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LAW3130 & 5230

Module 1 – Assessable income

Objectives
It is the objective that at the end of this module you should be able to:

● identify the sources of taxation law


● identify the major principles of statutory interpretation
● determine the resident status of an individual or a company for tax purposes
● determine the source of income receipts
● determine when income is ‘derived’
● determine with reference to case law, when the cash and accruals methods should be used
for tax purposes
● understand the concept of ‘income’ which is assessable under the Income Tax Assessment
Acts
● be able to differentiate between income and other receipts such as capital gains, gifts and
windfall gains
● be able to determine whether a taxpayer is carrying on a business
● be able to recognize the tests for income from isolated transactions as opposed to the
mere advantageous realization of capital assets
● be able to identify when particular receipts are exempt income
● be able to determine what is trading stock and to apply the valuation rules for the
determination of assessable income and allowable deductions in relation to such stock.

Readings
The Australian tax handbook is referred to as ATH.

The Australian tax casebook is referred to as ATC.

Income tax legislation is referred to as the Act.

References to the Income Tax Assessment Act 1936 are in bold while references to the
Income Tax Assessment Act 1997 are in ordinary text.

Suggested time for this module: See study schedule.

1.1 Introduction to Australian taxation


It is anticipated that from the study of this course you will gain an understanding of the
workings of taxation law in Australia, with the result that even though taxation law will
change, you will be able to update your knowledge based on the information you have
learned this semester. It is for this reason that we look generally at whether items are
assessable or deductible and the reason why they are assessable or deductible. It is the why
LAW3130 & 5230 Module 1 – Assessable Income

that is more important than the fact that an item is deductible or assessable as the case may
be. Once armed with this understanding you will be able to continually update your own
knowledge, should you intend to remain working in the field of taxation law.

This module introduces you to the basic structure and operation of the income tax system in
Australia and discusses in detail Australia’s taxing power and what constitutes assessable
income.

Use of cases in this course


Throughout this course, cases will be frequently mentioned. The importance of case law in
this subject cannot be over-emphasized. It is only through cases that we can develop a proper
perspective on the development of taxation law through to the present time. The number of
cases that are discussed in these notes is limited to the more important and the principles
established by these cases should be understood. The Australian tax casebook provides you
with a concise summary of the facts and decisions of cases mentioned in these study modules
and relevant cases should be read at the same time as you read through this material and the
text book.

As you progress through this course, you will find that many words used in the Act are not
defined in the Act and thus reference must be made to case law. Commercial or accounting
principles may be used, or even the generally understood meaning of a word may be used in
certain situations. To reiterate a point made previously the reason why a decision has been
reached or why a section has been interpreted in a particular way is more important than the
fact that a certain decision is reached. Please keep this in mind throughout your study in
this course.

Case law and citations


Decided cases provide tax practitioners and students of taxation law with a foundation for
understanding the application of tax legislation to particular transactions or events. There are
primarily two different case reporting services currently used in Australia for tax cases. They
are the Australian tax reports (ATR) and Australian tax cases (ATC). To demonstrate the
difference between the citation characteristics two cases are used:

Australian Tax Reports (ATR)

Henderson v FC of T (1970) 1 ATR 596.

FC of T v Dunn (1989) 20 ATR 356.

Australian Tax Cases (ATC)

Henderson v FC of T 70 ATC 4016.

FC of T v Dunn 89 ATC 4141.

In the first case reported, the taxpayer Henderson was the appellant and the Federal
Commissioner of Taxation was the respondent. The case was decided in 1970 and is reported
in volume 1 of Australian Tax Reports at page 576 and is also reported in the 1970 volume of
Australian Tax Cases at page 4016. In the second case the Federal Commissioner of Taxation
was the appellant and the taxpayer Dunn was the respondent. The case was decided in 1989
and is reported in volume 20 of Australian tax reports at page 356 and is also reported in the

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1989 volume of Australian tax cases at page 4141. Should you wish to access the full case
you can do so on-line through the library link on the USQ home page.

Tax cases are also reported in the Commonwealth law reports (CLR), Federal law reports
(FLR) and Federal court reports (FCR).

Basic components of the Australian income taxation system


The basic approach to income tax in Australia is to impose tax on the ‘taxable income’ of a
taxpayer. Section 4-15 provides that the taxable income of a taxpayer is the total of all
assessable income less any allowable deductions. This can be shown as follows in figure 1.1:

Figure 1: Calculation of taxable income

The Goods and Services Tax applies from 1 July 2000. Businesses collect GST in association
with their own income. The GST collected is not income of the business and is not assessable
to the business. To clarify this matter s 17-15 provides that when calculating assessable
income any GST payable to the ATO on a taxable supply is ignored. The use of the word
payable brings with it a requirement to determine the GST liability on the transaction not
necessarily the amount of GST charged or collected on a transaction. In relation to deductions
and GST you cannot deduct a loss or outgoing to the extent that the loss or outgoing includes
an amount of input tax credits to which you are entitled, s 27-5.

1.2 The legislative scheme


Income tax is imposed in Australia by a Commonwealth Act, the Income Tax Assessment Act
1936 or 1997 (Cth). The basis of the Commonwealth’s power is found in s 51 (ii) of the
Constitution which states that ‘the Parliament shall have power to make law with respect to…
taxation but so as not to discriminate between States or parts of States’.

The Income Tax Assessment Act 1936 and 1997 (Cth) deal only with assessment and
collection of income tax, while other Acts impose and declare the rates of the tax –
e.g. Income Tax (Rates) Act 1986. This practice has its rationale in s 53 and s 55 of the
Constitution. Briefly, s 53 states that proposed laws imposing taxation are not to originate in
the Senate and that the Senate may not amend such proposed laws. The Senate however may
return proposed legislation the House of Representatives with a request that certain parts of
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the proposed legislation be amended or in some cases deleted. Section 55 of the Constitution
provides that laws imposing taxation shall deal with one subject matter only.

1.2.1 Other taxes in Australia


Other sources of Commonwealth tax revenue include custom and excise duties, petroleum
rent resource tax and fringe benefits tax.

The State governments in Australia receive a share of the revenue raised by the
Commonwealth government from income tax and from 1 July 2000 they receive revenue
from the Goods and Services Tax. The States impose stamp duties and charges on certain
transactions in association with land taxes. Stamp duty is another major revenue earner used
by the States and is charged upon instruments and chargeable transactions (e.g. contracts for
the transfer of property). All States charge stamp duty on the conveyance or transfer of real
property (e.g. land and buildings). Different rates and thresholds apply in the different States.

State governments also levy payroll tax. Pay-roll tax is a significant revenue generator for the
States and is levied on employers whose total annual Australian wages exceed certain
threshold levels. There are differences between the rates of tax and the threshold levels in
each of the States. If you are providing advice in relation to payroll tax you will need to
consult the relevant State legislation.

Land tax is imposed by all States and the Australian Capital Territory but not by the Northern
Territory and is imposed on the value of the land. Liability for land tax generally (certain
variation exists in the Australian Capital Territory) vests with the owner of the land on a
particular date. Certain concessions exist for a taxpayer’s principal place of residence and
primary production land. Land tax is generally levied on the unimproved value of the land as
determined by a competent valuing body normally the Valuer-General in each State.

1.3 Broad based consumption tax – GST


Goods and Services Tax was introduced from 1 July 2000. Goods and Services Tax taxes the
supply of both goods and services at the rate of 10%. It is applied to the change in value at
each point in a production or distribution chain. Thus for example as goods travel through a
production chain from raw materials to the final retail sale GST will be imposed at each point
where there is a change in the value of the goods. A system of refunds applies to enable
registered businesses to reclaim the GST paid. The module on ‘Goods and Services Tax’ in
this course deals specifically with the operation of GST. A good understanding of the
operation of the GST is important as it will need to be considered on most business
transactions.

Reading activity
ATH: paras 1 010 to 1 190.

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1.4 Sources of tax law

1.4.1 Legislation and cases


The primary source of authority is income tax legislation contained in the Income Tax
Assessment Act 1936 and 1997. As with most other legislation it is sometimes necessary for
the courts to interpret such legislation and in Australia the courts are called upon regularly to
undertake this role. The courts are not an actual source of authority for taxation law and their
role is primarily one of interpretation. Nevertheless, court decisions are binding on decisions
made at lower levels. The Australian Court system includes the High Court and the Federal
Court with the former being the highest level of authority.

Australian case law may also emanate from the Administrative Appeals Tribunal (AAT)
which in 1986 replaced the Taxation Board of Review. The AAT is an administrative tribunal
rather than a formal part of the court system. The AAT is not bound by its own previous
decisions as it is an administrative body. The decisions of the AAT are binding on the
Australian Taxation Office (ATO) as the AAT can set aside the Commissioner’s decision on
an objection and substitute its own decision. The Commissioner or the taxpayer may appeal
against a decision of the AAT to the Federal Court. The Small Taxation Claim Tribunal
(STCT), which is operative from 1 July 1997, provides taxpayers, where the amount of tax in
dispute is less than $5000, with a less expensive and less formal method of resolving their
disputes with the Commissioner. The module titled ‘Administrative Provisions,
Offsets/rebates, tax rates and Medicare Levy’ discusses in more detail the issues associated
with objections and appeals.

1.4.2 ATO Rulings


The ATO from time to time issues a statement of the Commissioner’s interpretation of
particular tax issues; these are called rulings. Rulings could be considered to be an informal
source of law. Each Taxation Ruling represents the Commissioner’s view on a different
taxation issue. For example, a ruling may indicate how the Commissioner’s discretion may be
applied in certain circumstances. Note that the Commissioner also issues Tax Determinations.

Reading activity
ATH: paras 45 010 to 45 050

1.5 Statutory interpretation


Tax legislation often uses general rather than specific terms and applying the legislation to
specific factual situations may sometimes be difficult. A number of approaches to statutory
interpretation have emerged over the years. However, the dominant guidance to interpreting
legislation must come from the clear meaning of the words used in the legislation in
association with the intention of Parliament when passing the legislation. Section 15AA of
the Acts Interpretation Act 1981 gives guidance in this respect by providing:

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In the interpretation of a provision of an Act a construction that would promote the purpose
or object underlying the Act (whether that purpose or object is expressly stated in the Act or
not) shall be preferred to a construction that would not promote that purpose or object.

Reading activity
ATH: Interpreting Tax Legislation paras 1 250 to 1 330.

Exercise 1
To test how you have understood some of the material in this part of the course
you may wish to try the self-assessment quiz on the Study Desk entitled
‘Introduction to Australian taxation’.

1.6 Australia’s taxing power


Section 6-5 reflects Australia’s jurisdiction to levy income tax and that section provides that
the assessable income includes income according to ordinary concepts, which is called
ordinary income. Section 6-5 states that:

● 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
● if you are a foreign resident, your assessable income includes: the ordinary income you
derived directly or indirectly from all Australian sources and other ordinary income that a
provision includes in your assessable income on some basis other than having an
Australian source.

It can be seen from a review of s 6-5 that residents will be assessed on all income irrespective
of the source. On the other hand non-residents (foreign residents) will generally only be
assessable on income which has an Australian source. Thus it is important that we determine
when a taxpayer is resident and the source of a non-resident’s income to apply the provisions
of s 6-5.

Reading activity
ATH: paras 2 010 to 2 030.

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1.7 Residence
The test for residence is applied annually, FCT v Applegate (1979) 9 ATR 899. The fact that
a taxpayer is a resident in one year has no direct bearing on the taxpayer’s resident status for
past or future years of income.

Section 6(1) of the ITAA 1936 is the starting point to determine resident status. (Note that
section 995-1 discusses the concept of Australian Resident.) It provides rules that apply to
individuals and companies. This definition may also apply indirectly to business structures
such as trusts where the trustee is taxed as if the trust were a taxable Australian entity (see
s 95 definition of ‘net income’ of a trust) in which case the residence of the trustee will be a
relevant consideration.

1.7.1 Individuals
The definition of a ‘resident’ as it applies to individuals is found in s 6(1) and prescribes four
rules. Satisfaction of any one of these rules will be sufficient to establish that a person
(other than a company) is a resident of Australia in the particular income year that the test is
applied.

It should also be remembered that for tax purposes a taxpayer can be resident in more than
one place at the same time (Gregory v FCT (1937) 57 CLR 774). In other word a person may
be an Australian resident for tax purposes and be a resident of another country for tax
purposes on the basis of that country's tax residency rules. For the purpose of this course you
are only required to know the Australian residency rules.

The four rules are:

● A person who resides in Australia. (Within the ordinary meaning of the expression
‘resides in’ – Common Law Test.)
● Is domiciled in Australia, unless the Commissioner is satisfied his/her permanent place of
abode is outside Australia. (The Domicile Rule.)
● Has actually been in Australia, continuously or intermittently, during more than one-half
of the relevant year of income, unless the Commissioner is satisfied his/her usual place of
abode is outside of Australia and he/she does not intend to take up residence in Australia.
(The 183 Day Rule.)
● Is an eligible employee for the purposes of the Superannuation Act 1976 or is the spouse
or the child under sixteen years of age of that person. (The Super Fund Rule.)

Reading activity
ATH: para 2 050.

Rule 1: Resident of Australia (Common Law Test)


As far as the general law is concerned, residency, unlike domicile, does not have a single
concept in Australian law. ‘Residence may mean one thing for the purposes of founding
jurisdiction … over a defendant, another thing in taxation matters, and yet another thing in
matrimonial causes.’

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This part of the definition in s 6(1) uses the word ‘resides’ in the ordinary sense of the term.
No further definition or clarification of ‘resides’ is given in the legislation, and thus case law
is required to determine the meaning of resides in the ordinary sense and all the relevant
factors about a taxpayer must be weighed to arrive at a conclusion. ‘Reside’ is defined in the
Oxford English dictionary as:

….to dwell permanently, or for a considerable period of time, to have one’s settled or
usual abode, to live in or at a particular place.....

This is an accepted interpretation of ‘reside’ and is supported by Viscount Cave in Levene v


IRC [1928] AC 217:

… to dwell permanently or for a considerable time, to have one’s settled or usual abode,
to live in or at a particular place … He is not the less resident there because from time to
time he leaves it for the purposes of business or pleasure.

(Source: p. 222)

This definition may assist the courts with the meaning of reside, but it is inescapable that the
facts of each case will determine the ultimate outcome and application of such a definition.

Even so, the courts have considered various relevant matters to determine a person’s
residence. No one factor is decisive in itself nor is the list exhaustive. Taken as a whole, these
factors assist in determining resident status.

Factors determining resident status when using the Common Law Test
The various factors considered to determine if a taxpayer is a resident of a particular country
are:

● whether the taxpayer is physically present in that country at some time during the year of
income
● the nationality of the taxpayer
● the history of the taxpayer’s residence
● the taxpayer’s mode of life
● if the taxpayer is a visitor to the country, the frequency, regularity and duration of visits
and the purpose of the visits
● if the person is outside the country for part of the relevant year of income, the purpose of
the absence
● the family and business ties which the taxpayer has with the particular country
● whether a place of abode is maintained by the taxpayer in the relevant country or is
available for the taxpayer’s use while he is there.

The importance of each of these factors will vary from case to case. The Commissioner
supports the application of the above factors in Taxation Ruling TR 98/17.

The common law test applies for the period of time the taxpayer ‘resides’ in Australia – eg if
a person who immigrates to Australia arrives on 1 April 2014, the person is a resident from
that date, Case B2 (1951) 2 TBRD 15. Later cases before the AAT have clearly indicated this
is how the courts are applying the test. Case T41, 86 ATC 336 clearly shows how the timing
applies.

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Taxation Ruling TR 98/17

The Commissioner in Taxation Ruling TR 98/17 discusses what he considers the term
‘reside’ to mean. The Ruling provides the Commissioner’s interpretation of the ordinary
meaning of the word ‘resides’. The Ruling applies to most individuals entering Australia
including:

● migrants (also refer to Taxation Ruling IT 2681 ‘Income tax: residency status of business
migrants’)
● academics teaching or studying in Australia
● students studying in Australia
● visitors on holiday
● workers with pre-arranged employment contracts.

The Ruling does not apply to Australian resident individuals returning to Australia after
a temporary stay overseas where the individuals remained Australian residents while they
were overseas. The discussion in Taxation Ruling TR 98/17 relates primarily to whether a
person could be considered to normally reside in Australia – The Common Law Test. It is
noted that the Ruling can also be considered when reviewing the 183 Day Rule (Second
Statutory Test) which is discussed later.

Reading activity
ATH: para 2 060.

ATO Web Site (<http://www.ato.gov.au/>):


Taxation Ruling TR 98/17 and Taxation Ruling IT 2681
These rulings are an important resource.

Rule 2: The Domicile Rule


There are two separate parts to this rule, and each must be understood:

● Domicile – a person must have a domicile in Australia; and


● Permanent place of abode – they must not have established a permanent place of abode
overseas.

Domicile

A person’s domicile is the legal relationship between that person and a territory with a
distinctive legal system which invokes that system as his personal law: Henderson v
Henderson (1965) 1 All ER 179 at pages 180–1. Put another way, a person’s domicile is the
place which is considered by law to be the person’s permanent home: Udny v Udny (1869)
LR 1 HL (Sc) 441.

By law each person has a domicile; however, they may only have one domicile at any one
point in time. Common Law established three types of domicile:

● Domicile of origin...generally where a person was born and brought up.


● Domicile of choice …. generally the place where a person chooses to live.

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● Domicile of dependence... a person under 18 years will take the domicile of their parent
or guardian.

For Federal law purposes the common law has been replaced by the Domicile Act 1982 (Cth).
If a taxpayer satisfies one of the above types of domicile then that aspect of the domicile rule
has been satisfied.

Permanent place of abode

Lord Campbell, CJ in R v Hammond (1852) ER 1477 at page 1480 expressed it as ‘A man’s


residence, where he lives with his family and sleeps at night, is always his place of abode in
the full sense of that expression’.

Abode is the place in which one lives, one’s home. The leading case in Australia which
determines this question is FCT v Applegate (1979) 9 ATR 899; 79 ATC 4307. This is an
important case which should be well understood.

Reading activity
ATC: FCT v Applegate (1979) 9ATR 899; 79 ATC 4307.

One point remained unclear after the decision in Applegate’s case - how important is the
length of time the taxpayer expected to be away from Australia? This was explored in FCT v
Jenkins (1982) 12 ATR 745.

Reading activity
ATC: FCT v Jenkins (1982) 12 ATR 745.

The difference in the facts of this case over that of Applegate’s case can be summarised as
follows:

● the taxpayer still retained property in Australia


● the taxpayer still retained a bank account in Australia
● the taxpayer’s appointment to the New Hebrides was for a fixed term.

A critical fact in favour of the taxpayer in Applegate’s case was the indefinite duration of his
stay. As such, it was not possible to point to some place in Australia as his permanent place
of abode. However, in Jenkins’ case, the facts indicated the taxpayer did not have such an
intention to remain indefinitely in Vila and retained property in Australia, but was still able to
establish non-resident status through having a permanent place of abode in the New Hebrides
for a defined period of time.

Income Tax Ruling IT 2650 - Permanent place of abode


The Commissioner of Taxation has issued Income Tax Ruling IT 2650 which represents the
Australian Taxation Office’s (ATO’s) view of the law relating to the concept of a permanent
place of abode and the residence of individuals.

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Reading activity
ATH: para 2 070.

ATO Web Site: Taxation Ruling IT 2650.


This ruling is particularly important to read, especially paragraph 23 as
well as the examples at the end of the ruling.

Rule 3: 183 Day Rule


This rule specifies that a taxpayer will be a resident of Australia if they have been in
Australia for greater than 183 days either continuously or intermittently. This positive
component of the rule can be defeated only if the Commissioner is satisfied the usual place
of abode is outside Australia and the taxpayer does not intend to take up residence in
Australia.

The positive test is determined by counting down the hours to calculate the 183 day cut-off,
Wilkie v IRC (1952) 32 TC 495. If the calculation determines the taxpayer presence is for
greater than 183 days, then, by operation of s 6(a)(ii), the person is a resident for the whole of
the year of income unless the Commissioner is otherwise satisfied. Note that more recent
decisions would appear to suggest that a taxpayer will not necessarily be a resident for the
whole year if the test is satisfied but only from the time that they become a resident of
Australia.

Reading activity
ATC: Case 78 11 CTBR (OS) 232.

The 183 day rule was introduced in 1930 and was primarily directed to persons visiting or
staying in Australia for a short term – for example, visiting academics, teachers, students,
holiday makers etc. ‘The sub paragraph was not intended to classify persons as non-residents.
On the contrary it was intended to characterise certain persons as residents of Australia’.

Reading activity
ATC: Case S19, 85 ATC 225.

From the above reading you will see that the 183 day test applies to determine if a person has
commenced to reside in Australia, not if they have ceased to reside here. This simplifies
matters by restricting the application of the 183 day rule to persons arriving in Australia. It
will possibly apply where the other rules have failed.

Reading activity
ATH: para 2 080.

Taxation Ruling IT 2681 discusses the operation of the 183 day rule in some detail and
provides some useful practical applications and examples.

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Rule 4: The Super Fund Rule


This rule applies to ensure that diplomats, service personnel, government officials,
representatives of statutory authorities and their families (spouses and children under 16 years
of age) remain resident of Australia while posted abroad.

Reading activity
ATH: para 2 090.

Temporary Residents
Recently measures applicable to the taxation of temporary residents were introduced. These
measures essentially tax persons holding temporary entry visas in a manner similar to non-
residents with the exception that all salary and wage income (earned both in Australia and
outside of Australia) earned while a person is a temporary resident is assessable in Australia.
For capital gains tax purposes it is only CGT assets that are taxable Australia property that
are held by temporary residents that are subject to capital gains tax in Australia (same as non-
residents (foreign residents)).

Reading activity
ATH: para 2 100.

1.7.2 Companies
For Australian tax purposes a company is defined in s 995-1 to mean:

a. a body corporate
b. any other unincorporated association or body of persons

but does not include a partnership or a non-entity joint venture.

This is a wide definition.

Section 6(1)(b) of the ITAA 36 defines a resident company for tax purposes as:

● one that is incorporated in Australia or


● carries on business in Australia and has either:
– its central management or control in Australia or
– its voting power is controlled by shareholders who are residents of Australia.

The statutory definition extends the general law principle by including companies
incorporated in Australia regardless of where the central management and control is
exercised. The statutory definition of a resident company for tax purposes extends the
orginaly principles founded in the case of, De Beers Consolidated Mines Ltd v Howe [1906]
AC 455 in 1906.

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Reading activity
ATC: De Beers Consolidated Mines Ltd v Howe [1906] AC 455.

The Malayan Shipping Company Ltd v FCT (1946) 71 CLR 156 case dealt with a company
which was incorporated in Singapore but where the real control of the business was exercised
by an Australian resident in Australia. The case went on to hold that due to the importance of
the central management and control to that company it was considered to be carrying on a
business where its central management and control was located. The Commissioner in
Taxation Ruling TR 2004/15 outlines how the Malayan Shipping Company case effects the
application of the statutory residence tests for companies and is therefore an important ruling
to read.

Reading activity
ATC: Malayan Shipping Company Ltd v FCT (1946) 71 CLR 156.

In Esquire Nominees Ltd v FCT all directors of the company were resident of Norfolk Island
where all company meetings took place. A firm of accountants in Australia influenced the
company decisions to such a degree that the Commissioner argued that the real management
and control was in Australia. Gibbs J in the High Court rejected the Commissioner’s
argument, concluding that even though the Australian accountants had power to exert
influence, the directors held the power to bind the company and could have rejected any
proposals made by the accountants. Thus the company was found not to be a resident of
Australia.

Reading activity
ATC: Esquire Nominees v FCT (1972) 3 ATR 105.

If the director’s meetings are not the real occasions for the exercise of the company control
and management, then the company need not be resident at the place where such meetings
occur, see Malayan Shipping Company case and Unit Constructions Company Ltd v Bullock
(1959) 3 All ER 831.

Reading activity
ATC: Unit Constructions Company Ltd v Bullock (1959) 3 All ER 831.

The De Beers case and the Malayan Shipping Company case provide the most comprehensive
guide to the issues to consider when determining the resident status of a company. Other
cases mentioned provide distinguishing characteristics which must also be considered.

The Commissioner has issued Taxation Ruling TR 2004/15 which discusses the residence of
companies not incorporated in Australia with particular reference to carrying on business in
Australia and central management and control. The ruling provides guidelines for
determining whether a company, not incorporated in Australia, is a resident of Australia
under the second statutory test in paragraph (b) of the definition of ‘resident’ or ‘resident of
Australia’ in subsection 6(1) in the ITAA 1936.

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Reading activity
ATO Website: Taxation Ruling TR 2004/15.

Reading activity
ATH: para 2 150 provides a good summary of the important concepts.

1.7.3 Partnerships and Trust estates


There are no specific rules in relation to determining the residency of partners in a
partnership and accordingly the normal rules of residency apply to the individual partners
(depending on whether they are companies or individuals). In relation to trusts s 95(2) of the
ITAA 36 provides as follows:

[Resident trust estate]

For the purposes of this Division, a trust estate shall be taken to be a resident trust estate in
relation to a year of income if:

(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.

This definition applies to trust estates whether the trustee is a natural person or a company.
Sub-paragraph (a) alone is capable of implying the statutory tests of residence contained in
s 6(1) of the ITAA for both individuals and companies.

Sub-paragraph (b) is a broad provision in that it applies if at any time the central management
and control of the trust estate is in Australia.

For capital gains tax (CGT) purposes a resident trust for CGT purposes is defined in s 995-1.
The test in s 995-1 applies to unit trusts as well as ordinary trusts.

Reading activity
ATH: paras 2 160 and 2 170.

Exercise 2
To test how you have understood some of the material in this part of the course
you may wish to try the self-assessment quiz on the Study Desk entitled
‘Australia’s taxing power – residence’.

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1.8 Source of income


Once the residence of the taxpayer has been established, the second step is determining the
source of any income. The ascertainment of the source of the income is important by virtue of
s 6-5. Australian residents are assessed on all income irrespective of its source. Foreign
residents are assessed only on Australian source income. Thus it is important to identify the
source of the income.

Source is a question of fact and degree. Again it is necessary to look at various cases to
ascertain the source of income. The concept ‘source of income’ was explained by Isaacs J (as
he then was) in Nathan v FC of T (1918) 25 CLR 183 wherein he said:

….The legislature in using the word ‘source’ meant, not a legal concept, but something
which a practical man would regard as a real source of income. Legal concepts must, of
course, enter into the question when we have to consider to whom a given source belongs.
But the ascertainment of the actual source of a given income is a practical, hard matter of
fact. (p. 189)....

It may be that in certain cases income will have a number of sources because the activities
involved in earning such income took place in a number of locations. An example of this
situation is the case of C of T (NSW) v Cam and Sons Ltd (1936) 36 SR (NSW) 544.

Reading activity
ATC: C of T (NSW) v Cam and Sons Ltd (1936) 36 SR (NSW) 544.

We shall now look specifically at the source of various types of receipts.

1.8.1 Income from personal services, wages and professional fees


The case of FCT v French (1957) AITR 76 is the leading authority on the determination of
the source of personal services income including salary and wages and professional fees.

Reading activity
ATC: FCT v French (1957) AITR 76.

The Full High Court held that the source of the income was where the work was performed,
i.e. New Zealand and, accordingly, the income was derived from sources out of Australia
within the meaning of (the now repealed) s 23(q). Although s 23(q) has been repealed the
primary significance of French’s case is on establishing the source of salary and wage income
being the location of the services performed, and not on whether it is assessable. If the facts
in French’s case were considered now it would be clear that given that French was an
Australian resident he will be assessed on income from all sources including earnings in New
Zealand. French’s case is very persuasive but not totally conclusive on this point, as can be
seen from a reading of the more recent case of FC of T v Mitchum (1965) 113 CLR 401.

Reading activity
ATC: FC of T v Mitchum (1965) 113 CLR 401.

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LAW3130 & 5230 Module 1 – Assessable Income

Although Mitchum’s case did not actually decide the source of the income in that case (the
High Court merely remitting the case to a lower Court, having decided that it is not an
absolutely strict rule that source of wages will be where the services are performed),
nevertheless, the following principles are apparent:

● The source of income from wages or remuneration is generally the place where the work
is performed.
● Where special skills are involved such as giving business advice (independent personal
services), acting or consulting (Mitchum’s case) the source of the income may be the
place where the contract was made.

The more recent case of FCT v Efstathakis 79 ATC 4256 which dealt with salary and wage
(dependant personal services) income confirmed the earlier decision in French’s case being
that the source of salary and wage income will be where the work is performed..

Reading activity
ATC: FCT v Efstathakis 79 ATC 4256.

The decision in Mitchum’s case will generally not have the effect of excluding personal
services income from having a source in Australia where Australia has entered into a Double
Tax Agreement with the country of residence of the taxpayer because the DTAs generally
provide a statutory source for such income. Australia has entered into DTAs with most of the
countries that it normally transacts business.

1.8.2 Trading or business profits


The source of trading or business profits is generally where the acts are carried out by the
trader including services rendered by themselves or employees or agents. If however, the
making of a contract is the most significant factor (not the performance of the contract) then
the place of making of the contract is the source (not the performance). The opposite is the
case if the performance is the most significant. See Thorpe Nominees Pty Ltd v FCT 88 ATC
4886 and C of T (NSW) v Cam & Sons Ltd (supra).

Reading activity
ATC: Thorpe Nominees Pty Ltd v FCT 88 ATC 4886.

The Thorpe Nominees case involved an elaborate scheme to move offshore the purchase and
sale of two parcels of land held by the principles Mr and Mrs Thorpe’s family company. The
land was ripe for subdivision. The Full Federal Court held that the source of the payment was
Australian. The attempt to artificially establish a foreign source was unsuccessful. The
making of the contract is not the only consideration. The Court looked to the substance of the
transactions and not only the form.

1.8.3 Interest
The source of interest income is generally where the obligation to pay the interest arose, i.e.
where the contract of loan or credit was made. The place where payment is made is also

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LAW3130 & 5230 Module 1 – Assessable Income

relevant. The primary authority on the source of interest income is the case of Studebaker
Corporation of Australasia Ltd v C of T (NSW) (1921) 29 CLR 225.

Reading activity
ATC: Studebaker Corporation of Australasia Ltd v C of T (NSW) (1921) 29
CLR 225.

The following case reading in relation to the Spotless Services case is interesting as it
involves deposits of funds in the Cook Islands. Although the main component of the High
Court’s discussion in Spotless Services Ltd case relates to the application of the Anti-
Avoidance provisions in Part 1VA of ITAA 36. For the purposes of this module you should
focus primarily on the Federal Court’s discussion of the source of the interest.

Reading activity
ATC: Spotless Services Ltd v FCT (1996) 34 ATR 183; 96 ATC 5201.

1.8.4 Dividends
The 1936 Act provides a statutory source rule through s 44(1). The effect is to include
dividends paid out of profits derived in Australia. This rule restates the general law principle
which has developed through case law.

Reading activity
The Act: s 44(1) ITAA 36.

Notwithstanding the statutory rule, the starting point in a discussion about the source of a
dividend is Nathan v FCT (1918) 25 CLR 183 .

Reading activity
ATC: Nathan v FCT (1918) 25 CLR 183.

1.8.5 Royalties
The meaning of ‘royalty’ is defined in s 6(1) of the ITAA. The definition is extensive but not
exhaustive. The general law proposes that the source of a royalty is the location of the
property (i.e. patents, copyrights, trademarks) out of which the royalty is derived. If the
royalty arose from the supply of information (technical know-how), an intangible form of
property, the general rule that dominates is that the source of the royalty is where the contract
to supply the information was made. A case which discussed the source of royalties was FCT
v United Aircraft Corporation (1943) 68 CLR 525.

This case dealt with a situation where an Australian company paid royalties to a company
resident in the United States for the use of registered patents and designs for aircraft engines
and parts. All contracts and payments were undertaken in New York. The Full High Court
held that the royalties did not constitute income derived from Australian sources and were
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LAW3130 & 5230 Module 1 – Assessable Income

therefore exempt from tax in Australia. Note that there are statutory source rules for royalties
in ss 6C and 6CA ITAA 36 which operate in association with the royalty withholding tax
provisions have the effect of over-riding the United Aircraft decision to some extent.

1.8.6 Rent
There is no specific statutory provision that provides for the source of rent. General law
provides only a general understanding that the source of receipts is either the location of the
property, the place of making the contract or, in the case of personal services, the place of
performance. Rent from real property would follow the general rule and be sourced at the
location of the property. Rental of chattels would apply the place of contract test as a general
rule.

1.8.7 Capital gains


Part 3-1 of the ITAA 97 deals in detail with the assessment of capital gains (see capital gains
tax module). Division 855 provides for the assessment of capital gains to non-residents on
CGT assets that are taxable Australian property. These assets are defined under s 855-15. The
major items specified are land, buildings situated in Australia and assets used in carrying on a
business through a permanent establishment in Australia. The effect of the provision is to
assess non-residents to capital gains arising from the acquisition and disposal of ‘CGT assets
that are taxable Australian property’. The module on capital gains tax deals specifically with
Capital Gains Tax on all assets.

Reading activity
ATH: paras 2 200 to 2 240 provide further information and examples in relation
to the source of income rules.

Exercise 3
To test how you have understood some of the material in this part of the course
you may wish to try the self-assessment quiz entitled ‘Australia’s taxing power –
source’. This quiz is part of the course material that is provided with this course.

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LAW3130 & 5230 Module 1 – Assessable Income

Self Assessment Questions 1.1

This brings you to the end of the first part of Module 1. Please complete the self-assessment
questions. To get the most out of the questions please prepare your own answers before
consulting the prepared solutions.

Residency and source

1. Nicholas, an accountant, aged 32, who has lived in Toowoomba all his life, worked for
Kingsco, an agricultural company which supplies seed and fertilisers to farmers in the
Darling Downs region. He had been feeling tired and run-down in July 2014 and went to
his doctor for a check-up. His doctor, upon examining Nicholas, declared that he was
suffering from ‘executive stress’ which was indirectly caused by the additional work that
Nicholas was doing up to that time. His doctor prescribed that Nicholas should take an
indefinite amount of time off from work to relax and regain his full health. Nicholas took
a period of extended leave from his employer and decided that while he was not working
he would visit and stay with relatives in the State of Iowa in the United States. His wife
Katherine and their two young children Eliza (4) and Tommy (2) travelled with him on
4 September 2014 to the USA.
The rental market for property was very good at the time that they left and they rented out
their home using the services of a real estate agent to collect the rent and manage the
property. The agent sent the net rent to Nicholas at his overseas address. Nicholas brought
his savings of $50 000 in cash with him which he invested in the Iowa Bank and retained
a bank account with the Australian National Bank (ANB) to enable dividends from his
shares in BHP to be deposited.
Nicholas started to feel better in a matter of three months or so and one day while he was
playing a game of golf the manager of Growco, a US local agricultural company, offered
him a job as company accountant. Nicholas was initially dubious about taking on work
too soon but eventually signed a contract on 1 January 2015 for an initial period of two
years with an option to continue for a further eighteen months. Around this time Nicholas
and his family moved out of his relatives’ home and took out a two-year lease on a house
in down town Des Moines.
Nicholas earnings for the year ended 30 June 2015 are as follows:
Salary paid by Kingsco Au$13 500.
Salary paid by Growco Au$29 000.
Interest paid by Iowa Bank Au$1850.
Dividends paid by BHP Au$2500 (fully franked).
Net rental income AUD $8500 (consisting of $10 000 income and $1500 of expenses).
Required:
Discuss whether Nicholas is a resident or non-resident of Australia during the different
periods of the 2015 income year. What would be the source of each item of income
earned by Nicholas during the 2015 income year? Support your answers with case and
legislative authority and where appropriate any other relevant authority. (Nicholas was
never employed by the Commonwealth Government.)

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LAW3130 & 5230 Module 1 – Assessable Income

2. Noel, 33 years old, a qualified painter, was born in Melbourne, Australia and had lived
there all his life until 1 July 2014. On 1 July 2014 he travelled to France to take up a
position managing the painting and maintenance of the Eiffel Tower in Paris. For the year
of income ending 30 June 2015 he was paid A$37 000 salary for his work on the Eiffel
Tower. His French employment contract is for 3 years and Noel has enjoyed the work so
much that he would like to extend his stay when the current contract finishes. Noel
expects to visit Australia for a holiday once or twice during the 3 years that he is away.
Noel has leased out his Melbourne home, taking out a 3 year lease agreement with the
tenants. He has received $11 300 in rental income from this property during the 2015
income year, having incurred tax-deductible expenses for the year of $2500. He has a
bank account with Eastpac Bank in Melbourne to receive the rent and also received
$10 000 in interest income during the year from a term deposit he has with the same
bank. He currently resides in a house attached to the Eiffel Tower as he is required by his
employer to supervise the night security staff. The house is provided by his employer and
he pays no rent for the use of the house. Noel used to declare that he was an ‘eternal
bachelor’ and has no Australian relatives other than his parents and one sister and one
brother who live in Melbourne. However, since arriving in Paris he has met Louise and
has fallen madly in love with her.
Required:
a. Advise Noel whether you would consider him to be a resident or non-resident of
Australia as provided by the definition in s 6(1) of the Income Tax Assessment Act
1936. In your discussion you should refer to decided cases and any other relevant
authority.
b. Indicate the source of the receipts for taxation purposes and the implications for
taxing such receipts based on your conclusion in part (a).
3. Peter, a computer systems programmer, lived in England at all times until he won a return
air ticket to travel to Australia in a competition at his local pub. Peter was delighted to get
the opportunity to travel to Australia and as the ticket was valid for 1 year he would be
able to spend up to 12 months in Australia. Peter travelled to Australia on 1 December
2014 and arrived in Perth where he spent 2 months before moving on to Melbourne.
In Melbourne his finances began to run low and he took a job with Compusys Ltd. He
had stayed in hotel accommodation in Perth but entered into a lease of an apartment in
Melbourne as he expected to be there for a while. As at 30 June 2015 Peter was very
happy to be working in Melbourne and is considering staying there at least until
1 December 2015 when his return ticket runs out.
Required:
Advise Peter whether you consider him to be a resident of Australian for tax purposes.
Quote any relevant case or legislative authority to support your advice.
4. Japco Ltd was incorporated in Japan in 1993 and all of the directors meetings are held in
Japan while the annual directors’ meeting is held in Fiji. The company’s main business is
selling computer equipment to Australian businesses. Most of the contracts for sale are
signed in Brisbane by the managing director who is an Australian resident. The managing
director makes all the decisions in relation to the contracts entered into by the company.
Required:
Advise the company whether you consider it to be a resident of Australia for tax
purposes. Cite any relevant authority to support your advice.
5. Italco Ltd was incorporated in Italy in 1991 and since its incorporation it has been a
100%-owned subsidiary of Romaco Ltd, an Italian resident company. Italco Ltd operates
a retail store in Sydney selling ladies’ fashion accessories. Enrico is the managing
director of Italco Ltd and he resides in Sydney. All the goods sold in the store are

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LAW3130 & 5230 Module 1 – Assessable Income

purchased from Italy. Various Italian manufacturers send Enrico their catalogues and
from those catalogues Enrico orders the goods from Italy. The purchase orders are signed
by Enrico in Sydney and he faxes them to Italy to the manufacturers.
Required:
Advise Enrico of the residence of Italco Ltd for Australian tax purposes and whether any
of the trading receipts derived in the store will be assessable in Australia. You should
make appropriate reference to case law and any relevant legislation.
6. Daniel, 28 years, was born in Australia and until 1 March 2015 he had always worked
and lived in Australia. During a trip to Paris for Christmas 2014 he met and fell in love
with Lisel, the girl of his dreams. He decided to move to Paris indefinitely to be close to
her. On his arrival in Paris he entered into a 24 month lease of a house in which he and
Lisel lived.
Daniel worked as an accountant in a practice in Toowoomba up to the time that he left.
There were no other accountants in the practice just two office staff who assisted him
with typing etc. Just before leaving for Paris on 1 March 2015 he sold his accounting
practice to Dominic and Dominic agreed to collect Daniel’s outstanding fees for work
done to 28 February 2015. Daniel did not sell his home in Toowoomba but rented it out to
tenants for $250 per week using a three year contract.
Daniel advises you that the following information may be relevant to determining his
Australian tax liability for the year ended 30 June 2015:
● A dividend of $3000 paid to Daniel on 24 September 2014 in respect of shares held
by him in a German wine company. A further dividend of $2000 paid to Daniel on
1 May 2015 in respect of the shares held by him in the German wine company. The
wine company only operates in Germany.
● Accounting fees of $100 000 received by Daniel up to 28 February 2015 and $15 000
collected by Dominic after 1 March 2015 but before 30 June 2015 in respect of work
performed by Daniel up to 28 February 2015.
● Salary and wages received by Daniel in the period 15 March 2015 to 30 June 2015 as
a consultant to a French firm dealing with Australian clients.
● Rental income of $4000 earned from renting his home from March to June 2015.
Required:
Advise Daniel of his residency status for Australian taxation purposes for the year ended
30 June 2015. Support your advice with reference to any relevant authority. Assuming
that Daniel became a non-resident for Australian tax purposes on 1 March 2015, advise
him in relation to whether the amounts received by him are subject to tax in Australia for
the year ended 30 June 2015. Support your advice with reference to any relevant
authority.
7. Claire, 28 years, is a marketing consultant who was born in Paris, France. She has been
operating a marketing agency in Paris for four years. In the current year of income she
entered into a contract with Ozzie Ltd an Australian company to market their products in
France. The negotiations for the contract took place over a two-month period in France
and the contracts were finally signed in Sydney on 4 September 2014. The contracts
provided that Claire would promote Ozzie’s goods in France and receive a 5%
commission on all sales made. The commission would be paid into Claire’s bank account
in Sydney.
During October, November and December 2014 Claire actively promoted Ozzie’s goods
to French retailers. She was very successful in her efforts and from January 2015 she
commenced to receive commission income. Total commission of $37 000 was paid to
Claire up to 30 June 2015 and all of this amount was deposited to her bank account in
Sydney. Claire always had a burning passion to visit Australia and decided on 18 January
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LAW3130 & 5230 Module 1 – Assessable Income

2015 that she would travel to Australia on six (6) months visitor’s visa for a holiday.
While she was in Australia she travelled widely and expects to return to France on
12 July 2015.
Required
Advise Claire as to whether she will be liable to tax in Australia on any of the
commission income. You discussion should primarily focus on determining the source of
the commission income and whether Claire is a resident of Australia for tax purposes.
Support your advice with reference to any relevant authority.

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LAW3130 & 5230 Module 1 – Assessable Income

1.9 The derivation of income


Reading activity
The Act: s 6-5.

Having determined a taxpayer or entities residency status and the relevant source of income,
the next step is determining when that income is derived. This is what is often referred to as
the timing of income. Determining when income is derived (timing) is important as it might
mean the difference between inclusion in a current or later tax year. This can be an important
timing advantage for tax planning. Section 6-5 contains the word ‘derived’ in the context of
including assessable income in a tax year when it is derived. The concept of derivation has
been the subject of many decided cases.

1.9.1 Application of the cash or accruals method of accounting


The traditional view is that income is derived when received (ie. on a cash basis) and it is
only in the situation of trading or business income that the accrual basis of accounting is
appropriate. The matching principle in accounting requires you to match revenue and
expenses in applying the accruals basis of accounting, i.e. adjustments are made at the end of
the accounting period so as to include debtors and creditors as well as adjustments to expense
and income accounts and the inclusion of the value of trading stock. Keep in mind that timing
rules for taxation purposes and accounting purposes can be different. Taxation rules are
specific in terms of when particular types of income are derived and the basis used for
accounting purposes is not necessarily relevant.

The Courts have frequently had to consider whether various occupations can be classified as
trading, personal services or carrying on of a business. In order to reach any firm conclusion
on this point it is necessary to study the facts and judgements of the following Australian
cases:

● Carden’s case (1938) 63 CLR 108


● Henderson’s case (1970) 1 ATR 596
● Firstenberg’s case (1976) 6 ATR 297
● Dunn’s case (1989) 20 ATR 356
● Barratt’s case (1992) 23 ATR 339.

Reading activity
ATC: Carden’s case (C of T (SA) v The Executor Trustee and Agency Co of
South Australia Ltd).

ATC: Henderson v FC of T 70 ATC 4016; 1 ATR 596.

ATC: Dormer v FC of T 2002 ATC 5078

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LAW3130 & 5230 Module 1 – Assessable Income

From the decisions in Carden’s case (person operating on their own) and Henderson’s case
(large partnership) you might draw the prima facie conclusion that:

● sole traders can use the Cash Basis


● partnerships must use the Accrual Basis.

The question then arises as to whether or not a sole professional such as a lawyer or an
accountant with some support staff could account for their income on a cash basis. This was
the subject of further litigation in FC of T v Firstenberg and FCT v Dunn.

Reading activity
ATC: FC of T v Firstenberg 76 ATC 4141; (1976) 6 ATR 297.

ATC: FC of T v Dunn 89 ATC 4141; (1989) 20 ATR 356.

It can be seen that while Firstenberg’s and Dunn’s cases deal with sole practitioners (with
some support staff) providing professional services they are very much different to
Henderson’s case because of the size and scale of the partnership in that case. In other words
they are at opposite ends of the spectrum in terms of size of professional practices. The case
of Barratt also addressed the issue of derivation.

Reading activity
ATC: Barratt & Ors v FC of T 92 ATC 4275; (1992) 23 ATR 339.

The court held that the accruals method of accounting was most appropriate because of the
large number of staff who performed the vast majority of the work of the practice and the
extensive nature and size of the business operation.

Where can the line be drawn so that one can ascertain with any degree of certainty whether
the cash or the accruals basis can be used for those taxpayers providing professional services?
Unfortunately, there is no definite answer to this question and in each case it is ‘a question of
fact’. Nevertheless, in determining what is the appropriate basis of accounting for a particular
entity the principles enunciated in the decided cases on the issue will need to be considered.

1.9.2 Commissioner’s opinion


The Commissioner has issued a Taxation Ruling TR 98/1 on the issue of the derivation of
income. Prior to the issue of this ruling the determination of which method of accounting, i.e.
either the cash/receipts or the earnings/accruals method of accounting, should be used by
certain taxpayers relied solely on case law. This ruling outlines the factors which the
Commissioner considers are relevant in determining when either method should be used.

Under the receipts method taxpayers derive income when it is received and taxpayers using
the accruals method derive income when it is earned. Determining which method to apply
depends on the characteristics of the taxpayer and the income. The ruling indicates that the
receipts method may be appropriate for:

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LAW3130 & 5230 Module 1 – Assessable Income

● income derived by an employee


● non-business income derived from the provision of knowledge or the exercise of skill
possessed by the taxpayer
● business income where the income is derived from the provision of knowledge or the
exercise of skill possessed by the taxpayer in the provision of services. However, the
presence of any of the following factors to a significant degree would indicate that the
income is not simply a reward for the provision of personal services by the taxpayer:
c. the taxpayer’s income-producing activities involve the sale of trading stock
d. the outgoings incurred by the taxpayer, in the day-to-day conduct of the business,
have a direct relationship to income derived
e. the taxpayer relies on circulating capital or consumables to produce income or
f. the taxpayer relies on staff or equipment to produce income.

The ruling states that the earnings method is generally appropriate to determine business
income derived from a trading or manufacturing business.

If a taxpayer has a number of income sources, the determination of which basis to use should
be applied to each of the income-earning activities and just because a taxpayer uses the
accruals basis for trading income does not necessarily mean that the same basis should be
used for all other income.

Reading activity
ATH: para 3 250 provides an important summary of the concepts discussion
above.

ATO Web Site: Taxation Ruling TR 98/1 provides some worked examples of
principles of derivation.

1.9.3 Meaning of the term ‘derived’


Once the issue of ascertaining the method to determine income is decided, i.e. whether or not
the cash or accruals method is the most appropriate to give a true reflection of the taxpayer’s
assessable income, the next question is in what circumstances money received will be
regarded as being derived. We will now look at the application of the word ‘derived’.

The Act does not define the word ‘derived’ but s 6-5(4) refers to circumstances in which
income will be ‘deemed’ to be derived. The purpose of s 6-5(4) is to prevent a taxpayer
escaping tax, by the taxpayer avoiding actual receipt of the income but still having power to
control or direct where the income is to be employed.

Brent’s case discussed in detail the meaning of ‘derived’. In Brent v FC of T, the taxpayer
sold her memoirs for $65 250 of which only $10 000 was received during the 1970 income
year.

The High Court in this case held that because the nature of the receipt was a reward for
services performed by the taxpayer it could be classified in the nature of salary and wages.
Because the nature of the receipt was salary and wages the income should be derived on a
cash or receipts basis and, accordingly, only the amount received should be assessable. The
court held that all that had happened in this case was that the company had refrained from
making the payment and the taxpayer did not demand payment.
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LAW3130 & 5230 Module 1 – Assessable Income

Another case that highlights the timing of the derivation of income is Arthur Murray (NSW)
Pty Ltd v Federal Commissioner of Taxation (1965) 114 CLR 314. In this case, the taxpayer
company carried on a business of teaching dancing for fees of varying amounts per hour. The
question addressed by the Full High Court was whether the prepaid tuition fees were derived
by the taxpayer in the year the tuition was provided or in the year the fees were received.

The Court held on the basis of the facts that the taxpayer derived the prepaid tuition fees in
the year in which the tuition was provided rather than in the year in which the fees were
received. This was primarily due to the particular practices of the school and their refund
policy.

Another issue in ascertaining the derivation of income arises where goods are paid for over a
period of time, e.g. term sales, hire purchase. This question was decided in the J Rowe & Son
Pty Ltd case. In this case the taxpayer conducted a retail store and sold household goods on a
deferred payment basis. The issue addressed by the High Court was whether the full price of
goods sold on credit should be included in assessable income.

In summary, the general principles of income derivation are that trading income is derived on
the accruals basis, wages and salaries on a cash basis, rent and interest generally on a cash
basis with some exceptions, dividends when paid or credited to shareholders and, as we have
seen from the foregoing discussion, it will depend on the facts of the case as to how the
income from services will be treated. A full discussion of the principles of derivation is
provided in the following reading.

Reading activity
ATC: Brent v FC of T 71 ATC 4195; (1971) 2 ATR 563.

ATC: Arthur Murray (NSW) Pty Ltd v Federal Commissioner of Taxation


(1965) 114 CLR 314.

ATC: J Rowe & Son Pty Ltd v Federal Commissioner of Taxation 71 ATC
4001; (1970) 2 ATR 497.

ATH: paras 3 260 to 3 380.

Exercise 4
To test how you have understood some of the material in this part of the course
you may wish to try the self-assessment quiz on the Study Desk entitled
‘Derivation of income’.

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LAW3130 & 5230 Module 1 – Assessable Income

1.10 Assessable income – Ordinary Income


The Australian income tax system imposes a tax on ‘taxable income’. Taxable income is
calculated as ‘assessable income’ less ‘allowable deductions’. As outlined at the outset,
‘assessable income’ is comprised of both ‘ordinary income’ and ‘statury income’. Ordinary
income is termed as such because there is nowhere in the legislation that the term ‘income’ is
defined. As such, it is necessary to look at the ordinary meaning of income. A good definition
is contained in the decision of Jordan CJ in Scott v C of T (NSW) (1933) SR (NSW) 215 at
219.

Reading activity
ATC: Scott v C of T (NSW) (1933) SR (NSW) 215.

The most common problem faced in relation to determining ordinary income is the
distinction drawn between income and capital when there is a one-off, isolated or large value
transation or where there is an unusal or out of the ordinary transaction as part of a business.
Other valid distinctions you may come across are in relation to whether gifts, windfall gains
or the proceeds of a hobby are ordinary income or not.

1.10.1 Key features of ordinary income


The following section reviews some of the characteristics that are normally exhibited by
income according to ordinary concepts:

● income must be received by the taxpayer for their own benefit. This requires that there is
an actual gain recognised
● income must be money or money’s worth – requires a receipt of money or something that
is capable of being converted into money. If an amount is not convertible into money, it is
unlikely to be income according to ordinary concepts. This was confirmed in the decision
of FC of T v Cooke & Sherden 80 ATC 4140.

Reading activity
ATC: FC of T v Cooke & Sherden 80 ATC 4140.

Note that to circumvent the decision in the Cooke and Sherden case s 21A was introduced
to treat a non-cash business benefit as if it were convertible into cash. However, for non-
cash benefits received outside of a business relationship such receipts may not be
assessable. Consideration of Fringe Benefits Tax may be required however where a non-
cash benefit is provided and there is an employment relationship.

● Income must be received as income – requires that the receipt is characterised from the
perspective of the recipient. The case of Calvert (Insp of Taxes) v Wainwright (1947) 27
TC 475 held that tips received by a taxi driver were assessable income. The saving of an
outgoing is not necessarily income as was decided in the case of FC of T v Orica Ltd 98
ATC 4494.

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LAW3130 & 5230 Module 1 – Assessable Income

Reading activity
ATC: Calvert (Insp of Taxes) v Wainwright (1947) 27 TC 475.

ATC: FC of T v Orica Ltd 98 ATC 4494.

● Income will often exhibit periodicity, recurrence and regularity – requires some sort
of regular receipt such as salary and wages paid on a weekly basis. However, a lump-sum
amount may also be income.
● The normal proceeds of personal exertion, property or business are income while
windfall gains are not – requires that income is a reward for effort or the use of assets.
Windfall gains which are the result of chance are not income.
● In the case of Integrated Insurance Planning Pty Ltd & Anor v FC of T 2004 ATC 4054
the Federal Court held that the forgiveness of a loan was income. In that particular case
the loans were forgiven because the taxpayer achieved certain pre-determined
performance standards. When the waived amounts came into the hands of the taxpayers
they were entitled to them because they were an incident of that business which they had
carried on. Despite their infrequency and irregularity, by their intimate connection with
that business they were therefore in the character of income.
● Compensation receipts may be income, as in the case of where an individual receives an
amount to compensate them for the loss of income. However, compensation for the loss
of a capital asset (eg the loss of a limb) is not income according to ordinary concepts. See
Whitaker v FC of T 98 ATC 4285.
● A reimbursement of a deductible expense will not automatically be income, especially if
the amount is received by an individual taxpayer who is not carrying on a business. The
case of FCT v Rowe 97 ATC 4317 explored this issue in detail and the Full High Court
held that a taxpayer should not include in his assessable income the reimbursement of an
amount previously claimed as a deduction. Note that where a business receives a
reimbursement the situation is difference and it is likely to be assessable as was the case
in HR Sinclair & Son Pty Ltd v FC of T (1966) 114 CLR 537.
● Illegal or immoral receipts may be income. In other words, even if the activity from
which the receipt is derived is against the law, the receipt may still be income. Two cases
which discussed this issue were Partridge v Mallandaine (Surveyor of Taxes) (1886)
2 TC 179 and Lindsay & Ors v Inland Revenue Commissioners (1933) 18 TC 43.

Reading activity
ATC: Partridge v Mallandaine (Surveyor of Taxes) (1886) 2 TC 179 and
Lindsay & Ors v Inland Revenue Commissioners (1933) 18 TC 43.

● Capital gains are not ordinary income. They may, however, be assessable under the
capital gains provisions and are thus classified as statutory income (see the module on
‘Capital gains tax’).
● Mutual receipts are not income. Mutual receipts are a form of non-income where a
person’s money is returned to them. Many examples of the mutuality principle are found
in clubs and associations. See Bohemians Club v Acting F C of T (1918) 24 CLR 334.

Reading activity
ATC: Bohemians Club v Acting F C of T (1918) 24 CLR 334.

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LAW3130 & 5230 Module 1 – Assessable Income

ATH: paras 3 010 to 3 050 of your text extend this discussion on key features of
ordinary income and provide important further details.

1.11 Classes of income


Having convered some important intital principles of ordinary income, when faced with a
more complex factual scenario it helps to determine firstly the broad class of income you are
dealing with. This can help determine which specific cases and principles are most
applicable. There are three broad classes of income:

● income from personal services


● income from property
● income from business.

1.11.1 Personal services income


This includes receipts such as employee’s wages, remuneration paid to an independent
contractor and fees paid to professional persons.

Not every payment received by an employee will be assessable as income even if paid by the
employer. An issue may arise as to whether any payment is income or perhaps a genuine gift
which does not relate to services rendered under an employment agreement.

Gifts given pursuant to an employment relationship will be assessable as income if given in a


cash form but may give rise to taxable fringe benefits if given in a non-cash form.

Please read the cases listed in the reading activity where the issue of ‘income’ from personal
services has been considered. The cases consider a range of issues such as whether shares
from a previous employer were considered ordinary income. They also consider unsolicited
gifts from employers and inducement payments. Note also the case regarding the
sportsperson which deals both with whether income from personal exertion (sport) is ordinary
income and also whether sportspersons are considered carrying on a business.

Reading activity
ATC: FCT v Dixon (1952) 5 AITR 443.
ATC: Hayes v FCT (1956) 6 AITR 248.
ATC: Scott v FCT (1967) 10 AITR 290.
ATC: FCT v Harris (1980) 43 FLR 36.
ATC: Kelly v FC of T 85 ATC 4283.
ATC: Stone v FCT 2005 ATC 4234.

In summarise, in relation to income from personal sources, the following factors are relevant
in determining a receipt is income in the hands of the recipient:

● Is the payment a periodic or regular payment?


● Are the payments relied upon for regular living expenses or support?
● Is the payment referable to the performance of any services?

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LAW3130 & 5230 Module 1 – Assessable Income

● Is the payment in substitution of any income amounts?


● The motivation of the donor (relevant but not decisive).
● If the payment is referable to goodwill, what is the source of the goodwill (compare a
Christmas bonus to an employee to the gift in Scott’s case).

To characterise a receipt as income, not all of these factors need be present; it will be a
question of weighing the factors to properly characterise the receipt.

Reading activity
ATH: paras 4 010 to 4 130 and 6 500 to 6 640. These readings cover some
important additional concepts particularly in relation to windfall gains, not
discussed in the cases above.

1.11.2 Income from property


Income from property is income derived by a taxpayer from the use or enjoyment of property
or assets by some other person.

The major items of income from property are interest, rent, royalties and dividends. Your text
book provides good discussion in this area.

Reading activity
ATH: paras 6 250 to 6 360.

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LAW3130 & 5230 Module 1 – Assessable Income

1.12 Business Income


We have now covered some of the basic principles of ordinary income and the broad rules for
income from personal services and income from property. However, for more complex
transactions, particularly in the context of business income, it is important that you develop
the skill to differentiate between income and capital receipts. Although you may determine an
amount to be capital in nature rather than ordinary income, this does not mean the amount is
not assessable. If you determine an amount is capital rather than ordinary income, it is still
likely to be assessable under the capital gains tax legislation. However, keep in mind, that
items assessed under capital gains provisions are calculated differently and in some instances
more favourably to the taxpayer, so the distinction between ordinary income and capital
remains very important.

1.12.1 Income from isolated transactions of a business


The case of FCT v Whitfords Beach Pty Ltd (1981-82) 150CLR 355 confirmed the principle
that a profit arising from an isolated transaction could be assessable as income under
s 6-5(25(1)). It is arguable whether a correct view of the case is that it establishes that profit
from an isolated transaction can be assessable as income or that an isolated transaction may
constitute a business. The case did in any event expand the scope of s 6-5 and the concept of
income with the result that it is increasingly difficult for a taxpayer to argue that a particular
gain is capital because it arises from the ‘mere realisation’ of a capital asset. This decision
has been referred to in numerous subsequent cases.

Reading activity
ATC: FCT v Whitfords Beach Pty Ltd (1981-82) 150 CLR 355.

The Whitfords Beach case involved a consideration of a former section, s 26(a), as well as
s 6-5(25(1)). Section 26(a) was repealed in 1984 and replaced with s 15-15(25A) which was
intended for the similar purpose of specifically making assessable, as income, profit arising
from the sale of property acquired for re-sale at a profit or from profit-making undertakings
or schemes.

An issue in relation to s 15-15(25A) and/or s 6-5(25(1)) will often be whether an isolated


transaction is a profit-making undertaking or scheme, an adventure in the nature of trade or
business, or the mere advantageous realisation of a capital asset.

One of the tests of ‘business’ is sustained activity or repetition of transactions but this factor
must always be considered in the context of the nature of the activity and does not imply that
a single transaction cannot constitute a business venture.

In the Whitfords Beach case the taxpayer company had purchased land in 1954. The land was
initially acquired so that shareholders who owned adjacent land could continue to enjoy
direct access to the beach. The land increased in value and in 1967, instead of selling the
land, the shareholders sold their shares in the taxpayer company. The new shareholders
changed the Articles and Memorandum of the taxpayer and proceeded to develop the land
which was the taxpayer’s only asset. The land was rezoned, subdivided and developed, with
the construction of road works and head works providing all services. The total profit to the
company was approximately $7m which the Commissioner sought to assess as either income

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LAW3130 & 5230 Module 1 – Assessable Income

under s 6-5(25(1)) or a profit from a profit-making undertaking or scheme under the former
s 26(a).

The taxpayer argued that the profit resulted from the mere realisation of the company’s only
asset. The High Court unanimously upheld the Commissioner’s assessment that the profit
was assessable income under s 6-5(25(1)).

In the Whitfords Beach decision reference to Scottish Australian Mining Company Ltd v FC
of T (1950) 81 CLR 188 was made. The court distinguished the facts of Whitfords Beach
from the facts in Scottish Australian Mining Company Ltd v FC of T (1950) 81 CLR 188 on
the basis that the land in the Scottish Australian Mining case was purchased for the purpose
of mining.

Reading activity
ATC: Scottish Australian Mining Company Ltd v FC of T (1950) 81 CLR 188.

Two other cases which are relevant to this area are Californian Copper Syndicate Ltd v
Harris (Surveyor of Taxes) 5 TC 159 and Statham & Anor v FC of T 89 ATC 4070. See also
McCorkell v FC of T 98 ATC 2199 where on similar facts to Statham the AAT held that the
sale proceeds from selling a commercial orchard were not assessable as ordinary income.

Reading activity
ATC: Californian Copper Syndicate Ltd v Harris (Surveyor of Taxes) 5 TC 159
ATC: Statham & Anor v FC of T 89 ATC 4070.

A very important case in this area of the law is FCT v Myer Emporium (1987) 163 CLR 199.
In that case the taxpayer entered into a series of financing transactions whereby it lent $80m
to a subsidiary at interest and then assigned the right to the future interest income stream to a
bank for a lump sum of $45m. The assignment was done on an arm’s-length basis. The
Commissioner assessed the $45m as being profit on the transaction and assessable as income.
The High Court upheld the assessment and found that the amount was income.

Reading activity
ATC: FCT v Myer Emporium (1987) 163 CLR 199.

The following propositions emerge from the decision:

● Although a profit or gain made in the ordinary course of carrying on a business will be
income, it does not follow that a profit or gain made from a transaction not in the ordinary
course of business is not income.
● Generally speaking, 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, that profit or gain will be income despite the fact that the transaction was
extraordinary when judged by reference to the ordinary course of the taxpayer’s business.
● Profits derived in a business operation, or commercial transaction carrying out any profit-
making scheme will be income while the proceeds of a mere realisation or change of
investment or from an enhancement of capital are generally not income.
● Considerations such as periodicity, regularity and recurrence of a receipt may assist in
categorising receipts as income or capital in conventional situations, however, their
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LAW3130 & 5230 Module 1 – Assessable Income

significance is diminished when the receipt in question is generated in the course of


carrying on a business.

Although the transactions were outside the taxpayer’s ordinary course of business, that fact
did not take the receipt outside of its profit-making business. If a taxpayer makes a profit out
of an extraordinary transaction which is at least ancillary to a continuing business and
referable to the intention to make a profit, then, even if it is an isolated and novel transaction,
the profit will be assessable as income under s 6-5.

In the case of Westfield v FCT 91 ATC 4234 the taxpayer was in the business of constructing
and developing shopping centres which it managed and from which it derived lease income.
The taxpayer acquired land with the long-term aims of developing a shopping centre with a
joint-venturer. The taxpayer then sold the land to the joint-venturer and realised a profit on
the sale of about $267 000. The Commissioner of Taxation sought to assess this amount as
income and relied upon the Myer case. The Full Federal Court found for the taxpayer and
confirmed that the relevant amount was not assessable because the land was not purchased or
held for the purpose of sale in the ordinary course of business. It should be pointed out,
however, that this case was decided in relation to a transaction which took place prior to the
introduction of capital gains tax and it is very likely that it would now be subject to capital
gains tax provisions (see the module on ‘Capital gains tax’).

Reading activity
ATC: Westfield v FCT (1991) 91 ATC 4234.

The Commissioner of Taxation has issued Taxation Ruling TR 92/3 – Profits on Isolated
Transactions, to explain his view of the law as it applies to profits from isolated transactions.
It should be read critically and with caution.

In the case of FCT v Cooling (1990) 21 ATR 13 the Full Federal Court found that a lump-
sum lease incentive payment made to a partner in a law firm to induce the firm to move
business premises and enter into a new lease was assessable as income. It was a unique
transaction but within the ordinary course of business operations in that it involved relocating
business operations. The case might not be considered authority for the proposition that any
receipt in the course of business will be income. In Cooling’s case there was a clear profit
motive to the structure of the transaction whereby partners took purportedly capital incentives
in preference to a range of ‘revenue-neutral’ lease incentives involving rent holidays or
assistance with structural fit-outs which were also available to the firm but were not taken.

Reading activity
ATC: FCT v Cooling (1990) 21 ATR 13.

It is interesting to note that this case discussed the application of capital gains tax and
indicates the emerging relevance of capital gains tax rather than s 15-15(25A). There has
been a significant number of cases which have considered the issue of the assessability of
lease incentives and in cases such as Lees & Leech Pty Ltd v FC of T 97 ATC 4407 and
Selleck v FC of T 97 ATC 4856 it was held that a lease incentive was not assessable as
income. In neither of these cases could the courts find a sufficient profit motive and
accordingly distinguished Cooling’s case. However in the decision handed down by the High
Court in FC of T v Montgomery 99 ATC 4749 the Court held that a lease incentive paid to a
law firm to enter into a lease of a premises was assessable income. In coming to its
conclusion the Court considered that the receipt of the lease incentive was just part of

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LAW3130 & 5230 Module 1 – Assessable Income

carrying on its business and in coming to its decision made reference to the decision in
Cooling.

Reading activity
ATH: paras 3 100 to 130 and also 6 400 to 6 460.

ATC: Lees & Leech Pty Ltd v FC of T 97 ATC 4407,


ATC: Selleck v FC of T 97 ATC 4856
ATC: FC of T v Montgomery 99 ATC 4749

1.12.2 Further examples of distinguishing between capital and income


As discussed earlier, usually periodical/regular receipts tend to fall into the category of
income, with lump-sum receipts usually ending up as capital or distinghised as discussed in
the previous section.

However, it is worth examining a series of nine separate categories of receipts which provide
a wealth of case precedents highlighting decisions relevant to the question of income versus
capital. If you examine the following examples carefully, you will notice that the court
decisions build a pattern of precedents which enable consistent interpretation of what
constitutes capital and income.

1. Receipt for cancellation or variation of forward trade contracts


Generally speaking, amounts received in connection with the cancellation of contracts made
in the course of carrying on business are in the nature of income. Thus compensation received
by the taxpayer for cancelling or varying trade contracts is usually classified as assessable
income.

For example, in the case of Short Bros Ltd v I R Commissioners (1927) 12 TC 955 a sum
received for the cancellation of a contract to build ships was found to be a receipt of income
in the ordinary course of the company’s trade.

In the same way, the case of IR Commissioners v North Fleet Coal & Ballast Co Ltd (1927)
decided that a lump sum, received by a quarry company for relieving a purchaser from his
contract to purchase a quantity of chalk annually for a period of ten years and to build a wharf
at which it could be loaded, was held to be a trading profit.

In both cases the receipts were in the form of lump-sum payments but were still deemed to be
receipts of an income nature. The result of the decisions was that the recipients were liable to
taxation on the income. These cases should act as a warning that not all lump-sum receipts
are of a capital nature. The cases of Heavy Minerals Pty Ltd v FCT (1966) 10 AITR 140 and
also Californian Oil Products Ltd (in Liq) v FCT (1934) 52 CLR 28 discuss this issue.

Reading activity
ATC: Heavy Minerals Pty Ltd v FCT (1966) 10 AITR 140.

ATC: Californian Oil Products Ltd (in Liq) v FCT (1934) 52 CLR 28.

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LAW3130 & 5230 Module 1 – Assessable Income

2. Receipt for cancellation, assignment, etc of agency agreements


Receipts for cancellation, assignment, etc. of agency agreements may be either capital or
income. The logic behind this is that if such a cancellation tends to be outside the normal
trading activities of the business, it will be deemed that any resulting compensation for the
cancellation will be a capital receipt. However, if such cancellations are frequent, it will be
deemed that this is a normal pattern of trading and any resulting compensation will be
classified as income through the normal course of business.

For example, in the case of Chibbett v Joseph Robinson & Son (1924) 9 TC 48, the
respondents, a firm of ship managers, managed the business of a steamship company in
accordance with the provisions of the latter company’s Articles of Association. The
respondent’s income was almost wholly derived from this source. The steamship company
went into voluntary liquidation and authorised the liquidator to transfer bonds worth £50 000
to the respondents as compensation. The Court decided that such compensation was not a part
of the profit arising from the respondent’s business as ship managers and therefore was not an
assessable profit.

Notice in the preceding case that the compensation was in the form of a lump-sum payment.
This in itself is an indication that the receipt was of a capital nature. However, even in this
situation where the compensation is in the form of a lump-sum receipt, such receipts will still
be deemed as income if such compensations are found to be a normal part of the trading
activities of the business or the amount replaces another assessable amount. Such was not the
case in Chibbett v Robinson. The case of Van den Bergh’s Ltd v Clarke (1935) TC 390 offers
more insight on this issue.

Reading activity
ATC: Van den Bergh’s Ltd v Clarke (1935) TC 390.

3. Receipts for the sterilisation of assets


This is an interesting concept as it has been established through a number of case decisions
that in situations where taxpayers lose income-earning assets and are compensated for such a
loss, the compensation receipts are usually deemed to be of a capital nature, and therefore not
assessable. For instance, in Glenboig Fireclay Co Ltd v IRC (1922) 12 TC 427, a Fireclay
company had to forfeit access to certain quarry lands which were in close proximity to a
railway.

Reading activity
ATC: Glenboig Fireclay Co Ltd v IRC (1922) 12 TC 427.

The compensation received by the company was deemed by the Courts to be a capital receipt
on the ground that it was payment for the sterilisation of a capital asset. In the case of FC of T
v Sydney Refractive Surgery Centre Pty Ltd (2010) FCAFC 190 the Federal Court held that
compensation for a defamation action calculated on the basis of lost profits was considered to
be a receipt of capital because the compensation was received in relation to the reduction in
value of a capital asset being goodwill.

Reading activity
ATC: FC of T v Sydney Refractive Surgery Centre Pty Ltd (2010) FCAFC 190

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LAW3130 & 5230 Module 1 – Assessable Income

4. Receipts relating to contracts involving restricted covenants


Such receipts are interesting because they relate to restrictive trading contracts which are not
enforceable unless they are reasonable in both time and distance. It is common for such
contracts to be entered into when senior partners or executives of firms leave their position
within an organisation. The contract frequently takes the form of compensation being paid to
them on the understanding that they will not compete with the previous employing
organisation for a reasonable period of time (generally a number of years) and within a
reasonable distance.

Such receipts are often deemed to be of a capital nature, and therefore not subject to taxation
as ordinary income, but may be taxable capital gains. However, the Australian Taxation
Office, and the Courts in particular, will carefully examine the circumstances of each
individual case to determine what the original intention was for the parties involved in the
contract and the following cases disclose situations in which the Courts’ decisions varied.

Case A14 (1969) 69 ATC 80 concerned a professional footballer’s restrictive covenant. A


footballer of international standard, with the help of a solicitor experienced in such matters,
negotiated a very good contract with a Sydney rugby league club, under which he was, for a
signing-on fee of £5400 payable in three annual instalments plus match fees, to play football
for the club for three years, and thereafter, or on the earlier termination of the contract, he
covenanted, for £4600, that he would not play with any other Sydney club for three further
years. The Board of Review, by majority, confirmed the Commissioner’s assessment of an
instalment of the £4600, in effect on the ground that the purported dissection of the
consideration negotiated as a lump sum was a sham and, in substance, the payments for the
‘restrictive covenant’ were just as much rewards of professional football as were the
instalments of signing-on fee and the match fees. The dissenting member, on the other hand,
considered the agreement and the contract evidencing it to be genuine and the restrictive
covenant to be real and far from redundant. He thought that the principle in Beak v Robson
(1942) 25 TC 33 governed the matter.

In Beak v Robson (1942) 25 TC 33 a taxpayer received a lump-sum payment in consideration


for agreeing not to be involved for five years after the termination of employment in any
competing business within 50 miles of the current employer’s premises. The payment was not
considered to be a reward for services rendered or to be rendered, but for agreeing to restrict
his right to perform services for others in the future. Another case which dealt with a
footballer was FC of T v Woite 82 ATC 4578.

Reading activity
ATC: FC of T v Woite 82 ATC 4578.

In this case a footballer, in consideration of receiving $10 000, restricted his rights to play for
a particular club in Victoria should he decide to play football in Victoria. The footballer never
played football in Victoria and the Supreme Court of South Australia held that the amount
received was not assessable. The Court did go on to say that if he did play for the particular
club, the amount received would be very likely to be income.

In Jarrold v Boustead (1964) 41 TC 701 a rugby union footballer who received a sign-on fee
was characterised as being compensation for giving up the taxpayer’s amateur status, and
therefore not as remuneration for services to be rendered. Consequently it was a capital
receipt. The situation may be different where a taxpayer is already a professional player, as a
sign-on or similar payment may be considered to be a normal incident of the taxpayer’s
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LAW3130 & 5230 Module 1 – Assessable Income

income-earning activities (see Case R107 84 ATC 717). This was also the conclusion of the
AAT in Case 13/99 99 ATC 240 which held that a sign-on payment received by a rugby
league player was assessable as ordinary income.

Case D80 72 ATC 473 also dealt with a restrictive covenant receipt. In consideration of the
managing director of a company, with considerable expertise in his field, covenanting not to
carry on for five years the sort of business in which the company and its related companies
operated within 10 miles of any of the existing group outlets, he received $50 000 which was
held to be of a capital nature.

In Pickford v FC of T 98 ATC 2268 a payment of $20 000 to a new employee to induce him
to enter into the employment of a new employer and was held to be assessable income. The
payment was described as being compensation for the employee giving up their right to
shares in their former employer. However, despite the fact that the payment was designed to
compensate the employee for giving up his share rights on termination of employment with
his former employer the AAT held that the payment was an integral part of the employment
offer made by his new employer and accordingly just ordinary income.

Taxation Rulings IT 2307 and TR 1999/17 provide some interesting discussion on the
accessibility of sign-on payments generally and payments received by sportspersons.

5. Receipts in respect of ‘exclusive trade tie’ arrangements


This is an area similar to the previous category on contracts involving restricted covenants,
and the character of such receipts is subject to doubt, but the majority of court cases have
tended to indicate that the receipts are of a capital rather than income nature.

Such contracts are very common in the oil industry, where service stations contract to restrict
their activities to the handling of a single brand. However, other examples do exist.

For instance, in the case of Napier Motors Ltd v The Commissioner of Internal Revenue
(1969) 1 ATR 209, a local government authority would not permit the continued use by the
taxpayer company of certain premises for the retailing of petrol without substantial alterations
being effected. The oil company, BP (Australia) Ltd, offered a contribution to the taxpayer to
carry out these alterations. It was held that such a receipt was not a trading receipt and was
more correctly classified as capital. Obviously in this case the receipt could not be completely
divorced from the fact that there was an exclusive trading tie arrangement. See also
Dickenson v FCT (1958) 11 ATD 415.

Reading activity
ATC: Dickenson v FCT (1958) 11 ATD 415.

The Dickenson case also dealt with an oil company that entered into a trade-tie arrangement
with a service station and garage business. It was held that the amounts received were capital
receipts.

6. Compensation for loss of trading stock


As a general rule you can assume that such compensation receipts are assessable in the hands
of the taxpayer. This seems to be a sensible conclusion when it is remembered that the initial
outlay for acquisition of the trading stock is deductible. Therefore any receipt associated with
either the sale of the stock or compensation in the form of an insurance recovery arising out
of the destruction of the stock would automatically be classified as assessable income.
Sections 15-30, 20-20(2) confirm that such amounts are assessable.
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LAW3130 & 5230 Module 1 – Assessable Income

7. Compensation in connection with freeholds, leaseholds and structural


improvements
In many ways, such compensation can be seen as similar to the previous category of receipts
referred to as ‘the sterilisation of assets’. As with all other areas concerning differentiation
between income and capital, each case must be treated on its individual merits. In the case of
Watson v Sampson Bros (1959), the taxpayers were farmers who received compensation
under the Coastal Flooding Act of 1953 in respect of the rehabilitation of pasture land
damaged by salt water. The court decided that, since the primary purpose of the
compensation was to restore the pasture land to productivity, and that such land was a capital
asset, then the sums so received were capital receipts, and therefore not assessable.

8. Compensation for loss of profits or otherwise relating to a business


A general overview of the case law relating to receipts of this nature tends to indicate that
such receipts are generally interpreted as being of an income nature. Such compensation
payments tend to be in lieu of what would have otherwise been assessable income, and
should not be confused with compensation of a capital nature related to sterilisation of capital
assets.

9. Sale of secret knowledge and processes


Such sales usually involve the receipt of funds by the taxpayer for surrendering patents. The
majority of court decisions tend to treat such receipts as being similar in nature to those
associated with the sterilisation of capital assets or the disposal of capital assets. In other
words, such receipts are deemed to be of a capital nature.

Many of the decisions relating to such cases have been contested in the higher Courts and,
once again, each case must be treated on its individual merits. Of the utmost importance is
that payments for ‘know-how’ will be regarded as capital only where they are made in
conjunction with the continuance or disposal of a business or part of a business. If, on the
other hand, the taxpayer simply sells that ‘know-how’ on a restricted basis for the purchaser
to utilise it in a particular country, district or area, while the taxpayer continues to utilise the
‘know-how’ in his own area, then in such circumstances, receipts are more likely to be
deemed of an income or trading nature. A very interesting case in this area is Rolls Royce Ltd
v Jeffrey (Inspector of Taxes) (1962) 1 All ER 801.

Reading activity
ATC: Rolls Royce Ltd v Jeffrey (Inspector of Taxes) (1962) 1 All ER 801.

In the Rolls Royce case the taxpayer entered into licensing agreements where it supplied
certain know-how and provided additional professional assistance. The amount received
under the licensing arrangement was considered to be assessable income.

The sale of copyright in books and such items may also be considered to be a sale of know-
how and knowledge. The case of Mackenzie v Arnold (1952) 33 TC 363 held that whether an
amount for the sale of a book will be capital or income will depend on the characteristics of
the taxpayer. If the taxpayer sells many such books, then such receipts are likely to be
income; whereas a sale of a single book is likely to be capital receipt.

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LAW3130 & 5230 Module 1 – Assessable Income

Summary – capital v income


The preceding nine categories of receipts provide a convenient approach to consider the
income versus capital nature of receipts within the parameters established by the Courts.
Although each category of receipt is characterised by a general philosophy developed through
case precedent, you must remember that the whole question of differentiation between capital
and income is complex, and you must examine very carefully the details of each separate
case. The importance of this question is clear when you realise that in most cases, where the
receipts are deemed to be of a capital nature, then such receipts are usually not subject to
taxation as ordinary income but will still require consideration of capital gains tax.

1.12.3 Composite receipts


Much of the discussion so far has focused on differentiating between income and capital
receipts. An equally difficult area is the treatment of receipts which have both income and
capital components. A very interesting case in this area is McLaurin v FC of T (1961) 104
CLR 381. This case provides some discussion on whether un-dissected amounts including
both income and capital components are assessable. This case is authority for the proposition
that where an un-dissected amount is received in compensation for both income and non-
income claims the whole amount is considered to be capital.

Composite receipts are commonly found in receipts associated with compensation and
damages – for example, payments related to personal injury cases such as Workers’
Compensation payments for loss of limbs, etc. In general, where the compensation is in the
form of a lump-sum payment for an amount based on the extent of the injury, such receipts
are of a capital nature and non-assessable. However, if the compensation is paid periodically
on a basis associated with compensation for loss of earnings, then such receipts tend to be
classified as income and are fully assessable.

1.12.4 Recoupments
Division 20 deals with the assessability of recoupments. Section 20-25 defines a recoupment
as follows:

Recoupment of a loss or outgoing includes:

c. any kind of recoupment, reimbursement, refund, insurance, indemnity or recovery,


however described; and
d. a grant in respect of the loss or outgoing.

Section 20-20(2) deals with the assessability of insurance or indemnity amounts while section
20-20(3) deals with the assessability of other recoupments.

Reimbursements of general deductions under section 8-1 in a non-business context will not
always give rise to an assessable receipt. The case of FCT v Rowe 97 ATC 4317 explored this
issue in detail and the Full High Court held that a taxpayer should not include in his
assessable income the reimbursement of an amount previously claimed as a deduction.

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LAW3130 & 5230 Module 1 – Assessable Income

Reading activity
ATC: FCT v Rowe 97 ATC 4317.

Reading activity
ATH: paras 3 010 to 3 060.

Exercise 5
To test how you have understood some of the material in this part of the course
you may wish to try the self-assessment quiz on the study desk entitled
‘Assessable income – general’.

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LAW3130 & 5230 Module 1 – Assessable Income

1.12.5 How to determine if a taxpayer is carrying on a


business
The major area of dispute in relation to the concept of carrying on a business often concerns
the issue of whether a person is involved merely in the pursuit of a hobby, however rigorous,
or indeed carrying on a business. Often the dispute involves not questions of income but of
allowable deductions claimed by persons involved in activities which have produced losses.
Remember that if the taxpayer were found to be engaged in a hobby rather than a business,
receipts would be non-assessable and deductions would not be allowable. In either case the
tests for establishing the existence of a business are the same.

What constitutes carrying on a business?


The term ‘business’ is defined in s 995-1 of the Act as including any profession, trade,
employment, vocation or calling, but not including occupation as an employee.

The legislature has not attempted to define what constitutes carrying on a business. It is
necessary to look at decided cases to determine the important factors which characterise the
carrying on of a business and weight these againsts each other.

Important factors that have emerged from decided cases are as follows:

● System and organisation – there must be some form of commercial activity systematically
carried on – the activities must be more than a hobby.

Reading activity
ATC: Ferguson v FCT (1979) 9 ATR 873; 79 ATC 4261.

● Scale of the activities – the scale of operation may influence whether a business is being
carried on. A person may carry on a business even though they do it in a small way.

Reading activity
ATC: FC of T v JR Walker 85 ATC 4179.

● Repetition and regularity of activity are indicators of the existence of a business. It should
be noted that a business, depending on the type, may have a limited number of
transactions during the year. For example, a person in the business of buying and selling
land may have a limited number of sales when compared with a grocery store selling
many small-value items.

Reading activity
ATC: Shields v DFC of T 99 ATC 2037.

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LAW3130 & 5230 Module 1 – Assessable Income

● Profit motive is normally expected to exist, as a business is normally carried on to make a


profit. In some cases the courts have inferred a profit motive where the production was
well in excess of domestic production. The fact that a profit does not result will not
necessarily deny the existence of a business. What is required is a reasonable expectation
that a profit will eventuate in the long term.
● The commercial character of the transactions may indicate the existence of a business.
● The characteristics of the property dealt with may indicate the presence of a business. For
example, when a person deals in goods which could not be used for personal
consumption, this may indicate that the person has acquired them for business purposes.
● The characteristics of the taxpayer may indicate that they have the skills and experience
necessary to carry on such a business.
● Retention of business records and other business documents including business plans may
indicate the presence of a business.
In recent years the ATO has undertaken a significant amount of audit activity with a view to
determining whether taxpayers claiming losses from primary production against their salary
and wage income are in fact in the business of primary production. The Commissioner has
issued TR 97/11, entitled ‘Am I carrying on a business of primary production?’ on this
subject. This ruling provides guidelines on when the Commissioner considers that a taxpayer
is carrying on a business of primary production.
The ruling recognises that each case will depend on its own particular facts but that the
determination of the question is generally the result of a process of weighing all the relevant
indicators. The indicators identified in the Ruling are essentially the indicators outlined
earlier in this module. The indicators used in TR 97/11 are applicable to other business
activities as well.

Reading activity
ATO Web Site: Taxation Ruling TR 97/11 covers the indicators as listed above
as well as some very useful worked examples at the end.

Business of gambling
There has been quite a bit of interest over the years on whether persons involved in gambling
activities are in fact carrying on a business

A similar situation to Martin’s case arose in Babka v FCT (1989) 20 ATR 1251; 89 ATC
4963 where a punter had won almost $1.5 million in ten years. Despite his extensive records
and accounts, it was found that he was not involved in the business of gambling.

By contrast with the decisions in Martin and Babka’s case, the case of Prince v F C of T
(1959) 7 AITR 505 and Trautwein v F C of T (1936) 56 CLR 196 held that the taxpayers in
question were carrying on a business of gambling. Both are High Court cases.

Reading activity 1
ATC: Martin v FCT (1953) 90 CLR 470.
ATC: Babka v FCT (1989) 20 ATR 1251; 89 ATC 4963.
ATC: Prince v FC of T (1959) 7 AITR 505

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Non-commercial losses
The non-commercial loss provisions contained in Division 35 ITAA 97 addresses a large part
of the compliance risk associated with hobby activities. The measures are described as non-
commercial loss measures and limit the extent to which losses from an individual’s non-
commercial business activities are used to reduce tax paid on other income such as salary and
wage income. The rules do not change the existing general law tests that determine whether
an individual is carrying on a business. The rules ensure that individual taxpayers carrying on
a business either alone or in partnership may only claim a loss from that activity against their
other income in an income year if they satisfy one of the four tests set out in the legislation.
The non-commercial loss rules are not covered in detail in this course, however you should
be aware of their existence and the broad tests that need to be met.

Reading activity 2
ATH: paras 5 010 to 5 120 and review paras 8 600 to 6 620
.

1.13 Exempt income


Section 6-15 defines what is meant by non-assessable income and states that an amount that
is not ordinary income and is not statutory income is not assessable income. In addition if an
amount is exempt income it is not assessable income. Section 6-20 states that 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. If an amount of ordinary income or statutory income is non-
assessable non-exempt income, it is not exempt income. By way or explanation s 6-23
provides that an amount of ordinary income or statutory income is non-assessable non-
exempt income if a provision of the Act states that it is not assessable income and it is not
exempt income.

Division 11 contains an extensive list of classes of exempt income.

Reading activity
ATH: Review some of the examples of exempt income in Chapter 7.

Exercise 6
To test how you have understood some of the material in this part of the course
you may wish to try the self-assessment quiz on the Study Desk entitled
‘Business and other income’.

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LAW3130 & 5230 Module 1 – Assessable Income

Self Assessment Questions 1.2

To get the most out of the questions please prepare your own answers before consulting the
prepared solutions.

1. Sally Jones is a chartered accountant and tax agent with annual billings of $600 000. Her
practice includes the preparation of financial statements, income tax returns and giving
business advice. She has a staff of one qualified accountant and three trainee accountants,
a typist/receptionist and a computer operator.
Sally checks and signs all correspondence and financial statements. However, the
qualified accountant interviews a significant number of the clients and is responsible for
giving business advice to a group of larger business clients. The other accounting staff are
responsible for preparing the financial statements and income tax returns.
Required:
Discuss whether Sally should return her income on either a cash or an accruals basis in
the light of decided cases, relevant legislation and any other relevant authority.

2. Nicholas is a building site foreman working for Complex Constructions Pty Ltd, a
building company operating in Brisbane. His employer discovers that it has been
underpaying him for the past ten months and advised him on 27 June 2015 that it would
pay him the back pay of $5700 in his next pay, which will be on 2 July 2015.
Required:
Advise Nicholas whether he should include the $5700 received in his income tax return
for the year ended 30 June 2015. Support your advice with reference to decided cases and
any other authority.

3. Delany & Partners is a surveying firm which has four partners and employs 20 staff. The
firm’s main office is in Toowoomba but the firm provides service to many areas of
Australia. The work of the firm consists of providing surveying services to the building
industry and government departments. The firm has up to the current year of income
returned its income on a cash basis but is now considering changing to the accruals
method of accounting for tax purposes. The trading records of the firm show the
following details in relation to its operations for the current year:
Trade debtors/accounts receivable at 30 June 2014: $230 000
Trade debtors/accounts receivable at 30 June 2015: $180 000
Cash received from all professional services including debtors: $1 300 000
Work in progress at 30 June 2014 $125 000
Work in progress at 30 June 2015 $142 000

Required:
Advise the partners as to whether you consider that the accruals method of accounting
would be appropriate for the business for the year ended 30 June 2015. How would the
firm account for the trade debtors/accounts receivable owing at 30 June 2014 assuming
that the firm made the change? Should the work in progress be considered in calculating

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LAW3130 & 5230 Module 1 – Assessable Income

the assessable income of the firm under the accruals method of accounting? Support your
advice with reference to decided cases and any other authority.

4. Daniel, aged 22, is an enterprising young engineer who has had a number of receipts
during the year and is concerned whether any of them constitute assessable income.
Prize winnings. Daniel enters on average 10 competitions each week. The competitions
are generally on food containers and the prizes include holidays, cars, household goods
and cash. He has won a Holden Commodore car worth $32 000, a holiday to Hawaii
worth $4500 and $50 000 in cash during the 2015 income year. Because of his extensive
winnings he was invited to appear on the ‘Midday Show’ on TV and received $1000 for
his appearance.
Invention. Daniel designed and patented an automatic back-scratcher which operated
while the user was in the bath. He sold the rights to manufacture the invention in the US
and Europe to Itchy Ltd for $500 000 which he received in June 2015.
Grand Aunt Joyce. Ever since Daniel was a boy his grand aunt Joyce has placed $50 per
week in his bank account to provide for his upkeep. During the year he received $2600
from his grand aunt and earned $75 in interest on this bank account.
Salary. Daniel receives a weekly salary of $750 paid on a Thursday from his employer
but due to a computer malfunction his pay for Thursday, 25 June 2015 was not paid until
Thursday 2 July 2015.
Receipt from friend. Daniel drew plans of a security device for a friend who was having
problems with burglars. Daniel did not wish to receive anything for the work but his
friend gave him $50.
Required:
Advise Daniel on the assessability of the above amounts, citing case law and sections of
the Income Tax Assessment Act where appropriate.

5. Karen, a resident of Australia, is a journalist who works for The Courier News newspaper
in Brisbane. She graduated from the University of Southern Queensland with a Bachelor
of Arts (Journalism) degree three years ago and has worked for the current employer
since 1 August 2015. She had a number of receipts for the year ended 30 June 2015 as
follows:
Employment agreement: When Karen commenced work with her current employer she
was required to sign an employment agreement. The agreement provided that Karen was
required to work for the newspaper for a period of at least two years. She received $3000
for signing the contract on 1 August 2015.
Salary and wages: Karen receives a fixed salary of $25 000 per annum from her
employer and depending on her performance may receive a bonus at the end of the year.
Her employer paid her $22 900 in salary to 30 June 2015. On 29 June 2015 her supervisor
advised her that the firm was very pleased with her performance and would pay her a
bonus of $2400 in her next pay which would be on 3 July 2015.
Novels: Karen has written her first two novels in the past year. One, The exhibitionist,
was published on 1 November 2014 and has recorded very good sales. The agreement
with the publisher for The exhibitionist provides that Karen receives $1 for each book
sold and she has received $5600 prior to 30 June 2015 from the publisher. The publisher
still owes her $1200 for sales made prior to 30 June 2015. Karen sold the rights to the
other novel The chosen person for $50 000 to Channel 21, a television station which will
make a mini-series based on the novel. The payment of the $50 000 was received on
1 June 2015.

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LAW3130 & 5230 Module 1 – Assessable Income

Radio competition: On Friday March 7 2015 Karen phoned her local radio station, 4BG,
to take part in a phone-in competition. The station accepted the third, sixth and ninth
caller and Karen was the ninth caller. Her task was to tell a humorous/interesting story of
what she would be doing when she drank her first ‘Lite Cola’ (a new soft drink). Karen
told a good story which made the DJ burst into hilarious laughter and the competition
judge, ‘Big Bob’, declared Karen the winner. The prize was a ‘Lite Cola’ prize pack
which included many items of food and was worth $500.
Compensation payment: While reporting a story during the year Karen was in an
accident in which she lost part of a finger on her left hand. She received compensation of
$5700 from the Workers’ Compensation Board. She was not off from work while her
hand was recovering.
Newspaper reader: During the year a reader of the newspaper gave Karen $500 in cash.
The reader was motivated to make the payment because he was delighted that Karen had
written a story on under-privileged children and highlighted the plight of the less well off
in an inner suburb of the city. The reader also indicated in his note with the money that he
considered that Karen was a good journalist who told the truth at all times irrespective of
the consequences.
Journalist award: On 5 May 2015 the Australian Newspaper Journalists Association
awarded Karen ‘Young Journalist Award 2015’. The prize included $1500 in cash plus a
non-transferable trip to London. Karen was delighted with receiving the prize as it
recognised her hard work and skills.
Required:
Advise Karen on the assessability of the above amounts according to ordinary income
concepts, citing case law and sections of the Income Tax Assessment Act 1997 to support
your advice.

6. Frank operates a business which manufactures components for the automotive industry.
The business in general had been going very well during the year ended 30 June 2015.
However, during the year a freak cyclone caused serious damage to Frank’s business
premises and stock of finished stock. Luckily Frank was insured and he received the
following amounts from his insurance company:
Destruction of factory building: $1 300 000
Destroyed stock of finished goods: $346 000

Frank replaced the factory building with another building which cost $1 350 000 to build.
The destroyed stock had to be disposed of at the city waste dump.
Frank’s bad luck continued when only one month later one of his customers cancelled a
contract for the supply of parts. The customer paid Frank $30 000 compensation for the
cancellation of the contract. The contract is one of ten such contracts held by Frank.
During the year Frank was approached by Auto Parts Ltd which wanted to commence
manufacturing similar automotive parts in another State. Frank sold to Auto Parts his
‘know-how’ in relation to the secret manufacturing process he had developed himself.
The contract in relation to the ‘know how’ provided that Auto Parts was restricted to
using the secret manufacturing process in one State. Frank received $60 000 in relation to
the contract.
Required:
Advise Frank on the assessability of the above amounts, citing case law and sections of
the ITAA where appropriate. Do not consider the application of Capital Gains Tax.

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LAW3130 & 5230 Module 1 – Assessable Income

7. Chris is a high school mathematics teacher who has a very strong interest in horse-racing.
He became interested in horses when he was 14 when he went for a holiday with his
Uncle Steve who operates the largest horse-racing stable in Brisbane. For a couple of
years Chris rode as a jockey but had limited success and at the age of 19 had to cease
riding because of an injury to his back. Since then he has owned ‘Equine View’, a small
horse stud outside of Toowoomba, where he keeps about 5 mares and foals. He generally
sells all the foals but currently has two horses in training with his Uncle Steve. The two
racehorses have won a number of races but the winnings on average do not cover their
expenses.
To supplement his earnings from his breeding and racing activities, Chris does quite a bit
of gambling. He has employed his mathematical skills to develop a computer program
which he uses to identify likely race winners. During the past year his earnings from
gambling have shown a net loss of $5600 but Chris believes that with a bit of refinement
the computer program will be able to have a better winning percentage in the coming
year. The losses from his gambling activities Chris hopes to offset against his assessable
income from teaching.
Required:
Advise Chris whether you consider him to be carrying on a business of gambling and
whether he can legally offset his losses against his other assessable income. In your
advice make appropriate reference to decided cases and any other authority.

8. Helen, a resident of Australia, is a real estate agent who works for Ray Bright Real Estate
in Toowoomba. She has had a number of receipts during the year and seeks your advice
as to whether they are assessable.
Compensation and reimbursement of expenses: Prior to working for Ray Bright Real
Estate, Helen was an employee of Shady Real Estate. The manager of Shady Real Estate
had a practice of entering into illegal transactions and when Helen refused to become
involved in the illegal activities the manager terminated her employment. Helen went to
court to seek compensation for wrongful dismissal. She paid legal expenses of $5000 in
going to court and she successfully claimed this amount as a tax deduction in her income
tax return for the 2014 year. The manager of Shady Real Estate was required by the court
to pay Helen $17 000 for lost income. He paid Helen the $17 000 on 20 July 2015 and he
reimbursed her the $5000 in legal expenses on the same day.
Spotter’s fee: Occasionally when Helen does not have a suitable property to satisfy a
client’s needs she suggests that the client approach other real estate agents whom she
knows have suitable properties. On 14 May 2015 she recommended a person to approach
Hookhim Real Estate in relation to a property it was selling. Hookhim Real Estate was
delighted that Helen made the recommendation as it made a sale and paid her $750 on
25 May 2015.
Flower garden: In addition to her activity as a real estate agent Helen owns a commercial
flower garden from which she sells fresh flowers to florists in Toowoomba. She grows
the flowers on a 10 hectare piece of land she owns near the edge of the city. On 6 October
2014 a local chemical company paid her $27 000 as compensation for accidentally
spilling toxic chemicals on two hectares of her land. The chemical spill rendered the land
useless to grow flowers for at least five years and the compensation payment was
calculated by reference to future profits.
Required:

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LAW3130 & 5230 Module 1 – Assessable Income

Advise Helen on the assessability of the above amounts as income according to ordinary
concepts, providing a discussion of case law and sections of the Income Tax Assessment
Act to support your advice.

9. Cathy is a partner in a firm of engineers practising in Toowoomba. The firm had operated
in its own premises for 20 years. However in the current year of income the building in
which it had been operating was condemned by the local city council as being unsafe and
a demolition order was made on 1 August 2014. The firm initially considered re-building
on the site of the current building, however for two reasons it did not pursue this course
of action:
● It received a fabulous offer of $600 000 from a property developer for the vacant site
which they accepted
● It agreed to lease premises from the same property developer in another part of
Toowoomba.
As part of the agreement to enter into the lease agreement the engineering firm received
an amount of $200 000 as an incentive to enter the agreement. Cathy had a one quarter
(25%) interest in the firm and accordingly she received $50 000 as her share of the
distribution of the $200 000 to the owners of the firm. Currently there is a lot of
commercial buildings available for lease in the Toowoomba area and lease incentive
payments are quite common.
Required:
Advise Cathy on whether the amount of $50 000 received in an income or capital receipt.
In providing your advice you should discuss fully any relevant cases or any other
authority on the issue.

10. The members of Blackstump Services Club are very interested in encouraging the
development of more sporting activities in the area. They have seen the growth in the use
of social clubs to finance the fostering of sporting activity in other areas. In the current
year of income they completed the building of a social club on the outskirts of town. The
social club provides restaurant, gambling and dancing facilities to the public and intends
to give any trading surplus to the local soccer and golf clubs.
Required:
Advise the members whether any of the receipts of the social club will be exempt from
income tax under any provision of the ITAA. Make appropriate reference to any decided
cases on the issue.

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LAW3130 & 5230 Module 1 – Assessable Income

1.14 Income from trading stock

1.14.1 Trading stock


Section 70-10 defines ‘trading stock’ as including:

e. anything produced, manufactured or acquired that is held for purposes of manufacture,


sale or exchange in the ordinary course of a business: and
f. live stock.

What constitutes trading stock?


In the normal course of events one would expect that, in order to include items as trading
stock of a business, the items would be owned by the taxpayer. An important decision on the
meaning of trading stock was handed down by the High Court in 1985, as it held that in
certain circumstances you do not even have to be the legal owner of the trading stock in order
for it to constitute your trading stock.

In FCT v Sutton’s Motors (Chullora) Wholesale Pty Ltd (1985) 16 ATR 567 the taxpayer
company was a wholesaler of cars which were displayed under a floor plan arrangement.
Under this arrangement, a finance company legally owned the cars until such time as they
were purchased by a member of the public, at which time the taxpayer became liable to pay
the finance company for the car. Although legal title would not pass until this time, all parties
treated cars on the floor plan as though they were part of the taxpayer’s stock. The High
Court held that the cars were in fact trading stock of the taxpayer. Note that while this case
does confirm that ownership is not necessary in certain situations, in the vast majority of real
world scenarios the taxpayer will be the legal owner of the trading stock.

Reading activity
ATC: FCT v Sutton’s Motors (Chullora) Wholesale Pty Ltd (1985) 16 ATR 567.

Shares – can they be trading stock?


It was not until 1971 that the issue of whether or not shares were trading stock was finally
settled in the Investment and Merchant Finance case (71 ATC 4140). Also, in FC of T v
Westraders Pty Ltd (1980) 144 CLR 55, the Court held that shares, as trading stock, could be
the subject of an election under s 70-100.

Reading activity
ATC: Investment and Merchant Finance Corporation Ltd v FC of T (1971) 2
ATR 361
ATC:FC of T v Westraders Pty Ltd (1980) 144 CLR 55.
Note, when reading these cases focus only on the consideration of whether or
not shares were trading stock.

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LAW3130 & 5230 Module 1 – Assessable Income

Land – can it be trading stock?


Land can also be trading stock and this follows a logical extension of the reasoning employed
in relation to shares. This was decided in FC of T v St Hubert’s Island Pty Ltd (1978) 8 ATR
852, where it was held that undeveloped land was trading stock in the hands of an intending
developer.

Reading activity
ATC: FC of T v St Hubert’s Island Pty Ltd (1978) 8 ATR 852.

ATH: para 5 200.

Tax accounting for trading stock


Where a taxpayer trades or deals in a certain commodity, his assessable income includes the
gross proceeds of sales made in the course of that business. The gross proceeds are income
according to ordinary concepts. Expenditure incurred in acquiring trading stock will be
allowable as a deduction under s 8-1 when the trading stock is on hand: s 70-15 (1).
Section 70-25 clarifies that expenditure incurred in the purchase of trading stock is not an
outgoing of capital, thus bringing it within the general rule in s 8-1. For a full discussion
on s 8-1 refer to the module on ‘Allowable deductions’.

Therefore, apart from the statutory provisions concerning trading stock, the gross proceeds of
sales by a trader will be brought to account as income in the year in which they are derived,
and the cost of acquiring stocks will be an allowable deduction in the year in which it is
incurred. See module on deductions with particular reference to s 8-1 – general deductions.
Division 70 prescribes a method of tax accounting for ‘trading stock’ which draws heavily on
financial accounting principles.

The trading stock provisions from a tax point of view thus always have three steps;

- gross sales of trading stock are assessable income (s6-5)

- purchases of trading stock are deductible (s8-1)

- a trading stock adjustment is calculated which is either assessable or deductible


depending on the values of opening and closing stock (see discussion below).

Reading activity
ATH: para 5 210.

Trading stock adjustments


- Section 70-35(2) provides that the excess valuation of trading stock at the end of the
income year over opening stock is assessable as income.

OR

- Section 70-35(3) provides for an allowable deduction where the opening value
exceeds the closing value of such stock.

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LAW3130 & 5230 Module 1 – Assessable Income

Valuation of trading stock


Implementation of the trading stock provisions requires that a value be ascribed to trading
stock on hand at the beginning and end of a particular year. Section 70-40 confirms that the
value of each item of trading stock to be taken into account at the beginning of a year of
income is its value as ascertained under the Act at the end of the previous year. Thus, one
year’s closing value is the next year’s opening value.

Section 70-45 gives the taxpayer options as to the method of valuation by which they are
entitled to value each article of trading stock on hand at the end of the year of income. The
taxpayer may use either:

● cost price
● market selling value
● replacement price.

Section 70-50 displaces this general rule in special circumstances where the taxpayer may
elect to use a value which is reasonable in the circumstances. The value should be established
in consideration of obsolescence or for any other reason the value of the trading stock is
below the values set in s 70-45. Note that Taxation Ruling TR 93/23 discusses the concept of
obsolete stock for the purposes of the former s 31(2) but should equally apply to s 70-50.
Note that once stock is valued under this obsolescence rule they are considered to be unlikely
to be sold in the ordinary course of business.

Where trading stock is acquired otherwise than under an arm’s-length transaction, s 70-20
may apply to make the cost equal to an amount equal to arm’s-length value or market value.

What is the cost price of trading stock?


The cost price of an article of trading stock is accepted by the Commissioner to be the full
absorption cost – which includes all necessary and reasonable costs to bring the trading stock
to its existing condition and location; or includes expenses that relate to all those activities
which form part of the manufacturing operations and which are not related to selling
operations. This will include the cost of wages to those responsible for the setting up and
repair of machines, inspectors, costs of quality control, costs of disposal of waste substance,
and the cost of support staff such as employees in the company’s boiler-house, fitters,
electricians and greasers.

The case of Phillip Morris Ltd v FC of T, 79 ATC 4352 provides a good discussion in
relation to fixed and variable costs of production and confirms that a taxpayer’s fixed costs
(or an appropriate part thereof) should be included in the cost of trading stock on hand at the
end of the year. Taxation Ruling IT 2350 also provides good guidelines in relation to the
valuation of trading stock in a manufacturing environment.

Methods which the Commissioner will accept in approximating the cost price of a large
volume of stock (ie where exact values are impossible because which stock has been used is
not known) are as follows:

● FIFO
● work-in-progress and manufactured goods – full absorption cost, i.e. direct labour and
direct materials and overheads
● weighted average cost
● standard cost provided that the costs are reviewed regularly

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LAW3130 & 5230 Module 1 – Assessable Income

● retail inventory method – conditional acceptance only.

He will not accept the LIFO method or the base stock method. In the case of Minister of
National Revenue v Anaconda American Brass Ltd (1956), the LIFO method of valuation was
rejected. Taxation Ruling TR 2006/8 provides guidance on determining the cost of trading
stock in a retail and wholesale environment.

What is the market selling value of trading stock?


This is the value of stock by reference to the current value in the taxpayer’s particular selling
market, ie not a forced sale.

What is the replacement price?


This is the value to the taxpayer of replacement of the stock in the taxpayer’s normal
market. The case of Parfew Nominees Pty Ltd v FC of T 86 ATC 4673 held that the value
determined must not defy business reality. In other words, if a value is used, it must be
possible to acquire trading stock at that value in the normal market. See also Taxation
Determination TD 92/198 which provides that the stock in question must be available in the
market and be substantially identical to the stock on hand.

Reading activity
ATH: paras 5 220 to 5 370.

Disposals not in the ordinary course of business


Section 70-90 deals with the case where trading stock is disposed of by sale, gift or otherwise
(which extends to disposal by a company by way of an in specie distribution) not in the
ordinary course of the taxpayer’s business. In such a case, the market value of the trading
stock is to be brought in as assessable income.

If s 70-90 did not exist, the disposal of trading stock otherwise than in the course of business
might well produce a non-assessable capital profit.

In order for s 70-90 to operate, it is necessary that:

● the taxpayer disposes by sale, gift or otherwise of property being trading stock
● that property (trading stock) constitutes or constituted the whole or part of the assets of a
business which is or was carried on by the taxpayer
● the disposal is not in the ordinary course of business.

Should a disposal of trading stock meeting the above requirements occur, the disposal price
of the stock is not the value brought into the taxpayer’s assessable income but the market
value. In this case, s 70-90 operates so that the market value of the trading stock on the day of
disposal becomes the assessable income.

Example 1
A father gifts to his son livestock costing the father $10 000 so that his son may
commence business as a primary producer. The market price of the stock at the
date of disposal is $37 000. What is the amount assessable in the father’s hands

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LAW3130 & 5230 Module 1 – Assessable Income

and what value does the son bring in as a cost price for his livestock?

The disposal is not in the ordinary course of business. Thus, the father brings in
the selling price at the market price. He will be assessed on the difference
between this value and the cost price.

The son will bring in the livestock also at the market price, $37 000 (i.e. as if it
were purchased for this value), s 70-95. There is an election available under s
70-100 to enable certain transfers of trading stock to take place at the value that
the trading stock is held for tax purposes by the transferor.

Reading activity
ATH: paras 5 400 to 5 470.

Exercise 7
To test how you have understood some of the material in this part of the course
you may wish to try the self-assessment quiz on the Study Desk entitled ‘Income
from trading stock’.

Self Assessment Questions 1.3

To get the most out of the questions please prepare your own answers before consulting the
prepared solutions.

1. Hilary is in the furniture business where she buys and sells furniture and has supplied you
with the following information:
The trading details extracted from her records are summarised as follows:
30/06/13 30/06/14
Trading Stock
Market Value 167 000 185 000
Cost 135 000 150 000
Current Replacement 144 000 161 000
Cost

Hilary used current replacement cost in calculating her assessable income on 30 June
2015.
$
Cash Receipts:
Sales of trading stock 1 218 500
Cash Payments:

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LAW3130 & 5230 Module 1 – Assessable Income

Purchases of trading stock 780 000


Required:
Calculate Hilary’s assessable income from trading, ensuring that you minimise her
taxable income. Support your calculations with a discussion of the relevant authorities.
2. Paula has many business interests including trading in crude oil. She generally buys the
oil from one of the Persian Gulf States and then on-sells shiploads of the oil to oil
refineries throughout the world. On 26 June 2015 she entered into a transaction to pay
$560 000 for a shipload of crude oil from Saudi Arabia. The ship was loaded on 27 June
2015 and left Saudi Arabia on 28 June 2015. The terms of the transaction was that she
was to pay the $560 000 owing on 14 July 2015. On 4 July 2015, as the ship was
travelling in the Indian Ocean on its way to Australia, Paula sold the shipload of oil for
$610 000 to PB Refineries in Brisbane.
Required:
Discuss the issues relating to trading stock and advise Paula whether she should include
the shipload of crude oil in her trading stock on 30 June 2015. Include in your discussion
any relevant cases or other authorities.
3. Maria owns and operates a small grocery store in a shopping centre. On 23 December
2014 she donated several grocery hampers to the St Vincent de Paul Society for
distribution to the needy in the community. The items donated cost Maria $340 and had a
market value of $410 at the time they were donated.
Required:
Discuss the issues relating to trading stock and advise Maria of any tax implications
arising from her donation. Cite any relevant authority.

4. Daniel is a retailer of all types of footwear and operates a store in Toowoomba. Daniel
provides you with the following information which is relevant to determining his income
for the year ended 30 June 2015.
Income from Business (other than lay by):
Cash Sales (including debtors) $520 000
Trade Debtors at 30 June 2014 $15 000
Trade Debtors at 30 June 2015 $21 000

Lay By: To encourage sales Daniel commenced a lay-by scheme on 1 October 2014
where customers pay for the purchase of footwear over a period of time. The normal lay-
by agreement provides that ownership of the footwear does not pass to the customer until
the final instalment under the lay-by agreement is paid by the customer. When footwear is
put on lay-by, a customer is required under the agreement to pay a non-refundable 10%
deposit of the value of the footwear and the remainder of the purchase price is to be paid
over a time suitable to the customer. When the final instalment has been paid then the
customer can take the footwear. If at any time prior to the final instalment being made the
customer terminates the agreement Daniel is required to pay back any instalments made
with the exception of the 10% non-refundable deposit. Details of the lay-by arrangements
for the year are as follows:
Lay by Proceeds:
Cash received for finalised sales (not included in cash sales above $98 000
Non-Refundable deposits held at 30 June 2015 (not included in cash sales above) $15 000

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LAW3130 & 5230 Module 1 – Assessable Income

Instalments (other than non-refundable deposits) held on behalf of customers at 30 June


2015 (not included in cash sales above) $57 000
Trading Stock on Hand:
Valuation 30 June 2014 30 June 2015 30 June 2015
Method (no lay by existed (not under the (under the lay by
at 30 June 2014) lay by arrangement)
arrangement)
Market Value $280 000 $320 000 $150 000
Cost Price $112 000 $128 000 $60 000
Replacement P $140 000 $160 000 $75 000
rice

Required:
What is the appropriate method of tax accounting for the income of the business and what is
the appropriate tax treatment of the lay-by sales for the year ended 30 June 2015 including
the footwear held under the lay-by arrangements at 30 June 2015. Assume Daniel wishes to
minimise his assessable income calculate the assessable income for the year ended 30 June
2015 (Daniel used the cost method to value stock for tax purposes on 30 June 2014). In your
discussion make appropriate reference to decided cases and any other authority.

END OF MODULE

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