In the Australian income tax system, income tax is levied on ‘taxable income’ received during the income year. The income year is generally 1 July to 30 June.
‘Taxable Income’ = ‘Assessable Income’ less ‘Deductions’.
Assessable income includes ordinary income (income according to ordinary concepts) and statutory income (income specifically made assessable by the Income Tax Assessment Act 1997 – the ‘Tax Act’).
Deductions include deductions under the general deduction section 8-1 of the Tax Act, and specific deductions.
Tax offsets may be allowable in certain circumstances. They reduce the amount of tax payable on the taxable income.
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.
Your assessable income also includes your statutory income from all sources, whether in or out of Australia.
The term ‘ordinary income’ is not defined. Its meaning must be determined by reference to case law.
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:
i) 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.
ii) 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.
iii) 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.
iv) Income received from the holding of property (e.g. rent, interest, dividends).
v) Consideration received for an assignment of the right to future income.
Receipts which 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 in respect to the revenue or capital nature of expenses incurred. These may also be used to determine whether a receipt is 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.
The Tax Act has sections that include specific amounts in assessable income. These are referred to as 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 at section 10-5 of the Tax Act.
Derivation of ordinary income
Ordinary income is only included in assessable income when it has been derived.
The provisions of the Tax Act do 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.
Section 8-1 of the Tax Act is the main section that allows deductions and it allows you to deduct any loss or outgoing from your assessable income to the extent that:
- It is incurred in gaining or producing your assessable income; or
- It is necessarily incurred in carrying on a business for the purposes of gaining or producing your assessable income.
However, you cannot deduct a loss or outgoing to the extent that:
- It is a loss or outgoing of capital, or of a capital nature; or
- It is a loss or outgoing of a private or domestic nature; or
- It is incurred in relation to gaining or producing your exempt income; or
- A provision of the Act prevents you from deducting it.
A loss or outgoing that you can deduct under this section is called a general deduction.
Section 8-5 of the Tax Act provides that you can also deduct from your assessable income an amount that a provision under the Tax Act allows you to deduct. This is called a specific deduction.
It can therefore be seen that deductions are available when they satisfy the requirements of sections 8-1 or 8-5 (i.e. they are general deductions or specific deductions).
When is an amount incurred?
Before a general deduction can be deductible, it must be ‘incurred’ in a particular income year.
There is no statutory definition of ‘incurred’, so it’s necessary to go to the cases for guidance.
The cases have established that expenditure will be incurred where there is an existing liability to pay an amount. That is:
- A definite commitment in the year of income to the loss or outgoing; and
- An existing legal liability to pay the amount (i.e. the event that triggers the liability to payment has occurred).
An amount need not actually have been paid out for a loss or outgoing to be incurred. A loss or outgoing may be incurred within section 8-1 even though it remains unpaid, provided the taxpayer has completely subjected itself to the liability.
An example would be if you received the electricity bill for your business at the end of the year. That would be deductible as it has been incurred by the end of the year, even though it is not yet paid.
Nexus with assessable income
To be deductible, an amount must be a loss or outgoing that is:
i) Incurred in gaining or producing assessable income, or
ii) Necessarily incurred in carrying on business for the purpose of gaining or producing such income.
There must therefore be a nexus between the loss or outgoing and either the gaining or producing of assessable income, or the carrying on of a business for the purpose of gaining or producing such income.
i) and ii) are referred to as the first and second limbs of section 8-1. The first limb is available to all taxpayers. Only businesses can rely on the second limb, which is generally regarded as wider in its application.
If this nexus cannot be established, the deduction will not be available under section 8-1.
Assessable income does not actually have to be produced for a deduction to be available. All that is necessary is an expectation that assessable income will be produced.
Section 8-1 provides for the deductibility of losses or outgoings to the extent that they are incurred in gaining or producing the assessable income or carrying on a business for that purpose. The words ‘to the extent that’ permit apportionment of the deduction claimed where there is a dual purpose, one that’s deductible and one that’s not.
Where the amount of a loss or outgoing is considered disproportionate, the ATO can look to purpose and the facts to determine whether some part of the deduction should be disallowed.
Purpose will not be relevant where expenditure is incurred involuntarily (e.g. theft).
Deductions are not available under section 8-1 for a loss or outgoing of capital, or of a capital nature. (These amounts may be added to the cost base of assets and considered in determining the capital gain).
As the Tax Act does not state when an amount will be regarded as being of capital or of a capital nature, it is again necessary to go to case law for guidance.
The following table summarises the three matters the courts have found need to be looked at when determining whether an amount is capital in nature.
|1. The character of the advantage sought, and in this, its lasting qualities may play a part.||For example, is the taxpayer acquiring a fixed asset (e.g. office equipment), or an asset which will be consumed?||Lubricants for manufacturing machinery are not capital.|
|2. The manner in which it is to be used, relied upon or enjoyed.||If an asset is to be used as part of the process by which profits are derived, it is revenue.||Price tags in stores are an example of assets used as part of the process by which profits are derived.|
|If an asset is to be used as an element in the creation and maintenance (or extension) of the profit- earning entity or organisation, the expenditure will be capital.||The purchase of display shelves in the store would be an example of an asset to be used as an element in the creation and maintenance (or extension) of the profit-earning entity.|
|3. The means adopted to obtain it.||Whether the outlay is:|
|i) A periodic one covering the use of the asset each period||Lease payments on motor vehicles are an example of a periodic outlay.|
|ii) Calculated as a single provision for the future use or enjoyment of the asset.||The purchase of a motor vehicle is an example of an outlay calculated as a single final provision for the future use or enjoyment of an asset.|
Note that deductions for expenditure which are private or domestic in nature are not allowable under section 8-1.
Whether an outgoing is of a private or domestic nature is basically a question of fact.
Traditionally, the costs of childcare, clothing which is not protective in nature or a compulsory uniform, and travel to and from work have been regarded as being of a private or domestic nature.
Section 8-1 also provides that expenditure is not deductible if:
It is incurred in relation to gaining or producing exempt income; or a provision of the Tax Act prevents you from deducting it.
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