Ordinary Income
Ordinary Income TRADING STOCK Trading stock: ITAA 1997 Div 70 Generally div 70 trading stock rule apply to all business that have trading stock. After 1 July 2001 small businesses can elect through the SBE regime to adopt simplified trading stock. What is trading stock? anything produced, manufactured or acquired that is held for purposes of manufacture, sale or exchange in the ordinary course of business, and livestock but excludes Div 230 financial arrangements: s 70-10 Rules regarding trading stock Trading stock is deductable when incurred: s 8-1 ! Deduct market value for non-arm’s length transactions: s 70-25 ! If you bring items you own into trading stock you are deemed to have done so at cost or market value and sold it at the same: s 70-30 Accounting for trading stock on hand: ! Excess of closing stock over opening stock is included in assessable income: s 70-35(2) ! Excess of opening over closing stock is deductable: s 75-25(3) ! When is trading stock ‘on hand’? " When the taxpayer has the power to deal with the stock as if it were his own: Sutton Motors " Also goods en route in cargo ships are ‘in hand’ if the tax payer has bill of lading giving them the right to dispose of the goods: All States Frozen Foods ! GST: when valuing trading stock at end of year, disregard the input tax credit: s 70-45(1A) ! Obsolete stock: you can use a reasonable value: s 70-45 Value of opening stock ! You must use the same value of opening stock as that used at the end of the previous year: s 70-40 Value of closing stock ! You can elect to value each item of trading stock at the end of the income year at either: Cost: meaning all costs to get stock in its condition and location (Phillip Morris) Market selling value: the amount which will be realised in the company’s own selling market in ordinary course of business: Aus Jam Co Replacement: cost to replace goods on last day of the year of income, including freight insurance and any other costs Assessable income from trading stock Disposals outside ordinary course of business Such trading stock is to be included in your assessable income at market value: s 70-90 Eg: where you donate some stock to charity Disposal when stop holding trading stock If you stop holding but don’t dispose of the trading stock, you are required to include its market value in assessable income: s 70100 Eg a sole trader grocer commences a partnership with her children, s 70-100 would apply to the transfer of stock to the partnership Death of owner Upon death, the market value of trading stock needs to be included as assessable income, although the legal personal representative can elect to use another value: s 70-105
Stop holding but still own the stock ! You are treated as having sold it at cost: s 70-110 ! The stock will not be deductable under s 8-1 if stock taken for private use Eg a sheep Grazer takes a sheep for personal consumption Compensation for lost trading stock Include in assessable income an insurance or indemnity received for loss of trading stock if it is not otherwise assessable income: s 70-115
WAS THE INCOME DERIVED THIS YEAR? Income for an Aus resident must be derived during he income year: s 6-5(2) Meaning of derived ‘Derived’ is not defined, so we must rely on case law. ! Carden’s Case stated that: ‘the method of accounting that be adopted is that which ‘is calculated to give a substantially correct reflex of the taxpayer’s true income. Salary and wages General Rule ! derived when received: Brent v FCT (see p 122 of TB – wife of Great train Robber) Further Case Law ! where employee agrees to forgo part of salary for paid leave in a later period the deferred salary is assessable when received (derived): TD 93/242 ! where an amount is credited to an employee and can be drawn at any time, it is derived at the time of crediting: Garforth v Newsmith Stainless (1979) ! Acceptance of a cheque constitutes payment: Nicks v taylors. Even if postdated: Marreco v Richardson ! if an employee refuses to receive a cheque until after 30 June, the cheque will be derived when tendered to the taxpayer: Case D62 ATC 4195 ! It will still be assessable income even if the payer is not the proposed employer: see AAT Case 13/99 (on p 122 of TB) Interest Generally derived when it is received or credited: Leigh v IRC Rent ! Generally derived when it is received, ! However if payment made in advance will need to examine lease agreement to determine derivation ! For a business of renting out properties or other assets then the accruals basis will be appropriate. Income from business Sole traders and entity structures such as trusts, partnerships and companies running businesses will generally use accruals. Time of derivation regarding accruals: ! Under accruals income is derived when it is earned (receipt is not necessary): Rowe & Son v FCT ! “earned” means a recoverable debt must be created such that a taxpayer is not required to take further steps before becoming entitled to payment: Aus Gas light Co ! If part of the consideration received by a business cannot be ascertained due to a dispute, then the income is derived when the dispute is resolved: BHP v FCT Income from professional practices ! If small sole practitioner practice, use cash basis: See Carden ! if large professional practice, use accruals basis: See Henderson ! If medium sized professional practice the basis must be determined by considering the relevant factors as outlined in TR 98/1 (as there is no clear authority for medium sized firms): " Size of business " Circulating capital and consumables " The use of capital items to produce income " Credit policy and debt recovery " Books of account
The former simplified tax system From 1 July -30 June 2005, small business taxpayers could elect to join the STS and adopt a cash basis for accounting. Prepaid income If the income is subject to a contingency AND treated as a liability in the books: See Arthur Murray. ! If facts state the taxpayer does not provide refunds then there is no contingency Deemed derivation For both ordinary and statutory income, you are taken to have derived the income as soon as it is applied or dealt with in any way on your behalf or as you direct: see 6-5(4) and 6-10(3) ! Where a pension was directed by the taxpayer to his wife, the tax payer still had to include the pension in his assessable income: See CASE U52 87 ! Deemed derivation provisions do not apply, however, where a debtor refrains from making payment at the request of a creditor: see Brent v FCT
CHARACTERISTICS OF ORDINARY INCOME Is it convertible to money? ! The amount must be convertible into cash to be income: Cooke & Sherden Check that the mutuality principle doesn’t apply ! This principle only applies to certain types of organisations: non-profit sports clubs, arts and dance clubs. ! The principle of mutuality reflects a principle that you cannot earn income off yourself. Income must be derived from external sources: see Bohemians Club The requirements for the principle of mutuality are: ! Need a fund created and controlled by contributors for common purpose: Municipal Mutual Insurance v Hills ! the distribution of surplus to members must be distributed according to contributions: Coleambally Irrigation Mutual Cooperative " ie if all members put in $100 they must receive an equal percentage of that back upon winding up ! Trading profits are not covered by this principle and receipts from non-members constitute income (need to apportion): see Carlisle Silloth Golf Club v Smith Periodical gains ! If the payment is periodical or frequent and expected then the payments have the character of ordinary income: FCT v Dixon (1952). ! However periodicity is not always essential – there numerous cases of taxpayers converting income stream (interest or royalties) into a lump and arguing unsuccessfully that such lump sums where of a capital nature. " In FCT v Meyer Emporium the taxpayer assigned the right to receive interest income for a lump sum of $45m. HCA held: the taxpayer had merely converted future income into present income. " In Henry Jones (IXL) the taxpayer assigned its rights to royalties to a finance company for $7.6 m. Fed Court Held: the $7.6m was income under the Meyer decision. Windfall gains Windfall gains, gifts, gambling & lottery wins are generally not income Gifts ! Gifts are not income, unless they are related to employment, income-earning or business activity: Hayes; Scott " The test is objective, not subjective: Hayes " The character of the payment in the hands of the recipient is the important consideration: Hayes " Though the motive of the donor is relevant is will rarely be decisive: Hayes
Gambling winnings Lack the characteristics of income: Scott; Hayes
! In Martin v FCT a gambler made 602 bets, including 275 winning bets, during a three year period, was held not to be carrying on a business # not income ! An exception applies to gambling businesses such as bookmakers and casinos Lottery Winnings ARE NOT INCOME: Scott; Hayes Receipts from illegal activity The ‘illegality’ of the activity is irrelevant. If it’s systematic and producing a profit, or profit intention, then the gains will be viewed as income Partridge v Mallandaine Gains from use of property Gains from the use or enjoyment of property by another person will be ordinary income: FCT v Montgomery (1999) Income from use of property includes: " Rent " Interest " Dividends: ITAA 1936 s 44 (specifically includes dividends as ordinary income) " A monthly rent premium: Re Vendardos [1964] NSWR 254 " Lease incentives: Montgomery " Payment for the surrender of a lease of premises: Rotherwood Pty Ltd v FCT (1996) These receipts are NOT income: " The proceeds from selling property will generally be capital sums: Scottish Australian Mining Co ltd v FCT (1950) CLR " Annual payments of $10,000 were paid by miners to a farmer as rent. The payments were however to compensate the farmer for disturbance to the land. Court held payments were for the deprivation of part of a capital asset and thus were capital. Nullaga Pastoral Co Pty Ltd v FCT (1978) " Also pre-judgement interest on damages in a personal injury case is not assessable income per Whitaker v FCT (1998) " In respect of coal rights compulsorily acquired, the interest in respect of the compensation constituted capital rather than interest: Northumberland Deevleopment v FCT (1994) " However in federal Wharf v DCT (1930), in respect of property compulsorily acquired, the interest on the value of the property calculated from the time when the government took over the property constituted interest rather than compensation for the loss of the taxpayer’s asset. In this case the taxpayer had an independent right to interest calculated by reference to a liability.
Income from personal services These will usually be income These factors should be considered: ! *Degree of connection the employment or services rendered (most important factor) " Is directly related, incidental or unrelated? ! Reasonable expectation payment would be made ! Dependence upon payment to meet living expenses ! Payment replaces income ! Motive of payer: i.e. commercial or personal reasons ! Periodical, recurrent and regular ! Money or convertible into money THE DEGREE OF CONNECTION In determining this nexus the courts look to the nature of the receipt in the hands of the recipient: Dixon; Scott Directly related to employment or services Receipts directly related to employment or services are ordinary income: AG of British Columbia Such receipts include: ! salary, wages, commissions: AG of British Columbia ! a sportsperson’s retention payment/signing fee ! An unusual or disguised payment that is in substance directly related to personal services will be income: Reuter Incidental to employment or services Receipts incidental to employments/services may be income
! Footballer’s receipt of $20,000 for best and fairest was incidental to his employment even though his club did not pay it, as his employment caused the payment, thus had sufficient connection: Kelly " However the UK courts held otherwise in Moore Unrelated to employment or services Where there is no connection between the employment/services rendered and the receipt, such payments are not income. Gifts from employers ect: ! a former employer’s gift of shares to a taxpayer out of friendship is not income: Hayes ! a gift of $10,000 by the widow of a lawyer’s former client, to whom the lawyer also gave personal advice, was not income as was made in light of their friendship and therefore the connection to services provided was too indirect: Scott ! HOWEVER in Dixon there was no connection between the services rendered and the top up payments, yet because the payments were periodic, recurrent and regular, they constituted income.
Income from carrying on a business Will be ordinary income if: 1. The activity constitutes carrying on a business; and " ‘business’ - ‘any profession, trade, employment, vocation or calling, but does not include occupation as an employee’: s 995-1 ITAA97 " ‘carrying on a business’ – A subjective and objective determination made by regarding the nature and extent of the activities: Martin " See also Woods; Shields; Stone on p 176 2.
receipt meet requirements of ordinary income; and " derived " Convertible into money " Mutually principle does not apply
3.
the receipt has a sufficient connection to the business activity: FCT v Spedley Securities " *Connection to business activity (most important) " Reasonable expectation " Payment replaces income " Profit-making purpose " Periodical, recurrent and regular
IS THERE A SUFFICIENT CONNECTION Receipts received in the ordinary course of business Gains that directly relate to the business activity will be income: Californian Copper Syndicate Other case law Memorex Pty Ltd v FCT 87 ATC 5043 A business selling computers but also leasing them, that also sold the ex-lease computers second hand at for an mount exceeding their cost (profit) was held to be doing so in the ordinary course of business. It was not mere realisation of a capital asset because the taxpayer expected to make profits and had that purpose in mind when acquiring them FCT v Cyclone Scaffolding Pty ltd 87 ATC 5083 Facts: the taxpayer carried on a business of hiring (80% of business) and selling scaffolding equipment. Under the hiring agreement any equipment damaged or not returned was deemed to be sold at list price, which was always greater than cost. Fed Court Held: the profits were NOT income. The substantial purpose on acquiring the equipment was for hire, not resale. Receipts were from sale were extraordinary transactions, sales were not expected, only a mere possibility. Receipts incidental to the ordinary course of business If a receipt is incidental to carrying on a business it will be income: see Reynolds and Esso Aus Resources ! Reynolds: log hauler sold a truck it leased and the lessor permitted him to keep amount of sale exceeding the lease value. This was income because of close relationship to business activity ! Esso: taxpayer received $1.4m from joint venture for its deep water drilling technology. The payment was incidental to course of business, that being oil exploration.
Stop holding but still own the stock ! You are treated as having sold it at cost: s 70-110 ! The stock will not be deductable under s 8-1 if stock taken for private use Eg a sheep Grazer takes a sheep for personal consumption Compensation for lost trading stock Include in assessable income an insurance or indemnity received for loss of trading stock if it is not otherwise assessable income: s 70-115
WAS THE INCOME DERIVED THIS YEAR? Income for an Aus resident must be derived during he income year: s 6-5(2) Meaning of derived ‘Derived’ is not defined, so we must rely on case law. ! Carden’s Case stated that: ‘the method of accounting that be adopted is that which ‘is calculated to give a substantially correct reflex of the taxpayer’s true income. Salary and wages General Rule ! derived when received: Brent v FCT (see p 122 of TB – wife of Great train Robber) Further Case Law ! where employee agrees to forgo part of salary for paid leave in a later period the deferred salary is assessable when received (derived): TD 93/242 ! where an amount is credited to an employee and can be drawn at any time, it is derived at the time of crediting: Garforth v Newsmith Stainless (1979) ! Acceptance of a cheque constitutes payment: Nicks v taylors. Even if postdated: Marreco v Richardson ! if an employee refuses to receive a cheque until after 30 June, the cheque will be derived when tendered to the taxpayer: Case D62 ATC 4195 ! It will still be assessable income even if the payer is not the proposed employer: see AAT Case 13/99 (on p 122 of TB) Interest Generally derived when it is received or credited: Leigh v IRC Rent ! Generally derived when it is received, ! However if payment made in advance will need to examine lease agreement to determine derivation ! For a business of renting out properties or other assets then the accruals basis will be appropriate. Income from business Sole traders and entity structures such as trusts, partnerships and companies running businesses will generally use accruals. Time of derivation regarding accruals: ! Under accruals income is derived when it is earned (receipt is not necessary): Rowe & Son v FCT ! “earned” means a recoverable debt must be created such that a taxpayer is not required to take further steps before becoming entitled to payment: Aus Gas light Co ! If part of the consideration received by a business cannot be ascertained due to a dispute, then the income is derived when the dispute is resolved: BHP v FCT Income from professional practices ! If small sole practitioner practice, use cash basis: See Carden ! if large professional practice, use accruals basis: See Henderson ! If medium sized professional practice the basis must be determined by considering the relevant factors as outlined in TR 98/1 (as there is no clear authority for medium sized firms): " Size of business " Circulating capital and consumables " The use of capital items to produce income " Credit policy and debt recovery " Books of account
The former simplified tax system From 1 July -30 June 2005, small business taxpayers could elect to join the STS and adopt a cash basis for accounting. Prepaid income If the income is subject to a contingency AND treated as a liability in the books: See Arthur Murray. ! If facts state the taxpayer does not provide refunds then there is no contingency Deemed derivation For both ordinary and statutory income, you are taken to have derived the income as soon as it is applied or dealt with in any way on your behalf or as you direct: see 6-5(4) and 6-10(3) ! Where a pension was directed by the taxpayer to his wife, the tax payer still had to include the pension in his assessable income: See CASE U52 87 ! Deemed derivation provisions do not apply, however, where a debtor refrains from making payment at the request of a creditor: see Brent v FCT
CHARACTERISTICS OF ORDINARY INCOME Is it convertible to money? ! The amount must be convertible into cash to be income: Cooke & Sherden Check that the mutuality principle doesn’t apply ! This principle only applies to certain types of organisations: non-profit sports clubs, arts and dance clubs. ! The principle of mutuality reflects a principle that you cannot earn income off yourself. Income must be derived from external sources: see Bohemians Club The requirements for the principle of mutuality are: ! Need a fund created and controlled by contributors for common purpose: Municipal Mutual Insurance v Hills ! the distribution of surplus to members must be distributed according to contributions: Coleambally Irrigation Mutual Cooperative " ie if all members put in $100 they must receive an equal percentage of that back upon winding up ! Trading profits are not covered by this principle and receipts from non-members constitute income (need to apportion): see Carlisle Silloth Golf Club v Smith Periodical gains ! If the payment is periodical or frequent and expected then the payments have the character of ordinary income: FCT v Dixon (1952). ! However periodicity is not always essential – there numerous cases of taxpayers converting income stream (interest or royalties) into a lump and arguing unsuccessfully that such lump sums where of a capital nature. " In FCT v Meyer Emporium the taxpayer assigned the right to receive interest income for a lump sum of $45m. HCA held: the taxpayer had merely converted future income into present income. " In Henry Jones (IXL) the taxpayer assigned its rights to royalties to a finance company for $7.6 m. Fed Court Held: the $7.6m was income under the Meyer decision. Windfall gains Windfall gains, gifts, gambling & lottery wins are generally not income Gifts ! Gifts are not income, unless they are related to employment, income-earning or business activity: Hayes; Scott " The test is objective, not subjective: Hayes " The character of the payment in the hands of the recipient is the important consideration: Hayes " Though the motive of the donor is relevant is will rarely be decisive: Hayes
Gambling winnings Lack the characteristics of income: Scott; Hayes
! In Martin v FCT a gambler made 602 bets, including 275 winning bets, during a three year period, was held not to be carrying on a business # not income ! An exception applies to gambling businesses such as bookmakers and casinos Lottery Winnings ARE NOT INCOME: Scott; Hayes Receipts from illegal activity The ‘illegality’ of the activity is irrelevant. If it’s systematic and producing a profit, or profit intention, then the gains will be viewed as income Partridge v Mallandaine Gains from use of property Gains from the use or enjoyment of property by another person will be ordinary income: FCT v Montgomery (1999) Income from use of property includes: " Rent " Interest " Dividends: ITAA 1936 s 44 (specifically includes dividends as ordinary income) " A monthly rent premium: Re Vendardos [1964] NSWR 254 " Lease incentives: Montgomery " Payment for the surrender of a lease of premises: Rotherwood Pty Ltd v FCT (1996) These receipts are NOT income: " The proceeds from selling property will generally be capital sums: Scottish Australian Mining Co ltd v FCT (1950) CLR " Annual payments of $10,000 were paid by miners to a farmer as rent. The payments were however to compensate the farmer for disturbance to the land. Court held payments were for the deprivation of part of a capital asset and thus were capital. Nullaga Pastoral Co Pty Ltd v FCT (1978) " Also pre-judgement interest on damages in a personal injury case is not assessable income per Whitaker v FCT (1998) " In respect of coal rights compulsorily acquired, the interest in respect of the compensation constituted capital rather than interest: Northumberland Deevleopment v FCT (1994) " However in federal Wharf v DCT (1930), in respect of property compulsorily acquired, the interest on the value of the property calculated from the time when the government took over the property constituted interest rather than compensation for the loss of the taxpayer’s asset. In this case the taxpayer had an independent right to interest calculated by reference to a liability.
Income from personal services These will usually be income These factors should be considered: ! *Degree of connection the employment or services rendered (most important factor) " Is directly related, incidental or unrelated? ! Reasonable expectation payment would be made ! Dependence upon payment to meet living expenses ! Payment replaces income ! Motive of payer: i.e. commercial or personal reasons ! Periodical, recurrent and regular ! Money or convertible into money THE DEGREE OF CONNECTION In determining this nexus the courts look to the nature of the receipt in the hands of the recipient: Dixon; Scott Directly related to employment or services Receipts directly related to employment or services are ordinary income: AG of British Columbia Such receipts include: ! salary, wages, commissions: AG of British Columbia ! a sportsperson’s retention payment/signing fee ! An unusual or disguised payment that is in substance directly related to personal services will be income: Reuter Incidental to employment or services Receipts incidental to employments/services may be income
! Footballer’s receipt of $20,000 for best and fairest was incidental to his employment even though his club did not pay it, as his employment caused the payment, thus had sufficient connection: Kelly " However the UK courts held otherwise in Moore Unrelated to employment or services Where there is no connection between the employment/services rendered and the receipt, such payments are not income. Gifts from employers ect: ! a former employer’s gift of shares to a taxpayer out of friendship is not income: Hayes ! a gift of $10,000 by the widow of a lawyer’s former client, to whom the lawyer also gave personal advice, was not income as was made in light of their friendship and therefore the connection to services provided was too indirect: Scott ! HOWEVER in Dixon there was no connection between the services rendered and the top up payments, yet because the payments were periodic, recurrent and regular, they constituted income.
Income from carrying on a business Will be ordinary income if: 1. The activity constitutes carrying on a business; and " ‘business’ - ‘any profession, trade, employment, vocation or calling, but does not include occupation as an employee’: s 995-1 ITAA97 " ‘carrying on a business’ – A subjective and objective determination made by regarding the nature and extent of the activities: Martin " See also Woods; Shields; Stone on p 176 2.
receipt meet requirements of ordinary income; and " derived " Convertible into money " Mutually principle does not apply
3.
the receipt has a sufficient connection to the business activity: FCT v Spedley Securities " *Connection to business activity (most important) " Reasonable expectation " Payment replaces income " Profit-making purpose " Periodical, recurrent and regular
IS THERE A SUFFICIENT CONNECTION Receipts received in the ordinary course of business Gains that directly relate to the business activity will be income: Californian Copper Syndicate Other case law Memorex Pty Ltd v FCT 87 ATC 5043 A business selling computers but also leasing them, that also sold the ex-lease computers second hand at for an mount exceeding their cost (profit) was held to be doing so in the ordinary course of business. It was not mere realisation of a capital asset because the taxpayer expected to make profits and had that purpose in mind when acquiring them FCT v Cyclone Scaffolding Pty ltd 87 ATC 5083 Facts: the taxpayer carried on a business of hiring (80% of business) and selling scaffolding equipment. Under the hiring agreement any equipment damaged or not returned was deemed to be sold at list price, which was always greater than cost. Fed Court Held: the profits were NOT income. The substantial purpose on acquiring the equipment was for hire, not resale. Receipts were from sale were extraordinary transactions, sales were not expected, only a mere possibility. Receipts incidental to the ordinary course of business If a receipt is incidental to carrying on a business it will be income: see Reynolds and Esso Aus Resources ! Reynolds: log hauler sold a truck it leased and the lessor permitted him to keep amount of sale exceeding the lease value. This was income because of close relationship to business activity ! Esso: taxpayer received $1.4m from joint venture for its deep water drilling technology. The payment was incidental to course of business, that being oil exploration.
