties recovery see Recovery of unpaid taxes

V Valuation fringe benefits …. 7.24–7.27 gifts …. 9.53 trading stock see Trading stock Value shifting direct …. 13.131–13.141 active participant …. 13.134 affected owners …. 13.135 bonus issues …. 13.140 buy-backs …. 13.141 causation requirement …. 13.134 CGT consequences …. 13.137 consequences …. 13.136

control requirement …. 13.133 cost base adjustment …. 13.131 disposal treatment …. 13.136 down interest …. 13.135 neutral value shift …. 13.139 requirements for operation of Div 725 …. 13.132 revenue assets …. 13.138 roll-over treatment …. 13.136 trading stock …. 13.138 up interest …. 13.135 indirect …. 13.142–13.151 affected interests …. 13.145 affected owners …. 13.145 anti-overlap provisions …. 13.142, 13.150 common ownership nexus …. 13.144 consequences …. 13.151 degree of relationship required …. 13.143, 13.144 exclusions …. 13.149 gaining entity …. 13.143 intermediate controller …. 13.145 losing entity …. 13.143 provision of economic benefits …. 13.146–13.148 neutral value shift …. 13.139 provisions …. 13.129 rights over non-depreciating assets …. 13.130 trading stock …. 13.138 transactions …. 13.129 Venture capital entities CGT exemption …. 6.148

Vertical equity …. 1.2 Veterans’ Affairs pensions exempt income …. 2.31

W Wages see Salary or wages War widow/er’s pension exempt income …. 2.31 Windfalls …. 3.25 Withholding tax administration …. 18.50 anti-avoidance provisions …. 17.5, 18.48 dividends …. 13.53, 18.36, 18.38, 18.40 conduit foreign income exemption …. 13.53, 18.40 corporate tax entity …. 18.36 deemed dividends disregarded …. 13.29 double tax agreements …. 13.53 exemptions …. 13.53, 18.40 franked dividends …. 13.53, 18.40 tax rate …. 18.41 unfranked dividends …. 13.53, 18.40 final tax liability for that income …. 18.39 foreign residents …. 18.35–18.50 taxable Australian property …. 18.37 interest …. 18.38, 18.42 definition …. 18.44 exempt debentures …. 18.46

exemptions …. 18.45 lump sum payment substitution …. 18.44 tax rate …. 18.43 legislation …. 18.38 obligation to withhold …. 18.50 outline of scheme …. 18.39 overview …. 18.38 PAYG system see Pay-As-You-Go (PAYG) system royalties …. 5.13, 18.38, 18.47–18.49 anti-avoidance …. 18.48 tax rate …. 18.49 Work expenses deduction …. 9.72 depreciation of property …. 9.72 laundry expenses …. 9.72 meal allowance expense …. 9.72 substantiation …. 9.70, 9.72 exceptions …. 9.72 record-keeping requirements …. 9.74, 16.19 travel diary …. 9.74 transport expense …. 9.72 travel allowance expense …. 9.72 Work in progress partnership …. 14.35–14.43 change in composition …. 14.35–14.43 deductions for …. 14.42, 14.43 partnership not dissolved …. 14.43 retirement of partner …. 14.36–14.42 unbilled services, 14.42

payments assessable income …. 5.3, 5.20 assessable recoupments …. 5.23 deductibility …. 9.31 derivation …. 5.3, 5.20 partnership …. 14.35–14.43 trading stock, whether …. 11.5, 11.7, 11.14 disposal not in course of business …. 11.15 Workers compensation payments income, whether …. 3.19, 3.37

Y Youth allowance self-education deduction …. 8.15, 8.80

Related LexisNexis Titles Kenny, Blissenden & Vilios, Australian Tax 2018 Edition Kenny & Walpole, Concise Tax Legislation 2018 Edition Khoury, LexisNexis Case Summaries: Tax, 8th edition, 2015 Sangkuhl & Buttigieg, LexisNexis Questions and Answers: Taxation Law, 2016