What is Assessable Income?

Assessable income is defined as any amount that is ordinary income, an amount specified under income tax law as income, and not an amount specified under income tax law as exempt income or non assessable non exempt income. What exactly does this mean, and how is it related to taxable income?

WHAT IS ASSESSABLE INCOME?

Right at the start of the ITAA97 is subsection 4-15(1), which states:

Work out your taxable income for the income year like this:

Taxable income = Assessable income – Deductions

Therefore, to work out your taxable income (what you pay tax on), you first need to work out your assessable income. What, then, is assessable income?

The diagram below illustrates what is assessable income:

Section 6-5 goes further to state that:

6-5(1) Your assessable income includes income according to ordinary concepts, which is called ordinary income.

6-5(2) If you are an Australian resident, your assessable income includes the ordinary income you derived directly or indirectly from all sources, whether in or out of Australia, during the income year.

6-5(3) If you are a foreign resident, your assessable income includes:

(a) the ordinary income you derived directly or indirectly from all Australian sources during the income year; and

(b) other ordinary income that a provision includes in your assessable income for the income.

This means that if you’re a resident of Australia, your assessable income includes the ordinary income you derived directly or indirectly from all sources – whether in or out of Australia – during the income year. If you’re not a resident of Australia, you only include Australian sourced income.

WHAT IS ORDINARY INCOME?

Unfortunately, the term ‘ordinary income’ is not defined. Its meaning must be determined by reference to case law. The leading authority on this is Scott v Commissioner of Taxation (NSW) (1935) 3 ATD 142, which states:

The word “income” is not a term of art, and what forms of receipts are comprehended within it, and what principles are to be applied to ascertain how much of those receipts ought to be treated as income, must be determined following the ordinary concepts and usages of mankind.

These cases have determined the following re income:

  • Certain receipts falling into traditionally recognised categories such as rent, interest, wages, annuities, dividends, royalties, business profits, compensation and reimbursement for revenue expenses and loss of income are (with rare exceptions) classed as income.
  • Certain receipts will usually not be income unless they are the proceeds of employment or a business. For example, gifts and bequests, proceeds from the sale of capital assets, gambling and lottery wins etc. are not normally classed as income.
  • Income is either money or something that can be converted into money. For this reason, section 21A was inserted into the Tax Act to catch non-cash business benefits.
  • A taxpayer cannot receive income from himself/herself. This is called the mutuality principle. For this reason, clubs are not taxed on subscriptions and contributions from members. However, they are taxed on receipts from non-members (e.g. bank interest; poker machine proceeds and other payments by non-members).
  • Where a receipt ‘replaces’ a revenue loss, it is income. Where it replaces a capital loss, it is capital.

The cases have also established that income according to ordinary concepts includes the following types of receipts:

  • Income from the carrying on of a business. This includes all proceeds from the normal carrying on the business. Other proceeds made when carrying on a business will be income if a profit-making purpose can be inferred. In some cases, it may be necessary to determine whether a business is being carried on versus a hobby.
  • Income from carrying on a profit-making scheme or isolated business venture, so long as the taxpayer entered into the transaction with the dominant (or at least significant) purpose of making a profit or gain from the transaction, and the transaction was not a mere realisation of a capital asset at a profit.
  • Income received from the rendering of personal services (e.g. wages, bonuses, commissions, tips, gratuities and other payments incidental to employment), or in relation to the rendering of personal services.
  • Income received from the holding of property (e.g. rent, interest, dividends).
  • Consideration received for an assignment of the right to future income.

Taxation Ruling TR 1999/17, titled “Income tax: sportspeople – receipts and other benefits obtained from involvement in sport” states a good summary of what are the relevant factors in determining whether an amount is an ordinary income. These are:

  • Whether the payment is the product of any employment, services rendered, or any business;
  • The quality or character of the payment in the hands of the recipient;
  • The form of the receipt, that is, whether it is received as a lump sum or periodically; and
  • The motive of the person making the payment. Motive, however, is rarely decisive as in many cases a mixture of motives may exist.

IS CAPITAL ORDINARY INCOME?

You already know the answer if you think about the fact that we have a Capital Gain Tax… Receipts that are capital in nature are not income according to ordinary concepts. These receipts may be assessable under other provisions, such as the capital gains tax provisions. Generally, the test applied is whether the receipt falls within any of the categories of income discussed above. If not, it will be regarded as capital and not included in income as ordinary income.

The cases have established other tests concerning the revenue or capital nature of expenses incurred. These may also be used to determine whether a receipt is an income or capital in nature. The main test is contained in Sun Newspapers Ltd and Associated Newspapers Ltd v FCT (1938) 61 CLR 337. It states that a distinction must be made between the business entity, structure or organisation set up for the earning of profit and the process by which such an organisation operates to obtain its regular returns.

But, there are situations where what looks like a sale of a capital asset, is ordinary income. Even if what is occurring in the sale of an asset, if the objective facts of that particular transaction indicate a profit making purpose or business undertaking being carried on, any gain that arises as a consequence of that gain being carried on will be ordinary income (Commissioner v Myer Emporium Ltd [1987] HCA 18).

WHAT IS STATUTORY INCOME?

Section 6-10 reminds us that our assessable income also includes some amounts that are not ordinary income. It states that:

Amounts that are not * ordinary income, but are included in your assessable income by provisions about assessable income, are called statutory income.

One example is the way the Tax Act states that capital gains are to be included in assessable income. A list of all the provisions that include amounts in assessable income is provided in section 10-5. This table includes:

  • Net capital gains
  • Certain lump sum payments on termination of employment
  • Royalties
  • Insurance bonuses
  • Imputation credit
  • Bad debts recovered
  • Barter transactions

The start of section 10-5 looks like this:

Just like ordinary income, what statutory income you include in your assessable income depends on whether you are an Australian resident, and what is the source of the income:

 

6-10(4) If you are an Australian resident, your assessable income includes your * statutory income from all sources, whether in or out of Australia.

 

6-10(5)If you are a foreign resident, your assessable income includes:

 

(a) your * statutory income from all * Australian sources; and

 

(b) other * statutory income that a provision includes in your assessable income on some basis other than having an * Australian source.

WHAT IS EXEMPT INCOME AND NON ASSESSABLE AND NON EXEMPT INCOME?

There are amounts in the Tax Acts that are made exempt from tax. They may be ordinary or statutory income but they are not included in assessable income.

Sections 11-5 and 11-15 include a list of exempt income and include the income derived from charities, and payments. Examples of exempt income include:

  • certain Australian Government pensions, including the disability support pension paid by Centrelink to a person who is under age-pension age
  • certain Australian Government allowances and payments, including the carer allowance and the child care subsidy
  • certain overseas pay and allowances for Australian Defence Force and Federal Police personnel
  • Australian Government education payments, such as allowances for students under 16 years old
  • some scholarships, bursaries, grants and awards
  • a lump sum payment you received on surrender of an insurance policy where you are the original beneficial owner of the policy – generally these payments are not earned, expected, relied upon or occur regularly – examples include
  • mortgage protection
  • terminal illness
  • a permanent injury occurring at work

However, exempt income is used in some tax calculations. An amount of exempt income is taken into account in working out the amount of a tax loss that can be carried forward or can be used in a future year. This is where the idea of non assessable non exempt income arises. Unlike exempt income, an amount of non-assessable non-exempt income is not taken into account in working out the amount of a tax loss.

Section 11-55 lists all of the amounts the tax acts make non assessable non exempt income, including:

 

  • the tax-free component of an employment termination payment (ETP)
  • genuine redundancy payments and early retirement scheme payments shown as ‘Lump sum D’ amounts on your income statement
  • super co-contributions

WHEN IS ‘JUST A HOBBY’ NOT AN INCOME?

In Taxation Ruling TR 97/11, titled “Income tax: am I carrying on a business of primary production?” the Commissioner discusses when a business will be carried on, and so any income will be ordinary income.

He summarises the issues that need to be considered in the following table:

INDICATORS WHICH SUGGEST A BUSINESS IS BEING CARRIED ON

  • A significant commercial activity
  • Purpose and intention of the taxpayer in engaging in the activity
  • An intention to make a profit from the activity
  • The activity is or will be profitable
  • Repetition and regularity of activity
  • Activity is carried on in a similar manner to that of the ordinary trade
  • Activity organised and carried on in a businesslike manner and systematically – records are kept
  • Size and scale of the activity
  • Not a hobby, recreation of sporting activity
  • A business plan exists
  • Commercial sales of product
  • Taxpayers has knowledge or skill

INDICATORS WHICH SUGGEST A BUSINESS IS BEING CARRIED ON

  • Not a significant commercial activity
  • No purpose or intention of the taxpayer to carry on a business activity
  • No intention to make a profit from the activity
  • The activity is inherently unprofitable
  • Little repetition or regularity of activity
  • Activity carrier on in an ad hoc manner
  • Activity not organised or carried on in the same manner as the normal ordinary business activity – records not kept
  • Small size and scale
  • A hobby, recreation or sporting activity
  • There is no business plan
  • Sale of products to relatives and friends
  • Taxpayer lacks knowledge or skill

It should be noted that in Taxation Ruling TR 2019/1, titled “Income tax: when does a company carry on a business?”, the Commissioner concludes that every company (other than charities) is carrying on a business if it earns income, so this will always be ordinary income.

WHAT IS AN ASSESSABLE RECOUPMENT?

Subdivision 20-A states that if you receive an “assessable recoupment” then you must include the amount in your assessable income.

This could include recoupment, reimbursement, refund, insurance or similar payment of a loss or outgoing if the taxpayer has deducted or can deduct the whole of the loss or outgoing in an earlier income year.

Subsection 20-20(3) then establishes that an amount received by a taxpayer as ‘recoupment’ of a loss or outgoing is an ‘assessable recoupment’ if the taxpayer can deduct the loss or outgoing for an earlier income year under a provision listed in section 20-30. The table in subsection 20-30(1) (Item 1.2) lists rates or taxes deductible under section 8-1 as deductions for which recoupments are assessable and so in Taxation Determination TD 2004/21 the Commissioner concluded that where a fringe benefits tax liability (deductible) is refunded as a result of an amended fringe benefits assessment, the amount must be included in the taxpayer’s assessable income.

A more common example is where an asset depreciated under Division 40 is damaged and insurance provides the cash for a new asset. While a deduction can be claimed over the effective life of the asset, the insurance cash will be assessable recoupment which must be included in each year equal to the deduction in each year, until the total amount is included as assessable income.

ARE NON CASH BENEFITS INCOME?

Section 21A of the ITAA36 states that if a non-cash business benefit (whether or not convertible to cash) is income derived by a taxpayer the benefit shall be brought into account at its arm’s length value reduced by the recipient ‘ s contribution. In determining the income derived by a taxpayer, a non-cash business benefit that is not convertible to cash shall be treated as if it were convertible to cash. However, if the benefit is not convertible to cash – in determining the arm’s length value of the benefit, any conditions that would prevent or restrict the conversion of the benefit to cash shall be disregarded.

WHEN DO I DERIVE INCOME?

6-5(2) If you are an Australian resident, your assessable income includes the ordinary income you derived directly or indirectly from all sources, whether in or out of Australia, during the income year.

When we are working out what is our assessable income, we need to work out when the income was derived.

The first rule regarding when income is derived relates to when you may not have received the income, but it was applied or dealt with in any way on your behalf or as you direct. Have a look at these two paragraphs, one relating to ordinary income and one relating to statutory income:

6-5(4) In working out whether you have derived an amount of ordinary income, and (if so) when you derived it, you are taken to have received the amount as soon as it is applied or dealt with in any way on your behalf or as you direct.

6-10(3) If an amount would be * statutory income apart from the fact that you have not received it, it becomes statutory income as soon as it is applied or dealt with in any way on your behalf or as you direct.

Income is derived even if you did not receive it if you direct its use.

Note that the second paragraph above does not require statutory income to be derived. The provisions which include certain types of income as assessable income (i.e. as statutory income) usually also provide timing rules.

The cases specify when ordinary income is derived. They have established that the method of accounting for income will determine when income is derived.

If income is accounted for under the cash method, the income will be derived in the year it is received.

If income is accounted for under the accruals method, it will be derived in the year it is receivable (i.e. when it has been earned and there comes into existence a recoverable debt for which an immediate demand for payment may be made, although the debt is only payable in the future).

For example, if you account for your income on an accruals basis and send an invoice at the end of the year for goods provided, you will have to include the income in assessable income (even though you haven’t received it yet).

Over the years, it has been accepted that income is generally returned on a cash basis for:

  • Salary and wages and personal services income
  • Non-business income
  • Sole professional practitioners
  • Professional practice companies whose income flows mainly from the rendering of personal services by the professional practitioner
  • Income from investments

Income is generally returned on an accruals basis for:

  • Business income of a trading or manufacturing business
  • Business income from large professional practices – Henderson v FCT 1970

In Taxation Ruling TR 98/1 titled “Income tax: determination of income; receipts versus earnings” the Commissioner considers what types of income are derived on a cash or accruals basis (although he used different terms but they mean the same).

Here are a couple of examples from this Ruling:

EXAMPLE 1

Mr Done is a sole practitioner accountant. Mr Done’s practise also acts as an agent for a building society. His practice, including the income from his agency, is small with five regular employees (two of whom are family members). None of his regular employees has professional qualifications and Mr Done takes responsibility for all work that emanates from his office. On infrequent occasions, Mr Done hires an assistant accountant to do particular work for the practice.

The consistent business procedure maintained in his practice for many years is that records are kept and income tax returns are prepared based on cash received. Except for one or two clients who are billed quarterly, clients are billed when work is complete. No substantial credit is given or relied on by the practice.

It is accepted that Mr Done would find the earnings method an artificial, unreal and unreasonably burdensome method for arriving at the income derived. The particular circumstances that, on balance, would indicate this are:

  • Mr Done is the owner, operator and sole professional of a small professional practice;
  • he has been in business for many years and has always kept accounts on a receipts basis;
  • most clients are billed when work is completed and no substantial credit is given or relied on; and
  • the accountancy practice has no trading stock nor substantial fixed and circulating capital.

It is therefore accepted that a ‘substantially correct reflex’ of Mr Done’s income is calculated by the receipts method (cash basis).

EXAMPLE 2

Tammie is a dentist who runs her practice. Tammie employs another qualified dentist, Brian, two full time dental assistants and one full time receptionist/secretary. Although the majority of the patients who attend the practice are seen by Tammie, Brian performs work independently of Tammie and the income Brian generates is significant.

The equipment Tammie owns and uses in her business includes expensive and specialised dental chairs, drills and an X-ray machine. While Tammie requests patients pay at the time of each consultation, she regularly allows credit to patients and sends a reminder of the amount outstanding where necessary.

The relevant factors in this example are:

  • the income generated by Brian is significant;
  • Tammie relies on capital items, i.e., the equipment she owns and uses in the business; and
  • she extends credit and has procedures for the collection of debts.

It is considered that for purposes of tax, a substantially correct reflex of Tammie’s business income is given by the use of the earnings method (accruals method).

WHAT IS THE SOURCE OF INCOME?

If you are an Australian resident, then you include your income from all sources from all over the world.

However, if you are not an Australian Resident, then your assessable income only includes income from Australian sources.

The source of income is a question of fact, and a series of cases have made clear what is the source of various types of income.

The following is the source of various types of income:

  • Employment and contractual payments: Where the work is done
  • Income from trading: The place of the sale contract
  • Interest: Where the credit is provided
  • Dividends: Where the dividends are paid
  • Business services: Where the business is conducted

The challenge of assessing the source of income can be shown by similar cases coming to different outcomes. In the French case, an employee based in Sydney agreed in Sydney to work in NZ for two weeks for his Sydney employer. The source of the income was held to be New Zealand where the work was performed. In the Mitchum case, an actor agreed in Europe to work in Australia and the source was held to be Europe where the agreement was made. The difference was how important the agreement was.