ACC30005 Taxation

Swinburne Business School

Topic Two: Assessable Income - Part 2
Tutorial Questions – Solutions

Question one

ISSUE: Whether the proceeds of disposal are income or capital receipts.

RELEVANT LAW: Ordinary income is income under ordinary concepts and is
assessable under s. 6-5, usually on a gross basis. Capital receipts are not ordinary
income and may be subject to capital gains tax on a net basis under s. 102-5. The
capital gains discount could apply to the land. (Students note that CGT is covered in
topic 3).
Arguments for ordinary income (these would be submitted by the ATO)

 Skate has purchased land for resale at a profit as a real estate speculator so the
proceeds are ordinary income (Californian Copper Syndicate v Harris).

 The short term renting followed by sale and purchase of more land to develop
is inconsistent with the activity of being a landlord. Skate appears to be
carrying on a business of developing land for which the proceeds are ordinary
income under s. 6-5.

 Even if Skate initially acquired the land as a capital asset to earn rent from the
townhouses, the extensive activity of legal subdivision by strata title to
enhance the sale value indicates more than a mere sale of investment. Rather,
a change has occurred and the properties have been ventured into a new
business of development and sale of real estate and the proceeds are ordinary
income under s. 6-5 (FC of T v Whitfords Beach Pty Ltd).

 Even if a business does not exist, the nature and scale of the activity is
commercial such that any novel or once-off transaction for profit is ordinary
income (FC of T v The Myer Emporium).

Arguments for capital receipts

 Skate purchased the land to earn rental income. The land is held as a capital
asset such that any gain on disposal of the investment is not profit
(Californian Copper Syndicate v Harris).

 The legal subdivision and sale at enhanced value is merely the disposal of a
capital asset to its best advantage (Scottish Australian Mining Company v FC
of T).

 Even if the nature and scale of activities are commercial, Skate originally
purchased the land and built the townhouses as an investment. The original

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 arrangement was not entered into for a profit motive and so the gain should be
of a capital nature (Westfield Ltd v FC of T).

Conclusion
The evidence of only short term rental contracts, the effort at enhancing sales
value by subdivision and the subsequent purchase of further land to develop
suggests that the receipts are ordinary income as opposed to a mere disposal of
a capital asset.

Question two

Businesses often start on a small scale and conversely sometimes hobbies can
become very consuming. If a hobby makes a transition to a business, the timing may
be unclear.

ATO Tax Ruling 97/11 provides a useful summary of business indicators. Of

particular relevance is the commercial nature of the transactions and the profit
motive. However, scale and repetition may be relevant.

Stage 1: Lien has enrolled on the pottery course as a pastime. Whilst she has
charged for six sets of pottery, she has only sold a small quantity to friends and the
amount is only to cover costs. The small scale, non-commercial nature suggests that
the receipts a merely proceeds of a hobby and are not ordinary income.

Stage 2: Lien is devoting considerable spare time as her turnover is increasing. She
is charging a mark up on cost, however this is still well below the industry average. It
is unclear whether Lien is really making a profit with such a low markup just because
she has low overheads working from home or whether she is not aware of indirect
costs etc. It is possible that she is conducting a business on a small scale in its early
stages (FC of T v Walker, Ferguson v FC of T). However, the non-commercial
markup combined with activity being constrained to spare time in the evenings and
weekends might suggest that she is vigorously pursuing a hobby (Martin v FC of T).

Stage 3: Even without registering a business name, Lien is advertising to the public
and charges a commercial markup which suggests that she is carrying on a business
by the commercial nature of the transactions.

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Question three

Explain whether and to what extent the following receipts are assessable income.

(i) Compensation receipts generally take on the character of what they replace. The
$10,000 is awarded in respect of lost income and so it is ordinary income under
s. 6-5 (FC of T v Smith). The $500,000 has been awarded in respect of lost
capacity to earn income (as opposed to replacement of lost earnings) which
suggests a capital receipt. (Personal injury payments are also exempt from CGT
– topic 4).

(ii) Businesses make and perform contracts in the ordinary course of trading. Certain
contracts have a lasting strategic nature that make them capital assets such as
exclusive agency or profit share on a joint venture. However, the loss of agency in
this case does not appear to have caused significant and lasting damage to the
ability to trade at similar levels of profitability. It appears to be business as usual, so
the agency contract appears not to be on capital account. The cancellation payment
appears to be ordinary income by replacing profits of a contract on the revenue
account (Heavy Minerals Pty Ltd v FC of T).

(iii) The agreement is a restrictive covenant not to practice dentistry in competition

with the purchaser. The dentist is receiving a capital payment for giving up his
rights and not ordinary income (FC of T v Woite, Higgs (Inspector of Taxes) v
Olivier).

(NB: This will be subject to CGT – topic 4)

Question four

a) FC of T v Cooling 90 ATC 4472. A lease incentive payment was held to be

income according to ordinary concepts, because when a taxpayer operates from
leased premises, the move from one premise to another is in the course of its
business activity. A significant intention of the taxpayer was to obtain a commercial
profit by way of the incentive payment. Therefore the first strand of the Myer income
principle applied in that although the profit arising was from an unusual or
extraordinary transaction, it was nevertheless entered into by the taxpayer with the
intention of making a profit. Therefore each partner would derive ordinary $50,000 of
ordinary income under ITAA97 s6-5.

b) The building services are not convertible to cash and therefore not ordinary
income, FCT v Cooke & Sherden. However the arm’s length value $30,000 is
statutory income under s.21A ITAA36 as a non-cash business benefit and assessed
to each partner.

c) The rent-free period is a non-cash business benefit and not ordinary income, FCT
v Cooke & Sherden. The arm’s length value is also not statutory income because
business rent expenditure would otherwise have been income tax deductible had it

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been paid by the firm. The amount is excluded under the exception in s.21A(3)
ITAA36.

Question 5

To what extent are the following amounts assessable, and under which provision:

(i) Lump sum received from a newspaper publisher in full settlement of an action for
libel.

Answer: The lump sum appears not to be connected with any income
producing activity, rather it is received as damages for injury to personal
reputation. The payment is also exempt from capital gains tax (Topic 3).

(ii) Honorarium received by the honorary secretary of an athletics club.

Answer: Payments as a reward for providing services is ordinary income and

assessable under s. 6-5 (Brent v FC of T). An office bearer is rendering
personal services, therefore the outcome rests upon the connection with
services rendered.

If the payment automatically comes with the position or the amount varies with
seniority or the hours worked then it is connected with the services/office. If
the payments are regular, expected and depended upon then they may be
ordinary income by the nature of the receipts (FC of T v Dixon).

However, if the payments are merely token amounts to offset costs incurred
and each amount is not automatically paid but must be put to the club
committee for approval then the payments would be unlikely to be ordinary
income.

(iii) A lump sum legacy of $10,000 received from the estate of a deceased friend.

Answer: Gifts of natural love and affection are not ordinary income (Scott v FC
of T). A lump sum legacy is a testamentary gift and is not ordinary income.

(iv) A lifetime annuity of $500 per month received from the estate of a deceased
relative for which you are a beneficiary.

Answer: The annuity consists of periodical payments which are expected and
depended upon, they are ordinary income (FC of T v Dixon) and assessable
under s. 6-5. The characteristics of the receipts are in the nature of income
regardless of the fact that they arose from private family dealings.

(v) A tool allowance of $500 paid to an apprentice plumber.

Answer: The allowance is a payment incidental to the rendering of personal

services which would suggest ordinary income (Brent v FC of T) and
assessable under s.6-5. If the payment is not ordinary income then allowances
in respect of services rendered are statutory income under s. 15-2.

(vi) An employee is reimbursed for his own car use at the rate of 55 cents per km by
his employer. He travelled 100km for private purposes and another 100km to
attend a work-related conference.

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Answer: Amounts received from an employer by way of reimbursement of car
expenses using the cents per km method are statutory income under s. 15-70.
The employee must include $110 in their assessable income. They may be
entitled to a tax deduction for work-related use of their car in the deductions
part of their income tax return.

Question 6

Derivation of income

Income tax is payable on income derived by a taxpayer during the year of income.
For each of the following situations determine the appropriate basis of derivation and
what amount of income, if any, has been derived during the year of income ended 30
June 2020.

(i) On 23 June 2020 an employee received $6000 in respect of long service leave
which is to commence on 2 July 2020

An employee would derive salary and wages income on a receipts basis.

The cash is received on 23 June and so must be included in their
assessable income for the tax year ending 30 June 2020.

(ii) A finance company lends $20,000 on 1 July 2019 on the condition that both
the principal and interest, $22,499 in total, are repaid on 30 June 2020.
Payment was actually received on 1 July 2020.

A business of lending money would derive interest income on an

accruals or earnings basis. According to the terms of the loan contract,
the company has fulfilled its obligations and has the right to call for
interest payment on 30 June 2020. The company must include the
interest of $2,499 in its assessable income for the tax year ending 30
June 2020 in spite of having not received the cash until the next income
year.

(iii) A judo instruction school charges $150 for ten lessons payable in advance.
Prepaid fees are held in a suspense account until the lessons are taught, or
otherwise refunded if the student cannot complete the course. At 30 June the
school had received fees totalling $75,000 for the year of which fees received
for lessons still to be taught amounted to $7,500.

The school is a business that appears similar on all facts to the dancing
school in Arthur Murray (NSW) Pty Ltd v FC of T:

1) It uses an accruals basis for its fee income;

2) It separately accounts for prepaid income; and
3) It is prepared to refund fees for any unperformed lessons

Therefore the school may defer recognition of the prepaid fees, and may
include $67,500 of fee income in the 30 June tax return.

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(iv) Ben and Matt, Public Accountants, have practiced in partnership for several
years under the following conditions. Clients are billed in the partnership
name but revenue is to be allocated on a partner responsible basis.

Ben and Matt are not in a partnership as defined by general law. They
are not carrying on a business in common as defined by the relevant
state Partnership Acts and they are not in receipt of joint income. Each
person bills clients for their own services, regardless of the fact that
they use a common business letterhead. For example, if Matt went
surfing for 6 months then he would not derive any fee income from the
business because he would not be billing clients for services
performed.

Having established that we have two independent practising

professionals as opposed to a partnership, then either may derive their
fee income on a cash basis where they rely principally on their own
personal exertion (FC of T v Firstenberg).

(v) Would your answer change if you were told that Ben and Matt employ a
receptionist/secretary and a 1st year graduate accountant, as well as hiring
on a contract basis the services of a tax accountant.

If either individual outsources their principal work or relies on

professional employees then they must use the accruals method to
recognise their fee income (Henderson v FC of T).

Merely using the services of a receptionist or secretary for

administrative purposes would not be performance of principal work
and would not by itself be sufficient to require Ben or Matt to use
accruals accounting for their fee income (FC of T v Firstenberg,
Carden’s case). However, a contract accountant or an employee
accountant would be performing principal work and require either Ben
or Matt to use an accruals basis.

(vi) An individual conducts a business as a sole trader selling goods on credit

terms of 60 days. At 30 June 2020, invoices issued for goods sold during the
year amount to $120,000 but cash received is only $100,000.

A business involving circulating capital such as trading stock should

use accruals to recognise its trading receipts (J Rowe & Son Pty Ltd v
FC of T). The income is earned when the goods are delivered and the
invoice issued. Therefore the individual will include $120,000 in their
assessable income for the year ended 30 June 2020.

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Text book questions

Chapter 3

Question 3.13

The issue is whether the proceeds would be considered ordinary income from an
isolated transaction or a capital receipt. As the property was acquired prior to the
introduction of the Capital Gains Tax in 1985, if the proceeds are a capital receipt
they would be tax free (unless they can be characterised as proceeds from a profit-
making scheme under section 15-15).

Insofar as whether the proceeds are ordinary income from an isolated transaction,
the key question is whether this is a mere realisation of the property in the most
advantageous way (and hence, capital proceeds) or ordinary income from the
property development project. To answer this question consideration must be given
to the guidelines set out in FCT v Whitfords Beach [1982] HCA 8. Key considerations
in that case were the scale and complexity of the property development activities and
the intentions of the taxpayer. In this case there is no evidence of any busines-like
motivation to the project, the scale of the project is relatively small and provided the
works carried out are those only strictly necessary to secure development consent
from the local Council, the proceeds are unlikely to be assessable as ordinary
income from an isolated business transaction.

Question 3.14

(a) Periodical amounts equal to what they would have been paid had they
continued to be employed during the period of the pandemic.

These payments would be considered income. Compensation is income

where the payment is periodic and paid in the same amounts and on the
same terms as if the employment contract had not been terminated. See FCT
v Phillips [1936] HCA 11. In that case payments made as compensation for
termination of the taxpayer’s contract as a managing director of a theatre
company were deemed by the High Court to be assessable income. In that
case the payments were also paid periodically in the same amounts and the
same times as the income that would have been payable to the taxpayer had
the contract not been terminated. See further [3.8.1]

(b) Equal lump sum payments of $5000 to each former staff member three
years after the pandemic is over and the staff are now working
somewhere else.

These lump sum payments are unlikely to be considered assessable as a

product or incident of employment. Factors militating against assessability
include the fact that the payment was made to former employees many years
after the termination of employment, in a lump sum calculated without
reference to length of service, quality of work or former position held. The
case is similar in many of these respects to FCT v Harris [1980] FLR 36 – a
case in which the payments were also determined to be non-assessable
capital receipts.

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 (c) Payments made in coffee beans and food vouchers rather than
cash.

Generally speaking, to be assessable, a benefit must be in cash or

convertible to cash (FCT v Cooke & Sherden [1980] FCA 37). Provided the
coffee beans and food vouchers are convertible to cash they would be
assessable (although obviously this is only one of the factors to be
considered to determine assessability). Is it important to avoid making the
mistake of thinking non-cash benefits can never be treated as ordinary
income. They can, provided they are convertible to cash. Non-cash benefits
(sometimes called ‘benefits in kind’), which are convertible to cash, are valued
at their realisable value and an amount of income equal to that realisable
value can constitute assessable income according to ordinary income. See
further [3.2.3].

Question 9.11

The concept of derivation is about timing. Derivation determines which income year
an amount will be assessed in. There are two (2) alternative methods which have
been judicially accepted by which a taxpayer may recognise income:

(a) the cash basis accounting method (the receipts method); or

(b) the accrual basis accounting method (the earnings method).

Over the years the courts have determined the appropriate basis of accounting in
respect of the type of income being earned. Many of these principles are summarised
by the Commissioner in Taxation Ruling TR 98/1.

The most important point to bear in mind is that it is the nature of the income, not the
nature of the taxpayer that is relevant when determining whether to use the cash or
accruals basis for income recognition.

The toy store is carrying on a business. Trading income (ie. income from carrying on
a business) is recognised on the accruals basis. Taxpayers carrying on a business
are required to recognise income that they have earned from trading operations in
the year that it has been earned and not in the year that the cash is received. Other
income earned by a business will be classified by type of income.

Applying these principles leads to the following conclusions:

(a) Cash sales of $2,200 are assessable in the 2020 income year.
(b) Credit card sales totalling $4,200 are assessable to the toy store in the 2020
income year (ie. when the sale has occurred), not when the cash is received.
(c) For taxation purposes, interest income is assessable in the income year when
it is received (ie. cash basis). Consequently, despite the fact that six months
interest totalling $90 has been earned and accrued for accounting purposes
(from 1 April 2020 to 30 June 2020), none of this amount is assessable for tax
purposes during the current income year.
(d) In terms of the $100 gift voucher, the store has received the cash from the
customer and in return has provided the customer with a gift voucher that is
valid for 12 months and can be redeemed towards the purchase of any item
in the store. This is similar to the concept of revenue received in advance as
the store has an obligation to provide goods to the value of $100 in the future.

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As the store has received $100 cash and the gift voucher is non-refundable,
the $100 is assessable income on 30 June 2020, and not when the voucher is
redeemed by the customer sometime in the 2021 income year (see Taxation
Ruling TR 95/7).