Principles of Taxation Law 2021

Chapter 1 - Sources of taxation law

Key
points ............................................................................................
..................... [1.00]
Introduction...................................................................................
........................... [1.10]
Understanding tax law and the doctrine of
precedent .......................................... [1.30]
Technical differences between tax law and
accounting ......................................... [1.70]
Not all receipts are recognised for tax
purposes...................................................... [1.80]
Income tax law distinguishes between capital and revenue
expenses.................... [1.110]
Income tax law excludes some income and expenses for policy
reasons …............ [1.120]
Income tax law ignores some transactions on the basis of anti-
avoidance provisions........ [1.130]
Timing rules differ in income tax law and accounting principles
…………………………………..... [1.140]
Origins of judicial tax law
concepts .....................................................................................
[1.150]
Sources of tax
law ................................................................................................
............... [1.180]
Legislation .....................................................................................
...................................... [1.190] Income tax
legislation .....................................................................................
.................... [1.200]
FBT
legislation .....................................................................................
................................ [1.240]
Rates Act, Administration Act and International Agreements
Act ...................................... [1.245]
GST
legislation .....................................................................................
................................ [1.250]
Case
law.................................................................................................
............................... [1.270]
Rulings ..........................................................................................
....................................... [1.280]
Private
rulings ...........................................................................................
........................... [1.290]
Public
rulings ...........................................................................................
............................. [1.300]
Using this
chapter...........................................................................................
...................... [1.310]
Key points [1.00]
• The main tax legislation consists of two Income Tax Assessment Acts,
Fringe Benefits Tax Act and Goods and Services Tax Act.
• Tax legislation is interpreted using the doctrine of precedent, a process not
used in interpretation of financial accounting standards.
• There are five key differences between tax concepts and accounting
principles.
• Tax law exam problems usually involve facts that might attract two
alternative characterisations of a receipt or expense, and a good answer will
canvass both possibilities.
• The main sources of tax law are statutes and case precedents used to
interpret the provisions in tax law, but taxpayers can rely on Tax Office
rulings to avoid penalties when interpreting the law.

Introduction - [1.10]
Time and again, surveys show many commerce and business students view
taxation law as one of the most difficult subjects they encounter in their
studies. This need not be so provided, it is understood that the skills
necessary for the successful study of taxation law are fundamentally
different from other commerce subjects. If you understand the differences
and learn the essential techniques of how to study taxation law, you should
have no difficulty successfully completing the subject. [1.20] This chapter
gives valuable guidance on the skills that you need to develop to get the
most out of your study of tax law and explains how tax law differs from other
commerce subjects. The key points covered are as follows:
• The importance of the doctrine of precedent in interpreting tax law and its
absence from the interpretation of financial accounting standards: see
[1.30].
• Five technical differences between financial accounting and tax law: see
[1.70].
• Detail on how the doctrine of precedent led to different definitions of
“income” for financial accounting and tax law purposes: see [1.160].
• How to use the principal pieces of tax legislation in Australia and how the
main Acts work together: see [1.190].
• The importance of case law in the interpretation of the legislation: see
[1.270].

How you can most effectively access the hints set out in this chapter to
maximise higher grades in this subject is described at [1.310]

Understanding tax law and the doctrine of precedent [1.30]

Interpretation of the financial reporting standards is based on accounting
principles. The words in the standards are interpreted with a single aim: to
ensure amounts are recognised on a prudent and conservative basis that
reflects actual increases or decreases in a firm’s economic position.

The process of interpreting words in the tax legislation is fundamentally

different from the principle-based interpretation of financial reporting
standards. Terms in tax legislation are interpreted not by reference to any
commercial or economic principles, but instead on the basis of a system of
legal analysis known as the “doctrine of precedent”. The doctrine of
precedent is the foundation of the common law legal system used in English-
speaking countries. The doctrine of precedent requires judges (and, as a
result, tax officials) to interpret words in laws in a manner that is consistent
with the interpretation of those words in earlier judgments. If the facts of a
later case are the same as those in a previously decided case, a similar
result should follow in the later case. If the facts in the later case are slightly
different from the earlier case, the precedent may be distinguished and
another result might follow.

[1.40]
The first step in solving a tax law problem is to find the relevant rules in the
tax legislation. Rarely, however, will only one rule be relevant. More likely,
two or more provisions might potentially apply to the transaction described
in the problem, with the borderline between competing rules unclear. To
determine on which side of the borderline a given transaction will fall, the
tax accountant must proceed to the second step in solving a tax law
problem, which is to interpret the words in the different rules. This, as
mentioned at [1.30], is completed by looking at the judicial precedents in
earlier tax cases. The process is perhaps best explained with an illustration.

Example 1.1: Using precedents

A tax accountant is asked to advise a client who makes pottery whether
there is any tax liability when she gives a piece of pottery to a friend. First,
the accountant will turn to the tax legislation to find the relevant tax rules.
They are very clear. If the client’s activities amount to a business, the item of
pottery is trading stock and a tax liability is triggered when a taxpayer
disposes of trading stock outside the ordinary course of business. If the
client’s activities are merely a hobby, the pottery is a personal asset, not
trading stock, and there is no tax liability when a personal asset is given
away. The law is obvious – there is one legal consequence if the client’s
activities amount to a hobby and another if they amount to a business.

The tax legislation is silent, however, as to when activities cross the

threshold from being a hobby to becoming a business. To answer the crucial
question as to whether the client’s activities constitute a hobby or a
business, the accountant will look outside the legislation to the precedents of
previously decided court cases and try to find a case that closely resembles
the client’s situation. The outcomes in those precedents will provide a good
indication as to whether the client’s activities will amount to carrying on a
business as a matter of tax law. To the extent that the client’s situation is
similar to the situations of taxpayers described in the precedents, the same
characterisation is likely to apply to the client’s activities. To the extent that
the client’s situation differs from the situations of taxpayers described in the
precedents, a different characterisation may apply. The tax accountant must
decide whether the precedents will apply to the client and yield the same
characterisation of the client’s activities or whether the facts in the
precedents are sufficiently different for them to be distinguished with a
different characterisation applying to the client.

[1.50]
An important difference between tax law advice and accounting advice is the
relative level of certainty. The accountant providing accounting advice can
state with confidence that an outcome does or does not conform to
accounting standards. In fact, on audit, an accountant must be completely
certain before signing off on the audit.

In contrast, the accountant dispensing tax law advice may only state a
probability, based on the accountant’s interpretation of the precedents and
indications in public rulings issued by the Australian Taxation Office (ATO) of
how the Commissioner of Taxation (Commissioner) interprets those
precedents (the roles of the ATO and Commissioner are explained at
[1.280]). This advice will be expressed as a view of how the law is likely to
apply to the client but will caution that, as with any advice on legislation,
another interpretation is always possible.

The fact that there are two alternative arguments does not mean that there
is no “answer” to a tax question. When the facts of a particular case are
considered in light of the precedents, a probable answer will emerge and,
while there is no guarantee that a court will not prefer the alternative
argument, advice should set out the likely outcome with a summary of the
alternative answer that could prevail if the expected outcome does not
occur.

[1.60] Example 1.1 illustrates two aspects of tax law that commerce
students sometimes find troubling. The first is learning how to use the
doctrine of precedent – relying on decisions in previous cases to advise on
how the law will apply to a new set of facts. The second is coming to grips
with the inherent uncertainty of any advice based on precedents.

By definition, there is always a correct answer to an accounting problem.

Accounting students are trained to discover the answer by way of coherent
facts and unambiguous rules. But in tax law, students can only offer opinions
of how precedents are likely to apply. To provide an opinion that first explains
one possible outcome and then canvasses other possible competing views or
interpretations of precedent is contrary to everything that an accounting
student has previously been taught. No wonder then that commerce
students find tax law difficult until they master the new skills required to
succeed in the subject.

Technical differences between tax law and accounting [1.70]

The commerce subject that at first glance seems most similar to taxation law
is financial accounting. Both accounting and tax law scrutinise receipts and
expenditures and measure net gains over an annual accounting period.
However, these apparent similarities mask five key differences between the
two subjects:
• Not all receipts are recognised for tax purposes: see [1.80].
• Accounting principles recognise all outgoings but may record an offsetting
asset if an expenditure gives rise to an ongoing benefit or property. Income
tax law distinguishes between capital and revenue expenses and recognises
expenditures depending on their classification: see [1.110].
• Income tax law excludes some income and expenses for policy reasons:
see [1.120].
• Income tax law ignores some transactions on the basis of anti-avoidance
provisions: see [1.130].
• Timing rules differ in income tax law and accounting principles: see
[1.140].

Not all receipts are recognised for tax purposes [1.80]

To begin with, accounting rules and tax law take substantially different
approaches to recognising receipts.

The objects of accounting are to measure net gains or losses over a period
and to measure net assets and liabilities at the end of the period. To do this
accurately, accounting must recognise all receipts, whatever their character.
When preparing a set of accounts, an accountant starts with gross income,
meaning all amounts received by a business; profits from business activities,
returns on investments, an unexpected windfall and even a gift will be
included in the income account. If a receipt is genuinely unexpected or
unusual, the accountant will note that it is an unanticipated or one-off
receipt so readers of the accounts are alerted to the fact that the receipt
should not be regarded as typical and likely to be repeated each year. But
the receipt itself will be fully recognised for accounting purposes to the same
extent as repeated receipts such as ordinary and regularly received business
income.

[1.90] In contrast, some receipts are not recognised at all for tax law
purposes while others are recognised but partially excluded from tax
accounts. Many one-off or unusual receipts in particular are excluded or only
partially recognised for tax purposes.

Receipts that are recognised for tax purposes are known as “assessable
income”. Early Commonwealth income tax Acts defined assessable income
using language almost identical to that used in financial accounting. Indeed,
the early income tax laws looked very similar on paper to accounting
principles. However, drawing on concepts from other areas of the law, courts
concluded that gross income for tax purposes comprised only a subset of
gross accounting income. See [1.160] for more detail on how the courts
developed this narrow concept of income, now known as “ordinary income”.
As a result of the restricted judicial interpretation of “income” for tax
purposes, when income tax was first imposed in Australia, only a slice of
accounting gross income was transferred to the income side of a tax return:
see [1.150]–[1.170].

[1.100] Soon after income tax was first adopted by the Commonwealth
Government in 1915, the legislature began to broaden the tax base beyond
“ordinary income”. Over the years, many sections were added to the income
tax Acts to bring into assessable income various types of receipts, which had
been excluded from the judicial concept of “ordinary income”. Since 1997,
the receipts that have been brought into assessable income by specific
inclusion provisions have been known as “statutory income”.

As a result of these developments, the accountant’s gross income for

accounting purposes must be categorised into three boxes for tax purposes:
ordinary income, statutory income (now included in assessable income, but
often subject to concessional treatment or partial exclusion) and other
receipts. The third category of receipts – amounts that are neither ordinary
income nor statutory income – still falls completely outside the scope of
income tax law, though of course they are recognised for financial
accounting purposes.

Case study 1.1: Gifts

In FCT v Slater Holdings Ltd (1984) 156 CLR 447, the father of
shareholders in a company gifted money to the company. As gifts
are not characterised as ordinary income under the judicial concept
of income and there is no statutory income measure that includes
gifts, the amounts had not been included in the assessable income
of the company. However, the Full High Court agreed that the
payments were nevertheless “profits” of the company within the
accounting sense of that word.

Income tax law distinguishes between capital and revenue expenses

[1.110]
A second significant difference between financial accounting and tax law is
the treatment of expenses in the two systems. Accounting principles
recognise outgoings as expenses in the profit and loss statement unless the
expenditure yields an asset. In that case, the change is reflected on the
balance sheet by an increased value in long-term assets and a
corresponding decrease in short-term assets or cash, if the company’s own
resources are used to purchase the asset, or a corresponding increase in
external debt, if the company borrows to acquire the asset. The cost of the
asset is then recognised as deductions on the profit and loss statement as it
is used or depreciates in value. In contrast, tax law distinguishes between
two broad categories of expenditures: “revenue” expenses and “capital”
expenses. Revenue expenses are deducted when they are incurred. Capital
expenses incurred to acquire assets that waste over time, such as
machinery, buildings or intellectual property, are deducted over a period
under a “capital allowance” or a “capital works” system. Capital expenses
incurred to acquire assets that do not waste over time, such as land or
shares, are recognised as the cost base to calculate profits on disposal of the
assets.

However, the distinction between capital and revenue expenses is based on

judicial doctrines derived from case law and these may result in an expense
being labelled a “capital” expense even if no asset is acquired. Whether an
asset is acquired with the expenditure is not one of the factors considered
directly in the judicial doctrines that distinguish between revenue and capital
expenses. Instead, the judicial tests look at factors such as the frequency of
similar expenses and the relationship between the expense and a business’
income-earning “process” and income-earning “structure”. As a result,
income tax law permits immediate deductions for some expenses that would
be depreciated over a period of years for accounting purposes while it
requires deductions over many years for some expenses that would be
expensed immediately on a profit and loss statement in accounting practice.

Case study 1.2: Expenses to protect position

In Broken Hill Theatres Pty Ltd v FCT (1952) 85 CLR 423, the taxpayer
incurred legal expenses opposing a licence application by a potential
competitor. Licence applications were heard annually, and, as a result of the
expenditure, the taxpayer was protected from competition for at least 12
months. The taxpayer argued that the expense should be deductible as a
revenue expense as it did not alter or add to any asset of the taxpayer.
However, the Full High Court viewed the expense as one related to the
structure of the taxpayer’s business, namely its ability to continue to operate
without a competitor. Therefore, although the expense would be immediately
deductible for accounting purposes, the Court characterised the outgoing as
a capital expense for tax purposes and denied the taxpayer an immediate
deduction. The expense would now fall into one of the statutory provisions
that allow taxpayers to deduct capital expenses over a period. Under s 40-
880 of the Income Tax Assessment Act 1997 (Cth), a taxpayer would be able
to deduct a capital expense of this type in equal instalments over five years.

Income tax law excludes some income and expenses for policy
reasons [1.120]
A third major difference between financial accounting and tax law emanates
from the inclusion of many “policy” provisions in the income tax laws. In
terms of the profit and loss account, accountants pursue a single objective of
measuring net gains in the accounting period. The tax law, in contrast, is
used by politicians to achieve a wide variety of social and economic
objectives. Thus, for example, while an accountant records all income and
receipts for financial accounting purposes, the tax law explicitly exempts
some types of otherwise assessable receipts for policy reasons. On the
expenditure side, the financial accountant does not distinguish between
different types of expenses for policy reasons: if an expense was incurred in
a business, it is recognised for accounting purposes. The tax law, however,
explicitly denies taxpayers deductions for some types of payments. For
example, to discourage taxpayers from engaging in prohibited activity when
carrying on a business, the tax law denies deductions for expenses such as
fines, bribes and some expenses incurred in illegal businesses.

Income tax law ignores some transactions on the basis of anti-

avoidance provisions [1.130]
A fourth important difference between accounting and tax law derives from
the effect of numerous anti-avoidance provisions in the tax law. Financial
accounting measures net profits on an entity-by-entity basis. If one entity
pays an excessive amount to another related entity, accounting will ignore
the relationship between the two entities and record an expenditure by the
first entity and a receipt by the second. Tax law may ignore the transfer,
however, if it falls afoul of an anti-avoidance rule that seeks to prevent
taxpayers shifting profits from one entity subject to high tax rates to a
related entity (a relative or another entity owned by the same person)
subject to low tax rates. In addition to a large number of specific anti-
avoidance provisions in the tax legislation, there is a general anti-avoidance
rule in the income tax law made up of several sections that operate together
and which are collectively referred to as Pt IVA (pronounced “four A”, as the
IV is the roman numeral for the number four) after the location of the rule in
the Income Tax Assessment Act 1936 (Cth) (ITAA 1936). Like the specific
anti-avoidance measures, the general anti-avoidance provisions can lead to
divergences between financial accounting and tax law. Another general anti-
avoidance rule is included in the goods and services tax law, and a further
general anti-avoidance rule is included in the fringe benefits tax law.

Timing rules differ in income tax law and accounting principles

[1.140]
Finally, a fifth major difference between accounting and tax law arises as a
result of the different timing rules for when income receipts and expense
payments are recognised. Financial accounting principles roughly align with
a business’ economic position. Receipts are recorded on an accrual basis and
offset by provisions if the receipts relate to future obligations. Outgoings are
similarly recorded on an accrual basis and offset by assets if assets are
acquired as a result of the expenditures. These receipts and expenditures
are not reflected immediately in the profit or loss accounts; receipts
encumbered by future obligations are brought into profit or loss accounts
only as the offsetting obligations are satisfied and expenditures for assets
lasting beyond the end of the year are brought into profit or loss account
only as the offsetting assets are consumed. In contrast, income tax law
measures receipts when they are “derived” and evaluates expenses when
they are “incurred”.
As a result of judicial interpretation, the terms “derived” and “incurred” have
unique judicial meanings. Only sometimes do the tax rules relating to when
income is derived and when expenses are incurred coincide with accounting
principles that determine when receipts and outgoings enter profit and loss
accounts.

Origins of judicial tax law concepts [1.150]

We have seen that there are five main areas of difference between
accounting and tax law concepts: see [1.80]–[1.140]. Only two of these
differences are the result of specific rules in the tax legislation: the adoption
of special rules to achieve policy objectives other than the measurement of
net gains and the adoption of specific anti-avoidance provisions and one
general anti-avoidance rule. The remaining areas of divergence between
financial accounts and tax accounts result from judicial concepts: the judicial
distinction between ordinary income and other receipts, the judicial
distinction between revenue expenses and capital expenses, and the judicial
concepts of when amounts are derived and when expenses are incurred.
Understanding the origins of those concepts is crucial to learning how to
study tax law and write tax law exams.

[1.160] Income tax is imposed on a taxpayer’s “taxable income”, which is

defined as a person’s assessable income minus deductions. Assessable
income was defined in the original income tax laws as gross income while
deductions were allowed for expenses other than capital expenses.

Australian courts were not encountering these terms – “income” and “capital
expenses” – for the first time when they appeared in the original income tax
laws. Both terms had been used much earlier in trust law. Trust law
distinguished between two types of trust beneficiaries: income beneficiaries
and capital beneficiaries. All receipts derived by the trustee had to be
classified as either income gains or capital gains to determine which class of
beneficiaries would be entitled to the receipts. All expenses incurred by the
trustee had to be classified as either revenue expenses or capital expenses
to determine which class of beneficiaries would be charged for the
outgoings.

When income taxation was first adopted in Australia, the courts concluded
that the term “income” was intended to have the same meaning for tax law
as it did for trust law. As a result, only receipts meeting the trust law concept
of income were presumed to be income for tax purposes. Similarly, expenses
labelled capital outgoings under trust law doctrines were treated as capital
expenses for tax law purposes. As is pointed out at [5.20], while the original
trust law notions of income may be much narrower than those used in
accounting, they are probably similar to the understanding of income held by
an “ordinary” person on the street. It is for this reason that gains fitting in
the original judicial concept of income for tax purposes are usually labelled
“ordinary income”.
[1.170] Later chapters in this book explore in detail the nature of ordinary
income and the tests used by the courts to determine whether a receipt will
constitute ordinary income. As will be seen, one of the main features of
ordinary income is its identification with a source that generates the income.
If a receipt can be seen to be a product of labour or business activity or the
use or exploitation of property, it will acquire an income character under the
judicial tests.

Thus, for example, salaries are considered ordinary income from

employment, proceeds from the sale of trading stock are considered ordinary
income from business, and royalties or interest payments are considered
ordinary income from property.

The basic tests used by the courts to identify when a receipt might
constitute ordinary income from labour, business or the use of property are
bolstered by two supplementary judicial tests. The first supplementary test
treats a receipt as income if it has certain income-like characteristics,
namely that it is periodic in nature, expected by the recipient and applied to
the same uses as other types of income might be applied. The second test
treats a receipt as income if it is received as compensation for lost income or
in substitution for what would have been income receipts.

Sources of tax law [1.180]

While tax law ultimately derives from the statutes that impose the tax, as we
have noted, the coverage of the inclusion sections, exemption provisions and
deduction measures is based on interpretation of the law based on judicial
precedents. Thus, court cases have become a second source of law in
Australia. A third source for tax rules in practice, if not strictly as a matter of
law, is the interpretations issued by the Commissioner in the form of
“rulings”. These three sources are explained at [1.190]-[1.300].

Legislation [1.190]
As taxation law is a creation of statute, its primary source lies in legislation,
and the income tax part of a taxation course is based on the operation of
three pieces of legislation: Income Tax Assessment Act 1936 (Cth) (usually
referred to as the ITAA 1936), Income Tax Assessment Act 1997 (Cth)
(usually referred to as the ITAA 1997) and Fringe Benefits Tax Assessment
Act 1986 (Cth) (usually referred to as the FBTAA).

This section of the chapter explains why there are two income tax laws and a
separate fringe benefits tax law.

A fourth piece of legislation, A New Tax System (Goods and Services Tax) Act
1999 (Cth) (usually referred to as the GST Act), is also relevant to the study
of Australian tax law although it does not tax income but instead is a tax on
final consumption. The background to the GST Act is described at [1.250]-
[1.260] and the operation of the GST system is described in Chapter 25.
Four further Acts are relevant: an “income tax Act” contains the law which
imposes the tax on the base set out in the two Income Tax Assessment Acts,
a “rates” Act sets out the actual rates of income tax, a “tax administration”
Act sets out the administrative rules for all tax laws and an “international
agreements” Act modifies the income tax laws in the case of income derived
overseas or by a non-resident taxpayer, as explained in [1.245].

Income tax legislation [1.200] Parallel Commonwealth and State laws. The
first Commonwealth income tax in Australia was adopted in 1915. All six
States had previously adopted State income taxes, and, when the Federal
Government adopted its income tax in 1915, the Commonwealth law
operated in parallel to the State laws. As the States had already established
income tax administrations, it was agreed that the States would collect the
Commonwealth income tax on behalf of the Commonwealth.

The Commonwealth law differed in some respects from the State laws and
these, in turn, differed between each State. As a result, State income tax
administrators had to deal with two sets of laws and also had to divide
revenues, where businesses operated across State borders. An attempt to
better harmonise the laws in the 1920s brought the different laws somewhat
closer together for a brief period, and in 1936, the States and
Commonwealth agreed on a fully harmonised model that was enacted in
each State and by the Commonwealth to replace the differing laws. The
Commonwealth adopted the ITAA 1936 as a part of the harmonisation
program. The parallel State and Commonwealth income taxes remained in
effect only for a short time. In 1942, in the midst of the WWII, the
Commonwealth effectively appropriated the exclusive power to levy income
tax as a “temporary” wartime measure, instituting a system of transfer
payments to the States to replace their lost revenue. The income tax has
since remained a Commonwealth-only tax.

[1.210] Tax law rewrite. The gaps in the Australian income tax laws caused
by the somewhat narrow tax base (constrained by reliance on the judicial
concept of ordinary income) provided numerous opportunities for avoidance.
Rather than address the underlying problems that gave rise to resulting
avoidance schemes, the legislature usually responded to costly avoidance
arrangements with narrow and very ad hoc rules, including many piecemeal
rules that brought different types of receipts into assessable income as
statutory income. A deluge of avoidance arrangements in the late 1970s and
early 1980s led to an explosion of complicated tax provisions, and by the
mid-1980s, the income tax law was, in the eyes of many, extraordinarily
complex.
Reforms in the mid-1980s led to further income tax complexity, and in the
early 1990s, the Government announced a project to rewrite the income tax
law using plain-English drafting style. The Government hoped the different
drafting style might simplify the law. The first parts of the rewritten law were
released as the ITAA 1997. Over the following three years, many measures
were shifted from the ITAA 1936 to the ITAA 1997, but the plans to move the
entire income tax law across stalled by 2000, when a major Business Tax
Review known as the Ralph Review (named after the chairman of the review)
proposed a range of amendments to tax laws. Since that time, drafting
resources have been divided between enacting ongoing changes to the
income tax law and moving existing measures in the ITAA 1936 to the ITAA
1997, and more than two decades after the process started, most of the old
law has been redrafted but some important measures remain in the ITAA
1936.

[1.220] Concurrent Income Tax Assessment Acts.

Accordingly, there are two separate income tax Acts that tax students must
consider when answering income tax law problems: the ITAA 1936 and the
ITAA 1997. Students will mostly be concerned with the ITAA 1997 as the key
statutory income measures have been moved from the ITAA 1936 to the
ITAA 1997. As a general rule, it is easy to differentiate the provisions of the
two principal Acts because each Act adopts a different numbering system.

The sections of the ITAA 1936 are not hyphenated (e.g., s 44, s 63) while
sections in the ITAA 1997 are hyphenated (e.g., s 6-5, s 8-1).

[1.230] Capital gains tax.

Almost as soon as the Commonwealth income tax was enacted and the
courts read the law as applying only to the category of gross income that
they labelled “ordinary income”, the legislature started broadening the tax
base. From 1915 until 1985, the broadening of the tax base was achieved
through a continual stream of new inclusion amendments. Almost all
amendments were narrow measures targeted at particular types of receipts
or particular schemes aimed at taking taxpayers out of the tax net. The
growth of statutory income sections was matched on the deduction side by
the adoption of many provisions designed to recognise expenses that the
courts had labelled capital expenses and which therefore fell outside the
scope of the general deduction provision. Despite a growing array of
statutory income and capital expense provisions, many gains and outgoings
remained outside the tax system.

In 1985, the Government shifted its approach from the use of piecemeal
inclusion and deduction provisions to a more comprehensive solution, with
the adoption of broad-based capital gains measures designed to sweep up
most gains and losses that remained outside the tax base. The provisions,
which became known as the “capital gains” measures, were complex
because they used many artificial deeming rules to capture gains that did
not fall in the basic capital gains rules. The original capital gains rules were
replaced in 1998 by a revised capital gains regime, labelled the “capital
gains tax” or CGT provisions. A key feature of the new rules was the
replacement of the artificial deeming rules found in the original provisions
with a set of rules that described different CGT “events”, each aimed at a
different type of capital gain to be brought into the income tax. The new CGT
rules were placed in the ITAA 1997.

The name of the new rules, the CGT or capital gains “tax” rules, is the source
of some confusion as it suggests that capital gains are subject to a separate
tax. This is not the case. The CGT rules are discrete in the sense of matching
gains and losses to determine a net capital gain included in assessable
income. But despite its misleading name, the CGT is not a separate tax. It is
fine to talk about a gain being subject to the CGT, but it is important to
understand that any gain brought into the tax system via the CGT will
actually be taxed as part of assessable income subject to income tax under
the ITAA 1997.

FBT legislation [1.240]

The judicial concept of “ordinary income” under the income tax legislation
only included cash or non-cash benefits that could be converted to cash. A
receipt that otherwise would be treated as income from labour, business or
property would not be considered ordinary income if it did not take the form
of cash or a benefit that the recipient could turn into cash.

The effect of this restriction on the ordinary income concept was to exclude
from the tax base many types of fringe benefits (non-cash benefits) provided
by employers to employees. The legislature initially responded to the
problem by inserting a provision in the income tax law that included non-
cash fringe benefits in assessable income. However, the original provision
was not well drafted and, to the extent that it could function, it was poorly
administered.

As a consequence, many non-cash benefits continued to escape tax. Rather

than amend the income tax provision to repair its shortcomings, in the mid-
1980s, the Government decided to copy a New Zealand precedent and move
most employment fringe benefits into a separate assessment Act, the
FBTAA. FBT is collected from employers providing the benefits, rather than
the employees receiving them. The income tax law explicitly excludes from
an employee’s income for income tax purposes the value of any benefits
that are fringe benefits as defined by the FBTAA. Since fringe benefits are
explicitly excluded from the income tax, the FBTAA is the starting point for
any problem involving a benefit to an employee other than salary or wages
and, if the benefit satisfies the definition of a fringe benefit under the FBTAA,
it is not necessary to consider other tax laws.
The income tax law must be considered only if the problem involves a cash
benefit that does not fall within the broad understanding of salary or wages
since salary and wages are not a fringe benefit according to the FBTAA.

Rates Act, Administration Act and International Agreements Act

[1.245]
Four supplementary laws play important roles in the income tax system. The
first of these is the Income Tax Act 1986 (Cth). It is thought that the
Australian Constitution requires two separate laws to levy an income tax: an
assessment Act that measures taxable income that will be subject to tax and
an imposition Act that then imposes tax on that base. The Income Tax Act
1986 imposes a tax on taxable income at the rate of tax set out in a second
supplementary Act, the Income Tax Rates Act 1986 (Cth). Third, the Tax
Administration Act 1953 (Cth) contains the administration rules for collection
of the tax and various penalties to ensure compliance with the tax laws. The
fourth law is the International Tax Agreements Act 1953 (Cth). When
Australian residents derive income overseas, they will be potentially subject
to two tax systems. Australian residents are taxed on their worldwide
income, including income derived abroad. The country in which the income
was earned may also levy income tax as the “source” jurisdiction. Similarly,
non-residents who derive income in Australia will be subject to Australian tax
on income with a source in Australia and quite possibly to their own
country’s income tax on their worldwide income.

While both countries’ tax systems can solve the problem of double taxation
through their own various credit or exemption rules, the normal practice that
has emerged in the international arena is an agreed division of taxing rights
through a bilateral (two country) tax treaty. Australia has signed more than
40 tax treaties. The taxing rules in these treaties are given effect by the
International Tax Agreements Act 1953, which allows the treaties to override
the normal income tax assessment laws.

GST legislation [1.250]

To bolster tax revenues during the economic downturn that became the
Great Depression, the Commonwealth Government adopted in 1930 a
wholesale sales tax that applied to the sale of goods. The tax was
problematic in many respects, causing significant economic distortions by
levying different rates on different types of goods and not applying to
services at all. Over the following 70 years, there were many calls for its
replacement with a broad-based consumption tax that would apply to final
consumption only. This was finally achieved in 1999, with effect from mid-
2000, when the wholesale sales tax was replaced by the goods and services
tax (known as GST). While the GST is intended to be a tax on final
consumption only, it is levied at every level of the supply chain and then
reimbursed by way of credits or refunds to registered businesses in the
chain, leaving the full burden to be borne by the final consumer.
[1.260] The GST system operates independently of income tax and FBT
systems. In other words, there is little reason to be concerned about GST
when thinking of income tax or vice versa. However, for practical reasons,
the two must be viewed in parallel as both GST liability (and entitlement to
credits for GST included in the price of purchases) and certain income tax
payments (in particular an employer’s liability for income tax withheld from
the wages of employees) are reported on the same tax interim return known
as a Business Activity Statement (BAS). FBT liability is reported separately.
One point of intersection between the BAS and GST is the treatment of GST
payments in the income tax. In most cases, a business paying GST on its
purchases will be entitled to credit for the tax or a refund.

Because the GST paid on acquisitions will be returned to the business, it is

not considered a cost of doing business. Consequently, the income tax
contains a provision denying a deduction for GST that will be credited or
refunded back to the taxpayer. In some situations, a business is not entitled
to credits or refunds of GST on purchases. In those cases, the tax is
deductible as a cost of doing business for income tax purposes.

Case law [1.270]

We have seen that the meaning of the words in tax laws derives from judicial
precedents or decisions of courts interpreting the provisions in past cases.
The extent to which the precedents will be binding on future courts depends
on the level of the court creating the precedent.

Decisions of the Australian High Court, the final court of appeal in Australia,
are the strongest authority for interpretation of law. Decisions of the Federal
Court or State courts are followed if there is no High Court decision on a
point. In each case, the appeal levels (the “Full Federal Court” in the first
case and State “Supreme Courts” in the second case) take precedence over
decisions of lower courts. At the bottom of the precedent pole are decisions
of the Administrative Appeals Tribunal or its predecessor in tax cases, the
Board of Review. These are (or were, in the case of the Board) administrative
bodies with less authority than a court. In the early days of tax jurisprudence
in Australia, there was a significant reliance on precedents of UK courts. It is
far less common today to look at UK decisions to interpret the provisions of
the Australian tax law. However, many earlier UK cases continue to be
influential, and you will find a number of instances of reliance on decisions
by UK courts in the chapters which follow.

Rulings [1.280]
Australia’s income tax administration is built upon a somewhat unusual
foundation. The tax laws are administered by a government agency, the
ATO. However, the tax law does not actually create the agency. Rather, it
empowers a statutory officer (a government official whose appointment is
protected by a statute or public law) to administer the tax laws. That person
is known as the Commissioner of Taxation (Commissioner).

The ATO is the agency that carries out the actual administration, but in
theory, it is doing so on behalf of the Commissioner. As a result, it is common
to refer to actions of the ATO as acts of the Commissioner and to refer to
advice from the ATO as coming from the Commissioner. Australia’s income
tax law, FBT law and GST law all operate on what is known as a “self-
assessment” system. Under this system, taxpayers are responsible for
interpreting the tax law and applying it to their transactions when they
complete a tax return. The laws provide sometimes severe penalties for
incorrect reporting of tax liability as an incentive for taxpayers (or, in reality,
in most cases their professional advisers) to get it right.

Private rulings [1.290]

Taxpayers who are genuinely unsure how the law will apply to a particular
transaction can protect themselves from the risk of a penalty by asking the
Commissioner for a “private ruling” on how the ATO would apply the law to
that transaction. These rulings are “binding” on the Commissioner, meaning
that the Commissioner must honour the ruling and shield a taxpayer from
any penalties if the taxpayer follows the advice in the ruling, even if a court
later decides the ruling was not a correct interpretation of the law. While
private rulings are delivered directly to taxpayers who request them, the ATO
often produces a “sanitised” version that describes the question asked and
the Commissioner’s answer without identifying the taxpayer who originally
posed the question. These published versions of private rulings placed on
the website are known as ATO IDs, an acronym for ATO interpretative
decisions. Public rulings [1.300] In addition to providing individual taxpayers
with private rulings on request, the Commissioner often issues public rulings
which set out more generally the ATO’s views on the way in which a
provision of an Act should be applied to determine the extent of tax liability.
A public ruling may also be used to explain which factors will be taken into
account by the Commissioner when exercising a discretion provided in the
tax law and how those factors will affect the decision the Commissioner is
empowered to make. Like private rulings, public rulings are binding on the
Commissioner, meaning that a taxpayer who relies on the view in a public
ruling to complete a tax return cannot be penalised if that view is later found
by a court to be an incorrect interpretation of the law.

Using this chapter [1.310]

This chapter outlines some of the key differences between commerce and
accounting units and the tax law subject. Understanding these differences is
important to understanding how to study for a tax law exam and how to
answer a tax exam question. Chapter 2 provides some details on how to
study taxation law and prepare for exams. This chapter contains examples of
issues that will be covered in more detail in your tax law course. It only
touches upon these issues for the purpose of showing two things: how tax
law contains many borderlines between competing rules and how
precedents will be used in an exam answer to characterise a transaction and
explain on which side of the border a particular set of facts is likely to fall.
The other chapters in this book explain in much more detail the tax rules
mentioned in the examples in this chapter and the tests established in case
law precedents that are used to decide which tax rule will apply to a
transaction straddling the border between competing provisions. Return to
this chapter periodically during the course. There is a risk that, as you learn
about sections of the tax legislation and the case law tests used to interpret
those sections, you will lose sight of how this information should be digested
and used in an answer to a final exam question. Regular reviews of this
chapter may help remind you of the bigger picture and provide guidance on
translating what you learn about tax legislation and case law precedents into
higher grades in the exam.
Chapter 2 - Study skills for taxation law
Key
points ............................................................................................
.......... [2.00]
Introduction...................................................................................
................. [2.10]
Course
aims ..............................................................................................
..... [2.20]
Level of understanding
required ................................................................... [2.30]
Nature and timing of
assessment.................................................................. [2.40]
Format of the
examination ...........................................................................
[2.50]
Prepare a study
plan...................................................................................... [2.60]

Notes and
summaries ...................................................................................
[2.70]
Overviews ......................................................................................
............... [2.80]
Detailed
notes..............................................................................................
. [2.90]
Additional textbook
resources ...................................................................... [2.100]
Short answer
assignments ............................................................................
[2.105]
Written essay
assignments ...........................................................................
[2.110]
Research .......................................................................................
................ [2.120]
Step 1: Understand the question and the
facts ............................................ [2.130]
Step 2: Identify the
issues .............................................................................. [2.140]
Step 3: Research the relevant legislation and
cases ...................................... [2.150]
Step 4: Apply the law to the
problem ............................................................ [2.180]
Step 5: Form a
conclusion ..............................................................................
[2.190]
Planning and writing the
assignment ............................................................. [2.200]
Plan ..............................................................................................
................... [2.210]
Introduction ...................................................................................
................. [2.220]
Body of the
assignment ..................................................................................
[2.230]
Cite appropriate
authority ..............................................................................
[2.240]
Referencing and secondary
sources ................................................................ [2.250]
Conclusion .....................................................................................
.................. [2.260]
Exam
preparation ...................................................................................
......... [2.280]
Identifying examinable
material ...................................................................... [2.290]
Preparing revision notes and
summaries ........................................................ [2.300]
Developing problem-solving
skills ................................................................... [2.310]
Working in small
groups ..................................................................................
[2.320]
Traps to
avoid .............................................................................................
..... [2.330]
Examination
techniques...................................................................................
[2.340]
Supervised open-book
exams.......................................................................... [2.360]
Take-home
exams ...........................................................................................
[2.365]
Answering multiple
choice .............................................................................. [2.370]
Strategy ........................................................................................
................... [2.380]
Answering problem
questions ........................................................................ [2.390]
Identify the relevant
law ................................................................................ [2.400]
Apply the law to the
facts .............................................................................. [2.410]
Present a
conclusion .....................................................................................
. [2.420]
Sample examination answers and
analysis .................................................... [2.430]
Additional examination
tips ........................................................................... [2.460]
Using this
chapter...........................................................................................
[2.470]
Online
resources ......................................................................................
...... [2.480]
Glossary of terms used in assignments and exams
………............................... [2.490]

Key points [2.00]

• Have a clear understanding of the requirements of your course, including
the level of knowledge required for each topic and the assessment
requirements.
• Construct and implement a study plan.
• Prepare reliable notes after each class.
• Practise applying legislation and case precedent to tax law problems.
• Instructors are normally looking for you to show an understanding of the
law rather than answering a problem question with a simple “yes” or “no”.
• In problem-type questions, first identify the tax law issue(s) that are raised
by the facts.
• If you are having problems identifying the tax issue(s) in problem-type
questions, review your summaries of the law and look for key words in the
facts.
• In problem-type questions, do not form your conclusion until you have
explored and applied the law to the facts.
• Prepare broad summaries of your notes, legislation and cases as
preparation for the examination. • Organise your notes for open-book exams
and do not rely too heavily on the material you can take in; your summaries
are your best support in the exam.
• Practise sound exam technique so that you do not waste time in the exam.

• In problem-type exam questions, remember to: – clearly understand the

facts and the question; – state the tax issue(s) you have identified from the
facts; – identify the relevant law, legislation and cases; – apply the law to the
facts; – form your conclusion based on your discussion of the law and state
additional information that may be needed to clarify your conclusion.

Introduction [2.10]
To gain the most from the content of this chapter, it is important that you
practise these skills early in your course so that you are well prepared to
develop a sound study plan. However, it is also useful to return to this
chapter to help with specific study or assessment issues that you may face
during the course. The techniques presented in this chapter aim to improve
the efficiency and effectiveness of your study skills to enable you to gain the
most from your taxation law course and to perform your best in assessment
tasks. These techniques can be used for both face-to-face and online
learning, and can also be adapted to suit existing study and learning
patterns. Practical examples are provided to help explain some aspects of
these study skills, and these may make reference to taxation law which you
have not covered when you are reading this chapter. It is not important that
you understand the law used in these examples as they are for illustration
purposes only. It is more important to concentrate on the approach outlined,
rather than on the law used in the example.

Course aims [2.20]

Considerable variation exists between the approaches taken in taxation law
courses at various institutions and between courses undertaken by
accounting students, law students and legal studies students. Differences
also exist between introductory and advanced courses as introductory
courses are intended to provide an overview of the fundamentals underlying
taxation law rather than an in-depth understanding. The principles covered
in a basic course may then be applied in advanced courses to explore more
complex areas of the law and possibly tax planning techniques. Therefore, to
help you construct your study plan, you should first identify the:
• aims of the course;
• level of understanding required;
• nature and timing of the assessment; and
• format of the examination.

Identifying the course aims early will guide you in how you should approach
your preparation for assessment including the examination. Course aims will
usually be included in the subject outline or the reading guide. They may
also be found in the institution’s handbook in the description of the subject;
however, these are often brief and may not be sufficient. If you cannot
determine the aims of the course from the materials provided, you should
immediately contact your lecturer or tutor.

Level of understanding required [2.30]

Having identified the aims of the course, you should then determine the
level and detail of knowledge required to meet these aims. In particular, you
should establish the level of knowledge required with respect to legislation,
texts, case law and other readings. It is common in introductory courses for
this level to vary from topic to topic and even between areas in the same
topic. You must therefore note the level of knowledge for each segment of
the course before preparing your notes and other materials. Indication of the
level of understanding required will be evident from the amount of legislation
covered and the level of case law reading expected by your lecturer. Other
indications include the amount of class time allocated to a particular topic or
legal issue and any particular emphasis made by your lecturer. For example,
it is likely that considerable class time will be spent on developing an
understanding of the general assessable income provision (s 6-5 of the
Income Tax Assessment Act 1997 (Cth) (ITAA 1997)) and the general
deduction provision (s 8-1 of the ITAA 1997). However, other more specific
provisions may only be mentioned in passing and therefore require less
study time.

Nature and timing of assessment [2.40]

To plan your study approach and to determine the level of your note-taking,
you should ascertain early in your course the assessments required and their
due dates. You can then ensure that all relevant topics are prepared at the
appropriate level well in advance of assignments or examinations. Ascertain
the type of assessment and whether it is optional. Commonly, tax law
assessment concentrates on problem-type questions, where a set of facts is
presented and you are required to discuss the relevant law and determine
the likely application of the law to these facts. Other forms of assessment
include multiple-choice questions, short answer questions and theory-type
questions, which may require case analysis or commentary on contentious
legal issues.

If you are required to research areas not covered elsewhere in the course,
you will need to allow extra time for independent research using library and
online resources: see [2.150] and [2.480].

Format of the examination [2.50]

Preparation of your notes and summaries will also depend upon the format
of the examination paper(s) set for the unit. Taxation law exams tend to be
either open book or a limited open book. Closed-book examinations for
taxation law are rare because of the breadth of material to be covered and
because students need to refer to legislation. Where the exam is sat under
supervision, you should determine, before you commence your study,
exactly what may be taken into the examination room. For take-home
exams, it is important to ascertain the level of discussion required, any word
limit, the time allowed and the method of submission. Having a clear
understanding of the conditions of the examination is vital and will influence
how resource materials can be marked (if at all), and the format of notes and
summaries. If underlining alone is permitted, you must not annotate or
include any summaries in your texts or legislation. If you discover this late in
your course, you will not be able to use material you have already
annotated. If there are no restrictions on annotation, then it is very helpful to
place page tabs in your texts and notes so that you can find major legislation
and relevant summaries quickly.

Prepare a study plan [2.60]

It is important to construct your study plan early in the teaching period to
help map how you intend to cover the materials in the course. This will assist
you to be well prepared for timely submission of assessment tasks and
examinations. The plan should be based around a timetable appropriately
dividing the available course time between the topics to be covered. The
plan should allow for:
• reading and annotating texts and materials;
• preparing summaries of these readings and lecture notes;
• note variation in time required for more or less difficult topics or course
segments;
• preparation time for examinations and assessments; and
• critical workload periods for other subjects.

Taxation law courses normally require a large amount of reading, so it is

important to prepare your notes and summaries as you go as there will not
be sufficient time at the end of the teaching period. This is still the case if
there is a take-home exam even though it may seem that with the extra time
allowed there will be time to use texts, etc to research the question.
However, the exercise of preparing notes and summaries throughout the
study period is still very important to help develop and reinforce your
knowledge of the subject matter, which will be required for take-home
papers as they often require more in-depth analysis. A study plan is of no
use unless you carry it out. Ideally, the plan should be sufficiently flexible so
that it can be modified during the course if your circumstances change.

Notes and summaries [2.70]

Regardless of whether classes are presented face-to-face or via online
learning, there are several factors that will improve your understanding of
the course material and enable you to develop the skills of applying tax law
to new and unfamiliar fact situations. Most important of these are that you
attend classes (either face-to-face or via online presentation) and that you
take notes and summarise your readings. Many institutions now record
lectures and other classes, and although this provides flexibility as to when
you can access these resources, it is an important discipline of always attend
these classes when delivered, or to at least set aside a fixed time to access
the recording. Without this commitment, it can be easy to get behind in your
studies. Developing reliable topic notes and summaries is also essential in
studying taxation law and will be the most effective preparation for any
exam. Summaries are a powerful tool for building an understanding of the
fundamental issues within a topic. Without a clear awareness of the
important issues, you may find it difficult to use general legal principles to
solve unfamiliar problems of the kinds set in assessments. For example,
Figure 2.1 shows the essential elements of the decision as to whether an
expense is deductible or not. This summary, in a diagram form, shows that
you need to consider whether the deduction could fall under the “general” or
“specific” provisions of the legislation, and reminds you to consider any
possible exclusion from deductibility and relationships with other provisions.
This is a very broad summary, and each area listed would need to be
expanded with more detailed notes. However, having such a broad overview
of deductions is very valuable as it puts all the components into perspective
and would be an excellent reminder in an examination.

Reliable summaries also enable you to identify the key taxation law issues in
problem questions and the steps to their solution. To be most useful, each
summary should:
• provide you with an overview of the topic;
• identify the important issues in the topic;
• list and summarise the key sections of the legislation; and
• list and summarise relevant cases.

Writing summaries is a skill that can be learned and you can develop your
own specific approaches, but the essential components of good summary
notes are to:
• provide an overview of the law and list the main headings and essential
issues raised in the topic: see [2.80]; and
• develop more detailed notes on the broad topic areas to enable you to
build a better understanding of the relevant law: see [2.90]–[2.100].

Overviews [2.80]
A logical and thorough approach to addressing a tax problem begins with
identifying the legal issues raised by the facts presented. Your lectures,
study notes, and texts are the starting point for providing overviews of
particular areas of taxation law. Wider reading of legislation, case law and
other set readings is then vital for gaining a more in-depth understanding.
When studying taxation law, there is no substitute for careful reading of the
legislation and cases. Practical guidebooks and tax law case extracts are also
useful resources. Overviews of a topic can take many forms, which could
include:
• maps of the essential issues relating to a topic: see Figure 2.1;
• flowcharts of the decision processes required (e.g., residency of a
company): see Figure 2.2;
• lists of issues that the courts may use to define a term, such as “ordinary
income”: see Example 2.1;
• structure diagrams showing the steps required to apply relevant legislation
to a particular area of law: see Figure 2.2; and
• lists of relevant cases with a very brief reminder of the facts and decisions.

Detailed notes [2.90]

The materials assigned for a tax course are generally intended to be
adequate for normal study needs. However, you may wish to undertake
further research to help clarify issues that you find confusing. When reading
material from texts and other references, you should concentrate on
recognising and understanding the legal principles that are being discussed.
These principles are the most important aspect of the study of taxation law
because they provide the rules for the application of the law in practice.
When you are planning answers to problem questions, you will need to apply
these rules to the facts so that you can support your arguments as to the
likely outcome should these facts be considered by a court.

Example 2.1: Summary of legal principles – distinction between

capital and revenue expenditure Relevant cases: Sun Newspapers;
Broken Hill Theatres (list all those that are relevant) Main issues to consider:
• Is it a once-off expense?
• Does the expense have an enduring benefit?
• Has the expense altered the profit yielding structure?
Consider: – the character of the advantage sought; – the manner in which
the benefit is used; – the means adopted to obtain the benefit. Identifying
these key principles from the relevant cases provides the basis of the
analysis and discussion of a problem question relating to the distinction
between a capital expense (not deductible under s 8-1 of the ITAA 1997),
and an expense related to the operation of the business which may be
deductible under s 8-1 of the ITAA 1997. Some students find it difficult to
identify the major legal principles and tend to become frustrated by the
detail. To overcome this problem, you should first read the relevant area
from your text to gain a general understanding of the law and then re-read
the relevant cases to see how these principles were applied.

Taxation law is a very broad and complex area of study, and it is therefore
important that you are clear about which areas your course concentrates on
and which are of lesser or no importance. You can help yourself focus on the
major principles by:
• noting carefully the emphasis placed on different issues in classes and
study material; and
• following the basic heading structure of your text or study guide.

You should avoid spending too much time on minor issues as there is so
much material to be covered. If you are in doubt about the significance of a
particular issue, clarify this with your instructors.

Additional textbook resources [2.100]

To support your note preparation, you may also find practitioner guidebooks
a helpful complement to your textbooks. These guidebooks are designed to
assist practitioners preparing tax returns for clients and tend to give more
specific coverage of the technical aspects of the legislation. Guidebooks are
best used as a starting point for identifying relevant legislation for particular
issues, but where general legal principles need to be understood, it is
advisable to also refer to texts and other more comprehensive references.
Taxation law casebooks are also a valuable reference for obtaining more
detail of the facts and decisions in important tax law cases. Various styles of
casebooks provide case summaries, case extracts and commentary. In
courses where the emphasis is on practical problem-solving, question and
answer books may also be quite helpful. It is important to use a current
edition of question and answer books as tax law is constantly changing. For a
list of other resources that may be helpful during your studies, see [2.480].

Short answer assignments [2.105]

Although essay assignments (see [2.110]) are common in taxation law units,
some institutions use short answer and multiple choice to assess certain
aspects of the course. Short answer assignments are often used to assess a
wider range of more specific tax issues. Although short answer questions
may appear quite easy, there are some important traps to avoid. First, write
in your own words being concise, and immediately identify and state the key
legal issue(s). Second, always include relevant legislation and case law as
authority and present a well-formed conclusion. A common mistake that
students make is to discuss the law but not apply it to the facts to reach a
well-justified conclusion. An approach to answering multiple-choice questions
is covered in this chapter (see [2.370]), but when this type of assessment is
used during the course, it is very important that you read the instructions
carefully. For example, some tests deduct marks for incorrect answers and
some require you to select “one or more” of the options. These approaches
are often used to reduce the effect of guessing. Therefore, it may be better
to leave a question unanswered if you are not certain of the answer.

Written essay assignments [2.110]

Taxation law assignments are commonly set to assess whether you
understand the law and its application. Most assessors are not looking for
wrong or right answers nor do they want you to recite directly from the
legislation. Instead, you should demonstrate that you can recognise the legal
issues raised by the question and then apply the law in an attempt to predict
the outcome should this go to court. Do not concentrate on the conclusion to
an assignment question, but rather on demonstrating your knowledge of the
law, your ability to recognise issues and your ability to apply the law to the
facts in the problem. Your conclusion should then develop as you apply the
facts to the problem.

Assignment writing should be undertaken in two distinct steps. The first step
is to carry out the necessary research which will provide the basis of the
content for the second step, which is to plan and write the assignment. Each
of these two stages plays a vital part in the development of a logical legal
argument. However, the suggested approach is only a guide and may not
exactly suit all students and styles of preparation. Different assignment
types may require different approaches: see [2.40]. In these cases, it may be
useful to adapt part(s) of the approach outlined into your existing style. If
this is done, it is important to make certain that all requirements of the
assessment are still covered.
Research [2.120]
Tax research requires a “broad principles” approach as the range of
questions is limitless, and it is rare that questions can be substantially
answered directly from secondary materials such as texts and legal reporting
services. You will typically be asked to apply the law to a set of facts not
previously encountered. This type of analysis is extremely important
because this is what is required in the application of taxation law when
advising clients. Mistakes in your research approach often lead to poor
assignment answers. Some common mistakes include:
• Trying to find a case with similar facts and answering on that basis.
Questions based on a set of facts are often best approached by identifying
the relevant taxation law issue(s), rather than trying to find cases with
similar facts.
• Scanning the index of the Act or secondary sources, such as texts, journals
and legal reporting services. This approach can lead you to irrelevant areas
of the law and cause the broader general principles to be overlooked. Use
indexes after the legal issues have been identified.
• Trying to give a direct answer to the problem without identifying the
relevant legal principles needed to resolve the problem. This approach is
commonly seen in assignment answers that begin “the receipt is assessable
because ...” or “the expense is deductible because ...”. It is important to first
identify the issues and then discuss all aspects of these issues. The
conclusion should then develop out of this discussion. To avoid these
common mistakes, Figure 2.3 sets out the steps that can be used when
researching and answering a taxation law problem.
Each of these steps in the research process is mirrored in the preparation of
the written assignment, but it is vital that these steps are first taken in the
research stage so that the arguments presented in the written assignment
are developed logically.

Step 1: Understand the question and the facts [2.130]

Poor answers to problem-type questions often originate from a misreading or
incomplete understanding of the question and related fact
Avoid this by reading questions carefully and highlighting key words.
Complex facts can be better understood if they are summarised as a list of
events, with a timeline showing when each transaction occurred or a
diagram showing the transactions between parties. In Figure 2.4, the
diagram of the facts helps highlight the flow of funds and the transfer of
property to the parties concerned. For example, the fact that Kim’s
guarantee of the rent is shown as a transaction should draw attention to
whether it is relevant for income tax purposes.
As well as understanding the facts presented in the problem, it is also very
important to understand the requirements of the question itself: see [2.490].
For example, are you required to discuss the tax consequences for all parties
or just one of them? Where the question only requires discussion of one
party, make certain that only the relevant transactions are discussed.

Questions may also require only part of the law to be discussed, such as
“whether the transaction gives rise to ordinary income” or “discuss the
capital gains tax consequences only”. Where the requirements of the
question are limited, it is important to restrict your discussion to these areas
as marks will not be allocated for the discussion of irrelevant issues.

You may also face the problem that the facts presented in the question are
vague. This is often a deliberate mechanism used by instructors to test
whether you can recognise which facts are essential to the conclusion.
Irrelevant facts may also be included with the same intent. It is an important
skill in taxation law to be able to ascertain which facts are relevant and to
appreciate that part of the role of the tax adviser is to obtain these facts
from the client.

Step 2: Identify the issues [2.140]

Once the question and the facts are clearly understood, the next, and
perhaps most critical stage, is to determine the legal issues that are relevant
to the facts. If any legal issues are overlooked or are irrelevant to the
question, your answer will be incomplete or irrelevant. Assessors cannot
award marks for irrelevant discussion, and you lose marks for missing issues.
Where a question requires discussion of the tax consequences of the
transaction presented (e.g., “Are the receipts assessable?”), there is a strong
tendency for students to begin by answering “yes” or “no”. Avoid reaching a
conclusion before identifying the relevant legal issues, as this approach does
not show an understanding of the operation of the law.

Most assessors are looking for you to first demonstrate that you recognise
the legal issues raised by the facts and second, apply the relevant law to
show that you understand how these issues may be resolved. A conclusion is
important, but it is not the most important stage. In fact, if you use the
approach suggested here, you may find that the conclusion becomes
apparent from your research of the issues, rather than from a deliberate
search for the so-called answer. Most students need to actively work on the
problem-solving nature of taxation law studies and need to develop effective
and efficient strategies for identifying the relevant legal issues in problem-
type questions. The most reliable method of developing these skills is
through practice and by obtaining a broad understanding of the content of
the subject. This can be achieved through consistent study and regular
preparation of notes and summaries: see [2.70].

Example 2.2: Identifying tax issues through key words

The facts of the question state: Ashley has worked for his current employer
for the past ten years and recently announced his engagement to his boss’s
daughter. In his last pay packet Ashley was surprised and delighted to see an
amount of $500 in addition to his normal pay and a note from his boss
indicating that the additional amount was a gift from the firm in recognition
of his engagement. One of the factors affecting whether a receipt is
assessable as ordinary income is whether it is earned as a result of work
performed or whether it is a personal gift. The terms “gift” and “earned”
therefore have specific relevance to the law. So, in this question, your
starting point would be to identify the phrase “was a gift” as an important
pointer to the relevant issue.

Complex questions may also contain a range of legal issues, with some
being more important than others and some only being relevant after other
issues are decided. A common mistake made by students is to identify one
issue and discuss it fully and, having reached a conclusion, not realise that
the conclusion raises other issues. For example, if you conclude that an
expense is capital in nature and not deductible under the general deduction
provision, you then need to consider whether a deduction is available under
another specific provision of the Act, such as the capital allowances sections.

Step 3: Research the relevant legislation and cases [2.150]

Legislation.
Taxation law only exists because of legislation, and therefore, all relevant
legal principles originate from a specific provision of the legislation.
Consequently, all the issues identified in Step 2 must now be related to
relevant sections of the legislation. Where more than one section is
applicable to the same transaction, it is important that you show an
understanding of how these sections relate to each other and, ultimately,
which must be applied to the facts under consideration. You can access this
legislation from condensed paper versions or from online resources: see
[2.480].

[2.160] Case law. Relevant case authority should be introduced at this

stage to support the legislation and legal principles used in your answer.
Although the primary source of taxation law is legislation, the interpretation
of this legislation by the courts is critical for the application of the law in
practice. When identifying relevant cases, you may look for those with
similar facts, but you should also look more widely for cases where the
courts have considered similar issues even though the facts are different. For
example, if the question requires discussion of the nature of a capital
receipt, then look for the cases that consider this broader issue. A good
starting point is to use prescribed texts and follow-up the cases that they
refer to. Example 2.3 outlines how AustLII can be used to find cited cases.

Example 2.3: Sample search using AustLII (Australian Legal Information

Institute) To search for the case Commissioner of Taxation v Hart:
1. Go to the AustLII website: http://www.austlii.edu.au/.
2. Click on “LawCite” which is located in the top red heading menu.
3. LawCite provides a number of options for finding a particular case. For
example, if you know the full citation of the case (shown in the index or body
of this text), this will be the most reliable search approach. To find FCT v
Hart, you enter the citation “217 CLR 216” in the “Citation” search box and
click “Search”. There will be a link to the full case shown under the case
name at the top of the page and there is also a list of cases, where FCT v
Hart has been cited.
4. If you do not have the full citation, you can enter the party’s name in the
appropriate search boxes. The search may provide a list of cases with that
name, so it is important to select the correct one. For example, FCT v Hart
went all the way to the High Court, so unless you are looking at the history of
the case, you need to select the High Court decision ([2004] HCA 26).
5. If the search returns too long a list of cases, you can limit the search by
entering the court the case was decided in, in this case the High Court of
Australia.
6. LawCite can also be used to search for articles on areas of taxation law
that you are researching. For example, if you type “tax avoidance” in the
“Article Title” search box, a range of articles and cases will be returned and
you can select any that seem to be relevant for your research. If you cannot
easily find the case you are looking for on “LawCite”, there are other legal
databases that may report the case and which may be available via your
institution’s library: see [2.480].

[2.165] Reading and understanding cases.

If you have difficulties reading and summarising cases, you may find the
following approach helpful: see Figure 2.5. This approach breaks the process
into a number of steps that are aimed at gradually building up your
understanding of the facts, issues and legal principles arising from the
judgment. Although this approach may be helpful, it cannot be
overemphasised that there is no substitute for practice. You should read
cases carefully until you have a good understanding of them.

Step 1: Gather basic information about the case before reading it in

full. This ensures that when you read the case in full, you will have some
understanding of the decision and the facts. This can be done from the
headnotes (summary at the beginning of the case) or the first reading of the
case. A basic summary should be made of the following: • The parties
involved and who is the plaintiff (appellant) and who is the defendant
(respondent). This is important as the judges may not refer to the parties by
name but as “plaintiff” or “defendant”. • The transactions under
consideration – for example, the sale of shares. • The taxation issues in
dispute – for example, Was the sale capital or revenue in nature? • The
decision of the court – for example, The sale was of a capital nature.

Step 2: Summarise the relevant facts. One or more judges will describe
the facts in detail, and this is usually found at the beginning of each
judgment. Different judges may emphasise different facts, and this can
impact on the decision reached by the particular judge(s). Once the facts are
fully understood, it is important to summarise them in a diagram, a table or
in text form: see Example 2.4.
Step 3: Identify the legal issues that are the basis of the dispute.
Read the majority decision(s) first (the majority decision becomes law). This
will be identified in the headnote. The goal in reading the case at this point is
to clearly understand the taxation law issues that are the basis of the case.
In Example 2.4, the central issue in Europa Oil No 1 was whether the general
deduction provision allowed a deduction for the full amount of an expense,
which was clearly excessive, even though it was related to the operation of
the business.

Step 4: Read the majority decision(s) to understand the reasons for

the court’s decision and any legal principles arising from the
decision. More recent case reports may include headings, which can be
very useful for identifying where in the judgment the reasoning for the
court’s decision is explained. However, in older reports, this is not the case,
and it is therefore important to mark these parts of the judgment.

[2.170] Take detailed notes with references.

As you read and research material for your assignment, you must take good
notes and keep clear references of where you found your ideas and material.
It can be very frustrating to remember that you read something relevant on
a particular issue and then spend hours trying to find it again. It is also
important to keep accurate references so that you are able to complete the
necessary referencing when writing up your paper: see [2.250]. Keeping
good notes will also help you organise the material into a logical sequence
as the notes can be sorted and re-sorted into the appropriate order before
you begin writing the paper.
Experience has shown that taking notes, either electronically or in
handwriting, is far more effective than highlighting text on photocopies of
cases, etc. Highlighting text does not force you to write the ideas and
concepts gleaned from your readings in your own words and can mean that
you need to read the material again so that you can recall the importance of
the highlighted text. Making reliable notes will save time and help you
understand what you have read.

Step 4: Apply the law to the problem [2.180]

After identifying the relevant tax issues in the problem, applying the law to
the facts is the second most important stage in your research. Some
students perform poorly in their assessments because, even though they
correctly identify the relevant law, they fail to apply it to the question asked.

When applying the law to the facts of the problem, it is essential that you
consider both sides of any issue and never deliberately argue for the
taxpayer or the Commissioner (unless asked to do so). Always research
conflicting cases so as to gain a balanced and detached view of the law.

A starting point in applying the law is to refer back to the facts being
considered. You should then select one issue at a time and work on applying
the relevant law to it.

Example 2.5: Applying the case precedent to the facts

Imagine a case where the relevant issue is whether the taxpayer is
a resident of Australia for taxation purposes. How would you
approach it? Here are the suggested steps:
• consider which facts the courts have previously considered
relevant when deciding this issue; • then consider to what extent
these facts are present in the situation presented in the
assignment;
• then look in turn at each of these factors and apply them to the
facts in the question;
• this should help you reach a conclusion, as this approach often
makes it apparent, where the strongest arguments lie.

Tax rulings may be investigated at this stage to determine whether

a ruling has been issued, which expresses the Commissioner’s view
on how the law should be applied. It is important to remember that
rulings are not legally binding on the courts and should mainly be
used to obtain ideas on the types of legal issues that are raised by
the facts. Rulings must not be used as the sole justification for your
conclusion as they are not the legal authority but they can be
referred to as an indication of the Commissioner’s view on the
issue. When applying the law to the assignment question, do not
avoid conflicting points of view simply because they fail to support
your current line of argument. Generally, assessors are looking for
you to demonstrate that you can consider conflicting authorities
and recognise that there are other points of view.

Step 5: Form a conclusion [2.190]

This is the final stage of assignment preparation. Although you should
consider your possible conclusion during the writing process, it is important
that you keep an open mind throughout the research phase so that you do
not get locked into a narrow line of argument. It is dangerous to jump to
conclusions as this can prevent different views emerging. The final stage of
forming a conclusion is discussed in more detail at [2.260].

Planning and writing the assignment [2.200]

Once the research stage is completed, the actual preparation of the
assignment should be quite straightforward, but before you begin writing the
final paper, it is advisable to prepare a plan so that your paper is logically
presented: see [2.210].

Then you need to work on:

• the assignment’s introduction: see [2.220];
• the body of the assignment: see [2.230];
• citing authority: see [2.240];
• referencing: see [2.250]; and
• the assignment’s conclusion: see [2.260].

Plan [2.210]
It is important that you prepare a plan or a structure of how the assignment
question is to be answered and how your arguments are developed. Much of
the work for this plan has already been completed through the research
stage, but now it is important that you organise the information collected
into its logical structure. In your plan, briefly list the content of the
introduction, the headings to be used in the body of the assignment and the
main points to be made in the conclusion. Also, check that the order of
headings is logical so that the assessor can follow the arguments presented.

Introduction [2.220]
Having completed the research and developed a plan for the assignment, it
should be a relatively straightforward task for you to write the paper. The
introduction serves the important role of providing the assessor with an
overview of the assignment and facilitate a better understanding of the
arguments you are about to present. The content of an introduction may
vary depending on the style required for the course, so it is important to
follow any style guides provided. However, it is wise to keep an introduction
as brief as possible as it is only intended to provide an overview.

Body of the assignment [2.230]

Before writing the body of your assignment, check the requirements of the
question to determine if any specific form of presentation is required, such
as “advise the client”. Always present your answer using correct grammar
and formal legal terms. Write using complete sentences and do not use
slang. Assessors do not appreciate flippant assignments as they reflect badly
on your attitude.

The essential objective must be to discuss the law in relation to the issues
identified in the introduction. If appropriate, the law should then be applied
to the situation presented in the assignment question. It often helps use
headings which will enable you to inform the marker about the particular
aspect of the law or facts that are being discussed.

Cite appropriate authority [2.240]

Appropriate authority must be used to support all answers to taxation law
problems. As the primary source of income tax law is legislation, the first
authority given must be the relevant legislation and it must be cited
correctly (see your institution’s style guide).

Where more than one provision is applicable, it is also important to show

that you understand which provision has precedence and how this is
determined. Where relevant, appropriate case authority must be cited to
show how the legislation has been interpreted. However, the extent of the
discussion of these cases will vary depending on their importance to the
resolution of the issue. It may be helpful to categorise cases as those to be
discussed in detail because of their relevance to the problem and those
merely cited to support a legal principle.

You must aim to show your understanding of the legal principles derived
from the case and their application to the facts you are discussing. Where
conflicting authority exists, discuss this conflict and explain why one
authority was found to be more persuasive than another. Care should also be
taken to identify differing facts that may have affected these decisions. If
there is evidence to support the view that a case would not now be followed,
this should be presented, but it is important not to disregard cases simply
because they do not support your line of argument.

Referencing and secondary sources [2.250]

Most assignments will require referencing, usually in the form of footnotes.
This is essential to provide the assessor with details of your sources and to
avoid claims of plagiarism. You must ascertain what referencing is required
and the form of referencing expected. The Australian Guide to Legal Citation
is an excellent reference for guidance on correct citation, and it is available
online: https://law.unimelb.edu.au/mulr/aglc/about. However, if your
institution specifies a different style guide, please follow it. Textbooks or
other secondary sources must never be cited as authority because they
themselves are interpretations of the law; only primary authority from
legislation and cases should be referenced. Texts that are not primary
authority should be listed only in the bibliography and not in the body of the
assignment.

Conclusion [2.260]
Your written answer must contain a conclusion that addresses the question
asked in the assignment. It is not sufficient to cover all the issues and then
avoid coming to a conclusion. It is also important that your conclusion is
supported by your arguments, rather than being merely an afterthought. Do
not introduce new arguments or discussion in the conclusion as this
indicates poor planning or uncertainty about the validity of the arguments
already presented.

If you determine that the conclusion depends on information that is not

provided in the question, it is important not to make assumptions that avoid
answering the question. A better approach is to state what information
would be needed to assist in forming a reliable conclusion and explain why
this information is important. A brief comment could then be made on the
different conclusions that may be reached depending on the additional
information.

Taxation law questions often do not have precise answers. It is important to

come to grips with this reality and recognise that it is not the conclusion, but
the discussion of the law that normally contributes to the bulk of the
assessment. Where no clear conclusion can be formed, discuss all the
arguments for and against the issues that arise. However, following the
approach set out above should help you to develop a supportable
conclusion.

Exam preparation [2.280]

Previous discussion in this chapter detailed methods of developing general
study skills and techniques during your course: see [2.70]. In addition to
these general skills, particular attention is required throughout your studies
towards preparation for the examination, and this will be influenced by
whether the exam is supervised or take-home. Preparation for the
examination presents two very specific challenges. The first is identifying the
key examinable issues in the course and the second is developing problem-
solving skills so that the key issues can be applied to new and unfamiliar tax
law problems. The exam preparation techniques discussed at [2.290]–
[2.330] focus on these critical areas. Identifying examinable material [2.290]
It is simply not possible for an examiner to cover every aspect of income tax
law covered during your course in the final examination.

Instead, the examiner will normally concentrate on the issues encountered in

basic transactions of normal employment, business or investment
arrangements, as well as specific areas such as depreciation, capital gains
tax, fringe benefits tax and goods and services tax. If a transaction contains
elements that may point towards more specialised rules, you might be
expected to demonstrate to the examiner that you are aware of those rules,
but you would not normally be expected to apply them in detail in an
introductory unit.

It is therefore very important to ascertain from staff and unit resources,

which are the key areas to be studied and which require less detail. Clues to
identify the most important areas of study can be obtained from the
structure of lectures and the headings used in subject study guides,
textbooks and the type of questions set for tutorial discussion and for
assignments. Preparing your own summaries will also help you identify which
issues are critical and which are less important: see [2.70].

Preparing revision notes and summaries [2.300]

Preparing your own notes and summaries is crucial to your understanding of
tax law, as merely reading your texts, however many times you do it, is
generally not a reliable method of exam preparation. If the examination is a
take-home exam, there can be a false sense of security that questions can
be answered from texts and other primary resources without the need to
prepare summaries. However, this may not be the case as take-home exams
tend to require a more in-depth analysis, demanding a detailed
understanding of the law before the question can be understood. As a result,
it is still very important to prepare your own notes and summaries even for a
take-home exam.

In a supervised exam, there is only a few hours available in which some 35

or more hours of lectures and many more hours of reading must be
condensed into a manageable form. Preparing summaries for all forms of
examination will help you memorise key points and gain a better
understanding of the law so that you are better equipped for answering
problem-type questions. Thinking about how to express a point concisely and
clearly, and writing it down once you have done this, will also embed the
concept into your memory far better than continued reading of the same
point. Preparing a summary will also help you quickly make the connections
between differing arguments and differing issues. As you organise your
notes by subject matter and issues, you will pull together all the arguments
that must be raised in an exam answer.

Preparing checklists of issues or steps needed to be considered in resolving

particular tax issues will enable you to review and apply the key points
raised by the facts of the question: see Figure 2.6. Organising checklists will
also improve your understanding and increase the chances of recall for the
examination.
Developing problem-solving skills [2.310]
Taxation law is inherently complex and also considerably different from many
other courses because it raises more questions than answers. However,
there are some areas of certainty in tax law. For example, at one end of the
spectrum are receipts that are unquestionably assessable income (e.g.,
wages and salaries), and at the other end are gains that are clearly not
assessable (e.g., normal lottery winnings). Between these black and white
ends of the spectrum is a vast range of murky greys. It is this grey area that
provides the opportunity for assessors to set examination questions that
require you to demonstrate your knowledge and application of the law.
Therefore, it is important to develop the skills needed to identify these
doubtful areas of the law.

Working in small groups [2.320]

Working in a small group either in person or online to practise past exam
questions and problems set during the semester is a valuable means of
developing and reinforcing the skills needed to identify the issues in
problem-type questions. If you only practise old questions yourself, you may
catch one-third of the issues raised by the questions. If you are very good,
you may discover half the issues. But if you study with two or more other
students, together you are more likely to find 80%–90% of the issues.

Traps to avoid [2.330]

There are no shortcuts to good exam preparation. Students who attempt to
avoid the essential steps of preparing reliable and complete review notes
and who do not practise identifying the issues in problem-type questions,
generally do not perform well. The following approaches are to be avoided as
they can lead to a false impression as to your ability to write a high-quality
examination paper:
• preparing answers to past exam questions or other problem questions
before preparing and studying summaries can be very discouraging as it
may lead you to think that the task is impossible; • using answers to past
exam papers prepared by other students or supplied by instructors can lead
to a false sense of security. When reminded of the issues, most students
recognise the issues but are falsely led to believe that they could have
recognised these issues themselves. Answers prepared by other students
may also be wrong or incomplete;
• preparing complete answers to past examination questions in the hope
that similar questions will be asked in the current examination. Doing this
tends to cause some students to hope that the prepared answer is relevant
to the question and use it regardless;
• trying to remember and understand cases and notes from just underlining
and highlighting. Preparing summaries in your own words is a far more
reliable method of study as it develops a better level of understanding.

Examination techniques [2.340]

Most students can improve their performance in any examination simply by
applying basic exam techniques. Sitting any form of examination can be very
stressful, and strategies need to be learned and practised so that they are
automatically followed in an exam regardless of the level of stress. The
following examination techniques comprise an effective strategy for tackling
any exam. Using these guidelines should always enable you to present your
best possible examination paper:
• Well before the exam, carefully read the materials provided in subject
outlines, etc that explains the structure and format of the examination.
Finding the examination is not as expected can add to the level of stress
experienced: see [2.50] and [2.490].
• For supervised exams, only spend the amount of time on a question that is
indicated by the marks allocated to it. In most cases, you will earn most of
your marks in the early part of your answer, and if you are struggling with
your answer, there is no point persevering. You will typically earn more
marks if you go on to a question you can answer. With take-home exams,
take particular note of the total words permitted and allocate your words
according to the marks allocated.
• Read questions carefully paying particular note of the facts and what is
required. In a supervised exam, make good use of the reading time to plan
your approach to the paper.
• Select the easiest question and do that first. This can have a number of
advantages: it allows you to earn marks easily and reduce your level of
anxiety.
• Structure your answer so that you come to the point immediately. Do not
give background, repeat the question or restate parts of the legislation or
facts from cases.
• Always list relevant sections of the legislation and case names. Check with
your lecturer what level of citation is required for the examination.

• Make certain that you have answered the question asked and where
required applied the law to form a conclusion.
• In a supervised exam, wasted time is your greatest enemy and this is a
particular problem in open-book examinations. Do not expect that you will
have time to research an answer to a question during the examination time.
This is where well-prepared notes and summaries are extremely valuable.

Supervised open-book exams [2.360]

Where the examination is a supervised open-book exam, you will normally
be allowed to bring into the exam any notes, texts or, at the very least,
legislation. It is vital that you ascertain the conditions of the final
examination at the start of the course because this will influence whether
texts and Acts can be tabbed, noted and/or cross-referenced. With time an
overwhelming constraint, making effective use of texts, notes or study aids
means knowing exactly when and how to use the extra materials. Most
importantly, you should realise that the materials are there mostly as a
crutch to jog your memory or remind you of the steps to take in answering a
question. There will not be time in an exam to look for the answer to a
question. You either know the tax issues and just need your notes to remind
you of the relevant sections or cases or you do not know how to tackle the
problem.

If you do not know what law is relevant, you are far better off moving on to
the next question than trying to research the area from scratch.

Take-home exams [2.365]

All of what is covered in this chapter in relation to exam technique (see
[2.340]) and answering problem questions ([2.390]) is relevant for take-
home exams. However, it is inevitable that a take-home exam will require
more complex and in-depth analysis than a supervised exam as more time
will be allowed to submit responses. Whereas questions in a supervised
exam tend to focus on one or, maybe, two issues (e.g., capital vs income),
questions in a take-home paper may contain multiple issues. This provides
the examiner with a greater opportunity to examine more complex and more
detailed aspects of taxation law. As a result, the process of identifying the
tax issues raised by the facts in the question becomes even more important.
Also, as there is more time to plan your answer, there is a higher expectation
of the quality of the submission in relation to the reasoning, correct
referencing and presentation.

With more complex fact situations, well-organised summaries and notes

remain very important as they will help remind you of all the issues that may
arise, and the relevant legislation and cases. Good summaries and
flowcharts will assist with following up all aspects of the issues so that none
are overlooked.
Answering multiple choice [2.370]
Multiple-choice questions are sometimes used in taxation law examinations
to enable the assessment of a wide range of the material covered in the
subject. This type of question allows the examiner to broaden the coverage
of the course content, enabling some of the more specific and technical
areas to be examined.

Good preparation for answering multiple-choice questions is similar to the

preparation used for most types of tax law examination questions. Reliable
and concise summaries will enable you to quickly access the detail needed
to answer these questions in an open-book examination or to study for
closed-book examinations.

Strategy [2.380]
Most multiple-choice questions commonly have four to five alternative
answers to select from and, because of the nature of taxation law, more than
one of the answers may appear to be correct, but only one will be the most
appropriate. For example, if the facts presented in a question mean that
more than one provision of the Act is applicable, the examiner is testing
whether you understand which provision has precedence.

Example 2.6: Test of the most appropriate legislation

Section 15-2 of the ITAA 1997 only applies if a benefit is not ordinary income
under s 6-5: see s 15-2(3)(b). Therefore, if s 6-5 makes the benefit in the
question assessable, then s 15-2 does not apply and would be an incorrect
answer even if s 15-2 is also applicable.

One of the most important tips in answering multiple-choice questions is to

first identify the possible answers by eliminating the obviously incorrect
answers. For example, if the question requires a decision as to whether a
receipt is assessable, two alternatives may say that it is assessable and two
may say that it is not. In this case, it is first necessary to decide whether or
not it is assessable and then to select the best answer from the remaining
two options.

Answering problem questions [2.390]

The notes on preparing for tax exams at [2.280] and preparing for
assignments at [2.110] have stressed the importance of finding the legal
issues used to answer questions, rather than finding the answers
themselves. Problem questions test your ability to identify the law relevant
to the problem and to distinguish competing arguments and then form a
well-supported conclusion.

The facts of a problem question are very deliberately chosen, and so it is

likely no clear-cut answer is possible. At the back of an assessor’s mind,
there is probably an idea of a preferred conclusion. However, full marks
could still be given to a student coming up with the different conclusion,
provided the answer canvasses all the arguments and puts forward a
persuasive conclusion using relevant cases and sections that support the
answer.

Identify the relevant law [2.400]

A well-constructed answer to a problem question in a supervised or take-
home exam first requires you to identify the relevant taxation law issues that
relate to the facts presented in the problem: see [2.140]. If there is a range
of issues raised by the facts, you should first identify all these issues and
then commence to discuss the most important first.

Example 2.7: Legal expenses

Consider a question in which a taxpayer incurs a legal expense akin to a fine
but which is not actually a fine or a penalty covered by the legislation. To
approach this question, the first step would be to consider whether the
expense satisfies the positive limbs of s 8-1(1) of the ITAA 1997.
In other words, does the expense have a nexus with the derivation of
assessable income either directly or through a business?

If a problem question appears to have a very clear and definite answer, it

would be wise to give the question additional thought as it is unlikely that an
instructor would set a 20 or 30 mark question if the answer were that simple.

Apply the law to the facts [2.410]

It is not sufficient in the exam to just identify the issues and discuss the
relevant law in general. Problem questions require you to apply the law to
the facts and reach a supportable conclusion. At this point in your answer, it
is necessary to describe the competing views and support your answer with
case references. It is important not to immediately form a conclusion, but to
explain the competing arguments so that the marker can see that you
understand the alternative views that may exist.

Example 2.8: Explore all options

Every time you reach an apparent end of the road, you must look for and
pursue all other possibilities. Following on from Example 2.7, if you conclude
that an expense does not satisfy the positive limbs of s 8-1(1) of the ITAA
1997, be prepared to concede the matter is not certain and still consider
what would be concluded if it does satisfy the positive limbs. At that point,
you should move on to the negative limbs in s 8-1(2). Some of these lead to
their own dead ends. If the expense is personal, there is no deduction; if the
expense is incurred to derive exempt income, there is no deduction; and if a
deduction is expressly prohibited by another section of the Act, there is no
deduction. However, the capital exclusion opens the door to a range of
possibilities, all of which should be considered. For example:
• It may be that the expense can be depreciated or amortised under one of
the capital allowance regimes; for example, the depreciation provisions.
• In some instances, the expense can be added to the cost of another asset
for capital gains tax (CGT) purposes.
• In other cases, a capital expense may be eligible for deduction under the
“black hole” provisions in s 40-880 of the ITAA 1997.

Present a conclusion [2.420]

Having presented the competing arguments, it is important to arrive at a
view as to which case is stronger and therefore what you believe would be
the outcome if the issue was decided by a court. The conclusion is important
to show the examiner that you have weighed up the arguments and are able
to ascertain what you believe is the stronger argument. If you believe the
facts are too vague to be able to form a well-supported conclusion, then you
should explain what additional information would help to form a more certain
conclusion.

Sample examination answers and analysis [2.430]

To illustrate the important aspects of preparing sound exam answers, the
following examples are used to highlight some of the common mistakes
made and the characteristics of a well-argued answer. The first example
does not necessarily demonstrate a poor knowledge of the law, but it is
poorly structured and shows poor exam technique. The question to which
the following answers were given is in part as follows:

Example 2.9: Sample examination question and answer

Microhard is a computer software company. Its principal product was a
database program called Xhell. Microhard decided to expand its line of
software to include a word-processing program. It worked on the design of
the new software, which it decided to release under the brand name
“Wurdperphect”. The following events followed that decision. Soon after the
release of the program, a competitor, the “Courelle” company, sued
Microhard, claiming the name of its word-processing program was copied off
Courelle’s word-processing software, “Wordepurfex”. Microhard incurred
$500,000 legal fees to fight the action, which was eventually settled when
Microhard paid Courelle $4 million to drop the suit. Required: Discuss the
deductibility of the above transactions and events. To assist with the analysis
of the answer, it has been broken down into parts, with each section
identified by a letter. These letters are used as a reference for discussion. In
some parts, the full answer has not been reproduced.

ANSWER 1:
(A) A taxpayer’s taxable income is determined by aggregating all assessable
income and then deducting from such all allowable deductions (s 4-15(1)).
Under s 8-1, there are six limbs to the general deduction provision, two
positive and four negative limbs. Microhard would be seeking to claim the
$500,000 and $4 million payments to Courelle as deductions therefore
lowering its assessable income.

(B) Under s 8-1(1)(b), you can deduct a loss or outgoing if it is necessarily

incurred in carrying on a business for the purpose of gaining or producing
assessable income or for carrying on a business for the purpose of gaining or
producing assessable income.
(C) As a general rule, the Commissioner cannot decide whether the expense
incurred by the taxpayer was warranted. His only power is to decide whether
it is wholly or partially deductible.

(D) In Magna Alloys & Research v FCT (1980) 11 ATR 276, four agents and
three directors were accused of conspiracy. Prosecutions went ahead against
the company, and Magna Alloys incurred numerous costs. The question put
was whether the company was able to deduct costs involved in defending
the directors.

(E) The Court held yes because: “necessarily does not mean that the loss of
outgoing was unavoidable or essentially necessary, rather the expenditure
must be appropriate given the taxpayers business and adapted for the ends
of the business carried on, for the practical purposes and within the limits of
reasonable human conduct, it is for he who conducts the business to decide
what is necessarily incurred and what is not ...” (more quotes from a text).

(F) ... Microhard appears to be relying on Magna Alloys, however the

Commissioner will rely on the judgment in Herald and Weekly Times Ltd v
FCT (1932) 48 CLR 113 (H&WT). In this case, certain articles ....

(G) The compensation appears to replace some of the income stream;

therefore, it is assessable under s 15-30. However, in McLaurin v FCT (1961)
104 CLR 381, its assessability depends on whether the components of
capital and income can be separated. It appears they cannot.

(H) Thus, I believe the $500,000 will be held to be deductible because it was
a necessary expense, and the $4 million will not be deductible because it is
not a necessary expense in carrying on a business.

[2.440] It is evident that the answer in Example 2.9 has not been planned.
There is no clear identification of the critical issues that require discussion
and no headings have been used. Consequently, the answer is disjointed and
vague. Because no clear issue is first identified, there is no purpose or clear
direction to the discussion.

An obvious alternative approach to this question would have been to

recognise that there are two different expenses and to discuss them
separately, identifying the issues relevant to each. Failure to do this has
made the answer disjointed, and it has been difficult to formulate the
arguments for and against these issues.

The introduction in paragraph A is irrelevant to the question. It does not

come directly to the point of stating the issues that require discussion;
instead, it makes a general statement that does not show that the student
understands the question. Paragraph B comes the closest to identifying an
issue “is the expense necessarily incurred?”, but unfortunately, this is not
the primary issue and it does not state which expense it relates to and the
section number is quoted incorrectly. It is difficult to understand why this
issue was selected as the main area for discussion, but from later parts of
the answer, it may be speculated that it is because it was taken directly from
a text and that the real issues had not been understood. The statement
made in paragraph C is an extension of the issue cited, but does not add to
the answer and is no more than the obvious statement that the taxpayer will
be arguing for the expenses to be deductible.

Discussion in paragraphs D and E is relevant to the issue stated in paragraph

B, but it is little more than a restatement of the facts and the decision of one
case, and the language used suggests that it may have been copied directly
from a secondary source. The case used is relevant to the issue, but
paragraph E does not relate to the Court’s decision to the problem. The point
in paragraph F that the Commissioner would rely on the case H&WT shows a
lack of understanding of the case as it would also support the taxpayer’s
view.

Paragraph G is the first attempt to apply the law to the facts, but it is done
without justification and introduces a new section of the Act without any
discussion. The issue of whether the expense is a capital or income in nature
(one of the main issues) is first mentioned, but in relation to an assessable
income issue which is totally irrelevant given that this is a deduction
question.

Finally, in paragraph H, a conclusion is drawn, but it is based on a statement

of belief, rather than deriving from the arguments.

[2.450] The following sample answer given in Example 2.10 demonstrates

how the question could be answered in a more structured form, separately
discussing the main issues raised. This answer also follows the analysis
process described at [2.120].

Example 2.10: Sample examination question and answer

ANSWER 2: $4 million settlement
1. Does it satisfy the positive limbs of s 8-1? Is it incidental and
relevant to the earning of assessable income?
In H&WT, the Court said damages for defamation are an ordinary expense
for a newspaper as it is impossible to publish a daily paper and not defame
someone now and then. This may be distinguishable from our case, as
releasing new products and passing off someone else’s name is not an
ordinary day-to-day event for this company the way writing articles is for a
newspaper. However, releasing products is part of a software business and
you always run the risk of someone claiming your name is similar to theirs,
so this should be considered ordinary enough to satisfy the positive limbs.
The argument that “damages” or similar payments are non-deductible
“quasi-personal” expenses, that is, they are not incurred in a business
capacity since businesses were not supposed to commit wrongs, appears to
be defeated by H&WT. Damage expenses for wrongs can be ordinary
business expenses and satisfy the positive limbs of s 8-1 (H&WT).

2. Do any of the negative limbs deny the deduction?

The only relevant negative limb is the “capital” exclusion. Could this be a
capital expense? It is not regular, which suggests capital sometimes.
Applying the Sun Newspaper arguments, it could be argued that the expense
goes towards the income-earning process. In the highly competitive world of
software, new products and new releases are an essential part of doing
business and the risk of associated legal suits is a normal incident of the
income-earning process. The contrary argument is that this product is at the
heart of the taxpayer’s business. This goes to structure more than process
because it is not part of the software development and marketing process,
but rather deals with the right to sell the product itself. In contrast, it could
be argued that no-one is stopping them from selling the product, just
disputing the name they are using to label the product, so damages to use
the name goes with the day-to-day marketing of the product. Both
arguments are valid, but, in this day and age of rapid and changing product
development, the name is less likely to be part of the profit-earning structure
itself and is more likely to be part of the process of operating the structure.

3. What if it is capital?
It is concluded above that this expense is not likely to be capital, but if it is, it
is necessary to determine if any specific provision allows a deduction in part
or in full. In this case, no specific provision is applicable unless the expense
can be included in the cost base of an asset for CGT purposes.

Legal expenses
1. Does it satisfy the positive limbs of 8-1?
The Commissioner used to argue legal expenses incurred as a result of
wrongdoing did not meet the positive limbs because they were not
connected with the income-earning process but rather with wrongdoing by
the taxpayer. Snowden & Wilson and Magna Alloys show that courts have not
accepted this argument, and legal expenses can be legitimate business
expenses provided they are appropriate or adapted to the business activity.
Since all business carries the risk of civil litigation and if you are sued in
business you have to defend yourself, it is reasonable to conclude that
Microhard is doing just that. Its legal expenses are therefore incidental and
relevant, thus satisfying the positive limbs. This argument is similar to that
presented for the damages.

2. Is it knocked out by a negative limb?

The arguments about revenue versus capital for the damages apply equally
to the legal expenses. However, there is an additional element to consider
for the legal expenses. There is a line of cases that holds expenses incurred
to defend title to an asset are capital expenses. Originally, these were
current expenses (Hallstroms), but this was changed by the tests in Sun
Newspaper, which characterised them as capital expenses as in the Broken
Hill case. The facts in this problem imply that Microhard is defending title to
the name, and therefore, the legal expense is most likely capital.

3. What if it is capital?
No specific provision allows any deduction in part or full for this expense.
However, the fifth element of cost base for CGT (s 110-25(6)) allows the
inclusion of the costs of defending title of an asset. In this case, if Microhard
has registered the name Wurdperphect, they can add the litigation costs to
the cost of the asset (being their rights to use the name), meaning they will
recognise the cost if they dispose of the name.

Additional examination tips [2.460]

Following are some additional points that you should bear in mind when
preparing answers to problem-type examination questions:
• Marks are given for developing an argument and counterargument. Never
quote assertions from a text or handbook to back up an argument. The
guides and handbooks contain summaries of the law generally, but they are
not authority on the resolution of particular fact situations.
• Identify cases sufficiently so the instructor will know which case you are
referring to (check if there are rules on the citation required for exams at
your institution).
• Do not repeat the facts of the case without using them. Normally, there are
no marks for explaining what happened in a case. Marks are usually awarded
for showing how the facts support one conclusion or are distinguished to
support another conclusion.
• Do not quote from the legislation. Marks are allocated for the application of
the legislation to the problem, not quoting from the legislation. It is essential
to cite legislation correctly, but it is a waste of time quoting words from the
Act.
• Do not stop at your first answer. Remember, with problem questions there
may be further issues. Every time you reach an apparent end of the road,
you must look for other possible forks in the road and consider all the
possibilities.
• Organise your answer using headings and subheadings. An organised
answer makes the instructor realise you appreciate the range of issues
raised by the problem and helps ensure you do not miss any flow-on issues.
If you think of an additional point later, jot it down so you do not forget it and
add it on at the end of the answer.

Using this chapter [2.470]

To gain the most from the content of this chapter, it is important that you
use it early in your course so that you are well prepared to develop a sound
study plan. However, it is also useful to continue to return to this chapter to
help with specific study or assessment issues that you may face throughout
the course.
The techniques presented in this chapter aim to improve the efficiency and
effectiveness of your study skills to enable you to gain the most from your
taxation law course and to perform your best in the assessment. These
techniques can also be adapted to suit existing study and learning patterns.

Online resources [2.480]

Internet resources are a very valuable source of information relating to
current tax issues. Listed below are some useful sites.

General
• Australian Taxation Office: http://www.ato.gov.au. This site contains
valuable information, such as rulings, court and tribunal decisions and
information guides. These can be accessed from the “Legal Database” tab on
the right at the top of the page.

Reported cases
• Australasian Legal Information Institute (AustLII): http://www.austlii.edu.au.
This site has an extensive case database, as well as journals, consolidated
legislation, Bills and Explanatory Memoranda to Bills. See Example 2.3.

Legislation
• Australian Taxation Office: http://www.ato.gov.au. At the top right of the
page, click on “Legal Database”. Then click on “Quick access” and then
“Legislation”. Select the correct Act from the drop-down box and type in the
section number that (e.g., 8-1) you are looking for in the “Provision” box.
• Parliament of Australia Bills: http://www.aph.gov.au/bills. This site contains
the content of Bills (including income tax Bills) that have not yet become
legislation. You can also track their progress through this website.
• Australasian Legal Information Institute (AustLII): http://www.austlii.
edu.au. This site publishes consolidated legislation, Bills, Explanatory
Memoranda to Bills and cases. Use the search box at the top of the page to
find a particular Act.
• ComLaw: https://www.legislation.gov.au/. This site contains consolidated
legislation, Bills, Explanatory Memoranda to Bills, Legislative Instruments
and Statutory Rules. After selecting the appropriate area use the alphabetic
list to find the required legislation etc.

Policy
• Tax reform: https://treasury.gov.au/review/tax-white-paper/why-tax-reform-
and-why-now. This site brings together the submissions and discussion
towards a review of the Australian taxation system.
• Australian Treasury – Taxation policy: https://treasury.gov.au/policy-
topics/taxation. This site details Tax Bills and current and future initiatives for
the Australian taxation system. • Australia’s future tax systems:
https://www.aph.gov.au/About_
Parliament/Parliamentary_Departments/Parliamentary_Library/pubs/
BriefingBook43p/futuretaxsystem. This site contains a range of papers
relating to taxation policy proposals.
• Federal Budget: http://www.budget.gov.au/. This site contains the most
recent Federal Budget.
• Board of Taxation: taxboard.gov.au. This site contains information on
proposed tax law changes.
• Tax Practitioners Board: http://www.tpb.gov.au/. This site contains the
policies and requirements for registration as a tax agent, BAS agent and Tax
(financial) Advisor.

Glossary of terms used in assignments and exams [2.490]

The following glossary lists some of the terms commonly used in
assignments and exam questions. Note that a glossary of terms may be
included with your course outline and the meanings given there should be
used ahead of this list.
• Analyse – You should break the topic or case into its component parts or
show the essential components of the topic or case.
• Compare – You are to show how the two (or more) things are alike. Note
that it is sometimes necessary to show how they differ so that the essential
likenesses are stressed. For example, “Compare the decisions of the High
Court in Cecil Bros Pty Ltd v FCT (1964) 111 CLR 430 and FCT v Isherwood
and Dreyfus Pty Ltd (1979) 9 ATR 473”.
• Contrast – You are to show how the two (or more) things differ. Note that it
is sometimes necessary to show how they are similar so that the essential
differences are stressed. For example, “Contrast the decisions in Myer
Emporium v FCT (1987) 163 CLR 199 and Westfield v FCT (1991) 21 ATR
1398” or “Contrast the reasoning of the majority and the dissenting
judgment of Brennan J in FCT v Suttons Motors (Chullora) Wholesale Pty Ltd
(1985) 157 CLR 277; 16 ATR 567”.
• Critically examine (or critically discuss) – You are required to write a study
of the good and bad points and come to some conclusions.
• Define – You should distinguish this topic from all others like it. The clarity
of your definition will be the main consideration.
• Discuss – You should explain and assess the importance of the features of
the topic with a fairly full treatment of all the main points. It may be
necessary to introduce specific illustrations, quotations or details of cases
where relevant. Any implications of the topic should be covered.
• Explain – You are to show the examiner that you understand the particular
issue mentioned.
• Evaluate – You are required to weigh the topic carefully and make some
judgments or come to some definite conclusions about the topic. For
example, “Evaluate the significance of Lord Denning’s judgment in Newton v
FCT (1958) 98 CLR 1 on the effectiveness of s 260 of ITAA 1936”.
• Justify – You are required to produce evidence for your decision or view.
• Summarise – Present briefly, but leave out nothing of importance. For
example, “Summarise the reasoning of Barwick CJ in Curran v FCT (1974) 5
ATR 61 on why bonus shares have a cost to the person receiving them”.
Chapter 3 The taxation formula
Key
points ............................................................................................
......... [3.00]
Introduction...................................................................................
............... [3.10]
Power to
tax ................................................................................................
. [3.20]
Australian
taxes ............................................................................................
[3.30]
Medicare
levy ...............................................................................................
[3.40]
Basic levy
payable .........................................................................................
[3.50]
Relief for low-income
earners ...................................................................... [3.60]
Exemptions.....................................................................................
............... [3.70]
Medicare levy
surcharge ..............................................................................
[3.80]
Government study and training support
loans ............................................. [3.90]
Introduction to income
tax .......................................................................... [3.100]
Income tax
burden........................................................................................
[3.110]
The income tax
formula ...............................................................................
[3.120]
Taxable
income ..........................................................................................
.. [3.130]
Assessable
income .......................................................................................
[3.140]
Deductions ....................................................................................
............... [3.180]
Income tax
rates ...........................................................................................
[3.190]
Individuals .....................................................................................
................ [3.200]
Other
entities ..........................................................................................
...... [3.210]
Tax
offsets ...........................................................................................
.......... [3.220]
Questions ......................................................................................
................ [3.230]

Key points [3.00]

• The primary aim of the taxation regime is to provide government revenue
and fund government expenditure, although the tax system also has broader
socio-economic purposes.
• Over 90% of total Commonwealth Government revenue is sourced from
taxation revenue, primarily income tax revenue.
• Section 51(ii) of the Australian Constitution grants the Commonwealth
Parliament the power to “make laws ... with respect to ... taxation”.
• The income tax system also serves as a basis for the collection of certain
other amounts, such as the Medicare levy and repayments under the higher
education government assistance programs.
• Section 3-5 of the Income Tax Assessment Act 1997 (Cth) provides that
income tax is payable for each year by each individual, company and certain
other entities.
• Taxpayers are required to calculate their income tax for the financial year
according to the formula: Income Tax = (Taxable Income × Rate) − Tax
Offsets, which is set out in s 4-10(3). • Taxable income is calculated
according to the formula: Taxable Income = Assessable Income −
Deductions, which is set out in s 4-15.

Introduction [3.10]
This chapter provides an overview of the Australian tax regime, in particular,
the income tax system. The Australian tax system plays an important role in
Australian society as it is the main source of funding for government
expenditure. Government revenue is required to fund the provision of goods
and services which are considered “public goods”. These are goods and
services which the market is unlikely to satisfactorily provide due to the fact
that there is no additional cost from additional use of these goods and
services, and it is not possible to exclude a person from using these goods
and services. One example of a public good is a lighthouse. It is not possible
to exclude any ships at sea (or anyone in the area) from seeing the
lighthouse, and there is no additional cost incurred for additional ships at sea
using the lighthouse.
A second function of government is to provide social goods, such as
education, health and defence services. These are goods which could
potentially be provided by the private sector, but which Australians have
generally chosen to provide universally through government using
universally paid tax revenue rather than user-pays levies.

A third function of government is one of redistribution. Through the welfare

and social security systems funded by tax revenue, the government
transfers funds from those who have benefited from the market and enjoy a
greater ability to pay to those who have been less fortunate in the market
economy.

Figure 3.1 illustrates the distribution of projected Australian Commonwealth

Government expenditure of $670.3 billion for the 2020–2021 income year.

In addition to funding the government functions discussed above, the tax

system also has broader socio-economic purposes. The tax regime may also
be used for the purposes of social engineering, that is, encouraging certain
behaviour and discouraging other types of behaviour. For example, the
provision of a tax deduction for donations to charities is designed to
encourage taxpayers to donate to needy causes. Similarly, tax offsets for
expenditure on research and development are intended to promote research
and development activity in Australia. On the other hand, the so-called “sin
taxes” on alcohol, tobacco and gambling are designed to discourage
particular types of consumption. The “alcopops” tax is an attempt at curbing
excessive alcohol consumption among younger Australians. The introduction
of a tax on fast food or sugar is often suggested as a means of reducing
obesity. Taxes on petrol are intended in part to discourage excessive usage
of polluting fuel and to encourage manufacturers to produce more fuel-
efficient (and hence cheaper-to-operate) vehicles. When used in these ways,
tax tends to be a blunt instrument with varying degrees of success.
The projected government expenditure of $670.3 billion is a significant
increase on the previous year’s projected expenditure of $500.9 billion. The
increased expenditure is due to the COVID-19 pandemic which has had a
profound impact on Australia’s health system, community and economy. The
2020–2021 Budget is described as an “economic recovery plan” that will
create jobs, rebuild the economy and secure Australia’s future. For example,
expenditure on “other economic affairs” has increased significantly
compared to previous years as a result of various payments to support
businesses such as the JobKeeper and the Boosting Cash Flow for Employers
payments. Other measures include increased income support payments to
individuals and increased infrastructure spending to boost the economy.

For the 2020–2021 tax year, the income year we are focusing on, it is
predicted that total taxation receipts will be approximately $424.6 billion.
This amount is expected to contribute approximately 92% of total
government revenue. Table 3.1 highlights the importance of taxation
revenue in Australia.

As indicated by Table 3.1, non-taxation revenue contributes a very small

percentage of total government revenue. In Australia, non-taxation revenue
generally consists of income from the sale of goods and services
(privatisation or user-pays levies) and returns on investments.

Other means by which governments can raise revenue include

nationalisation (where governments appropriate private assets for public
good) or simply printing more money. However, these options are suboptimal
as they are likely to have negative effects. Nationalisation deters private
investment while printing money will cause inflation. Privatisation is one
option for raising revenue, but also raises problems in that there are some
goods or services which cannot or should not be privatised, and there are a
finite number of goods and services which can be sold. User-pays levies are
one alternative to taxation, but are not appropriate for “public goods” and
may be considered unsuitable for certain social goods and services. For
example, a user-pays levy for healthcare may result in low-income
individuals being unable to obtain adequate healthcare services.
Governments can also fund expenditure through loans from international
organisations, other governments or private investors. However, there is a
limit as to how much debt countries can enter into, and debt funding incurs
interest expenses which further increase government expenditure. As such,
taxation is generally the largest source of government revenue in most
countries.

Astute readers may have noticed that projected government revenue for
2020–2021 is significantly lower than projected government expenditure.
The COVID-19 pandemic is a once-in-a-century event that has required a
swift and expensive response from the Federal Government. This follows
unprecedented bushfires at the start of 2020 which also necessitated
significant government spending. As a result, the Federal Government is
operating at a deficit and the difference is being funded through debt. Gross
debt is expected to be 44.8% at the end of 2020–2021.

Power to tax [3.20]

The Commonwealth Government’s power to impose taxes stems from the
Australian Constitution. Section 51(ii) of the Constitution grants the
Commonwealth Parliament the power to “make laws for the peace, order and
good government of the Commonwealth with respect to ... taxation”. Section
51(ii) also provides the Commonwealth Government with the power to
impose laws regarding the collection and administration of taxes. For the
purposes of making tax laws, “taxation” is generally defined as a
“compulsory exaction of money by a public authority for public purposes,
enforceable by law, and is not a payment for services rendered”: Matthews v
Chicory Marketing Board (1938) 60 CLR 263 at 270. It has also been said
that “tax” is not a penalty and it cannot be arbitrary (i.e., a tax liability must
be capable of being determined in accordance with specific criteria):
MacCormick v FCT (1984) 15 ATR 437 at 446.

Section 51(ii) also specifies that any laws with respect to taxation cannot
discriminate between the States or parts of States. Section 114 prevents the
Commonwealth Government from imposing any tax “on property of any kind
belonging to a State”. When passing taxation laws, the Commonwealth
Parliament must ensure that the laws imposing taxation deal only with the
imposition of taxation and deal with one subject of taxation only: s 55 of the
Constitution. Any provision in an imposition Act which deals with another
matter will have no effect. This explains why we have so many different
Commonwealth Acts which impose different types of taxes. Taxation revenue
is raised through a number of different taxes, such as income tax, fringe
benefits tax, goods and services tax (GST), excise duties, customs duties,
luxury car tax, wine equalisation tax and other indirect taxes, each of which
is imposed in a separate Act. For each type of tax, we generally have an
imposition Act (which imposes the liability for the tax), a rates Act (which
specifies the applicable rate of tax) and an assessment Act (which sets out
the rules for working out what is subject to tax or how to calculate the tax
payable).

For example, we have the Income Tax Assessment Act 1936 (Cth) (ITAA
1936), the Income Tax Assessment Act 1997 (Cth) (ITAA 1997), the
Income Tax Rates Act 1986 (Cth) and the Income Tax Act 1986 (Cth),
all of which deal with the income tax. We have the Fringe Benefits Tax
Assessment Act 1986 (Cth) and the Fringe Benefits Tax Act 1986 (Cth) for the
fringe benefits tax and A New Tax System (Goods and Services Tax) Act 1999
(Cth) and A New Tax System (Goods and Services Tax Imposition – General)
Act 1999 (Cth) for the goods and services tax. As required by the
Constitution, the imposition Acts (e.g., Income Tax Act 1986, Fringe Benefits
Tax Act 1986) are relatively short and only deal with the imposition of tax
and with only one type of tax.

The Constitution also addresses the distribution of taxing rights between the
Commonwealth and State Governments. Some taxes may be imposed at
only one level of government (State or Commonwealth), while other taxes
may be shared by both levels of Government. For example, s 90 of the
Constitution stipulates that customs and excise duties can only be imposed
by the Commonwealth Government. Income tax, on the other hand, may be
shared by both levels of government and, from 1915 until 1942, both State
and Commonwealth Governments imposed income tax in Australia. Prior to
1915, only State Governments imposed income tax, and since 1942, only the
Commonwealth Government has imposed income tax. State Governments
continue to impose a number of taxes, such as stamp duty, land tax, payroll
tax and various transaction-based taxes, but the revenue from these taxes is
insufficient to fund the services provided by State Governments, such as
health and education. The introduction of the GST in 2000 was, in part, an
attempt to provide State Governments with a guaranteed source of funding.
Although GST is imposed and collected by the Commonwealth Government,
all GST revenue is distributed to State Governments under an agreement
between the Commonwealth and State Governments.

Australian taxes [3.30]

Australia’s taxation revenue comprises a number of different taxes. Figure
3.2 illustrates the different sources of revenue in Australia.
As illustrated in Figure 3.2, income tax is the largest contributor to Australian
revenue and it is the primary focus of this book. The Commonwealth
Government’s 2020–2021 Budget estimates that income tax (from
individuals, companies and superannuation funds) will contribute
approximately 74% of total taxation revenue for the 2021 income year.

We generally think of income tax as tax that we pay on common receipts,

such as salary, wages, business income, interest, dividends and rent
received. However, also included in the estimates of total income tax
revenue is revenue collected through the taxation of capital gains. This is
commonly referred to as capital gains tax, but it is important to note that, as
discussed in Chapter 11, capital gains tax is not a separate tax. Rather, net
capital gains form part of the taxpayer’s assessable income for the purposes
of determining the taxpayer’s income tax liability.

Related to the imposition of income tax on services income is the fringe

benefits tax. As discussed in Chapter 7, this is a tax imposed on employers
on the provision of benefits to employees (i.e., in substitution of income).
Although the fringe benefits tax only raises a small portion of total revenue,
it serves an important role by ensuring that all benefits received in a
services context are subject to tax.

The most recent substantive change to Australia’s tax regime was the
introduction of a GST in 2000. GST, as discussed in Chapter 25, is different to
income tax in that it is an indirect tax. An indirect tax is one which is
embedded in the price of goods or services and collected by an intermediary
from the entity which ultimately bears the economic burden of the tax. In
Australia, for example, GST is collected by suppliers of goods or services
when they receive payment for their supplies. This aspect of the GST (and
other indirect taxes) makes it attractive from an administrative perspective
as it is easier to calculate and collect taxes owed, and there are fewer
taxpayers to look after. Other examples of indirect taxes include customs
duties (e.g., on imports such as motor vehicles or clothing and footwear),
excise duties (e.g., on petrol, diesel, beer, tobacco and other alcoholic
beverages) and agricultural levies (e.g., on chicken meat).

Medicare levy [3.40]

The Australian tax system also serves as a collection mechanism for various
other amounts that may be payable by Australian tax residents. In addition
to the various taxes mentioned above, most Australian resident individual
taxpayers with incomes above a minimum threshold are also required to pay
the Medicare levy. The Medicare levy is imposed under the Medicare Levy
Act 1986 (Cth) with the criteria for determining the Medicare levy liability
contained in Pt VIIB of the ITAA 1936.

Medicare is the universal healthcare scheme that provides Australians with

access to healthcare services. The tests for residency for the imposition of
the Medicare levy are the same as the income tax tests for residency
discussed in Chapter 4. A part-year resident is required to pay the Medicare
levy for the part of the year when they are resident. However, note that the
tests for residency for the imposition of the Medicare levy are not the same
as the tests for residency for the purposes of determining an individual’s
entitlement to Medicare benefits: Ruling IT 2615. The entitlement to
Medicare benefits is determined in accordance with ss 3(1), 10 and 21 of the
Health Insurance Act 1973 (Cth). Therefore, it may be the case that
individuals are required to pay the Medicare levy as they are Australian
residents for tax purposes although they may not be entitled to Medicare
benefits as they are not “residents” for the purposes of the Health Insurance
Act 1973. This is in part addressed by the exemptions to the Medicare levy:
see [3.70].

Basic levy payable [3.50]

The Medicare levy is generally calculated at a flat rate on taxable income: s
251S(1)(a) of the ITAA 1936. The applicable rate is 2% from 1 July 2014
(previously 1.5%). The increase in the Medicare levy was introduced to fund
the National Disability Insurance Scheme (NDIS), which provides support for
people with permanent and significant disability and their families and
carers. The Medicare levy is imposed on the whole of the individual’s taxable
income, including any amount that may be subject to the tax-free threshold.
There is no maximum limit in respect of an individual’s Medicare levy.

Example 3.1: Calculation of Medicare levy Elisabeth has taxable income of

$50,000. The Medicare levy is calculated at 2% of Elisabeth’s taxable
income. Therefore, she will be liable to a levy of $1,000.

Example 3.2: Calculation of Medicare levy Roger has taxable income of $2

million. The Medicare levy is calculated at 2% of Roger’s taxable income.
Therefore, he will be liable to a levy of $40,000.

Relief for low-income earners [3.60]

A taxpayer who qualifies as a low-income earner is either fully or partially
exempted from the Medicare levy. The amount of the exemption will depend
on the individual’s taxable income and whether they qualify for the seniors
and pensioners tax offset (SAPTO).

Individuals with taxable income equal to or less than the “threshold amount”
receive a full exemption from the Medicare levy. Individuals with taxable
income greater than the “threshold amount”, but less than the “phase-in
limit”, pay the Medicare levy at a rate of 10 cents on every dollar of taxable
income above the “threshold amount”. Individuals with taxable income
above the “phase-in limit” are subject to the full Medicare levy, as discussed
at [3.50], but may be eligible for Medicare levy reduction based on family
taxable income in certain limited circumstances.

The “threshold amount” and “phase-in limit” for the 2019–2020 income year
are given in Table 3.2.

Table 3.2 Medicare levy low-income earner thresholds

Threshold amount Phase-in
limit
Individual entitled to the SAPTO $36,056 $45,069
All other taxpayers $22,801 $28,501

At the time of writing, any changes to the “threshold amount” and “phase-in
limit” for the 2020–2021 income year were yet to be announced.

Example 3.3: Medicare levy – low-income earner Rupert has taxable income
of $12,000. He is not entitled to the SAPTO. Rupert is not required to pay the
Medicare levy as his taxable income is below the “threshold amount”.

Example 3.4: Medicare levy – low-income earner Jacky has taxable income
of $25,000. She is not entitled to the SAPTO. Jacky’s Medicare levy is
calculated as ($25,000 − $22,801) × $0.10. Therefore, Jacky will have to pay
a Medicare levy of $219.90.

Exemptions [3.70]
Under ss 251T and 251U of the ITAA 1936, the following individuals are
exempt from the Medicare levy:
• members of the Australian Defence Forces and their relatives who are
entitled to free medical treatment in respect of every incapacity, disease or
disabling condition;
• persons entitled under the Veterans’ Entitlements Act 1986 (Cth) or the
Military Rehabilitation and Compensation Act 2004 (Cth) or the Australian
Participants in British Nuclear Tests and British Commonwealth Occupation
Force (Treatment) Act 2006 (Cth) to full free medical treatment for all
conditions;
• persons who receive a sickness allowance;
• persons who receive certain pensions or income support supplements in
specified circumstances; • non-residents;
• members of diplomatic missions or consular posts in Australia and
members of their families who are not Australian citizens and are not
ordinarily resident in Australia; and
• any person who would not have been entitled to Medicare benefits in
respect of services, treatment or care to which Medicare benefits under the
Health Insurance Act 1973 relate. The individual must provide a certificate
from Medicare Australia to qualify for the exemption. The Medicare levy
exemption certificate can be obtained from Medicare Australia by submitting
the appropriate application form. A separate application is required for each
financial year.

Individuals with dependants may need to satisfy additional requirements to

qualify for the exemption. A partial exemption may be available where the
individual satisfies one of the exemption categories for only part of the
income year.

Example 3.5: Medicare levy – exemption

Yang is an international student studying at a university in Australia. She is
an Australian resident for tax purposes as determined by the residency tests
in s 6 of the ITAA 1936 (see Chapter 4). However, under the Health Insurance
Act 1973, Yang is not entitled to Medicare benefits in respect of health
services provided in Australia. Yang has taxable income of $40,000.

Prima facie, Yang is required to pay the Medicare levy in respect of her
taxable income of $40,000 as she is a resident of Australia for tax purposes
and her taxable income is above the “threshold amount” (she is not entitled
to the SAPTO). However, as she is not entitled to Medicare benefits, she can
obtain a Medicare levy exemption certificate from Medicare Australia, which
will exempt her from paying the Medicare levy. Yang will have to obtain a
separate certificate for each financial year to obtain the Medicare levy
exemption. Medicare levy surcharge [3.80] In addition to the Medicare levy,
a Medicare levy surcharge is payable by taxpayers, where their income is
above a certain threshold and they do not have private health cover through
a registered private health insurance provider for the entire income year. The
Medicare levy surcharge is imposed in addition to the Medicare levy.
Individuals who are exempt from the Medicare levy are also exempt from the
Medicare levy surcharge (e.g., foreign residents). Taxpayers must calculate
their “income for surcharge purposes” to determine whether they have to
pay the Medicare levy surcharge. “Income for surcharge purposes” includes
the taxpayer’s:
• taxable income (including the net amount on which family trust distribution
tax has been paid);
• exempt foreign employment income;
• reportable fringe benefits amount;
• total net investment loss (includes both net financial investment loss and
net rental property loss); and
• reportable super contributions (includes both reportable employer super
contributions and deductible personal super contributions).

Taxpayers aged between 55 and 59 years old can deduct from this amount
any taxed element of a super lump sum, other than a death benefit, which
they received and does not exceed the low rate cap on super lump sum
benefits to determine their “income for surcharge purposes”.

The “income for surcharge purposes” is only used to ascertain a taxpayer’s

liability for the Medicare levy surcharge and the applicable rate. Once it is
determined that the taxpayer is liable for the Medicare levy surcharge, the
Medicare levy surcharge payable is calculated as follows:

Taxable income (including the net amount on which family trust distribution
tax has been paid and total reportable fringe benefits) × Surcharge rate

At the time of writing, the Medicare levy surcharge income thresholds and
rates are as given in Table 3.3.

The Medicare levy surcharge in effect serves as an incentive for taxpayers to

have private health insurance as the surcharge is not payable in respect of
any days when a taxpayer has private health insurance. In addition,
taxpayers with private health insurance receive a private health insurance
tax offset as a further incentive. The amount of the offset depends on the
taxpayer’s age and level of income and can be claimed as a reduction in
premiums or, if the full premium amounts are paid up-front, as a cash
payment from Medicare or as an offset on the annual income tax return. See
Chapter 15.

Government study and training support loans [3.90]

The government provides financial assistance in the form of loans to people
undertaking higher education, trade apprenticeships and other training
programs (e.g., Higher Education Loan Program (HELP)). The Australian
Taxation Office (ATO) is also responsible for the collection of these loans
through the tax system. The loans must be repaid once the person’s income
exceeds the repayment threshold. The compulsory repayments are collected
through the tax system, but voluntary repayments can also be made to
reduce the loan balance faster. Minimum repayments are required at the
rates given in Table 3.4.
Individuals with an outstanding government education loan who are living
overseas are also required to make loan repayments similar to if they were
living in Australia. The onus is on the person with an outstanding
government education loan to provide the ATO with their overseas contact
details within seven days of leaving the country if moving overseas for
longer than six months.

Introduction to income tax [3.100]

The rest of this chapter provides an overview of the income tax in Australia
and basic information as to how income tax is imposed and calculated. Each
of the elements introduced here is discussed in further detail in subsequent
chapters.

Income tax burden [3.110]

Section 3-5 of the ITAA 1997 provides that income tax is payable for each
year by each individual and company and certain other entities. In Australia,
personal income tax is imposed on each individual. Some countries may
impose personal income tax on a family unit or a couple, but this can
sometimes prove difficult in practice as it is not easy to define the family unit
or couple. For example, the family unit may encompass biological children,
stepchildren, dependent children under 18, non-dependent children under 18
and so on.

Similarly, a couple could be a married couple, a de facto couple, a same-sex

couple and so on. Although personal income tax is imposed on an individual
basis in Australia, family circumstances may be taken into consideration for
the purposes of determining certain welfare benefits delivered through the
tax system (e.g., the family tax benefit).

Note that partnerships and trusts are not included in s 3-5. Although subject
to the income tax system and required to lodge an annual income tax return,
partnerships and trusts are not separate taxpayers. Rather, the liability to
pay income tax on net gains gained or produced through partnerships and
trusts is generally borne by the individuals or entities that are partners in the
partnership or trustees and beneficiaries of the trust. The taxation of
partners and partnerships is discussed in Chapter 19, while Chapter 20
discusses the taxation of trusts and beneficiaries.

A company is treated as a separate taxpayer and pays income tax. However,

company tax is in effect a prepayment of the individual income tax of the
company’s shareholders. This is due to the operation of a credit arrangement
known as the dividend imputation system. The imputation system and the
taxation of companies and its shareholders more generally are discussed in
Chapter 21.

The ITAA 1997 generally uses the term “you” in referring to taxpayers. For
example, s 4-10 is in relation to “how much tax you must pay”. The meaning
of “you” is stipulated in s 4-5 which states that “you” applies to entities
generally, unless its application is expressly limited. A list of “entities” is
provided in s 9-1 and includes an individual, a company, a superannuation
provider, a corporate limited partnership and a trustee of a public trading
trust or corporate unit trust.

The income tax formula [3.120]

To calculate a taxpayer’s income tax liability, it is necessary to start at the
basic formula in s 4-10 of the ITAA 1997. Taxpayers are required to calculate
their income tax for the financial year as follows: Income Tax = (Taxable
Income × Rate) − Tax Offsets

The “financial year” is defined as the 12-month period beginning on 1 July:

ss 4-10(1) and 995-1 of the ITAA 1997. Taxpayers with a different financial
year for accounting purposes can use a “substituted accounting period” as
their income year if allowed by the Commissioner: s 4-10 Note 1 of the ITAA
1997; s 18 of the ITAA 1936. The Commissioner will generally grant an
application for a substituted accounting period, where the taxpayer’s
business needs demonstrate that 30 June is an inappropriate or impractical
balance date: Practice Statement PS LA 2007/21. For example, multinational
companies may seek to utilise a substituted accounting period to align
subsidiary companies’ accounting periods with that of the head company.
Such taxpayers are commonly referred to as a “SAP taxpayer”.

Taxable income [3.130]

It can be seen from the formula in [3.120] that taxable income is
fundamental to the calculation of a taxpayer’s income tax liability as it is the
basis upon which the amount of tax payable by a taxpayer is calculated.

Taxable income is determined under s 4-15 according to the following

formula:

Taxable Income = Assessable Income − Deductions

The method statement in s 4-15 refers the reader to Div 6 in relation to

assessable income and Div 8 in relation to deductions.

Assessable income [3.140]

Assessable income consists of ordinary income and statutory income: s 6-
1(1) of the ITAA 1997. However, some amounts of ordinary and statutory
income may be categorised as “exempt income” or “non-assessable non-
exempt” (NANE) income, in which case they are not assessable income: s 6-
1(2)–(4). As such, Assessable Income = Ordinary Income + Statutory
Income, but not Exempt Income or NANE Income.

Ordinary income essentially refers to amounts which have been held to be

assessable by the courts because they demonstrate certain characteristics,
while statutory income is those amounts that the legislature has stipulated
are assessable. Exempt and NANE income are those amounts that the
legislature has stipulated as not assessable.

[3.150] Ordinary income: Ordinary income is defined in s 6-5(1) of the

ITAA 1997 as income according to ordinary concepts. “Ordinary concepts” is
the term used to describe receipts that have an income character as set out
in doctrines that have been developed in the courts. The specific provision is
as follows:

6-5 Income according to ordinary concepts (ordinary income)

(1) Your assessable income includes income according to ordinary concepts,
which is called ordinary income.
(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.
(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 year on some basis other than having an Australian
source.
(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.

As is apparent from s 6-5(2) and (3), the determination of a taxpayer’s

ordinary income depends on whether the taxpayer is an Australian resident
or a foreign resident and the source of the income. These fundamental
concepts of residence and source are discussed in Chapter 4.

Section 6-5(4) ensures that taxpayers cannot avoid paying income tax by
directing that the income be paid to a different person and not receiving the
money themselves. This is known as the “constructive receipt rule”, whereby
the taxpayer is deemed to have derived the income when it is dealt with per
the taxpayer’s directions.

Example 3.7: Constructive receipt rule

Johnny provides his employer with instructions to pay half of his salary each
month to his elderly parents. Johnny is deemed to have derived the salary
under s 6-5(4), even though he did not physically receive the money, as it
has been dealt with per his directions.

The determination as to what constitutes ordinary income is a fundamental

issue in tax. The legislative reference to “income according to ordinary
concepts” alludes to Sir Fredrick Jordan’s statement in Scott v Commissioner
of Taxation (1935) 35 SR (NSW) 215; 52 WN (NSW) 44; 3 ATD 142 at 144:

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 in accordance with the ordinary concepts and usages of
mankind, except in so far as the statute states or indicates an intention that
receipts which are not income in ordinary parlance are to be treated as
income, or that special rules are to be applied for arriving at the taxable
amount of such receipts.

Case law has developed a number of characteristics of ordinary income to

assist in determining whether an amount constitutes ordinary income.
Chapter 5 outlines these principles.

[3.160] Statutory income: Statutory income consists of amounts that are

included in the taxpayer’s assessable income by a specific provision in the
income tax legislation: s 6-10(2) of the ITAA 1997. The statutory income of
an Australian resident includes statutory income from all sources, whether in
or outside Australia, whereas the statutory income of a foreign resident only
comprises statutory income from all Australian sources and any other
statutory income which is assessable on some basis other than having an
Australian source. As with ordinary income, there is a constructive receipt
rule in s 6-10(3) which deems that the taxpayer has derived a statutory
income amount if it is dealt with as per the taxpayer’s directions.

Division 10 lists the statutory income provisions contained in the income tax
legislation. Most types of statutory income are amounts that the legislature
wished to include in the income tax base but which fell outside the concept
of ordinary income. For example, s 26(e) of the ITAA 1936, which is now s 15-
2 of the ITAA 1997, was introduced to capture non-convertible benefits
provided to employees. The courts had held that the value of such benefits
was not ordinary income and therefore such benefits would not be subject to
tax in the absence of a statutory income provision.

Similarly, s 102-5 includes net capital gains in assessable income. Capital

gains would not otherwise be assessable as the courts have long accepted
that capital gains are not ordinary income.

However, in some cases, statutory income provisions capture amounts that

would otherwise be assessable as ordinary income, but the legislature has
considered it necessary to include a specific statutory income provision. For
example, dividend income would likely satisfy the requirements of ordinary
income, but it is also made assessable under s 44 of the ITAA 1936.

Where an amount of income constitutes both ordinary and statutory income,

s 6-25(1) ensures that the amount is only included in the taxpayer’s
assessable income once. The amount will generally constitute statutory
income unless a specific provision indicates otherwise: s 6-25(2). For
example, dividend income which is likely to constitute ordinary income but is
also assessable under s 44 would be included in assessable income as
statutory income under s 44.

However, s 15-2 of the ITAA 1997, for example, which includes in assessable
income allowances and other payments for services, only assesses such
amounts to the extent that they are not ordinary income (i.e., the section
gives precedence to ordinary income): s 15-2(3)(d). From a practical
perspective, it generally does not matter whether an amount is included in a
taxpayer’s assessable income as ordinary income or statutory income. In
either case, the amount is assessable and subject to tax.

[3.170] Non-assessable income:

If an amount is not ordinary income and not statutory income, then it is non-
assessable income (i.e., it is not subject to tax): s 6-15(1). An amount will
also be non-assessable income if the legislation stipulates that it is “exempt
income” or NANE income: ss 6-15(2) and (3), 6-20, 6-23. Amounts that are
classified as “exempt income” or NANE income may or may not constitute
ordinary or statutory income in the first place.

It must be noted that the term “non-assessable non-exempt” income is

simply the name of another category of income. While NANE amounts are
not assessable income, they are also not classified as “exempt income”.
Although both exempt income and NANE income are not subject to tax, it is
necessary to distinguish between the two categories due to other tax
consequences. For example, exempt income may be taken into account in
working out the amount of a tax loss under s 36-10, whereas NANE income is
not taken into account in working out the amount of a tax loss.

Subdivision 11-A lists the classes of exempt income, while subdiv 11-B lists
the particular kinds of NANE income.

There are two classes of exempt income:

• where the entity is exempt regardless of what type of income it has: s 11-5
(e.g., certain charitable institutions and local governments); and
• where the ordinary or statutory income is of a kind that is exempt: s 11-15
(e.g., certain education scholarships, family assistance benefits and
qualifying foreign employment income).

The provisions in the legislation which make an amount NANE income are
listed in s 11-55. Examples of NANE income include GST payable on a supply
(s 17-5) and the receipt of fringe benefits by employees (s 23L(1) of the ITAA
1936).

Deductions [3.180]
Deductions are generally expenses which are incurred by the taxpayer in
gaining or producing assessable income and therefore reduce the tax
payable by a taxpayer on their assessable income. There are two categories
of deductions: general deductions (s 8-1) and specific deductions (s 8-5).
Where an expense is deductible as both a general deduction and a specific
deduction, s 8-10 ensures that the taxpayer can only claim the deduction
once under the most specific provision. General deductions are discussed in
Chapter 12, while specific deductions are discussed in Chapter 13. Some
expenses that are not immediately deductible may be deductible over a
number of years: see Chapter 14.

The “value” of a deduction to a taxpayer depends on the taxpayer’s top

marginal income tax rate. See Example 3.8 for an illustration as to the
“value” of a deduction. Income tax rates [3.190] The applicable rate of
income tax depends on the type of taxpayer and is set out in the Income Tax
Rates Act 1986. The different types of taxpayers include:
• individuals who are Australian residents: see [3.200];
• individuals who are foreign residents: see [3.200];
• individuals who are working holiday-makers: see [3.200];
• companies below the turnover threshold: see [3.210]; and
• companies above the turnover threshold: see [3.210].

Individuals [3.200]
Individuals are subject to a progressive tax rate structure, whereby the
taxpayer’s tax burden increases as their taxable income (a measure of the
taxpayer’s ability to pay tax) increases. Under a progressive rate structure,
all individuals benefit from the different tax rates for different income
brackets. For example, the first $18,200 for an individual with $200,000 of
taxable income is tax-free.

An individual’s tax rate generally depends on whether the individual is a

resident of Australia for income tax purposes or not. Both resident and
foreign resident individuals are subject to the progressive rate structure but
at different rates. Tables 3.5 and 3.6 set out the applicable tax rates for
Australian resident taxpayers and foreign resident taxpayers for the year
ending 30 June 2021.

The above rates do not include the Medicare levy or the Medicare levy
surcharge discussed earlier in the chapter. The tax rates have remained
unchanged for several years, but the income thresholds were changed with
effect from 1 July 2020 to effectively reduce income taxes for most
individuals.

These changes were brought forward from their intended start date of 2022
in response to the COVID-19 pandemic and its impact on individual finances
and the economy.
There is a special category of individuals whose income tax obligations do
not depend on their residency for tax purposes. These are “working holiday-
makers” (i.e., backpackers) who are in Australia on a “Working Holiday” or
“Work and Holiday” visa. The following tax rates given in Table 3.7 apply to
the Australian sourced income of working holiday-makers regardless of their
tax residency.
Other entities [3.210]
Companies are generally subject to tax at a fixed rate on their taxable
income, regardless of their total amount of taxable income. This is known as
a flat or proportional tax. The applicable company tax rate depends on the
entity’s turnover. For the 2020–2021 income year, the company tax rate is
26% for companies with a turnover of less than $50 million. This rate will
decrease to 25% for the 2021–2022 and subsequent income years. However,
the lower company tax rate does not apply to a company if more than 80%
of the company’s assessable income is passive income (e.g., dividends,
royalties and interest), even though the company’s turnover may be below
the turnover threshold. For all other companies, the company tax rate is 30%
for the 2020–2021 and subsequent income years.

Example 3.10: Company income tax Big Profits Pty Ltd had taxable income
of $10 million, while Small Profits Pty Ltd had taxable income of $1 million
for the 2020–2021 income year. Assume that Big Profits Pty Ltd had an
annual turnover of $100 million, while Small Profits Pty Ltd had an annual
turnover of $10 million.
Big Profits tax payable = $10 million × 30% = $3,000,000.
Small Profits tax payable = $1 million × 26% = $260,000.

The tax rates which apply to superannuation funds and trustees are
discussed in Chapters 18 and 20 respectively.

Tax offsets [3.220]

Tax offsets or rebates are deducted from income tax payable and reduce the
amount of income tax which must be paid by the taxpayer. Tax offsets are
not the same as deductions as tax offsets reduce income tax payable,
whereas deductions reduce taxable income.

Example 3.11: Tax deductions vs tax offsets

Using the facts from Example 3.8, assume that, instead of having $10,000 of
deductions, Jack and Bobby have $10,000 of tax offsets.

Jack’s tax payable on taxable income of $200,000 = $60,667 − $10,000 =

$50,667.
Bobby’s tax payable on taxable income of $60,000 = $9,967 − $10,000 = −
$33.
Bobby will receive a refund of $33 if the tax offset is a refundable tax offset,
or he will have no tax liability for the current year and tax offsets of $33 to
be carried forward to the next year if the tax offset can be carried forward.

The example illustrates two important points. First, both Jack and Bobby
have significantly lower tax payable with tax offsets of $10,000, rather than
deductions of $10,000. Second, Jack and Bobby receive equal benefit from
the tax offset (reducing their tax liability by $10,000), as opposed to the
deductions, where the value of the benefit corresponds with the taxpayer’s
applicable marginal tax rate. Tax offsets generally do not reduce the
Medicare levy for individual taxpayers and may only be refundable in certain
limited circumstances. Tax offsets are listed in s 13-1 of the ITAA 1997 and
are discussed further in Chapter 15.

Questions [3.230]
3.1 What is the basic income tax payable for an Australian resident
individual with taxable income for the 2020–2021 income year of:
(a) $15,000?
(b) $50,000?
(c) $150,000?
(d) $300,000?

3.2 What is the basic income tax payable for a foreign resident
individual with taxable Australian income for the 2020–2021 income
year of:
(a) $15,000?
(b) $50,000?
(c) $150,000?
(d) $300,000?

3.3 Calculate the Medicare levy payable (if any) for the year ending
30 June 2021 on the following amounts for a single Australian
resident taxpayer who is not entitled to the SAPTO (assume the
same “threshold amount” and “phase-in limit” as for the 2019–2020
income year):
(a) $20,000
(b) $25,000
(c) $30,000

3.4 Calculate the Medicare levy surcharge payable (if any) on the
following taxable income amounts for a single Australian resident
taxpayer who does not have private health insurance for the entire
income year:
(a) $50,000
(b) $100,000

3.5 Following on from 3.4, calculate the Medicare levy surcharge

payable if the individual had private health insurance for 100 days
in the income year.
3.6 Jill is an Australian resident for tax purposes. She has
assessable income of $500,000. She has deductions of $100,000 and
franking credit tax offsets of $30,000. What is Jill’s tax payable for
the 2020–2021 income year?

3.7 Acme Pty Ltd has determined that its assessable income for the
year is $789,000 and it has deductions of $300,000. What is Acme’s
tax payable for the 2020–2021 income year? Assume that Acme’s
turnover is in excess of $50 million.

3.8 Linley is an Australian resident for income tax purposes. She

has taxable income of $277,000. She has been provided with a
receipt for an expense in the amount of $10,000. This expense will
constitute a deduction. How much tax will Linley save for the 2020–
2021 income year as a result of the additional deduction?

3.9 Following on from 3.8, Linley has a HELP debt of $25,000. How
much of the HELP debt would she be required to repay for the 2020–
2021 income year?
Chapter 4 - Residence and source
Key
points ............................................................................................
......... [4.00]
Introduction...................................................................................
............... [4.10]
Legislative
framework .................................................................................
[4.20]
Income tax rates for
individuals ................................................................. [4.30]
Residence ......................................................................................
............... [4.40]
Residence of Australia –
individuals............................................................. [4.50]
Residence according to ordinary
concepts .................................................. [4.60]
Domicile
test ...............................................................................................
[4.100]
183-day
test ...............................................................................................
. [4.130]
Superannuation
test ................................................................................... [4.140]
Period of
residence ....................................................................................
[4.145]
Temporary residents –
individuals ............................................................ [4.150]
Working holiday
makers ............................................................................ [4.155]
Foreign residents –
individuals .................................................................. [4.160]
Current review of individual
residence ..................................................... [4.165]
Residence of Australia –
companies ......................................................... [4.170]
Place of incorporation
test ........................................................................ [4.180]
Central management and control
test ...................................................... [4.190]
Controlling shareholders
test .................................................................... [4.210]
Dual residency and tie-breaker
provisions ................................................ [4.220]
Source ...........................................................................................
.............. [4.230]
Sale of goods – trading
stock ...................................................................... [4.240]
Sale of property other than trading
stock .................................................. [4.250]
Services ........................................................................................
............….[4.260]
Interest .........................................................................................
............... [4.270]
Dividends ......................................................................................
............... [4.280]
Royalties .......................................................................................
............... [4.290]
Questions ......................................................................................
.............. [4.300]

Key points [4.00]

• Residence and source are the bases upon which income tax is levied on
taxpayers under Australian domestic tax law.
• Australian residents are taxed on income from all sources.
• Foreign residents are taxed on income sourced in Australia.
• An individual is an Australian resident if he or she satisfies one of four
tests: the ordinary concepts test, the domicile test, the 183-day test and the
superannuation test.
• A company is a resident of Australia if it satisfies one of three tests: the
place of incorporation test, the place of central management and control test
and the controlling shareholder test.
• Source requires a geographical connection with Australia. There are both
statutory rules and common law rules which determine whether the
geographical connection exists.
• International tax treaties to which Australia is a party may override the
domestic principles of source.
• Determining the source of income requires the income to be categorised.
• For the purposes of source, a receipt is generally considered to fall within
the categories of income from the sale of goods or the sale of property other
than goods, income from the provision of services, or passive income in the
form of dividends, royalties or interest.
Introduction [4.10]
This chapter introduces the two key concepts upon which income tax is
imposed in Australia: residence and source. At the outset, students need to
remember two broad principles:
• A resident of Australia for tax purposes will be taxed on worldwide income,
that is, income from all sources.
• A foreign resident for tax purposes will be taxed on income sourced in
Australia only.

Both broad principles contain the concepts of residence and source. Figure
4.1 explains how these concepts fit together.

It is necessary to understand what is meant by these concepts to be able to

determine a taxpayer’s assessable income. Before we look at the meaning of
residence and source, we need to consider the reason why they are so
important in our income tax regime.

Legislative framework [4.20]

In order to understand the concepts of residence and source, it helps to
consider the legislative framework in which they operate. Both concepts are
contained in Div 6 of the Income Tax Assessment Act 1997 (ITAA 1997),
dealing with ordinary and statutory income. Students should revise Div 6 of
the ITAA 1997 as outlined in Chapter 3.

It is from these provisions that we find our general principles that Australian
residents are taxed on their worldwide income, while foreign residents are
taxed on income sourced in Australia. This is the first reason why residency
is important. There is a second reason why residency is important: where the
taxpayer is an individual, the applicable tax rates (set out in Chapter 3)
depend on residency status.

Income tax rates for individuals [4.30]

The income tax rates applied to individuals are different according to
whether the taxpayer is an Australian resident or a foreign resident.
Students should revise the individual rates of tax set out in Chapter 3. The
differences are as follows:
• foreign residents do not get the benefit of the tax-free threshold on any
Australian sourced income;
• the tax payable on the first bracket of income is at a higher rate;
• foreign residents do not have access to many personal tax offsets; and
• foreign residents are not liable for the Medicare levy. Now that we know
why it is so important to establish a taxpayer’s residency and source of
income at the outset, we can consider what is meant by each of these
concepts.

Residence [4.40]
Section 995-1 of the ITAA 1997 provides that “Australian resident” means a
person who is a resident of Australia for the purposes of the Income Tax
Assessment Act 1936 (ITAA 1936). If we refer to the ITAA 1936, we find a
definition of “resident” in s 6(1). Before we consider that definition, note
that:
• the status of an individual in migration law is not conclusive of his or her
residency status for taxation purposes;
• a taxpayer who does not fall within the legislative definition of “Australian
resident” is automatically considered a foreign resident for taxation
purposes;
• for tax purposes, a taxpayer may be a resident of more than one country;
• consistent with liability to tax being determined on a year-by-year basis, a
taxpayer’s residency status is also considered yearly; and
• events may be examined after year end to determine residency status.

Residence of Australia – individuals [4.50]

The definition of “resident” in s 6(1) of the ITAA 1997 contains four separate
and exhaustive tests for determining whether an individual is a resident of
Australia for taxation purposes. It provides that: resident or resident of
Australia means: (a) a person, other than a company, who resides in
Australia and includes a person:
(i) whose domicile is in Australia, unless the Commissioner is satisfied
that his permanent place of abode is outside Australia;
(ii) who has actually been in Australia, continuously or
intermittently, during more than one-half of the year of income,
unless the Commissioner is satisfied that his usual place of abode is outside
Australia and he does not intend to take up residence in Australia; or
(iii) who is:
(A) a member of the superannuation scheme established by deed
under the Superannuation Act 1990 (Cth); or

(B) an eligible spouse for the purposes of the Superannuation Act

1976 (Cth); or
(C) the spouse, or a child under 16, of a person covered by sub-
subparagraph (A) or (B).

A taxpayer needs to satisfy only one test to be considered a resident of

Australia. If a taxpayer does not satisfy any of the tests, he or she is
considered a foreign resident for taxation purposes. The four tests, one
common law test and three statutory tests, can be summarised as follows:
• A person who resides in Australia – This test is referred to as the
ordinary concepts test and is based on the common law: see [4.60].
• The domicile test – A person whose domicile is Australia, unless the
Commissioner is satisfied that his or her permanent place of abode is outside
Australia, is considered a resident of Australia: see [4.100].
• The 183-day test – A person who has actually been in Australia,
continuously or intermittently, during more than one-half of the year of
income, unless the Commissioner is satisfied that his or her usual place of
abode is outside Australia and that he or she does not intend to take up
residence in Australia, is considered a resident of Australia: see [4.130].
• The superannuation test – A person who is a member of a
superannuation scheme established by deed under the Superannuation Act
1990 (Cth) or an eligible employee for the purposes of the Superannuation
Act 1976 (Cth) or the spouse, or a child under 16, of a person covered by
those Acts, is considered a resident of Australia: see [4.140]. Residence
according to ordinary concepts [4.60] The primary test for determining
whether an individual is a resident of Australia is the “residence according to
ordinary concepts” test. It is a common law test that is somewhat circular
and which requires a consideration of where a person resides. The term
“resides” is not defined in the ITAA 1997 or ITAA 1936 and, as such, its
ordinary meaning is ascertained from a dictionary. Two examples are the
Macquarie Dictionary that defines “reside” as “to dwell permanently or for a
considerable time; have one’s abode for a time” and the Shorter Oxford
English Dictionary that defines it as “to dwell permanently or for a
considerable time, to have one’s settled or usual abode, to live, in or at a
particular place”: Ruling TR 98/17, para 14. The definition clearly covers
migrants but will also extend to persons dwelling in Australia for a
considerable period, such as students.

[4.70] The question of whether a person resides in Australia is a question of

fact and degree: Miller v FCT (1946) 73 CLR 93. The leading authorities on
what constitutes ordinary residence are the UK cases of Levene v IRC [1928]
AC 217 and IRC v Lysaght [1928] AC 234.

Case study 4.1: Residency – temporary visits abroad

In Levene v IRC [1928] AC 217, the taxpayer, who had always been a
resident of the UK, retired from business and sold his house. For the two
years following he lived at hotels in the UK. For the five years after that he
lived in hotels both in the UK and abroad. During this time he spent four or
five months a year in the UK to obtain medical advice, visit relatives and
attend religious ceremonies. The House of Lords held that, until the taxpayer
took a lease on a flat in Monte Carlo in 1925, he was a UK resident. This
conclusion was based on the fact that the purposes for going abroad were
nothing more than temporary. Taking into account his ties with the UK,
together with the temporary nature of the time abroad, the taxpayer was a
resident of the UK for taxation purposes until 1925.

Case study 4.2: Residency – moved abroad

IRC v Lysaght [1928] AC 234 also involved a taxpayer who spent
considerable time abroad. In this case, the taxpayer partially retired
and moved from England to an inherited estate in Ireland. He sold
his home in England but remained a non-executive director of the
family company. He travelled to England for approximately one
week per month, staying in hotels, to attend board meetings. It was
held that the taxpayer was resident and ordinarily resident in the
UK. Lord Buckmaster said (at 248): “If residence be once
established ordinarily resident means in my opinion no more than
the residence is not casual and uncertain but that the person held
to reside does so in the ordinary course of life.” Consistent with the
UK decisions, the Administrative Appeals Tribunal (AAT) decision of
Joachim v FCT (2002) 50 ATR 1072 highlights the approach adopted
in Australia. The same approach was adopted more recently in Pike
v Commissioner of Taxation [2019] FCA 2185 to the application of
the domestic law, although that case was complicated by the fact
that there was a double tax agreement in place that needed to be
considered because of dual residency (see Chapter 22).

Case study 4.3: Residency – family home in Australia and intention

to treat Australia as home
In Joachim v FCT (2002) 50 ATR 1072, the taxpayer and his family
had migrated to Australia in 1994. The taxpayer, a qualified master
mariner, was unable to find work in Australia so he obtained
employment on various Sri Lankan vessels which resulted in him
being outside Australia for 316 days. His family, who had Australian
permanent residency, remained in Australia during this time. The
taxpayer claimed that he was not a resident of Australia as he had a
permanent place of abode outside Australia. The AAT concluded
that the taxpayer was a resident of Australia as he maintained a
home for his family in Australia and, despite his absence, his
intention to treat Australia as his home had not changed.

[4.80] The cases illustrate that a broad range of factors will be considered in
determining ordinary residence, with relative weight given to each. The
factors considered by the courts are as follows:
• Physical presence in Australia – As a general principle, it is necessary that
the taxpayer spends at least some time physically present in Australia
during the year of income to be considered a resident under this test,
although see Case Study [4.3].
• If the person is a visitor, the frequency, regularity and duration of visits –
IRC v Lysaght [1928] AC 234 is an example of a taxpayer living in one
jurisdiction (Ireland) but visiting another (England) with frequency and
regularity. The duration of the visits will also be considered.
• The purpose of the visits to Australia and abroad – If the person is a visitor
to Australia, the purpose of the visit may be considered. Conversely, if the
person is outside Australia for part of the income year in question, the
purpose of the absence may also be relevant.
• The maintenance of a place of abode in Australia for the taxpayer’s use –
Whether a person has a home available for use in Australia is an important
factor in deciding whether he or she continues to be a resident in Australia.
• The person’s family, business and social ties – Similar to the maintenance
of a place of abode, the location of a person’s family, business and social ties
will provide evidence of residence: Levene v IRC [1928] AC 217.
• The person’s nationality – A person’s nationality will not normally be a
relevant factor in considering residency where other factors are clearly
decisive. However, if a case is borderline, nationality may be considered.

[4.90] Many of the factors above are discussed in Ruling TR 98/17, which
considers the residency status of individuals entering Australia, including
migrants, academics, students studying in Australia, visitors on holiday and
workers with pre-arranged employment contracts. The Ruling discusses the
facts and circumstances of an individual’s behaviour that the Commissioner
considers relevant in determining whether a person is an Australian resident.

While the taxpayer’s circumstances as a whole are relevant, and no single

factor is decisive, the Commissioner places emphasis on:
• intention or purpose of presence;
• family and business or employment ties;
• maintenance and location of assets; and
• social and living arrangements.

In addition to a person’s behaviour while in Australia, emphasis is placed on

physical presence in Australia. Generally, the Commissioner considers that
there must be sufficient time elapsed to demonstrate continuity, routine or
habit. This is a question of fact. However, it is considered in the Ruling that a
period of six months is considerable time for deciding whether an individual
resides in Australia.
Example 4.1: Residence according to ordinary concepts – Australian
resident
Promising Swedish soccer player Bjorn is offered an 18-month
contract to play for a club in the National Soccer League in
Australia. Bjorn lets out his house in Sweden, sells his car and
redirects the mail to Australia, where he intends to remain for the
full 18 months of the contract. The club provides accommodation in
Australia for Bjorn and his family, his children attend school and,
along with his wife, they become involved in sporting activities.
However, Bjorn has trouble adapting to Australian conditions and is
warned to perform “or else”. Eventually he is playing so badly that
the club’s management seeks to terminate his contract on the
ground of non-performance. The contract is paid out for an agreed
sum. Bjorn and his family return to Sweden four months after they
arrived in Australia. Bjorn explains to the Commissioner that,
although he was only in Australia for four months, he was residing
here for that four months and he argues that he is entitled to be
taxed as an Australian resident.

The Commissioner rules that Bjorn is a resident because Bjorn

established that he intended to live here for 18 months with his
family and his behaviour over the four months was consistent with
that intention. Source: Adapted from Example 1, Ruling TR 98/17.

Example 4.2: Residence according to ordinary concepts – foreign

resident
Michael, a South African diamond corporation executive, comes to
Australia to participate in an intensive eight-month advanced
management development program at a university. His wife and
children don’t come with him. While he is in Australia, he stays in
basic on-campus accommodation. Michael is in Australia solely to do
the course and spends his time studying or writing reports for his
company. At the end of the eight-month course, he returns to South
Africa. Michael is a foreign resident because he does not exhibit
behaviour that is consistent with residing in Australia. Note: Ruling
TR 98/17 only deals with the application of the residence according
to ordinary concepts test.
However, as Michael is in Australia for more than 183 days, we must
also consider the second statutory test. The Commissioner is likely
to conclude that Michael is not a resident under this test either, as
Michael has a usual place of abode outside of Australia and does not
intend to take up residence in Australia. Source: Adapted from
Example 2, Ruling TR 98/17.

Example 4.3: Residence according to ordinary concepts – Australian

resident
Jane is a Professor of Biology at the University of Warsaw. She
comes to Australia under a contract to work for five months on a
research project. She is single. Although she intends to leave after
five months, she takes on a six-month lease for a small furnished
flat near work. She also buys an old car. She spends time outside of
work seeing films, attending occasional dinner parties at her
colleagues’ houses, reading books and writing letters to everyone
at home. Jane intends to return to Warsaw at the end of the project.
The project extends and lasts for seven months, so she negotiates
an extra month on her flat’s lease. Apart from depositing her salary
into an Australian bank account to cover living expenses, Jane
retains all assets and investments in Poland, her country of
domicile. As her behaviour over the seven months in Australia is
consistent with residing here, Jane is regarded as a resident from
the time she arrives in Australia. Jane will be a resident for part of
the year only, that is, from the time she arrives in Australia until the
time she leaves Australia. Source: Adapted from Example 3, Ruling
TR 98/17.

Example 4.4: Residence according to ordinary concepts – foreign

resident
Michelle is a viticulturist. She comes to Australia for five months to
conduct research, but actually stays seven months to complete it.
She stays in a hostel and uses credit cards for living expenses. Her
husband and children stay in their home in Bordeaux and, from
Australia, Michelle helps her husband run the family business.
Michelle’s research is often interrupted because she has to
frequently communicate with her husband about their emerging
business problems. Eventually she needs to go home for a week to
sort out a major business issue. Although Michelle is in Australia for
a considerable time, the quality and character of her stay are closer
to that of a visitor who is temporarily in Australia than someone
residing here, so she is a foreign resident. Source: Adapted from
Example 4, Ruling TR 98/17.

Domicile test [4.100]

The first statutory test, known as the domicile test, provides that a person is
a resident of Australia if his or her domicile is in Australia, unless the
Commissioner is satisfied that the person has a permanent place of abode
outside Australia. The domicile test generally applies to outgoing individuals
where that person moves overseas (usually as a work posting), but does not
change his or her domicile. “Domicile” is a legal concept to be determined
according to the Domicile Act 1982 (Cth) and the common law rules. It
broadly means the jurisdiction with which a person has permanent legal ties.
A person acquires a domicile of origin at birth (usually the place of the
father’s permanent home), but may acquire a domicile of choice. Section 10
of the Domicile Act 1982 (Cth) provides that the intention that a person must
have in order to acquire a domicile of choice in a country is the intention to
make his home indefinitely in that country. For example, obtaining Australian
permanent residency is likely to demonstrate a domicile of choice in
Australia. On the other hand, a fixed period student visa or working visa
would not satisfy the test for domicile of choice.

As this test generally applies to individuals leaving Australia, the person will
have an Australian domicile. Therefore, the individual will be a resident of
Australia only if it is demonstrated that he or she does not have a
“permanent place of abode outside Australia”. Consequently, cases involving
this test deal with the question of “permanent place of abode outside
Australia”, rather than domicile. Whether a person has a permanent place of
abode outside Australia is a question of fact based on the individual
circumstances of the case. Most recently, the Full Federal Court held that the
word “place” referred to the town or country in which the taxpayer was
residing rather than the residence (apartments): see Harding v FCT [2019]
FCAFC 29.

[4.110] The leading case on what constitutes a permanent place of abode

outside Australia is FCT v Applegate (1979) 9 ATR 899. Case study 4.4:
Permanent place of abode In FCT v Applegate (1979) 9 ATR 899, the
taxpayer was a solicitor in Sydney who had been sent by his employer to
Vanuatu to open and operate a branch. The taxpayer gave up the lease on
his flat and, leaving no assets in Australia, left Sydney with his wife in
November 1971. A lease was obtained on a house and the taxpayer, who
obtained residency status, was admitted to practice in Vanuatu.

In June 1973, the taxpayer became ill and returned to Sydney for medical
treatment. After returning to Vanuatu for a short period, he came back to
Australia in September 1973. Subsequently, the Vanuatu office was closed. It
was always the intention of the taxpayer and his employer that he would
return to Australia eventually. While no time frame was specified, it was
intended to be substantial.

The issue was whether, during his time in Vanuatu, the taxpayer had a
permanent place of abode outside Australia. The Full Federal Court held that
the taxpayer had a place of abode outside Australia. The question therefore
was whether it was a permanent place of abode. The Court concluded that
permanent meant something less than everlasting or lasting forever, but
rather took its meaning from its context, in particular by reference to a
person who had retained his or her domicile. In this sense, permanent should
be contrasted with temporary or transitory. As such, the Court concluded
that the taxpayer had a permanent place of abode outside Australia and was
not a resident.

Case study 4.5: Permanent place of abode

A similar issue arose in FCT v Jenkins (1982) 12 ATR 745, where the
taxpayer, a bank employee, was transferred to Vanuatu for a fixed
three-year period. Prior to leaving Australia, the taxpayer
attempted to sell the family home but was unsuccessful. He
maintained a bank account in Australia but cancelled his health
insurance policy.

Due to the taxpayer’s inability to efficiently perform his duties, he

was repatriated back to Australia by his employer at the end of 18
months. The taxpayer claimed that he was not liable to income tax
on earnings while he was in Vanuatu as it was income derived by a
non-resident from a source outside Australia. The Court, applying
the decision in FCT v Applegate, concluded that the taxpayer had a
permanent place of abode outside Australia during his time in
Vanuatu.

[4.120] In response to FCT v Applegate and FCT v Jenkins, the

Commissioner issued Ruling IT 2650, setting out the various factors which
will be taken into account in ascertaining whether a taxpayer has a
permanent place of abode outside Australia. Factors considered relevant are
as follows:
• the intended and actual length of the taxpayer’s stay in the overseas
country;
• whether the taxpayer intended to stay in the overseas country only
temporarily and then to move on to another country or to return to Australia
at some definite point in time;
• whether the taxpayer has established a home (in the sense of dwelling
place; a house or other shelter that is the fixed residence of a person, a
family or a household) outside Australia;
• whether any residence or place of abode exists in Australia or has been
abandoned because of the overseas absence;
• the duration and continuity of the taxpayer’s presence in the overseas
country; and
• the durability of association that the person has with a particular place in
Australia, that is, maintaining bank accounts in Australia, informing
government departments such as Centrelink that he or she is leaving
permanently and that family allowance payments should be stopped, place
of education of the taxpayer’s children, family ties and so on.

Emphasis is often placed on the length of stay overseas. To this extent,

Ruling IT 2650 states that, as a broad rule of thumb, a period of two years or
longer will be considered a substantial period for the purposes of a
taxpayer’s stay in another country. However, a two-year rule should not be
automatically relied upon without considering the other factors.

Example 4.5: Domicile test – Australian resident

George is an Australian resident. He works for a mining company
and is transferred overseas for two years for a temporary work
assignment in order to gain wider work experience. He intends to
return to Australia at the end of the two years. George’s wife and
children go with him at first, but the children return to Australia to
go back to school.

George spends his annual holiday in Australia. While overseas he

rents out his Australian home and maintains bank accounts in
Australia. Except for what he spends on living expenses, George
sends all his money to Australia for investment. He makes no
investments overseas.
George is not considered to be a resident of Australia under the
ordinary meaning of “resident”, but is considered to be a resident
under the extended definition of that term. That is, George is a
resident of Australia under the domicile test. Source: Adapted from
Ruling IT 2650, para 31.

Example 4.6: Domicile test – foreign resident

As soon as Elise finished her degree, she decided to leave Australia
indefinitely. She went to work in one city in one overseas country to
gain work experience. Before leaving, she closed all her bank
accounts, except for a five-year interest-bearing deposit. She was
sharing a rented house while she studied and she has no spouse or
children. Elise became ill while she was overseas and had to come
back to Australia within 18 months.

Elise is a foreign resident as it was her original intention to remain

outside Australia for an unspecified period of time and she is
considered to have a permanent place of abode in the overseas
country.

Alternatively, after finishing her degree, Elise intended to spend

and indeed did spend a year each in two countries and then
travelled for a further year, living in youth hostels the whole time.
In this case, she did not have a permanent place of abode in any of
the overseas countries and continues to be a resident of Australia.
Source: Adapted from Ruling IT 2650, para 32.

Example 4.7: Domicile test – foreign resident

Seth is a bank manager. He is posted to the New Hebrides for two
years, where he lives with his family in a furnished house provided
by the bank. He expects he will receive another overseas posting
after this two-year period, so he lets out the family home in
Australia and advises Centrelink that the family is leaving Australia
permanently and that Family Tax Benefit payments should cease.

Seth is a foreign resident because he abandoned his place of

residence in Australia and formed the intention to, and did, reside
outside Australia. His place of abode in Vila was intended to be and
was his home for the two years. Seth will cease being an Australian
resident on the day he leaves Australia. Source: Adapted from
Ruling IT 2650, para 33.
[4.125] The Full Federal Court, in Harding v FCT [2019] FCAFC 29, recently
considered what constituted a permanent place of abode outside Australia.

Case study 4.6: Permanent place of abode

In Harding v FCT [2019] FCAFC 29, the taxpayer had spent a
considerable amount of time in Saudi Arabia as an aircraft engineer.
In 2004, he acquired a house in Australia which he moved into in
2006. In 2009, he returned to Saudi Arabia to work, living in
Bahrain. His wife and children remained in Australia but the
taxpayer leased a two bedroom apartment in Bahrain for the family
to visit. In the year ended 30 June 2011, the taxpayer returned to
the house in Australia to visit his family for a total of 91 days. In
2011, the taxpayer’s marriage broke down and the following year
he moved into a serviced apartment. The question before the court
was whether the taxpayer was a resident of Australia for the 2011
income tax year.

The Full Federal Court held that the taxpayer was not a resident of
Australia as he had a permanent place of abode outside Australia.
In coming to this conclusion, the Court found that the word “place”
in the phrase “permanent place of abode” invited consideration of
the town or country in which the taxpayer is physically residing
“permanently”. Provided the taxpayer had permanently abandoned
their residence in Australia, they were not required to be
permanently located in a particular dwelling. As such, the
taxpayer’s permanent place of abode in 2011 was Bahrain as that
was the place where he was living.

183-day test [4.130]

The second statutory test of residence, the 183-day test, requires physical
presence in Australia for more than one-half of the year. Given the
requirement of physical presence, this is a test that generally applies to
incoming individuals.

Under the test, an individual will be considered a resident of Australia where

he or she is in Australia for more than 183 days, whether continuously or
intermittently, unless the Commissioner is satisfied that the person’s usual
place of abode is outside Australia and that he or she does not intend to take
up residence in Australia.

The first part of this test is purely mathematical, taking into account hours if
necessary.
The second part of the test provides an exception. There are two limbs to the
exception – the taxpayer has a usual place of abode outside Australia, and
he or she did not intend to take up residence in Australia. Both limbs must
be satisfied.
The wording of the first limb to the exception varies from that in the first
statutory test. The domicile test requires a “permanent” place of abode
outside Australia, while the exception to the 183-day test merely requires a
“usual” place of abode outside Australia. While usual place of abode will
again mean something less than everlasting, the requirement under this test
will be less stringent and therefore easier to satisfy than the requirement
under the domicile test.

The second limb to the exception requires the Commissioner to be satisfied

that the person does not intend to take up residence in Australia. This
requires a consideration of the factors listed in the common law test of
residence according to ordinary concepts.

There have been numerous cases that have considered the application of the
183-day test to individuals on working holiday visas; see, for example, the
AAT decision of Re Koustrup v FCT [2015] AATA 126. In that case, despite the
taxpayer being in Australia for more than 183 days, she was held to have a
usual place of abode outside Australia and was therefore not entitled to the
tax-free threshold under the residency tax rates. This is consistent with
subsequent decisions. However, we also have special rules that apply to
working holiday makers: see [4.155].

As Ruling TR 98/17 (at paras 37–38) explains, “in most cases, if individuals
are not residing in Australia under ordinary concepts, their usual place of
abode is outside Australia”. However, “there may be situations where an
individual does not reside in Australia during a particular year but is present
in Australia for more than one-half of the income year (perhaps
intermittently) and intends to take up residence in Australia”.

Superannuation test [4.140]

The superannuation test applies to Commonwealth superannuation fund
members and their families, that is, Commonwealth public servants. This
test applies to relevant individuals who generally reside in Australia but
leave temporarily and are not actually in Australia during the income year. In
Baker v FCT [2012] AATA 168, it was held that “member of a superannuation
scheme” includes an inactive member, where the taxpayer is on leave
without pay.

Period of residence [4.145]

The question may arise as to whether a person is a resident of Australia for
the whole year or part of the year. The Commissioner accepts that where a
person is a resident under the ordinary concepts test, the person is only
considered a resident from the date he or she first resides in Australia.
Where a person has a permanent place of abode outside Australia under the
domicile test, they are considered to be a foreign resident for the actual
period they are out of Australia and a resident while in Australia. Where a
person is a resident for part of the year only, the tax-free threshold will be
pro-rated. Where a person is a resident under the 183-day test, it has
previously been understood that they are resident for the whole of the
income year and therefore entitled to the full tax-free threshold.

Temporary residents – individuals [4.150]

The concept of “temporary resident”, contained in subdiv 768-R of the ITAA
1997, was introduced from 1 July 2006. The object of Div 768 is to provide
temporary residents with tax relief on most foreign sourced income and
capital gains. As such, where a taxpayer is an individual who is a resident of
Australia for tax purposes but qualifies as a temporary resident, he or she
generally will not pay tax on his or her foreign income. A temporary resident
will pay tax at the Australian resident income tax rates. However, from 8
May 2012, temporary residents are no longer entitled to the 50% CGT
discount. Further, for property held before 9 May 2017, foreign residents no
longer qualify for the main residence exemption if the property was disposed
of after 1 July 2020. If the property was acquired after 9 May 2017, the
exemption does not apply no matter when the property is disposed of.

Taxpayers are temporary residents if:

• they hold a temporary visa granted under the Migration Act 1958 (Cth);
• they are not Australian residents within the meaning of the Social Security
Act 1991 (Cth); and
• their spouse is not an Australian resident within the meaning of the Social
Security Act.

For the purposes of the Social Security Act, an Australian resident is

generally a person who resides in Australia and is either an Australian citizen
or holds a permanent resident visa.

Where a resident taxpayer meets the temporary resident requirements, most

foreign sourced income is not taxed in Australia. An exception to this is
where the income is earned from employment performed overseas for short
periods while the taxpayer is a temporary resident. Further, any capital gains
or losses made by a temporary resident on the disposal of assets that do not
have the necessary connection with Australia, or are not taxable Australian
property, are disregarded. (Note: There are special rules for capital gains on
shares and rights acquired under employee share schemes.)

An ancillary object of subdiv 768-R is to relieve the burdens associated with

certain record-keeping and interest withholding tax obligations. As such, any
interest paid by a temporary resident to a foreign resident is exempt from
withholding tax and the record-keeping obligations for controlled foreign
companies and foreign investment funds are partly removed.

Working holiday makers [4.155]

Income earned by a working holiday maker on or after 1 January 2017 is
subject to a special rate of income tax. This tax is colloquially known as the
“backpacker tax”. A taxpayer is defined as a working holiday maker, where
they are in Australia under a 417 (working holiday) visa or a 462 (work and
holiday) visa. Where this is the case, the first $37,000 is taxed at 15% with
the balance taxed at ordinary rates. There has been a series of cases
recently dealing with working holiday makers. See Chapter 22, para [22.45],
for a further discussion.

Foreign residents – individuals [4.160]

The term “foreign resident” was introduced in the ITAA 1997 and is defined
as a person who is not a resident for the purposes of the ITAA 1936. Several
sections in the ITAA 1936 still contain the term non-resident and, in
substance, the terms foreign resident and non-resident mean the same
thing. An individual foreign resident will be subject to income tax only on
income sourced in Australia. Tax is paid at foreign resident rates.

Current review of individual residence [4.165]

Difficulties with applying the tests of residency are evidenced by recent
Federal Court cases. The three cases, all decided by Logan J of the Federal
Court, were handed down within three months of each other. Stockton v FCT
[2019] FCA 1679, Addy v Commissioner of Taxation [2019] FCA 1768 and
Pike v Commissioner of Taxation [2019] FCA 2185 all considered the
application of the residency rules and showed that it is difficult to determine
a person’s residency status for tax purposes.

The Board of Taxation has suggested that the rules be reformed and
delivered to the treasurer in March 2019 a report entitled “Reforming
Individual Residency Rules – A Model for Modernisation”. The Board
presented what it described as “a model to replace the existing residency
rules with modern, simple and certain rules that are appropriately designed
and targeted to align with existing policy settings”. The government is yet to
act on the report.

Residence of Australia – companies [4.170]

The definition of “resident” in s 6(1) of the ITAA 1936 provides that a
company is a resident of Australia, where it is incorporated in Australia or,
not being incorporated in Australia, where it carries on business in Australia
and has either its central management and control in Australia or its voting
power controlled by shareholders who are residents of Australia. The three
tests are known as:
• the place of incorporation test: see [4.180];
• the place of central management and control test: see [4.190]; and
• the controlling shareholders test: see [4.210].

Place of incorporation test [4.180]

Under the first statutory test, a company incorporated in Australia is
automatically a resident of Australia regardless of any other factors. Whether
a company is incorporated in Australia is a question of fact determined by
reference to the Corporations Act 2001 (Cth).

Central management and control test [4.190]

Under the second statutory test, a company is a resident of Australia if it
carries on business in Australia and has its central management and control
in Australia. The High Court case of Bywater Investments Limited & Ors v
Commissioner of Taxation [2016] HCA 45 clarifies the Court’s position on this
test. In that case, the Court held that the central management and control of
a foreign company is a question of fact and degree. Further, there is no
general presumption that the central management and control of a company
is the location of the directors or where board meetings take place.

[4.200] TR 2018/5 Income Tax: Central Management and Control Test of

Residency sets out the Commissioner’s views on how to apply the central
management and control test of company residency following the High Court
decision in Bywater Investments Limited & Ors v Commissioner of Taxation
[2016] HCA 45.

The Ruling states that four matters are relevant in determining whether a
company meets the two criteria of carrying on business in Australia and
having its central management and control in Australia:
1. Does the company carry on business in Australia?
2. What does central management and control mean?
3. Who exercises central management and control?
4. Where is central management and control exercised? The ruling can be
summarised as follows:
• First, the Ruling states that if a company has its central management and
control in Australia, and it carries on business, it will carry on business in
Australia within the meaning of the central management and control test of
residency. Further, it is not necessary for any part of the actual trading or
investment operations from which its profits are made to take place in
Australia because the central management and control of a business is
factually part of carrying on that business.
• Second, central management and control is the control and direction of a
company’s operations, and the question to be asked is the location of the
making of high-level decisions that set the company’s general policies and
determine the direction of its operations and the type of transactions it will
enter. This is different from the day-to-day conduct and management of its
activities and operations.
• Third, identifying who exercises central management and control is a
question of fact and is not determined by identifying who has the legal
power or authority to control and direct a company. Rather, the crucial
question is who controls and directs a company’s operations in reality.
• Fourth, a company will be controlled and directed where those making its
decisions do so as a matter of fact and substance. It is not where decisions
are merely recorded and formalised, or where the company’s constitution,
by-laws or articles of association require it be controlled and directed, if in
reality it occurs elsewhere.

In the October 2020 Budget, the Federal Government announced revised

residency rules for companies. The revised rules will consider a company to
be a resident of Australia if it has a “significant economic connection” to
Australia. This is defined as where both “the company’s core commercial
activities are undertaken in Australia and its central management and
controls are in Australia”. These amendments, once passed, will reflect the
ATO application of residency prior to the decision in Bywater Investments v
FCT.

Controlling shareholders test [4.210]

The third statutory test provides that a company is a resident of Australia
where its voting power is controlled by Australian residents, and it carries on
business in Australia. As with the second statutory test, this test also
contains two limbs. First, it is necessary to demonstrate that the voting
power is controlled by Australian residents.

The control of voting power appears to refer to the control of a majority, that
is, more than 50% of the voting power at general meetings. A shareholder is
a person who is entered on the company’s register or is absolutely entitled
to be registered.

It does not look through to the ultimate beneficial owner of the shares:
Patcorp Investments Ltd v FCT (1976) 6 ATR 420. The residence of individual
shareholders is determined by reference to the tests of residency as
discussed at [4.50]. The second limb of this test, the company is carrying on
business in Australia, is the same as it is for the central management and
control test: see [4.190].

Dual residency and tie-breaker provisions [4.220]

Both an individual and a company may be a dual resident. Double tax
agreements (see Chapter 22) also contain definitions of “residency” for
individuals and companies, which generally provide a tie-breaker rule, where
the taxpayer is considered a resident of both jurisdictions. The most common
tie-breaker rule for individuals is the taxpayer’s permanent home or, if this
does not resolve the issue, the place where the taxpayer has the personal,
social and economic ties.

The most common tie-breaker rule for companies is the place of effective
management. Source [4.230] As discussed at [4.20], ss 6-5 and 6-10 of the
ITAA 1997 provide that a resident of Australia is taxed on ordinary and
statutory income from all sources, while a foreign resident is taxed only on
ordinary income and statutory income sourced in Australia or deemed to be
assessable income on some other basis. Source rules are based on a
combination of common law principles and statutory provisions.
Different source rules have been adopted for different classes of income.
Therefore, to determine the source of the income, it is necessary to classify
the income into its relevant class. It is often stated that the question of
source is not considered a legal concept. Rather, it has been described as
“something which a practical man would regard as a real source of income”
and a “practical, hard matter of fact”: Nathan v FCT (1918) 25 CLR 183 at
189–190. While this is usually suggested as the starting point for
ascertaining source, it does little in the way of providing guidance as to the
relevant facts to be considered.

Of more practical importance is the particular class of income to which an

amount will be categorised and an examination of the current source rules
that apply to that particular class.
Sale of goods – trading stock [4.240]
The source of income from the sale of goods is generally the place, where
the trading activities take place. Where the business of the taxpayer involves
a number of activities situated in different locations, the income will be
apportioned between the places where the activities are carried out.
To determine the source and apportionment of the income from trading
stock, the question that needs to be asked is whether any part of the profits
were earned or produced within the jurisdiction, that is, what income arises
or accrues to the taxpayer from the business operations carried on within
the jurisdiction.

This is a question of fact: Commissioners of Taxation v Kirk [1900] AC 588.

The income allocated to a jurisdiction based on source is generally that
added within the jurisdiction. Where no value is added by one jurisdiction,
there will be no income allocated to that jurisdiction for the purposes of
source: C of T (WA) v D & W Murray Ltd (1929) 42 CLR 332.
Sale of property other than trading stock [4.250]
The source of income derived from the sale of property will depend on the
property being sold. Where the transaction involves real property, that is,
land and all things attached to it, the source will be the location of the
property.
Case study 4.7: Source of income overseas
In Rhodesia Metal Ltd (Liquidator) v Taxes Commr [1940] 3 All ER
422, the taxpayer was a company incorporated in England with its
central management and control in England. The taxpayer was in
the business of purchasing and developing immovable property in
Rhodesia and the sale of that property. The taxpayer went into
voluntary liquidation and sold its undertaking to another company
which had also been incorporated in England. The Privy Council held
that the profits were derived from sources in Rhodesia.
Case study 4.8: Source of income in Australia
In Thorpe Nominees Pty Ltd v FCT (1988) 19 ATR 1834, the Full
Federal Court ignored an elaborate arrangement involving various
structures and contracts outside Australia to hold that the source of
profits related to the sale of land located in Australia and,
therefore, the profits were sourced in Australia.
Where the income is derived from the sale of tangible or intangible property,
the source will be determined by reference to a number of factors, for
example, the place of contract, place of negotiation and place of payment. In
essence, it is always a case of being a practical hard matter of fact, where
the courts generally look at the location of the economic activity giving rise
to the income: Cliffs International Inc v FCT (1985) 16 ATR 601.

The capital gains tax provisions also need to be considered, where there is a
foreign resident holding taxable Australian property: see [22.320]–[22.330].
Services [4.260]
Remuneration for the provision of services under an employment contract or
contract for services will be in the form of salary, wages or fees. The source
of that services income is generally taken to be the place of the performance
of the services. Several cases are cited as authority for this general principle.

Case study 4.9: Source of services income

In FCT v French (1957) 98 CLR 398, the taxpayer was an engineer
employed by an Australian company to carry out work in New
Zealand. The taxpayer claimed that he was exempt from Australian
income tax because the income was sourced in New Zealand. The
High Court concluded that the payment was for services performed
in New Zealand; as such, the source of the payment was New
Zealand.
Case study 4.10: Source of services income
A similar conclusion was reached by the Full Federal Court in FCT v
Efstathakis (1979) 9 ATR 867. The taxpayer, a Greek national,
moved to Australia to work as a Greek Government public employee
at the Press and Information Service office in Australia. The salary
paid to her by cheques drawn on a Greek bank was subject to
income tax in Greece. The taxpayer claimed that the salary was
exempt from Australian tax under former s 23(q) of the ITAA 1936
as foreign sourced income. Section 23(q) exempted residents from
tax on foreign sourced income that had already been subject to tax
in the source jurisdiction. The Court held that any factors
supporting a finding that the income was sourced outside Australia
were outweighed by the residence of the taxpayer, the performance
of the services in Australia and the receipt of payment in Australia.
The general principle that the source of services income is the place
of the performance of the services must be considered in the
context of the possibility of other factors being relevant. For
example, where services can be performed in any location, the
place of contract or place of payment may be relevant: FCT v
Mitchum (1965) 113 CLR 401.

Case study 4.11: Source of services income

In FCT v Mitchum (1965) 113 CLR 401, the taxpayer was a well-
known US actor who entered into a contract with a Swiss company
for the provision of services. The Swiss company in turn contracted
with a UK subsidiary of a US film studio for the taxpayer to provide
services for a movie filmed in Australia. The Commissioner assessed
the taxpayer on the basis that his salary was sourced in Australia
because it was paid for acting in a movie that was filmed in
Australia. Although not actually reaching a decision on the source of
the income, the High Court held that FCT v French did not result in
the conclusion that the source of services income is always the
place of performance.
Interest [4.270]
The source of interest income involves a consideration of a number of
factors, including the place of contracting and the place where the funds are
advanced: Commissioner of IR v Philips Gleilampenfabrieken [1955] NZLR
868. In the more recent case of Spotless Services v FCT (1993) 25 ATR 344,
the Full Federal Court placed emphasis on the place where the contract for
the loan was made and the place where the money was advanced.
Dividends [4.280]
In the case of dividends, it is s 44(1) of the ITAA 1936 which provides that
dividends are assessable income. It further provides the source rule for
dividends as it states that the assessable income of a shareholder in a
company includes:
• if the shareholder is a resident, dividends that are paid to the shareholder
by the company out of profits derived by it from any source; and
• if the shareholder is a non-resident, dividends paid to the shareholder by
the company to the extent to which they are paid out of profits derived from
sources in Australia.
Case study 4.12: Dividends
The phrase “to the extent to which they are paid out of profits
derived from sources in Australia” was considered in Esquire
Nominees Ltd v FCT (1973) 129 CLR 177. The taxpayer was a
company incorporated in Norfolk Island and had its registered office
and its central management and control located there. In the
income year in question, the taxpayer, as trustee of a discretionary
trust, received dividends paid on shares held in another Norfolk
Island company. The dividends paid to the taxpayer were ultimately
distributed after a flow of dividends through two other companies
and which originated from the activities of a company resident in
Australia.
The Commissioner assessed the taxpayer as a non-resident trustee
deriving Australian sourced income that had not been distributed to
any beneficiaries. The High Court, in drawing a distinction between
the source of the dividend and the source of the money which
enables the dividend to be paid, held that the source of the
dividends was the holding of the shares in the Norfolk Island
company. Consequently, the non-resident trustee was not liable to
Australian tax on the dividends paid.
Royalties [4.290]
The common law principle in relation to royalties is that the source of the
royalty is the location of the industrial or intellectual property from which the
royalty flows. However, where a royalty is outgoing (i.e., paid by an
Australian business to a foreign entity), s 6C of the ITAA 1936 deems the
royalty to have an Australian source. It is also necessary to consider the
interaction of double tax agreements (see Chapter 22). In Satyam Computer
Services Ltd v FCT [2018] FCAFC 172, the Full Federal Court held that royalty
payments made to an Indian company from Australian clients was sourced in
Australia under the Australia–India double tax agreement.
Questions [4.300]
4.1 What is the income tax payable for an Australian resident
individual with taxable income for the 2019–2020 income tax year of
$120,000?
4.2 What difference does it make to Question 4.1 if the taxpayer is a
foreign resident?
4.3 Fred, an executive of a British corporation specialising in
management consultancy, comes to Australia to set up a branch of
his company. Although the length of his stay is not certain, he
leases a residence in Melbourne for 12 months. His wife
accompanies him on the trip but his teenage sons, having just
commenced college, stay in London. Fred rents out the family home.
Apart from the absence of his children, Fred’s daily behaviour is
relatively similar to his behaviour before entering Australia. As well
as the rent on the UK property, Fred earns interest from
investments he has in France. Because of ill health, Fred returns to
the UK 11 months after arriving in Australia. Discuss residency and
source issues.
4.4 Jenny is an accountant who works in Hong Kong. She is single
and lives in Hong Kong with her parents. Until April 2019, her work
does not involve travel. At that time she accepts an offer from her
employer to travel temporarily to Australia to provide business
advice to large numbers of former Hong Kong residents setting up
businesses in Melbourne, Sydney and Brisbane. Jenny enters
Australia on 25 April 2019. She intends to spend three months
travelling between the three cities, staying in various motels. Her
employer asks her towards the end of her three months to take up a
position in Sydney for a further nine months. In early July, she
leases a serviced executive apartment for nine months near her
workplace in Sydney. The apartment is her home base during her
stay here. She freights more clothing and some personal effects to
Australia. Her parents visit her on two occasions. Although based in
Sydney, her commitments require some limited travel. On average,
Jenny travels at least once a week to meet clients outside Sydney. Is
Jenny a resident of Australia for tax purposes?
4.5 Ajay is a student from India who comes to Australia to study for
a four-year bachelor degree in business. Ajay lives in rental
accommodation near the university with fellow students and works
part-time at the university social club as a barman. After six
months, he has to withdraw from his studies and return to India
because his father is ill. Is Ajay considered a resident of Australia?
4.6 After Misha finishes her Bachelor of Commerce degree, she
travels to the UK to work as an accountant for three years. During
that time she rents a flat and makes many friends. Her UK salary is
paid into a UK bank account. At the end of the three-year period,
she has saved enough money to travel. Misha then spends a year
travelling around Europe and a year travelling around North
America. At the end of the five years, she returns to Australia.
Discuss the residency of Misha.
4.7 The Big Bang Company was set up by Ed, an Australian resident.
It is incorporated in Singapore and has two directors who are
resident in Singapore and who hold board meetings in Singapore.
Each director has two shares in the Big Bang Company, which they
hold on trust for Ed. The Big Bang Company owns real property, all
of which is outside Australia, and makes its profits from commercial
property leases on a large scale. Ed does not attend the board
meetings in Singapore; however, the constitution of the Big Bang
Company provides that the decisions of the directors are only
effective if Ed concurs with them. The directors carry on all
operational activities, such as collecting rent, paying commission,
finding tenants, making minor repairs and maintaining the
buildings. Is there any possible scenario in which the Big Bang
Company could be considered a resident of Australia for tax
purposes?
4.8 Peter is an accountant for an international accountancy firm
based in Vanuatu. He has investments in Vanuatu comprising his
own home, a rental property, shares in local companies and cash
deposits in high interest bearing bank accounts. On 1 February
2020, Peter was transferred to the firm’s Brisbane office on a
temporary three-month secondment. The purpose of the
secondment was to establish networks with existing Australian
clients that have indicated the possibility of investing in Vanuatu.
During the secondment period, Peter remained an employee of the
Vanuatu office and his salary was paid into his Vanuatu bank
account. While Peter’s intention was to return to Vanuatu at the
conclusion of his secondment, he sought and was successfully
offered a permanent position in Brisbane. In early June 2020, he
became an employee of the Brisbane office. His relocation involved
purchasing an apartment in the Brisbane suburb of Ascot, renting
out his own home in Vanuatu and transferring a sum of cash to a
high interest bearing bank account in an Australian bank. Discuss
residency and source issues.

4.9 Your client was born in Sydney and lived in Australia until 1 July
of the current tax year. At that stage, he accepted a voluntary
redundancy with Qantas. A year earlier he had separated from his
wife of 20 years. A few months later he started a relationship with a
resident of Singapore. Upon accepting the redundancy, he began
travelling overseas to perform aircraft mechanic services at various
locations within Asia. Under his contract of employment with
Boeing, the taxpayer was provided with either hotel or short-term
apartment accommodation at each location he attended for work
purposes.
During the current income year, the taxpayer provided services in
Hong Kong, Spain, Greece, Thailand and Indonesia. The longest time
he stayed at any one place was 45 days in a serviced apartment in
Indonesia. The taxpayer visited his two teenage children and his
parents in Australia on two occasions for a total of 30 days and
visited his new partner in Singapore on four occasions for a total of
50 days. During the tax year what had been the family home in
Sydney was sold to complete a divorce settlement. While he no
longer had any place in Australia in respect of which he could call
his own, he also did not have ownership or leasehold in any
dwelling outside Australia. Nor did he apply for a long-term visa or
residency status anywhere outside Australia. Advise your client
whether he is a resident of Australia in the current tax year for
income tax purposes. (Your answer should assume the taxpayer was
able to travel normally and without COVID-19 restrictions during
this time.)
4.10 Bridget and her husband are moving from London to Australia
permanently under an employer-sponsored arrangement. Bridget
and her husband have a joint bank account in London which they
leave open for the purposes of the rent coming from their home
which they hold onto. They rent out what was the family home and
the money is deposited into the London bank account. The London
bank account also earns interest.
Bridget and her husband pay tax in the UK on both the rental
property income and interest income. Their UK accountant has
advised them that they will not have to pay tax on the income in
Australia because it is sourced in the UK.
Bridget and her husband come to you to confirm whether this
advice is correct. Advise your clients.
4.11 Mary is a citizen of the United States. Avoiding COVID-19
restrictions, she came to Australia in 2020 on a working holiday and
stayed for 10 months. Mary had grown up in the family home in the
United States and still had a room to return to. She had no prior
association with Australia until she arrived in September 2020. At
that stage, she spent nearly four months in Brisbane moving
between six different houses. She then spent a month travelling
from Brisbane to Canberra via six different locations. From late
January 2021 to late May 2021, Mary then lived in Melbourne
staying at six different houses. After returning to Brisbane for a
short period of time, she travelled to Sydney and then departed
Australia on 23 June 2021. During her time in Australia, she had two
different periods of employment, one in Brisbane for three months
and another in Melbourne for a period of three months. Mary claims
she is a resident of Australia for her time here, so she should pay
tax at the residency rate. Advise Mary. What difference would it
make if she was not on a working holiday visa? (Hint: see Stockton v
FCT [2019] FCA 1679.)

4.12 Matthew is a university lecturer at the University of Oxford in

the UK. He came to Australia for a holiday on 20 December 2019,
intending to go home at the end of January 2020. He decided not to
leave because of COVID-19 but intended to return home as soon as
it was safe. He started working remotely in Australia on 1 February,
teaching classes via Zoom for the University of Oxford. It is now
December 2020 and Matthew is still in Australia.
Discuss any residency and source issues for Australian tax
purposes. (Note: this question applies to the 2019–2020 income tax
year.)
Part 2 – Income
The first step in the taxation process is to determine assessable income.
“Income” is a complex and difficult concept to understand. From an income
tax perspective, assessable income is divided into income according to
ordinary concepts and statutory income. Income according to ordinary
concepts has been developed by the courts. A receipt is likely to be
considered income when it is a product of, yet severable from, a source such
as labour (or services), business or property. In addition to this basic
principle, a receipt which has income characteristics, such as being periodic,
expected and used for ordinary living expenses, can in some instances be
considered to be ordinary income even when it is not a product of labour,
business or property. Further, the courts have always held that a receipt
must be a genuine gain and be money or convertible to money to be
ordinary income.
Many receipts will be ordinary income which is assessable income under Div
6 of the Income Tax Assessment Act 1997 (Cth) (ITAA 1997). However, over
the years, it became apparent that not all receipts which should be taxable
were included as ordinary income. The judicial concept of income, first
adopted in Australia when federal income tax was introduced in 1915,
provided a narrow tax base with opportunities to shift receipts outside this
judicial concept of ordinary income. Accordingly, a second category of
income developed, statutory income, which shifts many types of gains and
receipts into the income tax base.
Assessable income (s 6-1) = Ordinary income (s 6-5) + Statutory income (s
6-10) − Exempt income (s 6-10)

Traditionally, income has been categorised according to the source to which

it attaches, that is, the receipt is a product of labour, business or property.
Because this has been the traditional approach to looking at receipts, the
common law has developed along these lines with the statutory regime, then
broadening the tax base of each category. However, propositions which have
developed to determine whether an amount is ordinary income are not
unique to income from any particular category. As such, the first chapter in
Part 2, Chapter 5, is an introduction to ordinary income. It outlines the
principles which apply to determine the types of gains that courts of law
consider to be of an income character and, in doing so, considers the general
propositions for ordinary income.
Chapter 6 specifically covers income from personal services and
employment. An examination of the general propositions developed by the
courts, discussed in Chapter 6, demonstrates that it is easy to manipulate
the ordinary income category by receiving benefits rather than salary or
wages. To counter this behaviour, certain types of statutory income
categories were introduced. The most significant category in relation to
labour is allowances in respect of employment or services in s 15-2 of the
ITAA 1997. Unfortunately, the statutory provisions have had limited success
in taxing benefits received as a result of labour. Consequently, fringe
benefits tax was introduced in 1986.
Chapter 7 follows on from the discussion on income from personal services
and employment to consider the fringe benefits tax regime. The key
difference and unique feature of this regime, which is separate to the income
tax regime, is that while the employee receives the benefit, it is the
employer who pays the tax. Chapter 7 explains the operation of this regime,
including a discussion of the various categories of benefits and the
concessions or exemptions available for certain benefits.
While the ordinary income concepts are generally no different, the source of
the receipt introduces unique issues. In relation to income from business, the
question that needs to be asked is: “What is a business for taxation
purposes?” Chapter 8 details the indicia of a business established by the
courts. A finding of the existence of a business is not sufficient to conclude
that all receipts are assessable income. It is also necessary to consider
whether the receipts arise as a result of activities within the scope of the
business and to what extent isolated and extraordinary transactions are
assessable. A third category of income, known as income from property, or
passive income, also introduces unique issues. Chapter 9 details income
from property, explaining the principles that apply to income from interest,
dividends, leases, royalties and annuities.
Taxpayers may receive various types of compensation payments. If the
compensation is for loss of income, then generally the compensation
payments themselves will be of an income character. Chapter 10 considers
the different categories of compensation which may substitute for loss of
income from labour, loss of income from business and loss of income from
property.
Although both statutory income and ordinary income are included in
assessable income, the rules for some types of statutory income are
concessional relative to those applying to ordinary income and it thus
remains very important to determine whether a receipt is assessable as
ordinary income or statutory income and, if the latter, which provision brings
the receipt into assessable income. The most important statutory income
measures are the “capital gains tax” rules which were adopted in 1985 to
sweep up a wide range of receipts that had not been captured by the
ordinary income concept or previously adopted statutory rules. Because of
the broad coverage of the capital gains rules and their operation as a code
within the broader income tax Act, these rules are often studied
independently from other types of income which fall on either side of the
ordinary income/capital gains borderline and, accordingly, Chapter 11 looks
at these rules separately.
Amounts that do not fall within the ordinary income or statutory income
provisions are either exempt income or non-assessable non-exempt income.
These amounts do not form part of the taxpayer’s assessable income and
are therefore not subject to tax. It is, however, necessary to distinguish
between the two due to other tax consequences.

Chapter 5 - Assessable income

Key
points ............................................................................................
.............. [5.00]
Introduction...................................................................................
.................... [5.10]
Ordinary income –
general ............................................................................... [5.20]
“In accordance with ordinary concepts and usages of
mankind” ................... [5.20]
Three categories of
income .............................................................................. [5.30]
Capital gains are not ordinary
income .............................................................. [5.40]
Prerequisites and characteristics of ordinary
income ...................................... [5.50]
Prerequisites .................................................................................
..................... [5.50]
Cash or cash
convertible ...................................................................................
[5.60]
Real
gain ...............................................................................................
............. [5.70]
Characteristics ...............................................................................
.................... [5.80]
Regular/periodic ............................................................................
.................... [5.90]
Flow ..............................................................................................
.................... [5.100]
Examples .......................................................................................
................... [5.120]
Some gains are ordinary income despite having no earnings
source............. [5.130]
Other general
principles ..................................................................................
[5.140]
Compensation takes on the character of the loss being
compensated......... [5.140]
Unrealised gains are not ordinary
income ..................................................... [5.145]
Legality of receipts does not affect their
assessability ................................... [5.150]
Whether a receipt is ordinary income is to be characterised in the
taxpayer’s hands ... [5.155]
Constructive
receipt ..........................................................................................
................ [5.160]
Benefit that saves taxpayer from incurring expenditure is not
ordinary income............. [5.165]
Principle of
“mutuality” ...................................................................................
.................. [5.170]
Questions ......................................................................................
..................................... [5.180]
Key points [5.00]
• Gains that are ordinary income will be assessable income under s 6-5 of
the Income Tax Assessment Act 1997 (Cth) (ITAA 1997).
• Gains will be ordinary income if they are the type of gains that courts of
law consider to be of an income character.
• For a gain to be ordinary income, it must be cash or cash convertible, as
well as a genuine gain.
• A gain that comes in regularly/periodically is more likely to be ordinary
income than a lump-sum gain.
• A gain that flows from an earnings source is likely to be ordinary income.
• Compensation takes the form of the loss being compensated.
• Whether or not a gain arises from an illegal activity does not affect
whether it is ordinary income.
Introduction [5.10]
As discussed in Chapter 1, assessable income includes gains that are
ordinary income and/or statutory income. This means that if a gain is
ordinary income it will be assessable income except if the legislation
explicitly states that it is not assessable.
What if a gain is not ordinary income: will it be assessable? If a gain is not
ordinary income, then it will only be assessable if it is statutory income, that
is only if it comes under one or more specific statutory provisions of the
Income Tax Assessment Act 1997 (Cth) (ITAA 1997) or the Income Tax
Assessment Act 1936 (Cth) (ITAA 1936) and provided the legislation does not
specifically state that it is not assessable.
So what is ordinary income? According to s 6-5(1) of the ITAA 1997, ordinary
income is “income according to ordinary concepts”. This means that a gain
that is regarded by courts as being of an income character will be “ordinary
income” and, as such, assessable under s 6-5.
This raises the question as to when courts will regard gains as being of an
income character. To determine which gains have an income character,
courts have developed a range of rules and guidelines, some of which are
vague and not always consistently applied. Some gains are clearly of an
income character and so will constitute ordinary income (such as a salary
received by an employee). Some gains are clearly not of an income
character and so will not be ordinary income (such as the capital proceeds
from the sale of a milk bar that you ran for the last three years). However,
given the uncertainty of the law, with some gains it is not possible to arrive
at a definitive answer as to whether they are ordinary income – in those
cases the best we can do is make an educated guess.
In this chapter, we discuss the prerequisites and characteristics of ordinary
income. Chapters 6, 8 and 9 look at specific types of gains (e.g., salaries,
normal business profits and rents) and discuss which of those gains are or
are not ordinary income.
Before the ITAA 1997 was in force, the provision that was roughly equivalent
to the current s 6-5 was s 25(1) of the ITAA 1936. This means that older case
law that discusses the law that applied before the ITAA 1997 came into force
will refer to s 25(1) of the ITAA 1936 when there is an issue of whether a gain
is of an income character.

Ordinary income – general

“In accordance with ordinary concepts and usages of mankind”
[5.20]
In discussing what gains are of an income character (and, as a consequence,
are ordinary income) in Scott v Commissioner of Taxation (1935) 35 SR
(NSW) 215 at 219; 52 WN (NSW) 44; 3 ATD 142, Jordan CJ said: 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 in
accordance with the ordinary concepts and usages of mankind ...
What his Honour appears to be saying is that the Court’s definition of income
resembles what most ordinary people would regard as income. While this
concept may have derived originally from trust law (see [1.160]), it
nevertheless approximately aligns with the contemporary tax law meaning
of income. For instance, most people would regard salaries and rent as
income, and these gains are also recognised by courts as being of an income
character. On the other hand, most people would intuitively regard a
personal gift or a lottery winning as not constituting income. This conclusion
is also consistent with the fact that courts do not consider such gains as
being of an income character. Because the ordinary meaning of income to
the layperson may change over time, the scope of ordinary income for tax
purposes will also evolve, as is discussed at [5.80].
While it is useful to keep in mind that the courts’ idea of income resembles
what many people intuitively regard as income, ultimately the law as to what
is ordinary income is determined by case law.
As seen from Figure 5.1, income is shown to have two essential prerequisites
and two characteristics (discussed later in this chapter). These four elements
are key to determining whether a receipt is income or not. It is also helpful to
categorise income into three broad areas as shown in Figure 5.1.
Three categories of income [5.30]
Income is commonly categorised into three broad areas:
• income from personal services and employment (e.g., salary): see Chapter
6;
• income from business (e.g., accounting firms selling accounting services):
see Chapter 8; or
• income from property (e.g., rent and dividends): see Chapter 9. However,
as discussed at [5.130], there are some relatively rare instances, where
receipts will be ordinary income despite not belonging in any of these three
categories.

Capital gains are not ordinary income [5.40]

Courts have made a distinction between gains that are capital and income
(see [1.160]–[1.170]). This means that gains that are capital will not be
ordinary income and gains that are ordinary income cannot be capital. It is
possible in some limited circumstances for a gain that is not capital to also
not be ordinary income either. So, in this context, gains can be thought of as
falling into one of three categories:
• ordinary income;
• capital; or
• not capital and not ordinary income.
The distinction between capital and income is a central issue in the
application of the Australian income tax legislation as it is relevant to both
the question of the assessability of receipts and the deduction of expenses
(see [12.160]–[12.210]). In relation to assessable income, the distinction
between capital and income is often considered through the application of
the “flow concept”: see [5.100].
Prerequisites and characteristics of ordinary income Prerequisites
[5.50]
For a gain to be ordinary income, it must fulfil two prerequisites (Figure 5.1).
These prerequisites are necessary but not sufficient for a gain to be ordinary
income. In other words, if a gain fulfils both prerequisites, then that gain
might or might not be ordinary income. But if a gain does not fulfil both
prerequisites, then it cannot be ordinary income. The two essential
prerequisites of a receipt being ordinary income are that it is:
• cash or convertible to cash; and
• a real gain to the taxpayer.
Cash or cash convertible [5.60]
If a gain is cash or cash convertible, it might be ordinary income. On the
other hand, if it is not cash or cash convertible, then it definitely will not be
ordinary income: FCT v Cooke and Sherden (1980) 10 ATR 696.
For an item to be cash convertible, it needs to be readily convertible to cash.
So a new or used car, real estate or even a transferrable holiday ticket would
all be regarded as cash convertible. However, the courts have indicated that
if it is illegal to sell a good, then receipt of that good cannot be regarded as
cash convertible: Payne v FCT (1996) 32 ATR 516. In practical terms, this
means that for most taxpayers, a receipt of cigarettes would not be regarded
as cash convertible because it is illegal to sell cigarettes without a licence.
Case study 5.1: Receipt of free accommodation was not income
In the UK case of Tennant v Smith [1892] AC 150, the taxpayer was
an agent for a bank and lived in free accommodation supplied by
the bank. The taxpayer was not allowed to sublet the
accommodation. The House of Lords held that the accommodation
was not regarded as income as it was neither cash nor cash-
convertible.
Case study 5.2: Receipt of non-cash-convertible holiday was not
ordinary income
In the Australian case of FCT v Cooke and Sherden (1980) 10 ATR
696, a few taxpayers sold drinks “door to door”. These taxpayers
received a free holiday from the soft drink manufacturer due to
them selling a certain number of soft drinks. The holidays were non-
transferrable and therefore could not be sold.
The Full Federal Court followed the principle in the case of Tennant
v Smith [1892] AC 150 and held that because the holidays were not
cash convertible, they were not ordinary income.
As discussed at [8.160], s 21A of the ITAA 1936 deems non-cash business
benefits as being cash-convertible. This means that for a business taxpayer
benefits can be assessable income despite not being cash or cash-
convertible. Had the case of FCT v Cooke and Sherden been decided after s
21A of the ITAA 1936 was introduced into the legislation, then it is very likely
that the Court would have decided that the free holiday was assessable as
this section would deem it to be convertible to cash.
It is important to note that s 21A does not deem the non-cash receipt to be
income, but rather it deems the benefit to have a cash value so that it
satisfies the prerequisite that ordinary income must be cash or convertible to
cash. This is in contrast to statutory income which specifically makes certain
receipts assessable income through a provision of the Act (see [5.10]).
Real gain [5.70]
If a receipt is a genuine gain (i.e., the taxpayer is better off financially), then
it could be ordinary income. But if it is not a real gain, it will not be ordinary
income: Hochstrasser v Mayes [1960] AC 376 (see Case Study [5.3]).

The principle that a receipt that is not a real gain will not be ordinary income
is more likely to apply in employment situations and clubs (see [5.170]) than
in other situations.
In an employment situation, the courts will usually only label a receipt as not
being a real gain when the receipt is related to an employment-related
expense. For instance, if an employee incurred work-related public transport
expenses and that expense is then reimbursed, this would not be regarded
as a real gain because the employee has only been compensated for a work-
related expense. The employee has effectively only been reimbursed for an
expense they incurred on behalf of the employer. In contrast, an employee
who is reimbursed for his or her private holiday would be regarded as
receiving a real gain as he or she has effectively been provided a benefit
over and above their wage.
It is also important to note that an employee that has been given a
predetermined amount for a specific work-related purpose and does not
have to return the unspent amount will be regarded as having received an
“allowance” rather than a “reimbursement”. Unlike work-related
reimbursements, allowances will generally constitute ordinary income,
though an offsetting deduction will be allowed to the extent that money has
been spent for allowable income-producing purposes. For example, a
taxpayer who receives $150 from his employer for travel purposes but ends
up only spending $60 of it and is allowed to keep the rest will be assessable
on the $150 allowance and will be able to deduct the $60 expenses (see
Chapter 12).
Case study 5.3: Reimbursement for work-related loss upon moving
premises was not assessable
In Hochstrasser v Mayes [1960] AC 376, the taxpayer’s employer
required him to move cities. The taxpayer sold his house in the city
he was relocating from. The house was sold by the taxpayer for less
than the price for which he had purchased it. The taxpayer’s
employer reimbursed him for the loss from selling his house. The
House of Lords held that this payment was not assessable. One of
the judges, Lord Denning, said that the payment was not assessable
because it was not a real gain because the taxpayer had been
compensated for a work-related expense. Lord Denning also
mentioned that had the taxpayer been compensated for a non-work-
related loss, the receipt would have been a real gain. He gave an
example that if a taxpayer’s employer compensated him for share
market-related losses, then this receipt would be a real gain
because in this example the taxpayer would have been
compensated for a non-work-related loss.

Characteristics [5.80]
Provided both of the prerequisites of income are satisfied, a receipt or
benefit will be ordinary income if it also shows sufficient of the
characteristics of income (Figure 5.1). However, these characteristics are not
black or white rules; they are only indicators or pointers to what constitutes
ordinary income. This has increasingly been the case in recent decades as
courts take a wider view of what gains are regarded as ordinary income.

The widening of courts’ views has been influenced by the fact that society
now regards certain gains as normal due to the fact that individuals and
businesses operate differently to how they did several decades ago. For
example, under the first strand in FCT v Myer Emporium Ltd (1987) 163 CLR
199 (see [8.210]–[8.250]), a gain can be ordinary income even when it does
not fulfil the characteristics described at [5.90]–[5.110].

The characteristics of income can be grouped into two broad areas:

• regular/periodical receipts; or
• the flow concept.
Regular/periodic [5.90]
All other things being constant, a gain that is regular or periodic is more
likely to be ordinary income than a gain that is received as a once-off lump
sum amount. For instance, the cases of FCT v Blake (1984) 15 ATR 1006 and
FCT v Harris (1980) 10 ATR 869 (see [6.50]) involved near identical facts –
except that in FCT v Blake the receipt was regular while in FCT v Harris it was
regarded as a one-off receipt. Consequently, in FCT v Blake, the Court held
that the receipt was of an income nature, whereas in FCT v Harris, the Court
held that the one-off receipt was not ordinary income but capital.
However, the regularity of a receipt is not a determinative factor in deciding
if a gain is ordinary income. For example, in Premier Automatic Ticket Issuers
v FCT (1933) 50 CLR 268, a lump sum was held to be ordinary income. It is
easy to think of many everyday instances of lump-sum gains being ordinary
income. For instance, a one-off receipt of interest under a loan agreement
which provides for one interest payment at the end of the loan term would
be ordinary income. Another example is someone who receives one single
payment under a contract to do a one-off job.
Less common but still possible is for a gain to be regular but not ordinary
income, such as where a taxpayer receives instalments for the sale of a
capital asset: Foley v Fletcher [1843–1860] All ER Rep 953. For example, if
the taxpayer (not a property developer) sells a block of land for $200,000
(capital sale) for 10 equal payments of $20,000, paid over the next 10 years,
then these receipts will remain capital and not be ordinary income even
though the receipts are regular. This is because each $20,000 receipt is a
part payment for the sale of the capital asset.
Flow [5.100]
When courts developed the judicial concept of what is and what is not of an
income character, they borrowed concepts from trust law: see [1.160]. Under
trust law, trust property may have income gains or capital gains. The two
were mutually exclusive; a gain could not be both an income gain and a
capital gain. To decide which trust gains were income and which were
capital, the courts used a “flow” concept. The courts stated that income
“flowed” from the capital. For example, if the trust property was a house, the
rent “flowed” from the house. This meant that for trust purposes, the rent
from an investment property was considered income, and appreciation of the
value of the house was regarded as capital. To use another example, if the
trust property was shares, then dividends flowing from the shares were
income, but profit from selling the shares was usually capital.
Tax law has used the same “flow” principle as trust law. Consequently, under
tax law, rent from an investment property is income, but profit from the
property’s increase in value is usually capital and not ordinary income.
This concept of “flow” is articulated in a paragraph from the US judgment
Eisner v Macomber 252 US 189 (1920) by Pitney J (at 206), where the
concept of flows was expressed in terms of fruit and trees. Under this
analogy, the fruit was income and the tree capital:
The fundamental relation of “capital” to “income” has been much discussed
by economists, the former being likened to the tree or the land, the latter to
the fruit or the crop; the former depicted as a reservoir supplied from
springs, the latter as the outlet stream, to be measured by its flow during a
period of time.
For an investment property, the rent is likened to the fruit and therefore
considered to be ordinary income, but the sale of the property itself is
likened to the sale of the tree and is capital. In an employment context, the
taxpayer’s ability to work and/or the employment contract would be
regarded as the tree, which means that payment for services is akin to the
fruit and is ordinary income.

[5.110] What exactly is meant by the concept that if a gain is likened to the
fruit from the tree, it is likely to be considered to be ordinary income? There
are a number of ways this concept can be viewed, but importantly the gain
(i.e., likened to the fruit) will have both of the following two related traits:

1. Having a nexus (a connection) with an earning source. Specifically, having

a nexus with one of the following three:
(a) property (e.g., rent has a nexus with property);
(b) business (e.g., an accounting firm’s profit has a clear nexus with the
accounting business); or
(c) personal services (e.g., a salary has a clear nexus with an employee
providing services).
2. Being severable from its earning source. Being severable means that the
gain can be extracted without affecting the underlying earnings source
(capital). For example, rent is clearly severable from underlying property in
that rent can be obtained from a rental property without affecting the
underlying property. An accounting firm’s profit can be obtained from an
accounting business without damaging the underlying accounting business.
Salary can be obtained without damaging the underlying work contract or
the employee’s ability to work. Although the “fruit and tree” analysis
distinguishes between income and capital gains, there are some receipts
that are neither income nor capital gains. Personal gifts or inheritances are
examples of this. Items that are neither ordinary income nor capital
generally do not fit into the “fruit” or “tree” concept.
Examples [5.120]
Examples 5.1 and 5.2 apply the introductory principles of the prerequisites
and characteristics of income.
Example 5.1: Receipt of rent and proceeds of property sale A
landlord owns an investment property. The rent collected from it is
ordinary income as it fulfils the prerequisites of ordinary income in
that it is:
• cash; and
• a genuine gain.
Furthermore, it has the characteristics of ordinary income in that it
is:
• regular (i.e., rent is usually received every month);
• an amount which “flows” from the underlying property as the
rent: – has a nexus with the house; and – is severable from the
house – in that it can be extracted without effecting the value of the
house.
On the other hand, profit from the sale of the house, although
fulfilling the prerequisites, in that it is:
• cash; and
• a genuine gain;

does not have the characteristics of ordinary income as it:

• is not a regular receipt; and
• does not “flow” from any underlying source.
This is the sale of the underlying tree and so would be regarded as
capital. Example 5.2: Business that regularly buys and sells houses.
Following on from Example 5.1, the profits from selling the house
would be regarded as capital, but what about a business that
regularly buys and sells houses? Putting aside the trading stock
implications (see Chapter 17), the sale of the houses would
generate ordinary income. First, the proceeds of sale would fulfil
the prerequisites of ordinary income, as they are:
• cash;
• a genuine gain.
Furthermore, they have the characteristics of ordinary income as
they:
• would have some regularity since this business regularly sells
such houses; and
• can be said to be the fruit of the underlying business. The
proceeds flow from the underlying business because they:
– have a nexus with the underlying business that buys and sells
properties; and
– are severable from the underlying business, in that selling a
property does not damage the underlying business.
Some gains are ordinary income despite having no earnings source
[5.130]
As discussed at [5.100], one of the major characteristics of ordinary income
is that it flows from an earnings source. In other words, most gains that are
ordinary income will have a nexus to and be severable from an earnings
source. However, this will not always be the case. For example, if receipts
are regular, expected and the taxpayer is able to depend upon them for
support, this will be enough to make them ordinary income even if they do
not flow from an earnings source.

Case study 5.4: Government age pension constitutes ordinary

income
In Keily v FCT (1983) 83 SASR 494, a single judge of the Federal
Court held that a government aged pension was ordinary income.
This was because of the traits it had: it was regular, expected and
depended upon by the taxpayer for support.
This same logic would apply to many other regular government
payments, such as unemployment benefits (e.g., Newstart
Allowance). Specifically, in Anstis v FCT (2010) 76 ATR 735, the High
Court held that Youth Allowance payments constituted ordinary
income. However, this principle is not restricted to government
benefits and could apply to other regular payments.
Case study 5.5: Top-up payments if employee joined the armed
forces during World War II
In FCT v Dixon (1952) 86 CLR 540, an employer offered his
employees “top-up” payments if they enlisted in the armed forces
during World War II. He said to them that if they ceased working for
him and signed up to be soldiers for World War II, he would pay
them the difference between their former salary and their military
salary. The High Court held that this “top-up” payment was ordinary
income. Two of the judges (Dixon CJ and Williams J) held that this
was because of the traits that the payments had: they were regular,
expected and depended upon by the taxpayer for personal living
expenses. A third judge (Fullagar J) held that the payments were
ordinary income due to the compensation principle discussed at
[5.140]: since the payments were a compensation for lost salary,
and the salary would have been ordinary income, the payments
themselves were ordinary income.

Other general principles

Compensation takes on the character of the loss being compensated
[5.140]
In general, compensation receipts take on the character of what they are
compensating. This specifically means that compensation for loss of ordinary
income is ordinary income, and compensation for loss of capital is capital.
For example, salary is ordinary income, so compensation for loss of salary is
also ordinary income. For a manufacturing business, its factories are capital,
so compensation for loss of one of its factories would be capital.

Compensation receipts are discussed in more detail in Chapter 10.

Unrealised gains are not ordinary income [5.145]
An unrealised gain will not be ordinary income: Eisner v Macomber 252 US
189 (1920). This is related to the flow principle (see [5.100]) as unrealised
gains are not yet regarded as a fruit flowing from a tree. For instance, if a
taxpayer in the business of share trading owns shares that have appreciated
in value but have yet to be sold, no ordinary income will have been
generated until such time that the gain has been realised through the sale of
the shares.
Legality of receipts does not affect their assessability [5.150]
The fact that a receipt is from an illegal activity does not prevent it being
assessable provided it would have been assessable had the activity been
legal: Minister of Finance (Canada) v Smith [1927] AC 193; Lindsay v IR
Commrs (1932) 18 TC 43; Taxation Ruling TR 93/25. This finding is
reasonable as it would be rewarding illegal activities if these proceeds were
not subject to tax. For instance, a taxpayer that is in the business of drug
dealing is assessable on the proceeds of drug sales despite the illegality of
the activities.
Whether a receipt is ordinary income is to be characterised in the
taxpayer’s hands [5.155] Whether a receipt is ordinary income or not
needs to be determined in the context of the taxpayer being assessed:
Federal Coke Co Pty Ltd v FCT (1977) 7 ATR 519. For instance, if an
employee receives a salary, that salary would clearly be ordinary income in
the hands of the employee: see [6.30]. However, if that same employee
asked their employer to have the salary paid to the employee’s spouse
instead, then the salary would not be regarded as ordinary income in the
hands of the spouse. This is because in the spouse’s hands the receipt does
not have one of the important characteristics of ordinary income – that is, it
does not flow from their property, business or services they have provided:
see [5.100]. In this situation, the salary would still be regarded as ordinary
income in the hands of the employee due to the principle of a constructive
receipt: see [5.160].
Constructive receipt [5.160]
The principle of a constructive receipt is that income is treated as being
derived by a person when that income has been dealt with as that person
directs. This means that if someone is entitled to receive income, but
arranges
to have someone else receive it, then the person originally entitled to
receive the income has constructively received it. This means that the
person originally entitled to receive the money will be assessable on it.
Originally, the concept of a constructive receipt was a principle of case law,
but it was later incorporated into the income tax legislation. Specifically, s 6-
5(4) of the ITAA 1997 covers the principle of constructive receipt for ordinary
income and s 6-10(3) covers the principle of constructive receipt for
statutory income.
Example 5.3: Constructive receipt
Alex works for an engineering firm. He is paid on a fortnightly basis.
One fortnight he tells his employer, “for this fortnight, don’t pay
me, pay my wife instead”. Although his wife receives his salary, it is
still the ordinary income of Alex. This is because the salary is
ordinary income and Alex has constructively received the salary,
and s 6-5(4) applies to make the salary the assessable income of
Alex. The reason Alex has constructively received the salary is
because he was able to receive the salary, but instead chose to
have it directed to his wife.
Case study 5.6: ATO loses because it did not use principle of
constructive receipt In Federal Coke Co Pty Ltd v FCT (1977) 7 ATR
519, Bellambi was an Australian company that owned a subsidiary,
Federal Coke. Bellambi had a long-term contract to supply mineral
coke to a French company Le Nickel and the mineral coke was
supplied by Bellambi’s subsidiary Federal Coke.
The world price for coke had declined since the contract price was
set and Le Nickel wished to be released from this contract and was
willing to compensate Bellambi for cancellation of the contract.
Bellambi was professionally advised that this compensation
payment from Le Nickel would be treated as their assessable
income. As a result of this advice, Bellambi returned the
compensation payment to Le Nickel and arranged for them to make
the payment to Federal Coke (subsidiary of Bellambi) instead.
Bellambi hoped that the compensation would not be assessable in
Federal Coke’s hands.
The Commissioner argued that the compensation was assessable
income of Federal Coke, but the Full Federal Court found that it was
not assessable income. Specifically, the Court said that the receipt
was not compensation, because Le Nickel did not have any
contractual or other legal obligations with Federal Coke that would
have made them owe Federal Coke compensation. Furthermore, the
lack of dealings between Le Nickel and Federal Coke meant that it
could not be argued that the receipt was ordinary income due to
being the product of business activities. However, Chief Justice
Bowen indicated that had the Commissioner assessed Bellambi
rather than Federal Coke, then it was possible that the
compensation would still have been assessable in Bellambi’s hands.
This was because Bellambi may have assessable income through the
principle of constructive receipt.

The reasoning was that Bellambi could have received the

compensation, but chose to have it redirected to Federal Coke. It
could therefore be argued that they had constructively received the
compensation payment and redirected it to their subsidiary Federal
Coke. Constructive receipt of a payment that would have been
ordinary income had it actually been received will constitute
ordinary income. In other words, Bellambi’s position was similar to
that of the husband in Example 5.3.
Benefit that saves taxpayer from incurring expenditure is not
ordinary income [5.165]
If a benefit is not received by the taxpayer, or has been received by the
taxpayer but is not cash or cash convertible, then even if it saves the
taxpayer from incurring expenditure, it will generally not constitute ordinary
income. For instance, in the case of FCT v Cooke and Sherden (see Case
Study [5.2]), the taxpayers’ receipt of a non-cash-convertible holiday would
have made them better off in the sense that it saved them from spending
their own funds on a holiday. Despite this, the receipt of the free holiday was
not ordinary income.
However, if the benefit that saved the taxpayer money could have been
directly received by the taxpayer, but they had chosen to redirect it
elsewhere, then it would be covered by the principle of constructive receipt
and so would generally be ordinary income (see [5.160]).
Principle of “mutuality” [5.170]
One of the prerequisites of income is that there must be a gain to the
taxpayer: see [5.50]. It therefore follows that if a taxpayer makes a payment
to himself or herself, there is no gain and the payment will not be income.
The principle of mutuality shows that funds given to a club/association by its
members are not assessable income of the club as the members are the
club, they are one and the same. Similarly, any refund of these fees back to
the members are also not assessable to the members because there is no
real gain as the members are only receiving back what was their money:
Bohemians Club v Acting FCT (1918) 24 CLR 334; RACV v FCT (1973) 4 ATR
567. These receipts are a type of “non-assessable non-exempt income”
under s 6-23 of the ITAA 1997. The principle of “mutuality” will most
commonly apply in situations involving non-profit recreational clubs and
Owners’ Corporations (previously known as Bodies Corporate).
However, receipts of clubs and associations will not be subject to the
mutuality principle if those receipts are from sources other than members,
such as interest on investments, income from trading, fees collected from
non-members and other relevant external income: Carlisle & Silloth Golf Club
v Smith [1912] 2 KB 177.
Case study 5.7: Mutual receipts of a club
In RACV v FCT (1973) 4 ATR 567, the Royal Automobile Club of
Victoria (RACV) was a membership-based club that provided a
number of services to members and non-members. These services
included driving lessons, breakdown assistance, a journal
containing commercial advertising, touring advice, vehicle testing
services, insurance referral, etc. The taxpayer argued that its
receipts were not assessable under the mutuality principle.
The Supreme Court of Victoria held that RACV was engaged in some
activities that were mutual and some that were not. The distinction
between mutual and non-mutual activities was made on the basis of
whether the service was provided to members only or whether it
was part of the RACV’s trading activities. The breakdown services,
towing services, vehicle testing, journal and travel services relating
to Australian travel were mutual services, whereas advertising in
the journal, financial and insurance services, overseas travel
services and driving tuition for non-members were non-mutual
activities.
Example 5.4: Receipts subject to mutuality principle
The following are transactions involving clubs/associations, only
some of which are subject to the mutuality principle:
• A local not-for-profit football club collects a $100 membership fee
from each of its members. It uses these fees to organise football
games that its members participate in. The collection of the fees
would be subject to the mutuality principle and would not be
assessable to the club.
• A football club also holds a lunch and charges its members $10
each to cover the cost of the lunch. The money collected by the club
is only from members and therefore is subject to the mutuality
principle and will not be assessable.
• A wine-tasting club has in the past collected a total of $3,000 fees
from its members. This club organises wine-tasting tours for its
members. The club has $2,000 of the $3,000 in fees collected
unspent and in the bank. The club winds up and decides to refund
the $2,000 back to its members. The money refunded to the
members will be subject to the mutuality principle and would not be
assessable income for the members.
• An Owners’ Corporation for a block of five units collects $1,200
from each of the unit owners. The $6,000 collected will be subject to
the mutuality principle and will not be assessable income to the
Owners’ Corporation.
• An Owners’ Corporation earns $200 in interest from the bank on
fees previously collected but not yet spent. This $200 is assessable.
It is not subject to the mutuality principle as the interest is not
earned from its members.
Questions [5.180]
5.1 Using the general principles discussed in this chapter, consider
whether the following are likely to be ordinary income:
(a) Salary received by an employee.
(b) Compensation received by an injured worker for loss of salary
because he was unable to work for four weeks.
(c) A Christmas present received by a daughter from her mother.
(d) Proceeds from selling the copyright to a book. The recipient was
an employee accountant who wrote a novel in her spare time over a
number of years.
(e) Proceeds from selling the copyright to a book, where the
recipient is in the business of writing books and selling his
copyright.
(f) Profit realised on the sale of shares that have been held for a
number of years, primarily for their capital growth.
(g) Unemployment benefits from the government received by an
unemployed person.

5.2 Look up some English dictionary definitions of “income”. In

what respects are these definitions of income similar to what tax
law regards as “ordinary income”? Why is there a similarity?
5.3 Consider the following situations and discuss, giving reasons,
whether any of the receipts are ordinary income.
The taxpayer has operated a business of purchasing vacant land
that can be subdivided into housing lots and then sell either the
vacant lots or the lots with a house build on it. A site office is
normally built on one of the subdivided blocks and this is staffed by
a salesperson. Sometimes the vacant blocks are sold directly after
subdivision, but in other cases, the business arranges for the
construction of a house on the subdivided block and sells the
property with the completed house. On less frequent occasions, the
sales are what are known as a house and land package. In these
cases, the purchaser agrees on a design for the house and the
business enters a contract to build the house on the block and the
total sale price includes the block of land plus the construction cost
of the house.
In the current year, the business made the following sales:
• vacant blocks of land for a total of $1,600,000;
• house and land packages for a total of $2,800,000;
• $250,000 for the land that the site office was located on. The site
office was moved to a new subdivision;
• $1,300,000 worth of farmland which the taxpayer inherited from
his parents. The taxpayer had leased this land to a farmer for the
past 10 years. This land was not suitable for subdivision, so he sold
it to the farmer who had been leasing it.
5.4 In the High Court decision in FCT v Dixon (1952) 86 CLR 540, the
taxpayer’s receipts were held to be ordinary income. However,
Dixon CJ and Williams J reached this conclusion based on different
reasoning from Fullagar J. In relation to this chapter’s analysis of
what is ordinary income under s 6-5 of the ITAA 1997, outline the
reasons given for concluding that the taxpayer’s receipts were
ordinary income, and discuss which you think is the most
convincing, giving reasons.
5.5 Ten employees agree to each contribute $5 per week to a fund
that is used to purchase a weekly lottery ticket. During the year
there have been sufficient winnings to pay for an end of year dinner
($100 per person) for the 10 members of the group. There was also
sufficient money left over to refund $200 to each contributor. Using
Figure 5.1 as a guide, which elements of the figure are relevant to
determining whether any of the benefits received are ordinary
income under s 6-5 of the ITAA 1997?
Chapter 6 - Income from personal services and employment
Key
points ............................................................................................
............................ [6.00]
Introduction...................................................................................
.................................. [6.10]
Ordinary income as a reward for
services ..................................................................... [6.20]
Does the receipt show a nexus with the
service? ......................................................... [6.30]
Salary
sacrifice .........................................................................................
....................... [6.60]
Prizes, voluntary payments and unexpected
payments ................................................ [6.70]
Tips ...............................................................................................
................................... [6.80]
Personal gifts and voluntary
payments........................................................................... [6.90]
Prizes and chance
winnings ........................................................................................
... [6.110]
Non-cash
benefits..........................................................................................
................. [6.130]
Capital receipt or personal
service ................................................................................
[6.140]
Changes to
entitlements ..................................................................................
............. [6.150]
Receipts for entering a restrictive
covenant ................................................................ [6.160]
Sign-on
fees................................................................................................
.................... [6.180]
Section 15-2: Statutory income from services and
employment ................................ [6.190]
Introduction ...................................................................................
............................... [6.190]
First
requirement ..................................................................................
........................ [6.200]
Second
requirement ..................................................................................
................... [6.210]
Third
requirement ..................................................................................
...................... [6.220]
Can compensation receipts be assessable under s 15-
2? ........................................... [6.230]
Section 15-2’s relationship with other tax
provisions ................................................. [6.240]
Section 15-3: Return-to-work
payments ..................................................................... [6.250]
Payments upon termination of
employment .............................................................. [6.260]
Employment termination payment – Div
82 ........................................................................ [6.270]
When is the payment “in consequence” of termination of
employment? ........................ [6.290]
When is there a genuine
termination? ...............................................................................
[6.310]
Genuine redundancy payments and early retirement scheme
payments – Div 83…......... [6.320]
What is a genuine redundancy
payment? ........................................................................... [6.330]
What is an early retirement scheme
payment? ...................................................................[6.340]
Further conditions for redundancy payments and early retirement
scheme payments ….[6.350]
Threshold ......................................................................................
........................................ [6.360] Calculation of tax payable on ETP
........................................................................................ [6.370]
Payments for unused annual and long service leave – Div
83............................................. [6.390]
Questions ......................................................................................
........................................ [6.400]

Key points [6.00]

• Receipts that show a nexus with the provision of a service are ordinary
income. It does not matter whether the service has been performed in the
past or will be performed in the future or who makes the payment.
• Unexpected or voluntary payments will be ordinary income if they are
linked to personal services. However, they will not be ordinary income if they
are paid for personal qualities rather than services.
• Prizes are not normally ordinary income unless they are the direct result of
an income-earning activity or a reward for particular skills.
• Benefits earned from personal services that are not cash or convertible to
cash are not ordinary income, but may be statutory income.
• Receipts paid for giving up valuable rights may be capital receipts and
therefore would not be ordinary income. Capital receipts may be subject to
capital gains tax.
• Some employment and services gains that are not ordinary income will be
assessable under s 15-2 of the Income Tax Assessment Act 1997 (Cth) (ITAA
1997) if they satisfy all three of its requirements.
• Payments given as an inducement for an employee to return to work will
be assessable under s 15-3 of the ITAA 1997.
• Payments given as a consequence of termination of employment will
generally be assessable under the employment termination payment (ETP)
provisions in Div 82 of the ITAA 1997. The relevant tax rates that apply will
depend on various factors, including the taxpayer’s age, the amount
received and who received the payment.
• Payments given to an employee who has been made genuinely redundant
or under an early retirement scheme will generally be tax free under Div 83
of the ITAA 1997 as long as they are under the relevant threshold.
• Payments given to an employee upon his or her termination for unused
annual leave and long service leave are assessable under Div 83 of the ITAA
1997 and are generally assessable at the taxpayer’s marginal tax rates.

Introduction [6.10]
Chapter 5 introduced the general concept of income under the income tax
legislation and explained that income may become assessable as either
“ordinary income” under s 6-5 of the Income Tax Assessment Act 1997 (Cth)
(ITAA 1997) or “statutory income” under s 6-10. Classifying how a particular
receipt is identified for the purposes of income tax is extremely important as
it may influence the amount that is assessable and the tax rate applicable to
that amount.
In addition to the classification of assessable income as ordinary and
statutory income, Chapter 5 also outlined how the courts have categorised
income according to how it is generated by way of:
• income from personal services and employment (personal exertion);
• income from business (Chapter 8); and
• income from property (Chapter 9).
This method of classification by the courts has partly been influenced by the
income tax legislation as, over time, it has been necessary for the courts to
categorise receipts in order to apply relevant legislation. For example, s 50
of the Income Tax Assessment Act 1936 (Cth) (ITAA 1936) prior to 1 July
1987 required, in some instances, that income be identified as “income from
personal exertion”, “income from property other than dividends” and
“income from dividends”. Currently this categorisation is not as important for
the application of the Income Tax Assessment Acts, but it remains a very
useful approach for understanding how the courts have defined “ordinary
income” and how statute has modified what is assessable for each of these
categories.

Ordinary income as a reward for services [6.20]

Receipts earned from personal services and employment (also known as
“personal exertion”, which encompasses both income from employment and
services) may be assessable as either ordinary or statutory income. Amounts
that are assessable as statutory income are discussed at [6.190]–[6.390]. It
is also important to appreciate that non-cash benefits received in respect of
employment may also be subject to fringe benefits tax (FBT): see Chapter 7.
If this is the case, these benefits are exempt from income tax for the
employee (s 23L(1) of the ITAA 1936) and need to be considered in relation
to FBT for the employer.
Amounts earned directly or indirectly by virtue of a taxpayer’s personal
services will constitute ordinary income: Moorhouse v Dooland [1955] 1 All
ER 93; Brown v FCT (2002) 49 ATR 301. An important factor in identifying
income from personal services is the connection or “nexus” that the receipt
has with the taxpayer’s personal service. The term “nexus” has been used
by the courts to identify this connection with an income-earning activity, but
the term has a similar meaning as the phrase “reward for services”.
Establishing that there is a nexus between the amount received and the
work performed is an essential element for determining whether the receipt
is ordinary income under s 6-5 of the ITAA 1997. This approach was followed
in Scott v FCT (1966) 117 CLR 514 and Hayes v FCT (1956) 96 CLR 47 (see
Case Studies [6.4] and [6.5]), where it was held that a receipt is not ordinary
income if it is not a product of employment or a reward for services: see
[6.90].
Does the receipt show a nexus with the service? [6.30]
Receipts in the form of wages are obviously assessable as ordinary income
and provide a good example of where the nexus between the receipt and the
service is clearly established. In contrast, a personal gift of cash from a
friend or family member in recognition of some occasion, such as a wedding,
has no nexus with any service and therefore is clearly not assessable as
ordinary income. These examples illustrate two receipts that can be easily
identified as either assessable or not because of the connection (or lack of a
connection) with an income-earning activity. However, there are many cases
in between these two extremes where it is more difficult to determine
whether or not the receipt is the result of a service. It is helpful to view this
distinction as a continuum with each distinct end separated by varying
degrees of uncertainty.

To reduce the degree of uncertainty between the two extremes, it is

necessary to consider the decided cases and to identify the factors that the
courts have used to assist with this decision. Generally, the courts have used
a two-step approach to determine whether an amount is ordinary income
from personal services: first, identifying the activity undertaken; and second,
determining whether the receipt is a reward for performing that particular
activity.
Case study 6.1: Property received as a reward for service was
assessable
In Brown v FCT (2002) 49 ATR 301, the taxpayer (Mr Brown)
received, free of charge from a property developer, a beachfront
apartment with all the costs of transfer and fitting out the
apartment paid for. The total value of the property and other costs
were over $1 million. Brown played an important role in the success
of a major property development project by (among other things)
introducing the purchaser to the property developer. The taxpayer
argued that the property received was a personal gift and not
ordinary income as it was given out of friendship and did not have a
nexus with any work performed or service provided. The
Commissioner argued that there was a benefit equal to the value of
the property received and that this benefit was as a result of the
services provided by Brown (the nexus).
The Full Federal Court found that the value of the benefits received
was ordinary income because the benefit received resulted from the
activities undertaken by Brown. It was held that the benefit
provided was primarily a reward to Brown for introducing the
prospective buyer to the property developer, and the nexus was
established because the reward would only be forthcoming if the
deal was finalised.
[6.40] Once it is shown that there is a nexus between the benefit and the
activity performed, it does not matter whether the payment is made before,
during or after the completion of the task: Hochstrasser v Mayes [1960] AC
376. It is also irrelevant whether the benefit is provided by the entity for
which the task was performed, or by an unrelated third party – it will still be
ordinary income: Kelly v FCT (1985) 16 ATR 478: see Case Study [6.6].
Payments from a third party (an entity other than the one the taxpayer is
employed by) will be ordinary income for the taxpayer if they are truly a
reward for services, but it is also necessary to consider whether they are a
personal gift (see [6.90]) given for some other reason: Hayes v FCT (1956)
96 CLR 47. An example of a third-party payment would be an employee
accountant who receives a voluntary payment from a client of the firm
because the client is very happy with the work that the employee performed.
This payment would be a third-party payment because the employee works
for the accounting firm, rather than for the client. Furthermore, it has a
strong nexus with the services that the employee performed and so would
constitute ordinary income.

Example 6.1: Income earned from personal services

Phillip is a lawyer who runs his own business and does not have any
employees. At 2.00 am one morning his friend Vincent phones and
tells Phillip that he has just been questioned by police about a drug
trafficking matter. Vincent informs Phillip that he has not been
arrested, but he would like to retain his services as his lawyer so
that he can call him any time he needs legal advice or
representation. Vincent adds that he will pay Phillip $50,000 per
year regardless of whether his services are needed. Phillip agrees
and he anonymously receives $50,000 into his bank account some
months after, even though Vincent has not called on him for any
legal advice.
The question of whether this is ordinary income under s 6-5 of the
ITAA 1997 will be resolved by looking at the activity that is
performed and whether the receipt is a reward for performing that
activity. The service agreed to is that Phillip will be available
whenever required and, even though he may not be called on, he is
still being paid to be available. As a result, the nexus between the
service and the receipt is established and the $50,000 per year
would be ordinary income even if Phillip did not provide any legal
work for Vincent.
Wages, salaries, commissions, bonuses, fees for services and other
payments that are an incident of employment or a reward for
service are clearly ordinary income. The characterisation of these
amounts as ordinary income is based on the nexus between the
activity and the benefit and is not affected by whether the amount
is received regularly or as a lump-sum payment. Similarly, it is
irrelevant whether the payments are from an ongoing regular
employment contract or a one-off receipt contractually required to
be paid for the performance of a given task: Brent v FCT (1971) 125
CLR 418: see Case Study [6.8].

[6.50] Determining whether a receipt is the product of personal services

may also be explored using a negative approach, by asking whether the
receipt arose for some reason other than employment or the provision of a
service: FCT v Harris (1980) 10 ATR 869; Laidler v Perry [1965] 2 All ER 121.
Case study 6.2: Payments to retired employee to help reduce effect
of inflation on pension payments
In FCT v Harris (1980) 10 ATR 869, Mr Harris, a retired bank
employee, received a one-off payment of $450 from the bank, which
was described as a pension top-up to counter the effects of
increasing inflation. The Full Federal Court by majority held that the
receipt was not a product of Harris’s past employment and
therefore was not ordinary income. Bowen CJ conceded that Harris
would not have received the payment had he not been a past
employee of the bank, but went on to conclude that the payment
was in no way related to the length or quality of his past service.
The payment was related to his pension and was therefore not a
product of his employment. The Court was influenced by the fact
that the gift was one-off rather than regular, though this factor was
not determinative.
Note that s 27H of the ITAA 1936 was enacted to make receipts
similar to that received by Harris assessable as statutory income.
Receipts arising out of employment contracts or other service
agreements may also be capital in nature (see [6.140]–[6.180]) and
not assessable as ordinary income, although they may be
assessable as statutory income: see [6.190]–[6.240].
Salary sacrifice [6.60]
Income is only assessable in the year derived (s 6-5(2) of the ITAA 1997: see
Chapter 16), and employment income is normally derived when it is received
and not at the time the work is performed. Consequently, if personal
services income is never derived, it will never be assessable: Ruling TR 98/1.
Over the years, there have been attempts by taxpayers to redirect
employment income to other family members, but these attempts have
invariably failed and are now specifically covered by the personal services
income anti-avoidance legislation: see Chapter 23, Div 85 of the ITAA 1997.
However, employment income will not be derived if it is redirected through
an effective salary sacrifice arrangement with the employer.

For a salary sacrifice arrangement to be effective, employment income must

be diverted before it is earned. This requires the employee to negotiate to
forego future salary or wages in exchange for some other benefit, such as
increased superannuation contributions by the employer. The Commissioner
accepts that effective salary sacrifice arrangements divert remuneration
before it is derived, and therefore it is not assessable to the employee:
Ruling TR 2001/ 10. However, any benefit accruing to the employee under
the salary sacrifice arrangement will need to be considered by employers as
to its possible effect on their liability to FBT: see Chapter 7.
Example 6.2: Salary sacrifice
Jo is aged 35 and is an employee of a large bank. His current salary
is $100,000 per year. To bolster his superannuation, Jo negotiates
with his employer to increase the employer superannuation
contribution by $10,000 per year. Jo’s employer agrees to this on
the condition that his wages are reduced to $90,000. As a result of
the salary sacrifice, since Jo is on the 39% tax rate (including
Medicare levy), Jo’s take-home pay will drop by $6,000 ($10,000 −
$3,900) and his superannuation will increase by $8,500 per year
($10,000 less 15% tax of $1,500 – employer contributions to
employee superannuation are taxed at 15%: see [18.110]).
Employer superannuation contributions to employee
superannuation funds are exempt from FBT: see [7.80].
Prizes, voluntary payments and unexpected payments [6.70]
Unexpected or voluntary payments received as a reward for service are
ordinary income as the benefit is an incident of employment: Laidler v Perry
[1965] 2 All ER 121. However, if the payment is made for some other reason,
such as for personal qualities, then the receipt is a personal gift and will not
be ordinary income as there is no connection with any personal service.
Case study 6.3: Christmas bonus was ordinary income
In Laidler v Perry [1965] 2 All ER 121, a Christmas bonus was paid to
all current and past employees in the form of a voucher that could
be redeemed for goods. These vouchers were provided regardless
of the pay rate or the personal circumstances of the employee and
were accompanied by a letter expressing the board’s thanks for
past services. It was held by the House of Lords that the voucher
was income as it arose out of employment, even though it was a
voluntary payment on behalf of
the employer. Lord Reid answered the question of nexus in the
negative by concluding that the benefit arose out of employment
because it did not arise out of anything else. Note that benefits
received in kind rather than as cash are often subject to FBT rather
than income tax: see [7.10].
Unexpected or voluntary payments may also be classified as
ordinary income based on the nature of the payment (see [5.130]),
rather than any nexus with employment or services: FCT v Dixon
(1952) 86 CLR 540; FCT v Blake (1984) 15 ATR 1006. In FCT v Dixon,
the fact that the taxpayer relied on these receipts to support
himself and his family was a factor in the Court concluding that the
receipts were a replacement for income and therefore assessable as
ordinary income.
Tips [6.80]
Tips are an example of a third-party gift and are voluntary payments
received by waiters, taxi drivers, hotel employees and others that provide a
personal service to the public. These payments are made voluntarily but are
made because of the level of service provided, and not for any other reason,
therefore establishing the nexus with the service and making them
assessable as ordinary income: Penn v Spiers & Pond Ltd [1908] 1 KB 766
(tips received by a railway dining car waiter); Calvert v Wainwright (1947) 27
TC 475 (tips received by a taxi driver).
Personal gifts and voluntary payments [6.90]
In contrast to income that is earned as the product of personal services, a
gift given for personal qualities is not regarded as ordinary income and
would not normally be assessable to the recipient: Hayes v FCT (1956) 96
CLR 47; Scott v FCT (1966) 117 CLR 514.
The treatment of personal gifts as non-assessable income for tax purposes is
based on the general meaning of “ordinary income”, which includes the
notion that income “flows” from a source such as capital. In the case of
personal services, the income flows from the taxpayer’s ability to work
and/or the employment contract: see [5.100]. Personal gifts therefore fall
outside of this concept of income because they arise from personal qualities.
However, a voluntary payment that is a reward for services will still
constitute ordinary income.
When distinguishing between a non-assessable personal gift and assessable
voluntary payments for service, the courts have given more weight to the
nature of the receipt in the hands of the recipient, rather than the motive of
the giver: Scott v FCT. Viewing the receipt from the point of view of the
recipient emphasises the importance of looking for any connection the
receipt may or may not have with any service provided or other income-
earning activity. The motive of the giver may be considered, but is less
important. An unsolicited gift therefore does not become ordinary income
only because it was prompted by gratitude for some service, as other factors
must also be considered: Scott v FCT (1966) 117 CLR 514; Squatting
Investment Co Ltd v FCT (1953) 86 CLR 570.

Case study 6.4: Characteristics of a personal gift

In Scott v FCT (1966) 117 CLR 514, the High Court held that the gift
of £10,000 paid by a client (Mrs Freestone) to Mr Scott (a solicitor)
was a personal gift and not ordinary income.
Scott had acted as solicitor for Freestone for some years and in this
case was acting as her solicitor in relation to the estate of her
deceased husband. Prior to Mr Freestone’s death, he and Scott had
known each other for many years and were associated in various
business activities. On the death of her husband, Mrs Freestone
engaged Scott to carry out work in relation to the administration of
her husband’s deceased estate, which included the sale of a number
of properties, the main one being an area of 82 acres known as
“Greenacres”. Scott played an important role in the sale of the
properties by successfully negotiating to have restrictions lifted
which prevented the property from being subdivided. As a result of
the lifting of the restrictions on the property, its value increased
substantially and it was eventually sold for a considerable profit.
Following the sale of “Greenacres”, Freestone was informed by
letter from Scott’s firm that the bill of costs would be prepared as
soon as possible, and it was later paid by Freestone. However,
before the bill was rendered, Freestone told Scott that she intended
to make a number of gifts from the sale of the property and this
included one to him of £10,000. In reaching its conclusion that the
£10,000 was not ordinary income, but rather a personal gift, the
High Court emphasised a number of elements to be considered in
determining the characteristics of the receipt:
• The character of the £10,000 should be assessed as a receipt in
the hands of the taxpayer.
• The receipt must be a product of the relevant activity to be
ordinary income; if it is a product of friendship or other personal
characteristics, then it is a personal gift.
• The fact that Scott was fully remunerated for his services
separately from the payment supported the case that the £10,000
was a personal gift.
• The fact that Scott did not expect the gift also supported the case
that the £10,000 was a personal gift.
• The personal relationship prior to the payment, as well as the fact
that the donor made other gifts at the same time, also supported
the argument that the £10,000 was a personal gift.
• The motives of the donor do not normally determine whether the
character of the receipt is ordinary income, although it might be
one of the factors to consider in deciding whether the receipt is
ordinary income.
[6.100] The characteristics of a personal gift established in Scott v FCT
(1966) 117 CLR 514 emphasise the importance of the personal relationship
of the parties in distinguishing between receipts that are a product of
personal services or a personal gift. In addition, where the payment is made
by an entity with which the taxpayer has an employment or commercial
connection, it is important to ascertain whether any service provided is
separately and fully paid for.
Ultimately, whether a voluntary payment is ordinary income or not will
depend on whether it has sufficient nexus to the service provided. If there is
sufficient nexus it will be ordinary income, but if there is not, then the
voluntary payment will be a personal gift. As the case law shows, there are a
number of factors that help in borderline cases to determine whether the
nexus is strong enough to make a voluntary payment ordinary income.
However, it must be stressed that these factors are not determinative and
only assist to make this decision.

The more important of these factors are:

• whether the gift was expected. Expected receipts are more likely to be
ordinary income: Scott v FCT (1966) 117 CLR 514;
• whether the gift consists of a lump-sum or regular payments. If it consists
of regular payments, then it is more likely to be ordinary income: FCT v Blake
(1984) 15 ATR 1006;
• the motive of the donor. If the donor intends the gift to be a reward for
services, the gift is more likely to be ordinary income: Scott v FCT;
• whether the recipient has already been remunerated for his or her
services. If so, this makes the voluntary payment less likely to be ordinary
income: Scott v FCT; Hayes v FCT (1956) 96 CLR 47; and
• whether there was a personal relationship between the donor and
recipient. The existence of a pre-existing personal relationship will make the
voluntary payment less likely to be ordinary income: Scott v FCT; Hayes v
FCT.

Case study 6.5: Characteristics of a gift

In Hayes v FCT (1956) 96 CLR 47, Hayes was the supervising and
general accountant for Mr Richardson’s meat and smallgoods
business. Mr Richardson’s business was taken over by a company of
which Hayes was a director, secretary and shareholder. Initially,
Richardson did not have a controlling interest in the company but
after several years gained control of the entity. Richardson
persuaded Hayes to sell his shares to him but Hayes remained a
director and secretary. The company became quite successful and
was incorporated as a public company in which Richardson was
allotted a considerable number of shares and he transferred 12,000
of these to Hayes. The Commissioner argued that the value of these
shares was ordinary income or assessable under s 26(e) of the ITAA
1936 (now s 15-2 of the ITAA 1997): see [6.190].

The High Court concluded that the value of the shares transferred
to Hayes was a personal gift and not ordinary income. In reaching
its decision, the Court noted that Hayes and Richardson had
developed a personal relationship, and that for the value of the
shares to be ordinary income they must be seen in the hands of the
recipient as a reward from employment or other services. In this
case, Hayes had been fully paid for his services and therefore the
shares were not additional reward for his work. This, together with
the personal relationship, was sufficient for the Court to find that
the value of the shares was a personal gift and not ordinary income,
or statutory income under s 26(e) of the ITAA 1936.
Example 6.3: Voluntary payments from employer
Kim is employed in the family business, which is a medium-sized
accounting firm. Both her parents are partners in the five-partner
firm that operates the business. Kim has been an employee for the
last three years. During the current tax year, Kim received several
amounts in addition to her normal wage which was equivalent to
other employees with similar experience and similar qualifications.
One evening during discussions over the dinner table, Kim’s father
asked her whether she had any good ideas on how to improve the
client base of the firm. Kim had been thinking about this for some
time and she prepared a two-page document outlining her ideas
which her father presented to the other partners. One of Kim’s
ideas was adopted and proved moderately successful in attracting
new clients. At the end of the financial year, Kim was surprised to
receive an envelope with a letter thanking her for her ideas and a
cheque for $2,000.

Characterising the $2,000 as ordinary income under s 6-5 of the

ITAA 1997 or as a non-assessable gift requires consideration of the
elements used in Scott v FCT. First, it is important to view the
receipt in Kim’s hands and give less importance to the motive of the
partners for making the payment. In this example, there is a strong
case to argue that the payment was a product of Kim’s suggestions
to the partners and therefore is assessable as ordinary income.
However, as she is fully remunerated for her work and there is a
family relationship, this would support the argument that the
$2,000 is a personal gift. On balance, the stronger case is that the
receipt is a product of her extra effort, and the personal
relationship appears to be weaker than that in Scott v FCT. An
alternative method of analysis, as used in FCT v Harris (see Case
Study [6.2]), is to ask what else gave rise to this income? Using this
approach, it would be difficult to argue that the $2,000 was
received for her personal qualities just because Kim’s parents are
partners of the firm, as they do not hold a majority.
During the year Kim also announced her engagement and at her
engagement party she was handed an envelope by her mother. The
envelope contained a card of congratulations signed by all the
partners and a cheque for $3,000 drawn on the firm’s account. Kim
also received a very generous gift directly from her parents.
In this case, it may be contended that Kim would not have received
the cheque for $3,000 if she had not been an employee. However,
that is not the test of whether the amount is a personal gift or
shows a nexus with her employment. This receipt is more clearly a
personal gift as it is in recognition of her engagement and is
therefore paid for personal qualities and is not connected to her
position as an employee of the firm.
Prizes and chance winnings [6.110]
An important characteristic of ordinary income is that it is earned as a result
of personal services. Windfall gains in the form of chance winnings or prizes,
which primarily depend on luck, are therefore not ordinary income, although
they may in some cases be income from business: see [8.60]–[8.80]. For
example, winnings from gambling will be a windfall gain unless the gambler
is in the business of gambling: Babka v FCT (1989) 20 ATR 1251.
For prizes to be classified as ordinary income, they would have to be earned
as a result of a business activity or the degree of personal services and skill
would have to outweigh the element of chance. For example, an employee’s
winnings from a football tipping competition organised and run by her
employer are clearly not ordinary income as they depend on chance and
have no connection with employment. Similarly, the winnings of a casual
participant in a television game show are not normally ordinary income as
the element of chance is generally far greater than any skill required: Case
37 (1966) 13 CTBR (NS) 235; Ruling IT 167.
It is a question of degree as to whether the level of personal services is
sufficient to turn a prize into ordinary income and, as with all questions of
degree, the difficulty is to determine the level of personal service that is
necessary to change the character of the receipt: Kelly v FCT (1985) 16 ATR
478.
Case study 6.6: Professional sportsperson’s prize
In Kelly v FCT (1985) 16 ATR 478, the taxpayer played football at the
highest level in the Western Australia competition and he was paid
a fixed amount for each match played. In 1978, he won a prestigious
award for the “best and fairest player”, known as the Sandover
Medal. Prior to the announcement of the winner of the medal, a
local television station publicly broadcast that it would pay $20,000
to the winner. The Commissioner assessed Kelly on the $20,000
prize on the basis that, although unexpected, the prize directly
related to his skill and performance as a professional footballer.
Franklyn J held in the Supreme Court of Western Australia that the
$20,000 was ordinary income. This was because the amount was
directly related to Kelly’s employment as a footballer, even though
it was unexpected and paid by an unrelated third party. First, Kelly
was eligible because he was a member of the football club and,
second, he was awarded the prize because of his skills and abilities.
[6.120] Given the increased profile of professional sporting people since the
decision in Kelly v FCT (1985) 16 ATR 478, it is most likely that all winnings
and prizes relating to their sporting activities will be ordinary income.
However, the distinction between a non-assessable prize and a prize that is
related to personal service is more difficult when the activity is not
associated with employment or professional activities.

Some of the factors used to make this distinction are:

• the degree of professionalism;
• whether the reward is for services rather than for personal qualities;
• whether the reward is paid before or after service; and
• whether the reward is related to the taxpayer’s contract.

Example 6.4: Prizes of a non-professional

As a young girl, Marlene had always loved dancing and she has
received training in a wide range of dancing styles. Over the years
she has participated in a number of local dancing competitions and
she has collected quite an array of cups and trophies. At present,
Marlene is employed as a full-time lawyer and she has not danced in
any competitions for the past six years. During the current tax year,
Marlene decided to get back into dancing and entered a local talent
competition which she won and received a cash prize of $200. The
receipt of $200 raises the issue of whether this payment is ordinary
income as a reward for personal services and her skill in the
performance or whether it is a non-assessable prize that primarily
depended upon luck. Marlene is clearly not a professional dancer
and she has voluntarily entered the competition, rather than being
engaged to dance by the co-ordinators. In addition, there is a
significant element of chance as to whether Marlene will win the
prize. Considering all these factors, the $200 receipt is not ordinary
income but is a non-assessable prize.

Later in the year Marlene responded to an advertisement to

participate in a television dancing competition. There were 5,000
applicants and only 50 would be selected after the auditions and
Marlene was one of the lucky few. On being selected, Marlene was
required to sign a contract with the television company agreeing to
quite stringent rules restricting what information could be disclosed
to the public, what media outlets she could talk to, where and when
she had to appear and what was required of her if she reached the
final 10 and if she won the competition. Marlene was very
successful and she reached the final 10, which required her to
commit four days per week to the television production and, as a
result, she took unpaid leave from her employment. During the final
weeks of the competition, a local newspaper offered a $10,000 prize
to the contestant that could record the fastest tapping in a tap
dance routine. Marlene won the $10,000, but she did not go on to
win the final competition.

Considering the factors listed above, there is a stronger case that

the $10,000 is ordinary income compared to the $200 prize. In this
situation, Marlene is required to sign a contract which indicates
that she is adopting a degree of professionalism. The prize was only
available to those contestants that had reached the final stages of
the competition and it was not paid for personal qualities but for
the demonstration of a particular skill.

Non-cash benefits [6.130]

The general definition of “ordinary income” discussed at [5.60] identifies one
of the prerequisites of ordinary income as being cash or convertible to cash.
Conversely, receipts that are not convertible to cash are not ordinary
income: Tennant v Smith [1892] AC 150; Payne v FCT (1996) 32 ATR 516;
FCT v Cooke and Sherden (1980) 10 ATR 696. This characteristic of ordinary
income is particularly relevant in relation to receipts from personal services,
as payments in kind (e.g., a free holiday) are quite common in employment
and service arrangements.
An example of the application of this characteristic of income can be seen in
Payne v FCT, where the Federal Court considered whether benefits received
from a customer loyalty program were, among other things, ordinary
income. Customer loyalty programs typically accumulate points that can be
redeemed as free travel, free accommodation, discounts on purchases or
other similar rewards.
Two issues arise in relation to taxation from these loyalty programs: first,
whether the rewards are cash or convertible to cash and, second, whether
the benefit is connected with personal service.
Case study 6.7: Frequent flyer points
In Payne v FCT (1996) 32 ATR 516, Janet Payne travelled regularly as
a result of her employment with a large accounting firm. The flights
were paid for by her employer as she was travelling for business
purposes. On one of these trips Payne was offered a brochure which
invited her to join the airline’s Frequent Flyer Club. She duly
completed the application form and paid the $95.00 membership
fee. Over the next two years, Payne accumulated sufficient points to
purchase airline tickets for her parents to fly from England to
Australia. The bulk of these points were accumulated through travel
that was paid for by her employer, although a small percentage was
from private travel (3.2%).
Foster J of the Federal Court held that the free flights earned by
Payne as a result of frequent flyer points generated through work
travel were not ordinary income. The primary reason for this
conclusion was that the tickets were not money or monies worth as
they could only be used by the program member or his or her
nominee. They could not be sold or in any way converted into
money.
The decision by Foster J in this case went on to consider whether
these benefits were assessable under s 26(e) of the ITAA 1936 (now
s 15-2 of the ITAA 1997): see Case Study [6.16].

Benefits that are not cash or cash convertible cannot be ordinary income and
are not assessable under s 6-5 of the ITAA 1997, but they may be assessable
under s 15-2 (see [6.190]–[6.240]) or subject to FBT: see Chapter 7.
However, if the benefit is convertible to money through sale or via some
other means, then the question of the benefit’s assessability as ordinary
income will rest with whether the benefit shows a nexus with personal
service: see [6.30].
Capital receipt or personal service [6.140]
Capital receipts are not ordinary income under general principles: see [5.40].
As a result, it is necessary to consider whether receipts from personal
services and employment are capital or not. The distinction between a
receipt that is a reward for services (and is therefore ordinary income) and a
receipt that is capital in nature is primarily concerned with whether the
taxpayer has given up a valuable right. It follows that where the payment is
for giving up a capital right, then the payment is most likely capital in nature
and not ordinary income. Conversely, if nothing substantial of a capital
nature is given up then, as discussed at [6.30], it is necessary to consider
whether the payment shows a nexus with any service, in which case it will
be ordinary income: Brent v FCT (1971) 125 CLR 418.
In the case of a restraint of trade, there may be a distinction between the
treatment of valuable rights depending on whether those rights are
relinquished on commencement, during or at the ending of an employment
contract: see [6.160]–[6.170]. For example, if a professional sportsperson
has included in her contract a clause that prevents her from playing with any
other club during the term of the contract, then any payment received as a
result of this agreement is an incident of the playing contract and is
therefore ordinary income. Clearly, no valuable right is given up in this
instance as the sportsperson is being paid to play for one club to the
exclusion of the other.
Case study 6.8: Payment for service of giving up valuable rights
In Brent v FCT (1971) 125 CLR 418, Mrs Brent was the wife of the
infamous criminal Ronald Biggs, who was one of the gang
responsible for the UK “Great Train Robbery”. Brent was arrested in
Melbourne where she had been living with Biggs following his
escape from a UK gaol. After her arrest, Brent was approached by a
number of newspapers with offers to publish her life’s story, and
she eventually signed an agreement with The Daily Telegraph. The
agreement gave the UK newspaper exclusive rights to the
publication of Brent’s story. It required her to be available for
interviews by newspaper staff who would then write her story for
publication. The taxpayer claimed the payments were not ordinary
income but that she was being paid for giving up the capital rights
to her story as she signed over the exclusive rights to the
newspaper.
The High Court held that Brent’s earnings from this agreement were
ordinary income. Brent was essentially paid for her services of
telling her story and she did not give up or dispose of any property.
Her secret knowledge was not property as it was not acquired
through the conduct of a business and did not relate to anything to
which copyright could be attached. Brent’s story was about her life
and she did not write the story nor did she possess any copyright
that she could assign to The Daily Telegraph. Consequently, the
Court held that nothing of a capital nature was given up and
therefore the payments were for the service of telling her story. The
High Court also placed little importance on the so-called “exclusive
rights” clause as this could not restrict any other author from
collecting information on Brent and publishing its own version of
her life’s story.
Changes to entitlements [6.150]
Payments for changes to entitlements under employment and service
contracts may give rise to capital receipts for the giving up of valuable
capital rights and therefore not fall into the category of ordinary income:
Bennett v FCT (1947) 75 CLR 480. This follows the principle that
compensation takes the form of what it replaces in that compensation for the
loss of capital rights will be a capital receipt: see [10.20]. If no capital right is
given up, as in FCT v Brent (1971) 125 CLR 418, then the receipt is more
likely to be ordinary income unless it is a personal gift.
Case study 6.9: Relinquishing employment rights
In Bennett v FCT (1947) 75 CLR 480, the taxpayer was employed as
the managing director of a company which he affectively controlled.
His original contract was terminated and he was re-appointed with
the same remuneration but he relinquished certain rights that he
previously held, including absolute control of the company. To
compensate for the loss of these rights, the company agreed to pay
Bennett three payments over a two-year period.
The High Court held that the payments were not for loss of income,
but were capital in nature for the removal of those rights that
Bennett possessed under the original agreement. Williams J applied
the compensation principle finding that because the payments were
not for the loss of income, they were capital payments for giving up
the right to control the company.

The nature of payments for changes to existing entitlements under an

employment contract was also considered by the Administrative Appeals
Tribunal in AAT Case 7,752 (1992) 23 ATR 1057. In this case, employees of
Shell Company Aust Ltd had their entitlements to rostered days off removed
without the employees’ knowledge and it was concluded that compensation
paid for the loss of these valuable rights was of a capital nature.
Receipts for entering a restrictive covenant [6.160]
A restrictive covenant or restraint of trade may be formed at the time of
entering a contract, during the contract’s operation or after the completion
of the service. For example, it is common for professional sportspeople to
sign restrictive covenants on entering new contracts which may limit their
rights to be interviewed by the media or appear on designated television
shows. Similarly, professional actors and movie stars may enter agreements
on the completion of a production to not perform in another production for a
given length of time. Another example would be an employment contract
entered into whereby an accounting firm requires an employee to sign a
restrictive covenant preventing the employee from registering as a tax
agent.
Characterising receipts from entering a restrictive covenant as capital or
ordinary income will depend on whether the payment is connected with the
current employment agreement or whether it is a separate agreement to
give up valuable rights. However, where the restrictive covenant is
commonly used as part of the normal employment contract, it will be
ordinary income as it is generally viewed as a payment for future services.
Although the decision in Higgs v Olivier [1952] Ch 311 found the restrictive
covenant to be capital, the comments in this case and in FCT v Woite (1982)
13 ATR 579 would suggest that restrictive covenant payments made as part
of an ongoing contract are more likely to be income.
[6.170] Payments made at the termination of a service agreement that
restricts the activities of the taxpayer are seen as capital as they do not
arise out of the employment or service contract and do not show a nexus
with the earning activity: Higgs v Olivier [1952] Ch 311; Hepples v FCT
(1991) 22 ATR 465.
Case study 6.10: Restrictive covenant – capital
In Higgs v Olivier [1952] Ch 311, the famous actor Sir Laurence
Olivier was paid £15,000 for agreeing to not appear in or direct any
film for a period of 18 months after he appeared in the film “Henry
V”. The English Court of Appeal held that the receipt of £15,000 was
not received as a result of his vocation as an actor and therefore
was not
assessable. The Court held that as the agreement to pay the
£15,000 was separate to his contract to perform in the film, and was
made after the completion of the film, it was not payment for his
performance as an actor but for his giving up the right to earn
income which was capital in nature.
Case study 6.11: Restrictive covenant – genuine capital payment
In Hepples v FCT (1991) 22 ATR 465, the taxpayer was paid $40,000
on his retirement for agreeing not to disclose the secrets of his
employer. Although this decision was mainly concerned with CGT,
the High Court had no difficulty in finding that this receipt was not a
substitute for income and was a capital payment for entering the
restrictive covenant on termination of employment.
Capital receipts may also arise out of a restrictive covenant agreed to at the
time of entering a contract, and the characterisation of these receipts will
again be based on whether the payment is for giving up a valuable right or
for services provided: FCT v Woite (1982) 13 ATR 579; Reuter v FCT (1993)
27 ATR 256.
Case study 6.12: Restrictive covenant – ordinary income
The taxpayer in Reuter v FCT (1993) 27 ATR 256 was involved in the
very famous takeover of John Fairfax Ltd. As part of the
arrangements in relation to the takeover, the taxpayer was paid $8
million to agree that he would not, without prior approval, claim the
success fee (normal payment for a successful takeover) for the
takeover against Bond Media. Hill J in the Federal Court looked at
the substance of the agreement, rather than its form, and held that
the receipt of $8 million was closely connected to the services
provided by the taxpayer to Rothwells Ltd and was therefore
ordinary income.
Case study 6.13: Restrictive covenant on entering a contract
In FCT v Woite (1982) 13 ATR 579, the taxpayer was a footballer
who played for a South Australian team. Woite received $10,000 for
entering an agreement with the North Melbourne Football Club to
not play football with any Victorian club other than North Melbourne
(Australian Rules Football did not have a national competition at
this time). The contract did not require Woite to play for North
Melbourne unless he decided to play football in the Victorian
league, which he never did.

The Supreme Court of South Australia held that the $10,000 was
capital in nature and was not ordinary income from his profession
as a footballer. Woite was contracted to the South Australian club
and the payment from the North Melbourne club was not a payment
for service, but a capital payment to give up the right to play for a
club other than North Melbourne. It is interesting to note, although
not part of the decision, that Mitchell J implied that it was highly
likely that the $10,000 could be ordinary income if Woite had
followed the signing of the restraint of trade by signing with the
North Melbourne Club and had subsequently played football for
them.
Example 6.5: Restraint of trade payments
Luke is a famous basketball player and he has been contracted to
play for his club for the last five years. Currently, Luke is in
negotiations with his club to renew his contract for an additional 12
months and one of the clauses in the contract states that he may
only do media appearances with TVX, a media company that has a
substantial interest in the club. Due to the inclusion of media
restrictions, Luke’s agent is able to have the annual playing fee
increased by $50,000.
Luke signs the new contract, but halfway through the season he has
a serious dispute with the club’s management as he is not being
picked to play on a regular basis. Following threats of legal action
by both parties, the club agrees to end Luke’s contract for no cost
to Luke and also pays him $100,000 for agreeing not to disclose the
reasons for the dispute with the club.
There may be an argument that the $50,000 is payment for giving
up the right to speak to any media Luke wishes, but it may also
simply be part of his employment contract which requires a range of
conditions. The comments in Higgs v Olivier [1952] Ch 311 and FCT
v Woite (1982) 13 ATR 579 would suggest that restrictive covenant
payments made as part of an ongoing contract are more likely to be
income. This is not unlike an employment contract that requires
certain restrictions of an employee, such as signing a secrecy
agreement. In contrast, the payment of $100,000 is on termination
of the contract and imposes a specific restraint on Luke and, as it is
not a payment related to his playing duties, it is more likely to be
capital, as in Hepples v FCT (1991) 22 ATR 465.

Receipts that are of a capital nature are not assessable under s 6-5(1) of the
ITAA 1997, but they may be statutory income under other provisions such as
the CGT provisions: see Chapter 11. It is important to distinguish receipts
that are ordinary income and those that are subject to CGT, as the method of
determining the liability to tax differs between these two forms of income.
Sign-on fees [6.180]
Sign-on payments enticing the party to enter the contract are quite common
in professional sporting contracts and some higher level professional
employment contracts. These receipts raise the issue of whether they are a
capital payment for giving up some valuable right or whether they are
ordinary income in the form of payments for future services.
Case study 6.14: Sign-on fees – capital in nature
In Jarrold v Boustead (1963) 41 TC 701, an amateur rugby player
was paid a £3,000 sign-on fee to give up his amateur status and
turn professional. At this time in UK, there were some advantages
in being an amateur and there was a chance that he could become
an international player at amateur level. The Court of Appeal held
that this receipt was capital in nature as it was a payment for giving
up the right to play amateur football, rather than a payment for
future services.
The view expressed by the Commissioner in Ruling TR 1999/17 is that where
a sign-on fee is a normal part of the practices of attracting sportspeople and
employees into a new contract, the payment is less likely to be capital and
more likely to be ordinary income as a one-off payment for future services:
Pickford v FCT (1998) 40 ATR 1078.
Case study 6.15: Sign-on fees – ordinary income
In Pickford v FCT (1998) 40 ATR 1078, the taxpayer was offered a
salary package to take up employment with another firm, and this
package included a one-off payment of $20,000 as compensation for
given-up share options in an employee share scheme with his
current employer. The Administrative Appeals Tribunal held that the
$20,000 was ordinary income because it was an incident of the
taxpayer’s income-earning activities and employment.

There is very little direct Australian case authority on this issue, which could
suggest that it is well settled that it is difficult to make a strong case that
these receipts are not an incident of an income-earning activity.
Income from personal services may be assessable as ordinary income or
statutory income. However, regardless of whether an amount is likely to be
ordinary income, it is still necessary to consider whether any statutory
provisions specifically apply to the receipt.
The discussion at [6.190]–[6.390] covers the most important statutory
provisions that apply to receipts from employment and services.
Section 15-2: Statutory income from services and employment
Introduction [6.190]
Section 15-2 of the ITAA 1997 (previously s 26(e) of the ITAA 1936) deems
certain gains arising from employment and services to be assessable as
statutory income. For the most part, s 15-2 has the same operation as its
predecessor. However, there is one major difference: s 26(e) did not have a
“contrary intention”. This meant that gains that were ordinary income and
covered by s 26(e) were taxed under s 26(e). However, the current s 15-2
does have a contrary intention in s 15-2(3)(d), which means that if a gain is
ordinary income, it will not be covered by s 15-2: see [3.80].
Specifically, s 15-2 covers gains from employment and services if they are
not ordinary income or a fringe benefit (see Chapter 7) and if they fulfil all
three of the requirements discussed at [6.200]–[6.220].

The application of s 15-2 is wider than ordinary income in two ways:

• For employment and service gains to be ordinary income, they need to be
cash or cash convertible. On the other hand, s 15-2 covers gains that are
cash, cash convertible and non-cash convertible.
• For employment and service gains to be ordinary income, there needs to
be a nexus between the gain and the services required: see [6.30]. For these
gains to be assessable under s 15-2, there must also be a nexus between the
gain and the services. However, case law indicates that the nexus test is
easier to satisfy under s 15-2 than it is for ordinary income. For example, in
Smith v FCT (1987) 19 ATR 274 (see Case Study [6.17]), Brennan J found no
reason that s 26(e) of the ITAA 1936 (the predecessor of s 15-2) should be
limited to benefits that are income in ordinary concepts, with the result that
s 15-2 could potentially include capital benefits.

Section 15-2 potentially only applies to gains from employment or the

provision of services. However, this could include services provided by a
business taxpayer and also amounts received from providing services under
an independent contract for services. Section 15-2 could therefore apply to
gains made by a business from providing engineering or accounting services.
Conversely, s 15-2 will not apply to gains made from holding property or
from business operations that do not involve the supply of services. For
instance, in FCT v Cooke and Sherden (see [5.60]), the taxpayer ran a
business selling soft drinks “door to door” and subsequently received a gift
from the soft drink manufacturer. In this case, the Court held that such a gift
was not assessable under the predecessor of s 15-2 because the income was
sourced from a business selling goods rather than from providing a service of
selling goods.
First requirement [6.200]
The first requirement for a gain to be assessable under s 15-2 of the ITAA
1997 is that there is an “allowance, gratuity, compensation, benefit, bonus
or premium”. These words are very wide and will cover a range of benefits
received by the taxpayer. This includes receipts that are cash, cash
convertible or non-cash convertible.
Some examples of receipts that meet the first requirement are:
• a cash payment for services, which is a “benefit” and so would fulfil this
requirement; and
• an employer giving an employee a free television or giving the employee
use of a car for personal purposes. Note also that this first requirement:
• is not confined to receipts that the taxpayer is entitled to receive, but can
also include gifts (gratuities) that have been received by the taxpayer; and
• will also be satisfied when the taxpayer receives something from an entity
to which he or she has not directly provided a service. For instance, free
hotel accommodation received by an employee of an accounting firm from
one of the firm’s clients would satisfy this first requirement.
An example of an item that satisfies the first requirement is an “allowance”.
An allowance is a predetermined amount given to a taxpayer for a specific
purpose where the taxpayer does not have to return any of the unspent
amount. This is in contrast to a “reimbursement”, where a taxpayer only
receives what he or she has spent. For example, a taxpayer who receives
$150 from her employer for travel purposes, but ends up only spending $60
of it and is allowed to keep the rest, is in receipt of an allowance. On the
other hand, a taxpayer who is reimbursed only her actual travel expenditure
would not be in receipt of an allowance, but rather a reimbursement.

While allowances will satisfy the first requirement of s 15-2, whether or not a
reimbursement is captured by s 15-2 is contentious, although it is of little
practical importance as, either way, it will be tax neutral. For example,
where an employee purchases paper for their work’s photocopier for $50 and
then is reimbursed $50, it may be argued that this is effectively not the
employee’s expense but the employer’s expense and the employee is simply
carrying out the purchase for the employer. If this is the case, then the
employee has no benefit and no assessable income or equivalent deduction.
Conversely, if s 15-2 makes the $50 assessable, then the employee will also
be entitled to a deduction (s 8-1 of the ITAA 1997) for the $50 expense
incurred, which is again tax neutral. Reimbursements are also not usually
ordinary income, but they may be subject to FBT: see Chapter 7.
Although allowances will generally fulfil the three requirements of s 15-2,
they also will usually constitute ordinary income (see [5.70]) in which case
they will be assessable as ordinary income under s 6-5 rather than s 15-2.
This is because of the contra-intention contained in s 15-2(3)(d) which
removes the application of s 15-2 if the amount is also ordinary income.
Second requirement [6.210]
The second requirement for a gain to be assessable under s 15-2 of the ITAA
1997 is that the allowance, benefit, etc is “provided to you” (i.e., the
taxpayer).
Usually, this requirement will be relatively simple for the taxpayer to fulfil.
For example, if a taxpayer has received cash, property or a benefit, like free
accommodation, it will have been “provided” to the taxpayer and this
second requirement will have been satisfied. Therefore, it is only in some
very limited circumstances that it will be unclear whether this requirement
has been met.
Case study 6.16: Free ticket due to frequent flyer points earned
from work-related travel not assessable
In Payne v FCT (1996) 32 ATR 516, the taxpayer worked for KPMG
and undertook considerable work-related travel. Payne signed up
for the Qantas Frequent Flyer program and accumulated a large
number of points due to her work-related travel. These points were
converted to free airline tickets.
The Court examined whether receipt of the free tickets was
assessable under s 26(e) of the ITAA 1936, the predecessor of s 15-
2 of the ITAA 1997. The Federal Court (single judge) held that the
free tickets were not assessable under s 26(e). One of the reasons
for this was that the equivalent of the second requirement of s 15-2
had not been met, because the benefit was due to a “crystallising of
contractual entitlements” under the Frequent Flyer program
agreement.
Third requirement [6.220]
The third requirement for a gain to be assessable under s 15-2 of the ITAA
1997 is that what has been received by the taxpayer is “in respect of, or for
or in relation directly or indirectly to, any employment of or services
rendered by the taxpayer”. This requirement will be satisfied when there is a
sufficient nexus between the receipt and services provided.
Earlier cases, such as Scott v FCT (1966) 117 CLR 514, FCT v Dixon (1952)
86 CLR 540 and Hayes v FCT (1956) 96 CLR 47, found that the nexus test
under s 15-2’s predecessor was identical to the nexus test for determining
whether a receipt is ordinary income.

However, more recent case law, such as Smith v FCT (1987) 19 ATR 274, has
seen courts take a different approach by indicating that the nexus test in s
15-2 is easier to meet than the nexus test for ordinary income. Despite this,
there still is a nexus requirement for this third requirement of s 15-2.
Courts have also explicitly stated that, in general, it is much easier to meet s
15-2’s nexus test where the taxpayer was legally entitled to the receipt
compared to when the taxpayer has received a gift: Smith v FCT (1987) 19
ATR 274; FCT v Holmes (1995) 31 ATR 71. Nevertheless, it is still possible for
gifts to pass the nexus requirements of s 15-2 under certain factual
scenarios.
Case study 6.17: Employee receipt from employer as reward for
studying assessable
In Smith v FCT (1987) 19 ATR 274, Westpac introduced a scheme to
encourage its employees to undertake study that it considered
related to banking. Under this scheme, the employer would give the
employees a certain dollar amount upon successful completion of
every subject of an approved degree and an extra amount upon
successful completion of that approved degree. At the time there
were no tertiary fees so, in effect, the employees who received this
money could use it for personal purposes. Smith was an employee
who undertook approved study and received money under this
scheme. The issue was whether the amount received under the
scheme was assessable under the predecessor to s 15-2, s 26(e) of
the ITAA 1936.
The High Court held that the taxpayer’s receipt was assessable.
Specifically, the Court addressed the nexus issue and said that
there was a sufficient nexus with employment in this case. This was
due to a combination of factors, the most important being that the
scheme existed to increase employee productivity by encouraging
them to be more highly educated. In addition, it was also an
important fact that Smith was eligible for the scheme by being
employed by the donor of the gift. The Court did not consider
whether the gain would have been assessable as ordinary income,
although it did state that it is easier for service-related gains to be
assessable under s 15-2’s predecessor than to constitute ordinary
income.
Case study 6.18: Receipt of free tickets due to frequent flyer points
lacks sufficient nexus
As discussed in Case Study [6.16], Payne v FCT (1996) 32 ATR 516
involved a taxpayer who acquired frequent flyer points through
work-related travel and used them to acquire free Qantas tickets.
The Federal Court held that this amount was not assessable under s
15-2’s predecessor (s 26(e) of the ITAA 1936) for two reasons.
First, the second requirement of s 26(e) was not satisfied: see
[6.210]. Second, the Court backed up its conclusion with another,
more convincing reason. It said that this third requirement of s 15-
2’s predecessor was not satisfied because there was an inadequate
nexus between the receipt of the free ticket and the services
provided by the employee in her capacity as a KPMG employee. It
was true that, had the taxpayer not provided services for KPMG,
and thus not done the amount of work-related travel, she would not
have earned enough points for a free ticket. However, the Court
stated that such facts were not enough to satisfy the nexus
requirements of s 15-2’s predecessor, even if its nexus test was
more lenient than required for a gain to be ordinary income. The
Court said that, on the facts, the free tickets were not a reward for
the taxpayer’s services to KPMG, but rather a reward for flying with
Qantas.

Case study 6.19: Receipt of reward money for helping to prevent an

environmental disaster was assessable
In FCT v Holmes (1995) 31 ATR 71, the taxpayer was an employee on
a shipping vessel which happened to be near a leaking oil tanker.
The leaking oil tanker was heading towards the shore; this meant
that there was a risk of the oil tanker losing most of its cargo and
causing an environmental disaster. The taxpayer and some of his co-
workers were able to use the vessel they were on to tow the oil
tanker out of danger. As a result of his effort, the taxpayer received
a payment of $23,381 “salvage reward”. The entitlement to this
reward was based on a principle in the law of Admiralty (laws
relating to ocean vessels) that an owner of salvaged property must
pay those that saved the salvaged property. The taxpayer would not
have received the reward had the efforts of towing the oil tanker to
safety been unsuccessful.
The Full Federal Court held that the reward money was assessable
under the predecessor of s 15-2. It stated that there was clearly a
nexus between the effort of the taxpayer in saving the oil tanker
and the reward money. The Court stated that the fact that the
taxpayer would not have received the money had the salvage been
unsuccessful only strengthened the case for there being a nexus
between the reward money and the services performed. In this
case, the Court did not need to consider whether the reward
constituted ordinary income, because the gain was assessable
under s 15-2’s predecessor. The predecessor of s 15-2 considered in
this case, unlike the current s 15-2, did not exclude amounts that
were also ordinary income. If this case were decided today, the
Court would first consider if the gain was ordinary income, and then
only if it decided that there was a chance that it was not ordinary
income, would the Court then proceed to apply s 15-2.
Can compensation receipts be assessable under s 15-2? [6.230]
Compensation paid to an employee takes on the form of what the employee
is being compensated for: see [10.20]. This means that compensation for
loss of salary is ordinary income and compensation paid for loss of the actual
job or some of the rights related to that job is generally capital. Could some
compensation payments that are not ordinary income be assessable under s
15-2 of the ITAA 1997?
This issue was considered in the following two cases.

Case study 6.20: Receipt of compensation payment mandated under

legislation not assessable under predecessor of s 15-2
In FCT v Inkster (1989) 20 ATR 1516, the taxpayer received
compensation from his ex-employer due to health problems
resulting from asbestos exposure that had occurred during their
previous employment relationship. This compensation payment was
for the taxpayer’s loss of earning ability rather than for his loss of
earnings. Furthermore, the payment was mandated and calculated
under legislation that applied at the time.
The Court held that the compensation was not assessable under the
predecessor of s 15-2 (s 26(e) of the ITAA 1936). The Court stated
that this was because the compensation payment was a mandatory
payment made by the ex-employer to compensate the taxpayer for
their loss of earning ability. The Court said that in contrast, if the
compensation payment had been a discretionary payment that was
paid to the taxpayer as a reward for his services, then the payment
would have fallen under s 15-2’s predecessor. However, it should be
noted that a discretionary reward for services would be very likely
to constitute ordinary income, and so would not be covered by s 15-
2 due to it excluding amounts that are ordinary income (s 15-2(3)
(d)).
It is not totally clear how the Court would have treated a
discretionary payment between the parties to compensate the
taxpayer for his loss of earning capacity; however, the Court did
appear to imply that such a payment would not be assessable under
s 15-2’s predecessor. It is also unclear how the Court would have
treated a mandated payment that was for compensation for loss of
earnings rather than loss of earning capacity. However, such a
payment would constitute ordinary income (see [10.80]) and so the
current s 15-2 could not apply to it due to s 15-2(3)(d).
Case study 6.21: Tribunal finds that receipt of compensation
payment for loss of fortnightly rostered day off assessable under
predecessor of s 15-2
In AAT Case 7752 (1992) 23 ATR 1057, the taxpayer was
compensated by his employer for losing the right to have a day off
every fortnight. The employer had unilaterally terminated the
taxpayer’s right to have a fortnightly day off and had compensated
him with three months’ salary paid over three instalments. The
Tribunal held that, while not being ordinary income, this payment
was assessable under the predecessor of s 15-2, as the taxpayer’s
employment was the cause of the payment. However, because this
is an AAT Case, it is not a binding precedent on future court
decisions.
Given the scarcity of court decisions on the issue, it is unclear to
what extent (if any) s 15-2 will cover compensation payments paid
to employees.
Section 15-2’s relationship with other tax provisions [6.240]
As discussed at [6.90], s 15-2 of the ITAA 1997 will not apply to gains that
are ordinary income, and it is wider than ordinary income in that it has a
more lenient nexus test and also applies to non-cash convertible items.
Section 23L(1) of the ITAA 1936 also states that if a gain is a fringe benefit, it
will not be assessable for income tax purposes. This means that gains that
are fringe benefits will not be assessable as ordinary income or under any
income tax provisions, including s 15-2, and may instead be subject to FBT
(which is not income tax). The precise definition of “fringe benefits” and
details about the operation of FBT are discussed in Chapter 7.
Note that, in general, most non-cash benefits provided by an employer to an
employee are fringe benefits. In some limited circumstances, cash payments
by an employer to an employee would also be regarded as a fringe benefit.
Example 6.6: Examples of the application of s 15-2
Because s 15-2 of the ITAA 1997 only applies to gains that are not ordinary
income and not fringe benefits, this leaves it with limited application. Some
examples of where s 15-2 might still operate are:
• the receipt of non-cash convertible items as a reward for volunteer work. In
such an instance, the gains would not be ordinary income as they are non-
cash convertible and they would not be fringe benefits because they have
not been provided by an employer to an employee;
• third-party payments for employment or services that are not cash
convertible, for example, the receipt of a free non-transferrable holiday by
an employee lawyer from a client of the law firm. Such receipts would not be
assessable as ordinary income because they are not cash convertible.
Furthermore, they would not be regarded as fringe benefits because they are
not provided by an employer to an employee (if the employer has arranged
for the third party to make this contribution to the employee, then it would
be regarded as a fringe benefit and would be taxed under the fringe benefits
regime: see Chapter 7); and
• third-party payments that are cash or cash convertible and have some
nexus with employment or services, but do not have a strong enough nexus
to constitute ordinary income. These would not be ordinary income due to
their insufficient nexus with the services. Furthermore, they would not be
fringe benefits as they are not provided by an employer to an employee.
Section 15-3: Return-to-work payments [6.250]
Payments made to a taxpayer as an inducement to return to work or provide
services will be assessable as statutory income under s 15-3 of the ITAA
1997. Section 15-3 does not have a contrary intention, so it will potentially
apply to payments that are also ordinary income.
Example 6.7: Return-to-work payment
Nadia works as a lawyer for a big law firm. She quits because she is
unhappy with the management of the firm. The firm would like to
re-employ Nadia and offers her a one-off payment of $20,000 on top
of her salary if she agrees to be re-employed by the firm.

If Nadia agreed to this and received the $20,000, this money would
be assessable under s 15-3.
Payments upon termination of employment [6.260]
The principle that compensation payments take on the character of what is
being compensated for is discussed at [10.20]. However, the compensation
principle does not apply to payments connected with the termination of
employment. In other words, where there is a payment connected to the
termination of employment that falls under one of the termination provisions
of the legislation, it does not matter whether the payment is compensation
for income or capital, as legislation dictates how such payments are taxed.
Depending on the precise nature of the termination payment, it may be
statutory income (such as an employment termination payment (ETP)) or
non-assessable income (such as genuine redundancy payments that are
below a certain threshold). The main termination payments include:

• ETPs: see [6.270] (for calculations on how ETP’s are taxed, see [6.370]);
• genuine redundancy payments and early retirement scheme payments:
see [6.320]; and
• payments for unused annual and long service leave: see [6.390].
Employment termination payment – Div 82 [6.270]
In general, an ETP is a payment given by an employer to the employee upon
termination. Payments can potentially be ETPs whether they are made
voluntarily, under industrial relations laws, under contractual obligations or
for some other reason. Payments can also be ETPs whether they are a result
of the employee resigning or the employer dismissing the employee,
although some redundancy payments are not regarded as ETPs: see [6.340]–
[6.380].
There are two broad sub-types of ETPs:
1. Life benefit termination payment: an ETP paid to the ex-employee for his
or her termination of employment.
2. Death benefit termination payment: a payment made after an employee
has died. This payment is usually (although not necessarily) made to a
relative of the former employee.
[6.280] Specifically, under s 82-130 of the ITAA 1997, a receipt is an ETP
when it is a payment made in consequence of termination of employment.

In other words, for a payment to be an ETP, it must be shown that the

following three requirements have been satisfied:
1. there was a payment “in consequence” of the employment termination:
see [6.290];
2. there was in fact a genuine termination of employment: see [6.310]; and
3. the payment did not fall into one of the exclusions below.

The following are specifically excluded from the definition of an ETP (ss 82-
130 and 82-135):
• superannuation payments (superannuation is subject to its own taxation
regime);
• pensions and annuities (pensions and annuities are usually taxable as
ordinary income, although annuities are also subject to statutory provisions
that usually reduce the tax payable on them: see [9.120]);
• genuine redundancy payments or early retirement scheme payments, but
only to the extent they are not above the relevant threshold (see [6.380]);
and
• a restraint of trade payment that is capital in nature: see [6.140]–[6.180].

The following payments are examples of ETPs:

• An employer voluntarily makes a payment to an employee upon retirement
(a life benefit termination payment).
• An employer makes a payment (required by an industrial award) as a result
of dismissing an employee for his or her unsatisfactory work (a life benefit
termination payment).
• An employer wrongly sacks an employee. The employee receives
compensation in a successful unfair dismissal claim (a life benefit
termination payment).
• As a result of an employee’s death, the employer makes a payment to the
employee’s spouse (a death benefit termination payment).

When is the payment “in consequence” of termination of employment?

[6.290] For a payment to be regarded as an ETP, it must be paid “in
consequence” of termination of employment. At first glance this would
appear to mean that the payment must be due to the employment
relationship ending. However, causation is never a simple matter. For
example, what is the cause of the payment to an employee of 10 years who
resigns and is given a termination payment of $12,000 based on the number
of years of service in accordance with the relevant industrial award? The
$12,000 is the result of several factors:
• the termination of employment;
• the fact that the employee worked for that employer for 10 years; and
• the terms of the relevant industrial award.
Termination of employment is one of the causes of the payment, but it is not
the only cause and probably not even the dominant cause. Case law on the
words “in consequence of termination of employment” shows that
termination of employment need only be one of the causes for the payment,
and it need not be the dominant cause for the payment to be an ETP: Reseck
v FCT (1975) 5 ATR 538; McIntosh v FCT (1979) 20 ATR 13.
Case study 6.22: Payment in consequence of termination of
employment
In Reseck v FCT (1975) 5 ATR 538, a construction worker worked on
one construction site between 25 November 1969 and 24
September 1971 and on a second site between 27 September 1971
and 11 February 1972. Both of these jobs were for the same
employer. At the end of each of the two work periods, Reseck
received a severance payment, even though the gap between the
first and second period of employment was just a weekend: see
[6.310]. For technical reasons, the Court had to accept that both
terminations were genuine. The main issue for the Court was
whether the payments were “in consequence” of termination of
employment.

The legislation being considered at the time had the requirement

that the payment be in “in consequence” of termination of
employment, which is the same as is required by the current ETP
provisions. Two out of three judges in the Full Federal Court (Gibbs
and Stephens JJ) decided that the payments were in consequence of
termination of employment. Although the language of these two
judges was different, they were in fact saying substantially the
same thing. Gibbs J stated that “in consequence” of termination
means that the payment was a result of termination of employment.
His Honour also stressed that the termination need not be the only
or even dominant cause of the payment. Here, the payments were a
result of a number of factors, including the fact that the employee’s
performance had been satisfactory, the industrial agreements and
the employment terminations. However, the payments were still “in
consequence” of termination of employment because the
terminations were one of the causes of the payments. Stephens J
stated that for the payment to be “in consequence of” termination
of employment, it must “follow on” from the termination. Like Gibbs
J, his Honour emphasised that the termination need not be the
dominant cause of the payment.

Case study 6.23: Conversion of pension entitlement to lump sum “in

consequence” of termination
In McIntosh v FCT (1979) 20 ATR 13, the taxpayer had worked for a
bank for many years. In those days compulsory superannuation was
still a few decades away, so most workers did not have
superannuation accounts. However, the employer promised a
private pension to some of its employees who had met the
requirement of a minimum length of service. Under the terms of this
entitlement, a retiring employee could convert part of the pension
to a lump sum. McIntosh retired and was entitled to the bank
pension and chose to convert half of it to a lump sum. The
legislation at the time, like the current ETP provisions, applied
where the payment was “in consequence” of termination of
employment. Under the laws of the time, if the payment was “in
consequence of termination of employment” the taxpayer would
have had to pay some tax on the lump sum. If it was not, then the
payment would have been tax free. The taxpayer argued that the
payment was not in consequence of termination of employment
because it was in consequence of the taxpayer’s decision to convert
his pension to a lump sum.
All three judges of the Full Federal Court (Brennan, Toohey and
Lockhart JJ) disagreed and decided that the lump-sum payment was
“in consequence” of termination of employment. As in Reseck v FCT
(1975) 5 ATR 538, the Court emphasised that retirement need not be the
dominant cause of the receipt in order for the receipt to be considered to be
“in consequence” of retirement. Brennan and Toohey JJ referred to Reseck v
FCT and stated that for a payment to be “in consequence” of retirement
there must be some connection between the retirement and the payment,
although retirement need not be the dominant cause. All three judges stated
that, while it was true that one of the causes of the payment was the
taxpayer’s election to convert the pension to a lump sum, the payment was
still “in consequence” of retirement. This was because if the taxpayer had
not retired, the taxpayer would not have been able to receive the lump sum.
Case study 6.24: Damages for unfair dismissal payment “in
consequence” of termination of employment
In Le Grand v FCT (2002) 51 ATR 139, the taxpayer worked as
managing director with the Business Council of Australia (BCA). BCA
terminated his employment and the taxpayer claimed that he had
been wrongfully dismissed. He sued BCA for loss of wages, loss of
reputation and some other related grounds, including the loss of
opportunity to earn money elsewhere. The case was settled without
going to court and the taxpayer was given nearly $550,000 in
compensation. Goldberg J of the Federal Court held that this
payment was “in consequence” of termination of employment. This
was because there was sufficient connection between the
compensation payment and the taxpayer’s termination. Like many
of the judges in the previous cases, Goldberg J stated that for a
payment to be “in consequence” of the termination of employment,
the termination need not be the dominant cause of the payment.

[6.300] These cases (at [6.290]) clearly illustrate the point that termination
of employment need not be the only reason a payment is received for the
payment to be considered “in consequence” of termination of employment.
However, just because a payment is given shortly after retirement does not
automatically mean that it is “in consequence of termination of
employment”. In other words, although termination of employment does not
have to be the only or a dominant cause of the payment, it still has to be
one of the causes. The fact that employment termination and the payment
happen at similar times is not enough to show causation between the
payment and retirement, per Brennan J in McIntosh v FCT (1979) 20 ATR 13.

Example 6.8: Post retirement payment not “in consequence” of

retirement
Three months before her retirement, Linda brings a new client to
the firm, which has a large impact on the firm’s profitability. The
firm voluntarily gives her a substantial bonus because of this and
ends up paying it to her one month after her retirement. Linda
would have received this bonus even if she had continued to work
for the firm.
Although the payment did occur shortly after her retirement, it
would not be regarded as “in consequence” of her retirement and
so would not be an ETP because the payment was for introducing
the new client, not because of her retirement.
Case study 6.25: Payment due to tax minimisation scheme not “in
consequence” of employment termination
In Freeman v FCT (1983) 14 ATR 457, the taxpayers worked for
Company A, which provided engineering consulting services. The
taxpayers were also shareholders and directors of Company A. The
taxpayers wanted the business transferred from Company A to
Company B, as Company B would be run through an entity that
would allow for less tax to be paid. This meant that the taxpayers
would then be employed by Company B, rather than Company A.
To facilitate this transaction, the taxpayers lent money to Company
B. Company B used this money to pay Company A for the purchase
of the engineering business and Company A then paid the taxpayers
certain sums of money. In other words, the money trail followed a
circle and ended up where it started. It went from the taxpayers to
Company B to Company A and then to the taxpayers. The taxpayers
claimed that the money they received from Company A should be
concessionally taxed as it was paid “in consequence” of termination
of employment. The Full Federal Court unanimously held the
payment was not “in consequence of” their employment ending.
The Court stated that this was partially due to the fact that the
payments from Company A were made almost 12 months after the
taxpayers had ceased working for Company A. The Court also
appeared to be highly influenced by the fact that the whole scenario
was a very contrived arrangement to reduce the amount of tax
payable, rather than a genuine redundancy payment for termination
of employment. Note: This case should not be interpreted as
meaning that a payment made 12 months after retirement cannot
be “in consequence” of employment terminating, although it does
indicate that, all other things being constant, the longer the time
lag between retirement and payment, the less likely the payment
will be “in consequence” of employment terminating.

When is there a genuine termination? [6.310]

“Termination” is defined as including cessation of employment due to
retirement, as well as cessation of employment due to the taxpayer’s death:
s 80-10 of the ITAA 1997. In most cases, it will be clear whether there is a
termination of employment. For example, where a taxpayer receives a
payment upon his or her redundancy, there will have been a termination of
employment. Where a worker dies and his or her spouse receives a payment,
there will have been a termination of employment. However, in a limited
number of cases, it might be unclear whether there has been a genuine
termination.
Case study 6.26: Fixed-term position made permanent not regarded
as “termination”
In Grealy v FCT (1989) 20 ATR 403, a university lecturer was on a
fixed-term contract. Before this contract ended, it was terminated
and the lecturer was given a permanent position by the same
employer. The Court held that there had not been a “termination” of
employment.
Case study 6.27: Termination and re-employment a few days later
may not be genuine
In the case of Reseck v FCT (1975) 5 ATR 538, discussed in Case
Study [6.18], a construction worker had his job terminated on Friday
and was re-employed the following Monday by the same employer,
but on a different construction site. For certain legal reasons, the
Court had to accept that the termination was genuine. All the Court
was asked to do was to decide whether the payment was “in
consequence” of a termination. The Court decided that it was.
However, Gibbs J did indicate that he was sceptical that there was a
genuine termination, but acknowledged that, for legal reasons, he
had to accept that there was a genuine termination.

Genuine redundancy payments and early retirement scheme

payments – Div 83 [6.320]
To the extent that genuine redundancy payments and early retirement
scheme payments do not exceed the relevant threshold, they are excluded
from being ETPs and are tax free: s 83-170 of the ITAA 1997. However, to the
extent that they are over the relevant threshold, they will be regarded as
forming part of an ETP and will be taxed as such.
What is a genuine redundancy payment? [6.330]
Under s 83-175 of the ITAA 1997, a genuine redundancy payment is a
payment made to an employee due to his or her position being genuinely
made redundant. However, this is limited to the extent that the payment
exceeds the amount that could be reasonably expected to be received if that
employee had voluntarily terminated his or her employment.
Example 6.9: Redundancy payment
Jane works for a bank. Jane was paid a genuine redundancy payout
of $30,000. To the extent the $30,000 is under the relevant
threshold (see [6.360]), it will be tax free.
What is an early retirement scheme payment? [6.340]
Under s 83-180 of the ITAA 1997, an early retirement scheme is a scheme
that satisfies all of the following conditions:
• The scheme is open to all of the employer’s employees who are in the
group that the Commissioner states are entitled to participate in the
scheme.
• The employer’s purpose in having the scheme is to reorganise the
operations in that workplace.
• The Commissioner has approved the scheme as an early retirement
scheme.
However, only the portion of the payment that exceeds the amount that
could be reasonably expected to have been received if that employee had
voluntarily terminated his or her employment is regarded as an early
retirement scheme payment.

Example 6.10: Early retirement scheme payment

Neil works as a production line worker for a clothing manufacturer.
The clothing manufacturer closes part of its operations due to
shifting production offshore. A likely scenario would be that: • the
Commissioner in writing states that this is an early retirement
scheme; and
• all the production line workers on that production line are
considered to be a group that should be eligible for the scheme;
and
• the purpose of the scheme is to reorganise the workplace in
question.
Subsequent to the Commissioner’s written approval, the employer
offers all employees on that production line $25,000 if they take a
redundancy package. This would be an early retirement scheme. To
the extent that the $25,000 would be under the relevant threshold
(see [6.360]), it will be tax free.
Further conditions for redundancy payments and early retirement
scheme payments [6.350] Sections 83-175 and 83-180 of the ITAA
1997 require that, for payments to be considered redundancy
payments and early retirement scheme payments, as well as
fulfilling the above conditions:
• the employee must be dismissed before he or she reaches the age
of 65;
• the payment must represent what would be payable under a
normal commercial arrangement; and
• there must be no arrangement at the time of dismissal that the
employee be re-employed by the employer.
Threshold [6.360]
Redundancy payments and early retirement scheme payments are not ETPs
and are tax free to the extent they are below the relevant threshold: s 83-
170 of the ITAA 1997. To the extent they are above the relevant threshold,
they will usually fall into the definition of ETPs and are taxed accordingly.
The formula for determining the relevant threshold for any given taxpayer is:
Base amount + (Service amount × Year / s of service)
The base amount and service amount are indexed every year. For the 2020–
2021 financial year, the amounts are $10,989 for the base amount and
$5,496 for the service amount.
Example 6.11: Taxation of redundancy payments
Katie has worked for her employer for 11 years. She is made
redundant and receives a payment of $80,000 on top of any annual
and long service leave entitlements.
This means that, of the $80,000 genuine redundancy payment:
• The relevant threshold for Katie would be $10,989 + ($5,496 × 11)
= $71,445. This means of the $80,000 genuine redundancy
payment, $71,445 would be tax free and the remaining portion of
the redundancy payment of $8,555 ($80,000 − $71,445) would be
taxable as an ETP.
Calculation of tax payable on ETP [6.370]
If there is an ETP, the next step is to calculate the amount of income tax
payable on the ETP. The amount of tax payable will depend on whether the
ETP is a life benefit termination payment or a death benefit termination
payment. The difference is that a life benefit termination payment is an ETP
given to a living taxpayer whose job has been terminated, whereas a death
benefit termination payment is an ETP given to someone due to the death of
another person (usually a relative): see [6.270]. For example, if a taxpayer
resigns and receives a payout from her former employer of $30,000, it will
be classified as a life benefit termination payment. An example of a death
benefit termination payment would be where a taxpayer dies and the
deceased’s employer pays his spouse $100,000 because of his death.
Where the ETP is taxed at concessional rates the concession is facilitated by
a tax rebate (offset) which effectively lowers the rate of tax. This rebate is
used to reduce the final tax liability for the employee. An important effect of
applying the concession through a tax rebate is that the total amount (less
any tax-free amount) will still be included in assessable income which can
influence other tax components such as the Medicare Surcharge.

An ETP will be taxed as follows:

• Tax-free component: ss 82-10(1), 82-65(1) and 82-70(1) of the ITAA 1997.
The tax-free component will include the following amounts (s 82-140):
1. The portion of the ETP that is attributable to pre-1 July 1983 employment:
s 82-155. For example, if the taxpayer has worked for his employer from July
1979 to July 2019, it might be reasonable to assume that 10% of an ETP is
due to his pre-1 July 1983 employment and is tax free. This is because, of his
40 years of employment, four are due to the pre-1 July 1983 period.
2. The portion of an ETP that is due to a taxpayer’s invalidity, referred to in
the legislation as an “invalidity segment”: s 82-150. For example, if a
taxpayer becomes permanently disabled due to a work injury, an ETP
received as a result will be tax free. Specifically, the portion of an ETP that
constitutes an “invalidity segment” is one:
(a) that is paid to a taxpayer due to the taxpayer being unable to work
because of his or her ill-health;
(b) where the taxpayer’s inability to work occurred before the age of 65; and
(c) where two medical doctors certify that the taxpayer is unlikely to ever be
able to be employed for the position that he or she is reasonably qualified to
work. Under s 82-150(2), the legislation puts a limit as to what portion of the
ETP can constitute an invalidity segment. This cap is based on how many
years of employment income the taxpayer has lost due to his or her
invalidity.
• Taxable component: Any portion of the ETP that is not a tax-free
component will be a taxable component: s 82-145. How the taxable
component is taxed depends on whether the ETP is a life benefit termination
payment or a death benefit termination payment. The taxable component of
a life benefit termination payment will be taxed at the rates shown in Table
6.1: s 82-10.

The threshold applied in Table 6.1 will be the lower of the following two
amounts (s 82-10(4)):
• $215,000: This figure is indexed annually and is correct for the 2020–2021
financial year.
• A $180,000 “whole-of-income cap” which is reduced by any non-ETP
taxable income of the taxpayer. This figure is fixed by legislation and not
annually indexed. Furthermore, this amount cannot be reduced below zero.
However, this threshold is unaffected by and is inapplicable to any of the
following excluded amounts (s 82-10(6)): – Genuine redundancy payments:
see [6.330]. This includes payments that are not strictly speaking genuine
redundancy payments because the taxpayer is 65 or older, but would have
been genuine redundancy payments had the taxpayer been under 65. Note
that this particular exclusion applies to the full genuine redundancy
payment, not only the part which is under the threshold discussed in [6.360].
– Early retirement scheme payments: see [6.340]. This includes payments
that are not strictly speaking early retirement scheme payments because
the taxpayer is 65 or older, but would have been early retirement payments
had the taxpayer been under 65. Note that this exclusion applies to the full
early retirement scheme payment, not only the part which is under the
threshold discussed in [6.360].
– An amount that includes an invalidity segment: see the earlier discussion
in this paragraph. This includes payments that are not strictly speaking
invalidity segments because the taxpayer is 65 or older, but would have
been an invalidity segment had the taxpayer been under 65.
– Compensation received due to employment disputes relating to personal
injury, harassment, discrimination or unfair dismissal to the extent that such
amount exceeds what the employee would have received had they
voluntarily resigned in the absence of such a dispute.
– Death benefit payments: see the earlier discussion in this paragraph.
However, note that if the taxpayer receives an ETP that has both excluded
and non-excluded components, the taxpayer is deemed to have received the
excluded component first (s 82-10(7)) and considered only against the
$215,000 cap. Also, because both non-excluded and excluded amounts have
been received, it is necessary to determine whether the $215,000 or the
$180,000 caps apply to the non-excluded ETPs.

Therefore, the $215,000 cap is first reduced by any excluded amount that
has already been applied against this cap (s 82-10(4)). An important effect of
these rules is that the total amount of an ETP payment that is capped at the
lower rate (15% or 30%, depending on age, plus Medicare levy) will not
exceed $215,000: see Example 6.16.

Example 6.12: ETP calculation

Nick aged 53 (under preservation age) resigns from his work and
receives a payment of $50,000. He has already earned $160,000 in
salary and investment income for the financial year. The full
$50,000 is regarded as an ETP. Although the $50,000 is less than
the $215,000 threshold, the $180,000 “whole-of-income cap” must
be reduced by the $160,000 taxable income (from salary and
investment income) that Nick has received, meaning that the cap is
in effect only $20,000 ($180,000 − $160,000). Since this $20,000
cap is less than the $215,000 threshold, the $20,000 cap is the one
that applies. This means that the first $20,000 of Nick’s ETP will be
capped at the tax rate in Table 6.1 at 30% plus Medicare levy (as
Nick is under preservation age). The remaining $30,000 will be
taxed at 45% plus Medicare.
Example 6.13: ETP calculation
Nathan is aged 51 (under preservation age) and made redundant
from his employment in a bank where he has been working for 11
years. He receives a genuine redundancy payment under s 83-175
of $161,445 in the current year on top of his annual and long
service leave entitlements. Had he resigned voluntarily, he would
have received only $30,000 (on top of his annual and long service
leave entitlements), leaving the rest of the payment as a genuine
redundancy payment under s 83-175. For the financial year so far,
Nathan received a salary of $250,000 and did not have any
deductions.
Nathan’s termination payment can be viewed as consisting of the
following amounts:
• $30,000 is an ETP as he would have received this amount if he
resigned and was not made redundant.
• $131,445 ($161,445 − $30,000) balance is a genuine redundancy
payment and not an ETP.

As Nathan has been working in this job for 11 years, $71,445

($10,989 + ($5,496 × 11)) of this is tax free (see [6.360]). The
remaining $60,000 ($131,445 − $71,445) is taxable as an ETP,
though it is still regarded as a genuine redundancy payment.
The total amount regarded as an ETP is therefore $90,000 ($30,000
+ $60,000).
The $60,000 portion of the ETP is an excluded amount due to it
being a genuine redundancy payment. Consequently, it is deemed
to have been received first (s 83-10(7)). As it is an excluded
amount, the “whole-of-income cap” does not apply to it, and only
the $215,000 threshold will be relevant. As the $60,000 is less than
the $215,000 threshold, the amount of tax on the $60,000 is capped
at 30% plus Medicare levy because Nathan is under his preservation
age (as, below the preservation age): see Table 6.1.
In addition, the $30,000 portion of the ETP will potentially be
subject to both thresholds. First, the $180,000 “whole-of-income
cap” is reduced (but not below zero) by the $250,000 salary he
received for the financial year, meaning that this cap becomes zero.
Second, the $215,000 threshold will be reduced by the $60,000
portion of the ETP payment (genuine redundancy excluded amount
that is not tax free) reducing it to $155,000. Since the “whole-of-
income cap” amount of zero is the lower of the two, it will be the
applicable threshold. This means that the whole $30,000 amount
will have breached this threshold and so will be taxed at the rate of
45% plus Medicare levy: see Table 6.1.
Example 6.14: ETP calculation
Amelia works for a major department store and is 61 years of age
(above preservation age). She resigns and receives a payout of
$178,000, and she has $5,000 of salary income for the financial
year. The full $178,000 is regarded as an ETP. The $180,000 “whole-
of-income cap” is reduced to $175,000 as Amelia has earned other
income ($5,000) for the financial year. As the $175,000 “whole-of-
income cap” is lower than the $215,000 threshold, the $175,000
threshold will apply. This means that the first $175,000 of Amelia’s
ETP is capped at 15% plus Medicare levy (as, she is over the
preservation age). The remaining $3,000 is taxed at the rate of 45%
plus Medicare levy: see Table 6.1.
Example 6.15: ETP calculation
William is aged 48 (under preservation age) and works for a car
importer. He loses his job and initially receives $65,000 from his
employer for ceasing employment (this did not qualify as a genuine
redundancy termination payment). This $65,000 is on top of his
annual and long service leave entitlements. He then sues his
employer for unfair dismissal, is successful, and so receives
damages of an additional $100,000. William has received other
taxable income for the financial year (his salary) of $150,000.
The full $165,000 ($65,000 + $100,000) is considered an ETP. The
$100,000 is excluded from the $180,000 “whole-of-income cap” as
it is compensation for unfair dismissal. Consequently, it is deemed
to have been received first (s 83-10(7)), and only needs to be
applied against the $215,000 threshold. As the $100,000 is below
the $215,000 threshold it would be capped at 30% plus Medicare
levy: see Table 6.1. The $65,000 portion of the ETP will be offset
against the lower of the two thresholds. First, the “whole-of-income
cap” is reduced from $180,000 to $30,000 due to the non-ETP
taxable income of $150,000. Second, the $215,000 threshold is
reduced by $100,000 to $115,000 due to the $100,000 portion of
the ETP. As the $30,000 is the lower of these two amounts, this is
the threshold that would be applicable to the $65,000 portion of the
ETP. This means that $30,000 of the $65,000 is capped at 30% plus
Medicare levy, whereas the remaining $35,000 would be taxed at
the top tax rate: see Table 6.1.
Example 6.16: Redundancy payment
Mia is aged 66 (above preservation age) and works for an electronic
parts distributor. Due to illness, she becomes unable to work and
resigns. Her work pays her $60,000 which is what she would have
received had she resigned under any situation (this $60,000 is on
top of her annual and long service leave entitlements), and an
additional $160,000 as an invalidity payment. Before her illness Mia
had earned taxable income of $70,000 (her salary) for the financial
year.
Although the full $220,000 ($160,000 + $60,000) is regarded as an
ETP, the $160,000 invalidity payment is excluded from the “whole-
of-income cap”. This is despite the fact that none of the invalidity
payment is tax-free due to Mia being 66 years old (over 65).
The $160,000 excluded portion of the ETP is dealt with first as it is
deemed to have been received first (s 83-10(7)) and only needs to
be tested against the $215,000 threshold. As the $160,000 is below
the $215,000 threshold, it is capped at the rate of 15% plus
Medicare levy: see Table 6.1. The remaining $60,000 is potentially
subject to the two thresholds. First, the “whole-of-income cap” is
reduced from $180,000 to $110,000 due to the $70,000 salary.
Second, the $215,000 threshold is reduced due to the $160,000
portion of the ETP being offset against it. This will mean that the
$215,000 threshold is reduced by the $160,000 to $55,000. As
$55,000 is the lesser of these two thresholds, it will be the relevant
amount. Consequently, $55,000 of the $60,000 will be capped at
15% plus Medicare levy, and the remaining $5,000 will be taxed at
45% plus Medicare: see Table 6.1.
[6.380] Taxation of the taxable component of a death benefit termination
payment depends on whether the recipient of the payment is a “dependent”
of the deceased. Under s 302-195 of the ITAA 1997, the recipient will be a
dependent if he or she is:
• the deceased’s spouse or ex-spouse (spouse will also include de facto and
same-sex partners in some circumstances);
• the deceased’s child who is under 18;
• a person who had an “interdependency relationship” with the deceased.
This means someone who the deceased lived with and had a close personal
relationship with. Furthermore, for someone to show he or she had a
“interdependency relationship” with the deceased, it is also required that at
least one of the parties involved provided financial support and at least one
of the parties involved provided domestic support; or
• anyone else dependent on the deceased before he or she died (this would
cover financial dependence).
The taxable component of a death benefit termination payment is taxed at
the rates shown in Table 6.2: ss 82-65 and 82-70.
Payments for unused annual and long service leave – Div 83 [6.390]
When an employee has his or her employment terminated, it is normal for
the employee to receive a lump-sum payment for any annual (holiday) leave
and long service leave owing to the employee. These receipts are assessable
as statutory income under s 83-10 of the ITAA 1997 for the annual leave
payments and s 83-80 for the long service leave payments. In many cases,
these provisions provide no tax concession as the annual leave and long
service leave payments are taxed at normal marginal tax rates. However,
under some limited circumstances, a concession in the form of the payments
being capped at the rate of 30% (plus Medicare levy) will apply. Under s 83-
15 of the ITAA 1997 (for annual leave) and s 83-85 of the ITAA 1997 (for long
service leave), this will be the case when:
• the payment was due to annual leave or long service leave accrued due to
services performed before 18 August 1993; or
• the payment was in connection with a payment that consists of a genuine
redundancy payment or early retirement scheme payment, or an invalidity
segment of an ETP.
Also, only 5% of any leave accrued prior to 16 August 1978 is subject to tax
(s 83-80).
Example 6.17: Annual and long service leave payment
Jack has worked for his current employee since January 2000 and he
resigns voluntarily. Under the relevant industrial award, he is
entitled to receive $10,000. Furthermore, he receives $12,000 in
annual and long service leave owing to him.
The $10,000 will be assessable as a life benefit termination
payment (a type of ETP) and the $12,000 in leave entitlements will
be assessable at normal marginal tax rates.
Example 6.18: Genuine redundancy and annual leave payment
Jill has worked for her current employee for three years and is made
redundant. She receives a genuine redundancy payment of $6,000,
as well as an ETP of $10,000. She also receives a $9,000 payment
for annual leave that is owed to her:
• The $6,000 will be tax free because it is below the maximum tax
free amount of $25,999 ($10,399 + ($5,200 × 3)).
• The $10,000 will be taxed as a life benefit termination payment
(ETP).
• The $9,000 will be subject to normal marginal tax rates, but will
be capped at the rate of 30% (plus Medicare levy) because it was
paid in connection with a genuine redundancy payment.

Questions [6.400]
6.1 During the current tax year, Erin received the following
amounts:
• Salary and wages income of $98,000.
• $4,200 interest from a bank term deposit of $50,000.
• $500 per week for 50 weeks of the year from a rental property she
owns.
• Winnings of $10,000 on the poker machines.
• $500 from selling eggs that her chickens laid to friends.
• A holiday bonus of $1,000 from her employer.
• A watch worth $200 from a happy client. What is Erin’s ordinary
income for the current tax year?
6.2 Jane and Sally are employed school teachers who have a very
wide general knowledge. Both decide to enter a television quiz
program called “Lease of the Decade”. Under the rules, contestants
receive $100 for each appearance, but if questions are answered
correctly, they receive substantial cash prizes and other prizes,
such as household items and holiday packages. The holiday
packages cannot be transferred or redeemed, but the organisers of
the program allow them to be converted into alternative venues and
accommodation.
Jane and Sally go on the show but Jane is eliminated in the first
contest and receives her $100. Sally, however, makes 10
appearances. She wins cash prizes of $50,000, household
appliances worth $20,000 and a trip to Europe with her family
valued at $30,000. Discuss the assessability of these prizes.
6.3 Hilary is a well-known mountain climber. The Daily Terror
newspaper offers her $10,000 for her life story, if she will write it.
Without the assistance of a ghost writer, she writes a story and
assigns all her right, title and interest in the copyright for $10,000
to the Daily Terror. The story is published and she is paid. She has
never written a story before. She also sells the manuscript to the
Mitchell Library for $5,000 and several photographs that she took
while mountain climbing for which she receives $2,000.
Discuss whether or not the three payments are income from
personal services. Would your answer differ if she wrote the story
for her own satisfaction and only decided to sell it later?
6.4 George is manager of Newcastle Steel Ltd. His contract is for 10
years. In the third year, George enters into a restrictive covenant
which provides that during the remainder of his contract he must
not reveal to another party the confidential information of his
employer. It further provides
that he must not work for a competitor during the remainder of the
employment agreement. Consideration for entering into the
agreement is $40,000. Is this capital or income in George’s hands?
6.5 A well-known television personality was paid a lump sum of
$400,000 to encourage her to join a new television network. She
accepted the offer and received an annual salary of $100,000 in
addition to the lump-sum payment. Discuss whether both the
$400,000 and the $100,000 receipts are assessable income.

6.6 Consider the following situations and discuss whether or not

they are income in ordinary concepts:
• A cash prize for being the best student in income tax law received
by a student who also receives a Youth Allowance from the
government.
• A gratuity (not being superannuation) received by a widow from
her husband’s former employer in recognition of her husband’s
services.
• An honorarium received by a student for acting as honorary
secretary of a small country town football club.
• A bonus received by an employee for a suggestion adopted by the
management.
6.7 Jane teaches company law at a regional university. For many
years she has had a passionate interest in amateur theatricals. She
has performed with several local groups. On 30 December Arthur
asked Jane if she would be interested in performing in the next
production of the group with which he performs. Jane, who has
several weeks free from performing, eagerly agrees. Jane has only
worked with this group once before, six years ago. After the last
performance, Charles, the producer of the play, handed Jane an
envelope which she assumes contains a thank-you card for
performing in the play. Jane opened the envelope late the next
morning and discovered that, in addition to a thank-you card, there
is a cheque for $49.28 for participating in the production. Jane has
never before been paid for appearing in any of the 60 productions
in which she has been involved. Jane endorsed the cheque to her
landlord as part-payment of her rent. Advise Jane of her income tax
liability with respect to $49.28.
6.8 Frederick has been out of work for the past five years, and he
has been using the Findjobs Ltd employment agency for the past 12
months to find employment. In April of this year a new case
manager, Albert, was given the task of finding Frederick a job. In a
matter of 10 days Albert had Frederick a permanent job. In
gratitude, Frederick bought a $1,000 gold watch (it was a very good
job he landed) and gave it to Albert as a mark of his appreciation.
Advise Albert as to whether this gift is assessable income.

6.9 Nadia is an accountant in a large accounting firm. She is on a

three-year contract, which still has two years to go. Her official job
title is “Manager” and under her contract she is entitled to her own
private office.
• Nadia is offered $6,000 if she changes her job title to “Senior
Accountant”, with no change in pay or length of the contract. She is
also offered $4,000 by her employer if she agrees to give up her
private office. She agrees to this.
• Advise Nadia as to her income tax liability with respect to the
$6,000 and $4,000 payments.
6.10 Dan is made redundant from his job that he has been working
for four years and receives $50,000 as a genuine redundancy
termination payment. Before the redundancy, Dan had earned
$120,000 for the tax year.
Advise Dan as to the tax implication of receiving the $120,000.
6.11 Bev is dismissed from her job and receives a $80,000
redundancy amount (not a genuine redundancy termination
payment). She then sues her ex-employer for unfair dismissal and
settles for $140,000. As the dismissal was early on in the tax year,
she had only received $20,000 in salary for the year.
Advise Bev as to the tax implications of the receipts of the $80,000
and $140,000 amounts.
6.12 Karen has been working in the same place for 15 years and
made redundant. She receives a genuine redundancy payment of
$200,000, after earning a salary of $90,000 in the current year.
Upon her redundancy, she also receives accrued unpaid leave of
$80,000. Advise Karen as to the tax implications of the $200,000
and $80,000 amounts.
Chapter - 7 Fringe benefits tax
Key
points ............................................................................................
......... [7.00]
Introduction...................................................................................
............... [7.10]
Definition of fringe
benefit .......................................................................... [7.20]
Benefit ..........................................................................................
................ [7.30]
Provided during the year of
tax ................................................................... [7.40]
Employer, associate or third-party
arranger ............................................... [7.50]
Employee or
associate .................................................................................
[7.60]
In respect of the employment of the
employee ......................................... [7.70]
Exclusions......................................................................................
................ [7.80]
Categories of fringe
benefits ........................................................................ [7.90]
Car fringe benefits – Div
2............................................................................. [7.100]
Exempt
benefits..........................................................................................
... [7.110]
Taxable
value..............................................................................................
... [7.120]
Debt waiver fringe benefits – Div
3 .............................................................. [7.150]
Taxable
value..............................................................................................
.... [7.160]
Loan fringe benefits – Div
4 ........................................................................... [7.170]
Exempt
benefits..........................................................................................
.... [7.180]
Taxable
value..............................................................................................
.... [7.190]
Expense payment fringe benefits – Div
5 ..................................................... [7.200]
Exempt
benefits..........................................................................................
... [7.210]
Taxable
value..............................................................................................
... [7.220]
Meal entertainment fringe benefits – Div
9A .............................................. [7.230]
Taxable
value..............................................................................................
... [7.240]
Property fringe benefits – Div
11 ................................................................. [7.250]
Exempt
benefits..........................................................................................
.. [7.260]
Taxable
value..............................................................................................
.. [7.270]
Residual fringe benefits – Div
12 ................................................................. [7.280]
Exempt
benefits..........................................................................................
.. [7.290]
Taxable
value..............................................................................................
... [7.300]
Exempt fringe
benefits .................................................................................
[7.310]
Minor benefits – s
58P.................................................................................. [7.320]
Work-related items – s
58X.......................................................................... [7.330]
Membership fees and subscriptions – s
58Y ............................................... [7.340]
Single-trip taxi travel – s
58Z ....................................................................... [7.350]
Reductions in taxable
value ......................................................................... [7.360]
In-house fringe
benefits ...............................................................................
[7.370]
Recipient’s
contribution ...............................................................................
[7.380]
Otherwise deductible
rule............................................................................. [7.390]
Type of fringe
benefit ...................................................................................
[7.400]
Fringe benefits taxable
amount.................................................................... [7.410]
FBT
liability ..........................................................................................
......... [7.420]
Interaction with income
tax......................................................................... [7.430]
Employer .......................................................................................
............... [7.430]
Employee.......................................................................................
............... [7.440]
Interaction with
GST ....................................................................................
[7.450]
Questions ......................................................................................
............... [7.460]
Key points [7.00]
• Fringe benefits tax is a different type of tax as it is imposed on the
provision of fringe benefits, rather than the derivation of income.
• Liability for fringe benefits tax is imposed on employers, not employees.
• A “fringe benefit” arises where an employer provides an employee with a
benefit, directly or indirectly, and the benefit is provided due to the
employment relationship.
• There are 13 categories of fringe benefits, and the calculation of the fringe
benefits tax liability arising in relation to a particular fringe benefit will
depend on its category.
• A number of benefits do not attract fringe benefits tax because they are
either excluded from the definition of “fringe benefit” or specifically made
exempt by the fringe benefits tax legislation.
• Fringe benefits tax paid by an employer and the cost of providing a fringe
benefit are generally deductible to the employer for income tax purposes.
• The receipt of fringe benefits by an employee is either exempt or non-
assessable, non-exempt income to the employee.
Introduction [7.10]
The introduction of a fringe benefits tax (FBT) was announced by then
Treasurer, the Hon Paul Keating, on 19 September 1985 and came into effect
on 1 July 1986. FBT was introduced to tax the provision of fringe benefits
(i.e., benefits other than salary) by employers to employees. At the time it
was estimated that almost 20% of the total remuneration of senior white-
collar employees comprised benefits other than salary: Reform of the
Australian Tax System, Draft White Paper (AGPS, Canberra, 1985) at 96. The
introduction of s 26(e) of the Income Tax Assessment Act 1936 (Cth) (ITAA
1936) (now s 15-2 of the Income Tax Assessment Act 1997 (Cth) (ITAA 1997))
(see [6.190]–[6.240]) was inadequate in capturing all non-cash benefits
provided by employers to employees within the tax system.
In particular, the section did not capture benefits provided to associates of
employees (e.g., spouses) and included in the employee’s assessable
income “the value to the taxpayer” of the benefit, which is a subjective
assessment. As will be seen, the FBT regime has a very wide scope and
captures all benefits provided in an employment context. It is through the
exclusions (see [7.80]) that some employment benefits, such as salary, are
subject to income tax in the employee’s hands. There are also a number of
exemptions that exclude certain employment benefits from tax altogether.
FBT is a different type of tax in that it is a tax that is imposed on the
provision of fringe benefits, rather than the derivation of income. As
discussed in Chapter 3, separate legislation is required for the imposition of
different taxes. The provisions regarding FBT are contained in the Fringe
Benefits Tax Assessment Act 1986 (Cth) (FBTAA) and the Fringe Benefits Tax
Act 1986 (Cth).
A key difference between income tax and FBT is the taxpayer. FBT is
imposed on the employer, not the employee: s 66(1) of the FBTAA. As such,
tax is imposed on the provision of fringe benefits, not on the receipt of them.
The imposition of FBT on the employer rather than the employee reduces the
administrative burden as there are far fewer employers than employees.
A second difference between the FBT system and the income tax system is
the tax year. Unlike the income tax year, which is from 1 July to 30 June, the
FBT year is from 1 April to 31 March: see definition of “year of tax” in s
136(1) of the FBTAA. The very first FBT year was a transitional year of only
nine months for the period 1 July 1986 to 31 March 1987. The different FBT
year spreads the tax compliance burden to a different time in the year,
ensuring that taxpayers and tax agents are able to meet their income tax
and FBT obligations in a timely manner.
The FBT legislation adopts a largely prescriptive and methodical approach to
determining the FBT consequences of a transaction. For example, the
legislation specifies what constitutes a fringe benefit, whether or not it is
subject to FBT, the value of the fringe benefit for FBT purposes and the
method of calculating the FBT liability. This step-by-step approach should be
adopted when determining the FBT consequences of a transaction. Figure
7.1 provides an overall guide to dealing with the tax consequences arising
on the provision of fringe benefits.
Definition of fringe benefit [7.20]
The term “fringe benefit” is defined in s 136(1) of the FBTAA and is central to
the imposition of FBT.
The first part of the definition provides that a fringe benefit exists, where
there is:
• a benefit: see [7.30];
• provided during the year of tax: see [7.40];
• by an employer, associate or third-party arranger: see [7.50];
• to an employee or an associate: see [7.60];
• in respect of the employment of the employee: see [7.70].

This very broad definition of “fringe benefit” essentially captures all benefits
provided by an employer to an employee, whether or not the benefits are
convertible to money. Importantly, the definition then excludes a number of
specific employment benefits (such as salary) from being “fringe benefits”:
see [7.80]. Note that FBT only applies to benefits received in an employment
context. Any benefits provided in the context of other working
arrangements, such as where independent contractors are engaged or
partners in a partnership, will fall outside the scope of FBT.
Benefit [7.30]
The term “benefit” is defined in s 136(1) of the FBTAA and includes any
right, privilege, service or facility provided under an arrangement in relation
to the performance of work. This definition is very wide and is likely to
capture most benefits provided by an employer to an employee, whether of
a monetary or non-monetary nature.
As we will see at [7.90], the legislation identifies a number of specific
categories of fringe benefits (such as private use of an employer-provided
car and loans) but there is an important final category, residual benefits (see
[7.280]), which captures any benefits that do not fall within the specific
categories and ensures the broad scope of the term “benefit”. Section 6 of
the FBTAA confirms this by providing that the specific categories of fringe
benefits do not limit the generality of the expression “benefit”.
While the scope of the term “benefit” is certainly broad, it is not unlimited. In
Slade Bloodstock Pty Ltd v FCT (2007) 68 ATR 911 (see Case Study [7.4]),
the Full Federal Court suggested that, where an employee makes a loan to
an employer, the repayment of the loan by the employer to the employee, in
whole or in part, is unlikely to constitute a “benefit” (to the employee) under
the definition of “benefit” in s 136(1) which includes a right, benefit,
privilege, service or facility that is provided under an arrangement for, or in
relation to, the lending of money.
Provided during the year of tax [7.40]
FBT is imposed annually and tax is imposed on fringe benefits provided
during, or in reference to, a particular FBT year – that is, 1 April to 31 March.
The term “provide” is defined in s 136(1) of the FBTAA. In relation to
benefits, it includes “allow, confer, give, grant or perform” and, in relation to
property, the disposal of a beneficial interest in or legal ownership of the
property. This definition is generally consistent with the common meaning of
the term. A benefit may also be deemed to be provided, where the benefit is
prohibited but the prohibition is not consistently enforced: s 148(3).

For example, where an employee is prohibited from using an employer-

provided car for private purposes but the employer “turns a blind eye”, the
private use of the car is a fringe benefit (see [7.100]) deemed to be provided
by the employer per s 148(3). Section 148(4) further specifies that a benefit
that is received or obtained by an employee in respect of employment is
deemed to be “provided”. This ensures that fringe benefits that are supplied
to an employee by a party other than the employer (see [7.55]–[7.58]) are
nonetheless “provided” by the employer.
Case study 7.1: Meaning of “provide”
In Westpac Banking Corporation v FCT (1996) 34 ATR 143, Hill J
considered the meaning of “provide” in an FBT context. The
taxpayer usually charged its customers a loan establishment fee
when entering into a loan arrangement. However, the fee was
waived in the case of loans made to employees. The taxpayer
argued that the definition required a positive act for a benefit to be
“provided”. The non-imposition of a fee could not be said to be a
benefit “provided” by the taxpayer. The Federal Court accepted the
Commissioner’s argument that the taxpayer had “provided” its
employees with a benefit – that is, the review and assessment of
the employee’s loan application for no fee.
Employer, associate or third-party arranger [7.50]
“Employer” is defined in s 136(1) of the FBTAA as a person who pays, or is
liable to pay, “salary or wages”. “Salary and wages” is discussed at [7.85].
Section 137 ensures that the FBT legislation applies in situations where there
is a clear employment relationship, but the employee is remunerated with
non-cash benefits instead of salary or wages. In other words, an employer
cannot escape being an “employer” under the FBT legislation by not paying
an employee salary and wages but providing non-cash benefits instead.
The definition includes current, former and future employers, but excludes
the Commonwealth or an authority of the Commonwealth. A “future
employer” is a person who will become a current employer, while a “former
employer” is a person who has been a current employer: s 136(1). The scope
of past and future employment relationships is discussed further at [7.60] in
the context of the definition of “employee”.
[7.55] It is important to note that a benefit does not have to be provided by
an employer to an employee directly to qualify as a fringe benefit. Benefits
provided by an associate of the employer may also qualify as a fringe benefit
provided by the employer. The definition of “associate” in s 136(1) refers to s
318 of the ITAA 1936 and s 159 of the FBTAA.
Where the employer is a “natural person”, the employer’s associates include:

• relatives;
• a partner of the employer and their spouse or child;
• a partnership in which the employer is or was a partner;
• trustees of trusts where the employer or the employer’s associates may be
a beneficiary; and
• companies formally or informally controlled by the employer (formal
control refers to a majority voting power in the company while informal
control refers to situations where the directors of a company usually act in
accordance with the employer’s directions).
“Relative” is defined in s 995-1 of the ITAA 1997 as a person’s spouse or that
person’s parent, grandparent, sibling, uncle, aunt, nephew, niece, lineal
descendant or adopted child of that person or that person’s spouse. The
spouse of any of these people is also a relative. “Spouse” is defined in s 995-
1 to include de facto and same sex relationships.
Where the employer is a “company”, its associates include:
• a partner (and their spouse or child if the partner is a natural person);
• a partnership in which the employer is or was a partner;
• companies which formally or informally control the employer;
• companies which are formally employer; and
• sister companies (i.e., companies with the same parent company). Section
159 specifies when authorities of the Commonwealth, a State or Territory are
associates.

Example 7.1: Fringe benefits from associates

Company A and Company B are part of the same wholly-owned
group, that is, they are owned by the same parent company. Jack is
an employee of Company A. Under the terms of his employment
contract, he is entitled to a 25% discount on goods purchased from
Company B. The provision of the goods at a discount by Company B
qualifies as a fringe benefit provided by Jack’s employer (Company
A) to Jack, as Company B is an associate of Company A under s 318
of the ITAA 1936.
[7.58] Fringe benefits can also be provided by an employer to an employee
indirectly through third-party arrangements. Although the benefit is provided
to the employee by a third party, it qualifies as a fringe benefit from the
employer to the employee where the third party does so under an
arrangement with the employer. Note that the employer must “participate in
or facilitate the provision or receipt of the benefit” for the benefit to qualify
as a fringe benefit: see para (ea) of the definition of “fringe benefit” in s
136(1) of the FBTAA. Paragraph (ea) was introduced following Payne v FCT
(1996) 32 ATR 516: see Case Studies [6.16] and [6.18]. In Ruling TR 1999/6,
the Commissioner confirms that frequent flyer points earned by an employee
for work-related travel do not constitute a fringe benefit as they have not
been provided by an employer, associate of the employer or a third-party
arranger. The frequent flyer points do not arise out of an arrangement
entered into by the employer with the airline, but are due to a private
arrangement between the employee and the airline.
Example 7.2: Fringe benefits from a third party
Big Bank waives the home loan application fees for all university
employees and provides them with a discount of 0.5% on the home
loan rate it offers all other customers. It waives the application fee
as it considers university employees “low risk” and it provides the
discounted home loan rate due to an arrangement with the
university whereby, in return, the university agreed to deal
exclusively with Big Bank.
The waiver of loan application fees does not qualify as a fringe
benefit as it does not arise through an arrangement between Big
Bank and the university but is a unilateral action by Big Bank. The
provision of the discounted home loan rate qualifies as a fringe
benefit provided by the university to its employees as it arises
under an arrangement between Big Bank and the university and has
therefore been facilitated by the university.

Example 7.3: Fringe benefits from third party under arrangement

Jack is an employee of Company A. Under the terms of his
employment contract, he is entitled to a discount for goods
purchased from various retailers, such as Coles and Woolworths,
pursuant to agreements in place between Company A and those
retailers.
The provision of goods at a discount by Coles and Woolworths
qualifies as a fringe benefit provided by Jack’s employer (Company
A) to Jack as the discount has been provided pursuant to an
arrangement between Company A and the retailers.
As mentioned at [7.40], s 148(4) ensures that fringe benefits that are
supplied by an associate of the employer or a third party are nonetheless
“provided” by the employer for the purposes of the FBT legislation. In this
chapter, any reference to the provision of fringe benefits by an employer is
intended to also include the provision of fringe benefits by associates of the
employer or third-party arrangers.
Employee or associate [7.60]
An “employee” is someone who receives salary and wages and includes
current, former and future employees: s 136(1) of the FBTAA. The term
“salary and wages” is discussed at [7.85].
A “future employee” is a person who will become a current employee, while
a “former employee” is a person who has been a current employee: s 136(1).
The extension of the definition of “employee” to cover former and future
employees ensures that benefits provided prior to the commencement of
employment (e.g., sign-on bonuses) or provided to former employees as a
result of the former employment relationship (e.g., low interest loans) are
captured by the FBT legislation. In Ruling MT 2016, the ATO confirms that a
person will only qualify as a future employee if it can be said that the person
will (not may) become an employee at the time the benefit is provided.
[7.65] A fringe benefit can also arise where the benefit is not provided to an
employee directly, but to an associate of an employee. This aspect of FBT
overcomes a limitation of s 15-2 of the ITAA 1997 (previously s 26(e) of the
ITAA 1936), which only captures the provision of benefits to an employee
directly. The meaning of “associate” was discussed at [7.55]. A person will
also be deemed to be an “associate” of the employee, where a benefit is
provided to the person due to an arrangement between the employer and
the employee: s 148(2). For example, where a benefit is provided to a friend
of an employee, the friend is not an “associate” of the employee under the
definition of “associate”, but is deemed to be an associate per s 148(2) of
the FBTAA.
Example 7.4: Provision of fringe benefits to associates
Simon is an employee of Company A. Under the terms of his
employment agreement, he and his wife are entitled to one free
interstate trip per year. The provision of the free trip to Simon’s
wife qualifies as a fringe benefit as it is provided by Simon’s
employer, Company A, to his associate – his wife.
The term “recipient” is used in this chapter to refer to an employee or an
associate of an employee. Note that in order to constitute a fringe benefit,
the benefit provided must relate to a particular employee: Essenbourne Pty
Ltd v FCT (2002) 51 ATR 629; FCT v Indooroopilly Children Services (Qld) Pty
Ltd (2007) 158 FCR 325.

In respect of the employment of the employee [7.70]

Finally, and most importantly, the benefit must be provided in respect of the
employee’s employment to qualify as a fringe benefit. As well as the
exclusions and exemptions, this is one of the key features of the FBT regime,
which ensures that only targeted benefits are subject to FBT. The definition
of “in respect of” in s 136(1) of the FBTAA specifies that, to qualify as a
fringe benefit, the benefit must be provided “by reason of, by virtue of, or for
or in relation directly or indirectly to, that employment”.
While most benefits provided by an employer to an employee would
generally be provided in respect of employment, this is not necessarily
always the case and the scope of this nexus requirement has been the
subject of judicial consideration. In J & G Knowles & Associates Pty Ltd v FCT
(2000) 44 ATR 22, the Full Federal Court said: The words “in respect of” have
no fixed meaning. They are capable of having a very wide meaning denoting
a relationship or connection between 2 things or subject matters. However,
the words must, as with any other statutory expression, be given a meaning
that depends on the context in which the words are found ... [W] hat is
required is a sufficient link for the purposes of the particular legislation. It
cannot be said that any causal relationship between the benefit and the
employment is a sufficient link so as to result in a taxable transaction.
Their Honours proceeded to suggest that, for the benefit to constitute a
fringe benefit, there must be a “sufficient and material relationship” between
the employment and the provision of the benefit.

Case study 7.2: “In respect of the employment”

In J & G Knowles & Associates Pty Ltd v FCT (2000) 44 ATR 22, the
taxpayer, a company, was the trustee of a unit trust. The units in
the unit trust were held by the family trusts of the four directors of
the company. The company permitted the directors to write cheques
for personal expenses on the company’s cheque account and the
amounts were treated as loans to the directors’ family trusts. The
directors were employees of the company for FBT purposes.
The question arose as to whether the loans were provided to the
directors in their capacity as directors and therefore in respect of
their employment (making the loans fringe benefits), or whether
the loans were provided because the directors were the
beneficiaries of family trusts (in which case the loans would not be
fringe benefits). The facts pointed in both directions. The directors
drew upon the trust’s assets as these assets were ultimately held
and applied for their benefit, but it was only because of their
position as directors of the company that they were permitted to do
so. The Court remitted the matter to the AAT to re-examine the
facts, but with the benefit of the guidance on the nexus
requirement mentioned above. The AAT found that the loans were
not made to the directors in their capacity as directors but because
they were the “ultimate owners of the business and its assets” and,
as such, the loans were not fringe benefits: Re J & G Knowles (2000)
45 ATR 1101.
Case study 7.3: Loan to company directors and shareholders not “in
respect of employment”
In Starrim Pty Ltd v FCT (2000) 44 ATR 487, the taxpayer was a
company owned by a husband and wife who were the only
shareholders and directors of the company. The company lent the
husband and wife money to purchase a block of land. The block of
land was the site of a business which had just been purchased by
the company and it was therefore in the company’s interests for the
transaction to take place. Lindgren J concurred with the AAT’s
conclusion that the taxpayer had made the loan because the
husband and wife were the purchasers of the property and not in
respect of their employment.
Case study 7.4: Repayments of loans, not fringe benefits
In Slade Bloodstock Pty Ltd v FCT (2007) 68 ATR 911, the taxpayer
company
provided loans to Mr and Mrs Slade, who were its sole shareholders.
The Slades made a series of loans to the taxpayer on the basis that
the taxpayer would repay any amounts owing at call and that the
taxpayer would direct the payments to any parties nominated by
the Slades. The loans represented the taxpayer’s only source of
working capital and, over time, the taxpayer paid a number of the
Slades’ private expenses such as children’s school fees or private
credit card balances. These payments were set off against the
amounts owing to the Slades. The Commissioner assessed the
taxpayer for FBT on the basis that the payments of the Slades’
private expenses (i.e., the loan repayments) constituted fringe
benefits. At issue was whether the payments had been made “in
respect of the employment of an employee”. The Slades accepted
that through their actions they were employees of the company, but
contended that the payments were made as a consequence of their
being creditors of the company and not because of the employment
relationship.
The AAT found in favour of the taxpayer but a single judge of the
Federal Court, Heerey J, found in favour of the Commissioner. By the
time the case reached the Full Federal Court, the Commissioner had
conceded that the payments were not in respect of the Slades’
employment as “there was no material relationship” between the
employment and the payments. In doing so, the Commissioner
accepted that the repayment of a loan owed by an employer to an
employee is not a benefit that is provided in respect of
employment, at least where there is a binding obligation to repay
the loan under the loan agreement and the obligation is imposed
without reference to the employment of the lender.

In such cases, the repayments are a product or incident of the

creditor/debtor relationship. The Full Federal Court noted that this
position is consistent with the policy of the FBT legislation, which is
to capture benefits that would have been income if provided as cash
to the employee.
[7.75] The scope of the requirement that the benefit be provided in respect
of the employment of the employee is potentially widened by s 148(1) of the
FBTAA, which states that a benefit is provided in respect of the employment
of the employee regardless of whether the benefit:
• is also provided in respect of another matter or thing;
• relates to past, current or future employment;
• is surplus to the needs or wants of the recipient;
• is also provided to another person;
• is offset by any inconvenience or disadvantage;
• is provided or used in connection with the employment;
• is in the nature of income; and
• is a reward for services rendered or to be rendered by the employee.
In Rulings MT 2016 and MT 2019, the ATO suggests that s 148(1) should not
be read as broadening the scope of FBT beyond the targeted benefits. In
Ruling MT 2016, the ATO states: Sub-section 148(1) seeks to anticipate
arguments that might otherwise be put so as to narrow the defined meaning
of “fringe benefit”. The subsection is based in part on experiences of
difficulties with the practical application of para 26(e) of the Income Tax
Assessment Act 1936 [now section 15-2 of ITAA 1997]. Sub-section 148(1)
does not remove in any circumstances, the fundamental requirement that,
before there can be a tax liability, the benefit under consideration has to be
provided in respect of the employment of the employee.
In Ruling MT 2019, the ATO suggests that a benefit provided to an employee
who is also a shareholder will not constitute a fringe benefit if it is provided
to the person solely because they are a shareholder. This is despite the fact
that s 148(1) deems the benefit to be provided in respect of employment.
Despite the ATO’s guidance, the application of s 148(1) remains uncertain. In
FCT v Slade Bloodstock Pty Ltd (2007) 68 ATR 911 (see Case Study [7.4]),
Heerey J found that payments by an employer to its employees, which were
loan repayments arising out of the debtor/creditor relationship, were
nonetheless fringe benefits due to the operation of s 148(1). By the time the
case reached the Full Federal Court, however, the ATO conceded that the
payments were not fringe benefits. Therefore, the operation of s 148(1) was
not fully considered by the Full Federal Court.
It is particularly important to ascertain whether a benefit is provided “in
respect of employment”, where there is another relationship between the
employer and the employee since that other relationship may be the reason
for the provision of the benefit. Essentially, for a benefit to be in respect of
the employee’s employment, the benefit must be provided to the person
because he or she is an employee and not for some other reason. The ATO’s
Fringe Benefits Tax: Guide for Employers (NAT 1054) suggests (at s 1.1) that
a useful question to ask when determining whether a fringe benefit is
provided “in respect of employment” is whether the person would have
received the benefit if he or she were not an employee. Where there is an
employment relationship as well as a family relationship, it is necessary to
consider whether the benefits are provided in an ordinary family setting and
would have been a normal incidence of family relationships.
Example 7.5: Benefit not provided in respect of employment
Kim works in the family business owned by his parents, which
imports furniture from overseas. For his birthday, Kim’s parents
gave him an expensive piece of furniture from the shop.

Although Kim is an employee who has received a benefit from his

employer, the benefit does not qualify as a fringe benefit as Kim did
not receive the benefit in respect of his employment. The benefit
was received by him due to the private, family relationship between
him and his employer. Source: Adapted from Example 2 (1.1 What is
a fringe benefit?) in the ATO’s Fringe Benefits Tax: Guide for
Employers (NAT 1054).
Example 7.6: Benefit not provided in respect of employment
Nora is an employee of Company X. She also owns shares in
Company X, which she purchased because all shareholders are
entitled to a 10% discount on goods sold by Company X. Nora
purchases goods from Company X at a 10% discount.
Although Nora is an employee who has received a benefit from her
employer, the benefit does not qualify as a fringe benefit as Nora
did not receive the benefit in respect of her employment. Rather,
the benefit was received by her in her capacity as a shareholder.
Example 7.7: Benefit provided in respect of employment
Janet is an electrician. She is employed under the terms of a
particular industrial award. The award requires Janet’s employer to
reimburse her for all travel expenses. Janet’s employer reimburses
her for her travel expenses in accordance with the terms of the
award. Although the employer provided the reimbursement due to
the terms of the award, the reimbursement of the travel expenses
is a benefit received in respect of Janet’s employment. The
reimbursement would not have been made if Janet was not an
employee. Source: Adapted from Example 1 (1.1 What is a fringe
benefit?) in the ATO’s Fringe Benefits Tax: Guide for Employers (NAT
1054) (original document).
Exclusions [7.80]
The definition of “fringe benefit” in s 136(1) of the FBTAA specifically
excludes certain items from being a fringe benefit, including:
• salary or wages (as defined by reference to Sch 1 of the Taxation
Administration Act 1953 (Cth), in particular, s 12-35 of that Schedule);
• superannuation contributions;
• payments from superannuation funds;
• benefits under an employee share scheme; and
• payments on termination of employment.
These items are excluded from the definition of “fringe benefit” as they are
dealt with under the income tax system.
[7.85] “Salary or wages” comprises payments (including commissions,
bonuses or allowances) to employees, company directors and office holders;
Commonwealth education or training payments; and compensation, sickness
or accident payments. These amounts are subject to the PAYG withholding
provisions in Sch 1 of the Taxation Administration Act 1953.
It has been said that the definition of “salary and wages” is “deliberately
wide” (Hill J in Roads & Traffic Authority of NSW v FCT (1993) 26 ATR 76 at
82) and a wide approach was adopted by the majority of the Full High Court
in Murdoch v Commr of Pay-roll Tax (Vic) (1980) 143 CLR 629. Essentially,
“salary and wages” comprise all amounts paid as a reward for services
rendered by an employee: FCT v J Walter Thompson (Australia) Pty Ltd
(1944) 69 CLR 227. The description of the payment is not determinative, and
it is necessary to look at the substance of the payment to determine its
character: Roads and Traffic Authority of New South Wales v FCT (1993) 26
ATR 76; Ruling TR 92/15.
One issue that often arises in an FBT context is whether a payment to an
employee constitutes an allowance (which is “salary and wages”) or a
reimbursement (which is not “salary and wages”). The term “reimburse” is
defined in s 136(1) of the FBTAA as “any act having the effect or result,
direct or indirect, of a reimbursement”. The scope of the term “reimburse”
was considered by Hill J in Roads & Traffic Authority of NSW v FCT (1993) 26
ATR 76. His Honour said that “the concept of reimbursement requires that
the payment in question be made by reference to actual cost ... [T] here
would need to be some correspondence between the payment and the
expenditure incurred”. As a general rule, an amount will constitute an
allowance, where it is a predetermined amount to cover an estimated
expense, while a reimbursement is a payment made in respect of the
taxpayer’s actual expenditure: Roads and Traffic Authority of New South
Wales v FCT (1993) 26 ATR 76; Ruling TR 92/15.
Example 7.8: Allowance versus reimbursement
Zhou and Beatrice are both employed by the same company. Under
the terms of his employment agreement, Zhou receives $500 per
month to cover the costs of entertaining clients. Under an industrial
award, Zhou also receives $50 per fortnight to cover his medical
insurance premiums. Zhou is required to provide a letter from the
health fund certifying that he is a member of the health fund, but is
not required to provide any further evidence in relation to the
payments.
Under the terms of her employment agreement, Beatrice is entitled
to a payment for her medical insurance premiums up to a limit of
$500 per year. In order to claim the payment, Beatrice is required to
provide the employer with her insurance premium statements
verifying the actual amount incurred by her in relation to the
premiums. The payments made to Zhou for entertaining clients and
his medical insurance premiums are allowances. He receives the
amounts regardless of his actual expenditure. The payments made
to Beatrice are reimbursements – that is, she is compensated for
the actual amount of her medical insurance and cannot make a
claim for payment without documentary evidence. The upper limit
of $500 per year does not alter the character of the payment as it is
based on the precise accounting of actual expenditure. Source:
Adapted from the Example in Ruling TR 92/15.
Allowances are classified as “salary and wages” and are excluded from the
definition of “fringe benefit”; on the other hand, reimbursements are not
excluded from the definition of “fringe benefit”.
Categories of fringe benefits [7.90]
There are 13 categories of fringe benefits in the legislation, and it is
important to determine the appropriate category a fringe benefit falls into as
the FBT consequences arising differ between each category. Each category
of fringe benefit is dealt with by a separate Division in the FBTAA. Each
Division describes when the fringe benefit arises, any exemptions applicable
to that particular category of fringe benefit and the taxable value of the
fringe benefit. Remember that the benefit must constitute a “fringe benefit”
as discussed at [7.20]. In particular, the benefit must be attributable to the
employment relationship.
The following categories of fringe benefits are discussed in detail in this
chapter:
• car fringe benefits: see [7.100];
• debt waiver fringe benefits: see [7.150];
• loan fringe benefits: see [7.170];
• expense payment fringe benefits: see [7.200];
• meal entertainment fringe benefits: see [7.230];
• property fringe benefits: see [7.250]; and
• residual fringe benefits: see [7.280].
The other categories of fringe benefits in the legislation which are less
common and are not discussed in further detail in this chapter are:
• housing fringe benefits: Div 6;
• living-away-from-home allowance fringe benefits: Div 7;
• airline transport fringe benefits: Div 8;
• board fringe benefits: Div 9;
• tax-exempt body entertainment fringe benefits: Div 10; and
• car parking fringe benefits: Div 10A.
Car fringe benefits – Div 2 [7.100]
One of the most common types of fringe benefits provided by employers to
employees is a car fringe benefit. A car fringe benefit arises where an
employer provides a car for an employee’s private use: s 7(1) of the FBTAA.
A “car” is defined in s 136(1) (by reference to s 995-1 of the ITAA 1997) as a
motor vehicle designed to carry a load of less than 1 tonne or fewer than
nine passengers. “Motor vehicle” is defined as any motor-powered road
vehicle, including a four-wheel drive vehicle. “Private use” is defined in s
136(1) as any use of a car by an employee or associate that is not
exclusively in the course of producing assessable income. As a general rule,
travel between home and work is not considered to be in the course of
producing assessable income and would constitute private use: see [12.390];
Ruling MT 2027.
It is important to note that it does not matter whether the employee actually
uses the car for private purposes; a fringe benefit arises as long as the car is
available for private use: s 7(1). This is relevant where the statutory formula
method (see [7.130]) is used to calculate the taxable value of the car as the
formula refers to the number of days the car was provided as a fringe
benefit.
For example, a car fringe benefit will arise where the car is garaged at or
near the residence of an employee or an associate of the employee: s 7(2).
In AAT Case 9824 (1994) 29 ATR 1246, the AAT found that a car that was
used solely in a business run from a home was a car fringe benefit under s
7(2) as the car was garaged at the home. In Determination TD 94/16, the
Commissioner suggests that a car fringe benefit will arise even where the
employee is overseas if the car is garaged at or near the employee’s home
during this time. There is an exception in s 7(2A) for ambulances, fire
fighting vehicles and police cars that are garaged at the employee’s home.
A car fringe benefit will also arise where an employee or an associate of the
employee has custody and control over the car and it is not being used for
employment purposes at the time: s 7(3). Finally, a car fringe benefit can still
arise where the employer prohibits the private use of a car if the prohibition
is not strictly enforced: s 7(4). In Determination TD 94/16, the Commissioner
suggests that the prohibition against private use must be made in clear and
unequivocal terms and a general instruction or understanding between the
employer and employee would be insufficient. The prohibition should be
enforced through disciplinary measures and consistent enforcement such as
checks of odometer readings.
Example 7.9: Car available for private use
John is provided with a car by his employer. John leaves the car in
an airport car park while travelling overseas for work purposes. The
car cannot be left at the employer’s premises as there are no car
parking facilities available there. The airport car park is not in the
vicinity of John’s residence.
If John retains the keys to the car while he is overseas, a car fringe
benefit will arise as he has custody and control over the car.
However, if John’s employer removes control and custody of the car
from John (e.g., by taking the car keys) and enforces a prohibition
on the private use of the car by John or his associates, a car fringe
benefit will not arise. Source: Adapted from the Example in
Determination TD 94/16.
Exempt benefits [7.110]
A car fringe benefit will be an exempt benefit, where the car provided by an
employer to an employee is only used for work-related travel and any
private use by the employee or an associate of the employee is minor,
infrequent and irregular: s 8(2) of the FBTAA. Note that, to be exempt, the
car must be a taxi, panel van, utility truck or other road vehicle not designed
for the principal purpose of carrying passengers: s 8(2)(a). A car fringe
benefit will also be exempt where the benefit arises in relation to an
unregistered car: s 8(3).
Any fringe benefits that may arise in relation to the provision of a car fringe
benefit are treated as exempt benefits under s 53. For example, payments
for fuel or repairs by the employer could be considered expense payment
fringe benefits, but are exempt due to the operation of s 53.

Taxable value [7.120]

There are two methods prescribed by the FBTAA for calculating the taxable
value of a car fringe benefit:
• statutory formula method (s 9): see [7.130]; and
• cost basis (s 10): see [7.140].
The statutory formula method applies automatically unless an employer
elects to use the cost basis: s 10(1). An employer can choose either method
for each car that gives rise to a car fringe benefit. An employer’s election to
use the cost basis is automatically disregarded if the statutory formula
method results in a lower taxable value: s 10(5).
[7.130] Statutory formula method (s 9 of the FBTAA). The taxable value of a
car fringe benefit under this method is the amount calculated in accordance
with the following formula:

Broadly, the base value of the car will be either its cost (if the car was
purchased by the provider) or the leased car value at the earliest time the
provider started to hold the car (if the car is leased). In either case, the
amount is reduced by one-third if the relevant FBT year commences at least
four years after the provider first started holding the car: s 9(2)(a).
In Taxation Ruling TR 2011/3, the ATO suggests that, in addition to the
purchase price, the “cost” of a car would include any other amounts that are
directly attributable to the acquisition or delivery of the car. For example,
dealer delivery charges would be included in the “cost” of a car, but
insurance costs and extended car warranties would not be included in
“cost”.
The recipient’s payment includes amounts paid directly by the employee to
the employer in relation to the car and amounts paid by the employee to a
third party, such as petrol costs, for which the employee was not reimbursed
by the employer.

Example 7.10: Taxable value of car fringe benefit – statutory formula

method
Raj is a troubleshooter for his employer. He visits the company’s
various premises to deal with any problems that may arise. He is
provided with a car for his work travel. The contract for the
provision of the car was entered into on 1 January 2020. Raj is
permitted to take the car home at the end of the day and there is no
restriction on his use of the car for non-work purposes. The car was
originally leased by Raj’s employer on 1 July 2014. The leased car
value at that time was $45,000. For the current FBT year, the
following expenses were incurred by the company in relation to the
car:
Raj is required to contribute $50 per month towards the car
expenses. He has determined that the total kilometres travelled by
the car for the year 1 April 2020 to 31 March 2021 is 50,000 km
(30,000 km related to business travel).
Note that the payment of the car expenses does not give rise to a separate
fringe benefit: s 53 of the FBTAA. Statutory formula method:

Where:
Base value = leased car value = $45,000, which is reduced by one-third as
the car has been held by Raj’s employer for more than four years.
Number of days in the FBT year when the car is provided as a fringe
benefit. There is no restriction on Raj’s private use of the car and he takes
the car home at the end of the day, which is deemed private use under s
7(2). As such, it appears that the car fringe benefit was provided for the
entire FBT year.
Number of days in the FBT year. As it is not a leap year, the total number
of days is 365.
Recipient’s contribution = $50 × 12 = $600.

[7.140] Cost basis (s 10 of the FBTAA). The taxable value of a car fringe
benefit using the cost basis is determined as follows:

Where:
C is the operating cost of the car during the holding period; BP is the
business use percentage of the car during the holding period; and R is the
amount of the recipient’s payment (if any).
The operating cost of the car consists of any expenses relating to the car
incurred by the provider or any other person during the holding period.
Examples of such expenses include repairs and maintenance, registration
and insurance attributable to the holding period. Where the car is owned by
the provider, an amount for deemed depreciation and deemed interest is
also included in operating cost (s 11 of the FBTAA describes how deemed
depreciation and interest are calculated). Where the car is leased by the
provider, the leasing costs attributable to the holding period are included in
operating cost: s 10(3)(a)(v).
The “business use percentage” is the percentage of the business kilometres
travelled by the car out of the total kilometres travelled by the car during the
holding period. Business kilometres refers to the number of kilometres on a
“business journey”, which is defined in s 136(1) as any use of the car other
than private use by an employee or associate.
The cost basis may provide a lower taxable value than the statutory formula
method, where the business use percentage of the car during the year is
high. However, log book records and odometer records must be maintained
when using the operating cost method, which increases the compliance
burden: ss 10A and 10B.
Example 7.11: Taxable value of car fringe benefit
Assume the same facts as Example 7.10 and that Raj has
maintained the necessary log book and odometer records. Cost
basis:

BP = business use percentage = (30,000/50,000) × 100% = 60%; R =

recipient’s contribution = $50 × 12 = $600. Comparing Examples
7.10 and 7.11, Raj’s employer should use the cost basis to
determine the taxable value of the car fringe benefit since it results
in a lower taxable value.
Debt waiver fringe benefits – Div 3 [7.150]
A debt waiver fringe benefit arises where an employee (or associate) owes
an amount to an employer and the employee (or associate) is released from
his or her obligation to repay all or some of that amount: s 14 of the FBTAA.
The debt must be waived due to the employment relationship and not for
some other reason (e.g., because it is irrecoverable) to constitute a debt
waiver fringe benefit.
Taxable value [7.160]
The taxable value of a debt waiver fringe benefit is the amount of the loan
that no longer needs to be repaid: s 15 of the FBTAA. Example 7.12: Debt
waiver fringe benefit
Due to unexpected personal misfortune, Miles was forced to borrow $30,000
from his employer on 1 September. On 1 January, his employer informed him
that he was only required to repay $20,000 of the loan. The debt was waived
because the employer values Miles as an employee and wants to reward him
for his loyalty. A debt waiver fringe benefit arises as Miles has been released
from his obligation to repay an amount that is owed to his employer and the
waiver was due to the employment relationship. The taxable value of the
debt waiver fringe benefit is $10,000, being the amount that Miles no longer
has to repay.
Loan fringe benefits – Div 4 [7.170]
A loan fringe benefit arises in each year when an employer provides an
employee (or associate) with a loan: s 16 of the FBTAA.

Exempt benefits [7.180]

A loan fringe benefit will be an exempt benefit where the loan is provided by
a person who provides loans to the general public in the ordinary course of
his or her business, and the loan to the employee is provided at an interest
rate at least equal to the interest rate prevailing at that time on similar loans
to the public (eg, a home loan to a bank employee at standard commercial
terms): s 17(1) and (2) of the FBTAA.
A loan fringe benefit will also be an exempt benefit where the loan is
essentially an advance to the employee so that the employee can meet
expenses that are reasonably expected to be incurred by the employee in
the next six months in the course of performing his or her duties of
employment: s 17(3) of the FBTAA.
Finally, a loan fringe benefit will also be exempt where the loan is provided to
enable the employee to pay a rental bond, security deposit in respect of gas,
electricity or telephone services or any similar amount. The employee must
be required to repay the loan amount within 12 months, and the loan must
be provided in conjunction with certain other fringe benefits to be exempt: s
17(4) of the FBTAA.
Taxable value [7.190]
The taxable value of a loan fringe benefit is determined as follows (s 18 of
the FBTAA):

Loan amount × [Statutory interest rate – Actual interest rate] × No of days

loan provided during the year/
No of days in FBT year
The statutory interest rate is published by the ATO at the start of each FBT
year. For the FBT year commencing on 1 April 2020, the applicable statutory
interest rate is 4.80% per annum.
Essentially, the fringe benefit represented by the taxable value is the
interest “saved” by the employee in obtaining a loan through the employer,
rather than at commercial market rates. Where the loan is provided at an
interest rate which is equal to or higher than the statutory interest rate, no
FBT liability arises as the taxable value is nil.
Where the loan is provided for only a portion of the FBT year, it is necessary
to adjust the taxable value for the loan period.

Example 7.13: Loan fringe benefit

Company Z provides its employee, Robyn, with a loan of $10,000 on
1 December 2020 at no interest. Robyn has not repaid any amount
of the loan at 31 March 2021.
A loan fringe benefit arises as Company Z has provided one of its
employees with a loan.
The taxable value of the loan fringe benefit =

$10,000 × [4.80% - 0%] x 121/365 = $159

Therefore, Robyn has “saved” $159 in interest by obtaining a loan
from her employer rather than at commercial rates.
Expense payment fringe benefits – Div 5 [7.200]
An expense payment fringe benefit arises, where:
• an employer pays an expense incurred by the employee; or
• an employer reimburses an employee for expenditure incurred by the
employee: s 20 of the FBTAA.
To constitute an expense payment fringe benefit, the expense must be
“incurred” by the employee. Broadly, an expense is incurred by an employee
when the employee is definitely committed to the expense. Some other
category of fringe benefit (eg, residual fringe benefits) may arise where an
employer pays an expense which is not incurred by the employee.
Example 7.14: Expense incurred by employee
Stefan’s employer pays for his mobile phone bills. His employer also
pays for him to go to a physiotherapist once a month as Stefan
often works long hours in front of his computer. Stefan would not
otherwise go to the physiotherapist.
The payment of Stefan’s mobile phone bills by his employer is an
expense payment fringe benefit as Stefan’s employer has paid an
expense incurred by Stefan (he is definitely committed to the
expense). The payment of the physiotherapist’s cost is not an
expense payment fringe benefit as Stefan has not incurred the
expense. However, it may constitute a residual fringe benefit.

Where an employer pays an amount to an employee in relation to

expenditure incurred by the employee, it is necessary to consider whether
the payment is a “reimbursement” or an “allowance”. The distinction gives
rise to very different tax consequences. “Reimbursements” are treated as
expense payment fringe benefits and taxed to the employer under the FBT
regime, while “allowances” constitute “salary and wages” (see [7.85]) and
are taxed to the employee under the income tax.

Exempt benefits [7.210]

An employer can make a “no-private-use declaration” in respect of all of the
employer’s expense payment fringe benefits, which means that the
employer will only pay or reimburse so much of an expense as would result
in a taxable value of nil (reductions in taxable value are discussed at
[7.360]). An expense payment fringe benefit covered by such a declaration
is an exempt benefit: s 20A of the FBTAA.
Certain accommodation expense payment benefits where the employee is
required to live away from his or her usual place of residence due to
employment reasons and certain car expense payment benefits are also
treated as exempt benefits: ss 21 and 22 of the FBTAA.
Taxable value [7.220]
The taxable value of an expense payment fringe benefit depends on whether
the fringe benefit is an in-house expense payment fringe benefit or an
external expense payment fringe benefit.
An expense payment fringe benefit is an in-house expense payment fringe
benefit, where the expense relates to goods or services provided by the
employer or an associate of the employer to outsiders in the ordinary course
of their business: definition of “in-house expense payment fringe benefit” in
s 136(1) of the FBTAA. For example, an employee purchases a laptop
computer from their employer who is a computer retailer. The employer
reimburses the employee for the cost of the computer. The reimbursement is
an expense payment fringe benefit, which is an in-house expense payment
fringe benefit since it relates to property that is sold by the employer in the
ordinary course of its business.
An expense payment fringe benefit is an external expense payment fringe
benefit if it is not an in-house expense payment fringe benefit: definition of
“external expense payment fringe benefit” in s 136(1). An employer
reimburses an employee for the employee’s children’s school fees. The
reimbursement is an external expense payment fringe benefit (assuming the
employer is not the school).
Broadly, the taxable value of an in-house expense payment fringe benefit is
the taxable value of the fringe benefit as if it was a property or residual
fringe benefit (i.e., assume the employer did not reimburse the employee
but provided the property or services directly): s 22A.
The taxable value of an external expense payment fringe benefit is the
amount of the expense or reimbursement incurred by the employer: s 23.
Example 7.15: Expense payment fringe benefit
Joe pays his telephone bill of $200 for which he is later reimbursed
by his employer, an accounting firm. The employer also pays $3,000
in fees directly to the university for a further study course he is
undertaking. There are two expense payment fringe benefits arising
as Joe’s employer has reimbursed him for the telephone bill and
paid for his university fees. Both expenses were incurred by Joe as
he is definitely committed to them.
Both expenses are external expense payment fringe benefits as the
benefits are not provided by Joe’s employer in the ordinary course
of its business. The taxable values of both benefits are $200 and
$3,000, respectively, being the amount paid by the employer in
relation to them. Depending on the facts, the “otherwise
deductible” rule (see [7.390]) may apply to reduce the taxable
value of both fringe benefits under s 24 of the FBTAA.
Meal entertainment fringe benefits – Div 9A [7.230]
Meal entertainment fringe benefits can be captured by a number of
categories, such as expense payment fringe benefits, property fringe
benefits and, of course, meal entertainment fringe benefits. Generally, the
most specific category is the relevant category for a fringe benefit. However,
in the case of meal entertainment, an employer can elect for Div 9A of the
FBTAA to apply to the provision of meal entertainment fringe benefits for a
particular FBT year, in which case the relevant fringe benefits will be taxed
under this Division and not another: ss 37AA and 37AF.
A meal entertainment fringe benefit arises where an employer provides its
employees with:
• entertainment by way of food or drink;
• accommodation or travel in connection with entertainment by way of food
or drink; or
• a reimbursement of expenses incurred by an employee in relation to the
above.
A meal entertainment fringe benefit arises regardless of whether or not the
meal entertainment relates to business purposes. Determining whether food
or drink is provided as “entertainment” will be a question of fact. In Ruling
TR 97/17, the ATO suggests that the following factors are relevant in
answering that question:
• why the food or drink is provided: the ATO suggests that food or drink
provided as refreshment (e.g., morning tea for employees) will not be
entertainment, but food or drink provided in a social situation (e.g., lunch at
a restaurant) will be classified as entertainment;
• what type of food or drink is provided: for example, morning or afternoon
tea, sandwiches or light meals are unlikely to constitute entertainment, while
a three-course meal will constitute entertainment;
• when the food or drink is provided: food or drink provided during work
hours, during overtime or while an employee is travelling for work purposes
is less likely to be entertainment; and
• where the food or drink is provided: food or drink provided at the
employer’s premises is less likely to be entertainment but food or drink
provided at a hotel, restaurant or café is more likely to be classified as
entertainment.
Although no single factor is determinative, the ATO suggests that the first
two factors will be the most important in determining whether food or drink
is provided as entertainment.
Taxable value [7.240]
There are two methods for calculating the taxable value of meal
entertainment fringe benefits:
• 50/50 split method; and
• 12-week register method.
The 50/50 split method will apply automatically unless the employer elects
for the 12-week register method to apply: s 37B of the FBTAA. Under the
50/50 split method, the taxable value of meal entertainment fringe benefits
is half of the expenses incurred by the employer during the FBT year in
providing meal entertainment: s 37BA.
Alternatively, the employer can elect to calculate the taxable value of meal
entertainment fringe benefits under the 12-week register method: s 37CA.

In this case, the employer must maintain a register of all meal entertainment
expenditure over a representative 12-week period and determine the
percentage of that expenditure which relates to the provision of meal
entertainment as fringe benefits (ie, meal entertainment provided to
employees or their associates and not to others, such as clients): s 37CB.
The percentage of total meal entertainment expenditure which constitutes
meal entertainment fringe benefits (ie, meal entertainment provided to
employees and their associates) is known as the “register percentage”: s
37CB.
The 12-week period chosen should be representative of the first FBT year in
which the register method is to be used for the register to be valid: s 37CC.
The register is valid for the FBT year in which it is first used and the four FBT
years following that year: s 37CD. Where the 12-week period spans more
than one FBT year, the register can only be used for the first time in the FBT
year in which the 12-week period ends: s 37CD(2). A register ceases to be
valid for a particular FBT year, where the total meal entertainment
expenditure in that year exceeds the total meal entertainment expenditure
in the year the register was first used by more than 20%: s 37CD(3).
The taxable value of meal entertainment fringe benefits under the register
method is calculated using the following formula (s 37CB): Total meal
entertainment expenditure incurred in the FBT year × Register percentage
Example 7.16: Meal entertainment fringe benefit
Company A incurred $5,000 in expenditure on meal entertainment for the
year. Assume Company A elects to apply Div 9A and treat the expenses as
meal entertainment fringe benefits.
Company A has maintained a register of all meal entertainment expenditure
for a period of 12 weeks, in accordance with the above requirements. The
register information indicates that 70% of the meal entertainment
expenditure was on clients (ie, not fringe benefits) while 30% related to
employees and their associates (ie, fringe benefits). Therefore, Company A’s
register percentage is 30%.

Under the 50/50 split method, the taxable value of the meal entertainment
fringe benefits is $2,500, being half the expenditure on providing meal
entertainment. Alternatively, if Company A elected to use the 12-week
register method, the taxable value of the meal entertainment fringe benefits
is $1,500, being $5,000 × 30%.

Therefore, in this case, it would be better for Company A to elect to use the
register method in calculating its FBT liability in relation to the provision of
meal entertainment fringe benefits.

The register method will generally provide a lower taxable value (and
therefore a lower FBT liability), where less than 50% of meal entertainment
expenditure is provided as fringe benefits (i.e., to employees and their
associates).
Property fringe benefits – Div 11 [7.250]
A property fringe benefit arises where an employer provides an employee (or
associate) with property: s 40 of the FBTAA. Note that a fringe benefit only
arises where the employer gives the employee the property, not just the use
of the property. The use of property may be captured by another category
such as residual benefits.
“Property” is defined in s 136(1) as tangible and intangible property.
“Tangible property” is defined to mean goods, and the definition specifies
that this includes animals, fish, gas and electricity. “Intangible property” is
defined as real property (i.e., land and buildings), a chose in action (i.e., a
right to sue) and any other kind of property that is not tangible property.
However, rights arising under a contract of insurance or a lease or licence in
respect of real or tangible property are specifically excluded.
Exempt benefits [7.260]
A property fringe benefit will be an exempt benefit where the property is
provided to a current employee and the property is provided to and
consumed by the employee on a working day and on the business premises
of the employer or a related company: s 41 of the FBTAA. For example,
biscuits or fruits provided to employees to be consumed on work premises
would be exempt property fringe benefits.
Taxable value [7.270]
The taxable value of a property fringe benefit depends on whether the
property fringe benefit is an in-house property fringe benefit or an external
property fringe benefit.
Broadly, a property fringe benefit is an in-house property fringe benefit,
where the property is provided by the employer or an associate of the
employer to outsiders in the ordinary course of their business: s 136(1) of
the FBTAA. A property fringe benefit is an external property fringe benefit if it
is not an in-house property fringe benefit: s 136(1).
The taxable value of an in-house property fringe benefit is determined under
s 42 and is broadly as follows:

1. Where the property is manufactured, produced, processed or treated by

the provider and:
(a) is sold in the ordinary course of business to manufacturers, wholesalers
or retailers – the taxable value is the lowest price at which the property was
sold; or
(b) is sold in the ordinary course of business to members of the public – the
taxable value is equal to 75% of the lowest price at which property was sold
to a member of the public; or
(c) in any other case – the taxable value is 75% of the amount that could
reasonably be paid to acquire the property from the provider in an arm’s
length transaction.
2. Where (1) does not apply and the property is acquired by the provider, the
taxable value is the lesser of:
(a) the cost of the property if acquired in an arm’s length transaction; or (b)
the amount that could reasonably be paid to acquire the property from the
provider in an arm’s length transaction.
3. In any other case, the taxable value is 75% of the amount that could
reasonably be paid to acquire the property from the provider in an arm’s
length transaction.
The determination of the taxable value of in-house property fringe benefits
essentially depends on whether the employer is a manufacturer or reseller
and whether the employer operates in the wholesale or retail market.
Employers can still provide employees with in-house property fringe benefits
without incurring FBT, where the employee pays the wholesale price of the
property. As we will see at [7.380], the taxable value of a fringe benefit is
reduced by the amount of the recipient’s contribution, if any. Both employers
and employees benefit in this case as the employer does not incur FBT, and
the employee pays the wholesale, rather than retail, price of the goods.
Example 7.17: In-house property fringe benefit
Ratna works at a second-hand computer shop. Her employer
provided her with a computer which cost the employer $1,000 to
acquire and is for sale to the public for $1,500. The provision of the
computer is an in-house property fringe benefit as Ratna’s employer
provides computers to outsiders in the ordinary course of its
business.
The taxable value of the fringe benefit is the lesser of:
• the cost of the property – $1,000; or
• the amount that could reasonably be paid to acquire the property
from Ratna’s employer – $1,500.

Therefore, the taxable value is $1,000.

Note that if Ratna paid her employer $1,000 for the computer, the taxable
value would be nil as the recipient’s contribution is deducted from taxable
value: see [7.380]. Both the employer and Ratna benefit in this situation as
the employer does not incur FBT and Ratna has paid $1,000, rather than the
retail price of $1,500, to acquire the computer.
Broadly, the taxable value of an external property fringe benefit is the cost
to the employer, or expenditure incurred by the employer to provide the
property: s 43. Where the employer can acquire the property for less than
the employee could (e.g., due to the employer’s purchasing power or
because it can purchase the property at wholesale prices) and the employee
reimburses the employer for the cost of acquiring the property, a win-win
situation arises since the employer has no FBT liability and the employee has
acquired the property for less than the retail price.
Example 7.18: External property fringe benefit
Following on from Example 7.17, Ratna’s employer also gave her a
brand new plasma television, which was acquired from a television
wholesaler for $2,000. The provision of the plasma television is an
external property fringe benefit since Ratna’s employer does not
provide plasma televisions to outsiders as part of its business.
The taxable value of the fringe benefit is the cost to Ratna’s
employer in acquiring the property, which is $2,000.
If Ratna paid her employer $2,000 for the television, the taxable
value is reduced to nil as the recipient’s contribution is deducted
from taxable value: see [7.380]. Both the employer and Ratna
benefit in this situation as the employer does not incur FBT and
Ratna has paid the wholesale price of $2,000 for the television,
rather than the retail price which is likely to be higher.
Residual fringe benefits – Div 12 [7.280]
The last category of fringe benefits is residual fringe benefits, which is a
catch-all category to capture any benefits that do not fall into any of the
other categories of fringe benefits: s 45 of the FBTAA. Examples of residual
benefits include the provision of services for free or at a discount; the
provision of caravans at work sites for the accommodation of employees
(Roads and Traffic Authority of NSW v FCT (1993) 26 ATR 76) and waivers of
loan establishment fees: Westpac Banking Corporation v FCT (1996) 34 ATR
143. Note that a residual benefit can arise in conjunction with another fringe
benefit, but not if the benefit is fully captured by another category: Westpac
Banking Corporation v FCT (1996) 34 ATR 143.
Case study 7.5: Residual fringe benefits
Following on from Case Study [7.1], in Westpac Banking Corporation
v FCT (1996) 34 ATR 143, the taxpayer sought to argue that the
waiver of the loan establishment fee was not a residual benefit as
the waiver was integrally related to the making of the loan to the
employee, and therefore there was only one benefit – that is, the
making of the loan. As such, the FBT consequences were to be
determined solely in accordance with Div 4 regarding loan fringe
benefits. Hill J found that Div 4 was not an exclusive code for all
benefits relating to loans. In this case, there were two separate
benefits – the loan that is dealt with under Div 4 and the fee waiver
that is captured as a residual fringe benefit.
Exempt benefits [7.290]
As the scope of residual fringe benefits is unlimited, there are a number of
residual benefits that are made exempt in s 47 of the FBTAA. For example,
“business operation facilities”, such as toilets, bathroom facilities, food or
drink vending machines, tea-or coffee-making facilities, water dispensers
and other such amenities, are exempt benefits under s 47(4). Recreational or
childcare facilities located on the employer’s premises are exempt under s
47(2). Ruling TR 2000/4 discusses the meaning of “business premises” in the
context of the s 47(2) exemption. Section 47(3) also provides an important
exemption for any private use of property located on the employer’s
premises, where the property is wholly or principally in connection with the
operation of the business. This exempts from FBT private phone calls or
personal printing at the employer’s premises.
Taxable value [7.300]
Similar to property fringe benefits (see [7.270]), the taxable value of a
residual fringe benefit depends on whether the residual fringe benefit is an
in-house residual fringe benefit or an external residual fringe benefit.

Broadly, the taxable value of an in-house residual fringe benefit under ss 48

and 49 of the FBTAA is:
• 75% of the lowest price at which an identical benefit is sold to a member of
the public under an arm’s length transaction; or
• in any other case, 75% of the amount that could reasonably be paid to
acquire the property from the provider in an arm’s length transaction.
The taxable value of an external residual fringe benefit is, broadly, the cost
to the employer or expenditure incurred by the employer in providing the
benefit: ss 50 and 51.
Example 7.19: In-house residual fringe benefit
Imogen works at a second-hand computer shop. She has had
problems with her computer and her employer services her
computer for free. The employer would normally charge customers
$60 for the service. The servicing of the computer would constitute
an in-house residual fringe benefit as the benefit does not fall
within any of the other categories of fringe benefits and as
Imogen’s employer services computers in the ordinary course of its
business. The taxable value of the fringe benefit is 75% of the
lowest price charged to members of the public in an arm’s length
transaction, which would be 75% × $60 = $45.
Example 7.20: External residual fringe benefit
Following on from Example 7.19, Imogen’s employer also gave her
two tickets to an upcoming classical music concert by an
international artist. The tickets cost $250 each.
The provision of the tickets would constitute an external residual
fringe benefit as they do not fall within any of the other categories
of fringe benefits and Imogen’s employer does not provide concert
tickets in the ordinary course of its business. Note that the payment
for the tickets does not constitute an expense payment fringe
benefit as Imogen has not “incurred” the expense.
The taxable value of the fringe benefit is the expenditure incurred
by Imogen’s employer in providing the benefit, which is $500.

Exempt fringe benefits [7.310]

There are a number of benefits that are exempt from FBT. No FBT liability
arises in relation to an exempt fringe benefit.
The exemptions can apply to a particular category of fringe benefit or fall
within Div 13 of the FBTAA, which covers “miscellaneous exempt benefits”.
The category-based exemptions were discussed under the relevant
categories at [7.100]–[7.300]. There are a number of exempt benefits in Div
13, such as:
• reimbursements for the costs of travelling to an interview or selection test
in connection with an application for employment with a new employer, or a
promotion or transfer with an existing employer (s 58A);
• various job relocation expenses (ss 58AA, 58B, 58C, 58D, 58E and 58F);
• certain medical benefits (ss 58K, 58L and 58M); and
• the cost of providing newspapers and periodicals to employees for
business purposes: s 58H.
The following common exemptions are discussed in detail:
• minor benefits: see [7.320];
• work-related items: see [7.330];
• membership fees and subscriptions: see [7.340]; and
• single-trip taxi travel: see [7.350].
Minor benefits – s 58P [7.320]
Broadly, a benefit will be exempt as a minor benefit, where the notional
taxable value of the benefit is less than $300. “Notional taxable value” is
defined in s 136(1). It is the taxable value of the fringe benefit as determined
for each category of fringe benefit taking into account any reduction for
recipient’s contribution but not any reduction of taxable value due to the
application of the otherwise deductible rule (see [7.360]). In the case of a car
fringe benefit, the notional taxable value is the taxable value determined as
if the car benefit was a residual benefit.

The $300 limit is applied to each benefit and is not a cumulative exemption.
However, to be treated as a minor benefit, the frequency and regularity of
the minor benefit (and similar or connected benefits) must be taken into
consideration, and it must be concluded that it would be unreasonable to
treat the minor benefit as a fringe benefit: s 58P(f) of the FBTAA; Ruling TR
2007/12. The exemption does not apply to in-house fringe benefits which are
subject to a $1,000 reduction in taxable value for each employee: see
[7.370]. The exemption is also not available for meal entertainment fringe
benefits if the employer uses the 50/50 split method (see [7.240]) to
calculate the taxable value of the meal entertainment: s 37BA; Ruling TR
2007/12.

Example 7.21: Infrequent but regular benefits qualify as minor

benefits
Joe provides each of his employees with a bottle of wine every
Christmas. The cost of each bottle is less than $300 and satisfies
the taxable value limit for minor benefits. The gifts are provided
infrequently (once a year) but regularly (every Christmas). There
are no similar or connected benefits. Upon evaluation of these
criteria, it can be concluded that the provision of the bottle of wine
is a minor benefit as it would be unreasonable to treat it as a fringe
benefit. Source: Adapted from Example 1 in Ruling TR 2007/12.
Example 7.22: Infrequent but regular benefits qualify as minor
benefits
Each year Nicholas provides all of his employees and their families
with an end of financial year dinner at a local restaurant. The total
value of the fringe benefit for each employee is less than $300. The
benefit is provided infrequently (once a year) but regularly (every
year). As the total value of the benefit and all connected benefits is
less than $300, and taking into account the other factors, it can be
concluded that the provision of the fringe benefit is a minor benefit
as it would be unreasonable to treat it as a fringe benefit. Source:
Adapted from Example 2 in Ruling TR 2007/12.
Example 7.23: Frequent and regular benefits not treated as minor
benefits
Big Firm provides its employees with a fine dining meal voucher
whenever they have to work late. The value of each voucher is less
than $300. However, employees generally work late at least once a
month. Although each benefit is less than $300, it would not be
reasonable to treat the meal vouchers as a minor benefit, taking
into consideration the frequency and regularity with which they are
provided and the fact that their cumulative value for each employee
is likely to exceed $300.
Work-related items – s 58X [7.330]
The following work-related items are treated as exempt fringe benefits:
• a portable electronic device;
• an item of computer software;
• an item of protective clothing;
• a briefcase; and
• a tool of trade: s 58X(2) of the FBTAA.
These items will only be eligible for the exemption, where they are primarily
for use in the employee’s employment. In ATO ID 2008/127, the ATO
suggests that the provision of a laptop computer to an employee who
regularly visits clients is primarily for use in the employee’s employment.
Further, the exemption is limited to one item of each type per employee per
FBT year unless the item is a replacement item: s 58X(3) and (4) of the
FBTAA. The limitation does not apply if the work-related item is a “portable
electronic device” and the employer is a “small business entity”. In this
context, a “small business entity” is a sole trader, partnership, company or
trust that operates a business for all or part of the income year and has an
aggregated turnover of less than $10 million. In the 2020 Federal Budget, it
was announced that the exemption on multiple work-related portable
devices would be extended to businesses with an aggregated annual
turnover of less than $50 million from 1 April 2021. Broadly, “aggregated
turnover” is the entity’s turnover plus the annual turnover of any business
that is connected or affiliated to the entity. Note that employees are not
entitled to depreciation deductions (see Chapter 14) in relation to these
items.
The legislation does not specify what is a “portable electronic device”, and in
ATO ID 2008/133, the ATO suggests that it should therefore take on its
ordinary meaning. The ATO further suggests that a portable electronic device
would be one which is:
• easily portable and designed for use away from an office environment;
• small and light;
• able to operate without an external power supply; and
• designed as a complete unit.
This includes mobile phones, laptop computers, GPS navigation receivers,
personal digital assistants and so on.
Membership fees and subscriptions – s 58Y [7.340]
The following benefits are exempt benefits whether paid for directly by the
employer or by way of a reimbursement:
• subscription to a trade or professional journal;
• entitlement to use a corporate credit card; and
• entitlement to use an airport lounge membership.

Single-trip taxi travel – s 58Z [7.350]

The provision of a single taxi trip beginning or ending at the employee’s
place of work is an exempt benefit. The definition of “taxi” was amended in
2020 to ensure that the FBT exemption extends to services obtained through
ride-sourcing platforms (e.g., Uber).
Reductions in taxable value [7.360]
Having determined the taxable value of a fringe benefit, it is then necessary
to determine whether the taxable value can be reduced because:
• it is an in-house fringe benefit: see [7.370];
• there is a recipient’s contribution: see [7.380]; or
• the otherwise deductible rule applies: see [7.390].
All of these reductions can apply individually or in conjunction with the
others.

In-house fringe benefits [7.370]

Under s 62 of the FBTAA, the taxable value of all in-house (expense, property
or residual) fringe benefits for each particular employee is reduced by
$1,000. Where the taxable value of all in-house fringe benefits to a particular
employee is less than $1,000, the taxable value is reduced to nil, and there
is effectively no FBT payable on the provision of the in-house fringe benefits
to that employee. Note that the reduction relates to the particular employee
and cannot be done on an aggregate basis.
Example 7.24: Reduction in taxable value for in-house property
fringe benefits
Company Y provides its employees Leonie and James with in-house
property fringe benefits. The taxable value of Leonie’s in-house
fringe benefits is $2,000 and the taxable value of James’ in-house
fringe benefits is $300.
Applying s 62 of the FBTAA, the taxable value of Leonie’s in-house
fringe benefits is reduced to $1,000 and the taxable value of James’
in-house fringe benefits is reduced to nil. The reduction relates to
the particular employee and cannot be done on an aggregate basis.
The unutilised $700 exemption in relation to James cannot be
applied to reduce Leonie’s liability.

Recipient’s contribution [7.380]

The definition of “taxable value” for most fringe benefits reduces the taxable
value of the fringe benefit by the amount of the recipient’s contribution (if
any). Of the categories of fringe benefits discussed in detail at [7.100]–
[7.300], this step is not required for car fringe benefits, debt waiver fringe
benefits and loan fringe benefits, as it is either not applicable or has been
incorporated into the determination of taxable value at first instance. Where
the fringe benefit is an expense payment fringe benefit that arises because
of a reimbursement, the amount of the employee’s expenditure is not
considered the recipient’s contribution: ss 22A(4) and 23 (as the employee
has been reimbursed for the expense).
In all other cases, reduce the taxable value by the amount of the recipient’s
contribution (if any).
Example 7.25: Reducing taxable value for recipient’s contribution
Belinda is a lawyer at a small law firm specialising in conveyancing.
She recently purchased her first home for $500,000. The firm
provided her with conveyancing services at a 50% discount. The
standard fee for conveyancing services on properties similar to
Belinda’s would be $2,000. The provision of conveyancing services
constitutes an in-house residual fringe benefit as the services are
provided to outsiders in the ordinary course of the employer’s
business. The taxable value of the fringe benefit is 75% of the
lowest price charged to customers, which would be 75% × $2,000 =
$1,500. The services were provided to Belinda at a 50% discount,
which means that she paid $1,000 towards the conveyancing fees.
The taxable value is therefore reduced for recipient’s contribution
to $500. (Note: The taxable value may be further reduced to nil by
applying the $1,000 reduction for in-house benefits, depending on
whether Belinda received any other in-house benefits during the
FBT year: s 62 of the FBTAA.)
Otherwise deductible rule [7.390]
Most categories of fringe benefits also include the “otherwise deductible
rule” to reduce the taxable value of a fringe benefit. Of the categories of
fringe benefits discussed in detail at [7.100]–[7.300], the otherwise
deductible rule is not applicable to car fringe benefits and debt waiver fringe
benefits.

Under the otherwise deductible rule, the taxable value of a fringe benefit is
reduced by the amount which would have been deductible to the employee
had the employee incurred an expense directly rather than received a fringe
benefit. It is important to note that the otherwise deductible rule only applies
in relation to the employee and not associates of the employee (i.e., the
expense must have been deductible to the employee).
It is also important to note that the expense must give rise to a one-time-
only deduction to the employee for the otherwise deductible rule to apply. An
expense which would be deductible to the employee over a number of years
(e.g., depreciation) would not qualify as an otherwise deductible expense. In
such cases, it may be preferable for the employee to incur the expense
themselves as the amount is excluded from the employee’s income (as
deductions), albeit over a period of years, rather than receive a benefit that
is fully taxable to the employer under FBT.
Example 7.26: Otherwise deductible rule
On 1 April 2020, Ali received a loan of $20,000 from his employer at
an interest rate of 1.80%. Ali used $10,000 to purchase shares,
$5,000 to pay his personal credit card debt and the remaining
$5,000 to purchase shares in his wife’s name.
The $20,000 provided by the employer to Ali is a loan fringe benefit.
The taxable value of the benefit is $20,000 × (4.80% − 1.80%) =
$600. The loan is provided for the entire FBT year, so there is no
need to adjust for the loan period. The $600 represents interest
that Ali has “saved” by obtaining a loan from his employer, rather
than at commercial rates. The relevant question when applying the
otherwise deductible rule is whether Ali would have been entitled to
a deduction for some or all of the $600 had he incurred the interest
expense directly by obtaining a loan at commercial interest rates
instead of receiving the fringe benefit. Half of the loan amount was
used to purchase shares and, as discussed in Chapter 12, interest
incurred in acquiring an income-producing asset is deductible for
tax purposes. Therefore, the interest expense which relates to that
portion of the loan (50% × $600 = $300) would have been
“otherwise deductible”.
Interest relating to the portion of the loan used to pay the credit
card debt would not be deductible as it is a private expense. The
interest relating to the purchase of shares in the wife’s name is also
not otherwise deductible as the interest expense is not deductible
to Ali, but to his wife. Therefore, the taxable value of the loan fringe
benefit is reduced from $600 to $300 by applying the otherwise
deductible rule.

Example 7.27: Otherwise deductible rule

Under the terms of his employment agreement, Jerry’s employer
has agreed to pay his tax agent’s fees of $550 for the preparation of
Jerry’s personal income tax return.
The payment of the tax agent’s fees by the employer constitutes an
external expense payment fringe benefit. The taxable value of the
fringe benefit is the amount of the expense, being $550. The cost of
managing one’s tax affairs is deductible under s 25-5 of the ITAA
1997: see Chapter 13. Therefore, if Jerry had paid the tax agent’s
fees himself, he would have been entitled to a deduction for the
fees. Applying the otherwise deductible rule, the taxable value of
the expense payment fringe benefit would be reduced to nil as the
$550 would have been fully deductible had it been incurred by Jerry.
Example 7.28: Otherwise deductible rule
Under the terms of her employment agreement, Jade’s employer
has agreed to pay her home phone bills totalling $2,200 for the
year. Only 20% of her calls were for work purposes.

The payment of the phone bills by the employer constitutes an

expense payment fringe benefit.
The taxable value of the fringe benefit is the amount of the
expense, being $2,200.
Twenty per cent of Jade’s calls are for work purposes and it is likely
that, had she paid the phone bills herself, she would have been
entitled to a deduction for 20% of the cost, being $440 (see Chapter
12). Therefore, applying the otherwise deductible rule, the taxable
value of the expense payment fringe benefit would be reduced by
$440 to $1,760.
Where a benefit is provided to an employee and their associate jointly, the
otherwise deductible rule is to be applied on a proportionate basis. The
otherwise deductible rule for loan fringe benefits, expense payment fringe
benefits, property fringe benefits and residual fringe benefits was amended
by Sch 4 of the Tax Laws Amendment (2008 Measures No 5) Act 2008 (Cth)
to ensure that the rule operated as such. The amendments were necessary
due to s 138(3), which deems a benefit jointly provided to an employee and
their associate to be provided solely to the employee.
In National Australia Bank v FCT (1993) 26 ATR 503, the Federal Court held
that the taxable value of a loan fringe benefit provided to an employee and
his spouse was reduced to nil under the otherwise deductible rule. This was
due to the operation of s 138(3), which deemed the benefit to be provided
solely to the employee. The following examples from Sch 4 of the Tax Laws
Amendment (2008 Measures No 5) Act 2008 illustrate the application of the
law following the amendments.
Example 7.29: Benefit provided to employee and associate
Francisca and her husband Peter receive a joint interest-free loan of
$50,000 from Peter’s employer. Assume that the taxable value of
the loan fringe benefit is $10,000. Francisca and Peter use the loan
to purchase $50,000 of shares which they will hold jointly with a
50% interest each. Francisca and Peter return 50% of the dividends
derived from the shares as assessable income in each of their
income tax returns.
Under the previous law (and as a result of the NAB case), the otherwise
deductible rule would apply to reduce the taxable value of the loan fringe
benefit ($10,000) (ie, in respect of both Francisca and Peter’s share of the
benefit) to nil and consequently the employer would have no FBT liability. As
a result of new paragraph 19(1)(i) and new subs 19(5), the notional
deduction of $10,000 is reduced by Peter’s percentage of interest in the
shares – that is, 50% so that the taxable value of the loan fringe benefit of
$10,000 is reduced by $5,000. The employer has an FBT liability on $5,000,
which reflects the share of the loan fringe benefit that was provided to
Francisca. Source: Adapted from Example 4.2 in Explanatory Memorandum
to the Tax Laws Amendment (2008 Measures No 5) Act 2008.
Example 7.30: Benefit provided to employee and associate
Assume Francisca and Peter only use 50% of the $50,000 loan for
acquiring shares. They use the other 50% ($25,000) for a private
overseas holiday. The taxable value of the loan fringe benefit that
relates to that part of the loan used for private purposes ($5,000) is
not deductible to either Francisca or Peter, so the otherwise
deductible rule does not apply to reduce that part of the loan fringe
benefit.
The taxable value of the loan fringe benefit that arises on the part
of the loan that is used for acquiring shares can be reduced by
Peter’s share of the benefit (i.e., $2,500). The employer can reduce
the taxable value of the loan fringe benefit ($10,000) by $2,500.
The taxable value of the loan fringe benefit provided to Francisca
and Peter that will be subject to FBT is therefore $7,500 ($10,000 −
$2,500) which represents the portion of the loan used for the
private holiday and the portion for Francisca’s ownership of the
shares. Source: Adapted from Example 4.3 in Explanatory
Memorandum to the Tax Laws Amendment (2008 Measures No 5)
Act 2008.
Type of fringe benefit [7.400]
Having determined the taxable value of each fringe benefit, it is then
necessary to determine whether the fringe benefit is a Type 1 fringe benefit
or a Type 2 fringe benefit.
A Type 1 fringe benefit exists where the employer is entitled to input tax
credits (i.e., a refund of GST paid) in relation to the provision of a fringe
benefit: ss 5C(3) and 149A of the FBTAA. See Chapter 25 for when a
taxpayer is entitled to input tax credits.
A Type 2 fringe benefit is any fringe benefit which is not a Type 1 fringe
benefit: s 5C(4). For example, where an employer did not pay GST in relation
to the provision of the fringe benefit, the fringe benefit will be a Type 2 fringe
benefit as the employer is not entitled to input tax credits in relation to that
fringe benefit. Debt waiver fringe benefits and loan fringe benefits are
always Type 2 fringe benefits as GST is not applicable to them.
The separation of fringe benefits into two types is necessary following the
introduction of the GST on 1 July 2000. As we will see in Chapter 25, GST is
borne by private consumers and not businesses. Where a fringe benefit is
provided by an employer, there is an additional benefit to the employee in
the GST that has not been paid – that is, if the employee had acquired the
benefit themselves they would have paid an additional 10% in GST, and the
GST “saved” is an additional benefit of receiving a fringe benefit. The gross-
up mechanism discussed at [7.410] adds the GST that has not been paid
back into the FBT base.
Fringe benefits taxable amount [7.410]
The next step is to calculate the “fringe benefits taxable amount” as
prescribed by s 5B of the FBTAA. The fringe benefits taxable amount is
calculated by “grossing-up” the taxable value of the fringe benefit by the
appropriate rate.
As mentioned at [7.400], the “gross-up” takes into account the fact that the
employee has received an additional benefit in the form of the “GST saved”
on receiving a benefit. The “gross-up” also adds the FBT payable on the
fringe benefit back into the tax base. Where an employee receives salary,
the tax on the salary is paid by the employee. However, where the employee
receives a fringe benefit, the tax on the fringe benefit (FBT) is paid by the
employer. As such, the employee has received an additional benefit since tax
is paid by the employer rather than the employee.
Example 7.31: Fringe benefits taxable amount
Ivo’s employer provides him with a mobile phone. The provision of
the mobile phone is a fringe benefit and the taxable value of the
fringe benefit is determined by the method discussed earlier. The
taxable value only relates to the provision of the mobile phone. In
addition, Ivo has also received a benefit in that he has not had to
pay GST on the acquisition of the phone. The “GST saved” is also a
benefit to Ivo and FBT is payable on that benefit. Ivo receives a
further benefit in that he does not pay income tax on the receipt of
these benefits. The “income tax saved” is also a benefit received by
Ivo, and FBT is payable on that benefit. The “gross-up” adds the
GST saved and the income tax saved by Ivo into the tax base – that
is, the amount upon which the FBT liability is ultimately calculated.
Many students, and even some tax professionals, often find it difficult to
understand the reasoning behind the “gross-up”. It is not essential in
determining the FBT consequences to understand the reasoning behind this
and the fringe benefits taxable amount can simply be calculated in
accordance with the following formulae:
For a Type 1 fringe benefit, the fringe benefits taxable amount equals:

With the current (i.e., for the year ending 31 March 2021) FBT rate of 47%
and GST rate of 10%, the fringe benefits taxable amount for Type 1 fringe
benefits equals:
Total taxable value of all Type 1 fringe benefits × 2.0802
For a Type 2 fringe benefit, the fringe benefits taxable amount equals:
With the current (i.e., for the year ending 31 March 2021) FBT rate of 47%,
the fringe benefits taxable amount for Type 2 fringe benefits equals: Total
taxable value of all Type 2 fringe benefits × 1.8868
FBT liability [7.420]
The final step is to determine the employer’s FBT liability, which is calculated
as:

[(Type 1 fringe benefits taxable amount) + (Type 2 fringe benefits

taxable amount)] x FBT rate

See ss 5B(1A) and 66 of the FBTAA. The “FBT rate” is equal to the highest
marginal tax rate plus the Medicare levy. For the FBT year ending 31 March
2021, the FBT rate is 47%.

Interaction with income tax

Employer [7.430]
From an employer’s perspective, any FBT liability incurred in relation to the
provision of fringe benefits and the cost of providing the fringe benefit are
generally deductible as ordinary business expenses under s 8-1 of the ITAA
1997: see also Ruling TR 95/24.
The FBT liability is generally deductible as an expense incurred in gaining or
producing assessable income that is not capital or capital in nature; private
or domestic in nature; incurred in gaining or producing exempt or non-
assessable non-exempt income; or a denied deduction: see Chapter 12. It
should also be noted that the deductibility of the FBT liability for income tax
purposes does not impact on an employer’s FBT liability. For example, an
employer’s FBT liability is not reduced because the employer chooses not to
claim a deduction for the FBT liability: Determination TD 94/42.
The cost of providing a fringe benefit is also generally deductible under s 8-1
of the ITAA 1997 as an ordinary business expense: see Chapter 12. Broadly,
the mechanism for calculating FBT and the fact that both the cost of
providing a fringe benefit and FBT are deductible to an employer mean that,
from a tax perspective, employers are generally indifferent in respect of
providing employees with salary or fringe benefits. The fact that a benefit is
an exempt benefit or that the taxable value of a benefit is reduced for any of
the reasons discussed at [7.360]–[7.390] generally does not affect the
employer’s entitlement to a deduction for the cost of providing the fringe
benefit.
There is an important interaction between FBT and the deductibility of
expenses which is worth noting. Certain expenses that are generally denied
deductions (see [12.240]–[12.260]) are deductible if incurred in the provision
of a fringe benefit. For example, entertainment expenses are generally not
deductible under s 32-5 of the ITAA 1997 but are deductible under s 32-30,
where the entertainment expenses are incurred in the provision of a fringe
benefit. The amount of the deduction will depend on the treatment of the
entertainment expenses for FBT purposes. For example, where the 50/50
split method is used for calculating the taxable value of meal entertainment
fringe benefits, only half the meal entertainment expenses will be deductible
for income tax purposes as only half the meal entertainment expenses have
been treated as a fringe benefit (see also s 51AEA of the ITAA 1936).
Other expenses that are generally not deductible for income tax purposes,
but which are deductible when provided as a fringe benefit, include:
• higher education contribution payments: s 26-20(2);
• a relative’s travel expenses: s 26-30(3);
• recreational club expenses: s 26-45(3); and
• leisure facility expenses: s 26-50(8).
These generally denied deductions are only deductible when provided as a
fringe benefit. If the benefit is an “exempt benefit”, a deduction is not
allowed as exempt benefits are not “fringe benefits”: see definition of “fringe
benefit” in s 136(1).

Example 7.32: Denied deductions and exempt fringe benefits

Following on from Example 7.22, the cost of the end of financial
year dinner is potentially deductible due to s 32-20 of the ITAA 1997
as the cost of providing entertainment by way of providing a fringe
benefit. However, as discussed in Example 7.22, the provision of the
dinner would qualify as a “minor benefit” and thus be an “exempt
benefit” under s 58P. Exempt benefits are not fringe benefits per
the definition of “fringe benefit” in s 136(1) and therefore, the cost
of the dinner is not deductible.
Finally, note that any amounts received directly by an employer
from an employee in respect of a fringe benefit (recipient’s
contribution) may constitute assessable income of the employer.
Employee [7.440]
For an employee, fringe benefits constitute non-assessable, non-exempt
income of the employee: s 23L(1) of the ITAA 1936; s 15-2 of the ITAA 1997.
This is the case even where little or no FBT has been paid in relation to the
fringe benefit because of a reduction to the taxable value of the fringe
benefit.
Exempt fringe benefits are treated as exempt income of the employee: s
23L(1A) of the ITAA 1936; s 15-2 of the ITAA 1997.
Where the taxable value of an employee’s fringe benefits exceeds $2,000,
the employer is required to report the fringe benefits on the employee’s
Payment Summary (subject to certain exceptions), and the employee is
required to report these fringe benefits on his or her income tax return.
These “reportable fringe benefits” do not affect the employee’s income tax
liability, but do affect the calculation of certain amounts, such as the
Medicare levy surcharge or Higher Education Loan Program (HELP)
repayments.
Interaction with GST [7.450]
As discussed at [7.410], the fact that an employer may be entitled to a
refund of GST paid on the acquisition of a fringe benefit, while an employee
would generally not be entitled to a refund, is taken into account in
determining the FBT liability through the grossing-up mechanism. As such,
the cost of a fringe benefit in determining taxable value is the GST-inclusive
cost: Ruling TR 2001/2. Where the fringe benefit relates to a reimbursement,
s 111-5 of the A New Tax System (Goods and Services Tax) Act 1999 (Cth)
deems the acquisition to have been made by the employer for GST
purposes. This provision enables the employer to obtain GST input tax
credits in relation to the acquisition (if entitled) even though the acquisition
was actually made by the employee and the employer only reimbursed the
employee.
As will be seen in Chapter 25, the provision of employee services and the
receipt of fringe benefits may be considered a barter transaction that gives
rise to GST consequences. However, s 9-75(3) of the A New Tax System
(Goods and Services Tax) Act 1999 provides that such transactions will not
give rise to a GST liability unless the recipient makes a contribution for the
benefit. Where the employee makes a contribution towards the benefit, the
employer is registered for GST purposes and the benefit is not GST-free or
input-taxed, the employer will have to remit one-eleventh of the recipient’s
contribution in GST to the ATO in respect of the supply of the fringe benefit.

Questions [7.460]
7.1 Determine whether the following benefits are fringe benefits or exempt
fringe benefits and, where applicable, the relevant category of fringe benefit.
Provide reasons for your answer:
(a) Payment to employee for the estimated cost of the employee’s home
phone bill as the employee sometimes has to use the home phone for work
purposes.
(b) Provision of accommodation at the family home to a child who is over 21
and works in the family business.
(c) Payment of employee’s superannuation contribution by the employer to a
complying superannuation fund.
(d) Loan by Company X to one of its directors, Rupert, who is also a
shareholder in the company. The company’s rules do not permit loans to
directors.
(e) Payment of taxi fare by employer for employee to travel home after
working late.
(f) Flowers sent to a sick employee. The flowers cost $75.
(g) Provision of a car for an employee’s private use, including payment of all
fuel costs by the employer.
(h) Provision of sandwiches at a lunchtime seminar held at the employer’s
premises.
(i) Provision of an all-expenses-paid holiday to an employee who has had to
work every weekend for the last six months.
(j) Provision of two laptop computers to an employee who regularly attends
clients’ premises.
7.2 Jill is a scientist at a research laboratory. Her employer provides her with
a protective coat to use while working. She is also reimbursed for any travel
expenses incurred for travel from home to work after hours. Jill sometimes
has to work late if the experiments take longer than expected. Jill usually
uses a ride-sourcing service rather than a taxi as it is cheaper.
Advise Jill and her employer as to the tax consequences arising out of the
above information.
7.3 Loo is an employee at a large real estate agency. He has negotiated the
following benefits with his employer:
• Provision of a car for work and personal use. Loo was provided with the car
for the period 1 April 2020 to 31 March 2021. The leased car value was
$22,000 at 1 April 2020, and the car had only been leased for a year at that
time. Loo is required to pay for any petrol costs which he has determined to
be $1,300 for the period 1 April 2020 to 31 March 2021.
• Provision of the latest model smart phone on 1 April each year as Loo is
usually “on the street” and needs a good phone to do his job. Loo estimates
that he uses the phone 70% for work purposes. The phone was purchased
new on 1 April 2020 for $1,100 (including GST).
Advise Loo’s employer as to the FBT consequences (including calculation of
any FBT liability) arising out of the above information. You may assume that
any benefits are Type 1 fringe benefits.
7.4 Shah is an engineer. His employer provides interest-free loans to its
employees as one of its employment benefits. At 31 March 2021, Shah had
an outstanding loan of $3,000 with his employer. Shah had borrowed the
money on 1 December 2020 to pay for some emergency renovations at
home. The employer has also agreed to reimburse Shah for the cost of his
children’s school fees. Shah received a payment of $30,000 from the
employer on 27 February 2021 in relation to this. Advise Shah’s employer as
to the FBT consequences (including calculation of any FBT liability) arising
out of the above information. You may assume that home renovations and
children’s school fees are not deductible expenses for tax purposes. You may
also assume that any benefits are Type 2 benefits.
7.5 Rita’s employer sells furniture. On 17 January 2021, Rita purchased a
table from her employer for $1,000. The table would usually be sold for
$3,000 and cost the employer $500 to purchase. The employer decided to
give Rita a tablecloth for the table as a “free gift” for the purchase of the
table. The tablecloth would usually be sold for $150 and cost the employer
$50 to purchase. Rita’s employer also decided to host a party on 28 February
2021 for all employees and their partners. In total, there were 20 attendees
(10 employees and 10 partners) and the party cost $3,300 (including GST).
The party was held at a local Mexican restaurant.
Advise Rita’s employer as to the FBT consequences (including calculation of
any FBT liability) arising out of the above information. You may assume that
any benefits are Type 1 benefits. You may also assume that Rita’s employer
has not provided Rita with any other benefits and that Rita’s employer has
no other meal entertainment expenditure for the year, elects for Div 9A to
apply to the provision of meal entertainment fringe benefits and determines
the taxable value of meal entertainment fringe benefits using the 50/50 split
method.
Chapter 8 - Income from business
Key
points ............................................................................................
......... [8.00]
Introduction...................................................................................
............... [8.10]
Step 1: Carrying on a
business...................................................................... [8.20]
Indicators of a business
activity .................................................................. [8.30]
Gambling .......................................................................................
.............. [8.60]
Sportspeople .................................................................................
.............. [8.80]
Investment
activities ...................................................................................
[8.90]
Land
sales .............................................................................................
....... [8.100]
Sharing
economy ........................................................................................
[8.105]
Crowdfunding
activities ..............................................................................
[8.107]
Commencement and termination of
business ........................................... [8.110]
Step 2: Normal proceeds of a
business ...................................................... [8.130]
Nature of the business – broad or narrow
approach?............................... [8.140]
Nexus of receipt with
business ................................................................... [8.150]
Non-cash business
benefits......................................................................... [8.160]
Extraordinary and isolated
transactions...................................................... [8.170]
Introduction ...................................................................................
.............. [8.170]
Transaction forms a business in itself under the
principle in FCT v Whitfords
Beach ............................................................. [8.180]
Principle applied to isolated
transactions ................................................... [8.180]
Principle applied to extraordinary
transactions .......................................... [8.190]
Calculating ordinary income under the principle in FCT v Whitfords
Beach ............................................................................................
........................... [8.200]
Two strands of
Myer ....................................................................................
[8.210]
First strand of
Myer ......................................................................................
[8.220]
Second strand of
Myer ................................................................................. [8.260]
Statutory provisions that may apply to extraordinary and isolated
transactions ..................................................................................
..................................... [8.265]
Capital gains
tax ............................................................................................
[8.270]
Section 15-10: Bounties and
subsidies ......................................................... [8.280]
Section 15-15: Profit-making undertaking or
plan ....................................... [8.290]
Section 25A: Profit from sale of asset acquired with the purpose of
resale ............................................................................................
............................ [8.300]
Questions ......................................................................................
................. [8.310]

Key points [8.00]

• Business income is ordinary income under s 6-5 of the Income Tax
Assessment Act 1997 (Cth).
• Whether a business is being carried on or not will be determined by
weighing up whether sufficient characteristics of a business are present.
• No one of the indicators of a business is decisive in classifying an activity
as a business.
• Some activities are by nature more likely to be pursued as a hobby or for
recreational purposes and are therefore less likely to be classified as a
business.
• As well as identifying the business, it is also necessary to decide when the
business commences and ends as receipts not associated with the operation
of the business are not business income.
• Receipts that are not the normal proceeds of the business are not
assessable as business income but may be assessable under one of the
other principles of ordinary income or statutory income.
• Non-cash business benefits are deemed to be convertible to cash by s 21A
of the Income Tax Assessment Act 1936 (Cth) and, provided they are income
of the business, they are assessable and valued at an arm’s length value.
• One-off transactions undertaken by taxpayers who are not running a
continuous business are called isolated transactions.
• Transactions undertaken by taxpayers that are running a continuing
business but that are not within the scope of that business are called
extraordinary transactions.
• Isolated and extraordinary transactions usually only generate ordinary
income if they fulfil the requirement of one or more of the following three:
• the principle in FCT v Whitfords Beach;
• the first strand of FCT v Myer Emporium; or
• the second strand of FCT v Myer Emporium.
• The principle in FCT v Whitfords Beach is likely to be satisfied if the
isolated/extraordinary transaction has sufficient characteristics of a business.
• The first strand of FCT v Myer Emporium will be satisfied if there is a
business/commercial transaction, a profit-making intention upon entering
the transaction and consistency between the way the profit is made and the
original intention.
• The second strand of FCT v Myer Emporium will be satisfied where a
taxpayer sells the right to income but retains ownership of the underlying
asset that is the source of the that income.
• Profits from isolated and extraordinary transactions will often be taxable
under capital gains tax.

Introduction [8.10]
Income earned from carrying on a business is ordinary income under s 6-5 of
the Income Tax Assessment Act 1997 (Cth) (ITAA 1997) following the general
concepts of income outlined in Chapter 5. This is in contrast to non-business
activities, such as hobby or pleasure activities, which do not generate
ordinary income and therefore are not assessable under s 6-5.
Characterising receipts as ordinary income from a business activity is a two-
step process that requires: 1. determine whether the taxpayer is carrying on
a business; and 2. consider whether the particular receipts are in fact the
normal proceeds of carrying on that business.
This two-step process removes from assessable income activities that are
undertaken as a hobby or recreational pursuit and receipts that are not the
normal proceeds of the business because they are outside the scope of the
business activity. However, receipts that are not the normal proceeds of the
business may still be assessable as ordinary or statutory income. This will be
the case if they are characterised as ordinary income by one of the other
general concepts of income (see [8.170]–[8.300]) or if they are specifically
made assessable by the legislation.
Step 1: Carrying on a business [8.20]
Disputes relating to whether or not a business is carried on often arise
because a taxpayer wishes to take advantage of concessions offered to
certain types of businesses, such as farming or the lower tax rates available
for some companies (see Chapter 21). Similarly, the taxpayer may wish to
use the losses from non-profitable activities, such as share trading, against
other taxable income. In contrast, the Commissioner may seek to classify an
activity as a business to collect tax on the profits realised, even though the
taxpayer is treating it as a hobby.

The term “business” is used throughout the legislation, and the definition in
s 995-1(1) of the ITAA 1997 “includes any profession, trade, employment,
vocation or calling, but does not include occupation as an employee”. This
definition is of little assistance as it only adds to the general meaning of
“business” by including any profession, trade, etc, and leaves open the
question of what is a business in the ordinary meaning of the word. As a
result, it is necessary to look at the decided cases to determine the factors
that have been used by the courts in making this decision: Ferguson v FCT
(1979) 9 ATR 873: see Case Study [8.1].
It is significant that the definition of “business” in s 995-1(1) states that it
does not include income from an “occupation as an employee”. This means
that in most cases, employment income will not be business income.
However, in some cases, an employee contract may not be solely a contract
of employment: Spriggs v FCT; Riddell v FCT (2009) 72 ATR 148: see [8.80].
While income from personal services and business income are both generally
assessable under s 6-5 as ordinary income, there are certain consequences
that follow depending on how the income is categorised. For instance, gains
that are business income can be subject to certain types of deductions that
are not available for income that is purely income from personal services:
see [8.80].
When considering if a business is being carried on, the courts have made a
distinction between activities that are conducted in a commercial-like
manner and activities that are pursued as a hobby or recreational activity. As
with other characteristics of ordinary income, this distinction is quite clear at
the extreme ends of the spectrum. However, it is difficult to identify the
point at which a hobby becomes a business, or the point at which activities
first undertaken for pleasure show sufficient characteristics of a commercial
approach to be later classified as a business.
Indicators of a business activity [8.30]
Over the years, the courts have identified a number of characteristics of a
business, and the presence, or lack, of these characteristics has been used
to classify the activity as a business or a hobby. However, this is a very
imprecise process, and it is extremely important to appreciate that the
characteristics used by the courts are not necessarily exhaustive and no one
characteristic alone is a single indicator of a business.
To ascertain whether a business exists, the courts use an accumulative
approach of weighing up the characteristics of a business that are present
and comparing them to those that are absent. On balance, a decision is then
reached as to whether the activity possesses sufficient of the characteristics
to be classified as a business. This approach involves a question of degree
(weighing up the facts toward a possible conclusion) and, like all other
questions of degree, it is difficult to draw a precise line between activities
that are a business and those that are not. It is also important to recognise
that the courts may place varying degrees of importance on particular
characteristics for different types of activities. For example, the courts tend
to look for a higher level of certainty that a business exists for activities such
as gambling: Evans v FCT (1989) 20 ATR 922; Brajkovich v FCT (1989) 20
ATR 1570.
[8.40] Although it is not possible to create an exhaustive list of the
characteristics of a business, the following are the most common factors that
have been considered by the courts (Ferguson v FCT (1979) 9 ATR 873: see
Case Study [8.1]; FCT v JR Walker (1985) 16 ATR 331: see Case Study [8.2]):
• Whether there is a profit-making intent. A profit-making intention is a
strong, though not determinative indication that there is a business. In
addition, a lack of profit-making intention does not necessarily preclude
there being a business, especially if the operation has sufficient other
characteristics of a business: Stone v FCT (2005) 59 ATR 50: see Case Study
[8.8]. Furthermore, it is not necessary to show the existence of an actual
profit to show a profit-making intent.
• The scale of activities, including the nature and type of capital and the
level of turnover. For example, the larger the business turnover, the more
likely it would be held to be a business, but this does not exclude small
activities from being held to be a business: FCT v JR Walker (1985) 16 ATR
331: see Case Study [8.2].
• Whether a commercial approach is taken. For example, whether
professional advice has been sought before and during the operation,
whether markets for produce have been explored and whether the produce
is more than that needed for domestic purposes.
• System and organisation employed. For example, the degree of planning
involved, the amount of time devoted to the activity and whether records are
kept. Generally, the courts have been willing to accept that taxpayers may
delegate many of the businesslike activities to a manager yet still be
considered to be running a business: Ferguson v FCT (1979) 9 ATR 873; FCT
v JR Walker (1985) 16 ATR 331.
• Methods characteristic of the particular line of business. For example,
using methods similar to those used in a similar commercial business, such
as a dairy farmer using planned breeding programs to increase milk
production.
• Sustained and frequent activity. For example, occasionally selling pups
from your pet dogs is not the same as regularly breeding a particular type of
dog and aiming to sell the offspring.
• The type of activity and the type of taxpayer. For example, a business of
trading in stamps would have to be much more than the traditional pastime
of a hobbyist collecting stamps and occasionally selling some duplicates.
Case study 8.1: Indicators of a business
In Ferguson v FCT (1979) 9 ATR 873, the taxpayer (Ferguson)
planned to purchase rural land on which he intended to establish a
full-scale cattle production business for his retirement in two to
three years’ time. To begin building up his planned herd of 200
Charolais cattle, Ferguson leased five females for four years and
bred them to a stud bull in order to establish his purebred herd.
Ferguson also entered into a management agreement with a rural
management firm for a period of 10 years for the purpose of
managing the leased cattle and their calves. The management
agreement required the manager to find suitable grazing for the
cattle and to manage their breeding. All resulting offspring became
the property of the taxpayer. The taxpayer contended that these
activities constituted a business, but the Commissioner argued that
this was only preparation for a future business.
The Full Federal Court held that Ferguson was carrying on a
business, even though it was small and even though it was
preliminary to his intended future business. Central to the
conclusion reached by the Court was the question of whether the
taxpayer was conducting this breeding program in a commercial
manner albeit carried out by a manager. In its decision, the Court
considered the following factors:
• A purpose of profit-making may be important but not essential.
• Repetition and regularity are considerations, but a business could
involve a single transaction and every business must commence
with a single transaction.
• Organisation and a businesslike approach with appropriate record
keeping, etc, is an indication of a business activity.
• Having other sources of income did not preclude this activity from
being a business. In other words, the fact that the taxpayer had a
full-time job was not inconsistent with him carrying on a business.
• The size of the operation and the amount of capital are relevant,
but must be looked at in the context of the type of activity. For
example, a recreational pursuit may have considerable effort and
resources contributed to it and still not be a business.
• These activities were more than preparation to begin a future
business.

[8.50] When using these factors to characterise an activity as a business or

not, the courts will weigh up the factors present in the context of the type of
activity, but there is no single determinative factor that is a reliable indicator
of a business. However, the courts may place a relatively higher degree of
importance on whether the taxpayer is taking a commercial approach, by
conducting the activity in a manner similar to that used in situations that are
clearly conducting a business: Thomas v FCT (1972) 3 ATR 165; Ferguson v
FCT (1979) 9 ATR 873; FCT v JR Walker (1985) 16 ATR 331.

Case study 8.2: A small-scale goat-breeding operation was a

business
In FCT v JR Walker (1985) 16 ATR 331, the taxpayer was a real
estate agent who was interested in breeding Angora goats. He
purchased one female Angora goat for $3,000, and then paid
another $2,000 to have the goat impregnated. The breeding process
undertaken by the taxpayer involved substantial assistance by a
veterinary surgeon called Dr Corbett, who undertook many of the
actions and decisions of the goat-breeding operation since the
taxpayer lived over 3,000 km away and so could not be directly
involved in its everyday running. The breeding eventually led to the
birth of four more goats, though the original goat and one of its
offspring prematurely died. Although the taxpayer stated that he
intended to profit from the breeding operation, in fact it only
produced losses. Consequently, after a few years the taxpayer quit
the goat-breeding operation. However, while the goat-breeding
venture was running, the taxpayer relied upon Dr Corbett for
advice, joined the Angora Breeding Society, read that society’s
journals and kept detailed books of accounts.

Justice Ryan of the Supreme Court of Queensland held that the

taxpayer had been running a business rather than a hobby. His
Honour applied the criteria outlined in Ferguson v FCT for deciding
if there was a business. Specifically, the conclusion that there was a
business was partially supported by the fact that the taxpayer had a
profit-making intention. It was also supported by the fact that there
was repetition and regularity in the breeding activities in that the
breeding process was undertaken repeatedly for a number of years.
The conclusion was also highly influenced by the fact that the
taxpayer conducted the operations in a businesslike manner, as
evidenced by his keeping of accounts, joining the Angora Breeding
Society, reading the relevant journal and generally keeping himself
informed about the Angora goat-breeding market. While many of
the actions and decisions were deferred to Dr Corbett, this was
understandable given the fact that the taxpayer lived some
distance from the operation and that Dr Corbett had much more
expertise and knowledge on the subject of breeding Angora goats.

The finding in FCT v JR Walker that the taxpayer was running a

business was despite the fact that the operation was small even
though size was mentioned in Ferguson v FCT as relevant in
determining the existence of a business. Therefore, although
volume of operations is a factor in deciding whether there is a
business, a small operation can still constitute a business if there
are sufficient other businesslike characteristics.
Case study 8.3: A small business or a hobby
In Thomas v FCT (1972) 3 ATR 165, the taxpayer (Thomas) was a
barrister who purchased 7.5 acres (3.04 ha) of land where he
constructed a private home and planted several varieties of trees
for timber, macadamia nut and avocado production, some of which
were irrigated. For the relevant period no income had been
produced and some of the trees had been destroyed by fire and
there had been some replanting. Thomas contended that he was
carrying on a business, but the Commissioner argued that this was
a hobby because it was not likely that there would be any
significant income and this type of agriculture was not common in
this area. The High Court held that there was a business of primary
production and that a business may exist even though it is
conducted on a small scale and has little or no short-term prospect
of making a profit. It was not significant that the taxpayer’s main
income was earned from his profession as a barrister or that only a
small amount of time was devoted to the farming activity. What was
important was that the tree planting was much greater than what
would be needed for domestic purposes and the activity was more
than a recreational pursuit or hobby. Walsh J was not swayed by
evidence that the business was conducted rather inefficiently, and
his Honour concluded that it is reasonable to accept that mistakes
will be made and the taxpayer did seek technical advice to assist
with management decisions.
Distinction between a business and hobby in Thomas v FCT centred
on the issue of whether the farming undertaken was more than a
recreational activity pursued for mainly leisure purposes.
Example 8.1: Degree of commercial approach
A taxpayer who plants vegetable and fruit trees in his own backyard
and uses the produce for his own personal consumption is clearly
not conducting a business. This would still be the case even if small
amounts of excess produce are sold to neighbours, as this is
unlikely to be enough to cross the border between a hobby and
business.

Establishment of a business for income tax purposes requires some

degree of commerciality, which would be indicated by production
being more than required for domestic consumption and a more
systematic and organised approach to the vegetable and fruit
production: Ferguson v FCT (1979) 9 ATR 873. Facts such as using
land other than the backyard, selling produce on a regular basis at
the local markets, seeking professional advice on production
techniques, planning production to meet demand and keeping
appropriate records would all help to indicate that a commercial
approach is being employed.
As previously mentioned, there is no exact formula for identifying
the dividing line between a business and a recreational activity or
hobby. Each case must be considered on its facts and decided in the
light of the factors that the courts have considered relevant in the
decided cases. Some examples to assist in narrowing the degree of
uncertainty in this decision include:
• gambling: see [8.60];
• sportspeople’s earnings: see [8.80];
• investment activities: see [8.90]; and
• land sales: see [8.100].
Gambling [8.60]
Taxpayers such as professional bookmakers and casino operators are clearly
running a business because they take a commercial approach in that they
operate on such a large scale that they can reasonably manage the odds of
winning and predict their likely profit.
On the other hand, an individual who gambles is very unlikely to be
considered to be in the business of gambling because such activities are
inherently recreational in nature. For instance, a person who regularly bets
on horse races or at the casino is normally undertaking a recreational pursuit
and is not considered to be in the business of gambling.
For an individual to be found to be carrying on a business of gambling, there
would need to be a significant level of commercial activity, such as regular
and systematic betting, large amounts of money wagered and possibly
integration with other business activities like horse racing and horse
breeding: Trautwein v FCT (1936) 56 CLR 196; Prince v FCT (1959) 7 AITR
505. Gambling on horse racing is more likely to be a business if the gambler
is associated with other related activities, such as owning horses, training
horses or operating as a bookmaker: Income Tax ruling IT 2655.

Case study 8.4: Gambling was part of business of horse racing

In Trautwein v FCT (1936) 56 CLR 196, the taxpayer had for a number of
years been interested in horse racing with a view to making a profit. He
devoted a substantial amount of time and money to the sport and
established a farm for breeding racehorses. Trautwein raced his own horses
as well as others that had been leased to him. The taxpayer was also
involved in frequent and systematic betting on horse races wagering large
amounts of money and using an agent to place bets and collect winnings. He
also regularly attended race meetings throughout the year. The High Court
held that the taxpayer’s gambling activities were part of his racehorse
business, and therefore his earnings were ordinary income. Influential to the
Court’s decision was the fact that the taxpayer’s gambling was closely
associated and integrated with his horse-racing business. Other factors
considered relevant were:
• the size of the bets;
• the systematic and organised approach;
• commitment of substantial amounts of money and time to betting; and
• employment of other people to place bets and collect winnings.
[8.70] In Australia, the courts have generally concluded that gambling does
not constitute a business if it is not conducted on a large scale and is not
connected to another business: Martin v FCT (1953) 90 CLR 470; Evans v
FCT (1989) 20 ATR 922; Brajkovich v FCT (1989) 20 ATR 1570. As a result of
the more recent decisions in Martin v FCT and Evans v FCT, it may be
suggested that if facts similar to Trautwein v FCT were considered by the
courts today, the same conclusion may not be reached.
Case study 8.5: Gambling was not a business even though
associated with horse breeding
In Martin v FCT (1953) 90 CLR 470, the taxpayer owned and bred
race horses and had previously carried on business as a hotelier
and then as a farmer. Over the years, he regularly engaged in
betting on horse races in a systematic manner and his accountant
kept the records of his expenses and winnings from gambling.
The High Court held that the taxpayer was not conducting a
business, but pursuing a recreational pastime despite the facts that
there were a large number of bets, he employed a system in his
betting and he had other interests in horse racing.

Case study 8.6: Gambling was not a business due to lack of

systematic approach
In Evans v FCT (1989) 20 ATR 922, the taxpayer earned over
$800,000 from betting on horse racing over a five-year period. The
Federal Court held that Evans was a lucky gambler and was not
conducting a business because of the lack of a systematic approach.
The Court relied on the fact that he did not place his bets with a
bookmaker and he often wagered on long-odds bets.
Case study 8.7: Gambling with no other source of income was not a
business
In Babka v FCT (1989) 20 ATR 1251, on retiring at the age of 51, the
taxpayer had commenced spending a large amount of time
gambling. The gambling was predominantly concentrated on horse
racing, although it included other activities such as card games and
casinos. The taxpayer did not have employees or an office. The
Commissioner claimed that the taxpayer was in the business of
gambling due to the fact that they had no other income, kept
detailed records of previous bets and utilised a betting system.
Justice Hill of the Federal Court held that Babka was not in the
business of gambling. His Honour stated that the fact that a
taxpayer devotes a large amount of time to their gambling
activities, uses a betting system and keeps detailed betting records
does not necessarily mean that they are in the business of
gambling.
Sportspeople [8.80]
Some sporting activities involve a high degree of professionalism to the
extent that participants are fully occupied by their sporting pursuits. Also,
there may be significant amounts of money involved, extensive use of
managers and agents to negotiate individual contracts and significant
involvement of the media and advertising industries. In these circumstances,
it is relatively clear that the participants are carrying on a business of
earning income or at least earning income from personal services: see
[6.30]. In contrast, sporting activities that are undertaken as a recreation
pursuit will not constitute the carrying on of a business although there may
still be income from personal services: see [6.30].

Identifying the receipts of a professional sportsperson as income from a

business or income from personal services (see [6.10]–[6.30]) is important.
This is because it may influence how they are treated for tax purposes as a
team-based professional sports person paid as an employee may have
limited tax deductions compared to a professional sports person judged to
be operating a business: Stone v FCT (2005) 59 ATR 50; Spriggs v FCT;
Riddell v FCT (2009) 72 ATR 148: see Case Studies [8.8] and [8.9].

The tax consequences of a professional sportsperson’s activities constituting

a business, or not, include the following:
• Any fees paid by the club that the professional sportsperson is playing for
will be ordinary income regardless of whether the taxpayer’s sporting
activities are regarded as a business. For example, club payments to a
professional footballer who is in the business of playing football could be
ordinary income from business, but if he is not in the business of playing
football, then the payments would be ordinary income from personal
services.
• Prizes for sporting achievements (see [6.110]) received by a sportsperson
whose sporting activities constitute a business will be ordinary income from
that business: Stone v FCT: see Case Study [8.8]. On the other hand, if the
sporting activities do not constitute a business, prizes received for sporting
achievement may still be regarded as ordinary income from personal
services: Kelly v FCT (1985) 16 ATR 478: see Case Study [6.6]. However, in
the case of sportspeople whose sporting activities constitute a business,
there may still be instances where sporting prizes may not be regarded as
ordinary income if the prize is awarded for the personal qualities of the
taxpayer: Stone v FCT.
• There could be a broader range of deductions available if the taxpayer’s
sporting activities are regarded as a business. For example, if a professional
football player is regarded as being in the business of playing football, then
any fees paid to a manager to enter into a contract with a new team would
be deductible: Spriggs v FCT; Riddell v FCT. However, such fees would not be
deductible if the football player’s sporting activities are not regarded as
being a business. This is because the first limb of s 8-1 of the ITAA 1997
(only available to employees) requires that the expense is incurred in the
course of earning the income, but agents’ fees are incurred before the
income is earned.
In recent years, the courts have been more likely to label professional
sportspeople as being in business. This has been the case for sportspeople
that regularly play team sports at a high level: Spriggs v FCT; Riddell v FCT.
It has also been the case for taxpayers that compete in non-team sports at
high levels of competitions, especially if the sportsperson also undertakes
related commercial activities, such as seeking corporate sponsorship: Stone
v FCT.

Case study 8.8: Javelin thrower was carrying on a business

In Stone v FCT (2005) 59 ATR 50, the taxpayer (Stone) was a world-
class javelin thrower and was also a full-time employee in the
Queensland Police Force. As well as performing her duties as a
police officer, Stone competed successfully in national and
international competitions, including being selected for the
Australian Olympic squad and winning the women’s javelin event in
the 1998 World Cup.
During the tax year ending 30 June 1999, Stone earned $136,448
from her sporting pursuits. This sum consisted of prize money,
grants from the Queensland Sports Academy, appearance fees and
sponsorship fees. The sponsorship fees were paid for her wearing
clothing of certain brands, as well as her agreeing to have
advertising material on her sporting clothes and the motor vehicle
that was provided to her. The taxpayer also employed a manager for
a short time to manage her sponsorships and appearances.
The High Court held that Stone was carrying on a business in
relation to her sporting activities and that all cash receipts from
this business were ordinary income under s 6-5 of the ITAA 1997.
The Court stated that although Stone lacked a clear profit motive,
an examination of the relevant activities indicated that she was
carrying on a business. In reaching this decision, the Court was
particularly influenced by the fact that Stone had entered into
sponsorship deals. The Court also mentioned that although the
presence of a profit motive is a strong, though not conclusive,
indication that the taxpayer is running a business, an operation can
still be a business despite the taxpayer lacking a profit motive.
Case study 8.9: Professional team sportspeople are carrying on a
business
In Spriggs v FCT; Riddell v FCT (2009) 72 ATR 148, both taxpayers
played football in their respective football leagues and arranged for
their managers to negotiate new player contracts upon them
changing clubs. Following the completion of the negotiations of the
player contracts, the managers charged their clients a fee, which
Spriggs and Riddell claimed as a tax deduction.
One issue considered by the High Court was whether Spriggs and
Riddell were carrying on a business and, if so, the extent of their
business activities. Due to the rules of deductibility, management
fees relating to entering contracts with new clubs would only have
been deductible if the sport-playing activities were business
activities: see [12.340]–[12.350].

It was accepted by all parties that activities outside their playing

duties (e.g., endorsement and media engagements) were business
activities. However, the Commissioner contended that the older
decision in Maddalena v FCT (1971) 2 ATR 541 should be followed.
In Maddalena v FCT, the Court had held that professional football
playing activities were employment activities and not business
activities. The High Court found that Maddalena v FCT did not apply
to the facts in Spriggs and Riddell and held that the taxpayers’
sports-playing activities were business activities. The Court
distinguished Maddalena v FCT on the basis that in Maddalena v
FCT the taxpayer played rugby part time and had no manager. In
contrast, the taxpayers in Spriggs and Riddell played football full
time and had managers. Furthermore, the Court was influenced by
the fact that modern-day football had changed since the case of
Maddalena v FCT in that changing clubs was easier and more
structured than had previously been the case.
Investment activities [8.90]
Investment income will normally be characterised as income from property
(see Chapter 9) because it is inherently passive in nature and is earned
without showing sufficient of the elements of a business: FCT v Radnor Pty
Ltd (1991) 22 ATR 344. However, whether investment income is property or
business income can be an important distinction as it will affect the tax
treatment of the transactions. Where investment income is classified as
property income, the acquisition of the underlying investments, such as
shares and rental property, will be treated as capital and the sale will not be
ordinary income. Conversely, if the investment activity is classified as a
business, the underlying investment, such as the shares, will be regarded as
trading stock (see Chapter 17) and treated on revenue account as ordinary
income, rather than as capital.
Identifying investment activities as a business is a question of degree which
will be determined from the facts, taking into account the previously
identified indicators of a business: see [8.30]–[8.50]. For example, large
superannuation funds and listed investment trusts are commonly in the
business of investment. However, there has to be something more than a
profit-making intention and frequent transactions to show that the taxpayer
is carrying on a business of investing.
In London Australia Investment Co Ltd v FCT (1977) 7 ATR 757, the High
Court held that a business of investment was being carried on due to the
high degree of activity in investing and reinvesting in shares to maintain a
minimum dividend yield. In contrast, a business that invests for long-term
growth, rather than speculative investment, will normally be classified as
earning property income and not income from a business: AGC (Investments)
Ltd v FCT (1992) 23 ATR 287; Smith v FCT [2010] AATA 576. For example, a
taxpayer who purchases a portfolio of shares as a long-term investment for
capital growth, but occasionally sells some of the shares to restructure the
portfolio, is not conducting a business of selling shares. This is illustrated by
the Commissioner’s view that a self-managed superannuation fund that
holds shares and/or rental property to earn passive income is not carrying on
a business: Self-Managed Superannuation Fund Ruling 2009/1. Whereas a
bank that holds a large portfolio of shares and regularly speculates on
movements in the share market and trades in these shares to maintain
liquidity is in the business of buying and selling shares.
In Taxation Ruling TR 2019/1, the Commissioner expresses the view that a
company, that is a small business entity for tax purposes, can be taken to be
carrying on a business even if the activities are quite limited. This would be
the case even if the company’s income consists mainly of passive income
such as rent or interest. Nevertheless, the statement in the draft ruling is
qualified with the comment that each case has to be determined on the
facts.

Case study 8.10: Holding shares for long-term growth was not
carrying on an investment business
In AGC (Investments) Ltd v FCT (1992) 23 ATR 287, the taxpayer
(AGC (Investments)) was a subsidiary of an insurance company and
was set up to earn dividend income and maximise long-term capital
growth for the parent company. The share portfolio was
professionally managed and the parent company treated the value
as a capital reserve in its balance sheet. In 1987, the taxpayer
decided to sell over 50% of its share portfolio, realising almost $80
million and a significant profit. AGC (Investments) then reinvested
the proceeds into fixed interest securities. The Full Federal Court
held that AGC (Investments) was not carrying on an investment
business but was holding the shares for long-term capital growth.
The key facts in reaching this decision were that there was clear
evidence that the investments were undertaken for long-term
growth rather than speculative returns. In addition, the shares were
not bought and sold to maintain liquidity for the parent company.
Under current legislation, the sale of these shares would be subject
to capital gains tax: see Chapter 11.
Most cases concerning the business status of share trading
activities have involved facts relating to larger financial
institutions. Even so, it is still possible for an individual to be
conducting a business of share trading. This is a question of fact as
it is with all other decisions as to whether an activity is a business
for tax purposes. For instance, in AAT Case 4083 [2011] AATA 545, it
was held that an individual taxpayer trading shares in his own name
was in the business of share trading for income tax purposes. The
primary reasons for reaching this conclusion, despite the small
number of sales in the year, were that the taxpayer operated on a
large scale (millions of dollars), he normally traded regularly, he
followed a systematic approach even though he did not have clear
goals and he was often seeking volatile shares.
Land sales [8.100]
As with other decisions as to whether a business is being carried on, it is
difficult to draw a clear line between the sale of land that is capital as a
“mere realisation” (disposal of an asset that is no longer required) of an
asset and the business of property development. Where the firm’s primary
activity is purchasing, developing and selling land, it is clearly undertaking
an ongoing business of selling land: FCT v St Hubert’s Island Pty Ltd (1978) 8
ATR 452. Conversely, a firm that sells a factory and accompanying land
because the property is no longer required is clearly not in the business of
selling land, even though it may conduct some other business in the factory.
However, if the land could potentially be rezoned as residential and the firm
decides to undertake extensive development activities, the question arises
as to whether the firm has entered a new business of property development:
see [8.170]–[8.200].
Whether the sale of land is part of an ongoing business activity will be
resolved by considering the extent to which the elements of a business are
present. However, land may also be sold as an isolated transaction, which
may be classified as ordinary income: see [8.170].
Sharing economy [8.105]
In recent years, there has been a rapid increase in the “sharing economy”,
as it has become known. The concept of the sharing economy is that the
Internet is used to connect a client with a service provider. Some of the more
common examples are the renting accommodation space (rooms or whole
houses) through such sites as Air BNB, Stayz and Booking.com; ride-sourcing
through Uber, DiDi, Ola and GoCatch; providing personal services through
Airtasker or Oneflare; retail activities operated through eBay; and renting
parking space through Parkhound. All of these activities allow providers to
make their services or product available to a wide range of potential clients
without the usual infrastructure such as websites and advertising that
businesses normally require to access their markets.
The sharing economy has come under scrutiny by the Australian Taxation
Office’s (ATO) Black Economy Taskforce as there is some concern that some
operators in the sharing economy are treating receipts as cash and not
considering whether they are assessable income.
Providers operating in the sharing economy need to be aware of the possible
income tax obligations that arise from providing services via these websites.
These obligations will primarily depend on whether they have earned income
from personal services (see Chapter 6) or whether they are conducting a
business. There could also be other taxation implications such as liability to
GST (see Chapter 25) and effects on CGT main residence concessions if part
of your main residence is available to the public for accommodation: see
later in this chapter.
Earlier in this chapter, the characteristics of a business were discussed in
detail, and this will be an important consideration as to whether the receipts
from these activities are assessable or not as ordinary income under s 6-5 of
the ITAA 1997. The primary distinction to be made is whether the activities
are undertaken for recreational purposes as a hobby (not ordinary income)
or conducted in a businesslike manner to earn assessable income.

Where these services are provided through a facilitating website, such as

Uber or Air BNB, it will be very difficult to make the case that this is a private
recreational activity (hobby) as there are significant characteristics of a
business present: see [8.40]. For example:
• pricing of the services on offer would indicate an intention to profit;
• the scale of the operation may be small, but this does not exclude the
activity from being a business if it is conducted in a businesslike manner.
Conducting the activity through a sharing economy website would be
evidence of a businesslike approach;
• a commercial approach is evident as the sharing economy websites require
a level of detail and professionalism in the offering of the service. For
example, Air BNB requires details of the facilities offered in the
accommodation, and they require a certain level of standard;
• the provider is required to be organised and satisfy the requirement of the
sharing economy website. For example, an Uber driver is required to meet
certain requirements including a vehicle inspection;
• there may or may not be sustained and frequent activities, but when these
activities are undertaken, they show many of the characteristics of a
business.
Note: The Commissioner of Taxation considers income earned from
the sharing economy to be assessable income.

If it is established that operating in the sharing economy is a business

activity, then the normal requirements of the income tax legislation will need
to be satisfied. Income will be assessable, and deductions can be used to
reduce the taxable amount. There will also be the normal record-keeping
requirements. Some of the tax implications of operating in the sharing
economy include:
• income is assessable income;
• liability to GST if the turnover is $75,000 or greater;
• interest relating to property, vehicles or other assets may be deductible in
part or in full based on the degree to which the assets are used to earn
assessable income;
• possible depreciation deductions for depreciating assets or Div 43 write-off
of buildings;
• partial or complete loss of CGT main residence concessions through renting
out part of a home that is designated as a main residence or making paid
parking space available on private property;
• requirements to register an Australian Business Number (ABN); and •
requirements to keep records for tax purposes.
Crowdfunding activities [8.107]
The concept of raising funds from the public for many and varied purposes is
by no means a new idea. In 1700s, Jonathon Swift established a process
whereby wealthier citizens (the crowd) could provide funds to be lent to the
poor in Dublin. However, the development of the Internet has facilitated the
rapid growth of this form of fund raising where a project is funded by raising
small contributions from a large number of people (contributor – the crowd).
The process begins with the initiator (recipient) proposing to raise funds for a
specific purpose (e.g., to develop a new product). They then engage an
Internet-based crowdfunding platform (intermediary’s such as Mycause and
GoFundMe) to promote and collect contributions, and then for a fee or
commission, pass the collected funds onto the initiator or recipient of the
project.
Crowdfunding has been used for a number of purposes including raising
funds for bushfire and drought relief, business start-ups, technology
development and recently, due to changes in government legislation (the
Corporations Amendment (Crowd-sourced Funding for Proprietary
Companies) Act 2018), making it possible for proprietary companies to use
crowdfunding for equity raising.
The income tax impact on funds raised through crowdfunding will depend on
the purpose the funds are raised for and the circumstances of the
taxpayer(s) involved. Generally, crowdfunding will either be:
• a donation (e.g., drought relief);
• reward-based (contributor receives goods or services based on the level of
contribution); and
• equity-based (the contributor obtains an interest in a project with rights to
returns).
For tax purposes, this means that the three parties involved in crowdfunding
need to consider the tax implications of their transactions:
• Initiator or recipient: Is this part of a business activity or not?
• Crowdfunding platform (intermediary): Is this activity a business or are
they operating as an agent?
• Contributor: Are contributions a tax deduction and any return assessable?
Initiator (recipient): Receipts from crowdfunding will be assessable if they
are connected to carrying on a business (see [8.20]), or the receipts are an
extraordinary or isolated transaction entered into with the intention of
making a profit (see [8.170]). However, it is also necessary to consider
whether or not the business has commenced at the time the crowdfunding
arrangements begin (see [8.110]). If the business has not commenced at this
stage, then the receipts will not be ordinary income under s 6-5 of the ITAA
1997 unless it is an extraordinary or isolated transaction. Similarly, if the
business has not commenced, then any expenses will not be deductible
under s 8-1 of the ITAA 1997, but it may be possible to obtain a specific
deduction under s 40-880 (see [12.130]).
Consideration also needs to be given to whether the project is of a capital
nature as capital receipts are not ordinary income but potentially subject to
CGT (see Chapter 11). Capital expenses are also not a general deduction, but
some specific deductions, such as depreciation, may be available (see
Chapter 14).
Intermediary: If the intermediary is in the business of sourcing
crowdfunding projects, promoting the scheme and collecting and distributing
funds, then their receipts will be ordinary income from business and
expenses will be deductible based on the normal tax deduction provisions
(see Chapters 12–14). Distributions to the initiator of the project will also be
deductible as these are an expense (not capital) in carrying on the business
(s 8-1 of the ITAA 1997).
However, if the intermediary acts as an agent (acts on behalf of the initiator)
so that the funds received are not the income of the intermediary but simply
passed to the initiator, then these funds are not ordinary income as they are
not derived by the taxpayer. In this case, the only assessable income would
be any commission received for acting as an agent.
If the intermediary is a tax-deductible charity, then these receipts will be tax
exempt (Div 50 of the ITAA 1997) provided the charity does not breach its
not-for-profit rules.
Contributor: Contributions that are made as a donation to a tax-deductible
charity will be tax deductible for amounts of $2 or more (see [13.130]). As
this is a donation, there will no right to receive any return and therefore
there cannot be any assessable income for the contributor.

Some crowdfunding projects provide the promise of a return to the

contributor depending on the level of contribution. For example, the initiator
has designed a new wine preservation device and seeks funds to put the
product into production. For a contribution of $100, the contributor is
promised one free wine preservation unit (retail value $150) if the
crowdfunding is successful and the product is manufactured. If the
contributor is a private person, then this arrangement is private in nature
and the cost of $100 is not deductible and the receipt of the free product is
not assessable. However, if the contribution is entered in the course of the
taxpayer’s business, the cost will be deductible and any goods or services
provided in return will be assessable as ordinary income.
Example 8.2: Taxation of a crowdfunded donation
A tax-deductible charity raises funds for donation to drought-stricken
farmers. The taxpayer making the donation will be entitled to a tax
deduction for contributions of $2 or more (see [13.130]). Provided the charity
does not breach its not-for-profit rules, then the receipt of these donations
will not be taxable income of the charity as they are exempt income.
If the funds distributed are used for business purposes such as the purchase
of farm supplies, stock feed and other deductible expenses, then the receipt
will be assessable to the recipient as ordinary income under the
compensation principle (see Chapter 10). However, the use of these funds to
purchase stock feed etc. will also result in an equivalent deduction. The ATO
has indicated that where these funds are spent on tax-deductible expenses
(e.g., stock feed), then there will be no net taxable income as the assessable
receipt will be offset by the equivalent deduction. If the funds are used for
private purposes (e.g., food and clothing), then they are not ordinary income
as they are a non-assessable gift (see [6.90]).
Crowdfunding used to raise equity would be treated in the same manner as
similar financial dealings that are currently undertaken.
Commencement and termination of business [8.110]
Once it has been established that there is a business, it may also be
necessary to determine whether a business is being “carried on” during the
relevant tax period. This makes it necessary to identify the times when the
business starts and when it ends. Transactions that occur before the
business commences or after it has ceased are treated differently for tax
purposes to those that occur during the business operation. For example,
expenses incurred before the business starts, or after it ends, may not be
deductible under the general deduction provision and may only be
deductible under a specific provision: see [12.130]–[12.140].
Example 8.3: Preliminary expenses
A taxpayer intending to start a new business may incur preliminary
costs to explore whether the proposed enterprise has a reasonable
chance of success. These costs may include professional advice,
market research, feasibility studies, product testing, pilot
production research, etc. If the business has not commenced, these
expenses will not be deductible under s 8-1 of the ITAA 1997,
although it may be possible to obtain a deduction under statutory
provisions such as s 40-880: see [12.130].
Ascertaining the time of commencement of a business is a question
of fact primarily based on the intention of the taxpayer at the
relevant point in time: Softwood Pulp and Paper Ltd v FCT (1976) 7
ATR 101. For example, product market testing may be undertaken
before the start of operation, but it may also be an ongoing activity
of the business once it has commenced trading. If product testing is
conducted to determine whether there is sufficient demand to
warrant commencing a new business, then this would be a
preliminary expense and not within the scope of the business.
Product testing of a new product line for a firm that already has 50
existing lines would be within the scope of the continuing business.
A key question which the courts have used in drawing this line between
preliminary expenses and operating expenses is: Has the taxpayer
“committed” to commencing the business or merely deciding whether or not
to go ahead? Softwood Pulp and Paper Ltd v FCT; Goodman Fielder Wattie
Ltd v FCT (1991) 22 ATR 26.

Case study 8.11: Feasibility study was not a commitment to

commence business
In Softwood Pulp and Paper Ltd v FCT (1976) 7 ATR 101, the
taxpayer company was incorporated to establish a paper mill for a
Canadian company. Following incorporation, Softwood Pulp
undertook a feasibility study to ascertain whether the proposed mill
would be viable. However, the project never proceeded due to a lack
of funds, and the company never made any substantial income.
The Supreme Court of Victoria found that no business was “carried
on” as these expenses were to determine whether the mill was
viable and, at this point, there had been no commitment to
commence operations. These expenses were incurred before the
income-earning activities commenced, and therefore they were not
deductible under the law at the time.
Case study 8.12: A business had already commenced while land was
being prepared for chestnut farming
In FCT v Osborne (1990) 21 ATR 888, the taxpayer leased land for
the purpose of planting and growing chestnuts. The taxpayer
subsequently entered into a contract to buy chestnut plants and
seedlings and also fertilised the soil due to the land having a
nitrogen deficiency. However, after a year the taxpayer decided to
abandon the chestnut venture because it was not economically
feasible. The venture was abandoned before the taxpayer had
planted chestnut seedlings or plants. The taxpayer wished to
deduct the cost of leasing the land, depreciation on equipment and
paying for labour.
The Full Federal Court held that a business had already commenced
when the taxpayer had taken steps to fertilise the land. However,
the costs were not deductible for a separate reason in that they
were of a capital nature: see Chapter 12 for a discussion on
deductibility of capital expenses.
[8.120] Issues regarding the deductibility of preliminary expenses have
been the main area of dispute that the courts have considered in relation to
the commencement and ending of a business. Nevertheless, the same test
as to whether a business is carried on would reasonably apply to income
earned prior to commencement, provided that the income did not fall into
another category of ordinary or statutory income. Similar principles also
apply when businesses cease to operate and are wound-up.

Example 8.4: Commencement of business

Michelle has for many years been a very keen seamstress, and she
made many of her children’s clothes when they were young.
Occasionally Michelle has also made clothes for friends for special
events, such as weddings and other formal functions. Twice her
friends insisted on paying her amounts of about $300 for the
clothes even though she never asked for any money.
Now that that the family has grown up and left home, Michelle
decided to look into renting a small shop and offer her services to
do clothing repairs and alterations, as well as make garments to
order for special occasions. Michelle’s first step prior to renting a
shop was to talk to her accountant to see whether she thought this
could be a viable enterprise. She also travelled to the nearest major
town to investigate whether there were any other businesses
offering similar services.
On 1 January, Michelle entered a lease for a small shop and spent
money on signs for the window, advertising in the local paper,
additional stocks of supplies, a new sewing machine and computer
to keep records and help with the design of the garments. On 4
March, Michelle received her first order and business has been quite
good ever since. Prior to renting the shop, Michelle is clearly not
carrying on a business as her sewing is mainly domestic and the
small amount of income would be income from a hobby and not
ordinary income under s 6-5 of the ITAA 1997. The costs of seeking
advice from her accountant and exploring the availability of sewing
services are most likely preliminary to commencement of the
business as there is no commitment at this point to commence
operations: Softwood Pulp and Paper Ltd v FCT (1976) 7 ATR 101:
see Case Study [8.11]. Entering the lease agreement is a clear
indication that Michelle has made a commitment to start her
income-earning activity and is a strong indicator of the
commencement of her business, even though no income is derived
until some months later.
Step 2: Normal proceeds of a business [8.130]
Identifying the factors that distinguish a business from a hobby or
recreational activity is the first step in characterising business income as
ordinary income under s 6-5 of the ITAA 1997. The second step is to
determine which receipts are the normal proceeds of the business and which
are not. If a receipt is not earned from “carrying on” the usual business of
the taxpayer, then it is not within the “normal proceeds” of the business,
although it may still be assessable for other reasons: see [8.170]–[8.300];
Californian Copper Syndicate v Harris (1904) 5 TC 159.
Characterising a receipt as part of the normal proceeds of the business
requires:
• an investigation of the nature of the business; and
• an assessment as to whether the receipt shows a nexus with the identified
business activity.

Example 8.5: Are receipts normal proceeds of the business?

Continuing Example 8.4, the nature of Michelle’s business is her
activity as a seamstress, and therefore the normal proceeds of this
business will be the earnings related to her seamstress activities.
However, if Michelle had negotiated a two-year contract to repair
uniforms for a local supermarket, but could not cope with the work
and sold the contract to another business, then this receipt is not
within the normal proceeds of her business. The nature of
Michelle’s business does not include arranging and selling
contracts, and therefore the money received from the disposal of
this contract does not have a nexus with normal business activity.
Consequently, the sale proceeds do not constitute the “normal
proceeds” of the business. Although the sale of the contract is not
the “normal” proceeds of the business, it may be assessable under
other general concepts (FCT v Myer Emporium Ltd (1987) 163 CLR
199: see Case Studies [8.23] and [8.24]) or statutory provisions,
such as capital gains tax: see [8.270].
Nature of the business – broad or narrow approach?[8.140]
The question of whether a receipt is the normal proceeds of the business is
influenced by whether the court adopts a broad or narrow view of what
activities make up the business. If a broad view of the business activities is
adopted, it is more likely that unusual receipts could still be treated as
business income: Memorex Pty Ltd v FCT (1987) 19 ATR 553; see Case Study
[8.15]; GP International Pipecoaters Pty Ltd v FCT (1990) 21 ATR 1; see Case
Study [8.14]. Conversely, if a narrower view is taken of the nature or the
business, it will be less likely that an unusual transaction will be held to be
normal proceeds of the business: Scottish Australian Mining Co Ltd v FCT
(1950) 81 CLR 188 (see Case Study [8.16]); FCT v Merv Brown Pty Ltd (1985)
16 ATR 218 (see Case Study [8.13]).
Example 8.6: Narrow or broad identification of the nature of the
business
A narrow approach to the identification of the nature of the
business may be to say that a scaffolding hire business is not in the
business of selling scaffolding equipment. Therefore, any income
from charges made because scaffolding had not been returned is
not within the normal proceeds of the business as it is effectively a
receipt for the sale of equipment. The narrow approach would be to
look at the primary purpose of the business (hiring scaffolding
equipment) and conclude that the receipts from the disposal of
equipment are not from hiring and therefore are not within the
scope of this business.
Conversely, a broad approach to the identification of the nature of the
business could be to say that income from charges made because
scaffolding had not been returned is a normal and regular component of the
hiring business. Therefore, any receipts resulting from the failure to return
equipment would be within the normal proceeds of the business activity.
Australian courts do not explicitly express whether a narrow or broad
approach is adopted when establishing the nature of the business. However,
case authority suggests that a broader approach is more common, but if a
broad approach is used, the courts then require a strong connection between
the taxpayer’s core business and the unusual activity to show a nexus with
the core business: Memorex Pty Ltd v FCT.
Case study 8.13: Sale of unwanted import quotas were not proceeds of the
business (narrow approach) In FCT v Merv Brown Pty Ltd (1985) 16 ATR 218,
the taxpayer was a clothing importer, but changes to government policy
reduced the profitability of some imported lines. As a result, the taxpayer
decided to sell the import quotas for these less profitable items. The quotas
sold only represented a small percentage of the total number of import
quotas held by the taxpayer.
The Full Federal Court held that the sale of the quotas was of a capital nature
and not within the “normal proceeds” of the business. The majority identified
the taxpayer’s business as the purchase and sale of clothing and material
(narrow approach), and therefore the sale of the import quotas was not the
normal proceeds of this business activity. This decision relied on the fact that
the taxpayer did not normally sell quotas and that these sales were a
reorganisation of the taxpayer’s business as a result of changes to
government policy.
Case study 8.14: Receipts from a contract were within the scope of business
(broad approach) In GP International Pipecoaters Pty Ltd v FCT (1990) 21 ATR
1, two companies successfully tendered to coat pipes that were to be
supplied
to the State Electricity Commission of Western Australia (SECWA) for the
construction of a natural gas pipeline. A requirement of the tender was that
the pipes be coated in Australia, which necessitated constructing a pipe
coating factory. The taxpayer (GP Inter-national Pipecoaters Pty Ltd) was
incorporated by the successful tender companies to construct the pipe
coating facility and carry out the pipe coating required. SECWA paid the
taxpayer a sum of over $5 million to cover some of the cost of constructing
the pipe coating factory, and the taxpayer argued that the receipt of the
money was capital and not within the scope of the business. The High Court
held that the receipt was within the normal proceeds of the business
because the money was received as a result of work which was required to
be carried out due to successfully winning the tender to coat pipes. A broad
approach was used to identify the scope of the business arising out of the
successful tender, holding that the business included both the construction
of the plant and the coating of the pipes.
Nexus of receipt with business [8.150]
Having established the nature of the business, the second step is to
ascertain whether the receipts in question have a nexus to the business
activity and so are the normal proceeds of that business. Case law such as
FCT v Hyteco Hiring Pty Ltd (1992) 24 ATR 218 and Westfield Ltd v FCT
(1991) 21 ATR 1398 (see Case Study [8.22]) indicates that receipts will be
normal business proceeds when they are a product of:
• a transaction that is part of the ordinary business activity, such as a share
trader’s receipts from the sale of shares; or
• a transaction that is an ordinary incident of the business activities – for
example, the sale of ex-lease goods by a leasing company would in some
circumstances be business income: see Case Study [8.15].
Some court decisions suggest that an important consideration in this second
step is the frequency and magnitude of the activity that generated the
receipt: Memorex Pty Ltd v FCT (1987) 19 ATR 553 (see Case Study [8.15]).
However, each of the steps in this process is to some degree interrelated.
For example, in FCT v Merv Brown Pty Ltd (1985) 16 ATR 218 (see Case
Study [8.13]), the sale of the import quotas was held to be outside the
normal proceeds of the business. This was because the nature of the
business was limited to the sale of imported clothing and material, and the
sale of quotas was infrequent and therefore not part of that business. On the
other hand, if the sale of quotas was a regular activity, then it may have
been included in the nature of the business.

Case study 8.15: Sale of leased equipment was within the scope of
the business
In Memorex Pty Ltd v FCT (1987) 19 ATR 553, the taxpayer operated
a business of selling and leasing computer equipment, as well as
providing advice on the design of computer systems. The
commercial life of the computer equipment was about five years.
Due to the rapid development of the technology, some customers
preferred to lease the equipment rather than purchase it outright.
Typical lease agreements were two to four years, and at the end of
the lease the equipment was either re-leased to the customer,
returned or sold to the lessee. Receipts from the sale of the leased
equipment were not a major component of the taxpayer’s business,
and the taxpayer argued that they were capital in nature and not
the normal proceeds of the business.
The Full Federal Court held that receipts from the sale of the leased
equipment were part of the normal proceeds of the business and
were not capital in nature. In reaching this conclusion, the Court
identified the nature of the business as selling and leasing of
computer equipment and that the receipts from the sale of leased
equipment showed a nexus with this core business activity. The
nexus was established on the basis that, although these sales were
not a major component of the business, they were of sufficient
magnitude, frequency and regularity to be judged as a normal
incident of the business operations.
Receipts that are the normal proceeds of a business are ordinary income
under s 6-5 of the ITAA 1997. However, if the receipt is not a normal proceed
of the business, it may still be ordinary income as an isolated business
transaction (see [8.210]): FCT v Myer Emporium Ltd (1987) 163 CLR 199
(see Case Studies [8.23] and [8.24]).
Non-cash business benefits [8.160]
Under general principles, ordinary income does not include receipts that are
not cash or convertible to cash: see [5.60]. Consequently, business income
will also not include amounts that are non-cash business benefits: FCT v
Cooke and Sherden (1980) 10 ATR 696 (see Case Study [5.2]). Following the
decision in FCT v Cooke and Sherden, s 21A of the Income Tax Assessment
Act 1936 (Cth) (ITAA 1936) was enacted with the aim of bringing these non-
cash business benefits into the meaning or ordinary income by deeming the
benefits as being convertible to cash.
Section 21A of the ITAA 1936 only applies to non-cash business benefits and
not to other categories of income, such as property income or income from
personal services. Section 21A also does not deem non-cash business
benefits to be ordinary income for tax purposes; it merely deems non-cash
business receipts to be cash convertible and then prescribes a method of
valuing the non-cash benefit. The result is that business receipts that are not
ordinary income only because they lack cash convertibility are deemed to be
cash convertible and therefore will constitute ordinary income. Therefore,
before s 21A is applied, it is first necessary to determine if the benefit is truly
income in nature as a benefit derived from carrying on a business,
disregarding whether it is cash or convertible to cash.
Provided the non-cash business benefit has the character of income, then s
21A(1) treats it as convertible to cash and s 21A(2) requires the benefit to be
brought to account at its arm’s length value, less any amount that the
taxpayer contributed to acquiring the benefit or to the extent that the
recipient could have obtained a tax deduction if they had paid for the benefit
themselves. To avoid double taxation, s 21A does not apply to non-cash
business benefits that are non-deductible for the provider of the benefit
(e.g., entertainment expenses): s 21A(4). Also, to avoid dealing with very
small amounts, s 23L(2) of the ITAA 1936 exempts the application of s 21A if
the total amount applicable for the tax year is $300 or less.
Example 8.7: Non-cash business benefit
Tan owns and operates a thriving mobile phone business located in a large
city shopping centre. To promote its product, one of the mobile phone
companies provides Tan with two new top-of-the-range mobiles each year.
During the current tax year, Tan received two free mobile phones, each
valued at $900. Both of these phones were locked, so that they could only be
used on Tan’s account and the SIM cards were also locked so the phone
could not be used with a different phone number. Tan kept one phone for his
personal use and gave the other to his wife. As the phones cannot be used
by anyone else, they cannot be converted to cash and therefore are not
ordinary income under s 6-5 of the ITAA 1997: FCT v Cooke and Sherden
(1980) 10 ATR 696. However, the benefit is received as an incident of
carrying on the business and would be income of the business except for the
fact that the phones are not convertible to cash. This satisfies the first
requirement of s 21A(2) and (5) and, as a result, s 21A(1) deems the benefit
be treated as if it is convertible to cash. Section 21A(2)(a) then brings the
benefit to account at its “arm’s length value”, which is defined in s 21A(5) as
the amount the taxpayer would have reasonably expected to pay had he or
she been dealing at arm’s length. In this example, the arm’s length value will
be the usual price of $900 each.

The next step is to determine whether any of the value is excluded from the
application of s 21A. Of the exclusions possible the only one that is relevant
is whether Tan could have claimed a deduction had he paid for the phones.
Clearly this would not be the case for the phone given to his wife, but Tan
may be able to argue that the cost of the phone he used for work could be
deductible. If Tan is successful in arguing that the phone he kept would have
been deductible, if he acquired it, then he will have assessable income of
$900 for his wife’s phone less any cost he may have contributed to the
acquisition of the phone provided to his wife.
Extraordinary and isolated transactions Introduction [8.170]
As discussed at [8.130]–[8.150], receipts of a business that are the normal
proceeds of the business will be ordinary income. Transactions that are not
within the normal proceeds of the business have generally been labelled by
the courts as “extraordinary transactions”: FCT v Myer Emporium Ltd (1987)
163 CLR 199 (see Case Studies [8.23] and [8.24]); Westfield Ltd v FCT (1991)
21 ATR 1398 (see Case Study [8.22]). Extraordinary transactions may give
rise to ordinary income or capital, and the remainder of this chapter
discusses how the courts have attempted to make this distinction.
Courts have also labelled transactions that are one-off in nature and not
undertaken by an existing business operation as “isolated transactions”: FCT
v Whitfords Beach Pty Ltd (1982) 12 ATR 692 (see Case Study [8.17]).
Isolated transactions may also give rise, in some instances, to ordinary
income and at other times will constitute capital.
Example 8.8: Extraordinary and isolated transactions
A bed manufacturer owned five factories and decided to close one
of its factories. It arranged to demolish the factory, then extensively
developed the land and sold it. This would be an extraordinary
transaction because when the taxpayer sells the land, it is in a
continuing business of bed manufacturing. Since the proceeds from
the development and sale of land are not the normal proceeds of
the business, it is an extraordinary transaction.
An example of an isolated transaction would be where an employee
accountant owns a holiday house in the country on a large piece of
land.

He knocks down the house, extensively develops the land, builds

multiple residential units and then sells them. This is an isolated
transaction because it is not associated with an existing business.
The case law discussed below indicates that proceeds from isolated and
extraordinary transactions can generate ordinary income if they fall into at
least one of three categories, where the transaction:
• forms a business in itself: see [8.180]–[8.200];
• falls under the first strand of FCT v Myer Emporium: see [8.220]–[8.250]; or
• falls under the second strand of FCT v Myer Emporium: see [8.260].
These categories are not mutually exclusive, so it is possible for a
transaction to fall into more than one category. Taxation Ruling TR 92/3 gives
the ATO’s view on this issue, but a tribunal decision held that parts of this
ruling are “wrong and should be rewritten”: Case [1999] AATA 66; Case 1/99
(1999) 41 ATR 1117.
Transaction forms a business in itself under the principle in FCT v Whitfords
Beach
Principle applied to isolated transactions [8.180]
Case law indicates that if an isolated transaction has sufficient indicators of a
business (see [8.20]–[8.100]), then it will generate ordinary income even
though it is a one-off transaction. In other words, if an isolated transaction
exhibits sufficient characteristics of a business, then profit from it will be
considered a form of business income and so will constitute ordinary income.
This is more likely to be the case if an isolated transaction involves a
sufficient amount of effort, capital and planning. The leading case on this
issue is FCT v Whitfords Beach Pty Ltd (1982) 12 ATR 692 (see Case Study
[8.17]), where the Full High Court held as ordinary income the profits from an
extensive land development project undertaken by a company that
previously had no other business activities.
The difference between an isolated transaction that does or does not
produce ordinary income under this principle was described in the English
case Californian Copper Syndicate v Harris (1904) 5 TC 159, where the Court
made a distinction between:
• a “mere realisation” of a capital good made by enhancing its value is
characterised as a capital gain; and
• a gain made from carrying on a business is characterised as ordinary
income.

Example 8.9: Extensiveness of isolated transaction influences

whether it generates ordinary income
Jake had been a farmer for many years and retired from farming two
years ago, and his land has been unused since his retirement. He
has now decided to develop and sell his farm land, so that it can be
used for residential purposes. The development was a very minor
one and just involved clearing and subdividing the land. This is
clearly an isolated transaction as it is a one-off event not
undertaken by a continuing business. As the development of the
land is relatively minor, the sale will not generate ordinary income.
This is because the process of developing and selling the land did
not involve much capital and/or effort and could not be said to have
sufficient of the characteristics of a business. This will come under
the first category of Californian Copper Syndicate v Harris (1904) 5
TC 159 and will constitute a “mere realisation” which is capital in
nature.
Sean is also farmer who, like Jake, became tired of farming. He gave
up farming for a few years and left his land unused. He then
decided to develop and sell his farm land, so that it can be used for
residential purposes. Sean was directly involved in the development
and sale of the land. The development was extensive and involved
subdividing the land and arranging to have electricity, gas and
sewerage supplied to each subdivided lot. It also involved Sean
arranging to have roads built on the land. In other words, he
developed the land so that each subdivided lot was ready to have a
house built on it.
Like Jake’s development and sale, this is an isolated transaction.
However, since Sean has extensively developed the land before
selling it, there is a strong argument that the isolated transaction
has generated ordinary income. This is very much influenced by the
fact that the development was extensive and required considerable
effort and capital. Although the transaction was a one-off isolated
transaction, it had enough characteristics of a business to conclude
that the profits are ordinary income. This will come under the
second category of Californian Copper Syndicate v Harris.
Case study 8.16: Isolated transaction – proceeds were held not to be
ordinary income
In Scottish Australian Mining Co Ltd v FCT (1950) 81 CLR 188, the
taxpayer was originally a mining company which subsequently
stopped operating as a miner. The taxpayer then extensively
developed one of the pieces of land it had previously used for
mining purposes and sold it. The development was very extensive
and included laying roads and building a railway station.
This case was heard in front of a single judge of the High Court,
where Williams J held that the proceeds of sale were not ordinary
income. Williams J stated that, since the taxpayer was not in the
business of land sale, proceeds from the sale were not ordinary
income. In the later High Court case FCT v Whitfords Beach Pty Ltd
(1982) 12 ATR 692, at least two of the three judges that commented
on Scottish Australian Mining Co Ltd v FCT (Mason and Wilson JJ)
stated or implied that they believed that Scottish Australian Mining
Co Ltd v FCT had been wrongly decided. Their reasoning was that,
since the development of land was so extensive, it could be argued
that the development activities had the characteristics of a
business, so that its proceeds would have generated ordinary
income. Given what the judges in FCT v Whitfords Beach said about
Scottish Australian Mining Co Ltd v FCT, it could be argued that if
Scottish Australian Mining Co Ltd v FCT were to be decided today,
then the Court would find that the taxpayer generated ordinary
income.
Case study 8.17: Isolated transaction – proceeds were held to be
ordinary income
In FCT v Whitfords Beach Pty Ltd (1982) 12 ATR 692, the taxpayer
(Whitfords Beach Pty Ltd) was a company that owned beachfront
land. The company’s shareholders were fishermen who had formed
the company, so that they could use the company’s land to access
their fishing shacks. In other words, the taxpayer company
originally owned the land, so that its shareholders could use it for
recreational, rather than commercial, purposes. Several years later,
the shares in Whitfords Beach Pty Ltd were sold to a property
developer. It is important to note that Whitfords Beach Pty Ltd
remained the owner of the land, as only the shares in the company
were sold to the developer, not the land.
The new shareholders changed the Articles of the taxpayer to state
that the company’s purpose was to develop land (the Articles of a
company were documents of a company that, among other things,
stated the purpose of the company – companies incorporated
nowadays would have a constitution instead). The taxpayer then
extensively developed the land and sold it at a substantial profit.
The Full High Court held that the profit from the developed land was
ordinary income. Of the three judges who held that the profit only
(not the gross receipts) was ordinary income, one (Gibbs CJ) stated
that, had the development and sale been undertaken when the
company was owned by its original shareholders (who were using
the land for recreational purposes), the proceeds of the sale would
not have generated ordinary income.
The other two judges (Mason and Wilson JJ), who held that the sale
had generated ordinary income, appeared to have relied on
different reasoning to support their finding. Their conclusion was
highly influenced by the fact that the development and sale was so
extensive that it had the characteristics of a business. Both Mason
and Wilson JJ implied that had the development and sale of the land
been undertaken by the original shareholders, then the sale would
still have generated ordinary income. However, they both indicated
that the fact that the company had been bought by developers who
changed its Articles strengthened the argument that the sale
proceeds generated ordinary income. Given the majority opinion of
Mason and Wilson JJ, there is a strong argument that their approach
is the one that has set the law.
Case study 8.18: Farmer who developed and sold farm land did not
generate ordinary income
In Statham v FCT (1988) 20 ATR 228, the deceased (the taxpayer
was the trustee of the deceased’s estate) owned a piece of land on
which he both lived and operated a farming business. Because the
farm was financially unsuccessful, he had ceased farming and
arranged for the local city council to develop the land. This included
connecting the land to the electricity grid and constructing roads.
The land was also subdivided and finally sold piece by piece through
a real estate agent.

The Full Federal Court held that the gain was not ordinary income
but a “mere realisation”. The Court was influenced by the fact that
the deceased had arranged for the council to develop the land,
rather than arranging to do so himself. The Court was also
influenced by the fact that the deceased used a real estate agent to
sell the land and was not in any way directly involved in the sales
process. The Court indicated that, had the deceased arranged to
develop the land himself (rather than through the council), it would
be more likely that the sale would have generated ordinary income.

Case study 8.19: Ex-farmer who extensively developed and sold

land generated ordinary income In Stevenson v FCT (1991) 22 ATR
56, the taxpayer was a farmer who had owned land that he had
used as a farm for many years. He gave up farming and had the
land subdivided and extensively developed. Stevenson was in
charge of the development and subsequent sale process and the
sale of the land took place over a number of years.

The Administrative Appeals Tribunal (AAT) held that the sale did
generate ordinary income and was not a “mere realisation”. On
appeal to the Federal Court (single judge), it was held that the AAT
had not made an error in its decision. The Court was influenced by
the fact that the taxpayer was the sole decision-maker regarding
the development process, that he had sought finance for the
development and that he had controlled the marketing of the
blocks.
Case study 8.20: Ex-farmer did not generate ordinary income by
only developing land to the extent necessary to gain subdivision
Casimaty v FCT (1997) 37 ATR 358 involved a taxpayer who had
originally used land for farming, ceased farming and then followed
on by subdividing, developing and selling the land. The
development mostly consisted of constructing roads, providing
water and sewerage facilities to the land and constructing external
fencing. The taxpayer had only developed the land to the extent
necessary to gain approval to have the land subdivided. The Federal
Court (single judge) held that the taxpayer’s sale had amounted to
a “mere realisation” and was not ordinary income. However, the
Court did say that, had the taxpayer gone further in his
development, such as building internal fences or units, then the
Court would have been more inclined to find that the taxpayer had
generated ordinary income. In other words, the Court’s finding that
the profit was capital was influenced by the fact that the taxpayer
had not done anything more than the minimum required to get
subdivision approval.
The Court also stated that it would have been more inclined to find
that the taxpayer generated ordinary income had he participated
more actively in the selling off the land, rather than leaving the
whole sale process up to a real estate agent.
FCT v Whitfords Beach (see Case Study [8.17]) and later cases on the same
issue show that there are no strict rules, only guidelines, in deciding whether
an isolated transaction has amounted to a “mere realisation” or generates
ordinary income. This means that, although in some cases it might be easy
to distinguish between a “mere realisation” and a transaction that produces
ordinary income, in more borderline cases it is difficult to predict what a
court may decide should the case be disputed. However, Case Studies
[8.16]–[8.19] do indicate that, at least in the case of land development, a
taxpayer who is actively involved in the development and sales process (as
opposed to delegating those activities) is more likely to fall under the
principle in FCT v Whitfords Beach.
Principle applied to extraordinary transactions [8.190]
Although the principle in FCT v Whitfords Beach Pty Ltd (1982) 12 ATR 692
has only been applied to isolated transactions, there is an argument that it
could also apply to extraordinary transactions. However, this issue has not
been tested in court.
Example 8.10: How the principle in FCT v Whitfords Beach may
apply to extraordinary transactions
Bed Pty Ltd is a bed manufacturer that has four factories. It decides
to close one of its factories and sell off the associated land. To do
this, the company arranges to demolish the factory, subdivide the
land and have gas, electricity and sewerage supplied to each piece
of subdivided land. This is an extraordinary transaction because
proceeds from developing and selling land are not the normal
proceeds of a bed manufacturer. However, there is a convincing
argument that since the process of developing and selling land was
so extensive, Bed Pty Ltd was for that time not only a bed
manufacturer, but also a land developer. This analysis leads to the
conclusion that the profits from land sale would generate ordinary
income. Pillow Pty Ltd also has four factories that it uses to
manufacture pillows and it decides to close one of its factories. The
company then arranges to demolish the factory, remove the
concrete from the factory’s car park and sell the land without
further development. This is an extraordinary transaction because
the proceeds of selling land are not the normal proceeds of a pillow
manufacturer, but this transaction would still not generate ordinary
income. This is because developing the land for sale did not have
sufficient characteristics of a business to be classed a business in
itself.
Calculating ordinary income under the principle in FCT v Whitfords
Beach [8.200]
For most taxpayers, gross revenue will form assessable income, and
deductions will be taken away from this to give taxable income. However, it
was mentioned in FCT v Whitfords Beach Pty Ltd (1982) 12 ATR 692 (see
Case Study [8.17]) that for an isolated transaction that falls under the
principle of that case, it is the profit (not the total sales proceeds) that is
assessable as ordinary income.
This profit is calculated as the sales proceeds less the value of the land at
the time the isolated transaction commenced and the costs of developing
the land.
Example 8.11: Calculation of profit from proceeds of an
extraordinary transaction that falls under the principle in FCT v
Whitfords Beach
Nathan has been a farmer for 20 years. Two years ago his farm was worth $2
million, and at that time he ceased farming and undertook extensive
redevelopment of the land. This development cost $4 million and when it
was completed he sold the land piece by piece for a total of $11 million.
Assuming that this transaction is covered by the principle in FCT v Whitfords
Beach Pty Ltd (1982) 12 ATR 692, Nathan’s assessable income from the
development and sale of the land is the profit of $5 million ($11 million − ($2
million + $4 million)).
Two strands of Myer [8.210]
The important High Court case of FCT v Myer Emporium Ltd (1987) 163 CLR
199 (see Case Studies [8.23] and [8.24]) shows that the proceeds of an
isolated or extraordinary transaction will be ordinary income if the conditions
of one of the two approaches followed in the decision are satisfied. The two
approaches applied in FCT v Myer Emporium have become known as the
“first strand of Myer” and the “second strand of Myer”. These two strands
are independent principles relied on by the Court in FCT v Myer Emporium in
arriving at its conclusion that the taxpayer had generated ordinary income.
For further discussion of:
• the first strand of Myer: see [8.220]–[8.250]; • the second strand of Myer:
see [8.260]; and
• the facts of the case: see Case Studies [8.21] and [8.23].

Case study 8.21: FCT v Myer Emporium

In FCT v Myer Emporium Ltd (1987) 163 CLR 199, the taxpayer
(Myer) lent $80 million to its subsidiary, Myer Finance. Interest was
chargeable on this loan at a commercial interest rate of 12.5% pa.
At the time the loan was made, Myer intended to sell the “right to
interest” on this loan to Citicorp. As planned, three days after Myer
lent the money to Myer Finance, Myer sold the “right to interest” on
this loan to Citicorp in exchange for Myer receiving a lump sum of
approximately $45 million. This meant that Myer was still entitled to
be repaid the principal of $80 million from Myer Finance. However,
the interest on this loan was now to be paid by Myer Finance to
Citicorp. The issue that the Full High Court had to decide was
whether the $45 million received by Myer was ordinary income. The
Full High Court decided that the proceeds were ordinary income.
The reasoning of the Court is not particularly clear, but subsequent
cases (see later discussion in this chapter) have interpreted the
decision in FCT v Myer Emporium as meaning that the proceeds
from an extraordinary or isolated transaction will be ordinary
income if it satisfies the requirements of either what have now
become known as the first strand or second strand of Myer. In this
case, both the first strand of Myer (see Case Study [8.23]) and
second strand of Myer (see Case Study [8.26]) were fulfilled,
although fulfilling one of them would have been sufficient.
First strand of Myer [8.220]
The first strand of Myer expresses the principle that extraordinary or isolated
transactions that satisfy three particular requirements will be ordinary
income. The first two requirements originate from the case of FCT v Myer
Emporium Ltd (1987) 163 CLR 199. The third requirement, although
originally implied in FCT v Myer Emporium, was stated more explicitly in the
case of Westfield Ltd v FCT (1991) 21 ATR 1398 (see Case Study [8.22]). The
three requirements are as follows:
1. There was a business operation or commercial transaction: see [8.230].
2. There was a profit-making intention upon entering the transaction: see
[8.240].
3. The profit was made by means consistent with the original intention: see
[8.250].
[8.230] Profit resulted from “business operation or commercial transaction”.
If the relevant transaction is an extraordinary transaction, then the first
requirement will be automatically fulfilled. As explained at [8.130]–[8.150],
an extraordinary transaction occurs when a business undertakes a
transaction that generates proceeds which are not the normal proceeds of
that business. As an extraordinary transaction is undertaken by a business,
the first requirement of a “business operation or commercial transaction” will
always be satisfied.
With an isolated transaction, the first requirement of there being a “business
operation or commercial transaction” will not automatically be satisfied. An
isolated transaction occurs where there is a one-off transaction without a
continuing business operation: see [8.180]. This means that an isolated
transaction will only fulfil the first requirement if there is a “commercial
transaction”. Unfortunately, there is little case law that explains what exactly
is meant by the term “commercial transaction”. However, Ruling TR 92/3
gives a few examples of what the Commissioner believes is a “commercial
transaction”, though it does not mention what case law the examples are
based on. According to the ruling, a taxpayer who buys and resells $100,000
of gold bars in a short time is undertaking a commercial transaction. On the
other hand, the ruling states that a taxpayer who purchases an investment
property to earn rent and later sells it is not regarded as undertaking a
commercial transaction.
Although there is limited guidance as to when an isolated transaction will be
considered a “commercial transaction”, this condition is more likely to be
satisfied when the transaction concerned is entrepreneurial in nature, but it
is less likely to be fulfilled if the transaction is of the type that a typical
salary earner might enter into.
Greig v FCT [2020] FCAFC 25 considered the issue of whether the first strand
of Myer requires that the taxpayer must be carrying on a business for the
Myer principle to apply. Although the Myer decision has primarily been
applied to income, in this case the taxpayer argued that it applied to
deductions. The taxpayer claimed a tax deduction under s 8-1 of the ITAA
1997 for losses of $11.85 million realised on the sale of shares. The taxpayer
argued that the losses were revenue losses on the basis that they were
incurred as a “commercial transaction” as was the case in Myer. The majority
of the Full Federal Court allowed the deduction. They agreed that even
though the taxpayer was not in the business of share trading, the large scale
of the share dealings and the commercial steps undertaken were sufficient to
show a profit-making intention (although a loss was realised) which was then
sufficient to make it a business or commercial transaction for the purposes of
Myer. The decision gives further weight to the argument that the Myer
principle can still apply even when the activities under consideration are not
held to be a business for tax purposes.
[8.240] Profit-making intention upon entering the transaction. The second
requirement of the first strand of Myer is that the taxpayer had a profit-
making intention upon “entering the transaction”. This profit-making
intention need not be the taxpayer’s sole or dominant intention: FCT v
Cooling (1990) 21 ATR 13 (see Case Study [8.24]).

Many extraordinary or isolated transactions involve selling assets and, where

a profit is realised, the time of “entering the transaction” will be when the
asset was purchased. In other words, if the taxpayer did not have a profit-
making intention when buying the asset, but had a profit-making intention
only when selling it, the second requirement of the first strand of Myer would
not be satisfied. In reality, there will often be a lack of clear evidence as to
what a taxpayer’s intention was at the time of entering into the transaction.
In August v FCT [2013] FCAFC 85, the Full Federal Court dismissed the
taxpayer’s appeal from a single judge of the Federal Court and confirmed the
decision that the gains made following the purchase, leasing and sale of
several commercial shopping centres were ordinary income. This was
despite the fact that these properties had been owned and leased for up to
seven years. Central to this decision was that the facts showed there was an
initial intention to purchase, develop, lease and then sell the shopping
centres as long-term tenanted properties. The initial intention to profit via
sale was critical to this decision even though the properties were leased to
earn income for some time before sale.
[8.250] Profit made by means consistent with original intention. For the first
strand of Myer to be fulfilled, the way the profit is eventually made must be
consistent with the original profit-making intention of the taxpayer upon
entering the transaction: Westfield Ltd v FCT (1991) 21 ATR 1398. If the
taxpayer has more than one intention upon entering the transaction, the
way the profit was made need only be consistent with one of those
intentions: August v FCT [2013] FCAFC 85.
Case study 8.22: First strand of Myer was not satisfied as the profit
realised was inconsistent with the original intention
In Westfield Ltd v FCT (1991) 21 ATR 1398, the taxpayer (Westfield)
was in the business of designing, constructing and operating
shopping centres. Westfield purchased a piece of land with the
intention of jointly developing a shopping centre on the land with
Australian Mutual Provident (AMP) Society. At the time of purchase,
the taxpayer knew there was a possibility that it might end up
selling the land to AMP Society rather than developing a shopping
centre, but selling it was not its original intention. Eventually the
taxpayer did sell the land to AMP Society rather than developing a
shopping centre.
The Full Federal Court held that the proceeds from sale were not
ordinary income. It found that the transaction was an extraordinary
transaction as the proceeds of the sale were not the normal
proceeds of the taxpayer’s business, and these proceeds would be
ordinary income if the requirements of the first strand of Myer were
satisfied. However, the way the taxpayer made the profit (resale)
was not consistent with the original profit-making intention
(developing a shopping centre with AMP Society). The fact that at
the time of purchase the taxpayer knew of the possibility of resale
was not the same as the taxpayer having an intention to profit from
resale. As a result, the first strand of Myer did not apply, and the
sale proceeds were not ordinary income.
Case study 8.23: Summary of the decision in Myer
The facts of FCT v Myer Emporium Ltd (1987) 163 CLR 199 are
described in Case Study [8.21]. As discussed in Case Study [8.21],
both the first and second strands of Myer were satisfied on the facts
of this case. Specifically, the first strand of Myer was fulfilled
because the taxpayer was running a business operation, had a
profit-making intention upon entering the transaction (when it lent
the money it intended to sell the right to interest a few days later)
and the profit was eventually realised as initially intended.
Case study 8.24: Lease incentive falls under the first strand of Myer
In FCT v Cooling (1990) 21 ATR 13, the taxpayer was a partner in a
Brisbane law firm which wished to move premises. Upon signing the
lease for the new premises, the landlord paid a lease incentive of
which Cooling received a share. A lease incentive is when the
landlord gives the lessee money as an inducement to enter into the
lease. At that time it was common in Brisbane for lease incentives
to be paid upon a commercial lessee entering into a long-term
commercial lease because there was an excess of office space
available for lease and it was difficult for landlords to attract a
tenant. The Full Federal Court held that the lease incentive was
ordinary income. The Court appeared to be of the view that the
incentive was ordinary income because moving premises from time
to time was in the ordinary course of the taxpayer’s business, which
meant that the proceeds were the normal proceeds of the
taxpayer’s business. In addition, the Court went on to say that,
even if the proceeds of the transaction were not considered to be
the normal proceeds, they would still be ordinary income due to the
satisfaction of the requirements of the first strand of Myer.

The Court noted that one of the purposes that the taxpayer had
when entering the new lease was to make a profit from receiving
the lease incentive. Although this was not its dominant intention, it
was still one of its “not insignificant” purposes of entering into the
lease.
Example 8.12: First strand of Myer applies to extraordinary
transaction
A television manufacturer owned three factories, and it purchased a vacant
piece of land because it believed that the land would rise in value and could
be sold in the future for a profit. Three years later, it sold the land at a profit
without using the land in the meantime. This is likely to be considered an
extraordinary transaction as income from speculating in real estate does not
constitute the normal proceeds for a television manufacturer. Although it is
an extraordinary transaction, it will be ordinary income as it satisfies the first
strand of Myer. This is because:
• there was a business operation: the taxpayer is in the business of
manufacturing TVs;
• there was a profit-making intention at the time the land was purchased:
the land was purchased because the taxpayer believed it could later be sold
for a profit; and
• the way the profit was eventually realised was through selling the land.
This is consistent with how the taxpayer intended to profit when entering the
transaction, that is, when the taxpayer purchased the land.

Case study 8.25: First strand of Myer applied to an isolated

transaction
In McCurry v FCT (1998) 39 ATR 121, the taxpayers were two
brothers who in 1986 purchased a block of land with a run-down
house on it. They obtained permission for and built three
townhouses on the land. During May 1987, the taxpayers advertised
the townhouses for sale but were unable to sell them.
Subsequently, in June 1987, attempts to sell were put on hold, and
the brothers and their families used two of the townhouses as their
private residence as their family had purchased a nearby news
agency. The third townhouse was also used by them for private
purposes. After living in the townhouses for some time, they were
again advertised for sale in July 1988 and subsequently sold in
December 1988 for a substantial profit.
Justice Davies from the Federal Court held that the profit was
assessable as ordinary income. In substance he applied the
principle in the first strand of Myer.
One of the requirements for the first strand of Myer was that the
profit must have resulted from either a business or a commercial
transaction. As the taxpayers had no continuing business, the issue
was whether the activity was commercial in nature. His Honour
found that the venture, which involved purchasing the house and
land, demolishing the house and building three townhouses,
combined with the profit-making purpose, was commercial in
character. However, his Honour did not appear to find that all the
characteristics of the venture needed to be commercial, but rather
that their presence in some aspects of this case clearly showed that
it was a commercial activity.

Furthermore, his Honour found that the taxpayers had an intention

to profit from building and selling the townhouses when they
initially purchased the land. This decision was reached despite the
fact that the taxpayers claimed that at the time of purchase, they
were unsure whether they intended to rent or sell the new
townhouses. However, the Court found that this claim was not
supported by the evidence. For instance, the evidence indicated
that the brothers had never made inquiries as to how much rent
they could collect on the townhouses. Consequently, the Court
concluded that while the possibility of renting the townhouses did
enter the minds of the brothers at the time of purchase, their
dominant intention at this time had been to profit from selling the
townhouses.

Justice Davies also found the profit was made in a manner that was
consistent with the taxpayers’ original intention when purchasing
the land. This was despite the fact that the taxpayers had argued
that the original profit-making venture was abandoned. The
taxpayers’ argument was based on the fact that their first attempt
to sell the properties failed, so they used them for private
purposes, and only then re-advertised and sold them over a year
later. However, his Honour found that the facts did not support the
finding that the taxpayers’ original profit-making plan was
abandoned. Rather, their initial plans had been temporarily
interrupted.
Second strand of Myer [8.260]
The Court in FCT v Myer Emporium Ltd (1987) 163 CLR 199
established that one of the reasons the proceeds in that case were
ordinary income was due to what is now known as the “first strand
of Myer”: see [8.220]–[8.250]. However, the Court also identified a
second reason for the proceeds being ordinary income. This second
reason has become known as the “second strand of Myer”.
The second strand of Myer expresses the principle that the
proceeds from a transaction will be ordinary income if the taxpayer
sells the right to income from an asset without selling the
underlying asset. This is an application of the compensation
principle, where compensation for loss of income is deemed to be
ordinary income: see [10.20]. Unlike the principle in FCT v Whitfords
Beach Pty Ltd (1982) 12 ATR 692 (see Case Study [8.17]) and the
first strand of Myer, the second strand of Myer potentially only
applies to a very narrow set of circumstances.
Case study 8.26: Second strand of Myer
The facts of FCT v Myer Emporium Ltd (1987) 163 CLR 199 are
described in Case Study [8.21].
The second reason the Court held that the sale of the right to
interest was ordinary income has become known as the “second
strand of Myer”. The taxpayer sold the right to income while
keeping ownership of the underlying property. Specifically, Myer
sold the right to interest on the loan (the right to receive income
that would have been ordinary income) and retained the underlying
property (the right to be repaid). If Myer had continued to receive
the interest from its loan, it would have clearly been ordinary
income: see [9.20]. Therefore, by applying the second strand of
Myer, the Court concluded that selling the right to receive an
income stream for a lump sum will not change its nature as ordinary
income. Even though the right to interest was received as a lump
sum, it was still ordinary income as the payment was compensation
for the loss of an income stream (the interest).
Case study 8.27: Application of the second strand of Myer
In Henry Jones (IXL) Ltd v FCT (1991) 22 ATR 328, the taxpayer
owned trademarks of certain brands of canned fruits. The
taxpayer’s subsidiary manufactured and sold canned fruits, using
the trademarks owned by the taxpayer. The taxpayer decided that
the canned fruit business run by its subsidiary was not meeting
profit targets and decided to sell the whole canned fruit business.
However, the taxpayer did not proceed with the sale, but rather
entered into an agreement with two other canned fruit producers
(SPC and Ardmona) which gave them exclusive use of the
taxpayer’s trademarks for 10 years (the trademarks themselves
were not transferred). In exchange, SPC and Ardmona were to pay
the taxpayer royalties of 5% of the net sales of products that used
the trademarks in question (subject to a minimum payment).
A few months later, the taxpayer sold the right to these royalties to
a third party in exchange for a lump sum of approximately $7.5
million. When the taxpayer entered into its initial royalty agreement
with SPC and Ardmona, it had intended to sell the royalty
agreement for a lump sum of $7.5 million.
The Full Federal Court held that the first strand of Myer did not
apply, but the second strand of Myer did and, as a result, the $7.5
million was found to be ordinary income. The Court based its
reasoning on the view that the taxpayer did not have a profit-
making intention of selling the rights to the royalties at the time of
entering into the royalty contract. While it was true that at the time
of entering the royalty agreement the taxpayer intended to sell
rights under the agreement for $7.5 million, on the current facts,
this did not constitute a profit-making intention.

The Court appeared to state that this was because the intention of
the taxpayer in entering this agreement was to dispose of its
canned fruit business in the form of getting of a lump sum receipt
and therefore the first strand of Myer did not apply. However, the
second strand of Myer did apply because the taxpayer sold the right
to what would be ordinary income for a lump sum, while retaining
the underlying property. Henry Jones (IXL) disposed of its right to
income (the royalties), but kept the underlying property (the
trademark) and therefore the proceeds from the sale constituted
ordinary income.
Statutory provisions that may apply to extraordinary and isolated
transactions [8.265]
Income from business activities may be assessable as ordinary income under
s 6-5 of the ITAA 1997 or as statutory income via s 6-10 of the ITAA 1997.
However, regardless of whether an amount is likely to be ordinary income, it
is still necessary to consider whether any statutory provisions specifically
apply to the receipt. This is important because some statutory provisions
apply different tax rates, as is the case with capital gains which are taxed
differently to ordinary income.
If a receipt is both ordinary and statutory income under the Act, s 6-25 of the
ITAA 1997 states that it is included in assessable income only once and it will
normally be taxed under the statutory provision rather than as ordinary
income. The exception to this rule occurs if the statutory provision states
that it only applies if the amount is not ordinary income: see [3.80]. For
example, s 15-20 deems certain royalties to be assessable income but also
states that the section does not apply if the royalty is ordinary income under
s 6-5: s 15-20(2).

The following discussion covers some of the more common statutory

provisions that apply to receipts from business activities.
Capital gains tax [8.270]
Extraordinary and isolated transactions that do not produce ordinary income
and involve an asset acquired after 19 September 1985 will often be subject
to capital gains tax (CGT). As explained in Chapter 11, gains that are subject
to CGT may incur less tax than gains that are taxed under s 6-5 of the ITAA
1997 as ordinary income. Consequently, it is important to be able to
ascertain whether or not gains from extraordinary/isolated transactions are
ordinary income or capital.
Section 15-10: Bounties and subsidies [8.280]
Section 15-10 of the ITAA 1997 states that bounties and subsidies received
in relation to carrying on a business are assessable as statutory income. A
bounty or subsidy is a payment from the government in order to assist the
recipient in carrying on its business. However, s 15-10 does not apply to
gains that are ordinary income: s 15-10(b).
Example 8.13: Government subsidy – assessability as statutory
income
A car manufacturer receives a government subsidy for every car it makes.
These payments are ordinary income as they would be regarded as normal
proceeds of the business. As the receipts are ordinary income, they would
not be assessable under s 15-10 of the ITAA 1997. Another car manufacturer
receives a government subsidy to purchase new machinery for its existing
factory.

This receipt is not ordinary income as it would not be regarded as normal

proceeds of the business and is not covered by the principal in FCT v
Whitfords Beach Pty Ltd (1982) 12 ATR 692 or either of the strands of Myer.
However, this receipt would be assessable under s 15-10 as being a bounty
or subsidy received in relation to the business.
Section 15-15: Profit-making undertaking or plan [8.290]
Section 15-15 of the ITAA 1997 states that the profits from a profit-making
undertaking or plan are assessable and so will constitute statutory income.
However, s 15-15 does not apply to:
• gains that are ordinary income (s 15-15(2)(a)); or
• gains that involve assets purchased on or after 20 September 1985 (s 15-
15(2)(b)).

A profit-making undertaking or plan for the purposes of s 15-15 is a course of

conduct that produces a profit and involves something more complex than
the taxpayer simply buying and then selling property or outlaying money in
the hope of making a return: Steinberg v FCT (1975) 5 ATR 565; Clowes v
FCT (1954) 91 CLR 209.
In practical terms, s 15-15 will seldom apply because transactions that
potentially are a profit-making undertaking or plan will often be ordinary
income due to FCT v Whitfords Beach Pty Ltd (1982) 12 ATR 692 and so will
not be covered by s 15-15. The section also has limited application since it
only applies to assets purchased before the introduction of CGT.
Example 8.14: Section 15-15 – difficulty of application
In 1984, Jell Pty Ltd, a manufacturer of doors, purchased vacant
land as an investment which it sells in the current tax year. This
would not be assessable under s 15-15 of the ITAA 1997 because it
is a mere “buy and sell” and so would not constitute a profit-
making undertaking or plan.
Jack farms land that he purchased in 1983. He is tired of farming, so
he subdivides the farm land, installs amenities on it and then builds
roads and townhouses on the subdivided land. Jack then sells the
subdivided lots one by one. Although this is a profit-making
undertaking or plan, it is unlikely to be assessable under s 15-15.
This is because the profit from this transaction is likely to be
ordinary income under the principle in FCT v Whitfords Beach Pty
Ltd (1982) 12 ATR 692 and s 15-15 does not apply to gains that are
ordinary income.
Section 25A: Profit from sale of asset acquired with the purpose of resale
[8.300] Section 25A of the ITAA 1936 makes assessable certain profits from
selling an asset that was initially acquired for the purpose of resale.
However, s 25A will seldom apply because of the following limitations: • it
only applies to assets purchased prior to 20 September 1985 (s 25(1A)); and
• it only applies where the intention to profit by resale that existed at the
time of purchase was the sole or dominant purpose of the taxpayer: Eisner v
FCT (1971) 2 ATR 3.

Example 8.15: Profit from asset acquired with purpose of resale and
subsequently assessable under s 25A
Alan purchased vacant land in 1983 with the sole purpose of
reselling it at a profit. He sells it in the current tax year and realises
a profit of $500,000. This profit will be assessable under s 25A of
the ITAA 1936 because it was made from selling an asset that was
purchased with the purpose of making a profit by reselling it.
For property purchased before 20 September 1985, it will become
more and more difficult to establish that there was, at the time of
the purchase, a profit-making intent through resale. This is
because, as time passes, it will become more difficult to elicit
evidence and also the longer property is held, the more likely it was
held for some other purpose than simply resale at a profit.
Questions [8.310]
8.1 After entering into a management agreement two years ago for
the purpose of starting a business in cattle breeding next year,
Georgina paid $5,250 by cheque to ACM, whose business was
transferring embryos from stud cows to ordinary breeding cows.
Under the agreement she was guaranteed six calves in the next two
years. If the venture failed, ACM remained liable to supply the
calves from another source. Having paid her fees for Year 2, she did
not receive any subsequent notification that the implants in her
recipient cows were successful. She did not follow up after the
implantation notices to find out whether any of her cows were
pregnant. Nor did she enquire whether her cows had been
implanted a second time as contemplated by the terms of the
Management Agreement, which provided that each recipient cow
would be implanted once in each of the 12-month contractual
periods. She said that she had spoken to her accountant who told
her things were progressing, but slower than anticipated. After
paying her Year 2 Fees in June, Georgina heard nothing specific from
ACM except by way of newsletters containing general information.
She made no attempt to contact ACM in the current year about
extending the lease on her recipient cows. She said she was going
through a very difficult time. Her 12-month-old child had contracted
a serious illness and she had to focus on looking after him. Is
Georgina carrying on business?

8.2 Axis Holdings Ltd was founded eight years ago by Lucas and
Tait, who were the initial shareholders and directors. Lucas and Tait
had for many years been involved in property development. Seven
years ago, Axis purchased two properties in an area where there
was extensive real estate development. For six years, the
properties were used for cattle breeding and the properties were
improved for that purpose. Owing to unforeseen circumstances, the
cattle breeding proved to be unprofitable and there was an
imminent zoning change whereby the properties could only be
disposed of in 100-hectare lots instead of 25-hectare lots. Axis
therefore arranged to subdivide the land up into 25-hectare blocks
and sold the whole property to one purchaser. The Commissioner
assessed Axis on the gross receipts in s 6-5 of the ITAA 1997.
Discuss.
8.3 Peter is a farmer with 15 hectares of land on which he has
grown oranges since 1970. He inherited the land from his father in
that year. The farm has gradually been surrounded by urban
development and, three years ago, following complaints from
neighbours about pesticides, he decided to sell the land.
Two years ago, Peter contracted with a consulting engineer and
surveyor who prepared a subdivision plan and who applied to the
local council for rezoning. Peter was not directly involved in the
plan or the rezoning, which was granted by the council later that
year. Nearly all expenses were paid by Peter, although he had to
borrow $120,000 to cover some incidental expenses.
Following completion of the development, the land went on sale
through a real estate firm and to date 150 of the 200 blocks have
now been sold for residential housing. Blocks sell for an average of
$150,000 each. Advise Peter as to his tax liability, if any.
8.4 Five years ago, Bruce purchases 10 hectares of land for $1
million in an area that was ripe for subdivision. At the time of
purchase he intended to get planning permission from the local
council to develop the land by subdivision and then resell it at a
profit, but instead he leased it for grazing horses. Three years ago,
Bruce attempted to get planning permission to subdivide his 10
hectares, but it proved very difficult, and finally in March of the
current tax year the local council refused permission to subdivide.
Bruce reluctantly sold the land in May for $3 million.
What are the tax consequences of Bruce’s sale?
8.5 Two years ago, Peta purchased a house in Kew. This house had
two old tennis courts down the back which were in poor condition.
She purchased the property for two reasons:

• so that she and her family could live in the house; and • so that
she could build three units on the tennis courts and sell them at a
profit.
In the current tax year, the tennis club next door offered to buy the
old tennis courts, but only if Peta first restored them to good
condition. Peta decided to accept the club’s offer instead of going
ahead with her plan to build and sell units.
Peta spent $100,000 on preparing the tennis courts for sale. This
involved a great deal of work. Peta had to resurface the tennis
courts and build new fences around them.
She then sold the tennis courts in the current tax year to the tennis
club for $600,000.
Ignoring capital gains tax, discuss whether the receipt of $600,000
is ordinary income under s 6-5.
8.6 Mrs Jones is the owner of a large racehorse stud and horse
training business. She employs eight staff and holds a training
licence. Mrs Jones’ involvement in the racing business is her full-
time occupation and she attends as many race meetings as possible
(over one per week). Mrs Jones is also a very keen punter, betting
on both her own and other horses, and during the last year she had
several very big wins which netted her $120,000 in winnings for the
year. Discuss whether the receipt of $120,000 is ordinary income
under s 6-5.
8.7 Pierre has operated his market garden business in Queensland
for the last 25 years. During recent flooding, his total crop was
destroyed along with most of his buildings, irrigation equipment
and fencing. As a result of this flood, Pierre received a payment
from the government of $300,000 to purchase new green houses for
raising seedlings so he can get back into business more quickly. He
also received a payment from the government of $50,000 to dispose
of damaged crops. Discuss whether the receipt is ordinary or
statutory income.
8.8 New Coal Pty Ltd (New Coal) is a large coal mining company with
several large coal mines in Australia. During the current tax year,
New Coal employed a consulting firm to investigate the feasibility of
the company constructing and operating a coal fired power station.
New Coal has never operated a power station in the past. Discuss
whether the proposal to investigate the viability of the power
station is a separate business for tax purposes or would it be within
the scope of the existing coal mining business?
8.9 Kerryn works full time as an employee accountant. She loves to
sing and regularly records songs she wrote herself and posts them
on YouTube. For the last three years she would on average spend
approximately 20 hours a week on this activity. Because her cousin
Joel owned a recording studio, she was able to use his recording
facilities for free. Occasionally Kerryn would dream that one day she
would be discovered as a star and could make enough money to
retire from her job, though in reality Kerryn told herself that this
was unlikely to happen. On average, Kerryn would post a new song
on YouTube every two weeks.
Since Kerryn found quite a following (some of her songs had over
100,000 hits), in an attempt to profit from her new found fame, she
auctioned some of her old clothes and jewellery online (that she had
bought many years ago) and manages to sell them for $8,000.
Advise Kerryn on whether the $8,000 would constitute ordinary
income.
8.10 Zoe Barker has lived in her current home for the past 20 years.
Three years ago, she converted the garage (separate from her
house) into a luxurious single bedroom apartment at a cost of
$110,000. Zoe advertises her apartment for short-term
accommodation via several online accommodation booking
platforms and earns about $5,000 per month. Her costs are mainly
contract cleaners, property costs (eg, rates and power) and
commission paid to the online booking platforms. One very satisfied
customer (James) enjoyed the accommodation so much that he
offered Zoe the opportunity to stay at his holiday apartment for two
weeks free of charge, which would normally have cost $3,500. Also,
during the year, the government severely restricted travel within
the state which reduced Zoe’s income to only $1,000 per month. As
a result of the restrictions, Zoe received a monthly government
subsidy of $3,000 to help cover her fixed costs.
Advise Zoe on the assessability of her receipts and benefits.

Chapter 9 - Income from property

Key
points ............................................................................................
......... [9.00]
Introduction...................................................................................
............... [9.10]
Interest .........................................................................................
................ [9.20]
Discounts and
premiums .............................................................................
[9.30]
Timing of interest
receipts .......................................................................... [9.50]
Division 16E, s 26BB and s 70B of the
Income Tax Assessment Act 1936
(Cth) ...................................................... [9.60]
Taxation of financial arrangements (TOFA)
– Div 230 of the ITAA
1997 .......................................................................... [9.70]
Interest and
compensation .........................................................................
[9.80]
Interest relating to compensation for damages for
property .................... [9.90]
Interest relating to compensation for damages for personal
injury .......... [9.100]
Section 51-57: Exemption of post-judgment interest on
personal injury
compensation .....................................................................
[9.110]
Interest compensation and
CGT .................................................................. [9.120]
Section 15-35: Interest on overpayment and early payment of tax
……..... [9.130]
Interest portion of instalment
payments .................................................... [9.140]
Dividends.......................................................................................
................ [9.150]
Rental and lease
income .............................................................................. [9.160]
Rent ..............................................................................................
................ [9.160]
Lease
premiums ......................................................................................
..... [9.170]
Section 15-25 – Amount received for lease obligation to
repair ................ [9.180]
Royalties .......................................................................................
................ [9.190]
Introduction ...................................................................................
.............. [9.190]
Assessability of
royalties ..............................................................................
[9.200]
Annuities .......................................................................................
............... [9.210]
Questions ......................................................................................
............... [9.220]
Key points [9.00]
• Property income is an application of the “flow” concept of ordinary income.
• Interest is usually ordinary income as it flows from the lending/ investment
of capital.
• Payments on loans to compensate for increased risk of non-repayment
may not be interest.
• Loan discounts and premiums may alter the timing of taxable income.
• The timing for tax purposes of gains on financial instruments is subject to
legislation under Div 16E, s 26BB and s 70B of the Income Tax Assessment
Act 1936 (Cth) (ITAA 1936) and Div 230 of the Income Tax Assessment Act
1997 (Cth) (ITAA 1997).
• Interest paid as a part of compensation payments is treated differently for
taxation purposes depending on whether it is paid for the loss of property or
as damages for personal injury.
• In Australia, the courts have been reluctant to carve out interest from
capital payments unless it is clearly identifiable.
• Dividends are ordinary income, but they are specifically made assessable
as statutory income under s 44 of the ITAA 1936.
• Division 974 of the ITAA 1997 provides rules for distinguishing payments of
dividends from payments of interest.
• Rent is ordinary income even when received as a one-off lump sum. •
Lease premiums are capital unless the taxpayer is in the business of
receiving premiums or the premium is a substitute for rent.
• Royalties include payments that are calculated based on the usage of
intellectual property. Royalties can also be payments based on the
quantity/value resources taken from a taxpayer.
• Most royalties are ordinary income and those that are not are assessable
under s 15-20 of the ITAA 1997.
Introduction [9.10]
Chapter 5 outlined the essential characteristics of income that have been
developed by the courts, one of which is the notion that income “flows” from
capital. As a result, receipts such as interest, rent, royalties and dividends
that “flow” from the passive ownership of capital investments will be
ordinary income under s 6-5 of the Income Tax Assessment Act 1997 (Cth)
(ITAA 1997). Following the “fruit and tree” analysis (see [5.100]), these
receipts are generated from capital without the capital being diminished in
any way. For example, interest flows from fixed-term investments, rent flows
from the ownership of property, dividends flow from investments in shares
and royalties flow from intellectual property, such as copyright.
Income earned from the passive ownership of capital is generally known as
property income, but this is not to be confused with the gains realised on the
sale of the property itself. Taxation of the gains from the sale of the property
itself may be assessable as business income, subject to capital gains tax or
other relevant statutory provisions.
Property income is a class of ordinary income, but certain forms of property
income may also be specifically deemed assessable as statutory income. It is
important to distinguish whether property income is ordinary or statutory
income because this may influence the amount that is assessable and/or the
tax due.
If a receipt is both ordinary and statutory income under the Act, s 6-25 of the
ITAA 1997 states that it is included in assessable income only once and it will
normally be taxed under the statutory provision rather than as ordinary
income. The exception to this rule occurs if the statutory provision states
that it only applies if the amount is not ordinary income: see [3.80]. For
example, s 15-20 deems certain royalties to be assessable income but also
states (s 15-20(2)) that the section does not apply if the royalty is ordinary
income under s 6-5.
In this chapter, the main areas of property income are discussed as ordinary
or statutory income under the following headings:
• interest: see [9.20]–[9.140];
• dividends: see [9.150];
• rental and lease income: see [9.160]–[9.180];
• royalties: see [9.190]–[9.200];
• annuities: see [9.210].

Interest [9.20]
Most people understand the common use of the term “interest” to mean the
cost of borrowed funds or the return from fixed-term investments, such as
bank term deposits or debentures. In this form, receipts of interest provide a
clear example of income from property which is therefore ordinary income
and assessable under s 6-5 of the ITAA 1997: Lomax v Peter Dixon & Son Ltd
[1943] 1 KB 671 (see Case Study [9.1]). However, the term “interest” is not
specifically defined in the tax legislation and therefore it is necessary to rely
on case authority for a definition. In Riches v Westminster Bank Ltd [1947]
AC 390 at 400, interest is described as “a payment which becomes due
because the creditor has not had his money at the due date”. Interest
therefore is the return that flows from the lending of money and is the
compensation for the loss of use of that money. The capital sum lent is not
affected by the payment of interest providing a clear application of the
“flow” concept of income.
Although interest in its normal form is ordinary income, there are some
specific statutory provisions which impact on the taxation of interest. In
addition, there are issues relating to the timing of its assessability and
whether it may in some circumstances be treated as capital.
Discounts and premiums [9.30]
Commercial rates of interest are relatively easy to establish for various types
of lending, but these rates are substantially influenced by the degree of risk
associated with the debt. Lenders may increase the standard interest rate to
account for the increased risk of non-repayment or they may retain the
standard rate of interest and negotiate a discount or premium on the debt. A
discounted loan is one where the amount provided to the borrower is less
than the amount of the loan. A loan premium is one where the borrower has
to repay more than the amount advanced by the lender.

Example 9.1: Loan discounts and premiums

Loan discount XYZ Pty Ltd arranges a loan of $1 million (notional
principal) for one year to finance the development of a new
production process. This loan is an interest-only loan and the
interest rate is well below that expected for similar loans. The
principal of $1 million is to be repaid in full at the end of the one-
year term. However, the lender advances only $900,000 to XYZ Pty
Ltd, not the full $1 million, but the loan agreement states that the
full $1 million has to be repaid. The $100,000 difference between
the amount advanced and the amount repaid is known as the
“discount”.

Note that interest will still be paid on the $1 million even though only
$900,000 is advanced to the borrower.
Loan premium
ABC Pty Ltd arranges a loan of $900,000 (notional principal) for one year to
finance the development of a new production process. This is an interest-
only loan and the interest rate is well below the rate that might be expected
for similar loans. However, at the end of the loan, ABC Pty Ltd is required to
repay $1 million, consisting of the $900,000 debt plus a “premium” of
$100,000. In this case, the annual interest will still be based on the $900,000
borrowed.
Difference between discounts and premiums
The difference between a loan discount and premium is very subtle and may
best be understood by comparing the two notional principals for each of the
arrangements above. With the discount arrangement, the notional principal
is $1 million with a discount of $100,000, which means that only $900,000 is
received by the borrower. On the other hand, with the loan premium, the
notional principal is $900,000 and the borrower has to pay an additional
premium of $100,000 on maturity of the debt giving a total repayment of $1
million. The other important difference is that for the loan discount, interest
is levied on the principal of $1 million, but on the loan premium, the interest
is only charged on the $900,000 advance.
It may appear from Example 9.1 that loan premiums and discounts are no
more than different terms for the same arrangement, that is, paying back a
larger amount than the amount received. In addition, the discount or
premium could be simply seen as a substitute for interest. However, these
types of financial arrangements have also been developed to alter the timing
of assessable income and as an attempt to characterise the discount or
premium as capital rather than ordinary income: Lomax v Peter Dixon & Son
Ltd [1943] 1 KB 671.
Case study 9.1: Interest or compensation for risk
In Lomax v Peter Dixon & Son Ltd [1943] 1 KB 671 (an English case),
the English taxpayer lent money to an associated Finnish company
just before the outbreak of World War II. The taxpayer was not in
the business of lending money, but determined that there was a
high level of risk associated with this loan. As a result, the taxpayer
required a much higher rate of return than would normally be
accepted, but this was not achieved by charging a higher-than-
usual interest rate. In fact, the stated interest rate was comparable
to normal commercial lending. The additional risk of non-repayment
was catered for by the borrower being required to pay both a
premium and a discount on the debt.

The House of Lords accepted the argument by the taxpayer that the
benefits received as a result of the discount and premium were
capital in nature and not interest. The Court appears to have taken
into account in this decision the facts that a commercial rate of
interest was charged and that the taxpayer was not in the business
of lending money.
[9.40] The importance of the decision in Lomax v Peter Dixon & Son Ltd
[1943] 1 KB 671 is that it shows that there is a distinction between interest
which is ordinary income and a capital return that results from an allowance
for risk. However, this case is also important as it is often cited as authority
for the principle that if the discount is simply a replacement for interest, then
it will be ordinary income. This same conclusion would be reached via the
application of the first strand of Myer: see [8.220].
Case study 9.2: Gain on a discounted security was ordinary income
In FCT v Hurley Holdings (NSW) Pty Ltd (1989) 20 ATR 1293, the
taxpayer’s main business was investing in the hotel industry. The
company had realised some of its investments so that they could be
held in a more liquid form until the managing director’s son took
control of the company. As part of this process, the taxpayer
purchased a discounted bill for $442,200 with a face value of
$500,000 and a maturity date of just over one year. No actual
interest was paid on this investment, but on maturity, the value of
the investment had increased by $57,800, which is a notional return
of 13% on the original investment of $442,200. The Commissioner
assessed the $57,800 as ordinary income, but the taxpayer argued
that it was capital.
The Federal Court held that the gain made on the realisation of the
investment was ordinary income. In reaching this conclusion,
Gummow J distinguished the facts in this case from Lomax v Peter
Dixon & Son Ltd [1943] 1 KB 671. The basis of this distinction was
because Hurley Holdings did not receive interest and the discount
was more akin to a substitute for interest and not simply an
increase in capital value. This same conclusion was reached through
the application of the first strand of Myer: see [8.220].
With the increased complexity and sophistication of financial markets, and
the application of the first strand of Myer, the courts may be more inclined in
today’s financial climate to view premiums and discounts as ordinary
income. Nevertheless, the decision in Lomax v Peter Dixon and Son Ltd is
good authority and it is still conceivable that a genuine discount or premium
could be held to be capital if:
• interest was payable on the loan;
• the interest and the terms of the loan were commercially justifiable; and
• the discount took into account the risk of non-repayment.
Timing of interest receipts [9.50]
Even though discounts or premiums will generally be ordinary income,
deferring the receipt of the gain to when the debt is redeemed may delay
the time when the gain is assessable as interest is normally derived and
assessable on a cash basis. For example, if interest is paid on an annual
basis, the interest will be derived and assessable under s 6-5(2) of the ITAA
1997 in that year. However, to the extent that the gain is realised via a
discount or premium at the end of the loan, it will not be derived and
assessable under s 6-5(2) until that later date: FCT v AGC (1984) 15 ATR
982.
Deferral of the taxation of interest earned by way of a discount or premium
may cause an imbalance in the taxation system. This happens if the
borrower can claim a deduction on a yearly basis, but the lender only has
assessable income when the loan is repaid. As a result of this potential
imbalance, a range of legislation was introduced to counter the possible
deferral of tax through discount and premium arrangements.
Division 16E, s 26BB and s 70B of the Income Tax Assessment Act 1936 (Cth)
[9.60] Division 16E of the Income Tax Assessment Act 1936 (Cth) (ITAA
1936) deals with the timing of assessable income and deductions relating to
discount and deferred interest payments on “qualifying securities”. Division
16E only affects the timing of assessable income and deduction and does
not determine whether or not these payments are assessable. This means
that the first step when presented with a premium or discount on a
qualifying security is to determine whether the discount or premium is
ordinary income. If it is ordinary income, then the second step is to apply Div
16E.
The effect of Div 16E is that the gains made on these securities are included
in assessable income of the lender annually over the life of the loan. This will
be the case even though the actual receipt of these monies may not occur
until the end of the loan. Under this Division, the borrower is also entitled to
a deduction on an annual basis, regardless of when the discount or deferred
interest is paid.

Sections 26BB and 70B of the ITAA 1936 apply to “traditional securities”
acquired after 10 May 1989. These provisions deem premiums and discounts
to be assessable income to the recipient and deductible for the payer, even
when they are capital in nature. Traditional securities are taxed on realisation
and are not taxed on an annual basis like those subject to Div 16E.
The distinction between “qualifying securities” and “traditional securities” is
based on the amount of the premium/discount. Traditional securities have a
return (other than periodic interest) equal to or less than 1.5% pa and
qualifying securities have a return (other than periodic interest) of greater
than 1.5% pa, or where the return cannot be determined at the time of issue.
Example 9.2: Difference between qualifying and traditional
securities
Two 10-year loans are available, both with a repayable face value of $1,000.
The first is issued at $750 and the second is issued at $900. The benchmark
amount for differentiating between the qualified and traditional security is
$150 (1.5% × 10 years × $1,000). The first loan’s return is $250 ($1,000 −
$750), which is greater than the $150 benchmark and so would be a
qualifying security. The second loan’s return is $100 ($1,000 − $900), which
is less than the $150 benchmark and so would be a traditional security.
Example 9.3: Illustration of Div 16E – Qualifying security
Kathie lends money under a four-year loan with a repayable face
value of $20,000. However, the loan is subject to a discount and is
issued at $17,000. This is a qualifying security because the return
due to the discount is greater than 1.5% pa: ($20,000 − $17,000) =
$3,000 which is a return of $750 pa ($3,000/4 years) or 3.75% pa
($750/$20,000) of the $20,000 loan. The first step is to decide
whether the discount of $3,000 is income or capital. This will
depend on the individual facts of the case, such as what (if any)
interest rate is charged in addition to the discount. If the $3,000 is
ordinary income, then, under Div 16E, its assessability will be
apportioned over four years (the life of the loan). On the other
hand, if it is capital, Div 16E will not apply, but Kathie will almost
definitely be subject to capital gains tax upon repayment of the
loan: see Chapter 11. Furthermore, any actual interest payable
during the term of the loan will be Kathie’s ordinary income.

Example 9.4: Illustration of s 26BB – Traditional security

Cindy lends money under a four-year loan agreement. The terms are
that the repayable face value is $20,000, but the loan is subject to a
discount so that the loan is issued at $19,000. This is a traditional
security because the return due to the discount is less than 1.5%
pa: ($20,000 − $19,000) = $1,000 which is a return of $250 pa or
1.25% pa ($250/ $20,000) of the $20,000 loan. The $1,000 gain will
be Cindy’s statutory income under s 26BB at the end of the term of
the loan. Any interest payable during the term of the loan will be
Cindy’s ordinary income.
Taxation of financial arrangements (TOFA) – Div 230 of the ITAA
1997 [9.70]
Division 230 of the ITAA 1997 was introduced into the ITAA 1997 because the
previous timing provisions for financial instruments did not adequately cater
for some of the more complex and newer financial arrangements. It was also
justified on the basis that the previous provision did not take into account
the time value of money, that is, because of inflation and lost interest
earning capacity; for example, $1 earned today is more valuable than $1
earned in one year’s time. These rules apply to financial instruments
acquired on or after 1 July 2010, but a taxpayer may also elect to apply
these rules from 1 July 2009.
The primary aim of the Taxation of Financial Arrangements (TOFA) provisions
is to reduce the mismatch between the timing of the deductions for
payments on financial instruments and the timing of the assessability of
those payments. This will effectively reduce the opportunity for deferral of
the income from these arrangements and will treat all the gains as income,
rather than capital.
The TOFA rules are very complex and have been subject to frequent
amendment. However, these rules do not apply to individuals and therefore
only apply to a limited number of taxpayers such as those dealing with
bonds, promissory notes, debentures and risk shifting arrangements.
Taxpayers not subject to the TOFA provisions will still be taxed under Div
16E, s 26BB and s 70B of the ITAA 1936.
Interest and compensation [9.80]
Interest is normally the return to the lender/investor for the loss of the use of
funds: see [9.20]. However, interest may also be paid on damages and
compensation payments to compensate for the time lag between the loss
and the receipt of the compensation. For example, a person injured in a car
accident who receives $100,000 compensation, but has to wait 12 months
for the final decision and receipt of payment, may be entitled to interest on
the $100,000 because of the delay.
If the compensation itself is ordinary income, any interest paid on the
compensation will also be ordinary income under the compensation
principle: see [10.20]. However, if the compensation itself is not ordinary
income, the question arises as to the tax treatment of the interest
component of the compensation payments: Federal Wharf Co Ltd v DCT
(1930) 44 CLR 24 (see Case Study [9.3]).
These interest payments may be:
• ordinary income;
• capital because it cannot be separated from compensation of a capital
nature (this may be subject to capital gains tax, although some capital
compensation is exempt from CGT: see [11.290]);
• capital for other reasons, such as being pre-judgment interest on personal
injury payments: see [9.100]; or
• specifically made exempt by the ITAA 1997: see [3.90].
Before considering the impact of the specific statutory provisions on interest
relating to compensation for loss of capital, it is first necessary to
understand how these receipts have been categorised by the courts. Case
law shows that different approaches may be used for compensation for the
loss of property and compensation for personal injury: Federal Wharf Co Ltd
v DCT (1930) 44 CLR 24; Whitaker v FCT (1998) 38 ATR 219.
Interest relating to compensation for damages for property [9.90]
The decision in Federal Wharf Co Ltd v DCT (1930) 44 CLR 24 illustrates that
interest compensation relating to property will be ordinary income where the
interest component of the compensation is a clearly identifiable amount.
This is effectively an application of the compensation principle. However, if
the capital and interest components are undissected (the components of the
compensation cannot be ascertained), then the court is more likely to treat
the total compensation as capital, even though it may include some
component of income, such as interest: see [10.240].
Case study 9.3: Interest on capital compensation is ordinary income
In Federal Wharf Co Ltd v DCT (1930) 44 CLR 24, the taxpayer’s
property was compulsorily acquired under legislation and the
relevant Act allowed for interest at the rate of 4% pa to be paid on
the amount owing from the time of acquisition to the time the
compensation was paid.

The compensation for the loss of property was clearly capital, but
Federal Wharf argued that the 4% pa (interest) component formed
part of the compensation for resumption of the land and was also
capital. The High Court held that the interest component of the
compensation was ordinary income because it was paid to account
for the fact that the taxpayer had been deprived of the use of the
funds that it was due. Rich J followed the analogy that if the funds
were received immediately, they could have been invested and any
interest received would be ordinary income.
In Federal Wharf Co Ltd v DCT, the interest component of the
compensation was clearly identifiable. As a result, it was possible
for the Court to separate the capital component for the resumption
of the land from the income component in the form of interest.
Interest relating to compensation for damages for personal injury
[9.100]
Interest paid as part of compensation for personal injury can be separated
into pre-judgment and post-judgment interest. Pre-judgment interest is
interest accumulated between the time of the event giving rise to the
compensation and the time of the judgment; post-judgment interest is the
interest accrued between the time of the judgment and the time of receipt of
the compensation.
Case study 9.4: Pre-judgment and post-judgment interest
In Whitaker v FCT (1998) 38 ATR 219, the taxpayer was awarded
compensation of about $808,000 following surgery which left her
blind. The sum awarded included pre-judgment interest of $65,000.
Whitaker also received approximately $288,000 in post-judgment
interest because the compensation remained unpaid for over two
years due to the case being appealed. The Commissioner included
both the post-and pre-judgment interest in the taxpayer’s
assessable income. On appeal to the Full Federal Court, it was held
that the pre-judgment interest was capital in nature and not
ordinary income, but the post-judgment interest was ordinary
income and therefore assessable. The Court had little difficulty in
concluding that the post-judgment interest was ordinary income
because it was paid to compensate for the delay in the payment of
the compensation. This interest had nothing to do with the damages
awarded for the injury. However, pre-judgment interest was seen as
part of the compensation awarded for the injury suffered and
therefore was capital in nature.
Although the judgment was unanimous, the reasoning varied but
generally related to the fact that although the pre-judgment
interest is compensation for being deprived of the money, the
amount is not certain until the award is made and it is just one
component of the compensation for the loss suffered. It was also
suggested that it could not reasonably be assumed that these funds
would have been available for investment as they did not crystallise
until the judgment was made. Note that the decision in this case
relating to post-judgment interest has been made redundant due to
the enactment of s 51-57 of the ITAA 1997: see [9.110].
Section 51-57: Exemption of post-judgment interest on personal
injury compensation [9.110] The decision in Whitaker v FCT (1998)
38 ATR 219 generated considerable media interest and political
debate regarding the issue of whether it was fair and equitable to
tax post-judgment interest from personal injury compensation.
Consequently, retrospective legislation was introduced, effective
from the 1992–1993 tax year, to exempt post-judgment interest
from assessable income.
Under s 51-57 of the ITAA 1997, the interest is exempt if it relates
to damages for personal injury and is in respect of the period
between the original judgment and the ending of any appeal
process or the time of any out-of-court settlement. Any interest
arising between settlement and the date of receipt of the
compensation is not covered by the s 51-57 exemption. This interest
would be subject to the decision in Whitaker v FCT and would be
categorised as ordinary income.
Interest compensation and CGT [9.120]
Compensation of a capital nature may be subject to CGT provided it is not
exempted by s 118-37 of the ITAA 1997: see Chapters 10 and 11. As a result,
any interest component that cannot be clearly identified may be included in
the amount subject to CGT. For example, where the compensation is for a
capital loss and in the form of an undissected amount (see [10.240]), then
the total amount of compensation will be treated as capital. This will be the
case even if the final amount was determined after consideration of
compensation for the loss of use of funds (ie, interest).

Section 15-35: Interest on overpayment and early payment of tax [9.130]

Where a taxpayer has paid his or her tax but has disputed the assessment
and is successful in having the tax assessment reduced, the taxpayer is
entitled to be paid interest on the overpaid tax: Taxation (Interest on
Overpayments and Early Payments) Act 1983 (Cth). The refund of the tax
already paid will therefore include compensation in the form of interest to
account for the fact that the tax had previously been overpaid.
This compensation, paid in the form of interest, is specifically deemed to be
assessable under s 15-35 of the ITAA 1997. Although such payments will also
constitute ordinary income, they will be assessable only under s 15-35, as
gains that are both ordinary and statutory income are taxed under the
statutory provision (s 6-25 of the ITAA 1997) unless the specific provision
requires otherwise: see [3.80].
Interest portion of instalment payments [9.140]
Interest could also be imputed into periodic payments for capital items. For
example, on the sale of a retail business, the vendor may agree that the
purchaser can pay for the business with equal quarterly payments over a
three-year period. This type of arrangement is commonly known as a “term
sale” or “vendor financing” and may occur where purchasers cannot obtain
their own finance.
If this type of arrangement states a specific interest rate to be charged on
the outstanding balance, then that interest will clearly be ordinary income.
However, if no explicit interest rate is included in the agreement, the issue
arises as to whether there is an implied interest included in the periodic
payments.
Australian courts have generally been reluctant to impute an interest
component into periodic capital payments and are more inclined to treat the
total amount as capital if there is no identifiable amount of interest:
Californian Oil Products Ltd (in liq) v FCT (1934) 52 CLR 28. However, these
amounts may be subject to the CGT provisions: see Chapter 11.
Example 9.5: Interest component of periodic capital payments
Mr Gan wishes to sell his gardening and home maintenance
business as a going concern, and he has a willing purchaser. Mr Gan
has advertised the business (equipment, customer lists and forward
bookings) for $160,000, but he would sell it for $150,000. The
potential purchaser is very keen to buy the business, but she
cannot obtain the finance for the purchase.

As a result, Mr Gan agrees to sell the business for 10 quarterly

payments of $16,000 each and secures the payments by taking a
mortgage over the purchaser’s private home. There is no mention
of interest in the agreement.
As there is no mention of interest in this contract, the full payment
will most likely be treated as capital. However, provided CGT is
applicable, Mr Gan will have realised a capital gain for tax purposes
on the date of the agreement to sell. As a result, he will be subject
to tax on the gain in the year of the sale, regardless of the fact that
he will not be paid in full until over two years later.
Dividends [9.150]
Dividends are paid to company shareholders as their share of company
profits. It therefore follows that dividends flow from the ownership of shares
and are ordinary income under s 6-5 of the ITAA 1997. However, dividends
are also specifically made assessable as statutory income under s 44 of the
ITAA 1936 and because of s 6-25 of the ITAA 1997, this specific provision has
precedence over the general provision, s 6-5: see [3.80]. Consequently,
dividends are brought to assessable income via s 44 rather than s 6-5: see
[21.40].
Section 6(1) of the ITAA 1936 defines a “dividend” as including:
• any distribution in the form of money or property that a company makes to
its shareholders; and
• any amount credited by the company to any of its shareholders as
shareholders.
The meaning of “dividend” for tax purposes is discussed in detail at
[21.130], but in most situations, it will be clear what a dividend is. However,
over the years, many complex financial instruments have been developed in
an attempt to alter the tax effect of benefits paid to shareholders. This has
created some confusion as to whether the payments are interest on debt,
dividends or of a capital nature. Of particular concern is whether the
payments by a company are dividends paid to the holder of shares (equity)
or interest paid on debt. This distinction is important as it alters the tax
treatment for both the company and the investor.
Example 9.6: Company payment on debt
Rupert has lent (debt) $50,000 to his family private company, of
which he is a shareholder, and the agreement is that the company
pays Rupert 8% pa interest and the debt is to be repaid at the end
of three years. In this case, the company will have a tax deduction
for the interest payment and Rupert will be assessable on the
interest receipt as ordinary income. The repayment of the loan at
the end of three years is capital in nature with no income tax
implications for either the company or Rupert. The important
characteristics of Rupert’s investment are that there is a known
fixed amount of return and the repayment of the capital is also
agreed to.
Example 9.7: Company payment on equity
Gertrude purchases $50,000 of shares (equity) in a private
company. Gertrude will only receive a dividend from her investment
if the company makes a profit and decides it can afford to distribute
a dividend to its shareholders. If the company does pay a dividend
to Gertrude, the company will not be able to claim the payment as a
deduction because it is not an expense, but a distribution of profits.
Gertrude will have assessable income under s 44 of the ITAA 1936,
but may be entitled to a rebate via the dividend imputation system
to account for the tax the company has already paid on its profits
before paying the dividend: see [21.420]. The only means for
Gertrude to realise the capital value of her shares is to sell them or
for the company to buy them back, both which could give rise to
CGT: see Chapter 11.
The important characteristics of Gertrude’s investment in equity are that the
returns are not certain and the capital value can only be realised through
sale.
The main differences between investments in debt and equity are:
• the different level of risk borne by the investor, in that lenders are exposed
to less risk than shareholders; and
• the different tax treatments.
Given the different tax treatment of investments in debt and equity,
companies have devised securities which blur the boundary between
payments of interest and dividends. This has been done to alter the tax
situation for both the company and investor. As a result, Div 974 of the ITAA
1997 was enacted to provide a clearer definition of debt and equity
investments. These rules are very complex, but in essence, the distinction
between debt and equity is made on the basis of the certainty, or otherwise,
of the return and the level of risk to which the investor is exposed.
Rental and lease income
Rent [9.160]
Rent is a payment by one party in exchange for the exclusive possession of
the other party’s property for an agreed amount of time. The receipt of rent
by a lessor clearly constitutes ordinary income as it is income from property.
Under the flow concept, rent is income that flows from an investment in
property: see [5.100]. Although rent receipts are usually periodical in nature,
rent will still constitute ordinary income when it is paid as a lump sum.
Lease premiums [9.170]
A lease premium is a payment by a potential lessee to induce a lessor to
enter a lease agreement.
Receipt of a lease premium by a lessor is normally treated as capital because
it is regarded as a receipt for realising an interest in the asset. Lease
premiums that are capital will usually be assessable under the CGT
provisions: see Chapter 11.

However, lease premiums will constitute ordinary income in either of the two
following situations:
• where the taxpayer is in the business of receiving lease premiums:
Kosciusko Thredbo Pty Ltd v FCT (1983) 15 ATR 165 (see Case Study [9.5]).
This is usually only the case if the taxpayer regularly receives lease
premiums; and
• where the lease premium is in reality a substitute for rent: Dickenson v FCT
(1958) 98 CLR 460.
Example 9.8: Lease premium – Capital
Pete owns a rental property and wants to find a tenant to enter a
one-year rental agreement. He believes he can charge rent of
$1,500 per month, but at this rate, he receives far more prospective
tenants than he expected. One particular applicant, Alex, offers to
pay Pete a one-off premium of $1,200 on top of the rent if he is
chosen as the tenant, and Pete accepts this offer. The rent of $1,500
will be ordinary income, but the lease premium of $1,200 will be
capital and subject to CGT.

Example 9.9: Lease premium – Business income

Build Pty Ltd builds and rents out office buildings. It regularly
enters into three-year leases with its tenants. Every time it finds a
new tenant, it charges the tenant a one-off lease premium on top of
the monthly rent. Because it owns many offices, Build Pty Ltd
regularly receives lease premiums. In this instance, receipt of the
lease premiums would constitute ordinary income and would be
assessable under s 6-5 of the ITAA 1997. The receipt of the lease
premiums is regarded as normal proceeds of Build Pty Ltd’s
business because it receives them on a regular basis as part of its
business activities.
Example 9.10: Lease premium – Substitute for rent
Jemima owns a rental property and wants to charge $1,800 rent per
calendar month. However, a friend of hers told her that lease
premiums are not ordinary income. As a result, she enters into a
lease agreement with a tenant where she is paid $1,000 per month
rent and $800 per month “premium”. The $1,000 per month rent
would be ordinary income and assessable under s 6-5. The $800 per
month “premium” would also be ordinary income in this situation as
it is clearly a substitute for rent.
Case study 9.5: Taxpayer in business of receiving lease premiums
In Kosciusko Thredbo Pty Ltd v FCT (1983) 15 ATR 165, the taxpayer,
in its capacity as a tenant, entered into a 45-year lease of a State
park. The taxpayer then proceeded to develop the land, which
included building facilities and apartments. The taxpayer
subsequently sublet the apartments and other facilities to various
tenants and received lease premiums upon granting some of these
leases. The Court held that the lease premiums constituted ordinary
income as they were part of the normal proceeds of the taxpayer’s
business. This was because the receipt of lease premiums was
repetitive and an essential ingredient of the taxpayer’s business.
Consequently, the scope of the taxpayer’s business included
receiving lease premiums.

Section 15-25 – Amount received for lease obligation to repair

[9.180]
Section 15-25 of the ITAA 1997 states that amounts received by a lessor
from a lessee due to the lessee failing to comply with a lease obligation to
repair the premises are assessable income. However, s 15-25 will only apply
where:
• the lessee has used the premises for producing assessable income; and
• the payment is not ordinary income.
Example 9.11: Amount assessable under s 15-25
Alice owns an office that she leases to Bob. Bob runs a consulting
business from the leased premises. There is a condition in the lease
agreement that Bob must make any necessary repairs to the office
and that if he fails to do so, he must pay a contractual penalty to
Alice.
The office requires repairs and Bob fails to carry them out. As a
result, Bob pays Alice money as determined under the lease
agreement. This amount is assessable under s 15-25. Note that
there is an equivalent deduction under s 25-15 of the ITAA 1997 for
expenses incurred in carrying out these repairs.
Royalties Introduction [9.190]
A royalty is a payment that is calculated based on the usage of intellectual
property or the quantity/value of a substance taken, such as coal taken from
a mine. The following would be royalties:
• When a taxpayer is paid for use of his or her intellectual property. For
example, Simone wrote a book and, as a result, owns the copyright to it. A
publisher then enters into an agreement with Simone to publish and sell her
book in exchange for giving her $2 per sale. This payment constitutes a
royalty because it is calculated based on the usage of the copyright.
• When the owner of intellectual property agrees to sell his or her intellectual
property for an amount based on its usage. For instance, Steve writes a book
and owns the copyright to it. A publisher who wishes to publish and sell
Steve’s book offers to give him $2 per sale in consideration for Steve selling
the copyright to the publisher. The amount received by Steve will constitute
a royalty. This differs from the first example because in the first example, the
author retains ownership of the copyright, but in this example, the copyright
is being sold. Nevertheless, in both cases, the payments constitute royalties
as the amounts are calculated on the usage of intellectual property.
• Where someone is paid to produce intellectual property and the payment is
based on its subsequent usage. For instance, Christie agrees with a publisher
to write a book for them in exchange for a payment of $2 per book sold. The
copyright in this example will always have been owned by the publisher
because, under copyright law, if a writer enters a contract to write a piece
for someone (such as a publisher), the copyright usually rests with the party
that is paying.
However, despite the fact that Christie never owned the copyright, the
payment will still be a royalty because it is calculated according to the usage
of intellectual property.
• Where a taxpayer is paid for his or her physical resources based on the
quantity of resources taken. For example, Alexia owns land that has oil
reserves. A mining company pays her $20 for every barrel of oil that it
extracts from her land. This amount will constitute a royalty.
Case study 9.6: Taxpayer paid for timber taken from his land in
receipt of royalty
In McCauley v FCT (1944) 69 CLR 235, the taxpayer was a dairy
farmer who owned land with trees on it. The taxpayer entered into
an agreement with Laver, where Laver would cut and take the trees
from the taxpayer’s land. The agreement stated that Laver would
pay the taxpayer an amount based on the quantity of timber that
had been cut and removed from the land.
The High Court held by a 2:1 majority that the payment received by
the taxpayer was a royalty as it was a payment made in relation to
the amount of timber removed.
Assessability of royalties [9.200]
Section 15-20 of the ITAA 1997 deems royalties to be assessable as statutory
income. However, s 15-20 does not apply to royalties that are ordinary
income under s 6-5 of the ITAA 1997. This means that royalties that are
ordinary income will be assessable under s 6-5 and those that are not
ordinary income will be assessable under s 15-20. This raises the issue of
which royalties are ordinary income.

Royalties that are a product of exploiting intellectual property (such as the

first three points in the list at [9.190]) will constitute ordinary income. In the
case of Stanton v FCT (1955) 92 CLR 630 (see Case Study [9.7]), the
majority arguably implied that payments for physical resources (such as the
last of the points at [9.190]) will be capital royalties. However, the case law
on what constitutes a capital royalty is unclear, and it is also arguable that
royalty payments for physical resources are ordinary income.
Case study 9.7: Farmer’s receipt from a sawmiller for right to take
timber was not a royalty
In Stanton v FCT (1955) 92 CLR 630, the taxpayer was a farmer who
granted a sawmiller the right to come on to his land and remove
timber in exchange for a predetermined sum to be paid quarterly.
The agreement also prescribed a maximum amount of timber that
could be removed and gave a proportionate reduction of the
payment if less than this maximum was removed. For instance, if
only half the timber was removed, then the taxpayer would end up
receiving only half the pre-agreed amount.
The High Court held that the payments received by the farmer were
not royalties and were capital in nature. Consequently, the payment
was not assessable as it was not ordinary income and s 15-20’s
predecessor did not apply as the payment was not a royalty. The
Court stated that the taxpayer’s receipt was not a royalty because
the agreement expressed the payment as a predetermined amount.
This was despite the fact the agreed pro-rata reduction of the
predetermined payment meant that, in substance, the amount paid
was linked to the amount of timber removed. In other words, the
Court appeared to define royalty by its form rather than its
substance.
If this case was decided today, it is likely that the Court would still find that
the payment was not a royalty. However, it is likely that a modern court
would find that the payment was ordinary income under other grounds. For
instance, it is possible that the court would find the payment is ordinary
income as the normal proceeds of the taxpayer’s farming business. This is
likely because courts may now take a wider view of what are normal
business proceeds: see [8.130]–[8.160]. Furthermore, even if modern courts
decided that the payment did not constitute normal business proceeds, they
are likely to find that the payment was ordinary income due to satisfying the
first strand of Myer: see [8.220]–[8.250]. Finally, if a court held that such a
payment was not ordinary income, it would be assessable under the CGT
provisions: see Chapter 11.

Annuities [9.210]
An annuity is a stream of payments that occur at regular intervals (e.g.,
monthly or quarterly), and this may be for a fixed length of time or for the
life of an individual. Where the annuity is purchased, it is known as a
“purchased annuity”, which occurs where the taxpayer pays an entity, such
as an insurance company, a lump sum in exchange for that entity paying the
taxpayer a regular income stream.
The main two types of annuities are fixed-term and life annuities. A fixed-
term annuity is where the payments are made by the annuity provider for a
predetermined amount of time. A life annuity occurs when the terms of the
annuity contract state that annuity payments are to be made for the rest of
the recipient’s life. At the end of the annuity period, the original purchase
price of the annuity will usually have been totally consumed and the
recipient will not be entitled to any final capital payment. In effect, the
provider of the annuity has repaid over the life of the annuity the purchase
price plus any interest earned during the annuity period. However, in some
limited cases, the taxpayer will be entitled to receive part of the purchase
price of the annuity at the end of the annuity period, but this ultimately
depends on the term of the annuity agreement.
Example 9.12: Fixed-term and life annuities
A taxpayer purchases an annuity from an insurance company for
$100,000 in exchange for a 10-year annuity. The terms of this
particular annuity provide the taxpayer with regular payments for
the next 10 years that amount to $14,500 pa. This is an example of
a fixed-term annuity.
Another taxpayer pays an annuity provider $60,000 in exchange for
the taxpayer receiving regular payments of $7,000 pa for the rest of
his life. This is an example of a life annuity.
Under case law, the full amount of the regular annuity payments is
regarded as ordinary income because it is a regular payment in the
form of income: Egerton-Warburton v DCT (1934) 51 CLR 568. This is
an unjust outcome because only part of the annuity payment is a
real gain, whereas the rest is a return of the taxpayer’s purchase
price, which is capital: see [5.70]. As a result, the Government
enacted s 27H of the ITAA 1936, which makes the return of the
annuity’s capital component tax free. Section 27H only applies to
non-superannuation annuities as superannuation annuities are
subject to other legislative provisions: see Chapter 18.

Example 9.13: Section 27H of the ITAA 1936 reduces assessable

component of annuity
Stan pays $80,000 in exchange for an eight-year annuity that pays
$13,000 pa. Under the terms of the agreement, Stan is not entitled
to have any of the purchase price returned at the end of the eight
years. Stan’s purchase price of $80,000 apportioned over the term
of the annuity amounts to $10,000 per year. This means that, due to
s 27H, $10,000 of the yearly annuity receipt is tax free. The other
$3,000 will be assessable as ordinary income.
Questions [9.220]
9.1 Your client has invested $10,000 in a savings bond that matures
in five years’ time and pays interest at 8% pa, but the interest is
paid as a lump sum on the redemption of the bond in five years’
time. How will the interest be treated for income tax purposes?
9.2 Your client has purchased an investment apartment that has a
rent guarantee from the developer of 5% pa for a period of four
years. During the current financial year, your client has been unable
to rent the apartment, so is relying on the rent guarantee payment
to compensate her for not being able to find a tenant. The
developer is due to pay the amount as a lump sum and your client is
not sure whether the amount is income. Advise her.
9.3 Your client was injured in a work-related accident and has
received damages of $300,000 for the loss of his ability to work. In
the final judgment, the Court awarded $12,000 in pre-judgment
interest and $5,000 in post-judgment interest. Which amounts, if
any, are assessable income?
9.4 Your client makes most of her income from writing hit songs for
various performing artists and receives a large amount of royalties
from overseas record companies. Is this assessable income and how
will it be taxed?
9.5 Your client has just written his first book of his experience as a
hostage of a terrorist group. He spent the last two years writing the
book and he has received two offers from a publishing company
that wished to publish his book. The first offer is to purchase the
copyright for a lump sum payment of $10,000 provided your client
gives up future claims to the copyright and royalties. The second
offer is to pay 10% of the sale price of each book sold provided your
client agrees to assign the copyright in the book to the publisher for
10 years. Discuss the effect on assessable income of each of the two
offers.
9.6 Your client is a parent who lent $40,000 to her son to provide a
short-term housing loan. The agreement is that the son will repay
$50,000 at the end of five years.
Reconsider this question in light of the following facts. The loan was
made to the son without any formal agreement and without any
security provided for the sum lent. In addition, the client (the
mother) has informed you that she told her son that he need not
pay interest. However, the son repaid the full amount after two
years and included in his payment an additional amount which was
equal to 5% pa on the amount borrowed. Only one cheque was
presented for the total amount.
Discuss the effect on the assessable income of the parent.
9.7 Helen is 68 years old and single. Three years ago (when she was
65) she purchased a lifetime annuity for a lump sum of $1 million
(not through her superannuation) that will give her an income of
$60,000 a year for the rest of her life. The annuity has no
guaranteed minimum annuity period and no amount payable to her
estate upon her death. Assume that according to the government
actuarial tables, a 65-year-old female has a life expectancy of 89.
How would Helen’s $60,000 receipt be treated for income tax
purposes?
9.8 Ms Kim works as a nurse at the local private hospital and in
addition to her private home, she owns a commercial property
which she rents to a tenant who operates a retail business from the
property. As part of the rental agreement Ms Kim requires a bond of
$2,000 to be paid on signing of the rental agreement, and the
tenant also agrees to rectify any damage to the property caused by
the tenant. During the current tax year, the tenant stopped paying
rent and on inspection of the property Ms Kim found the tenant had
vacated and there was $3,000 worth of damage caused by the
tenant. As a result, she retained the full $2,000 bond and used it to
repair the damage caused by the tenants. How will Ms Kim’s
retention of the $2,000 bond be treated for income tax purposes?
9.9 Trevor lends money under a five-year loan agreement. The
terms of the loan are that $60,000 is to be repaid at the end of the
five-year period, but the loan is subject to a discount so that the
borrower receives only $55,000. The agreement also states that the
borrower pays 2% per annum in interest.
What ordinary and/or statutory income, if any, will Trevor be
assessable on under this arrangement?
Chapter 11 - Capital gains tax
Key
points ............................................................................................
....... [11.00]
Introduction...................................................................................
............. [11.10]
Step 1 – Have you made a capital gain or a capital
loss? ......................... [11.30]
Question 1: Has a CGT event happened to the
taxpayer? ....................... [11.40]
Subdivision 104-A:
Disposals ..................................................................... [11.50]
Subdivision 104-B: Use and enjoyment before title
passes ...................... [11.60]
Subdivision 104-C: End of a CGT
asset ....................................................... [11.70]
Subdivision 104-D: Bringing into existence a CGT
asset ............................ [11.80]
Subdivision 104-E:
Trusts ............................................................................ [11.90]
Subdivision 104-F:
Leases .......................................................................... [11.100]
Subdivision 104-G:
Shares ......................................................................... [11.110]
Subdivision 104-H: Special capital
receipts .............................................. [11.120]
Subdivision 104-I: Australian residency
ends ........................................... [11.130]
Subdivision 104-J: CGT events relating to
rollovers ................................. [11.140]
Subdivision 104-K: Other CGT
events ....................................................... [11.150]
Subdivision 104-L: Consolidated groups and multiple entry
consolidated
groups............................................................................................
............. [11.160]
Question 2: Is the asset a CGT
asset? ....................................................... [11.170]
Collectables ...................................................................................
............. [11.180]
Personal use
assets ....................................................................................
[11.190]
Separate CGT
assets ...................................................................................
[11.200]
Time of acquisition of CGT
asset ................................................................ [11.210]
Question 3: Does an exception or exemption
apply? ................................ [11.220]
Disregarded capital gains and losses on certain
assets .............................. [11.230]
Exempt or loss denying
transactions ........................................................... [11.280]
Anti-overlap
provisions ................................................................................
[11.310]
Small business
relief .....................................................................................
[11.320]
Main residence
exemption ...........................................................................
[11.380]
Death ............................................................................................
................. [11.425]
Question 4: Can there be a
rollover? ............................................................ [11.430]
Step 2 – Work out amount of capital gain or
loss ......................................... [11.440]
What is a capital gain or
loss? ........................................................................ [11.450]
What factors come into calculating a capital gain or
loss? ........................... [11.460]
Capital
proceeds .......................................................................................
....... [11.470]
Cost
base ..............................................................................................
............ [11.480]
Reduced cost
base ...........................................................................................
[11.500]
Step 3 – Work out your net capital gain or loss for the income
year ............. [11.510]
Calculation
1 ...................................................................................................
.. [11.520]
Calculation
2 ...................................................................................................
.. [11.530]
Calculation
3 ...................................................................................................
.. [11.540]
Calculation
4 ...................................................................................................
.. [11.550]
Calculation
5 ...................................................................................................
... [11.560]
Capital
losses ............................................................................................
...... [11.570]
Indexation
figures ...........................................................................................
[11.580]
Current index reference
base ......................................................................... [11.580]
Questions ......................................................................................
................... [11.590]
Key points [11.00]
• Capital gains tax (CGT) affects a taxpayer’s income because assessable
income includes the net capital gain for the income year. As such, there is no
such thing as a separate CGT. Rather, capital gains are taxed as statutory
income under the Income Tax Assessment Act 1997 (Cth).
• A taxpayer’s net capital gain for an income year is the total of the capital
gains for the income year minus certain capital losses for the income year.
• Capital losses cannot be deducted from assessable income. This is known
as quarantining. However, capital losses may be carried forward to be offset
against capital gains in future income years.
• A taxpayer makes a capital gain or a capital loss only if a CGT event
happens; that is, CGT applies only to realised gains.
• Most CGT events involve a CGT asset.
• There are certain exemptions or exceptions that reduce the capital gain or
loss or allow the taxpayer to disregard it altogether.
• Gains and losses made on assets acquired before 20 September 1985 are
generally exempt from CGT.
• There are certain rollovers that allow a taxpayer to defer a capital gain or
loss from a CGT event.
• A taxpayer generally makes a capital gain if he or she receives capital
amounts (known as capital proceeds) that exceed the total costs (known as
the cost base) associated with the CGT event.
• A taxpayer generally makes a capital loss if he or she receives capital
amounts (known as capital proceeds) that are less than the total costs
(known as the reduced cost base) associated with the CGT event.
• In certain circumstances, a taxpayer may be able to take into account
inflation or apply a general discount to a capital gain.
Introduction [11.10]
The topics covered so far have considered whether a receipt is income or
capital and whether that receipt is ordinary or statutory income. The focus
has then been on the tax consequences of a receipt of income. This chapter
considers the consequences of a receipt of capital or, more specifically,
capital gains tax (CGT). Gains that are assessable under the CGT regime are
a form of statutory income.
The capital gains and capital losses provisions (commonly referred to as
capital gains tax or CGT) are contained in Pts 3-1 and 3-3 of Ch 3 of the
Income Tax Assessment Act 1997 (Cth) (ITAA 1997). Part 3-1 deals with
capital gains and losses general topics, while Pt 3-3 deals with special topics,
such as rollovers and small business concessions.
A taxpayer’s income tax liability is affected by CGT because assessable
income includes the net capital gain for the income year (s 102-5(1)), where
net capital gains consist of the total capital gains for the year reduced by
certain capital losses. A taxpayer cannot deduct a net capital loss. However,
a loss may be carried forward to be offset against gains in future years.
The starting point for considering the application of the CGT provisions is
generally Div 104 which contains all of the CGT events. Once it has been
established that there is a CGT event, it is possible to consider the other
Divisions of the CGT Parts of the Act. For example, it will be necessary to
consider Div 108 which provides a definition of a CGT asset, Div 110 which
provides the rules relating to the cost base of the asset, Div 116 which
provides the rules relating to the capital proceeds from the event and Div
118 which provides many of the exemptions available.
[11.15] One of the most important aspects of calculating a taxpayer’s net
capital gain is determining whether the general discount percentage applies.
The general discount percentage is applied at the third step outlined below
after determining whether there is a gain or loss and the amount of that gain
or loss. However, because it ultimately reduces the net capital gain to be
included in assessable income, it is worth noting at the outset. A 50%
general discount applies to qualifying capital gains: s 115-5. To qualify, the
asset must be acquired at least 12 months before the CGT event giving rise
to the gain. The general discount percentage is discussed further in
[11.540].
[11.20] Taxpayers need to be aware of the types of situations where a
capital gain or loss may arise. Most taxpayers will be aware that a gain or
loss may arise where there is the disposal of a CGT asset. However, while
most CGT events involve a CGT asset, the trigger for a gain or loss is a CGT
event. Examples of CGT events include leases, inheritance, subdividing land,
goodwill, contracts, options, a company liquidation, leaving Australia,
marriage breakdown, working from home, shares, a civil court case, trusts,
bankruptcy and incorporating a company: s 100-10(3) of the ITAA 1997.
To determine whether a taxpayer is affected by the CGT provisions, it is
necessary to follow a three-step process described in Div 100 of the ITAA
1997. Within each of these three steps, we ask a series of questions to
ultimately determine the effect of the CGT provisions on a taxpayer’s liability
to pay income tax.
Step 1 – Have you made a capital gain or a capital loss? [11.30]
The first step is to determine whether the taxpayer has made a capital gain
or loss. To help us determine whether there is a capital gain or loss in the
current income year, we ask four questions.

Question 1: Has a CGT event happened to the taxpayer?

[11.40] A taxpayer makes a capital gain or loss if, and only if, a CGT event
happens: s 102-20 of the ITAA 1997. Therefore, the first step in the CGT
process is to determine whether a CGT event happens to the taxpayer’s
situation. If more than one CGT event happens, subject to certain
exceptions, you use the one that is the most specific to the situation: s 102-
25(1). The capital gain or loss will be taken into account in the tax year in
which the CGT event happens.
Division 104 sets out all of the CGT events for which a taxpayer can make a
capital gain or loss. Division 104 also tells you how to work out whether the
taxpayer has made a gain or loss from the CGT event and the time of the
CGT event. The Division also contains some exceptions for gains and losses,
as well as some of the cost base adjustment rules.
A summary of CGT events is contained in s 104-5. There are 12 major
categories of CGT events: • 104-A – disposals;
• 104-B – use and enjoyment before title passes;
• 104-C – end of a CGT asset;
• 104-D – bringing into existence a CGT asset;
• 104-E – trusts;
• 104-F – leases;
• 104-G – shares;
• 104-H – special capital receipts;
• 104-I – Australian residency ends;
• 104-J – CGT event relating to rollovers;
• 104-K – other CGT events;
• 104-L – consolidated groups and multiple entry consolidated (MEC) groups.
Subdivision 104-A: Disposals [11.50]
CGT event A1 is the most common CGT event. CGT event A1 happens if a
taxpayer disposes of a CGT asset: s 104-10(1) of the ITAA 1997. A disposal
occurs where there is a change in ownership because of some act or event
or by operation of law. However, a change of ownership does not occur if the
taxpayer stops being the legal owner, but continues to be the beneficial
owner, or merely because of a change of trustee: s 104-10(2).
The time of CGT event A1 is when the taxpayer enters into the contract or, if
there is no contract, when the change of ownership occurs: s 104-10(3).
Where there is more than one contract – for example, an original contract
and a subsequent contract varying the terms – the date of disposal will be
determined by reference to the contract that gives rise to the obligation to
sell or transfer the asset: FCT v Sara Lee Household & Body Care (Australia)
Pty Ltd (2000) 44 ATR 370. Further, in the context of an acquisition, the court
has held that an oral contract, whether enforceable or not, will determine the
date of acquisition: McDonald v FCT (1998) 38 ATR 563. However, where the
contract is preliminary and not the actual contract for acquisition, the date of
acquisition will be the latter contract: Elmslie v FCT (1993) 26 ATR 611.
Where there is no contract, the time of the event will be the time of the
change of ownership to be determined on the facts – for example, the
provision of access to the property, such as the handing over of the keys.
Where CGT event A1 occurs, you make a capital gain if the capital proceeds
from the disposal are more than the asset’s cost base and you make a
capital loss if those proceeds are less than the asset’s reduced cost base: s
104-10(4). The cost base is generally the total costs associated with the CGT
event (see [11.480]), while the capital proceeds are generally the amount
the taxpayer receives, or is entitled to receive, from the CGT event: see
[11.470].

Example 11.1: Event A1

In June 2020, Kylie enters into a contract to sell land. The contract is
settled in October 2020. Kylie makes a capital gain of $50,000. The
$50,000 gain is made in the 2019–2020 income year, that is, the
year in which the contract is entered into, and not the 2020–2021
income year. Source: Adapted from s 104-10 of the ITAA 1997.
Case study 11.1: Time of disposal In FCT v Sara Lee Household &
Body Care (Australia) Pty Ltd (2000) 44 ATR 370, the taxpayer was a
subsidiary of a US company involved in the pharmaceuticals and
healthcare product market. On 31 May 1991, the taxpayer entered
into a contract with Roche to sell its business. On 30 August 1991, a
number of amendments were made to the original agreement,
including an adjustment to the purchase price and the name of the
purchaser. The issue before the High Court was whether the
relevant date of the contract for CGT purposes was 31 May 1991 or
30 August 1991.
The High Court held that it is a question as to which contract gave
rise to the obligation to effect the disposal. In this case, although
the terms of the original agreement were varied in August, the
obligation established on 31 May 1991 did not change. Therefore,
the date of disposal for CGT purposes was 31 May 1991.

Subdivision 104-B: Use and enjoyment before title passes [11.60]

CGT event B1 happens if a taxpayer enters into an agreement under which
the right to the use and the enjoyment of a CGT asset owned by the
taxpayer passes to another entity and title in the asset will or may pass to
that entity before the end of the agreement: s 104-15(1) of the ITAA 1997.
The time of the event is when the other entity first obtains the use and
enjoyment of the asset: s 104-15(2).
Example 11.2: Event B1 Mark agrees to rent an investment property to John
for a period of two years. The agreement entered into by the parties
provides that at any time during the two-year period John has the right to
purchase the property from Mark. Event B1 occurs when Mark starts renting
the property.

Subdivision 104-C: End of a CGT asset [11.70]

Category C, dealing with the end of a CGT asset, contains three separate
events.
CGT event C1, the loss or destruction of a CGT asset, happens if a CGT asset
that the taxpayer owns is lost or destroyed: s 104-20(1) of the ITAA 1997.
The time of CGT event C1 is when the taxpayer first receives compensation
for the loss or destruction or, if no compensation is received, when the loss is
discovered or the destruction occurred: s 104-20(2).
Example 11.3: Event C1
Erin owns a factory that burns down. She has insurance that
compensates her for the loss. CGT event C1 happens when the
factory is destroyed, and the time of the event is when she receives
the insurance payment.
CGT event C2, covering cancellation, surrender and similar endings,
happens where the taxpayer’s ownership of an intangible asset
ends by the asset:
• being redeemed or cancelled; or
• being released, discharged or satisfied; or
• expiring; or
• being abandoned, surrendered or forfeited; or
• if the asset is an option – being exercised; or
• if the asset is a convertible interest – being converted: s 104-
25(1).

The time of CGT event C2 is when the taxpayer enters into the
contract that results in the asset ending or, if there is no contract,
when the asset ends: s 104-25(2).
Example 11.4: Event C2
Tim has a contract with Acme Co to be the exclusive supplier of
their widgets for the next 10 years. Acme Co terminates the
agreement with Tim after five years. Tim is paid $5,000 as
compensation for the early termination of the contract.
CGT event C2 happens as Tim’s intangible asset, that is, his rights
under the agreement, have come to an end.
Later we will see that the capital gain will be the $5,000 less any
costs associated with the event (eg, legal fees).

CGT event C3, the end of an option to acquire shares, happens if an

option that a company or trustee of a unit trust granted to an entity
to acquire a CGT asset, which is shares in the company (or units in
the unit trust or debentures in the company or unit trust), ends
because it is not exercised by the latest time for its exercise, is
cancelled, released or abandoned: s 104-30(1). Event C3 only deals
with company issued options. All other options are dealt with as a
D2 event, with the difference being the time of the event. The time
of event C3 is when the option ends: s 104-30(2).
Example 11.5: Event C3
On 1 January 2020, Gina pays Acme Co $100 for the right to acquire
10,000 shares in the company for $1 per share. The option to
acquire shares must be exercised within 12 months of entering into
the option. Gina decides not to exercise the option. As a result, the
option expires and CGT event C3 happens on 1 January 2021.
Acme Co makes a capital gain of $100 (less any associated
expenses) on 1 January 2021.
Subdivision 104-D: Bringing into existence a CGT asset [11.80]
Category D, bringing into existence a CGT asset, has four separate
events. CGT event D1 happens where a taxpayer creates a
contractual or other legal right in another entity: s 104-35(1). The
bringing into existence of an asset that triggers a CGT event D1
often leads to a CGT event C2 when the asset created comes to an
end.
Example 11.6: Event D1
Bart sells his business to Lucy. As part of the agreement, Bart
agrees not to operate a similar business within a 5-km radius for
the next two years. Lucy pays $10,000 for Bart to agree to this
restraint of trade. A contractual right in favour of Lucy has been
created. If Bart breaches the contract, Lucy can enforce that right.
CGT event D1 happens when the contract for the restraint of trade
is entered into and Bart will have a capital gain. At the end of the
two-year period, CGT event C2 will happen and Lucy will have a
capital loss. Source: Adapted from s 104-35 of the ITAA 1997.

CGT event D2 happens if a taxpayer grants an option to an entity or

extends an option already granted: s 104-40(1). Event D2 does not
happen if CGT event C3 applies to the situation, that is, the option
is for the acquisition of shares in a company.
Example 11.7: Event D2
Ben pays Sara $5,000 for an option to purchase her business. The
one-month option is granted on 1 January 2021. Ben decides not to
exercise the option.
CGT event D2 happens on 1 January 2021 and Sara has a capital
gain of $5,000 less any associated expenses. If Ben exercises the
option, CGT event D2 is ignored and CGT event A1 happens: see
[11.50].
CGT event D3 happens if a taxpayer who owns a prospecting
entitlement or mining entitlement grants the right to receive
income from the operation of the entitlement: s 104-45(1).
CGT event D4 happens if a taxpayer enters into a conservation
covenant over land that he or she owns: s 104-47(1).

Subdivision 104-E: Trusts [11.90]

There are ten CGT events relating to trusts listed in subdiv 104-E of the ITAA
1997:
• creating a trust over a CGT asset – CGT event E1;
• transferring a CGT asset to a trust – CGT event E2;
• converting a trust to a unit trust – CGT event E3;
• capital payment for trust interest – CGT event E4;
• beneficiary becoming entitled to a trust asset – CGT event E5;
• disposal to beneficiary to end income right – CGT event E6;
• disposal to beneficiary to end capital interest – CGT event E7;
• disposal by beneficiary of capital interest – CGT event E8;
• creating a trust over future property – CGT event E9;
• annual cost base reduction exceeds cost base of interest in AMIT – CGT
event E10.

Subdivision 104-F: Leases [11.100]

There are five CGT events relating to leases listed in subdiv 104-F of the ITAA
1997:
• granting a lease – CGT event F1;
• granting a long-term lease – CGT event F2;
• lessor pays lessee to get lease changed – CGT event F3;
• lessee receives payment for changing lease – CGT event F4;
• lessor receives payment for changing lease – CGT event F5.
Example 11.8: Event F4
On 1 January 2021, Jake (the lessee) enters into a lease. On 1 May
2021, Jake agrees to waive a term. Eastfield (the lessor) pays Jake
$1,000 for this. If Jake’s cost base at the time of the waiver is
$2,500, it is reduced from $2,500 to $1,500.
On 1 September 2021, Jake agrees to waive another term. Eastfield
pays Jake $2,000 for this. If Jake’s cost base at the time of the
waiver is $1,500, Jake makes a capital gain of $500 and the cost
base is reduced to nil. Source: Adapted from s 104-125 of the ITAA
1997.
Example 11.9: Event F5
Eastfield owns a shopping centre. Con (the lessee of a shop in the
centre) pays Eastfield $10,000 for agreeing to change the terms of
its lease. Eastfield incurs expenses of $1,000 for a solicitor and
$500 for a valuer. Eastfield makes a capital gain of $8,500. Source:
Adapted from s 104-130 of the ITAA 1997.
Subdivision 104-G: Shares [11.110]
There are two CGT events relating to shares listed in subdiv 104-G of the
ITAA 1997.
CGT event G1 happens if a company makes a payment to a taxpayer in
respect of shares the taxpayer owns in the company and the payment is not
a dividend: s 104-135(1).
CGT event G3 happens if a taxpayer owns shares in a company and a
liquidator or administrator declares the shares worthless: s 104-145(1).
Subdivision 104-H: Special capital receipts [11.120] There are two CGT
events relating to special capital receipts listed in subdiv 104-H of the ITAA
1997.
CGT event H1 happens if a deposit paid to a taxpayer is forfeited because a
prospective sale or other transaction does not proceed: s 104-150(1).
Example 11.10: Event H1
Barry decides to sell land to Judy. A contract of sale for $120,000 is
entered into, and Judy pays Barry a 10% deposit. Judy fails to
complete the contract, and the deposit is forfeited. CGT event H1
happens, and Barry has a capital gain of $12,000 less any costs
associated with the failed transaction.
CGT event H2 happens if an act, transaction or event occurs in
relation to a CGT asset that the taxpayer owns, and the act,
transaction or event does not result in an adjustment being made to
the asset’s cost base or reduced cost base: s 104-155(1).
Example 11.11: Event H2
Max owns land on which he intends to construct a manufacturing
facility. A business promotion organisation pays Max $50,000 as an
inducement to start work early. No contractual rights or obligations
are created by the arrangement.
The payment is made because of an event (the inducement to start
construction early) in relation to Max’s land, so a CGT event H2
happens and Max has a capital gain of $50,000 (less any costs
associated with starting early). Source: Adapted from s 104-155 of
the ITAA 1997.
Subdivision 104-I: Australian residency ends [11.130]
There are two CGT events relating to the ending of Australian residency
listed in subdiv 104-I of the ITAA 1997.

CGT event I1 happens when a taxpayer stops being an Australian resident: s

104-160(1). However, an Australian resident individual may choose to
disregard making a capital gain or capital loss, in which case the assets will
be deemed to be taxable Australian property until a CGT event happens to
those assets or the taxpayer becomes an Australian resident again.
CGT event I2 happens if a trust stops being a resident trust for CGT
purposes: s 104-170(1).
Subdivision 104-J: CGT events relating to rollovers [11.140]
There are five CGT events relating to rollovers listed in subdiv 104-J of the
ITAA 1997 (note that CGT event J3 has been repealed):
• company ceasing to be a member of wholly owned group after rollover –
CGT event J1;
• change of status of replacement asset for a rollover under subdiv 152-E –
CGT event J2;
• trust failing to cease to exist after rollover under subdiv 124-N – CGT event
J4;
• failure to acquire replacement asset and to incur fourth element
expenditure after a rollover under subdiv 152-E – CGT event J5;
• cost of acquisition of replacement asset or amount of fourth element
expenditure, or both, not sufficient to cover disregarded capital gain – CGT
event J6.
Subdivision 104-K: Other CGT events [11.150]
There are 12 CGT events listed in subdiv 104-K of the ITAA 1997. They are as
follows:
• incoming international transfer of emissions unit – CGT event K1;
• bankrupt pays amount in relation to debt – CGT event K2;
• asset passing to tax-advantaged entity – CGT event K3;
• CGT asset starts being trading stock – CGT event K4;
• special collectable losses – CGT event K5;
• pre-CGT shares or trust interest – CGT event K6;
• balancing adjustment events for depreciating assets and s 73BA
depreciating assets – CGT event K7;
• direct value shifts – CGT event K8;
• carried interests – CGT event K9;
• certain short-term forex realisation gains – CGT event K10;
• certain short-term forex realisation losses – CGT event K11;
• foreign hybrids – CGT event K12.
Subdivision 104-L: Consolidated groups and multiple entry
consolidated groups [11.160]
There are seven CGT events relating to consolidated groups and MEC groups
listed in subdiv 104-L of the ITAA 1997:
• loss of pre-CGT status of membership interests in entity becoming
subsidiary member – CGT event L1;
• where pre-formation intragroup rollover reduction results in negative
allocable cost amount – CGT event L2;
• where tax cost setting amounts for retained cost base assets exceeds
joining allocable cost amount – CGT event L3;
• where no reset cost base assets and excess of net allocable cost amount
on joining – CGT event L4;
• where amount remaining after step 4 of leaving allocable cost amount is
negative – CGT event L5;
• error in calculation of tax cost setting amount for joining entity’s assets –
CGT event L6;
• where reduction in tax cost setting amounts for reset cost base assets
cannot be allocated – CGT event L8.
Question 2: Is the asset a CGT asset? [11.170]
Most CGT events involve a CGT asset. Division 108 of the ITAA 1997 defines
the various categories of assets that are relevant to working out a taxpayer’s
capital gains and losses. A “CGT asset” is defined as any kind of property or
a legal or equitable right that is not property: s 108-5(1). The definition
includes part of, or an interest in, an asset as defined, goodwill or an interest
in it, and an interest in an asset of a partnership. Division 108 also sets out
when land, buildings and capital improvements are taken to be separate CGT
assets. The first part of the definition contained in s 108-5(1)(a) provides
that a CGT asset is any type of property, including both tangible property,
such as land and buildings, as well as intangible property, such as copyright
and patents. The second part of the definition contained in s 108-5(1)(b)
provides that a CGT asset is a legal or equitable right that is not property.
This category includes those assets that are not transferable, such as the
right to sue, and rights under an insurance contract.
Examples of CGT assets from s 108-5 include the following:
• land and buildings;
• shares in a company;
• units in a unit trust;
• options;
• debts owed to you;
• a right to enforce a contractual obligation; and
• foreign currency.
While the definition of “CGT asset” is very broad, there are certain things
that are not considered CGT assets. Generally, a right that is not property
must be enforceable by legal or equitable proceedings. For example, general
freedoms, such as the right to work, are not CGT assets nor are the right of a
landlord to enter into a lease and the right to a refund. Although, the
Commissioner of Taxation has recently expressed the view that bitcoin is a
CGT asset.
It is important to classify CGT assets into their relevant categories as special
rules apply to each. The relevant categories of assets in Div 108 are as
follows:
• CGT assets;
• collectables: see [11.180]; and
• personal use assets: see [11.190].
Each CGT asset needs to be classified into one of the three categories as
there are special rules that apply to collectables and personal use assets. An
item not considered to fall within the subcategories collectables or personal
use assets is a general CGT asset.
Collectables [11.180]
“Collectable” is defined in s 108-10(2) of the ITAA 1997 as:
• artwork, jewellery, an antique or a coin or medallion; or
• a rare folio, manuscript or book; or
• a postage stamp or first day cover,
that is used or kept mainly for personal use or enjoyment.
It is important to remember that there are two limbs to this definition. First,
the item must be one of the kind listed. For example, the Commissioner
considers that an antique is an “object of artistic or historical significance
that is of an age exceeding 100 years”: Determination TD 1999/40. Second,
the asset must be used or kept mainly for personal use or enjoyment. This
means that artwork that is purchased as an investment rather than to enjoy
will not be considered a collectable.
Where an item is defined as a collectable, there are four specific rules that
apply: 1. Capital gains and capital losses made from collectables are
disregarded where the first element of the asset’s cost base is $500 or less.
2. When working out the cost base of a collectable, disregard the third
element (non-capital costs of ownership).
3. Capital losses from collectables can only be used to reduce capital gains
from collectables. This is known as a quarantining rule. Any losses not used
in the current tax year can be carried forward to be offset against gains from
collectables in future years. Note, however, that the quarantining rule only
applies one way – that is, you are able to offset losses from the sale of
ordinary CGT assets against gains from collectables.

Example 11.12: Losses from collectables

Bridgette has a capital gain from collectables of $200 and capital losses from
collectables of $400. She has other capital gains of $500. She has a net
capital gain of $500 and a net capital loss of $200. The $200 loss can be
carried forward to be offset against any capital gain from collectables she
has in future tax years. However, it cannot be used to reduce the $500
capital gain. Source: Adapted from s 108-10 of the ITAA 1997.
Example 11.13: Gains from collectables but losses from ordinary
CGT assets
Brodie has a capital gain from collectables of $200 and capital losses from
ordinary CGT assets of $600. She has other capital gains of $500. She has a
net capital gain of $100, as the losses can be used to reduce both the $200
capital gain and the $500 capital gain.
4. If you own collectables that are part of a set, then that set of collectables
is treated as a single collectable.
Example 11.14: Sets
Lily buys a set of three books for $900. If the books are of equal value, she
has acquired the books for $300 each. However, the books are taken to be a
single collectable. Lily will not get the exemption in s 118-10 because she
acquired the set for more than $500. Source: Adapted from s 108-15 of the
ITAA 1997.
Personal use assets [11.190]
“Personal use asset” is defined in s 108-20(2) of the ITAA 1997 as a CGT
asset (other than a collectable) that is used or kept mainly for personal use
or enjoyment.

Where an item is defined as a “personal use asset”, there are four specific
rules that apply:
1. Capital gains made from personal use assets are disregarded where the
first element of the asset’s cost base is $10,000 or less.
2. When working out the cost base of a personal use asset, disregard the
third element (non-capital costs of ownership).
3. A capital loss made from a personal use asset is disregarded.
4. If you own personal use assets that are part of a set, then that set of
personal use assets is treated as a single personal use asset.

Examples of personal use assets include:

• a television at home;
• mobile telephone for private use;
• a bicycle; or
• a yacht owned for personal use and enjoyment.
Section 108-20(3) provides that a personal use asset does not include a land
or a building. Further, if an asset is considered a collectable, it will not be
treated as a personal use asset.
Given that a gain made from a personal use asset acquired for $10,000 or
less is disregarded, it is difficult to think of many personal use assets that
would be subject to tax on any gains. Examples commonly cited are yachts
and racehorses.

Separate CGT assets [11.200]

Subdivision 108-D of the ITAA 1997 provides special rules for separate CGT
assets. In particular, it provides an exception to the common law principle
that what is attached to the land is part of the land, special rules about
buildings and adjacent land, and rules about when a capital improvement to
a CGT asset is treated as a separate asset.
The following specific rules are provided:
• If land is acquired on or after 20 September 1985, a building or structure
on the land is taken to be a separate asset if the depreciating asset or
research and development balancing adjustment provisions apply.
Example 11.15: Separate CGT assets
Mills Pty Ltd constructs a timber mill on land it already owns. The
building is subject to a balancing adjustment on disposal, loss or
destruction. The timber mill is considered a separate CGT asset.
Source: Adapted from s 108-55(1) of the ITAA 1997.

• If land was acquired before 20 September 1985, a building or structure

constructed on the land is taken to be a separate CGT asset if the contract
for construction was entered into on or after that day or, if there is no
contract, the construction started on or after that day.
Example 11.16: Separate CGT assets Acme Co purchases a block of land with
a building on it on 1 January 1980. On 1 January 2010, Acme Co enters a
contract to have another building erected on the land. The second building is
taken to be a separate CGT asset. Source: Adapted from s 108-55(2) of the
ITAA 1997.
A depreciating asset that is part of a building is a separate CGT asset.
Example 11.17: Separate CGT assets
Acme Co carries on a business of producing widgets from its factory. It
installs new bathrooms for the employees. The plumbing fixtures and fittings
are depreciable assets. They are separate CGT assets to the factory. The
factory will be subject to the CGT provisions, but the depreciable assets will
be disregarded for CGT purposes. Source: Adapted from s 108-60 of the ITAA
1997.
Land acquired on or after 20 September 1985 that is adjacent to land
already owned is taken to be a separate CGT asset if the two parcels of land
are combined into the one title.
Example 11.18: Separate CGT assets
In 1980, David purchased a block of land. In 1990, David purchased
the adjacent block of land and amalgamated the two titles into one.
The second block is a separate CGT asset. A capital gain will be
made on the second block when the land is disposed of. Source:
Adapted from s 108-65 of the ITAA 1997.
A capital improvement is a separate CGT asset to the land if:
• a balancing adjustment provision applies to the land;
• the cost base of the capital improvement to an asset acquired before 20
September 1985 is more than the improvement threshold for the relevant
income year and more than 5% of the capital proceeds from the event; or
• the total cost base of related capital improvements to an asset acquired
before 20 September 1985 is more than the improvement threshold for the
relevant income year and more than 5% of the capital proceeds from the
event.
The improvement threshold is $50,000 indexed from 1985. For the year
ended 30 June 2019, it is $150,386 (TD 2018/8): for the year ended 30 June
2020, it is $153,093 and for the year ended 30 June 2021 it is $155,849.
Example 11.19: Improvements to CGT assets
In 1980, William purchased a boat. In 1991, he installed a new mast
for $30,000. He sold the boat in 2020–2021 for $150,000. Assuming
the cost base of the improvement in the year of sale is $41,000, the
improvement will not be considered a separate CGT asset as it is
below the $155,849 threshold. Therefore, the capital gain or loss on
the boat will be fully exempt. Source: Adapted from s 108-70 of the
ITAA 1997.
Time of acquisition of CGT asset [11.210]
The time of the acquisition of a CGT asset needs to be considered for two
specific reasons. First, an asset acquired before 20 September 1985 is
generally exempt from CGT. Second, indexation or the CGT general discount
only applies where an asset is held for at least 12 months. Acquisition rules
are dealt with in Div 109 of the ITAA 1997.
In general, a taxpayer acquires an asset when he or she becomes its owner:
s 109-5(1). Where a taxpayer acquires a CGT asset as a result of a CGT
event, specific rules contained in s 109-5(2) will apply before the general
provision. For example, s 109-5(2) provides that where there is event A1 and
an entity disposes of a CGT asset to a taxpayer, the taxpayer acquires the
asset when the disposal contract is entered into or, if none, when the entity
stops being the assets owner. Specific rules will also apply where a CGT
asset comes into existence without a CGT event. For example, a taxpayer
may construct or create a CGT asset. In this case, the time of acquisition is
when the construction or work that resulted in the creation started: s 109-10
Item 1. It should be noted that s 109-10 Item 1 only applies where the
taxpayer or the taxpayer’s agent constructs the asset. If the asset is created
by an independent contractor, s 109-5(1) will apply as the asset is
constructed by the contractor with the taxpayer’s acquisition date being at
some later date when ownership is passed to the taxpayer.

Question 3: Does an exception or exemption apply? [11.220]

Where it is determined that there is a CGT event, it is necessary to establish
whether there is an exception or exemption that would reduce the capital
gain or loss or allow the taxpayer to disregard it. We have already briefly
discussed some of these exceptions and exemptions when we considered
Div 104 and the special rules relating to collectables and personal use
assets. The exemptions for capital gains and capital losses on these assets,
as well as many other exemptions, are contained in Div 118 of the ITAA
1997.
The most common exception that we saw in Div 104 applies to CGT events
where the CGT asset was acquired before 20 September 1985. Where this is
the case, the capital gain or loss is generally disregarded.

In this section of the chapter, we are going to consider some of the other
common exemptions. Exemptions can be divided into four broad categories:
• exempt gains and losses on certain assets: see [11.230];
• exempt or loss denying transactions: see [11.280];
• anti-overlap provisions: see [11.310]; and
• small business relief: see [11.320].
Disregarded capital gains and losses on certain assets [11.230]
Cars, motor cycles and valour decorations. A capital gain or capital loss
made from a car, motor cycle or similar vehicle, or a decoration awarded for
valour or brave conduct, is disregarded in terms of CGT: s 118-5 of the ITAA
1997. “Car” is defined in s 995-1 to mean a motor vehicle designed to carry
a load of less than one tonne and fewer than nine passengers. Any capital
gain made on the disposal of a decoration awarded for valour or brave
conduct is ignored provided the taxpayer did not pay any money or give
property for it.
[11.240] Collectables and personal use assets.
A capital gain or capital loss made from a collectable is disregarded if the
first element of its cost base is $500 or less: s 118-10(1). Where a capital
loss is made from a collectable with a cost base of more than $500, it can
only be used to reduce capital gains from collectables: s 108-10(1). A capital
gain from a personal use asset is disregarded if the first element of its cost
base is $10,000 or less (s 118-10(3)), while a capital loss from a personal use
asset is always disregarded: s 108-20(1).
[11.250] Assets used to produce exempt income.
Subject to certain exceptions, a capital gain or capital loss made from a CGT
asset that is used solely to produce exempt income or non-assessable non-
exempt income is disregarded: s 118-12(1).
[11.260] Shares in a pooled development fund (PDF).
A capital gain or capital loss made from a CGT event happening in relation to
shares in a PDF is disregarded: s 118-13.

[11.265] Investments made in start-up companies.

From 1 July 2016, there is a CGT exemption for investments made in a start-
up company where they are held for more than 12 months and less than 10
years: subdiv 360-A.
[11.270] Depreciating assets.
A capital gain or capital loss made from a CGT event that involves the
disposal of a depreciating asset is disregarded provided the event is also a
balancing adjustment event where the asset was used wholly for a taxable
purpose and the decline in value was worked out under Div 40: s 118-24(1).
If the asset was not used wholly for a taxable purpose, any disposal of it may
give rise to both a capital gain or loss and a balancing adjustment.
[11.275] Trading stock.
A capital gain or capital loss made from a CGT asset is disregarded if the
asset is trading stock: s 118-25 of the ITAA 1997. This is because the
treatment of trading stock is dealt with in Div 70 of the ITAA 1997.
Exempt or loss denying transactions [11.280]
Subdivision 118-A of the ITAA 1997 contains various exempt or loss denying
transactions, for example, payments made under certain government grants
and arrangements. However, the two most common exemptions in this
category relate to compensation payments (see [11.290]) and gambling or
competitions: see [11.300].
[11.290] Compensation.
A capital gain or capital loss is disregarded if it is made from a CGT event
that relates directly to compensation or damages received for any wrong or
injury suffered in an occupation or for any wrong, injury or illness that a
taxpayer or a relative suffers personally: s 118-37(1) (a) and (b). In Ruling TR
95/35, the Commissioner states that the exemption includes out-of-court
settlements and should be read as widely as possible to cover the full range
of employment and professional type claims and include claims for
discrimination, harassment and victimisation (or any directly related claims)
arising out of State and Commonwealth anti-discrimination legislation, as
well as wrongful dismissal. It should be noted that not all compensation
payments are exempt. For example, compensation for a breach of contract
may still be assessable: see Chapter 10.
[11.300] Gambling and competitions with prizes.
A capital gain or capital loss made from a CGT event relating to gambling, a
game or a competition with prizes is disregarded: s 118-37(1)(c). However,
the exemption will not apply to capital gains or losses where the taxpayer is
considered to be in the business of gambling under the ordinary income
provisions.
Anti-overlap provisions [11.310]
The most important anti-overlap provision is s 118-20 of the ITAA 1997,
which provides that any capital gain made from a CGT event is reduced if,
because of the event, a provision of the Act includes an amount in the
taxpayer’s assessable income or exempt income: s 118-20(1). In essence, if
an amount is considered ordinary or statutory income under another
provision of the ITAA 1997 or the Income Tax Assessment Act 1936 (Cth),
that amount will not be included in the capital gain.
Example 11.20: Reducing capital gains where the amount is
otherwise assessable
Ross purchases land in 1995 as part of a profit-making scheme. In December
2020, he sells it for a profit of $100,000. This amount is included in his
assessable income as ordinary income under s 6-5 of the ITAA 1997. Ross
determines that the capital gain he made from the land is $70,000. This
amount will be reduced to zero as the ordinary income is greater than the
capital gain.
Further anti-overlap provisions include eligible termination payments (s 118-
22), film copyright (s 118-30) and research and development: s 118-35.
Small business relief [11.320]
As a measure to help small business, provided the basic conditions for relief
are satisfied, any capital gains arising from the disposal of the business can
be reduced by various concessions in Div 152 of the ITAA 1997. The four
available small business concessions are as follows:
• 15-year exemption: see [11.340];
• 50% reduction: see [11.350];
• retirement concession: see [11.360]; and
• rollover relief: see [11.370].
[11.330] Basic conditions for relief.
For a taxpayer to be able to access the CGT small business relief, certain
conditions must be met. The three basic conditions, contained in subdiv 152-
A of the ITAA 1997, are as follows:
• The entity must be a small business entity or a partner in a partnership
that is a small business entity, or the net value of assets that the entity and
related entities own must not exceed $6 million. A taxpayer will also be a
small business entity if it is an individual, partner, partnership, company or
trust that is carrying on a business and has an aggregated turnover of less
than $2 million in the previous or current year (either as an estimate or an
actual turnover). From 1 July 2016, the aggregate turnover test for a small
business has increased to $10 million. However, this new threshold does not
apply to CGT concessions.
• The CGT asset must be an active asset. An active asset may be a tangible
asset or an intangible asset. The asset will be an active asset if it is used or
held ready for use in the course of carrying on the business or, if an
intangible asset, it is inherently connected with the business – for example,
goodwill.
• If the asset is a share or interest in a trust, there must be a CGT concession
stakeholder (a significant individual or spouse of a significant individual) just
before the CGT event, and the entity claiming the concession must be a CGT
concession stakeholder in the company or trust, or CGT concession
stakeholders in the company or trust must have a small business
participation percentage in the entity of at least 90%.
Legislation currently before Parliament proposes to amend s 152-5 of the
ITAA 1997 to reflect the fact that an entity must be what is known as a “CGT
small business entity” to have access to the CGT small business concessions.
Basic conditions for relief will not be affected.
[11.340] 15-year exemption.
The 15-year exemption provides a total exemption for any capital gain on
the disposal of a CGT asset owned for at least 15 years where the taxpayer
is 55 years of age or over and retiring or is permanently incapacitated. If this
exemption applies, it is not necessary to consider any of the other
exemptions as it will take priority.
Example 11.21: 15-year exemption
Jo is 60 years old. He has owned the local news agency that he purchased in
1986 for $50,000. Jo decides to retire as he wants to travel the world. In
March 2021, Jo sells the business for $250,000, making a capital gain of
$200,000.
Assuming Jo meets the three basic conditions to qualify for the small
business exemptions, he will qualify for the 15-year exemption as he is over
55 years and has owned the business for more than 15 years. As this will
exempt all capital gains made from the sale of the business, Jo will not need
to consider any other exemptions or concessions nor will he need to consider
indexation.
[11.350] 50% reduction.
The 50% reduction allows a qualifying taxpayer to reduce the amount of its
capital gain by 50%. The 50% reduction may be used after the capital gain
has been reduced by the general 50% discount percentage, giving a total
discount of 75%. Further, the gain may also be reduced by the small
business retirement exemption or a small business rollover.

Example 11.22: 50% reduction

Zara, who operates a small manufacturing business, disposes of a
CGT asset. She owned the CGT asset for three years. It was used as
an active asset of the business.

Zara qualifies for the CGT general discount and for the small
business 50% reduction. From the CGT event, she makes a capital
gain of $20,000, and she sells another asset, which gives her an
additional capital loss of $5,000 in the income year.
Zara calculates her net capital gain for the year as follows:
$20,000 − $5,000 = $15,000 $15,000 − (50% × $15,000) = $7,500
$7,500 − (50% × $7,500) = $3,750
Assuming the small business retirement exemption and the small
business rollover do not apply, Zara’s net capital gain for the year is
$3,750. If she chose the rollover or the retirement exemption, some
or all of the remaining capital gain would be disregarded. Source:
Adapted from ATO, Advanced Guide to Capital Gains Tax
Concessions for Small Business available at https://www.ato.gov.au/
uploadedFiles/Content/MEI/downloads/39821n33590614.pdf.
[11.360] Retirement concession.
A taxpayer may choose to disregard a capital gain arising from the sale of a
CGT asset connected with a small business if the proceeds are used in
connection with the taxpayer’s retirement. There is a lifetime limit of
$500,000. However, the taxpayer may apply other concessions to reduce the
amount before applying the retirement concession.
If the taxpayer is under 55 years, the proceeds must be paid into a
complying superannuation fund, approved deposit fund or retirement
savings account. If a taxpayer is over 55 years, the concession is available
automatically, and it is not necessary to rollover the capital gain to a
complying superannuation fund.
Example 11.23: Retirement concession
Jack acquired a farm in 2013. In December 2020, at the age of 60
years, he retires and transfers the farm to his son for no
consideration. The market value of the farm was $1 million, so the
market value substitution rule applies. It deems that the capital
proceeds equal the market value of the farm.
The cost base of the farm was $600,000, so, assuming the other
retirement exemption conditions are satisfied, Jack made a capital
gain of $400,000. Jack reduces his capital gain twice: first, by the
50% CGT general discount to $200,000 and then further, by the 50%
active asset reduction, to $100,000. Although he received no capital
proceeds, and assuming the other retirement exemption conditions
are satisfied, Jack may choose to apply the retirement exemption
for the full amount of the remaining $100,000 capital gain. Source:
Adapted from ATO, Advanced Guide to Capital Gains Tax
Concessions for Small Business available at https://www.ato.gov.au/
uploadedFiles/Content/MEI/downloads/39821n33590614.pdf.
[11.370] Rollover relief. If a taxpayer chooses a rollover, all or part of the
capital gain is not included in the taxpayer’s assessable income until
circumstances change. A taxpayer may defer paying tax on a capital gain
made from a CGT event in relation to a small business if the taxpayer
acquires a replacement active asset and elects to obtain a rollover. The
rollover relief may be applied after the CGT general discount and active
asset reduction.
Example 11.24: Partial rollover relief
Jude’s small business has an original capital gain of $100,000. After
Jude applies the CGT general discount and 50% active asset
reduction, his original capital gain is reduced to $25,000.
If we assume the first and second elements of the cost base of the
business’ replacement asset total $20,000, this amount can be
disregarded under the rollover, leaving Jude with a final capital gain
of $5,000. Source: Adapted from ATO, Advanced Guide to Capital
Gains Tax Concessions for Small Business available at
https://www.ato.gov.au/
uploadedFiles/Content/MEI/downloads/39821n33590614.pdf.
Main residence exemption [11.380]
A capital gain or loss as a result of a CGT event happening to a taxpayer’s
main residence is generally ignored. Specifically, subdiv 118-100 of Pt 3-1 of
the ITAA 1997 provides that you can disregard a capital gain or capital loss
made from a CGT event that happens to a dwelling that is the taxpayer’s
main residence.
The full exemption on gains or losses on a main residence is known as the
base case. However, this full exemption, or base case, will only apply where
the residence was the main residence during the whole of the ownership
period and it was not used for the purposes of producing assessable income.
There are some specific rules that may extend the exemption and other
specific rules that may limit the exemption. Section 118-105 contains a map
of subdiv 118-B as reproduced in Figure 11.3.

As of 30 June 2020, the main residence exemption is no longer available to

foreign residents: s 118-110(3) the ITAA 1997. Transitional arrangements
were put in place to ensure certain dwellings held before 7:30 pm on 9 May
2017 and disposed of on or before 30 June 2020 were still eligible for the
exemption.

[11.390] Basic case.

The basic exemption provides that a capital gain or capital loss made from a
CGT event that happens in relation to a CGT asset that is a dwelling is
disregarded if:
• the taxpayer is an individual; and
• the dwelling was the taxpayer’s main residence throughout the whole of
the ownership period: s 118-110(1) of the ITAA 1997.

A dwelling includes a unit of accommodation that is a building that consists

wholly or mainly of residential accommodation, a caravan, houseboat or
mobile home and the land immediately under the accommodation: s 118-
115(1). The exemption also applies to land that is adjacent to the dwelling,
up to a maximum of two hectares, provided it is used for private or domestic
purposes: s 118-120.

The basic case applies where the taxpayer lives in the property for the whole
of the ownership period. Where this is the case and the taxpayer sells the
property, the capital gain or loss will be disregarded. There are instances
where the taxpayer does not live in the property for the whole of the
ownership period but can still disregard the capital gain or loss on disposal.
These rules extend the exemption. Where a taxpayer is able to extend the
exemption, it is not necessary to consider the partial exemption rules.
[11.400] Rules that may extend the exemption.
The following rules may extend the main residence exemption:
• The main residence exemption extends to cover the period from the time
of acquisition to the time when it is first practicable for the taxpayer to move
into the dwelling: s 118-135 of the ITAA 1997.
• A taxpayer who acquires a new dwelling that is intended to be a main
residence, but still holds an existing main residence, may treat both
dwellings as a main residence for the six-month period before the disposal of
the old dwelling or the period between the acquisition of the new dwelling
and disposal of the old dwelling, whichever is the shorter: s 118-140(1). The
extension only applies, however, if the original main residence was the
taxpayer’s main residence for a continuous period of at least three months in
the 12 months before it is disposed of and it was not used to produce income
during any part of that 12-month period: s 118-140(2).
• A taxpayer may be entitled to treat a dwelling as his or her main residence
during a period of absence provided no other dwelling is treated as a main
residence during the period of absence. If a dwelling that was the taxpayer’s
main residence ceases to be the main residence, and the taxpayer uses the
dwelling for the purposes of producing income, the taxpayer may choose to
continue to treat the dwelling as his or her main residence for a maximum
period of six years: s 118-145(2). If the dwelling is not used for the purposes
of producing income, a taxpayer may treat the dwelling as a main residence
indefinitely: s 118-145(3).
• Where a taxpayer builds, repairs or renovates a dwelling, provided no
other dwelling is treated as a main residence, a taxpayer may choose to
treat the dwelling as his or her main residence from the time of acquisition,
provided it becomes the taxpayer’s main residence as soon as practicable
after the work has finished: s 118-150(2). This extension can only operate for
the shorter of four years before the dwelling becomes the taxpayer’s main
residence or the period between the date of acquisition of the land the
dwelling becoming the main residence: s 118-150(4). TD 2017/13 deals with
the situation where you build a dwelling on land acquired pre-CGT and wish
to claim the main residence exemption before it becomes your main
residence. In that case, a choice needs to be made under s 118-150(2).
• Where a dwelling that is a taxpayer’s main residence is accidentally
destroyed and a CGT event happens in relation to the land, provided there is
no other main residence, the taxpayer may choose to apply the exemption
to the period after destruction until the land is sold: s 118-160.
[11.410] Rules that may limit the exemption.
The following rules may limit the main residence exemption:
• The main residence exemption does not apply to a CGT event that happens
in relation to land, or a garage, storeroom or other structure, to which the
exemption can extend if the event does not also happen in relation to the
dwelling: s 118-165 of the ITAA 1997.
• A taxpayer and his or her spouse will generally have the same main
residence. Where the taxpayer and spouse have different main residences,
the parties must choose one of the dwellings as the main residence of both
or nominate the different dwellings as the main residences: s 118-170(1). If
the parties nominate different residences, the entitlement to the main
residence exemption is split between the two dwellings in accordance with s
118-170(3) and (4). Where the taxpayer’s interest in his or her main
residence is not more than half, the dwelling is taken to be the main
residence during the period. Otherwise the dwelling is taken to be the
taxpayer’s main residence for half of the period. The same principle applies
to the main residence of the taxpayer’s spouse.
• A taxpayer and his or her dependent child or children will generally have
the same main residence. If another dwelling is the main residence of a
dependent child under 18 years, the taxpayer must choose one main
residence for both themselves and the dependant: s 118-175.
• The main residence exemption will be limited where the dwelling is
acquired by a taxpayer under the marriage breakdown rollover provisions. In
these circumstances, the taxpayer’s exemption will be apportioned
according to how the dwelling was used both before and after the rollover: s
118-178.
[11.420] Partial exemption rules.
In addition to the rules that extend or limit the main residence exemption,
there are two situations where a taxpayer may be entitled to a partial
exemption only.

A taxpayer will only be entitled to a partial exemption for a CGT event that
happens in relation to a main residence if the dwelling was the taxpayer’s
main residence for part only of the ownership period. Where only a partial
exemption is allowed, the capital gain is apportioned according to the days
the dwelling was the taxpayer’s main residence: s 118-185 of the ITAA 1997.
Where a taxpayer is only entitled to a partial exemption because the
property is used for income-producing purposes and that income-producing
purpose first occurred after 20 August 1996, the partial exemption is
calculated by reference to s 118-192. This section deems the taxpayer to
have acquired the property at market value at the date it first produces
income.
Example 11.25: Partial exemption
Rebecca bought a house in March 2010 for $200,000 and moved in
immediately. In March 2013, she purchased another property, which she
immediately began to treat as her main residence. She moved out of the first
property and began to rent it out. At that time, it was valued at $350,000.
She sold it in March 2021 for $360,000. The capital gain or capital loss will
be calculated using s 118-192 to value the property. Rebecca will have made
a capital gain of $10,000.
Example 11.26: Partial exemption using s 118-145 to extend the
exemption
Connor bought a house on 1 July 2010 for $200,000 and moved in
immediately. On 1 July 2013, he moved out and began to rent it out. At that
time, it was valued at $350,000. He sold it on 1 July 2020 for $360,000.
Connor chooses to continue to treat the dwelling as his main residence
under s 118-145 (about absences) for the first six of the seven years during
which he rented the house out.
The capital gain or capital loss (ignoring leap years as per the example
provided in s 118-185) will be calculated using the following formula:
Capital gain or capital loss amount × Non-main residence days /Days in
ownership period
Connor will be taken to have made a capital gain of:
$10,000 x 366 / 2,557 = $1,431
A taxpayer will only be entitled to a partial exemption for a CGT event that
happens in relation to a main residence if the dwelling was used for the
purpose of producing assessable income during all or part of the period of
ownership: s 118-190. The test to determine whether the property was used
to earn assessable income is based on whether the interest is or would be
deductible if incurred: s 118-190.
Example 11.27: Partial exemption
Sandra’s house purchase contract was settled on 1 January 2017,
and the house was her main residence for the entire four years she
owned it, until she sold it under a contract entered into on 1
November 2020 and settled on 31 December 2020. From the time
Sandra bought it until 31 December 2018 (75% of the ownership
period), she used 25% of her house to run her photographic
business. The rooms were modified for that purpose so were no
longer suitable for private and domestic use. Sandra made a capital
gain of $10,000 when she sold the house and used the following
formula to calculate the taxable portion: Capital gain × % of floor
area not used as main residence × % of period of ownership that
that part of the home was not used as main residence = taxable
portion $10,000 × 25% × 75% = $1,875
Death [11.425]
Division 128 of the ITAA 1997 sets out what happens when a taxpayer dies
and a CGT asset devolves to a legal personal representative or a beneficiary
of the estate. The capital gain or capital loss made by the deceased from the
CGT event is disregarded: s 128-10. There are, however, consequences for
the beneficiary. The beneficiary will have acquired either a pre-CGT asset or
a post-CGT asset. Where the beneficiary acquires a pre-CGT asset, he or she
is deemed to have acquired the asset for the market value on the date of
death: s 128-15(4). Where the beneficiary acquired a post-CGT asset, he or
she is deemed to have acquired the asset for the deceased person’s cost
base as at date of death: s 128-15(4). For the purposes of applying the
discount, the asset is taken to be acquired when the deceased person
acquired them if they are post-CGT assets: s 115-30. If, however, the CGT
asset was the deceased’s main residence, the beneficiary is deemed to have
acquired the asset for market value at the date of death: s 128-15(4).

Question 4: Can there be a rollover? [11.430]

In certain specific situations, rollovers allow a taxpayer to defer or disregard
a capital gain or loss from a CGT event. A rollover is either automatic or
requires the taxpayer to make an election. Rollovers apply only to specific
situations.
Rollovers are divided into two categories: replacement asset rollovers and
same asset rollovers.
With a replacement asset rollover, the taxpayer is allowed the deferral of a
capital gain or loss from one CGT event until a later CGT event happens
where one CGT asset is replaced with another. Replacement asset rollovers
are dealt with in subdiv 112-C of the ITAA 1997. A replacement asset rollover
involves one CGT asset ending and the taxpayer acquiring another.
The consequence of a replacement asset rollover is that the cost base of the
replacement asset is modified. If the taxpayer acquired the original CGT
asset before 20 September 1985, the replacement asset is taken to have
been acquired before that day. If a taxpayer acquired the original asset on or
after 20 September 1985, the cost base of the replacement asset is
modified. The first element of the replacement asset’s cost base (or reduced
cost base) is replaced by the original asset’s cost base (or reduced cost
base) at the time the replacement asset was acquired.
All replacement asset rollovers are listed in a table in s 112-115. However,
some common examples of replacement asset rollovers are as follows:
• disposal of assets by an individual, trustee or partners to a wholly owned
company;
• where an asset is compulsorily acquired, lost or destroyed;
• strata title conversion;
• Crown leases;
• scrip for scrip; and
• demergers.
With a same asset rollover, the taxpayer is allowed to disregard a capital
gain or loss from a CGT event where the same CGT asset is involved. Same
asset rollovers are dealt with in subdiv 112-D. A same asset rollover allows a
taxpayer to disregard a capital gain or loss from the disposal or creation of a
CGT asset to another taxpayer. The gain or loss is effectively transferred to
the other taxpayer and deferred until there is a CGT event in the hands of
that taxpayer.

All same asset rollovers are listed in a table in s 112-150. However, some
common examples of sale asset rollovers are as follows:
• transfer of a CGT asset from one spouse to another because of a marriage
breakdown;
• transfer of a CGT asset to a wholly owned company; and
• transfer of an asset between related companies.
From 1 July 2016, optional rollover relief is available where a small business
undertakes a genuine restructure, but the ultimate legal ownership of the
asset remains unchanged. This rollover extends beyond CGT assets to apply
to gains and losses on trading stock, revenue assets and depreciating assets
as well.
Step 2 – Work out amount of capital gain or loss [11.440]
Once we have answered the four questions in Step 1 and determined that
the taxpayer has made a capital gain or loss, it is necessary to work out the
amount of that capital gain or loss. This requires us to consider two more
questions:
• What is a capital gain or loss for the particular CGT event? See [11.450].
• What factors come into calculating a capital gain or loss for the particular
CGT event? See [11.460].
Columns 3 and 4 of the table contained in s 104-5 of the ITAA 1997 provide a
useful summary of when a capital gain or a capital loss arises for each CGT
event.
What is a capital gain or loss? [11.450]
For most CGT events the taxpayer makes a capital gain where the capital
amount received (or that the taxpayer is entitled to receive) from a CGT
event exceeds the total costs associated with that event and makes a capital
loss where total costs associated with a CGT event exceed the capital
amount received (or that the taxpayer is entitled to receive).
CGT event A1, the disposal of a CGT asset, is the most common event.
Section 104-10(4) of the ITAA 1997 specifically provides: You make a capital
gain if the capital proceeds from the disposal are more than the asset’s cost
base. You make a capital loss if those capital proceeds are less than the
asset’s reduced cost base.
If you re-examine the other CGT events, you will find a similar section for
each. In each provision is the use of various terms that have specific
legislative
meaning. The terms are capital proceeds, cost base and reduced cost base.
They are known as the factors that come into calculating a capital gain or
loss.
What factors come into calculating a capital gain or loss? [11.460]
The next question we ask is what factors come into calculating a capital gain
or loss? The main factors are the capital proceeds, cost base and reduced
cost base. Once we know these figures, we can calculate the capital gain or
loss for most CGT events. Before considering the statutory meaning of these
terms, note the calculations required to determine the gain or loss from a
CGT event.
Capital proceeds [11.470]
For most CGT events, the capital amounts that the taxpayer receives or is
entitled to receive are the capital proceeds. Section 116-20 of the ITAA 1997
defines the capital proceeds from an event as the total amount of money the
taxpayer has received or is entitled to receive in relation to a CGT event
happening and the market value of any other property the taxpayer has
received or is entitled to receive in respect of the event happening. The Full
Federal Court has held that an entitlement to receive money is not affected
even if the money is received from a third party: Quality Publications
Australia Pty Ltd v FC of T [2012] FCA 256. For the purposes of determining
the proceeds of a CGT event, any GST on the supply is disregarded: s 116-
20(5).
The definition in s 116-20 is known as the general rule about capital
proceeds. In addition to this general rule, there are six modifications that
may be relevant: 1. The first modification rule is the market value
substitution rule, which is relevant if a taxpayer receives no capital proceeds
from a CGT event or some or all of the capital proceeds cannot be valued, or
the taxpayer did not deal at arm’s length with another entity in connection
with the event: s 116-30. In other words, there is a connection between the
parties; for example, they are related or good friends. The capital proceeds
are deemed to be the market value determined at the time of the CGT event.
“Market value” is determined by reference to its ordinary meaning and is
generally understood to mean the price that a willing purchaser at that date
would have had to pay: Spencer v Commonwealth (1907) 5 CLR 418 at 441
per Isaacs J.
Example 11.28: Market value substitution rule
Bill gives a rental property to his daughter and does not receive any
consideration. Bill is taken to have received the market value of the
property, which is a CGT asset. Source: Adapted from s 116-30 of
the ITAA 1997.
2. The second modification rule is an apportionment rule, which is
relevant if a payment received by a taxpayer in connection with a
transaction relates in part only to a CGT event: s 116-40. The capital
proceeds from each event are so much of the payment as is
reasonably attributable to that event.

Betty sells a block of land and a boat for a total of $100,000. This
transaction involves two CGT events.
The $100,000 must be divided among the two events. The capital
proceeds from the disposal of the land are so much of the $100,000
as is reasonably attributable to it. The rest relates to the boat.
Source: Adapted from s 116-40 of the ITAA 1997.
3. The third modification rule is a non-receipt rule, which is relevant
if the taxpayer does not receive or is not likely to receive, some or
all of the capital proceeds from a CGT event: s 116-45. The capital
proceeds are reduced by the amount not received.
Example 11.30: Non-receipt rule
Lyn sells a painting to Mat for $5,000 (the capital proceeds). Lyn
agrees to accept monthly instalments of $100.
Lyn receives $2,000, but then Mat stops making payments. It
becomes clear that Lyn is not likely to receive the remaining $3,000.
The capital proceeds are reduced to $2,000. Source: Adapted from s
116-45 of the ITAA 1997.
4. The fourth modification rule is a repaid rule, which is relevant if
the taxpayer is required to repay some or all of the capital proceeds
from a CGT event: s 116-50. The capital proceeds are reduced by
the amount repaid.
Example 11.31: Repaid rule
Simon sells a block of land for $50,000 (the capital proceeds).
Siobhan (the purchaser) later finds out that Simon misrepresented a
term in the contract. Siobhan sues Simon, and the court orders him
to pay $10,000 in damages to Siobhan.
The capital proceeds are reduced by $10,000, to $40,000. Source:
Adapted from s 116-50 of the ITAA 1997.

5. The fifth modification rule is an assumption of liability rule, which

is relevant if another entity assumes a liability in connection with a
CGT event: s 116-55. The capital proceeds are increased by the
amount of the liability.
Example 11.32: Assumption of liability rule
Olivia sells land for $150,000. She receives $50,000 (the capital
proceeds), and Angus (the buyer) becomes responsible for a
$100,000 liability under an outstanding mortgage.
The capital proceeds are increased by $100,000, to $150,000.
Source: Adapted from s 116-55 of the ITAA 1997.
6. The sixth modification rule is a misappropriation rule, which is
relevant if an employee or agent misappropriates all or part of the
proceeds. The capital proceeds will be reduced by the amount
misappropriated: s 116-60.
Cost base [11.480]
For most CGT assets, the cost base is the total of the costs associated with
the CGT asset. The cost base is used for the purpose of working out a capital
gain. Where the taxpayer is registered for GST, the cost base will be net of
any GST credits available. If, however, the taxpayer is not registered for GST,
any GST paid will be included in the cost base of the asset.
Subdivision 110-A of the ITAA 1997 sets out the rules for determining the
cost base of a CGT asset. The cost base of a CGT asset has five elements:
• Element 1: The money paid by the taxpayer, or required to be paid, in
respect of acquiring the asset and the market value of any other property
given or required to be given in respect of acquiring the asset: s 110-25(2).
• Element 2: The incidental costs incurred by the taxpayer. There are a
number of incidental costs that a taxpayer may have incurred. The following
nine categories of costs, the first eight of which must occur in relation to the
acquisition or event, are listed in s 110-35 as incidental costs:
– remuneration for the services of a surveyor, valuer, auctioneer,
accountant, broker, agent, consultant or legal adviser;
– cost of transfer;
– stamp duty;
– cost of advertising or marketing to find a buyer or seller;
– costs for any valuation or apportionment;
– search fees relating to a CGT asset;
– cost of a conveyancing kit;
– borrowing expenses; and
– expenditure incurred by the head company of a consolidated group to an
entity that is not a member of a group and the cost reasonably relates to a
CGT asset held by the head company and is incurred because of a
transaction between members of the group.
• Element 3: The costs of owning the CGT asset (only if the asset is
acquired after 20 August 1991) including the items listed in s 110-25(4):
– interest on money borrowed to acquire the asset;
– costs of maintaining, repairing or insuring it;
– rates or land tax, if the asset is land;
– interest on money borrowed to refinance the money borrowed to acquire
the asset; and
– interest on money borrowed to finance the capital expenditure incurred to
increase the asset’s value.
• Element 4: Capital costs incurred to increase or preserve the assets value
or expenditure incurred to install or move the asset: s 110-25(5).
• Element 5: Capital costs incurred to establish, preserve or defend the title
to the asset or a right over the asset: s 110-25(6).
Once the costs associated with a CGT event have been determined
according to the five elements, it is necessary to determine those costs that
do not form part of the cost base because they are specifically excluded. The
following amounts are excluded from the cost base: • expenditure that does
not form part of the second or third element of the cost base to the extent
that you have deducted or can deduct it: ss 110-40(2)–110-45(1B);
• expenditure that does not form part of any element of the cost base to the
extent that it has been recouped unless the amount is included in assessable
income: ss 110-40(3) and 110-45(3);
• expenditure that is prevented from being a deduction under s 26-54
(certain offences), s 110-38(1) or s 26-5 (penalties): s 110-38(4);
• expenditure to the extent that it is a bribe to a public official: s 110-38(2);
and
• expenditure to the extent that it is in respect of providing entertainment: s
110-38(3).

[11.490] In addition to the basic rules about cost base, there are cost base
modification rules that need to be considered:

• The first modification rule is the market value substitution rule. The first
element of the cost base will be replaced with the market value if the
taxpayer did not incur any expenditure to acquire the asset, some or all of
the expenditure cannot be valued or the taxpayer did not deal at arm’s
length in relation to the acquisition: s 112-20(1). Where it is the case that
the parties did not deal at arm’s length with each other and the acquisition
resulted from another entity doing something that did not constitute a CGT
event happening, the market value will only be substituted where the
taxpayer paid more than market value: s 112-20(2). However, there are
circumstances where the market value substitution rule will not apply – for
example, where CGT event D1 happens and the taxpayer did not pay
anything for it.
• The second modification rule deals with split, changed or merged
assets. If a CGT asset is split into two or more assets or a CGT asset changes
into an asset of a different nature, the splitting or change is not a new CGT
asset. However, the cost base needs to be worked out for the new assets.
The cost base of each asset is a reasonable apportionment of the cost base
of the original asset. If two or more assets are merged, the cost base of the
new asset is the sum of the elements of each original asset: s 112-25.
• The third modification rule deals with the apportionment of expenditure
where the expenditure relates in part only to the CGT asset. The expenditure
allocated to the CGT asset is that which is reasonably attributable to each
element: s 112-30.
• The fourth modification rule is the assumption of liability rule. If a
taxpayer acquires a CGT asset from another taxpayer and that asset is
subject to a liability, the first element of the asset’s cost base includes the
amount of the liability: s 112-35.
• The fifth modification rule relates to put options and provides that the
first element of the cost base of the right to dispose of a share in a company
acquired as a result of CGT event D2 happening to the company is the
amount included in the taxpayer’s assessable income as ordinary income as
a result of the acquisition of the right, plus any amount paid to acquire the
right: s 112-37.
Modification provisions are contained in the capital proceeds rules with each
of the cost base modification rules discussed above having a mirror
equivalent in relation to capital proceeds.
[11.495] Indexation.
A CGT asset acquired at or before 11.45 am on 21 September 1999 may
have an indexed cost base. Indexation takes into account inflation up to
September 1999. All of the elements, except for the third element, may be
indexed. However, a taxpayer can only index the cost base of a CGT asset
acquired at least 12 months before the CGT event. Where a taxpayer
acquires an asset before 21 September, they will have a choice to use either
indexation or the CGT general discount discussed below in Step 3 and may
use whichever gives them the best result.

Subdivision 960-M of the ITAA 1997 shows how to apply indexation and
calculate the indexation factor. The calculation involves multiplying the
separate elements of the cost base by the indexation factor. The indexation
factor is determined by dividing the index number for the quarter in which
the CGT event occurred (or September 1999 if the CGT event occurred after
that date) by the index number of the quarter in which the expenditure was
incurred. Note that the indexation factor is always rounded to three decimal
places. See [11.580] for a table of indexation figures.
Example 11.33: Indexation and discounting
Peter purchased a building as an investment on 1 January 1987 for
$250,000. This amount forms the first element of his cost base. He
sold the building on 1 February 2021 for $500,000.
The cost base can only be indexed up to the September 1999
quarter. The indexation number for that quarter is 68.7. The index
number for the quarter in which he purchased the building (the
March quarter 1987) is 45.3.
Applying s 960-275, work out the indexation factor as follows:
68.7/45.3 = 1.517

The indexed first element of Peter’s cost base is: 1.517 × $250,000
= $379,250
Assuming Peter has no other costs associated with the property, his
capital gain under the indexation method would be: $500,000 −
$379,250 = $120,750
Peter’s capital gain using the CGT general discount would be:
$500,000 − $250,000 = $250,000 less 50% discount = $125,000
In this case, Peter would be advised to use the indexation method
to determine his net capital gain from the sale of the property as it
results in the least capital gain. Source: Adapted from s 114-1 of the
ITAA 1997.

Reduced cost base [11.500]

For most CGT events, the reduced cost base is the total of the costs
associated with the CGT event. The reduced cost base is used for the
purpose of working out a capital loss. The reduced cost base also consists of
five elements. All the elements are the same as the cost base (see [11.480])
except for the third element. The third element of the reduced cost base is
an amount included in the taxpayer’s assessable income because of certain
balancing adjustments. Further, the elements of the reduced cost base
cannot be indexed.
The reduced cost base does not include any of the costs the taxpayer has
previously claimed or can claim in the current year as a deduction. For
example, the cost base must be reduced by any capital works deductions
claimed for capital expenditure.
Example 11.34: Capital works deduction – effect on reduced cost
base
Kate acquires a new income-producing asset on 1 January 2005 for
$250,000. She sold it for $200,000 in May of the current tax year. While she
owned it, she claimed capital works deductions of $30,000 for expenditure
she incurred. Her capital loss is worked out as follows:
Cost base $250,000
Less capital works deductions ($30,000)
Reduced cost base $220,000
Less capital proceeds ($200,000)
Capital loss $20,000
Step 3 – Work out your net capital gain or loss for the income year
[11.510]
Step 2 required calculations to be performed to determine the capital gain or
loss from a CGT event. However, in an income year, a taxpayer may have
more than one CGT event. Step 3 reconciles the gains or losses made from
the individual events. It involves a determination of a taxpayer’s net capital
gain or loss, that is, we need to calculate the amount of gain to be included
in assessable income or the amount of loss to be carried forward to future
years. This requires five calculations.
Calculation 1 [11.520]
The first calculation involves reducing your capital gains for the income year
by your capital losses for the income year. Taxpayers may reduce the capital
gains in any order they choose. This allows taxpayers to maximise the value
of any losses. At this stage, remember that there are special rules for
collectables (see [11.180]) and personal use assets: see [11.190]. In
particular, losses from personal use assets are disregarded and losses from
collectables are quarantined to be used only against gains from collectables.
Generally, a taxpayer will apply any losses against gains that cannot utilise
the 50% general discount or indexation. It will then normally be a case of
applying losses against indexed capital gains and, finally, against gains that
attract the 50% CGT general discount.
Calculation 2 [11.530]
If a taxpayer still has capital gains after deducting the current year capital
losses, he or she can then reduce those capital gains in the order he or she
chooses by any losses of previous years. The losses, however, are applied in
the order in which they were incurred.
Example 11.35: Taking into account losses
Lily has capital gains for the current income year of $1,000 and capital
losses for the current income year of $600. Her capital losses are subtracted
from her capital gains, to leave a balance of $400.
If she also has net capital losses of $300 from the previous year and $200
from the year before that, she can reduce the current balance of $400 to nil.
The net capital losses are applied in the order in which she made them.
Therefore, the $200 will be used and $200 of the $300 will be used, leaving
her with $100 to be carried forward. Source: Adapted from s 102-15 of the
ITAA 1997.
Calculation 3 [11.540]
Calculation 3 allows some taxpayers to reduce any discount capital gain by
the discount percentage. Discount capital gains are dealt with in Div 115 of
the ITAA 1997.
In certain circumstances, the cost base of a CGT asset may be indexed to
take into account inflation: see [11.490] and Example 11.33. As of 21
September 1999, indexation was abolished and replaced with a CGT general
discount. Individuals and trusts receive a 50% general discount on the
capital gain from certain CGT events, while complying superannuation funds
receive a one-third general discount.

A taxpayer may apply the general discount where a CGT event occurs on or
after 11.45 am on 21 September 1999 and he or she has held the asset for
more than 12 months. A further 10% discount specifically available for
investors disposing of property used for affordable housing was introduced
with effect from 1 January 2020: see s 115-125 of the ITAA 1997.
Where a CGT asset is acquired before 21 September 1999 and the CGT event
occurs after that date, the taxpayer may elect to use indexation or apply the
general discount. Taxpayers cannot use both.
There are also certain CGT events that do not attract the CGT general
discount, generally because the 12-month rule is not satisfied. For example,
the CGT general discount does not apply to any of the D category events. In
certain circumstances, a discount capital gain may be recalculated without
reference to indexation.
Example 11.36: Recalculation without reference to indexation
Maxine acquired land from her ex-husband under a court order made under
the Family Law Act 1975 (Cth) in 1995. Her ex-husband’s indexed cost base
for the land was $56,000, and Maxine was treated as having paid that
amount for it. Her ex-husband’s cost base for the land then was $40,000.
Maxine sold the land in the current tax year for capital proceeds of
$150,000.
Maxine’s discount capital gain on the land is calculated as:
Capital proceeds − Cost base for the land without indexation
$150,000 − $40,000 = $110,000
Source: Adapted from s 115-20(2) of the ITAA 1997.

Calculation 4 [11.550]
Once any losses are taken into account, as well as any CGT general discount
available, a taxpayer who is entitled to any of the small business
concessions may apply them at this stage: see [11.320].
Calculation 5 [11.560]
Calculation 5 requires a taxpayer to add up any remaining capital gains that
are not discount capital gains and any remaining discount capital gains to
determine the net capital gain to be included in assessable income. A net
capital gain is included in a taxpayer’s assessable income as statutory
income.

Capital losses [11.570]

A net capital loss is determined via similar steps to determine a net capital
gain. However, a taxpayer cannot deduct from his or her assessable income
a net capital loss for any income: s 102-10(2) of the ITAA 1997. Therefore,
there is only a three-step process to follow to determine a taxpayer’s net
capital loss. To the extent that a net capital loss cannot be applied in an
income year, it can be carried forward to a later income year: s 102-15(1).
Indexation figures Current index reference base
Questions [11.590]
11.1 Anita is a client of yours. To fund her career as an artist, Anita
sold some of her art collection by other artists. It consisted of:
(a) An antique ceramic bowl purchased in February 1985 for $4,000.
She sold the bowl on 1 December of the current tax year for
$12,000.

(b) A sculpture purchased in December 1993 for $5,500. She sold

the sculpture on 1 January of the current tax year for $6,000.
(c) A bronze figure purchased in October 1987 for $14,000. She sold
the bronze figure on 20 March of the current tax year for $13,000.
(d) A painting purchased in March 1987 for $470. She sold the
painting on 1 July of the current tax year for $5,000. Consider the
CGT consequences of the above transactions.
11.2 Other than the examples provided in this chapter, provide an
example for each of CGT events A1, B1, C1, C2, D1 and D2.
11.3 Are the following CGT assets collectables or personal use
assets: (a) An engagement ring that cost $5,000? (b) A second-hand
car purchased for $2,000? (c) Shares in BHP? (d) Your home? (e) A
painting hung in the foyer of your accounting firm? (f) A holiday
house at Byron Bay?
11.4 List five things that you own that are considered personal use
assets. Can you think of any collectables that you may own?
11.5 What CGT events apply to the following transactions: (a) You
sell shares in BHP for $5,000. (b) You receive $100,000 in return for
signing a three-year contract to play AFL with the Brisbane Lions.
(c) You sell your holiday home at Byron Bay for $750,000.
(d) You sell your hairdressing salon for $200,000 and receive an
additional $20,000 for agreeing not to open another salon within a
10-km radius for the next three years.
(e) You pay Shelby $50,000 for the option to purchase her
hairdressing salon in three years time.
(f) In three years time, you exercise the option to purchase Shelby’s
salon for $300,000.
(g) You sell a diamond ring for $20,000. You paid $12,000 for the
ring in 1984.
11.6 Dave Solomon is 59 years of age and is planning for his
retirement. Following a visit to his financial adviser in March of the
current tax year, Dave wants to contribute funds to his personal
superannuation fund before 30 June of the current tax year. He has
decided to sell the majority of his assets to raise the $1,000,000. He
then intends to rent a city apartment and withdraw tax-free
amounts from his personal superannuation account once he turns
60 years in August of the next year. Dave has provided you with the
following details of the assets he has sold:

(a) A two-storey residence at St Lucia in which he purchased and

has lived in since 1984. He paid $70,000 to purchase the property
and received $850,000 on 27 June of the current tax year after the
real estate agent deducted commissions of $15,000. The residence
was originally sold at auction, and the buyer placed an $85,000
deposit on the property. Unfortunately, two weeks later, the buyer
indicated that he did not have sufficient funds to proceed with the
purchase, thereby forfeiting his deposit to Dave on 1 May of the
current tax year. The real estate agents then negotiated the sale of
the residence to another interested party.
(b) A painting by Pro Hart that he purchased on 20 September 1985
for $15,000. The painting was sold at auction on 31 May of the
current tax year for $125,000.
(c) A luxury motor cruiser that he has moored at the Manly Yacht
club. He purchased the boat in late 2004 for $110,000. He sold it on
1 June of the current tax year to a local boat broker for $60,000.
(d) On 5 June of the current tax year, he sold for $80,000 a parcel of
shares in a newly listed mining company. He purchased these
shares on 10 January of the current tax year for $75,000. He
borrowed $70,000 to fund the purchase of these shares and
incurred $5,000 in interest on the loan. He also paid $750 in
brokerage on the sale of the shares and $250 in stamp duty on the
purchase of these shares. Dave has contacted the ATO, and they
have advised him that the interest on the loan will not be an
allowable deduction because the shares are not generating any
assessable income.
Dave has also indicated that his taxation return for the year ended
30 June of the previous year shows a net capital loss of $10,000
from the sale of shares. These shares were the only assets he sold
in that year.
(a) Based on the information above, determine Dave Solomon’s net
capital gain or net capital loss for the year ended 30 June of the
current tax year.
(b) If Dave has a net capital gain, what does he do with this
amount? (c) If Dave has a net capital loss, what does he do with this
amount?
11.7 Your client is an investor and antique collector. You have
ascertained that she is not carrying on a business. Your client
provides the following information of sales of various assets during
the current tax year. Based on this information, determine your
client’s net capital gain or net capital loss for the year ended 30
June of the current tax year. (a) Block of vacant land. On 3 June of
the current tax year, your client signed a contract to sell a block of
vacant land for $320,000. She acquired this land in January 2001 for
$100,000 and incurred $20,000 in local council, water and sewerage
rates and land taxes during her period of ownership of the land. The
contract of sale stipulates that a deposit of $20,000 is payable to
her when the contract of sale is signed and the balance is payable
on 3 January of the next tax year, when the change of ownership will
be registered.
(b) Antique bed. On 12 November of the current tax year, your client
had an antique four-poster Louis XIV bed stolen from her house.
She recently had the bed valued for insurance purposes and the
market value at 31 October of the current tax year was $25,000.
She purchased the bed for $3,500 on 21 July 1986. Although the
furniture was in very good condition, the bed needed alterations to
allow for the installation of an innerspring mattress. These
alterations significantly increased the value of the bed, and cost
$1,500. She paid for the alterations on 29 October 1986. On 13
November of the current tax year, she lodged a claim with her
insurance company seeking to recover her loss. On 16 January of
the current tax year, her insurance company advised her that the
antique bed had not been a specified item on her insurance policy.
Therefore, the maximum amount she would be paid under her
household contents policy was $11,000. This amount was paid to
her on 21 January of the current tax year.
(c) Painting. Your client acquired a painting by a well-known
Australian artist on 2 May 1985 for $2,000. The painting had
significantly risen in value due to the death of the artist. She sold
the painting for $125,000 at an art auction on 3 April of the current
tax year.
(d) Shares. Your client has a substantial share portfolio that she has
acquired over many years. She sold the following shares in the
relevant year of income: (i) 1,000 Common Bank Ltd shares
acquired in 2001 for $15 per share and sold on 4 July of the current
tax year for $47 per share. She incurred $550 in brokerage fees on
the sale and $750 in stamp duty costs on purchase.
(ii) 2,500 shares in PHB Iron Ore Ltd. These shares were also
acquired in 2001 for $12 per share and sold on 14 February of the
current tax year for $25 per share. She incurred $1,000 in
brokerage fees on the sale and $1,500 in stamp duty costs on
purchase.
(iii) 1,200 shares in Young Kids Learning Ltd. These shares were
acquired in 2005 for $5 per share and sold on 14 February of the
current tax year for $0.50 per share. She incurred $100 in
brokerage fees on the sale and $500 in stamp duty costs on
purchase.
(iv) 10,000 shares in Share Build Ltd. These shares were acquired
on 5 July of the current tax year for $1 per share and sold on 22
January of the current tax year for $2.50 per share. She incurred
$900 in brokerage fees on the sale and $1,100 in stamp duty costs
on purchase.
(e) Violin. Your client also has an interest in collecting musical
instruments. She plays the violin very well and has several violins in
her collection, all of which she plays on a regular basis. On 1 May of
the current tax year, she sold one of these violins for $12,000 to
neighbour who is in the Queensland Symphony Orchestra. The violin
cost her $5,500 when she acquired it on 1 June 1999. Your client
also has a total of $8,500 in capital losses carried forward from the
previous tax year, $1,500 of which are attributable to a loss on the
sale of a piece of sculpture that she sold in April of the previous
year.
11.8 Scott is an accountant who purchased a vacant block of land in
Brisbane on 1 October 1980. On 1 September 1986, Scott built a
house on the land. At the time, the land was valued at $90,000 and
the cost of construction was $60,000. The property has been rented
out since construction was completed. On 1 March of the current tax
year, Scott sold the property at auction for $800,000. (a) Based on
the information above, determine Scott’s net capital gain or net
capital loss for the year ended 30 June of the current tax year.
(b) How would your answer to (a) differ if Scott sold the property to
his daughter for $200,000?
(c) How would your answer to (a) differ if the owner of the property
was a company instead of an individual?
11.9 On 1 July 1986, Sophia acquires an office block under a
contract of purchase for $750,000. She also incurred stamp duty
associated with the purchase of $25,000 as well as conveyancing
and legal costs incidental to the purchase of $15,800. These costs
were incurred on the date of settlement, which was 1 September
1986. Sophia was immediately sued and incurred $50,000 in legal
costs defending her right to the office block against a person
challenging the legal validity of her title. These costs were paid on
15 February 1987. Ongoing expenses during the ownership period
were interest totalling $120,000, deductible repairs to the property
of $50,000 and rates and taxes totalling $85,000. On 7 April 1991,
Sophia made capital improvements to the building totalling
$75,000.
On 1 September 2020, Sophia sold the office block under a contract
of sale for $1,200,000. In doing so, she spent $7,500 in advertising
costs in relation to the sale and paid sales commission to the real
estate agent of $48,000.
The four offices in the block had been rented out to tenants for the
period of ownership.
Sophia wants to know whether she is better off using the indexation
method for calculating her capital gain or the discount method.
Based on your calculations, advise her.
11.10 Discuss the CGT consequences of the following in relation to
the main residence exemption: (a) Your client purchases a property
to live in and does so for four months. They are then sent overseas
by their employer for 12 months during which time the residence is
rented out.
(b) Your client purchases a new home and moves in immediately.
Four months later, their previous main residence is sold.
(c) Your client purchases a new home and moves in immediately.
Nine months later, their previous main residence is sold.
(d) Your client decides to make extra income by renting out their
spare bedroom in their main residence on Airbnb.
11.11 Martin purchased a home in Brisbane on 7 April 2011 and
moved into it once the contract was settled. Martin lived there until
he moved into a retirement facility on 18 September 2016. At that
stage, he rented the house to long-term tenants.
On 20 January 2020, Martin passed away. Martin’s daughter, Millie,
was the beneficiary of the estate and inherited the house. Millie
then sold the house on 20 December 2020.
What are the CGT consequences of the sale?
Part 3 - Deductions and Offsets
Taxpayers can reduce their income tax payable by taking into account
certain deductions and offsets. Once assessable income is determined, as
discussed in Part 2, deductions are subtracted to determine taxable income.
Deductions consist of what are commonly referred to as general deductions
and specific deductions. Not all expenses incurred by a taxpayer are
deductible and it is necessary to comply with a provision of the legislation
before deducting an expense.
Chapter 12 begins by explaining how all of the deductions available to a
taxpayer fit within the legislative regime. It then concentrates on the general
deduction provision, s 8-1 of the Income Tax Assessment Act 1997 (Cth)
(ITAA 1997). The chapter explains that s 8-1 provides taxpayers with a
deduction for expenses incurred in gaining or producing assessable income
or necessarily incurred in carrying on a business. However, s 8-1 also
provides that expenses are not deductible under that section where they are
capital or capital in nature, private or domestic, incurred in gaining exempt
or non-assessable non-exempt income, or prevented from being deducted by
a specific provision of the legislation. Finally, Chapter 12 discusses the
deductibility of some commonly incurred expenses, such as expenses
incurred in gaining employment, relocation expenses, child care, travel, self-
education, home office, clothing, interest and legal expenses.
Some expenses, which may or may not be deductible under the general
deduction provision, may fall within a specific deduction provision. There are
two categories of specific deductions: those which are immediately
deductible and those which can be deducted over a number of years.
Chapter 13 examines deductions which are immediately deductible and
allowed because the legislation specifically provides a deduction for a
specific type of expense. Examples of specific deductions discussed are the
cost of managing tax affairs, gifts and donations, repairs, bad debts,
memberships, travel and tax losses from previous years.
Chapter 14 examines deductions available for capital expenditure. While not
immediately deductible, these expenses are deductible over a number of
years under the capital allowances regime. The most common deductible
capital expenditure is the cost of acquiring a depreciating asset which is
used for income-producing purposes. Other business expenses which are not
normally deductible may also be allowed over a period of time.
In addition to being able to deduct certain expenses, a taxpayer may also
reduce his or her income tax payable through various tax offsets (often
known as rebates and credits). Tax offsets are more limited than deductions
as a taxpayer needs to meet certain criteria to qualify. However, where a
taxpayer does qualify for a tax offset, it is substantially more valuable than a
deduction. This is because a deduction reduces taxable income, whereas a
tax offset is deducted directly from income tax payable. Chapter 15 explains
how tax offsets work and then explains the concepts relating to the largest
group of offsets, known as concessional offsets.

Chapter - 12 General deductions

Key
points ............................................................................................
....... [12.00]
Introduction...................................................................................
............. [12.10]
General deduction
rule .............................................................................. [12.20]
"Loss or
outgoing ........................................................................................
[12.30]
The nexus test – positive limbs of section 8-
1 ........................................... [12.40]
Judicial
tests ..............................................................................................
. [12.50]
Is the nexus sufficiently direct or too remote to
satisfy the positive limbs of s 8-
1?.............................................................. [12.70]
Expenses involving alleged or actual wrongdoing by
taxpayer ................. [12.80]
Expenses to reduce future
expenditure ................................................... [12.100]
Involuntary losses or
outgoings ................................................................ [12.110]
Is there a sufficient temporal nexus or
connection to satisfy the positive limbs of s 8-
1? .................................... [12.120]
Expenses related to the production of assessable
income in future
years............................................................................... [12.130]
Expenses related to the production of assessable
income in prior
years.................................................................................
[12.140]
Summary .......................................................................................
............ [12.150]
Non-deductible expenses – the negative limbs of section 8-
1 ................ [12.160]
Capital or capital in
nature ........................................................................ [12.170]
Judicial
tests ..............................................................................................
. [12.180]
Form and
substance ..................................................................................
[12.200]
Summary .......................................................................................
............. [12.210]
Private or
domestic ...................................................................................
[12.220]
Incurred in gaining or producing exempt or non-assessable non-
exempt
income...........................................................................................
............ [12.230]
Denied
deductions ....................................................................................
[12.240]
Entertainment
expenses ...........................................................................
[12.250]
Reimbursed
expenditure ...........................................................................
[12.260]
Apportionment – deductibility of dual purpose
expenses ....................... [12.270]
Amount of
deduction ................................................................................
[12.290]
Reasonable vs actual
expense ................................................................... [12.300]
Tax minimisation situations – purpose
………............................................. [12.310]
Substantiation of
deductions .................................................................... [12.320]
Application of section 8-1 to commonly incurred
expenses .................... [12.330]
Expenses incurred in gaining
employment ............................................... [12.340]
Business
taxpayers .....................................................................................
[12.350]
Relocation
expenses...................................................................................
[12.360]
Child care
expenses ...................................................................................
[12.370]
Travel
expenses .......................................................................................
.. [12.380]
Travel between home and
work ............................................................... [12.390]
Itinerant
workers .......................................................................................
[12.410]
Transportation of bulky
items ................................................................... [12.420]
Alternative
workplace ...........................................................................
[12.430]
Travel between two places of
work ..................................................... [12.440]
Car
expenses .......................................................................................
.. [12.450]
“Cents per kilometre”
method .............................................................. [12.460]
“Logbook”
method ................................................................................
[12.550]

Self-education
expenses ......................................................................... [12.580]
Positive limbs of s 8-
1 ............................................................................. [12.590]
Self-education expenses relate to taxpayer’s current
career… ............. [12.600]
Current career requires taxpayer to stay up to
date ............................. [12.630]
Self-education expenses not related to employment
income .............. [12.640]
Negative limbs of s 8-
1 ........................................................................... [12.650]
Capital
expenses .....................................................................................
[12.660]
Private or domestic
expenses ................................................................ [12.670]
Non-deductible self-education
expenses ............................................... [12.680]
Apportionment ...............................................................................
........ [12.690]
Home office
expenses ............................................................................
[12.700]
Genuine home
office............................................................................... [12.710]
Home office for convenience
only ......................................................... [12.720]
Apportionment and capital
expenses .................................................... [12.730]
Clothing and dry-cleaning
expenses ...................................................... [12.740]
Conventional clothing and related
items .............................................. [12.750]
Abnormal expenditure on conventional
clothing .................................. [12.760]
Expenditure caused by taxpayer’s work
conditions ............................... [12.780]
Occupation-specific clothing, protective clothing and uniforms …..
…... [12.790]
Capital
expenses .....................................................................................
[12.800]
Interest
expenses.....................................................................................
[12.810]
Gearing .........................................................................................
........... [12.820]
Capital
expenses ......................................................................................
[12.830]
Legal
expenses........................................................................................
.. [12.840]
Questions ......................................................................................
........... [12.860]
Key points [12.00]
• Expenses incurred by taxpayers in gaining or producing assessable income
may be deducted against that income to reduce the taxpayer’s final tax
liability.
• Expenses may be immediately deductible under the general deduction
provision in s 8-1 of the Income Tax Assessment Act 1997 (Cth) (ITAA 1997)
or under a specific deduction provision.
• Expenses that are deductible under a specific deduction provision should
be deducted under that provision as it is the most appropriate provision.
• Expenses must be incurred by the taxpayer in gaining or producing
assessable income or necessarily incurred in carrying on a business to gain
or produce assessable income to be deductible under s 8-1 of the ITAA 1997.
• An expense that is capital or capital in nature, private or domestic,
incurred in gaining or producing exempt or non-assessable non-exempt
income, or specifically denied by another provision in the income tax
legislation, cannot be deducted under s 8-1 of the ITAA 1997.
• Capital expenses that are not immediately deductible may be deductible
over a period of years.
• Taxpayers may claim a deduction for a part of an expense where only a
part of the expense satisfies the requirements of s 8-1 of the ITAA 1997, for
example, an expense partly incurred to gain or produce assessable income
and partly incurred for private purposes.
• Taxpayers are required to maintain adequate records when claiming a
deduction for an expense.
• Common expenses that may or may not be deductible under s 8-1 of the
ITAA 1997 include: – expenses incurred in gaining employment; – relocation
expenses; – child care expenses; – travel expenses; – self-education
expenses; – home office expenses; – clothing expenses; – interest expenses;
and – legal expenses.

Introduction [12.10]
Recall from Chapter 3 that the basic formula in s 4-10 of the Income Tax
Assessment Act 1997 (Cth) (ITAA 1997) which determines the amount of tax
that a taxpayer has to pay for a particular year is: Tax payable = (Taxable
income × Tax rate) − Tax offsets
Section 4-15 provides that: Taxable income = Assessable income −
Deductions
Part 2 considered when an amount will be assessable income of the
taxpayer. In this and subsequent chapters, we consider when an amount will
be a deduction to the taxpayer. Broadly, a deduction is an expense of the
taxpayer which is deductible for tax purposes as it is incurred in gaining or
producing income that is assessable for tax purposes. The deduction is
applied against the taxpayer’s assessable income to determine “taxable
income” upon which the taxpayer’s tax liability is calculated. “Taxable
income” is considered a better reflection of the taxpayer’s taxable capacity
or ability to pay.
Deductions are set out in Div 8 of the ITAA 1997 and are divided into two
categories: • general deductions: s 8-1; and • specific deductions: s 8-5.
General deductions are discussed in this chapter, while specific deductions
are discussed in Chapter 13.
Expenses may be deductible under both the general deduction provision and
a specific deduction provision. In this case, s 8-10 provides that the expense
should be deducted under the “most appropriate” section. As a general rule
of statutory construction, the specific rule (the specific deduction provision)
should apply over the general rule (the general deduction provision). In any
case, s 8-10 makes it clear that an expense can only be deducted once.
There are also some expenses that may not be immediately deductible
under either a specific deduction provision or the general deduction
provision but which may nonetheless be deductible over a period of years.
These expenses are discussed in Chapter 14.
Figure 12.1 illustrates the approach to determining when an expense is
deductible for tax purposes.
General deduction rule [12.20]
The main provision that gives taxpayers a deduction for an expense is s 8-1
of the ITAA 1997, which is known as the general deduction provision. It is a
“general” deduction provision as it has the potential to apply to any expense
of the taxpayer. Section 8-1(3) states that a loss or outgoing that is
deductible under s 8-1 is called a “general deduction”.
Note that s 8-1 of the ITAA 1997 was formerly s 51(1) of the Income Tax
Assessment Act 1936 (Cth) (ITAA 1936). Case law or rulings which refer to s
51(1) are equally applicable to s 8-1.
Section 8-1(1) of the ITAA 1997 provides that a taxpayer can deduct from his
or her assessable income a loss or outgoing to the extent that it is:
• incurred in gaining or producing assessable income; or
• necessarily incurred in carrying on a business for the purpose of gaining or
producing assessable income. These two elements of s 8-1 are commonly
known as the “positive limbs” of s 8-1 as an expense must satisfy one of
these elements to be deductible.
However, s 8-1(2) stipulates that an expense that satisfies the positive limbs
of s 8-1 may nonetheless not be deductible under s 8-1 to the extent that it
is:
• capital or capital in nature: see [12.170];
• private or domestic: see [12.220];
• incurred in gaining exempt or non-assessable non-exempt income: see
[12.230]; or
• prevented from being deducted by a specific provision of the income tax
legislation: see [12.240].
These four elements are commonly known as the “negative limbs” of s 8-1
as an expense which satisfies any one of these elements will not be
deductible.
Note that the deductibility of an expense is determined from the taxpayer’s
perspective in accordance with the requirements of s 8-1 and the treatment
of the amount in the recipient’s hands (ie, whether or not it is assessable) is
generally not relevant.
Figure 12.2 provides a guide to determining when an expense would be
deductible under the general deduction rule.
Loss or outgoing [12.30]
The first thing to note about s 8-1 of the ITAA 1997 is that it applies to both
losses and outgoings. As a result, s 8-1 is not limited to direct expenses of
the taxpayer and can provide a deduction for a loss. The ability to deduct
losses under s 8-1 was confirmed by the High Court in Charles Moore & Co
(WA) Pty

Ltd v FCT (1956) 95 CLR 344 (see Case Study [12.1]), which considered the
predecessor to s 8-1. Example 12.1: Outgoings
Sarah paid her office phone bill of $220. The payment of $220 is an outgoing
which is deductible under s 8-1 if all of the other requirements of the section
are satisfied.
Example 12.2: Losses
Sarah undertook a profit-making land development scheme as in
FCT v Whitfords Beach Pty Ltd (1982) 150 CLR 355 (see Chapter 8).
She purchased the land for $1 million, spent $1 million on
development of the land and sold the land for $1.5 million.
Sarah has a net loss of $500,000 from the scheme, which is
deductible under s 8-1 if all of the other requirements of the section
are satisfied: see Ruling TR 92/4.
The existence of a “loss or outgoing” is generally not an issue in
claiming a deduction under s 8-1, and it is the positive and negative
limbs of s 8-1 which require detailed consideration when
determining the deductibility of a loss or outgoing.
The nexus test – positive limbs of section 8-1 [12.40]
The first hurdle for a loss or outgoing to be deductible under s 8-1 of the
ITAA 1997 is the nexus requirement. Under s 8-1(1), the loss or outgoing
must be:
• incurred in gaining or producing assessable income; or
• necessarily incurred in carrying on a business to gain or produce
assessable income.
There is some uncertainty as to whether the second positive limb
(“necessarily incurred in carrying on a business to gain or produce
assessable income”) adds in any way to the first positive limb since a loss or
outgoing which satisfies the second positive limb is likely to also satisfy the
first. There is potentially an argument that the first positive limb requires a
direct connection between the expense and the production of assessable
income, whereas the second positive limb ensures that expenses that are
necessary for the operation of a business that produces assessable income
are deductible even though the expenses may not have a direct connection
to the production of assessable income. This distinction is rarely focused on
in practice.

In essence, the first positive limb requires a connection between the expense
and the production of assessable income, while the second positive limb
requires a connection between the expense and the carrying on of a
business to produce assessable income. Note that s 8-1(1) provides that an
expense is deductible “to the extent that” it satisfies one of the positive
limbs. This means that an expense may be partially deductible under s 8-1
where the expense only partially satisfies the positive limbs of s 8-1.
Apportionment and the deductibility of dual purpose expenses are
considered further at [12.270].
The courts have long accepted that when looking at the positive limbs of s 8-
1, the phrase “in gaining or producing assessable income” is to be
interpreted as “in the course of gaining or producing assessable income”:
Amalgamated Zinc (De Bavay’s) Ltd v FCT (1935) 54 CLR 295; Charles Moore
& Co (WA) Pty Ltd v FCT (1956) 95 CLR 344; FCT v Day (2008) 70 ATR 14. In
Ronpibon Tin No Liability v FCT (1949) 78 CLR 47 at 57, the High Court
stated that: to come within the initial part of [s 8-1] it is both sufficient and
necessary that the occasion of the loss or outgoing should be found in
whatever is productive of the assessable income or, if none be produced,
would be expected to produce assessable income.
In other words, the connection between the expense and the production of
assessable income is determined in the context of the taxpayer’s overall
activities and not by narrowly looking at the direct impact of the expense on
the taxpayer’s production of assessable income.
Case study 12.1: Losses incurred in the course of gaining or
producing assessable income
In Charles Moore & Co (WA) Pty Ltd v FCT (1956) 95 CLR 344, the
taxpayer was a retail company, the normal operations of which
included an employee taking the day’s earnings to the bank daily.
The employee was robbed while on the way to the bank. The
taxpayer’s claim for a deduction for the loss was denied by the
Commissioner, who argued that the loss was not sufficiently
connected to the production of assessable income by the taxpayer.

In concluding that the loss was deductible, the Full High Court
stated that “in gaining or producing assessable income” should be
interpreted as “in the course of gaining or producing assessable
income”. In this case, the taxpayer’s normal business operations
included banking the daily earnings and, as the loss had been
incurred as part of that normal business operation, the loss was
incurred in the production of assessable income and satisfied the
positive limbs of the predecessor to s 8-1.

Judicial tests [12.50]

The determination as to whether an expense is incurred in the course of
gaining or producing a taxpayer’s assessable income is not straightforward,
and the courts have adopted a number of approaches in addressing this
issue. The key tests that have been utilised by the courts are:
• the incidental and relevant test;
• the essential character test; and
• the occasion of the expenditure test.
There was also an attempt to develop a “condition of employment test”
under which expenses would satisfy the positive limbs of s 8-1 where the
expense arose as a result of the taxpayer’s conditions of employment. This
test was specifically rejected by the court in FCT v Wilkinson (1983) 14 ATR
218 as it could be easily manipulated – taxpayers would simply need to
include the expenses in their employment contracts and the expenses would
be deductible under such a test.
In applying the tests listed above, the courts have consistently stated that
no single test can be applied to the positive limbs of s 8-1 and a case-by-
case approach is appropriate. This point was reiterated by the High Court in
FCT v Day (2008) 70 ATR 14 (see Case Study [12.2]) where the High Court
stated (at [30]) that:
Section 8-1(1)(a) is couched in terms intended to cover any number of
factual and legal situations in which expenditure is incurred by a taxpayer.
Its language and breadth of application do not make possible a formula
capable of application to the circumstances of each case.
Earlier cases, such as W Nevill & Co Ltd v FCT (see Case Study [12.7]),
Ronpibon Tin No Liability v FCT (1949) 78 CLR 47 (see Case Study [12.18])
and Charles Moore & Co (WA) Pty Ltd v FCT (1956) 95 CLR 344 (see Case
Study [12.1]) adopted the incidental and relevant test in determining
whether a loss or outgoing had the necessary connection to the production
of assessable income. As stated by Dixon J in W Nevill, a loss or outgoing
would be sufficiently connected to the production of assessable income
where “the expenditure ... is incidental and relevant to the operations or
activities regularly carried on for the production of income” (at 305). In
Charles Moore, the High Court stated (at 351) that phrases such as:
“incidental and relevant” when used in relation to the allowability of losses
as deductions do not refer to the frequency, expectedness or likelihood of
their occurrence or the antecedent risk of their being incurred, but to their
nature or character. What matters is their connection with the operations
which more directly gain or produce the assessable income.
[12.60] In later cases, such as Lunney v FCT; Hayley v FCT (1958) 100 CLR
478, the courts looked at the essential character of an expense in
determining whether the expense was sufficiently connected to the
production of assessableincome. In Lunney v FCT; Hayley v FCT, the High
Court denied the taxpayers a deduction for expenses incurred in travelling
from home to work on the basis that the “essential character” of the
expenses was to put the taxpayers in a position to gain or produce
assessable income rather than being incurred in the production of
assessable income.
More recently, the High Court in FCT v Payne (2001) 202 CLR 93 and FCT v
Day (2008) 70 ATR 14 suggested that, in determining whether an expense is
incurred in the course of gaining or producing assessable income, it is
necessary to consider whether the occasion of the expenditure arises out of
the taxpayer’s income-producing activities. Expenses will be sufficiently
connected to the production of assessable income where they arise out of
the taxpayer’s income-producing activities. Utilising this approach therefore
requires an assessment as to what is productive of the taxpayer’s assessable
income, which is determined in accordance with the taxpayer’s individual
circumstances.
On the application of the “relevant and incidental test” and the “essential
character test”, the High Court in FCT v Day (2008) 70 ATR 14 at 26 stated:
Expressions used in the cases, such as “incidental and relevant”, as
referable to a business, should not be thought to add more to the meaning of
provisions such as s 8-1(1)(a) of the ITAA, or to narrow its operation. They
should be taken to describe an attribute of an expenditure in a particular
case, rather than being an exhaustive test for ascertaining the limits of the
operation of the provision. Reference in some cases to the expenditure
having an “essential characteristic” must likewise be treated with some care.
As Gaudron and Gummow JJ observed in Payne, the use of the term may
avoid the evaluation which the section requires. It is perhaps better
understood as a statement of conclusion than of reasoning.
Following the High Court’s comments in FCT v Payne and FCT v Day, it would
appear that the “incidental and relevant” and “essential character” tests are
not as relevant in determining whether the positive limbs of s 8-1 are
satisfied, and it is necessary to focus on whether the loss or outgoing arises
out of the taxpayer’s income-producing activities. However, as cautioned by
the High Court, this should not be considered the determinative test as to
whether an expense satisfies the positive limbs of s 8-1, and a case-by-case
approach is to be adopted.
Note that the courts have consistently rejected any consideration of the
taxpayer’s subjective purpose or intention in incurring an expense in
determining whether the positive limbs of s 8-1 are satisfied. This was
reiterated by the High Court in FCT v Anstis (2010) 76 ATR 735 (see Case
Study [12.34]). However, a taxpayer’s subjective purpose may be relevant in
certain limited situations: see [12.310].
We will now look at some of the key cases that considered whether the
positive limbs of s 8-1 (or its predecessors) were satisfied. the positive limbs
of s 8-1?
[12.70] There are two aspects to the nexus or connection issue as to
whether a loss or outgoing is incurred in the course of gaining or producing
assessable income. The first is the question of direct or remote connection. If
the link between an expense and the production of assessable income is too
remote, it will not be deductible. The second is the question of a link in time
or temporal nexus. The necessary connection between the expense and the
production of assessable income may be broken where the expense is
incurred too far in advance of, or too long after, the production of assessable
income. Cases related to the temporal connection will be examined at
[12.120].
In the vast majority of cases, it is generally simple to see whether an
expense is directly related to the production of assessable income or so
remote from the production of income that it would not satisfy the positive
limbs of s 8-1. For example, the cost of a taxi trip to visit a client’s premises
would generally be related to the production of assessable income, whereas
the cost of a taxi trip to visit a friend would not be connected to the
production of assessable income. There are, however, a number of cases
where there was some question as to whether the expenses were sufficiently
connected to the taxpayer’s income-producing activities. These cases are
considered in the following paragraphs.
Expenses involving alleged or actual wrongdoing by taxpayer
[12.80]
A number of cases have considered whether expenses arising due to alleged
or actual wrongdoing by the taxpayer can satisfy the positive limbs of s 8-1.
As the expenses related to the taxpayer’s conduct, they were arguably
“quasi-personal” (i.e., incurred in a personal rather than professional or
business capacity) and the question arose as to whether the expenses were
incurred in the production of the taxpayer’s assessable income or
necessarily incurred in carrying on a business for the production of
assessable income. In each of the cases, the Court took a broad approach
and found that the positive limbs of s 8-1 (or its predecessors) were satisfied.
Case study 12.2: Legal expenses incurred in defending improper
conduct charges
In FCT v Day (2008) 70 ATR 14, the taxpayer was a customs officer
who was charged with failing to fulfil his duties as an officer under
the Public Service Act 1922 (Cth). The taxpayer incurred legal
expenses in defending the charges, which involved a variety of
allegations, including improper use of his position, assisting with an
improper diesel fuel rebate claim, improper use of a work vehicle
and improper attempts to conceal his absences from work. The
taxpayer successfully defended himself against some of the
charges, but not others.
The Commissioner denied the taxpayer’s deduction for the legal
expenses on the basis that the expenses related to conduct
unconnected to the performance of the taxpayer’s income-
producing activities and, therefore, the nexus requirement in s 8-1
was not satisfied as the expenses were not “incurred in gaining or
producing ... assessable income”. The Full High Court found that the
legal expenses were incurred by the taxpayer in gaining or
producing assessable income as the occasion of the expenditure
arose out of his income-producing activities. The taxpayer was
subject to the Public Service Act 1922 (Cth) because of his
employment as a customs officer and the legal expenses related to
defending himself against charges under that Act. In reaching its
conclusion, the Court distinguished the legal expenses in this case
to expenses which may be incurred by a taxpayer in general civil or
criminal proceedings. The key factor here was that it was the
taxpayer’s employment that exposed him to the charges that
resulted in the legal expenses being incurred.
The courts have also accepted that expenses resulting from the
taxpayer’s alleged or actual wrongdoing can satisfy the second
positive limb despite the requirement that the expense be
“necessarily incurred” in the carrying on of the taxpayer’s business.
Case study 12.3: Necessarily incurred in carrying on a business
In Herald and Weekly Times Ltd v FCT (1932) 48 CLR 113, the
taxpayer was a newspaper publisher that incurred expenses in the
form of damages with respect to libel claims made against it.
The Full High Court considered the deductibility of the
compensatory damages. The majority of the Court accepted that the
libel or alleged libel was published with the sole purpose of selling
newspapers. Therefore, the liability to damages was incurred
because of the publishing of the newspaper, which was “the thing
which produced assessable income”. In reaching its conclusion that
the damages were deductible, the Court noted that the potential for
libel claims was a regular and almost unavoidable incident of
publishing, which meant that there was sufficient connection
between the cause of the expense and the taxpayer’s business.
Case study 12.4: Necessarily incurred in carrying on a business In
FCT v Snowden & Willson Pty Ltd (1958) 99 CLR 431, the taxpayer
was a building company that was the subject of a number of
complaints and at the centre of investigations. The complaints and
investigations were public knowledge, and the taxpayer incurred
expenses on advertising and legal fees in defending its reputation.
The taxpayer sought to deduct these expenses on the basis that
they were ordinary business expenses, while the Commissioner
sought to deny a deduction on the basis that the expenses were not
necessarily incurred by the taxpayer in the carrying on of its
business. In concluding that the expenses were deductible, the Full
High Court found that an expense is necessarily incurred where the
expenditure is dictated by business purposes, those purposes being
part of or incidental to the business itself. In this case, the
expenses were incurred in defending the taxpayer’s reputation and
in enabling the continued operation of the business to gain or
produce assessable income, which was clearly a legitimate business
purpose. In reaching its conclusion, the Court appears to suggest
that allegations of wrongdoing are an ordinary incident of business
and expenses incurred in defending the taxpayer against such
allegations are necessary for the continued operation of the
business and therefore appropriate (and deductible). The
taxpayer’s guilt or innocence in relation to the allegations is
irrelevant.
[12.90] In the cases of Herald and Weekly Times Ltd v FCT (1932) 48 CLR
113 (see Case Study [12.3]) and FCT v Snowden & Willson Pty Ltd (1958) 99
CLR 431 (see Case Study [12.4]), the taxpayers’ alleged or actual
wrongdoing was related to their business activities and the allegations of
wrongdoing were considered by the courts to be an ordinary incident of the
particular business. In FCT v Day, the charges against the taxpayer arose
under the Public Service Act 1922 (Cth), to which the taxpayer was only
subject due to the nature of his employment. As such, the connection
between the expenses and the production of assessable income may seem
more apparent. The following cases considered the deductibility of expenses
related to criminal or illegal behaviour, which potentially suggests a personal
element. Both cases considered whether expenses related to criminal or
illegal behaviour were “necessarily incurred” in carrying on a business,
thereby satisfying the second positive limb.

Case study 12.5: Legal expenses incurred in defending criminal

charges
In Magna Alloys & Research Pty Ltd v FCT (1980) 11 ATR 276, the
taxpayer incurred legal expenses in defending itself and its
directors in criminal proceedings. The taxpayer was accused of
paying illegal secret commissions to boost sales of its products. The
proceedings against the taxpayer were subsequently dropped and
the legal expenses primarily related to the directors’ defence. The
Commissioner denied the deduction on the basis that the legal
expenses were primarily for the directors’ personal benefit.
The Full Federal Court found that the legal expenses were
necessarily incurred in carrying on a business to gain or produce
assessable income. The Court noted that “necessary” does not
mean that the expense has to be unavoidable or essential. The
Court also stated (at 293) that “it is no part of the function of the
Act or of those who administer it to dictate to taxpayers in what
business they shall engage or how to run their business profitably
or economically”.
The Court concluded that the expenses were deductible as the
taxpayer was inextricably involved in the proceedings and its
reputation and interests were tied to the directors. It was therefore
in the taxpayer’s interests to pay for the legal expenses to defend
the directors. The Court suggested that the directors knew that the
legal expenses were incurred not only in their own interests but
also to protect the taxpayer’s business. The Court articulated what
has become known as the “business judgment rule” – that is, an
expense will be necessarily incurred in carrying on a business to
gain or produce assessable income where the persons who run the
business consider the expense desirable and appropriate in
achieving business ends.
Case study 12.6: Expenses related to illegal business
In FCT v La Rosa (2003) 53 ATR 1, the taxpayer was a convicted drug
dealer who was robbed of cash during an intended drug purchase.
The Commissioner sought to assess the taxpayer on the income he
had earned from drug dealing. The taxpayer claimed a deduction for
the loss incurred in the robbery per Charles Moore & Co (WA) Pty
Ltd v FCT (1956) 95 CLR 344: see Case Study [12.1]. The
Commissioner argued that the taxpayer should be denied a
deduction for the loss on public policy grounds, while including the
gross proceeds from the sale as assessable income. The Full Federal
Court confirmed that proceeds from an illegal business or activity
may be assessable and corresponding expenses or losses
deductible. The Court did not accept the Commissioner’s public
policy argument for denying the deductions as there was no legal
basis for doing so. The loss was deductible as it was necessarily
incurred in carrying on the taxpayer’s business to gain or produce
assessable income. Not surprisingly, the case attracted widespread
publicity and the government responded by introducing s 26-54,
which denies a deduction
for “a loss or outgoing to the extent that it was incurred in the
furtherance of, or directly in relation to, a physical element of an
offence against an Australian law of which you have been convicted
if the offence was, or could have been, prosecuted on indictment”:
see [12.240].
The decisions in Magna Alloys & Research Pty Ltd v FCT and FCT v
La Rosa further support a broad approach in determining the
connection between a loss or outgoing and the production of
assessable income. It should be noted that a deduction is available
in these situations regardless of the taxpayer’s guilt or innocence in
relation to the allegations: FCT v Snowden & Willson Pty Ltd and
Magna Alloys & Research Pty Ltd v FCT.

Expenses to reduce future expenditure [12.100]

The deductibility of expenses incurred in improving business efficiency which
will result in a reduction of future expenditure is an interesting issue. Strictly
speaking, such expenses increase “taxable income” (by reducing
deductions) and not assessable income as required by s 8-1. The Full High
Court considered whether such expenses were “necessarily incurred” in
carrying on a business and satisfied the second positive limb of the
predecessor to s 8-1 in W Nevill & Co Ltd v FCT (1937) 56 CLR 290. The
Court held that an expense that improves the taxpayer’s business overall
and reduces future expenses, although not directly incurred in gaining or
producing assessable income, is not too remote and satisfies the second
positive limb of the predecessor to s 8-1.
Case study 12.7: Necessarily incurred in carrying on a business
In W Nevill & Co Ltd v FCT (1937) 56 CLR 290, the taxpayer was a company
that had two managing directors. The joint management system was found
not to be working and therefore it was decided that the contract of one of
the managing directors would be terminated and a compensation payment
made.
Among other things, the Commissioner argued that the compensation
payment was not deductible as it was not incurred in gaining or producing
assessable income. The taxpayer argued that the amount was deductible as
it was saving on future salary costs, which would have been deductible, and
that terminating the managing director would improve the efficiency of the
business, which would increase assessable income. The Full High Court found
that the payment satisfied the positive limbs of the predecessor to s 8-1 and
was therefore deductible. In reaching this
conclusion, the Court noted that no expense directly increases a taxpayer’s
assessable income and therefore an overall approach is appropriate. Here,
the Commissioner erred in looking at the compensation payment in isolation.
The Court held that the compensation payment must be viewed in context
with the original agreement with the managing director, which was clearly
entered into in the production of assessable income. The compensation
payment, which resulted from an amendment to the original agreement,
must therefore also be for the purpose of gaining or producing assessable
income.
Therefore, an expense which improves the taxpayer’s overall business
efficiency and operation would be incurred in gaining or producing
assessable income. Further, the Court also found that an expense that
reduces a taxpayer’s future deductible expenditure is incurred in gaining or
producing assessable income.
Involuntary losses or outgoings [12.110]
As discussed at [12.30], s 8-1 of the ITAA 1997 contemplates that a “loss”
may be deductible. However, the question arises as to whether a loss or
outgoing is sufficiently connected to the production of assessable income
where the taxpayer has not chosen to incur the loss or outgoing and it is
involuntary or unforeseen, or unavoidable. In these situations, the loss or
outgoing may be too remote to the production of assessable income. The
issue was considered by the High Court in Charles Moore & Co (WA) Pty Ltd v
FCT (1956) 95 CLR 344 (see Case Study [12.1]) where the taxpayer suffered
a loss due to theft. The Full High Court found that an involuntary loss or
outgoing may be sufficiently connected to the production of assessable
income where it arises out of the taxpayer’s income-producing activities.
Is there a sufficient temporal nexus or connection to satisfy the positive
limbs of s 8-1?
[12.120] In the cases considered so far, the loss or outgoing was incurred in
the same income year as the production of assessable income. The question
in those cases was whether the loss or outgoing was sufficiently connected
to or too remote from the production of assessable income. A separate
question arises as to whether expenses incurred prior to or after the
production of assessable income are sufficiently connected to the production
of assessable income. Expenses related to the production of assessable
income in future years
[12.130] The courts (eg, in Steele v DCT (1999) 41 ATR 139) have accepted
that an expense incurred to gain or produce assessable income in future
income years may satisfy the positive limbs of s 8-1 of the ITAA 1997 in
certain circumstances.
Case study 12.8: Expenses related to income gained or produced in
future years
In Steele v DCT (1999) 41 ATR 139, the taxpayer was an individual who had
obtained a loan to purchase property for use in a business venture. For
various reasons, the venture did not go ahead and the taxpayer did not gain
or produce assessable income in relation to the property as intended.
The taxpayer sought a deduction for the interest expenses incurred on the
loan to purchase the property on the basis that the expenses were incurred
to gain or produce future assessable income. The Commissioner sought to
deny the taxpayer’s claim on the basis that there was no connection
between the interest expenses and the production of assessable income –
that is, the positive limbs of the predecessor to s 8-1 were not satisfied. The
Full High Court held that such expenses would be deductible if the taxpayer
could demonstrate that the expenses were incurred in order to gain or
produce assessable income. The factual question was remitted back to the
AAT, which found that the evidence showed that the taxpayer had no other
purpose in incurring the interest expense other than for the production of
assessable income. The expenses were thus deductible under the
predecessor to s 8-1.
Despite the High Court’s decision in Steele v DCT, the deductibility of
expenses related to the production of future assessable income can be a
tricky issue and should be decided on a case-by-case basis. It is important to
note that Steele v DCT considered a deduction for interest expenses
associated with the acquisition of an income-producing asset. A deduction
for such expenses may be considered desirable from a policy perspective as
it promotes investment in income-producing assets, such as shares and
property.
In a business context, expenses incurred in anticipation of future assessable
income may not be deductible on the basis that the business has not
actually commenced at that time: see [8.110]–[8.120]. In an employment
context, the courts may find that the expenses are incurred to put the
taxpayer in a position to gain or produce assessable income, rather than
being incurred in the production of assessable income: see [12.340],
[12.360]–[12.370], [12.390].
While the Full High Court’s decision in Steele v DCT stands for the
proposition that expenses incurred in anticipation of future income may be
deductible, this is more likely to be the case where the expenses relate to
the acquisition of an income-producing asset, and such expenses may still
be considered to be “too soon” in an employment or business context.
Expenses related to the production of assessable income in prior years
[12.140] A question also arises as to whether an expense is incurred “in
gaining or producing assessable income”, where the expense relates to the
production of income in previous years. In particular, there is an issue as to
whether a sufficient connection continues to exist between the expense and
the income where the taxpayer has ceased to carry on its previous income-
producing activities. In Amalgamated Zinc (De Bavay’s) Ltd v FCT (1935) 54
CLR 295, the Full High Court denied the taxpayer deductions for expenses
that related to its past business activities, which it no longer carried on at
the time the expenses were incurred. Although this case has not been
expressly overturned by subsequent cases, it is no longer considered good
authority on the issue. A number of subsequent cases have permitted the
taxpayer a deduction for expenses relating to past business activities
provided that the expense was caused by the past income-producing
activities of the taxpayer.
In AGC (Advances) Ltd v FCT (1975) 132 CLR 175, the Full High Court allowed
the taxpayer a deduction for expenses that related to past business
activities. However, the difference between this case and Amalgamated Zinc
v FCT was that, in AGC (Advances) Ltd v FCT, the taxpayer had restarted its
business at the time of claiming the deduction.
The Full Federal Court subsequently applied AGC (Advances) Ltd v FCT to
permit taxpayers a deduction for expenses relating to past business
activities, even where the business activities have ceased at the time of
incurring the expense: see, for example, FCT v EA Marr and Sons (Sales) Ltd
(1984) 15 ATR 879; Placer Pacific Management Pty Ltd v FCT (1995) 31 ATR
253.
Case study 12.9: Expenses related to the production of assessable
income in prior years
In Placer Pacific Management Pty Ltd v FCT (1995) 31 ATR 253, the taxpayer
incurred expenses in satisfying obligations arising out of its previous
business of manufacturing conveyor belts. At the time of incurring the
expenses, the taxpayer was only involved with the investment and
management of related companies.
The taxpayer sought a deduction for the expenses on the basis that they
were incurred in producing assessable income. The Commissioner argued
that the nexus between the taxpayer’s income-producing activities and the
expense was broken by the fact that the taxpayer had ceased carrying on
the business of manufacturing conveyor belts.
The Full Federal Court allowed the taxpayer a deduction for the expenses on
the basis that they arose out of or were caused by the taxpayer’s past
activities of manufacturing conveyor belts, from which it produced
assessable income. The fact that the business had since ceased was
therefore irrelevant.
The Commissioner’s application for special leave to appeal was refused by
the High Court.
More recent cases, such as FCT v Brown (1999) 43 ATR 1 and FCT v Jones
(2002) 49 ATR 188, have also permitted taxpayers a deduction for interest
expenses on loans related to prior business activities which have since
ceased.
The key to determining whether an expense incurred in producing
assessable income in prior years satisfies the positive limbs of s 8-1 of the
ITAA 1997 is to establish whether the expense was caused by the taxpayer’s
prior income-producing activities. If the expenses have been caused by the
taxpayer’s previous income-producing activities, then they will be
deductible.

Summary [12.150]
The above discussion and case studies indicate that a broad approach is to
be adopted when determining whether an expense is incurred in the
production of assessable income, or is necessarily incurred in carrying on a
business for the production of assessable income. This broad approach is
supported by the fact that courts have accepted that the phrase “in gaining
or producing assessable income” is to be interpreted as “in the course of
gaining or producing assessable income”: FCT v Day (2008) 70 ATR 14;
Charles Moore & Co (WA) Pty Ltd v FCT (1956) 95 CLR 344. In the context of
an individual, it is necessary to consider whether the expenditure arises out
of the taxpayer’s income-producing activities (ie, the “occasion of the
expenditure”): see FCT v Payne (2001) 202 CLR 93; FCT v Day (2008) 70 ATR
14.
In a business context, the courts have not applied a narrow interpretation to
“necessarily incurred” and have concluded that involuntary, unavoidable,
unforeseen or even apparently illogical outgoings may be incurred in gaining
or producing assessable income: Charles Moore & Co (WA) Pty Ltd v FCT
(1956) 95 CLR 344; Magna Alloys & Research Pty Ltd v FCT (1980) 11 ATR
276. The determination as to whether an expense is desirable and
appropriate towards business ends is a decision for the directors or persons
responsible for carrying on the business: Magna Alloys & Research Pty Ltd v
FCT (1980) 11 ATR 276. Further, the connection between an expense and the
production of assessable income cannot be made in isolation and an overall
approach should be adopted: W Nevill & Co Ltd v FCT (1937) 56 CLR 290.
Finally, the courts have accepted that expenses may be deductible even
where they relate to assessable income gained or produced in future or prior
years. Expenses in anticipation of future assessable income will be
deductible if it can be shown that the expenses were incurred in order to
gain or produce assessable income. However, it may be necessary to
consider whether the expenses were incurred to put the taxpayer in a
position to gain or produce assessable income, or prior to the
commencement of a business. Expenses related to the production of prior
year assessable income will be deductible where the expenses were caused
by the taxpayer’s prior income-producing activities.
Non-deductible expenses – the negative limbs of section 8-1
[12.160]
An expense that satisfies the positive limbs of s 8-1 of the ITAA 1997 may
nevertheless not be deductible under s 8-1 if it satisfies any one of the
elements of s 8-1(2). Note that s 8-1(2) provides that an expense is not
deductible “to the extent that” it satisfies any one of the negative limbs. This
means that an expense may be partially deductible under s 8-1 where it only
partially satisfies one of the negative limbs of s 8-1. Apportionment and
deductibility of dual purpose expenses are considered further at [12.270].
Capital or capital in nature [12.170]
The first of the negative limbs in s 8-1 of the ITAA 1997 is often the main
issue in determining whether an expense is deductible under s 8-1,
particularly in a business context. Under s 8-1(2)(a), a loss or outgoing that
is capital or capital in nature will not be deductible under s 8-1. Expenses
that are not capital or capital in nature are often termed “revenue
expenses”, although this expression does not appear in the legislation.
Unfortunately, there is no clear test in the legislation as to when an expense
will be a capital expense or a revenue expense. Broadly, an expense that
relates to the taxpayer’s income-producing process will be a revenue
expense, while an expense that relates to the taxpayer’s income-producing
structure will be a capital expense (this distinction is sometimes known as
the “business entity” test or “business structure or process” test or “profit-
yielding structure” test). Revenue expenses generally provide the taxpayer
with benefits in the current year, while capital expenses generally provide
the taxpayer with benefits over a period of years.
Although capital expenses are not immediately deductible under s 8-1, the
taxpayer may be entitled to deduct a portion of the expenses over a number
of years to correspond with the expected benefits from the expense: see
Chapter 14. In other cases, the taxpayer may be able to recognise the
expense upon disposal of the asset or some other event under the provisions
regarding the taxation of capital gains: see Chapter 11.
Judicial tests [12.180]
One of the earliest attempts to distinguish between capital and revenue
expenses occurred in Vallambrosa Rubber Co Ltd v Farmer (1910) 5 TC 529.
In that case, Lord Dunedin stated that “capital expenditure is a thing that is
going to be spent once and for all, and income expenditure is a thing that is
going to recur every year” (at 536). The test merely required an examination
of the form of the expense. While such a test had the advantage of
simplicity, in practice, it soon proved to be inadequate. In British Insulated
and Helsby Cables Ltd v Atherton [1926] AC 205 at 213–214, Viscount Cave
LC suggested that “where an expenditure is made, not only once and for all,
but with a view to bringing into existence an asset or an advantage for the
enduring benefit of a trade, I think that there is a very good reason ... for
treating such an expenditure as properly attributable not to revenue but to
capital”. This became known as the “enduring benefit test” and focused on
the effect of the expense in determining its character. This test is often still
referred to, and while it can be useful in distinguishing between revenue and
capital expenses, it is sometimes difficult in practice to determine the
expected benefit from an expense when it is incurred.
The courts continued to apply various tests in characterising expenses with
no definitive guidance emerging from the cases until Sun Newspapers Ltd
and Associated Newspapers Ltd v FCT (1938) 61 CLR 337, one of the most
important cases in income tax. In Sun Newspapers, Dixon J (as he then was)
set out the distinction between expenses related to business processes
(revenue expenses) and expenses related to business structure (capital
expenses), mentioned above. This distinction was not new and had been
variously argued and applied in previous cases, but Dixon J’s clear
articulation of the test has resulted in the case being the leading precedent
for distinguishing between capital and revenue expenses.
Case study 12.10: Capital expenses
In Sun Newspapers Ltd and Associated Newspapers Ltd v FCT (1938) 61 CLR
337, the taxpayer was a newspaper publisher. The taxpayer’s principal
competitor was the World published by Sydney Newspapers Ltd. Sydney
Newspapers proposed to introduce a rival paper, the Star, which would sell
for two-thirds of the price of the Sun, published by the taxpayer. The
taxpayer made a payment to Sydney Newspapers for the right to use its
plant and equipment for a period of three years and for an agreement that it
would not establish a new newspaper, the Star, for the same period. The
taxpayer immediately ceased publication of the World once it took over the
plant and equipment. In effect, the payment resulted in Sun Newspapers
shutting down an existing rival newspaper (the World) and preventing the
publication of a new rival (the Star) for a period of three years.
The taxpayer tried to claim a deduction for the payment over a period of
three years, but there was no provision in the income tax legislation which
would allow it to do so. The taxpayer then claimed an immediate deduction
for the payment on the basis that the expenses would safeguard and
increase the taxpayer’s revenue (ie, its assessable income). The
Commissioner argued that as the payment resulted in an addition to the
goodwill of the business, benefited the business as a whole and was a
monopoly for a capital asset, the payment was therefore capital in nature. A
majority of the High Court concluded that the payment was a non-deductible
capital expense as the taxpayer had acquired a non-wasting capital benefit
(ie, an “enduring benefit”) by effectively shutting down its competitor. Dixon
J reached the same conclusion by distinguishing between expenses related
to the taxpayer’s income-producing process and expenses related to the
taxpayer’s income-producing structure. The payment strengthened or
preserved the taxpayer’s business structure and, as such, was capital in
nature.
In applying the distinction between business structure and business process,
Dixon J suggested that the following three factors should be considered:
• Character of the advantage sought. This requires a consideration as to
whether the expense results in a lasting or a temporary benefit for the
taxpayer. An expense that results in the taxpayer receiving a lasting benefit
is more likely to be a capital expense, whereas an expense that results in the
taxpayer receiving a temporary benefit is less likely to be a capital expense.
• Manner in which the benefit is to be used, relied upon or enjoyed. This is
similar to the first factor and requires a consideration as to whether the
benefit received by the taxpayer is a single, substantial, enduring benefit
upon which the taxpayer relies in a constant way, or rather a benefit that is
relied upon, or enjoyed, in a short-term sense, though recurrently. A benefit
received once and for all is more likely to be a capital expense, whereas a
benefit that is received recurrently, for short-term periods, is more likely to
be a revenue expense.
• Means adopted to obtain the benefit. This looks at whether the taxpayer
acquired the benefit through recurrent payments or a one-off payment. A
recurrent payment is less likely to be capital expense, while a lump sum
payment is more likely to be a capital expense.
In discussing these three factors, Dixon J clearly stated that none of the
factors is definitive and all three factors are to be considered together in
reaching a conclusion as to whether an expense is a capital expense. With
modern financing practices, the third factor has become much less useful as
it is possible for taxpayers to purchase capital assets through instalment
payments, rather than lump sum amounts.
Since Sun Newspapers, courts generally conclude that a capital expense is
the acquisition of a means of production (related to the income-producing
structure), whereas a revenue or non-capital expense would be for the use of
the means of production (related to the income-producing process).

Example 12.3: Capital expenses

Dominic owns a pizza-making business. He incurs an expense of $3,000 to
purchase an oven which he uses to make pizzas and approximately $100 in
monthly electricity expenses.
Applying Dixon J’s three factors to the two expenses:
Character of the advantage sought
• The pizza oven will provide Dominic with a long-lasting benefit and is
therefore more likely to be a capital expense.
• The monthly electricity expenditure is for a short-term, one-month benefit
(albeit a benefit that could continue, provided Dominic pays the next
monthly bill) and is therefore more likely to be a revenue expense.
Manner in which the benefit is to be used or enjoyed
• The pizza oven will provide Dominic with a benefit that he can rely on once
and for all and is therefore more likely to be a capital expense.
• The electricity is a recurring benefit (in that he uses it by the month, on a
recurring basis) and is therefore more likely to be a revenue expense.
Means adopted to obtain the benefit
• Dominic paid for the pizza oven in one lump sum payment of $3,000,
which indicates that the expense is more likely to be capital.
• The electricity bills are recurrent monthly expenses, which are more likely
not to be capital.
Looking at the three factors overall, it is likely that the payment for the pizza
oven would be a capital expense, whereas the electricity payments would
not be. Further, the acquisition of the pizza oven is the acquisition of a
means of production (to make pizzas), which relates to Dominic’s income-
producing structure, whereas the electricity payments are for the use of that
means of production, which relates to Dominic’s income-producing activities
or process.
[12.190] Although there is a clear articulation of the distinction between
capital and revenue expenses and three factors which can be looked at to
make that determination, the characterisation of capital and revenue
expenses is not quite so straightforward in practice. In fact, the
Commissioner and the taxpayer often apply these same tests in reaching
opposite conclusions. As observed by Green MR in IRC v British Salmson Aero
Engines Ltd [1938] 2 KB 482 at 488, “in many cases it is almost true to say
that a spin of the coin would decide the matter almost as satisfactorily as an
attempt to find reasons”. The following cases illustrate the difficulty in
characterising expenses as revenue or capital, even when applying Dixon J’s
test and factors to the same or similar facts.
Case study 12.11: Exclusivity payments not capital in nature
In BP Australia Ltd v FCT (1965) 112 CLR 386, the taxpayer was a petrol
wholesaler. The taxpayer entered into “tied house” agreements with several
service stations. Under the agreements, the service stations agreed to sell
the taxpayer’s petrol exclusively for an average period of just under five
years in return for a lump sum payment. Prior to the agreement, the service
stations sold petrol from several different wholesalers. The Privy Council
considered the application of Dixon J’s test and factors in characterising the
payments.

As to the first factor, the character of the advantage sought, the Privy
Council suggested that it is necessary to consider the lasting qualities of the
benefits, the recurrence of the benefits and the reasons for the expenditure.
Looking at the facts that the expenses came about because of a change in
marketing practices in 1951, the relatively short exclusivity period and the
lack of a permanent solution, their Lordships suggested that the payments
were a revenue expense. As to the second factor, their Lordships concluded
that “the benefit was to be used in the continuous and recurrent struggle to
get orders and sell petrol” and were part of the ordinary process of selling,
which made them revenue in nature. Their Lordships did not find the third
factor particularly useful as it did not point clearly in either direction. Their
Lordships stated that “the case is not easy to decide” but “an allocation to
revenue is slightly preferable”. In concluding that the payments were
revenue expenses, the Privy Council reversed the decision of the High Court
of Australia in BP Australia Ltd v FCT (1964) 110 CLR 387. The majority of the
High Court (Dixon CJ dissenting) applied the same test and factors to
conclude that the payments were capital in nature.
Case study 12.12: Exclusivity payments capital in nature
In Strick v Regent Oil Co Ltd [1966] AC 295, the taxpayer secured exclusive
sales ties through a lease premium arrangement. Under the arrangement,
the retailers leased their stations to the taxpayer for between 10 and 20
years in exchange for a lump sum lease premium. The taxpayer then sublet
the stations back to the retailers at nominal rent on condition that the
retailer sold the taxpayer’s oil exclusively. The House of Lords found that the
lease premium payments were capital in nature. An important element in
this case was the fact that the lease premium arrangements provided the
taxpayer with a substantially longer benefit than the taxpayer in BP
Australia. Lord Reid stated: “I would have great difficulty in regarding a
payment to cover 20 years as anything other than a capital outlay.”
Form and substance [12.200]
BP Australia Ltd v FCT (1965) 112 CLR 386 (see Case Study [12.11]) and
Strick v Regent Oil Co Ltd [1966] AC 295 (see Case Study [12.12]) suggest
that the frequency of payments may be relevant in characterising an
expense as capital or revenue. Other cases indicate that the courts will
examine the substance of a payment and not just its form in determining
whether an expense is capital or revenue in nature.
Case study 12.13: Lump sum payment held to be revenue expense
In National Australia Bank Ltd v FCT (1997) 37 ATR 378, the taxpayer made a
large lump sum payment to the Commonwealth Government. In return, the
taxpayer became the exclusive lender under a Commonwealth subsidised
home loan scheme for members of the defence force for a period of 15
years. The taxpayer sought a deduction for the lump sum payment on the
basis that it was akin to a marketing expense or minimum royalty payment.
The Commissioner argued that the payment was a capital expense as it
resulted in the taxpayer having a monopoly over a particular class of
taxpayers and therefore provided the taxpayer with an enduring benefit.
The Full Federal Court concluded that the lump sum payment was a
deductible revenue expense. In applying Dixon J’s test and factors, the Court
held that the character of the advantage sought was the expansion of its
customer base and the potential increase in its income from loan activities.
Importantly, the payment was not considered to create a monopoly or add to
the structure of the taxpayer’s business as defence force members were not
required to obtain their home loan from the taxpayer and could go to other
banks.
Case study 12.14: Monthly “rental” payments held to be capital
expense
In Colonial Mutual Life Assurance Society Ltd v FCT (1953) 89 CLR 428, the
taxpayer purchased a block of land. The consideration for the transfer was a
“rent charge” to be paid monthly for a period of 50 years. The “rent charge”
was equal to 90% of the annual rents on three shops and a basement on the
transferred land. Payment of the “rent charge” was conditional on the rents
being received.
The Full High Court concluded that the “rent charge” was a capital expense.
The so-called rental payments were in effect consideration for the acquisition
of the land. Fullager J stated that “the documents make it quite clear that
these payments constitute the price payable on the purchase of land, and
that appears to me to be the end of the matter. It does not matter how they
are calculated, or how they are payable, or when they are payable, or
whether they may for a period cease to be payable. If they are paid as parts
of the purchase price of an asset forming part of the fixed capital of the
company, they are outgoings of capital or of a capital nature”.
The examination of the substance of an expense is not limited to the
frequency of the payments. In FCT v Star City Pty Ltd (2009) 72 ATR 431, the
Full Federal Court looked beyond the contract documents to additional
background information in concluding that the substance of a payment was
capital in nature although the form of the payment suggested otherwise.
Case study 12.15: Payment held to be capital based on substance
rather than form
In FCT v Star City Pty Ltd (2009) 72 ATR 431, the taxpayer had an exclusive
licence to operate a casino in Sydney. Under the terms of its agreement with
the NSW Government, the taxpayer was granted a 99-year lease over the
land where the casino was located and a 12-year exclusive licence to
operate the casino. The taxpayer was required to make an upfront payment
for the licence plus a payment of $120 million, which was described as
prepaid “rent” for the first 12 years of land rental. The Full Federal Court
examined the background documentation, which clearly indicated that the
value of the rent was related to the benefits that would be enjoyed by the
taxpayer in operating the casino under an exclusive licence, and held that
the “rent” was a capital expense. The High Court refused the taxpayer
special leave to appeal from the decision of the Full Federal Court.
A similar conclusion was reached by the Full Federal Court in Jupiters Ltd v
DCT (2002) 50 ATR 236. The taxpayer entered into an agreement with the
Queensland Government under which, in return for “special rent” payments,
the Government would not permit the operation of another casino within 60
km of the taxpayer’s casino. The “rent” payments were frequent and regular,
but the Court concluded that they were capital in nature as the benefit
acquired was “to secure the advantage of exclusivity and freedom from
competition”, which relates to the taxpayer’s income-producing structure.
Summary [12.210]
As illustrated by the cases discussed here, the characterisation of an
expense as capital or revenue is not an easy issue. It is necessary to apply
the three factors from Sun Newspapers Ltd and Associated Newspapers Ltd v
FCT (1938) 61 CLR 337 (see Case Study [12.10]) to the expense and
consider whether the expense relates to the taxpayer’s income-producing
process (revenue expense) or income-producing structure (capital expense).
In some cases, it may be necessary to look beyond the form of the
transaction or payment and examine its substance to determine its
character. Remember that although capital expenses are not immediately
deductible under s 8-1, the expenses may be deductible over a period of
years (see Chapter 14) or taken into account when an event, such as a
disposal, happens to the relevant asset: see Chapter 11.
The distinction between capital and revenue expenses will be considered
further when we look at some commonly incurred expenses: see [12.330].
The distinction can be particularly difficult to apply in the case of legal
expenses: see [12.840].
Private or domestic [12.220]
Under s 8-1(2)(b) of the ITAA 1997, losses or outgoings of a private or
domestic nature will not be deductible under s 8-1. There is some question
as to whether the second negative limb is strictly necessary, as expenses
which are private or domestic in nature are unlikely to be incurred in gaining
or producing assessable income and therefore would not satisfy either of the
positive limbs of s 8-1. Nonetheless, the second negative limb ensures that
such expenses would not be deductible under s 8-1.
There is no clear test as to whether an expense is private or domestic in
nature. In broad terms, private or domestic expenses are those which are
incurred to put the taxpayer in a position to gain or produce assessable
income, as opposed to expenses incurred in gaining or producing assessable
income. Another way of looking at it is that private or domestic expenses are
incurred regardless of the taxpayer’s income-producing activities (eg, food
and shelter). But it does not necessarily follow that an expense will not be
private or domestic in nature simply because it has some connection to the
taxpayer’s income-producing activities. This was made clear by the Full
Federal Court in FCT v Cooper (1991) 21 ATR 1616.
Case study 12.16: Private or domestic expenses
In FCT v Cooper (1991) 21 ATR 1616, the taxpayer was a professional rugby
player who received instructions from his coach requiring him to eat more
meat and potatoes and drink more beer, in addition to his normal meals, to
improve his fitness for the following season. The taxpayer sought a
deduction for the additional food and alcohol costs on the basis that the
expenses were incurred in gaining or producing his assessable income.

The Commissioner denied the taxpayer a deduction on the basis that the
expenses were private or domestic in nature. The Full Federal Court agreed
with the Commissioner’s argument, finding that the expenses were incurred
in putting the taxpayer in a position to carry out his income-producing
activities, rather than being incurred in the carrying on of those activities.
Therefore, the expenses did not satisfy the positive limbs of the predecessor
to s 8-1 and were specifically excluded from being deductible as they were
private or domestic in nature. The fact that the taxpayer was instructed by
his coach to consume the additional food and drink, and therefore incur the
additional expenditure, did not change the character of the expenditure,
which was for food and drink to sustain life.
In FCT v Cooper, the Full Federal Court also stated that the taxpayer’s
income-producing activities did not include the consumption of food and
drink and, as such, the expenditure on food and drink was not related to the
production of the taxpayer’s assessable income. Where the consumption of
food and drink is incurred in the course of gaining or producing the
taxpayer’s assessable income, expenditure on food or drink will be
sufficiently connected to the production of assessable income and not
constitute a private or domestic expense. For example, a food critic incurs
expenditure on food or drink in the course of gaining or producing their
assessable income. Similarly, expenditure on food or drink incurred while a
taxpayer is required to travel overnight for work purposes is incurred in the
course of gaining or producing assessable income: see Ruling TR 98/9.
Case study 12.17: Expenses not private or domestic
In FCT v Day (2008) 70 ATR 14 (see Case Study [12.2]), the Commissioner
also argued that the legal expenses were not deductible as they were a
private or domestic expense. The High Court rejected this argument and
found that the legal expenses were not private or domestic in nature. Crucial
to the taxpayer’s success on this issue were the facts that the taxpayer was
exposed to the action because of his employment and the charges were
brought against him by his employer.
Several other cases regarding private or domestic expenses will be
considered later in the chapter when we consider the application of s 8-1 to
some commonly incurred expenses: see [12.330].
Incurred in gaining or producing exempt or non-assessable non-
exempt income [12.230]
As with the second negative limb, there is some question as to whether the
third negative limb is strictly necessary, as expenses that are incurred in
gaining or producing exempt or non-assessable non-exempt income would
not satisfy either of the positive limbs of s 8-1 of the ITAA 1997 as they
would not be incurred in gaining or producing assessable income.
Nevertheless, s 8-1(2)(c) ensures that such expenses would not be
deductible under s 8-1 since the income to which the expense relates is not
subject to tax in Australia. To allow a deduction for such expenses would
inappropriately reduce the taxpayer’s tax payable on any other unrelated
income.
Example 12.4: Expenses incurred in gaining or producing exempt
income
Leela is a primary school teacher who is a resident of Australia for
income tax purposes. She has taken a five-year leave of absence
from her job and is currently teaching English in Africa. She is
employed by a charitable institution that is exempt from income tax
under s 50-50(1)(c) of the ITAA 1997. Leela incurred annual
membership fees of $200 for the Teaching Institute of Australia. She
is required to be a member of the Institute to be employed by the
charity.
Leela’s salary for teaching in Africa is exempt from tax in Australia
under s 23AG of the ITAA 1936. Leela will not be able to claim a
deduction for her membership fees as they relate to the production
of exempt income.
Denied deductions [12.240]
The last of the negative limbs in s 8-1 of the ITAA 1997 provides that an
expense will not be deductible under s 8-1 where another section in the
income tax legislation states that the expense is not deductible for tax
purposes. The provisions that operate to deny a deduction are mainly
contained in Div 26, but there are also a number of other provisions
scattered throughout both the ITAA 1936 and the ITAA 1997. The provisions
may operate to deny a deduction for an expense either in whole or in part.
The expenses that are denied deductions are generally not deductible for
policy reasons, such as where the government does not want to reward or
promote certain types of behaviour. Some examples of expenses that are not
deductible for tax purposes are: • Penalties – All forms of penalties, whether
or not they are described as penalties, imposed under Australian or foreign
laws are not deductible under s 26-5(a). Any court-ordered amounts payable
in respect of a conviction under an Australian or foreign law are also not
deductible: s 26-5(b).
– Disallowing a tax deduction for penalties preserves the policy intent of the
penalty, which is generally to discourage taxpayers from undertaking certain
behaviour.
– Note that the penalty must be imposed under a government law and
therefore s 26-5 only applies to government penalties and not to penalties
arising in a private context (e.g., penalties imposed by sporting clubs or
libraries).
– Note also that penalties are different to damages. Penalties are “imposed
as a punishment of the offender considered as a responsible person owing
obedience to the law”: Gavin Duffy CJ and Dixon J in Herald and Weekly
Times Ltd v FCT (1932) 48 CLR 113 at 120. Damages, on the other hand, are
an attempt to compensate a plaintiff (the victim) in financial terms for harm
suffered due to the actions of the defendant (the alleged wrongdoer). As we
have seen in cases such as Herald and Weekly Times (see Case Study
[12.3]), payments for damages may be deductible where the requirements
of s 8-1 are satisfied.
• Expenditure related to rebatable benefits – In response to FCT v Anstis
(2010) 76 ATR 735 (see Case Study [12.34]), the government introduced s
26-19 which denies taxpayers a deduction for losses or outgoings incurred in
gaining or producing a rebatable benefit (e.g., Youth Allowance, Austudy).
• Assistance to students – As discussed in Chapter 3, the government
provides financial assistance in the form of loans to people undertaking
higher education, trade apprenticeships and other training programs.
Repayments of some of these debts or student contributions under the
Higher Education Support Act 2003 (Cth) are not deductible due to s 26-20.
– The non-deductibility of such expenses ensures that taxpayers do not get
an additional benefit in relation to their higher education fees in the form of
a reduction to their tax payable as the system already provides for financial
assistance and/or subsidised higher education.
– However, such expenditure is deductible when provided as a fringe benefit:
s 26-20(2).
– Note that s 26-20 does not prevent a deduction for full course fees where
the requirements of s 8-1 are satisfied. This is the case even
where the fees have been funded by the Higher Education Loan Programme
(FEE-HELP): see, for example, ATO ID 2005/26.
• Gifts or donations – Section 26-22 denies business taxpayers a deduction
for political gifts and donations: see [13.150]. Individuals can claim a
maximum deduction of $1,500 for political gifts or donations but not if the
gift or donation is made in the course of carrying on a business: ss 30-242
and 30-243. Where an individual makes a political gift or contribution in the
course of carrying on a business, the amount is not deductible due to s 26-
22.
– Section 26-55 stipulates that a taxpayer is not entitled to a deduction for a
gift or donation where the deduction would result in the taxpayer incurring or
increasing a tax loss for the year: see [13.140].
– A deduction for a gift or donation may also be denied due to s 78A of the
ITAA 1936: see [13.140].
• Relative’s travel expenses – Under s 26-30, expenses incurred by a
taxpayer attributable to a relative’s travel, so that the relative can
accompany the taxpayer on a work-related trip, are not deductible.
“Relative” is defined in s 995-1 as (a) the person’s spouse; or (b) parent,
grandparent, brother, sister, uncle, aunt, nephew, niece, lineal descendant
or adopted child of that person or of that person’s spouse; or (c) the spouse
of a person referred to in paragraph (b). “Spouse” is defined in s 995-1 to
include a person in a de facto relationship with the taxpayer, including same-
sex relationships.
– In Re WTPG v FCT [2016] AATA 971, the Administrative Appeals Tribunal
denied a deduction for a disabled taxpayer’s wife’s travel costs where she
accompanied him to overseas conferences because he required a carer. The
deduction was denied on the basis that the expenditure was private or
domestic in nature and because of s 26-30. The AAT held that it was not
possible to read into s 26-30 an exception for a relative accompanying a
taxpayer as a carer.
– The relative’s travel expenses will be deductible where the relative
accompanies the taxpayer in his or her own capacity as an employee and
would have done so regardless of the personal relationship (s 26-30(2)) or
where the travel expenditure is provided as a fringe benefit: s 26-30(3).
• Amounts paid to related entities – Section 26-35 provides that taxpayers
can only deduct so much of an expense paid to a related entity as the
Commissioner considers reasonable.
– “Related entities” are defined in s 26-35(2) as the taxpayer’s relative or a
partnership in which the taxpayer’s relative is a partner.
– Note that under s 26-35(4), any excess payment that is not deductible is
treated as non-assessable non-exempt income of the recipient. Therefore,
any amount in excess of what the Commissioner considers to be reasonable
is effectively treated as a gift from the taxpayer to the related entity. This is
an unusual situation where the assessability of an amount for one taxpayer
is determined by the deductibility of the amount for another taxpayer.
Example 12.5: Payments to related entities
Linda is a lawyer with her own successful legal practice. She recently
employed her son Scott, a university student, to work in her practice three
days a week as a receptionist. The market rate for receptionists is $20 per
hour, but Linda decided to pay Scott $40 an hour so that he does not need to
get a second job and can concentrate on his university studies. Generally,
salary and wages are fully deductible under s 8-1 as an ordinary business
expense. In this case, however, Linda’s deduction in relation to the salary
and wages paid to Scott is likely to be limited to $20 per hour (or some other
amount the Commissioner considers reasonable) as Scott is Linda’s son and
is therefore a “related entity”: s 26-35. Under s 26-35(4), Scott is only
required to include the amount that is deductible to Linda in his assessable
income and not the $40 per hour which he actually receives.
• Recreational club expenses – Membership fees or other related payments
for a recreational club are not deductible under s 26-45.
– “Recreational clubs” are defined in s 26-45(2) as companies providing their
members with facilities for drinking, dining, recreation or entertainment.
– However, under s 26-45(3), such expenses would be deductible where
provided as a fringe benefit.
• Bribes to foreign public officials and public officials – Sections 26-52 and
26-53 prevent taxpayers from claiming a deduction for bribes to foreign
public officials and public officials, respectively. Such expenses are not
deductible for policy reasons as the government seeks to discourage such
behaviour.
• Expenditure relating to illegal activities – Under s 26-54, taxpayers cannot
claim a deduction for a loss or outgoing incurred in the furtherance of, or
directly in relation to, a physical element of an offence against an Australian
law of which the taxpayer has been convicted if the offence was, or could
have been, prosecuted on indictment. The section was introduced in direct
response to FCT v La Rosa (2003) 53 ATR 1 (see Case Study [12.6]), where
the Full Federal Court permitted the taxpayer, a convicted drug dealer, a
deduction under s 8-1 for losses related to his drug-dealing operations.
• Travel expenses related to earning assessable income from residential
premises – Under s 26-31, taxpayers are denied a deduction for travel
expenses incurred in earning assessable income from residential premises.
Examples of such expenses include travel expenses to collect rent or to
inspect or maintain the property. The relevant travel expenses could relate
to motor vehicle expenses, taxi or hire car costs, airfares, public transport
costs, and any meals or accommodation related to the travel. The
deductibility of expenses incurred in engaging third parties, such as a real
estate agent, to manage investment properties is not affected by the
provision.
– The restriction on deducting travel expenditure does not apply if the
expenditure is: a) necessarily incurred in carrying on a business; b) incurred
by a corporate tax entity; c) incurred by a superannuation fund that is not a
self-managed fund, a managed investment trust or a public unit trust; or
d) incurred by a unit trust or partnership, provided each member of the trust
or partnership is one of the entities described in (b) or (c).
– Law Companion Ruling LCR 2018/7 provides guidance on the meaning of
“residential premises” and the meaning of “carrying on a business” for the
purposes of s 26-31. The Ruling also addresses the application of s 26-31 to
travel expenditure that serves more than one purpose.
• Non-compliant payments for work and services – From 1 July 2019, non-
compliant payments for work and services are not deductible under s 26-
105. A non-compliant payment arises where the payment is subject to the
withholding provisions in Sch 1 of the Taxation Administration Act 1953 (Cth)
(e.g., payments to employees or payments to contractors where a valid ABN
is not provided) and the payer does not comply with those provisions.
Entertainment expenses [12.250]
One of the main types of expenses that is not deductible is entertainment
expenses: Div 32 of the ITAA 1997. Section 32-5 is the key provision and
states that entertainment expenses are not deductible under s 8-1.
“Entertainment” is defined in s 32-10(1) as entertainment by way of food,
drink or recreation, or accommodation or travel related to the provision of
entertainment by way of food, drink or recreation. The expenses are
considered to be “entertainment” even if business discussions or
transactions take place: s 32-10(2). The note to s 32-10(2) suggests that
business lunches and social lunches will constitute entertainment, but meals
on business travel overnight, theatre attendance by a critic or a restaurant
meal consumed by a food writer are not considered to be entertainment.
The legislation thus takes a broad-brush approach to the denial of
deductions for entertainment expenses through ss 32-5 and 32-10. A
number of exceptions are then created in subdiv 32-B.
The main exception to the non-deductibility of entertainment expenses is for
entertainment provided by way of a fringe benefit: s 32-20. The amount of
the deduction in this case will depend on how the taxpayer has treated the
expenditure for fringe benefits tax purposes: see Chapter 7.
Example 12.6: Entertainment expenses provided as fringe benefit
Michael is a senior manager at a large accounting firm. He recently took one
of his key clients to lunch to discuss the upcoming audit process. The lunch
cost $200.
Prima facie, the firm cannot claim a deduction for the $200 as it constitutes
an entertainment expense. This is despite the fact that the purpose of the
lunch was to discuss the upcoming audit and therefore relates to the
production of assessable income by the firm. However, as Michael is an
employee, the firm may be entitled to a deduction for a portion of the lunch
cost as the cost of providing a fringe benefit. The amount of the deduction
will depend on how the firm treats meal entertainment expenses for fringe
benefits tax purposes. For example, if the firm elects to apply Div 9A of the
Fringe Benefits Tax Assessment Act 1986 (Cth) to meal entertainment
expenses and uses the 50/50 method to calculate taxable value, the taxable
value in this example would be $100 (50% of total meal entertainment
expenses). The firm would be entitled to a deduction of $100 in relation to
the meal expense: s 51AEA of the ITAA 1936. In this situation, the $100 is
treated as the cost of providing a fringe benefit (a deductible expense),
rather than as an entertainment expense.
Subject to the prescribed conditions being satisfied, some other expenses
that are excepted from the operation of s 32-5 and may be deductible under
s 8-1 include:
• expenses incurred in providing food or drink in an in-house dining facility: s
32-30, items 1.1–1.3;
• provision of food or drink to an employee under industrial arrangements
relating to overtime: s 32-30, item 1.4;
• an allowance to an employee that is included in the employee’s assessable
income: s 32-30, item 1.8;
• expenses on food, drink, accommodation or travel that are incidental to
the attendance at a seminar that lasts for at least four hours: s 32-35, item
2.1;
• the ordinary course of the taxpayer’s business or duties that include the
provision of entertainment (e.g., a restaurant providing meals to customers):
s 32-40; and
• promotion and advertising expenses: s 32-45.
Reimbursed expenditure [12.260]
Finally, s 51AH of the ITAA 1936 prevents taxpayers from claiming a
deduction for reimbursed expenditure. The denial of a deduction for
reimbursed expenditure is logical as the taxpayer is not actually out-of-
pocket as a result of the expense. In other words, they are in the same
economic position despite the expense. Further, a double deduction could
result if the entity making the reimbursement is entitled to a deduction (e.g.,
the employer) as well as the taxpayer who incurred the original expense
which has been reimbursed (e.g., the employee).
Example 12.7: Reimbursed expenditure
Sarah is a tax accountant. She paid a fee of $440 for her
membership of the Taxation Institute of Australia. Her employer
subsequently repaid Sarah for the expense.
Sarah cannot claim a deduction for the $440 membership fee as she
has been reimbursed for the expense by her employer.

Apportionment – deductibility of dual purpose expenses [12.270]

The phrase “to the extent that” appears twice in s 8-1 of the ITAA 1997 and
has important consequences. The phrase ensures that a loss or outgoing
may still be partially deductible even though:
• some portion of the loss or outgoing does not satisfy either of the positive
limbs of s 8-1; or
• some portion of the loss or outgoing does satisfy one of the negative limbs
of s 8-1.
The fact that a loss or outgoing may be partially deductible where the
taxpayer has a dual purpose in relation to the expense has long been
accepted: see, for example, Ronpibon Tin No Liability v FCT (1949) 78 CLR
47. The difficulty with regard to dual purpose expenses is in determining the
extent to which the expense may be deductible. The High Court in Ronpibon
Tin considered the appropriate apportionment formula for a partially
deductible expense and found that there can be no precise formula and the
apportionment is to be done on a case-by-case basis depending on individual
circumstances.
Case study 12.18: Dual purpose expenses
In Ronpibon Tin No Liability v FCT (1949) 78 CLR 47, the taxpayer produced
income from mines in Thailand (then Siam) which was exempt income in
Australia. The taxpayer also produced investment income in Australia, which
was subject to tax. During World War II, the taxpayer’s Siamese mines were
confiscated by the Japanese and the taxpayer did not receive any income
from the mines. The taxpayer incurred administrative and management
expenses which related to its production of Australian-sourced investment
income and its Siamese mining operations. The investment income was only
a small percentage of the taxpayer’s total income. Prior to the confiscation
of the Siamese mines, the Commissioner permitted the taxpayer a deduction
for only a small portion of the taxpayer’s expenses relating to the production
of Australian-sourced investment income.
Following the confiscation of the mines, the Commissioner continued to only
permit a deduction for a small percentage of the taxpayer’s expenses. The
taxpayer argued that apportionment was not required as it was no longer
gaining or producing exempt income from the overseas mines. Its only
income was the investment income, which was fully assessable. This
argument was rejected by the Full High Court. The expenses were not
incurred solely in relation to the investment income and continued to relate
to the halted overseas operations (e.g., the taxpayer made some
support payments to the families of employees who had been in Siam at the
time of the invasion). As such, apportionment was required and allowed for
by the predecessor to s 8-1 of the ITAA 1997. As to how much of the
expenses should be apportioned to the taxpayer’s overseas activities and
the investment income, the High Court concluded that this was a question of
fact that must be based on the taxpayer’s actual expenditure and activities.
The Court stated that “it is not for the court or the Commissioner to say how
much a taxpayer ought to spend in obtaining his income, but only how much
he has spent”. This is similar to the “business judgment rule” later espoused
by the Court in Magna Alloys & Research Pty Ltd v FCT (1980) 11 ATR 276:
see Case Study [12.5].
[12.280] Where the portion of the expense that relates to the production of
income is distinct and severable from the portion that is not related to the
production of income, the expense is apportioned between the two activities
accordingly. However, where the expense serves both an income-producing
purpose and some other purpose indifferently, it may be necessary to
examine the taxpayer’s purpose in incurring the expenditure to determine
the appropriate amount that is deductible. The High Court in Ronpibon Tin
No Liability v FCT (1949) 78 CLR 47 recognised that there can be no precise
formula for apportionment in such cases and it will be necessary to
determine a fair and reasonable division based on the taxpayer’s particular
circumstances.
Example 12.8: Dual purpose expenses
Hoong is a lawyer at a large firm. His mobile phone expenses for the
previous income year totalled $2,200. Hoong estimates that 70% of
his mobile phone use is for work purposes.
Hoong is entitled to a deduction for a portion of his mobile phone
expenses as he uses his phone for income-producing activities and
therefore the expense is incurred in gaining or producing Hoong’s
assessable income. The amount of the deduction should be a fair
and reasonable estimate which, in this case, is likely to be $2,200 ×
70% based on Hoong’s estimated use of his mobile phone.
Example 12.9: Dual purpose expenses
Leela is a primary school teacher who is a resident of Australia for
income tax purposes. She recently taught English in Africa for six
months. She was employed to teach in Africa by a charitable
institution, which is exempt from income tax under s 50-50(1)(c) of
the ITAA 1997.

Leela incurred expenses of $200 for her annual membership fees of

the Teaching Institute of Australia. Leela is required to be a member
of the Institute in order to teach in Australia and with the charitable
institution.
Leela’s salary for teaching in Africa is exempt from tax in Australia
under s 23AG of the ITAA 1936.
The $200 membership fees are deductible under s 8-1 as they are
incurred in the production of Leela’s assessable income. However,
some portion of the $200 may not be deductible if it relates to
Leela’s overseas income, which is not assessable in Australia. Leela
will need to make a fair and reasonable estimate of the portion of
the expense that relates to her Australian assessable income. This
may be done, for example, on the basis of the percentage of
assessable teaching income over total teaching income.
The apportionment of expenses incurred for income-producing and
private purposes is discussed in more detail later in this chapter
when we consider the application of s 8-1 to some commonly
incurred expenses: see, in particular, [12.690].

Amount of deduction [12.290]

As a general rule, taxpayers are entitled to deduct the full amount of an
expense or loss once it is determined that the requirements of s 8-1 of the
ITAA 1997 are satisfied. However, the question has arisen in some situations
as to whether the full amount or some lesser amount is deductible. In
particular, the courts have considered whether a taxpayer’s expense needs
to be “reasonable” to be deductible and whether consideration should be
given to the taxpayer’s subjective purpose in incurring an expense.
Reasonable vs actual expense [12.300]
The courts have consistently stated that the deductibility of a loss or
outgoing does not depend on whether it is commercially realistic or
reasonable but that it is a question of judgment to be made by the taxpayer
based on their individual circumstances. As stated by Ferguson J in Tooheys
Ltd v Commissioner of Taxation for NSW (1922) 22 SR (NSW) 432 at 440–
441: A taxpayer is liable to be taxed on the income he has made, not on
what he might have made. It is nothing to the point that if he had been more
capable, more experienced or more prudent, he might have cut down his
expenses. The question is what he did in fact spend on his business. If he
chooses to employ a hundred men where twenty would have been ample,
that is his own affair. Of course, it may still be a matter for enquiry whether
these men were really employed in the business, or were merely put on the
pay-roll as a device to swell the apparent expenses of the business; but that
is another matter.
In Tweedle v FCT (1942) 7 ATD 186 at 190, Williams J stated:
It is not suggested that it is the function of income tax Acts or those who
administer them to dictate to taxpayers in what business they shall engage
or how to run their business profitably or economically. The Act must operate
upon the results of a taxpayer’s activities as it finds them. If a taxpayer is in
fact engaged in two businesses, one profitable and the other showing a loss,
the Commissioner is not entitled to say he must close down the unprofitable
business and cut his losses even if it might be better in his own interest and
although it certainly would be better in the interests of the Commissioner if
he did so.
Similar comments were made by the Full High Court in Ronpibon Tin No
Liability v FCT (1949) 78 CLR 47 at 60 (see Case Study [12.18]), where it was
stated that “it is not for the Court or the commissioner to say how much a
taxpayer ought to spend in obtaining his income, but only how much he has
spent”. In Magna Alloys & Research Pty Ltd v FCT (1980) 11 ATR 276 (see
Case Study [12.5]), Deane and Fischer JJ articulated the “business judgment
rule” – that it is for the people who run the business to determine what is
desirable and appropriate for that business.
The courts’ comments in these and other cases are generally well accepted
and, as a result, taxpayers are entitled to deduct the full amount of any
expenses incurred if the requirements of s 8-1 are satisfied. For example, a
first-class airfare or the cost of designer (e.g., Prada) sunglasses incurred in
gaining or producing assessable income will be deductible under s 8-1, as
long as the requirements of the section are met. The amount of the expense
cannot be limited to an economy-class airfare or a non-designer pair of
sunglasses. However, note that a statutory provision may apply in certain
circumstances to limit the amount of a deduction to a reasonable amount. As
we have seen at [12.240], s 26-35 operates to limit the amount of a
deduction for a payment made to a related entity to what is considered
reasonable by the Commissioner. In other situations, the Commissioner could
potentially seek to apply the general anti-avoidance provision in Pt IVA of the
ITAA 1936 (see Chapter 23) to deny a deduction. In an international context,
Div 815 of the ITAA 1997 permits the Commissioner to substitute the
“transfer price” (i.e., the price at which related parties transact) with an
arm’s length amount (see Chapter 22).
Tax minimisation situations – purpose [12.310]
As mentioned at [12.60], a taxpayer’s subjective purpose or intention in
incurring an expense is generally not relevant in determining deductibility.
Traditionally, the courts have adopted a legal rights approach in determining
whether the elements of s 8-1 are satisfied. Under this approach,
courts have only considered the objective circumstances of a loss or
outgoing in determining its deductibility under s 8-1 and not the taxpayer’s
subjective purpose or intention in incurring the expense. The leading case on
the legal rights doctrine is Europa Oil (NZ) Ltd v CIR (NZ) (No 2) (1976) 5 ATR
744, where the Privy Council only looked at the actual legal rights acquired
as a result of an expense without considering any related benefits or
arrangements which were not set out in the contract itself.
The Privy Council’s precedent was followed in several Australian cases in the
1970s. For example, in FCT v South Australian Battery Makers Pty Ltd (1978)
14 CLR 645, a majority of the High Court permitted the taxpayer a deduction
for the full amount of rental payments on a property even though the rental
payments in effect reduced the purchase price of the property for a related
company. The Commissioner had sought to argue that a portion of the rental
payments should be attributable to the purchase price of the property and
thus a capital expense, but this argument was not accepted by the Court.
Applying the legal rights approach, the majority concluded that the only
benefit acquired from the rental payments was the rental of the property and
the entire payment was therefore deductible as an ordinary business
expense.
By the 1980s, however, Australian courts sought to move away from the
traditional legal rights approach and considered the taxpayer’s purpose or
intention in incurring an expense in certain circumstances. Broadly, the
taxpayer’s subjective purpose or intention in incurring an expense may be
relevant where the taxpayer is in a loss position for tax purposes (ie,
deductions exceed assessable income) and the taxpayer’s purpose in
incurring a particular expense appears to be one of tax minimisation: Ure v
FCT (1981) 11 ATR 484; Fletcher v FCT (1991) 173 CLR 1. In such cases, the
amount of the deduction may be limited to the amount of income produced
by the expense, even though the elements of s 8-1 are satisfied.
Case study 12.19: Expenses incurred with a tax minimisation
purpose
In Ure v FCT (1981) 11 ATR 484, the taxpayer borrowed money at interest
rates ranging from 7.5% to 12.5%. He then on-lent the borrowed money to
his wife and a family trust at an interest rate of 1%, thereby producing
assessable income from the funds and making the interest payable on the
original loans deductible for tax purposes. The wife and the family trust
directly and indirectly invested the funds in debt instruments paying
competitive market rates.
Although the Full Federal Court did not expressly rest its decision on the
taxpayer’s purpose in incurring the expenditure, that is essentially what it
did in finding that most of the interest expense was not deductible as it was
a private or domestic outgoing. The Court concluded that the only
explanation for the 1% interest rate was that it was a private or domestic
arrangement. As a result, the Court limited the amount of the taxpayer’s
deduction for the interest expenditure to the amount of interest income
gained or produced under the on-lending arrangement, that is, 1%.
Case study 12.20: Expenses incurred with a tax minimisation
purpose
Fletcher v FCT (1991) 173 CLR 1 involved a complex arrangement whereby
the taxpayer effectively incurred substantial interest expenses with little or
no actual outlay. The interest expenses related to the purchase of an annuity.
Under the applicable tax accounting rules, the interest payments
substantially exceeded the assessable annuity amounts in the early years of
the arrangement. This resulted in a tax loss that could be applied to reduce
the taxpayer’s overall tax liability. The annuity amounts would in later years
exceed the interest payments, but the taxpayer had the option of ending the
arrangement prior to that time.
The Commissioner argued that the taxpayer did not intend to continue the
arrangement until it generated assessable income in excess of the interest
deductions. Therefore, the interest expenses should not be deductible under
s 8-1 taking into account the taxpayer’s subjective purpose or intention in
incurring the expense since the taxpayer’s purpose was not to gain or
produce assessable income. The High Court found that the taxpayer’s
subjective purpose or intention was relevant in these circumstances. If it
could be shown that, at the outset, the taxpayer intended to end the
arrangement prior to it being profitable, the interest expenses would not be
deductible under s 8-1. The High Court remitted the matter back to the AAT
for a factual determination of purpose. In AAT Case 5489A (1992) 23 ATR
1068, the AAT found that the taxpayer’s dominant purpose in incurring the
expense was to minimise tax and not to gain assessable income. The
taxpayer’s appeal to the Full Federal Court from the AAT’s decision was
dismissed in Fletcher v FCT (1992) 92 ATC 4611.
The decisions in Ure and Fletcher endorse the view that a taxpayer’s
subjective purpose or intention may be relevant where the taxpayer incurs
the expenses in such a way as to only generate a small amount of
assessable income which results in a tax loss. The expenses that are
deductible under s 8-1 may be limited in these circumstances. Note that
these situations are different to negative gearing, which is discussed at
[12.820]. Here, the taxpayers never intended for the arrangements to be
profitable, whereas in a negative gearing arrangement, the taxpayer
generally intends that the arrangement will be profitable overall. The
Commissioner’s guidance on the relevance of subjective purpose, motive or
intention in determining the deductibility of losses and outgoings is
contained in Ruling TR 95/33.
Note also that in these situations, the Commissioner could apply the general
anti-avoidance provision in Pt IVA of the ITAA 1936 (see Chapter 23) to deny
the deduction.

Substantiation of deductions [12.320]

In order to claim a deduction for tax purposes, taxpayers must be able to
substantiate the deduction by maintaining proper records and
documentation. The substantiation requirements are outlined in Div 900 of
the ITAA 1997 and taxpayers are generally expected to keep evidence and
records relating to the expense for a period of five years under s 900-165.
For most expenses, taxpayers should obtain a document from the supplier
containing the following information (s 900-115):
• name or business of the supplier;
• amount of the expense;
• nature of the goods and services;
• date expense incurred; and
• date of document.
Specific substantiation rules may apply in relation to certain expenses, such
as car expenses: see [12.450]–[12.570]. To reduce the compliance burden,
taxpayers may deduct up to $300 of work expenses and $150 of laundry
expenses without written evidence: ss 900-35 and 900-40.
Where a taxpayer receives a travel or overtime meal allowance, the
taxpayer is exempted from the substantiation rules where the amounts
claimed in relation to the allowance do not exceed the Commissioner’s
reasonable limits: ss 900-50, 900-55, 900-60. The Commissioner’s
reasonable limits are set out in Determination TD 2020/5 for the 2020–2021
income year. The Determination should be read in conjunction with Ruling TR
2004/6, which discusses the substantiation exception for reasonable travel
and overtime meal allowance expenses.
Application of section 8-1 to commonly incurred expenses [12.330]
We have now examined the key issues in relation to deducting an expense
under s 8-1 of the ITAA 1997. In the rest of this chapter, we will apply these
rules to consider the deductibility under s 8-1 of the following commonly
incurred expenses:
• expenses incurred in gaining employment: see [12.340];
• relocation expenses: see [12.360];
• child care expenses: see [12.370];
• travel expenses: see [12.380];
• self-education expenses: see [12.580];
• home office expenses: see [12.700];
• clothing expenses: see [12.740];
• interest expenses: see [12.810]; and
• legal expenses: see [12.840].
Many of these expenses may be considered quasi-personal, and the courts
have had to consider whether the expenses are sufficiently connected to the
production of assessable income or whether they could be considered
private or domestic. In other situations, such as with legal expenses, the
issue is generally whether the expenses are capital or revenue in nature. The
Commissioner’s guidance on the deductibility of employee work expenses
under s 8-1 is contained in Taxation Ruling TR 2020/1.

Expenses incurred in gaining employment [12.340]

As discussed at [12.130], expenses related to gaining or producing future
assessable income can sometimes satisfy the positive limbs of s 8-1.
However, in the case of expenses incurred in gaining employment (e.g.,
travel expenses to attend an interview or legal expenses to review an
employment contract), the expenses are generally considered to be too early
for the production of assessable income. The expenses are considered to
have been incurred to put the taxpayer in a position to gain or produce
assessable income, not in gaining or producing assessable income: FCT v
Maddalena (1971) 2 ATR 541.
Case study 12.21: Expenses incurred in gaining employment not
deductible
In FCT v Maddalena (1971) 2 ATR 541, the taxpayer was an
electrician who was also a rugby player. The taxpayer incurred
travel and legal expenses in considering whether to change rugby
clubs, which he sought to deduct under the predecessor to s 8-1.

The Full High Court agreed with the Commissioner in concluding

that the expenses were not deductible under the predecessor to s
8-1 as they were not sufficiently connected to the taxpayer’s
production of assessable income. The expenses were incurred in
putting the taxpayer in a position to produce assessable income,
rather than in producing assessable income. As such, the positive
limbs of the predecessor to s 8-1 were not satisfied.
Business taxpayers [12.350]
In Spriggs v FCT; Riddell v FCT (2009) 72 ATR 148, with regard to expenses
incurred in gaining employment, the High Court drew a distinction between
taxpayers who are carrying on a business and those who are not.
Case study 12.22: Expenses incurred in gaining employment –
business taxpayers
In Spriggs v FCT; Riddell v FCT (2009) 72 ATR 148 (see Case Study [8.9]), the
taxpayers were a professional football player and a professional rugby
player, respectively. The taxpayers incurred management fees, and the
deductibility of these fees was in dispute. It was accepted by all parties that
the management fees were in fact incurred in the negotiation of employment
contracts. Following FCT v Maddalena (1971) 2 ATR 541 (see Case Study
[12.21]), the Full Federal Court denied the taxpayers a deduction for the
management fees on the basis that they were incurred in negotiating
employment contracts and were therefore incurred in putting the taxpayers
in a position to gain or produce assessable income, rather than in the course
of gaining or producing assessable income. It was not in dispute that the
non-playing activities of the taxpayers constituted a business for tax
purposes.

The Full High Court found that the negotiated contracts were employment
contracts, but that they were not solely employment contracts as they
included terms and conditions regarding promotional activities to be carried
on independently of the players’ clubs. This meant that the employment
contracts also related to the production of the taxpayers’ business income.
As such, the Court found that all of the taxpayers’ activities (playing and
non-playing) constituted a business for tax purposes. The Court rejected the
Commissioner’s argument that it was necessary to separate the taxpayers’
playing activities (employment) from their non-playing activities (business).

The Court noted that taxpayers can have different income-producing

activities and even different businesses, but that was not the case here.
Looking at the relevant indicia for a business, the Court found that the
taxpayers were engaged in the business of commercially exploiting their
sporting prowess and associated celebrity for a limited period. Following the
conclusion that all of the taxpayers’ activities amounted to a business, the
Court found that the management fees were incurred in gaining or producing
assessable income as there was sufficient connection between the
management fees and the production of business income. The Court held
that FCT v Maddalena was distinguishable from the present case as there
was no evidence as to any of the indicia for business in that case. It could
not be said that the taxpayer in FCT v Maddalena was carrying on a
business, a part of which included the taxpayer’s employment as a rugby
player.
Following the High Court’s decision in Spriggs v FCT; Riddell v FCT, it would
appear that expenses incurred in gaining employment may be deductible
where the taxpayer is carrying on a business and the employment contract
contributes towards the production of business income (i.e., the employment
contract is not solely an employment contract). This is likely to be the case
for elite sportspeople and celebrities, such as television or radio
personalities. In such cases, it will be necessary to examine the contractual
framework and connection between the taxpayer’s various activities. In all
other cases, the precedent set by FCT v Maddalena remains unchanged and
expenses incurred in gaining employment are unlikely to be deductible as
they are incurred in putting the taxpayer in a position to produce assessable
income, rather than in gaining or producing assessable income.
Relocation expenses [12.360]
Expenses incurred by a taxpayer in relocating his or her home have similarly
been held to be non-deductible under s 8-1 of the ITAA 1997 as they are
incurred in putting the taxpayer in a position to produce assessable income,
rather than being incurred in gaining or producing assessable income:
Fullerton v FCT (1991) 22 ATR 757. As a result, such expenses would not
satisfy the positive limbs of s 8-1. In addition, the expenses are likely to fall
foul of the second negative limb of s 8-1 in that they are private or domestic
expenses. This would be the case even where the taxpayer is required to
relocate by the employer.
Case study 12.23: Relocation expenses not deductible
In Fullerton v FCT (1991) 22 ATR 757, the taxpayer was a professional
forester who had to accept a transfer or be retrenched. His employer
reimbursed him for a portion of his relocation costs and the taxpayer. The
Federal Court held that the expenses were not deductible as they were
incurred in putting the taxpayer in a position to produce assessable income,
rather than incurred in gaining or producing assessable income (i.e., the
positive limbs of the predecessor to s 8-1 were not satisfied). Further, the
expenses were a private or domestic outgoing, which meant that the
expenses were also not deductible under the second negative limb of the
predecessor to s 8-1.
Child care expenses [12.370]
Child care expenses have long been held to be non-deductible under s 8-1 of
the ITAA 1997 (and its predecessors) as they are incurred in putting the
taxpayer in a position to gain or produce assessable income and are not
incurred in the production of assessable income: Lodge v FCT (1972) 3 ATR
254; Martin v FCT (1984) 15 ATR 808. Again, the expenses do not satisfy the
positive limbs of s 8-1 and are also likely to not be deductible due to the
second negative limb as they are private or domestic expenses. This is the
case regardless of whether the taxpayer is self-employed or an employee.
However, the Federal Government does provide some assistance in relation
to child care expenses through rebates for taxpayers and exemptions for
employers from fringe benefits tax on qualifying child care facilities.
Travel expenses [12.380]
The deductibility of travel expenses will depend on the type of travel
undertaken, which could be:
• travel between home and work: see [12.390]–[12.430]; and
• travel between two workplaces: see [12.440].
Where the travel expenses are car expenses (i.e., the taxpayer owns or
leases a car during the year and the car is used in gaining or producing the
taxpayer’s assessable income), Div 28 of the ITAA 1997 sets out the rules for
calculating the amount of the deduction: see [12.450]–[12.570].
Travel expenses that relate to recreation and income-producing activities are
a tricky issue and are discussed at [12.620] in the context of self-education
travel expenses.

Travel between home and work [12.390]

As a general rule, expenses incurred in travelling between a taxpayer’s
ordinary home and his or her regular work location are not deductible under
s 8-1 of the ITAA 1997: Lunney v FCT; Hayley v FCT (1958) 100 CLR 478;
Draft Ruling TR 2019/D7. As with the other expenses discussed so far,
expenses on travel between a taxpayer’s ordinary home and regular work
location are considered to be incurred in putting the taxpayer in a position to
gain or produce assessable income, rather than in the production of
assessable income. As such, these expenses do not satisfy the positive limbs
of s 8-1 and are further prevented from being deductible under the second
negative limb as private or domestic expenses. This travel is required for an
employee to commence work or to depart after work is completed.
In some situations, the determination as to whether the travel between
home and work relates to private travel or work travel may not be
straightforward and it is necessary to examine all relevant factors.
Case study 12.24: Travel to work site on “fly in-fly out” basis
In John Holland Group Pty Ltd v FCT (2015) FCAFC 82, the Full Federal Court
considered the deductibility of airfares paid by an employer of “fly in-fly out”
employees for travel from Perth airport to Geraldton, Western Australia,
where the employees worked. The Commissioner argued that the expenses
were not deductible as they were incurred in putting the taxpayers in a
position to gain or produce assessable income rather than being incurred in
gaining or producing assessable income.

The Full Federal Court found that the expenses were deductible on the basis
that under their employment contracts, the employees commenced their
employment duties from the time they arrived at Perth airport (i.e., they
were paid for their travel time from Perth airport to Geraldton); all travel
between Perth airport and Geraldton was controlled, arranged and paid for
by the employer; and the employer paid for the employees’ transportation
from Geraldton airport to their accommodation in Geraldton, which was also
paid for and funded by the employer. Given these factual circumstances, the
employees could not be said to be travelling to work when flying from Perth
to Geraldton but rather were travelling on work.
Note that this case concerned the fringe benefits tax implications of
the airfares paid by the employer and the deductibility of the
airfares was considered by the Court in the context of the
“otherwise deductible rule” (see Chapter 7).

Case study 12.25: After-hours travel from home to work

In FCT v Collings (1976) 6 ATR 476, the taxpayer was a computer consultant
who generally worked in her employer’s offices. She was required to be “on
call” after work hours and deal with any queries from her home. However,
when she was unable to resolve the queries from home, she was required to
go into the office to deal with them. The Court permitted the taxpayer a
deduction for the travel expenses on the basis that the taxpayer commenced
working at home and therefore the travel expenses were incurred in the
course of gaining or producing assessable income, rather than in putting the
taxpayer in a position to gain or produce assessable income. The positive
limbs of the predecessor to s 8-1 were satisfied and the expenses did not fall
within any of the negative limbs. The case does not create a general
exception for all after-hours travel, but is limited to taxpayers in similar
situations. The key factor here was that the taxpayer had commenced
working at home prior to undertaking the travel and was not simply “on call”,
but rather was required to work wherever she was located.
In Draft Ruling TR 2019/D7, the Commissioner notes that in determining
whether the relevant travel expenses are incurred in gaining or producing
assessable income, it is important not to look at the employment contract
only, but to also look at the nature of the work as a matter of substance. The
Commissioner suggests that the following factors may support a finding that
the expenses are incurred in gaining or producing assessable income:
• the travel occurs during work hours;
• the travel occurs when the employee is under the direction of the
employer;
• the travel fits within the duties of employment;
• the travel is relevant to the practical demands of carrying out the work
duties; and
• the employer asks the employee to undertake the travel.
[12.400] A number of exceptions to the general rule that travel from home
to work is not deductible have arisen through case law, as follows.
Itinerant workers [12.410]
Taxpayers who do not have a fixed place of work, such as travelling
salespeople, are known as itinerant workers. In their case, travel between
home and work is deductible under s 8-1 as they are considered to have
commenced work from the time they leave home and, as such, the travel
expenses are incurred in the course of gaining or producing assessable
income: FCT v Wiener (1978) 8 ATR 335; Ruling TR 95/34. The key factor is
that the travel must be a fundamental part of the taxpayer’s employment. In
Hill v FCT [2016] AATA 514, the Tribunal held that a taxpayer with multiple
unrelated jobs was not an itinerant worker as he was not required to travel to
different locations in the course of his employment.

Case study 12.26: Travel expenses of itinerant workers

In FCT v Wiener (1978) 8 ATR 335, the taxpayer was a teacher who was
required to teach at a minimum of four schools each day.
The Court permitted the taxpayer a deduction for expenses incurred on
travel from home to work on the basis that the travel was a fundamental
part of the taxpayer’s employment and therefore the taxpayer commenced
working from the time she left home. As a result, the travel expenses were
incurred in the course of gaining or producing assessable income, rather
than in putting the taxpayer in a position to gain or produce assessable
income. The positive limbs of the predecessor to s 8-1 were satisfied and the
expenses did not fall within any of the negative limbs.
Transportation of bulky items [12.420]
Taxpayers who are required to carry bulky items to perform their
employment duties are permitted a deduction under s 8-1 for expenses
incurred in travelling between home and work: FCT v Vogt (1975) 5 ATR 274.
In this case, the taxpayer was a professional musician who was required to
carry a large musical instrument between home and work.
In this situation, the travel expenses are attributable to transportation of the
equipment and not the taxpayer’s travel between home and work. As such,
they are considered to be incurred in the course of gaining or producing
assessable income. The expenses are sufficiently connected to the
production of the taxpayer’s assessable income and the positive limbs of s 8-
1 are satisfied. Further, the expenses are not considered a private or
domestic outgoing and therefore do not fall within any of the negative limbs
of s 8-1.
However, the expenses would not be deductible where the taxpayer carries
the items between home and work as a matter of convenience only. In this
situation, the travel expenses are not attributable to the transportation of
the items and, as such, are not incurred in the course of gaining or producing
assessable income. The positive limbs of s 8-1 are not satisfied. Further, the
expenses are considered a private or domestic outgoing and are not
deductible due to the second negative limb of s 8-1.
Case study 12.27: Travel expenses not deductible where bulky item
transported for convenience only
In Brandon v FCT (2010) 2010 ATC 10-143, the AAT denied the taxpayer a
deduction for travel expenses from home to work as the transportation of
the bulky item was for the taxpayer’s convenience only. The taxpayer was a
soldier in the Australian Defence Force who took his deployment kit home.
While it was accepted that the deployment kit was a bulky item, the AAT
found that the taxpayer only took it home as a matter of convenience as the
kit could be stored securely at the taxpayer’s barracks. As such, the
“essential character” of the taxpayer’s expenses was a private or domestic
outgoing and the travel expenses were not attributable to the transportation
of the deployment kit. The expenses were not sufficiently connected to the
production of the taxpayer’s assessable income, so the positive limbs of s 8-
1 were not satisfied. Further, the expenses were not deductible due to the
second negative limb of s 8-1 as they were considered a private or domestic
expense. In Ford v FCT (2014) AATA 361, the AAT denied the taxpayer a
deduction for work-related car expenses to transport essential equipment
from his home to work on the basis that the equipment could be stored in a
locker provided by the employer and the taxpayer took the equipment home
as a matter of personal choice. See also Reany v FCT (2016) AATA 672;
Rafferty v FCT (2017) AATA 636.
Alternative workplace [12.430]
Taxpayers are permitted a deduction under s 8-1 for expenses incurred on
travel between home and an alternative workplace as the travel is
considered to be incurred in gaining or producing assessable income: FCT v
Ballesty (1977) 7 ATR 411; Draft Ruling TR 2019/D7. Here, the travel is
attributable to the employee having to work in more than one place, rather
than their choice about where to live. However, a deduction would not be
permitted for such expenses where the taxpayer is employed to work at
different workplaces on a fixed or regular basis.

Example 12.10: Travel between alternative workplace and home

deductible
Sarah is an accountant with a large accounting firm. She is
occasionally required to attend client premises as part of her
employment duties and travels directly home from the client’s
offices.
Any expenses incurred by Sarah in travelling from the client’s
premises to her home will be deductible under s 8-1 of the ITAA
1997 as the expenses are incurred in the course of gaining or
producing assessable income.
Example 12.11: Travel between alternative workplace and home not
deductible
Sarah is an accountant with a large accounting firm. Under the
terms of her employment contract, she works in the firm’s city
office on Mondays, Tuesdays and Thursdays and at a suburban
branch office on Wednesdays and Fridays. Sarah is not under her
employer’s direction and control for the period when she is
travelling to either workplace and she does not receive any extra
compensation for having two workplaces. Any expenses incurred by
Sarah in travelling between her home and either of her employer’s
offices are not deductible under s 8-1 of the ITAA 1997. The offices
are not an alternative workplace and Sarah simply has two different
workplaces.
Travel between two places of work [12.440]
The deductibility of expenses incurred in travelling between two places of
work will depend on whether the two places relate to the same income-
producing activity.
Where the two places of work relate to the same income-producing activity,
any expenses incurred in travelling between the two places of work are
deductible under s 8-1 of the ITAA 1997 as the travel is undertaken in
gaining or producing assessable income.
Example 12.12: Travel between two workplaces deductible
Sarah is an accountant with a large accounting firm. Under the
terms of her employment contract, she works in the firm’s city
office on Mondays, Tuesdays and Thursdays and at a suburban
branch office on Wednesdays and Fridays. On occasion, Sarah is
required to travel between the two offices.
Any expenses incurred by Sarah in travelling between the two
offices would be deductible under s 8-1 of the ITAA 1997 as they
relate to the same income-producing activity and are therefore
incurred in the course of gaining or producing assessable income.
However, where the two places of work relate to different income-
producing activities, the High Court in FCT v Payne (2001) 202 CLR
93 held that expenses incurred on such travel are not deductible
under s 8-1 as the expenses are incurred in putting the taxpayer in
a position to produce assessable income, rather than in gaining or
producing assessable income. As such, the positive limbs of s 8-1
are not satisfied.
Case study 12.28: Travel between two workplaces not deductible
In FCT v Payne (2001) 202 CLR 93, the taxpayer was a Qantas pilot who also
owned a deer-farming property. The taxpayer sought a deduction for
expenses incurred in travelling between the airport and the deer-farming
property.
The Full High Court found that the expenses were not deductible under the
predecessor to s 8-1 of the ITAA 1997 as the positive limbs of the
predecessor to s 8-1 were not satisfied and the expenses were not
sufficiently connected to the production of the taxpayer’s assessable
income. The taxpayer’s travel between the airport and the deer farm was
not related to the production of income from his deer-farming activities or his
occupation as a pilot. As such, the expenses were not incurred in the course
of his income-producing activities and were instead incurred in putting him in
a position to gain or produce assessable income.
Following FCT v Payne, the government inserted s 25-100 into the ITAA 1997,
which provides taxpayers with a deduction for expenses incurred in
travelling between two unrelated workplaces: see [13.110]. Therefore, travel
expenses incurred in travelling between two unrelated workplaces will not be
a general deduction (per FCT v Payne) but may be a specific deduction if the
requirements of s 25-100 are satisfied.
Car expenses [12.450]
Where the travel expenses relate to a car, special rules govern the amount
of the car expenses that are deductible under s 8-1. Division 28 of the ITAA
1997 sets out the rules for calculating the amount of a deduction for car
expenses where a taxpayer owns or leases a car during the year and the car
is used in the production of the taxpayer’s assessable income. It is important
to note that Div 28 does not provide a specific deduction for car expenses.
Rather, it provides two methods for determining the amount of the deduction
under another section. Consequently, the deductibility of car expenses is
generally determined under s 8-1, with the amount of the deduction
determined by reference to Div 28.
Example 12.13: Deductibility of car expenses
Rebecca is a florist’s assistant. As part of her employment duties, she is
required to deliver flowers to clients. Rebecca uses her own car for this
purpose. The car was purchased with a bank loan of $50,000. Each month,
Rebecca makes repayments of principal and payments of interest. The
repayments of principal are not deductible under s 8-1 as they are capital
expenses. The interest payments are deductible under s 8-1, but the amount
of the deduction will depend on Rebecca’s choice of method for car expenses
under Div 28. Source: Adapted from the Example in s 28-90(2) of the ITAA
1997.
It is also important to note that Div 28 only applies to individuals and
partnerships that include at least one individual: s 28-10. The Division
provides taxpayers with the following two methods for calculating car
expense deductions:
• “cents per kilometre” method: see [12.460]; or
• “logbook” method: see [12.550].
Taxpayers may choose which method to use in a particular income year, but
the choice of one method precludes the use of the other method: s 28-20(1).
However, taxpayers are entitled to change their choice of method for a
particular income year: s 28-20(2). Further, taxpayers may use different
methods for different cars in one income year and different methods for the
same car in different income years: s 28-20(3). A taxpayer’s choice of
method will depend on their individual circumstances as the two methods
involve different substantiation requirements.
Example 12.14: Choice of method
Ivana claimed a deduction of $3,000 for car expenses using the “logbook”
method. However, on audit, the Commissioner determines that her
deduction should be reduced to $500. She would be entitled to a deduction
of $1,000 under the “cents per kilometre” method. Ivana can change her
choice and deduct $1,000. Source: Adapted from the Example in s 28-20(2)
of the ITAA 1997.

Figure 12.3 provides an overview of the application of Div 28 on calculating

deductions in relation to car expenses.

“Cents per kilometre” method [12.460]

Under the “cents per kilometre” method (s 28-25 of the ITAA 1997), the
deduction for car expenses is equal to:
Number of business kilometres the car travelled in the income year ×
Number of cents per kilometre
The number of business kilometres is the number of kilometres the car
travelled in the course of the taxpayer’s production of assessable income or
between workplaces. The taxpayer must calculate the number of business
kilometres by making a reasonable estimate.
The number of cents per kilometre is 72 for the 2020–2021 income year:
Income Tax Assessment Act 1997 – Cents per Kilometre Deduction Rate for
Car Expenses 2020. This rate applies to subsequent income years until the
Commissioner varies the rate, as permitted by s 28-25(4).
[12.470] Advantages.
The advantage of the “cents per kilometre” method is that the taxpayer is
not required to substantiate the car expenses: s 28-35 of the ITAA 1997.
[12.480] Limitations.
The significant limitation of the “cents per kilometre” method is that it can
only be used for the first 5,000 business kilometres travelled by the car. Any
business travel in excess of 5,000 kilometres is disregarded in calculating
the taxpayer’s deduction for car expenses under this method: s 28-25(2).
Example 12.15: Cents per kilometre method
Gregor and Barkly are partners in their own suburban medical practice. They
sometimes make house calls to visit patients who are unable to visit the
practice. They use their own cars when travelling to see patients. For the
year ended 30 June 2021, Gregor travelled a total of 6,000 km to see
patients and Barkly travelled 4,000 km.
Using the “cents per kilometre” method, they would each claim a deduction
for car expenses as follows:
• Gregor: 5,000 × 0.72 = $3,600 (the excess 1,000 km is disregarded);
• Barkly: 4,000 × 0.72 = $2,880.
“Logbook” method [12.550]
Under the “logbook” method, the amount of the deduction for car expenses
is calculated as follows under s 28-90 of the ITAA 1997: Amount of each car
expense × Business use percentage
A “car expense” is defined in s 28-13 as a loss or outgoing to do with a car,
including a loss or outgoing to do with operating a car and the decline in
value of a car. Examples of car expenses include petrol costs, repairs,
registration, insurance and depreciation or leasing costs.
The business use percentage is calculated as follows:
Number of business kms the car travelled in the period when the taxpayer
held the car /
Total number of kms travelled by the car in that period × 100%
The taxpayer is taken to hold the car while he or she owned or leased it and
the car was used in gaining or producing assessable income, regardless of
any other use of the car during the period: s 28-90(6).
The number of business kilometres is the number of kilometres the car
travelled in the course of the taxpayer’s production of assessable income or
in travelling between workplaces: s 28-90(4). Although the number of
business kilometres is calculated by making a reasonable estimate, the
estimate must take into account all relevant matters, including (s 28-90(5)):
• any logbooks, odometer records or other records maintained by the
taxpayer;
• any variations in the pattern of use of the car; and • any changes in the
number of cars used by the taxpayer in the course of gaining or producing
assessable income.
Section 28-90(2) makes it clear that the car expenses must qualify for a
deduction under some other provision of the income tax legislation (e.g., s 8-
1) in order to be deductible.

[12.560] Advantages.
With the “logbook” method, the deduction for car expenses takes into
account the taxpayer’s actual expenditure and the extent to which the car is
used in gaining or producing assessable income.
[12.570] Limitations.
The “logbook” method is only available where the taxpayer “held” a car
during the income year; that is, the taxpayer owned or leased a car that was
used in gaining or producing the taxpayer’s assessable income.
The taxpayer is required to substantiate all car expenses in accordance with
the requirements in subdiv 900-C of the ITAA 1997: see [12.320]. This
generally requires the taxpayer to maintain written records of all expenses.
In addition, the taxpayer must maintain a logbook. Subdivision 28-G explains
how and how often the taxpayer needs to keep a logbook. Broadly, the
taxpayer is required to maintain a logbook for a period of 12 continuous
weeks. The taxpayer can choose the relevant period subject to certain
legislative requirements, but must record the following information in the
logbook:
• when the logbook period begins and ends;
• the car’s odometer readings at the start and end of the period;
• the total number of kilometres the car travelled during the period; and
• the number of kilometres the car travelled, in the course of gaining or
producing the taxpayer’s assessable income, on journeys recorded in the
logbook.
In order to record a journey undertaken by the taxpayer in gaining or
producing his or her assessable income, the taxpayer must specify:
• the day the journey began and the day it ended;
• the car’s odometer readings at the start and end of the journey;
• how many kilometres the car travelled on the journey; and
• the reason for the journey. Example 12.16: Logbook method
Malik is a health and safety inspector for the local government. He is
required to travel to at least three sites per day to conduct inspections. He
leases a car for $2,000 per month. He has had the car for the whole income
year. Malik has maintained written records of all expenses, and his car
expenses for the year were:
• Oil and fuel costs = $3,000;
• Registration = $2,000;
• Insurance = $700.
Malik maintained a logbook for a 12-week period and determined his
business use percentage to be 95%.
Under the “logbook” method, Malik’s deduction for car expenses would be:
($24,000 + $3,000 + $2,000 + $700) × 95% = $28,215
Note that the car expenses would be deductible under s 8-1 as they are
incurred in gaining or producing assessable income and are not capital in
nature.

Self-education expenses [12.580]

Expenses incurred by a taxpayer on self-education are another example of a
potentially quasi-personal expense. While the expense may relate to the
taxpayer’s income-producing activities, they may also relate to the personal
development of the taxpayer and thus be considered private or domestic.
Self-education includes undertaking a course at an education institution,
attending a work-related conference or seminar, completing a self-study
course or going on a study tour in Australia or overseas. Examples of self-
education expenses that may be deductible under s 8-1 include course fees,
books, stationery and travel to attend conferences or seminars. Meals and
accommodation expenses may be deductible where the taxpayer is away
from home overnight.
As with all other expenses, self-education expenses must satisfy the positive
limbs of s 8-1 and not fall within any of the negative limbs of s 8-1 to be
deductible.
Positive limbs of s 8-1 [12.590]
Generally, self-education expenses will be sufficiently connected to the
taxpayer’s production of assessable income where:
• the education will improve the taxpayer’s prospects of promotion or
earning a higher income in the taxpayer’s current career: FCT v Hatchett
(1971) 2 ATR 557; FCT v Studdert (1991) 22 ATR 762; Ruling TR 98/9 (see
[12.600]); or
• the taxpayer works in an occupation which requires them to be constantly
up to date: Ruling TR 98/9 (see [12.630]).
However, this general rule has been called into question where the expenses
relate to non-employment income: see [12.640].
Self-education expenses relate to taxpayer’s current career
[12.600]
Self-education expenses related to the taxpayer’s current career will be
sufficiently connected to the production of the taxpayer’s assessable income
where the expenses will improve the taxpayer’s prospects of promotion or
earning a higher income in their existing career.
Case study 12.29: Deductibility of self-education expenses
In FCT v Hatchett (1971) 2 ATR 557, the taxpayer was a primary school
teacher who incurred expenses in obtaining a Teacher’s Higher Certificate
and in completing an Arts degree at university. The Teacher’s Higher
Certificate would enable the taxpayer to be promoted and was required for
certain teaching positions. The Arts degree, while recommended by the
Education Department, would not lead directly to a promotion or higher
income for the taxpayer in his current job.
The High Court permitted the taxpayer a deduction for the expenses
incurred in relation to the Teacher’s Higher Certificate as it had a sufficient
nexus to his income-producing activities (ie, the positive limbs of the
predecessor to s 8-1 were satisfied and the expenses did not fall within the
negative limbs of the predecessor to s 8-1). However, the expenses in
relation to the Arts degree were not deductible as the positive limbs of the
predecessor to s 8-1 were not satisfied. There was an insufficient connection
between the expenses and the taxpayer’s current income-producing
activities.

Case study 12.30: Deductibility of self-education expenses

In FCT v Studdert (1991) 22 ATR 762, the taxpayer was a flight
engineer who incurred expenses in undertaking flying lessons. The
taxpayer argued hat the expenses were deductible as the flying
lessons would improve his skills as a flight engineer and lead to a
promotion and higher income. The Commissioner argued that the
flying lessons were not deductible as they related to a new career
as a pilot and not the taxpayer’s current income-producing
activities as a flight engineer.
In the Federal Court, Hill J allowed the taxpayer a deduction for the
flying lessons on the basis of the evidence presented that the flying
lessons would improve the taxpayer’s skills as a flight engineer and
lead to a promotion and higher income in his current career. As
such, the expenses were sufficiently connected to the taxpayer’s
current income-producing activities and satisfied the positive limbs
of the predecessor to s 8-1. The expenses were not private or
domestic in nature and did not satisfy any of the other negative
limbs of the predecessor to s 8-1. The Court noted that self-
education expenses relating to a new career are not deductible
under the predecessor to s 8-1 as they are incurred in putting the
taxpayer in a position to gain or produce assessable income.
However, although the flying lessons may lead to the taxpayer
obtaining a new career as a pilot, the expenses remained deductible
as they were sufficiently connected to the taxpayer’s current
income-producing activities as a flight engineer. The taxpayer’s
ulterior purpose in incurring the expenses on flying lessons (to
retrain as a pilot) was not considered relevant as it was a subsidiary
purpose and there was sufficient connection to the production of
the taxpayer’s current assessable income. As discussed at [12.310],
a taxpayer’s purpose in incurring an expense is not generally
relevant in determining its deductibility.
As noted by the Court in FCT v Studdert, self-education expenses relating to
a new career are not deductible. In this situation, the expenses are not
incurred in gaining or producing assessable income, but rather in putting the
taxpayer in a position to gain or produce assessable income. Such expenses
are considered to have been incurred too early and do not satisfy the
positive limbs of s 8-1.
Example 12.17: Self-education expenses relate to new career
Jenna works as a receptionist at an accounting firm. Her employer
encouraged her to study accounting and suggested that she would be able
to get an accounting position with the firm at the end of her studies. Jenna
undertakes a course in accounting while continuing to work as a receptionist
at the firm.
The cost of the accounting course is not deductible as it relates to a new
career and is incurred at a point too soon to be regarded as incurred in
gaining or producing Jenna’s assessable income. The positive limbs of s 8-1
are therefore not satisfied.
[12.610] Establishing the nexus.
Where self-education expenses directly relate to the taxpayer’s income-
producing activities (e.g., a particular skill or specific knowledge), the
connection between the expenses and the taxpayer’s income-producing
activities may be easy to identify. However, where the self-education
expenses are general in nature, it will be necessary to examine the
taxpayer’s particular circumstances to determine whether a sufficient
connection exists.

Example 12.18: Self-education expenses directly related to

taxpayer’s income-producing activities
Ricco is working as a trainee bookkeeper. He undertakes a course at
a local educational institution related to bookkeeping. The course
will improve his skills and knowledge and increase his income-
producing prospects in his current career.
The cost of the bookkeeping course will be deductible under s 8-1
as it is sufficiently connected to his income-producing activities and
will increase his prospects in his current occupation. The positive
limbs of s 8-1 are satisfied.
Example 12.19: Self-education expenses indirectly related to
taxpayer’s income-producing activity
Maxine is a journalist. Her employment duties include conducting
interviews and making presentations. Maxine incurs expenses on a
speech course to improve her ability to conduct interviews and
make presentations.
Although the speech course is not directly related to Maxine’s
income-producing activities as a journalist, the course will improve
her skills in her current occupation and the expenses are thus
deductible under s 8-1. The positive limbs of s 8-1 are satisfied and
the expenses are not considered private or domestic in nature so
the negative limbs of s 8-1 are not met. Source: Adapted from Case
Z42 (1992) 24 ATR 1183.
Example 12.20: Self-education expenses not related to taxpayer’s
income-producing activity
Hasmin is a company director. She is struggling to cope with work due to
stress caused by a family situation. She attended a stress-management
course after hours, which she paid for herself.

The cost of the course is not deductible as it is not related to her income-
producing activities or skills or knowledge and is private or domestic in
nature. The positive limbs of s 8-1 are not satisfied and the expense falls
within the scope of the second negative limb of s 8-1. Source: Adapted from
the example in Ruling TR 98/9.
[12.620] Travel expenses.
The deductibility of travel expenses related to self-education is often a tricky
issue, particularly where the travel has a recreational element. For the
expenses to be deductible, it is necessary to show that the travel relates to
the taxpayer’s income-producing activities and that the travel would
increase the taxpayer’s income-producing prospects in their current career.
The High Court in FCT v Finn (1961) 106 CLR 60 (see Case Study [12.31])
suggested that the following factors may be relevant in determining the
deductibility of travel expenses related to self-education:
• whether the employer supports the taxpayer’s travel (although this will
depend on the exact circumstances of a particular situation);
• whether the taxpayer is able to show clear evidence that the travel was
devoted to the collation of information that is related to their income-
producing activities; and
• whether the application of such information to the taxpayer’s income-
producing activities will improve their opportunities for promotion and/ or
more income.
Courts will look at these factors in determining whether self-education travel
expenses are deductible, but, to be deductible, it is not necessarily the case
that the expenses must satisfy each of these factors or that expenses that
do satisfy all of these factors will automatically be deductible. The ultimate
determination will depend on the taxpayer’s individual circumstances.
Case study 12.31: Recreational travel expenses including a work
purpose deductible
In FCT v Finn (1961) 106 CLR 60, the taxpayer was an architect with the
West Australian Government who had accumulated both annual and long
service leave. The taxpayer planned to use the leave to travel to the UK and
Europe to study current architectural trends. The taxpayer’s employer asked
him to extend his trip to include South America and the employer agreed to
cover the taxpayer’s costs of the additional travel. The taxpayer sought a
deduction for his non-reimbursed travel expenses on the basis that all of his
time while travelling was devoted to the study of architecture. The evidence
showed, and the Commissioner accepted, that all of the taxpayer’s activities
while overseas were devoted to the study of architecture. The
Commissioner’s contention was that the expenses were not incurred in
gaining or producing assessable income as it was not certain that the
taxpayer’s improved knowledge would result in increased pay or chances of
a promotion.
The Full High Court permitted the taxpayer a deduction for the travel
expenses on the basis of the factors discussed above: the employer had
endorsed the taxpayer’s travel; the taxpayer had extensive evidence of the
information collated while travelling and the fact that the information would
improve the taxpayer’s income-producing capacity in his current career. As
such, the expenses were incurred in gaining or producing assessable income
and satisfied the positive limbs of the predecessor to s 8-1.
Case study 12.32: Recreational travel expenses including a work
purpose partially deductible
In Peter Lenten v FCT (2008) 71 ATR 862, the taxpayer was a secondary
school teacher who incurred expenses in travelling throughout Asia, the UK
and Europe with his wife while on long service leave. The taxpayer described
his trip as a “self-guided educational discovery tour” which consisted
primarily of general package tours and self-guided expeditions to places of
historical interest and significance. He did not attend any professional
conferences or lectures or visit any educational institutions during the trip,
but he did attend lectures at museums. The taxpayer claimed a portion of
his travel expenses as a deduction on the basis that it was incurred in
gaining or producing his assessable income.

The taxpayer pointed to the fact that he had been promoted to head of
faculty after the trip as evidence of the impact of the trip on his production
of assessable income. While the trip was not a condition of the promotion,
the taxpayer argued that it had certainly been a factor and that it was
important for him to demonstrate initiative as he felt that his age may have
hampered his chances of being promoted. Noting that the deductibility of
travel expenses in these circumstances depends on the individual facts of
the case, the AAT found that the taxpayer was entitled to a deduction for
75% of the travel expenses incurred. The remaining 25% was attributable to
inevitable recreational portions of the trip and thus not deductible as a
private or domestic expense under the second negative limb of s 8-1. In this
case, the AAT was satisfied that the taxpayer’s dominant purpose in
undertaking the overseas travel was to improve his knowledge and skill
levels as a teacher, which would (and, in fact, did) enhance his promotional
opportunities. As such, the expenses were sufficiently connected to the
taxpayer’s income-producing activities and the positive limbs of s 8-1 were
therefore satisfied.

Case study 12.33: Recreational travel expenses including a work

purpose partially deductible
In Carlos Sanchez v FCT (2008) 73 ATR 650, the taxpayer was a travel agent
employed by STA Travel. The taxpayer undertook a number of overseas
holidays while on annual leave and claimed a portion of the expenses
incurred on the trips as a deduction.
The taxpayer argued that it was necessary for him to travel as the motto of
STA is “we know because we go”. The taxpayer also presented evidence
showing the importance of travel by sales consultants to the STA business
model and the taxpayer’s success as a travel consultant as a result of his
trips.
The AAT allowed the taxpayer a deduction for a portion of his overseas travel
expenses. On the basis of the evidence presented, the AAT found that the
trips were not just holidays and were clearly related to the taxpayer’s
production of assessable income as a sales consultant employed to sell
holiday-related travel products. In fact, there was evidence that his sales
increased following the trips and therefore the positive limbs of s 8-1 were
satisfied. The expenses were not considered private or domestic outgoings
and therefore did not fall foul of the second negative limb of s 8-1.
The AAT rejected the Commissioner’s argument that a sufficient nexus was
not established because the taxpayer did not visit a single travel agency
during his trips. The AAT concluded that this was not relevant as the
taxpayer did not run a travel agency business and therefore it was
unnecessary for him to see how they were run overseas.
In order to claim a deduction for travel expenses related to self-education,
taxpayers should maintain complete records of the trips (such as a travel
diary detailing the taxpayer’s activities each day of the trip) which evidence
a connection between the trips and the taxpayer’s income-producing
activities. It is also important for a taxpayer to show that the trips have or
could have increased the taxpayer’s assessable income or promotional
opportunities in the taxpayer’s existing career.
Current career requires taxpayer to stay up to date [12.630]
Self-education expenses will also be deductible where the taxpayer works in
an occupation that requires the taxpayer to be constantly up to date, and
the expenses are incurred for that purpose: Ruling TR 98/9.

Example 12.21: Self-education expenses deductible

Sarah is an accountant with a large accounting firm. Due to the nature of her
work, Sarah is required to stay up to date with the latest changes in
accounting standards. Sarah pays $700 a year to attend weekly update
seminars held by a professional accounting organisation. The $700 paid by
Sarah would be deductible self-education expenses under s 8-1 of the ITAA
1997 as Sarah works in an occupation which requires her to stay up to date
and, as such, the expenses are incurred in gaining or producing her
assessable income.
Self-education expenses not related to employment income [12.640]

The general rule that self-education expenses will only be sufficiently

connected to the taxpayer’s production of assessable income where the
expenses will increase the taxpayer’s prospects of promotion and/or earning
a higher income in their current career, or the taxpayer is in a career which
requires them to stay up to date, has been found not to apply where the self-
education expenses do not relate to employment income: FCT v Anstis
(2010) 76 ATR 735 (see Case Study [12.34]).
Case study 12.34: Self-education expenses related to non-
employment income
In FCT v Anstis (2010) 76 ATR 735, the taxpayer was enrolled as a full-time
student in a teaching degree at the Australian Catholic University. The
taxpayer included in her assessable income wages earned as a part-time
sales assistant in a clothing store and Youth Allowance of $3,622. The
taxpayer claimed a deduction of $920 for self-education expenses related to
her teaching degree, although she did not declare any income from
teaching. The expenses primarily related to computer depreciation,
textbooks and stationery.
The taxpayer claimed a deduction for the expenses on the basis that a
condition of receiving Youth Allowance is that the recipient must be enrolled
in and make satisfactory progress in an acceptable course of study and the
expenses were incurred by the taxpayer in meeting those requirements. The
Commissioner denied the taxpayer’s deductions on the basis that self-
education expenses are only deductible if they would lead to an increase in
income from the taxpayer’s current income-producing activities. Here, the
amount of Youth Allowance received by the taxpayer was constant. The
taxpayer sought to distinguish existing case law on the basis that the cases
related to the production of income through labour or employment, not from
study.
In the Federal Court, Ryan J held that the expenses were deductible as the
expenditure was incurred because of the requirements of the Youth
Allowance, which is assessable income. His Honour noted that the expenses
were not incurred in putting the taxpayer in a position to receive Youth
Allowance, but rather were incurred in satisfactorily completing her course of
study. Therefore, they were incurred in gaining or producing assessable
income. The fact that the amount of the Youth Allowance did not vary based
upon the course of study or the expenses incurred by the taxpayer was held
to be irrelevant. As in FCT v Studdert (1991) 22 ATR 762 (see Case Study
[12.30]), the Court found that the taxpayer’s purpose in undertaking the
course (to become a teacher) was irrelevant. The Full Federal Court rejected
the Commissioner’s arguments that the primary judge had erred in his
reasoning. As to the Commissioner’s argument that the self-education
expenses were incurred “too soon”, the Full Federal Court held that that
would be correct if the expenses were only referable to the production of
income in future when the taxpayer was a teacher. However, that was not
the case here as the expenses were referable to the production of Youth
Allowance, which is assessable income.
The Full High Court confirmed that Youth Allowance is assessable as ordinary
income. The Court found that the taxpayer’s expenses were deductible
against that income as they were “productive of the assessable income”.
The taxpayer’s reasons or motives in incurring those expenses were found
not to be relevant. The High Court also held that the expenses were not
private or domestic in nature.
The fact that the taxpayer may have been studying for reasons other than to
maintain her entitlement to Youth Allowance did not sever the necessary
connection between the expenses and her assessable Youth Allowance
income.
As discussed at [12.240], the Government has introduced s 26-19 to deny a
deduction for expenses related to rebatable benefits. Self-education
expenses related to the production of Youth Allowance income (and similar
Government payments) are therefore not deductible from 1 July 2011.
However, the principle in FCT v Anstis is potentially relevant in determining
the deductibility of self-education expenses related to the production of
assessable study income received in a private context. The deductibility of
such expenses will depend on the particular circumstances such as whether
a condition of the receipt of such income is that the recipient must make
satisfactory progress in their educational pursuits.

Negative limbs of s 8-1 [12.650]

Self-education expenses that are sufficiently connected to the taxpayer’s
production of assessable income may nonetheless not be deductible if any
one of the negative limbs of s 8-1 is satisfied.
Capital expenses [12.660]
A self-education expense may not be deductible under s 8-1 if it is a capital
expense: see [12.170]–[12.210]. Examples of self-education expenses that
may be capital include the cost of personal computers, laptops, calculators,
professional libraries, furniture such as desks and filing cabinets, technical
instruments and equipment. These expenses result in the acquisition of
assets which provide the taxpayer with a lasting benefit and are generally
considered capital expenses. While such expenses may not be immediately
deductible under s 8-1, they may be deductible over a period of years under
the capital allowances regime: see Chapter 14.
Note that the courts in FCT v Finn (1961) 106 CLR 60 and FCT v Hatchett
(1971) 2 ATR 557 expressly rejected any argument that self-education
expenses are generally capital in nature because the improvement to the
taxpayer’s skills or knowledge provides an enduring benefit.
Private or domestic expenses [12.670]
Self-education expenses will not be deductible where they are private or
domestic in nature. For example, self-education travel expenses may relate
to a conference, but the taxpayer may also at the same time have a holiday
or visit family, which are private pursuits. In this situation, the taxpayer may
be entitled to a partial deduction for the self-education expenses.
Apportionment of self-education expenses is discussed at [12.690].
Non-deductible self-education expenses [12.680]
Any payments made under the government assistance schemes such as
under the Higher Education Support Act 2003 (Cth) that are not deductible
under s 26-20 (see [12.240]) remain non-deductible even where they qualify
as self-education expenses. However, the prohibition on deductibility does
not apply where the payments are incurred in the provision of a fringe
benefit: s 26-20(2) of the ITAA 1997. As discussed at [12.240] and [12.640],
expenses related to rebatable benefits are not deductible under s 26-19.
Further, s 82A of the ITAA 1936 prevents the first $250 of self-education
expenses incurred by a taxpayer from being deductible. In this context, self-
education expenses are defined as expenses necessarily incurred by the
taxpayer for or in connection with a course of education provided by a
school, college, university or other place of education and undertaken by the
taxpayer for the purpose of gaining qualifications for use in the carrying on
of a profession, business or trade or in the course of employment: s 82A(2).
The section was introduced due to the availability of a tax offset for self-
education expenses, which has since been abolished.

Although s 82A continues to operate, the impact of the provision has been
diminished by the fact that the $250 threshold may be applied to any non-
deductible expenses incurred by the taxpayer which are necessarily incurred
in relation to the education course: Ruling TR 98/9. In addition, taxpayers are
not required to substantiate any self-education expenses disallowed under s
82A: Determination TD 93/97.
Example 12.22: Application of s 82A to self-education expenses
Sarah is tax consultant with a large accounting firm. She is currently enrolled
in a Masters of Tax degree at the local university. Sarah paid $3,000 to enrol
in a subject to complete her degree. The classes are held after hours. Sarah
had to employ a babysitter so that she could attend the course, which cost
her $100. The $3,000 course fees incurred by Sarah are deductible under s
8-1 of the ITAA 1997 as they are sufficiently connected to her income-
producing activities because Sarah works in an occupation which requires
her to be up to date. However, the first $250 of self-education expenses
would not be deductible under s 82A of the ITAA 1936.
However, Sarah can apply the $250 exemption towards her child care costs
as the expenses are necessarily incurred by her to enable her to attend the
course. It does not matter that child care expenses are a non-deductible
expense (see [12.370]): Ruling TR 98/9. Therefore, Sarah can claim a
deduction of $2,850 for self-education expenses under s 8-1. The $250 s 82A
exemption is first applied towards her child care costs, thereby reducing the
exemption amount to $150. The remaining $150 s 82A exemption is applied
towards the course fees of $3,000.
Apportionment [12.690]
As discussed at [12.270], dual purpose expenses are partially deductible
under s 8-1. Where self-education expenses relate to both income-producing
and private purposes, the taxpayer may be required to apportion the
expenses and only a partial deduction will be allowed under s 8-1. In Ruling
TR 98/9, the Commissioner suggests that, if the income-producing purpose is
merely incidental to the main private purpose, only the expenses that relate
directly to the income-producing purpose will be deductible. However, where
the private purpose is merely incidental to the main income-producing
purpose, apportionment is not required and the expenses will be fully
deductible under s 8-1.
Example 12.23: Apportionment not required for incidental private
pursuits
Roger, a dermatologist, attends an eight-day work-related conference in
Aruba. One day of the conference involves sightseeing. As Roger’s main
purpose in attending the conference was related to his income-producing
activities, the total cost of the conference (airfares, accommodation and
meals) will be deductible under s 8-1. The day of sightseeing is incidental to
the main purpose and does not affect the characterisation of the self-
education expenses. Source: Adapted from the Example in Ruling TR 98/9.
Example 12.24: Direct self-education expenses deductible where
primary purpose is private
Stacey, a lawyer, was holidaying in Cairns when she became aware of a
work-related seminar on mediation. The cost of the seminar was $300.
Stacey can claim a deduction for the cost of attending the seminar as a self-
education expense. However, her airfare to Cairns and holiday
accommodation are not deductible as her primary purpose in going to Cairns
was private. Source: Adapted from the Example in Ruling TR 98/9.
Example 12.25: Apportionment of self-education expenses required
where dual purpose
Luthor, a scientist, has two equal purposes when he decides to attend a five-
day international conference in France to be followed by a five-day holiday in
London.
Luthor is entitled to a deduction for the conference fees, meals and
accommodation costs in France. He is required to apportion his airfare as he
has two equal purposes in incurring the expense. Any expenses incurred in
London are not deductible as they are private or domestic in nature. Source:
Adapted from the Example in Ruling TR 98/9.

In Determination TD 93/195, the Commissioner provides some guidance as

to the deductibility of registration fees for continuing professional
development seminars where the fee includes the cost of food and drink to
be provided at the seminar. The deductibility of the registration fee will
depend on whether the food and drink is considered “entertainment”. See
[7.230] as to when food and drink will be considered “entertainment”.
Home office expenses [12.700]
Generally, expenses incurred by a taxpayer in relation to his or her home are
not deductible under s 8-1 of the ITAA 1997 as they constitute private or
domestic outgoings. However, such expenses may be deductible where the
taxpayer uses a part of the home as an office in relation to the taxpayer’s
income-producing activities.
Expenses incurred by a taxpayer in running a home office generally fall into
two categories:
• running expenses, which relate to the use of facilities within the home and
are affected by the use of the home for income-producing activities (e.g.,
electricity, cleaning costs, depreciation); and
• occupancy expenses, which relate to ownership or use of the home and are
not affected by the taxpayer’s income-producing activities (e.g., rent,
interest on a mortgage, insurance, rates).
The deductibility of expenses falling into each category depends on whether
the taxpayer uses the home office as a genuine home office or as a matter of
convenience only.
Genuine home office [12.710]
Where the taxpayer’s home office is a genuine home office, that is, a part of
the home is set aside for use in the taxpayer’s income-producing activities
only, a portion of both running and occupancy expenses incurred by the
taxpayer will be deductible under s 8-1 of the ITAA 1997. In Ruling TR 93/ 30,
the Commissioner suggests that the following factors will be relevant when
determining whether the home office is a “genuine home office” or “place of
business”:
• the area is clearly identifiable as a place of business;
• the area is not readily suitable or adaptable for use for private or domestic
purposes in association with the home generally;
• the area is used exclusively or almost exclusively for carrying on a
business; or
• the area is used regularly for visits from clients or customers.

The absence of an alternative place for conducting income-producing

activities may also be relevant in determining whether an area is a genuine
home office. In Swinford v FCT (1984) 15 ATR 1154, the Court was influenced
by this fact in concluding that a self-employed scriptwriter who used one
room of a flat for writing purposes and for meeting with television station
staff had a “place of business” at her home.
Example 12.26: Running and occupancy expenses deductible for
genuine home office
Lara has her own accounting practice, which she runs out of her own home.
She has set aside one room in her house, which she uses exclusively as an
office for her business.
Lara’s use of one room in her house as an office is a genuine home office
rather than being for convenience only. As such, Lara will be entitled to
deduct a portion of her running and occupancy costs under s 8-1 of the ITAA
1997 as the expenses are incurred in gaining or producing her assessable
income. The expenses satisfy the positive limbs of s 8-1 and are not
considered private or domestic outgoings and therefore do not satisfy any of
the negative limbs of s 8-1.
Home office for convenience only [12.720]
Where the taxpayer uses an area of the home for income-producing
activities but the area does not constitute a “genuine home office” or “place
of business”, the home office is considered to be for the taxpayer’s
convenience only. In such situations, the courts have suggested that some
portion of the taxpayer’s running expenses will be deductible as they relate
to the taxpayer’s production of assessable income, but any occupancy-
related expenses will not be deductible as they remain a private or domestic
expense: FCT v Faichney (1972) 3 ATR 435; Handley v FCT (1981) 11 ATR
644; FCT v Forsyth (1981) 11 ATR 657.
Case study 12.35: No deduction for occupancy expenses related to
home office used for convenience only
In FCT v Faichney (1972) 3 ATR 435, the taxpayer was a scientist who used
his study at home for work-related activities, such as reading, writing reports
and so on.
The High Court permitted the taxpayer a deduction for a portion of his
running expenses, but not for any occupancy expenses, as the taxpayer
used the study for work purposes as a matter of convenience only.

Case study 12.36: No deduction for occupancy expenses related to

home office used for convenience only.
In Handley v FCT (1981) 11 ATR 644, the taxpayer was a barrister who used
his study at home for work-related activities. The Commissioner had allowed
the taxpayer deductions for a portion of electricity and cleaning expenses,
but not for a portion of the occupancy expenses (interest on a mortgage,
rates and insurance premiums).
The High Court agreed with the Commissioner and did not permit a
deduction for the occupancy expenses as the taxpayer used his study for
work purposes as a matter of convenience only. As stated by Murphy J (at
198):
Acceptance of the taxpayer’s claim could lead to curious or even absurd
results. Many lawyers, to the annoyance of their domestic partners, do a lot
of legal reading in the bedroom. Also there is much scientific and anecdotal
evidence in favour of the view that intellectual work goes on subconsciously
as well as consciously, even during sleep. Perhaps the next claim would be
for deducting part of the upkeep of the bedroom, or even a claim for part of
the upkeep of the garden in which a barrister thinks about the conduct of
cases whilst resting or strolling.
In FCT v Forsyth (1981) 11 ATR 657, the High Court denied the taxpayer a
deduction for rental payments on his home as the taxpayer, a barrister, used
his home study for work purposes for convenience only.
The key element in all three of these cases was that the taxpayers had an
alternative workplace (i.e., an office or barristers’ chambers) and the use of
the home as an office was for convenience only.
Apportionment and capital expenses [12.730]
The quantum of home office expenses that is deductible under s 8-1 will
depend on the taxpayer’s individual circumstances. In Ruling TR 93/ 30, the
Commissioner suggests that, in the case of occupancy expenses, it may be
appropriate to apportion the expenses in accordance with floor area. The
expenses may also need to be apportioned on a time basis where the
taxpayer did not use the area as a home office for the entire year. In the
case of running expenses, one possible method is to apportion the expenses
based on hours of usage. Practice Statement PS LA 2001/6 provides
guidance on calculating and substantiating home office running expenses.
Home office expenses that are capital in nature (see [12.170]–[12.210]) will
not be deductible under s 8-1, but the taxpayer may be entitled to deduct
the expenses over a period of time: see Chapter 14. Examples of home office
expenses which are capital in nature include furniture, such as a desk or
filing cabinet, a home library, a computer or a printer.

Clothing and dry-cleaning expenses [12.740]

The deductibility of expenses on clothing depends on the type of clothing
worn by the taxpayer in relation to his or her income-producing activities:
Ruling TR 97/12. The deductibility of dry-cleaning expenses is determined in
accordance with the same tests as for the deductibility of clothing expenses.
Conventional clothing and related items [12.750]
Conventional clothing refers to ordinary clothing that is not a uniform or
specific to the taxpayer’s occupation. Such clothing can be worn in day-to-
day living and is considered a natural part of living in society and is private
or domestic in nature. As such, expenses incurred by a taxpayer on
conventional clothing are not deductible under s 8-1 of the ITAA 1997 as
they are not incurred in gaining or producing assessable income. The
positive limbs of s 8-1 are not satisfied, and, further, the second negative
limb will operate to deny a deduction as the expenses are private or
domestic in nature. This would be the case even where the clothing is
required by the taxpayer’s income-producing activities.
Case study 12.37: Expenses on conventional clothing not deductible
In Case U80 (1987) 87 ATC 470, the taxpayer was a shop assistant at the
retailer David Jones. She was required to wear “all black” clothing when
performing her employment duties. The clothing was not distinctive or
unusual and could be worn outside the taxpayer’s employment. The
taxpayer tried to argue that the clothing was not suitable for private use as
the colour did not suit her and she would not ordinarily wear black clothing.
The AAT found that, as the garments were conventional attire, the clothing
expenses were a private or domestic expense. As such, the expenses were
not deductible due to the second negative limb of the predecessor to s 8-1.
A similar outcome was reached by the AAT in Westcott v FCT (1997) 37 ATR
1017, which denied the taxpayer, a manager and head waiter at a
restaurant, a deduction for the cost of black trousers purchased in order to
perform his employment duties. The taxpayer was required by his employer
to wear black trousers and did not wear the black trousers on any other
occasions apart from work. Nonetheless, the fact that the taxpayer could
wear the black trousers outside of work meant that they were a private or
domestic expense and not deductible due to the second negative limb of the
predecessor to s 8-1.
However, two main exceptions to the general rule regarding the non-
deductibility of expenses on conventional clothing have developed from case
law.
Abnormal expenditure on conventional clothing [12.760]
In FCT v Edwards (1994) 28 ATR 87, the Full Federal Court permitted the
taxpayer a deduction for expenses incurred on conventional clothing as the
expenses incurred were clearly an abnormal cost unique to the taxpayer’s
employment and the expenses were therefore incurred in gaining or
producing assessable income, rather than being a private expense.
Case study 12.38: Expenses on conventional clothing an abnormal
cost
In FCT v Edwards (1994) 28 ATR 87, the taxpayer was the personal secretary
to the wife of the Governor of Queensland. As part of her job, the taxpayer
incurred expenditure on formal daytime clothing and evening wear. The
amount of the expenditure was fairly significant as the taxpayer was
required to change outfits many times during the day for her job. She was
also required to travel interstate where laundry facilities were not readily
available, and the taxpayer was required to have a number of outfits so that
she had immediately wearable fresh clothing. The taxpayer had previously
been an executive secretary for a large international hotel chain where she
was required to wear high-quality clothing but her wardrobe was not as
extensive (and not required to be).

The taxpayer sought a deduction for a portion of her clothing expenditure on

the basis that the additional expenditure was clearly incurred in gaining or
producing her assessable income. The additional expenditure was incurred in
purchasing the additional outfits that the taxpayer required to fulfil her
duties in her new role. During the period August to November 1990, the
taxpayer purchased 51 new items of clothing. The taxpayer also argued that,
as she was required to live in Government House and her employment was
seven days a week, she had very little personal time and very seldom had
the opportunity to wear her official wardrobe in her private time.
The Commissioner denied the deductions on the basis that the expenditure
related to conventional clothing and was therefore a private or domestic
outgoing.
The Full Federal Court permitted the taxpayer a deduction for the additional
clothing expenses as it was clear that the taxpayer incurred
an abnormal cost in relation to her clothing due to her job and that she
would not otherwise wear such clothes, especially the formal evening wear.
The Court referred to the AAT’s factual findings that while one set of clothes
for the day may be attributable to her private purposes, the only explanation
for the additional clothing was to satisfy her employment duties. Therefore,
the expenses were incurred in the course of gaining or producing the
taxpayer’s assessable income (satisfying the positive limbs of the
predecessor to s 8-1) and were not a private or domestic expense (thereby
not attracting the second negative limb of the predecessor to s 8-1).
[12.770] Although expenses on conventional clothing may therefore be
deductible under s 8-1 of the ITAA 1997, it should be noted that FCT v
Edwards (1994) 28 ATR 87 involved unique circumstances and taxpayers will
need to be able to similarly demonstrate that their expenditure on
conventional clothing is an abnormal cost that is related to their income-
producing activities. The Commissioner’s guidance as to when a taxpayer
may be able to deduct abnormal expenditure incurred on conventional
clothing is contained in Ruling TR 94/22. In that Ruling, the Commissioner
suggests that a sufficient connection will not be established in most cases.
For example, in Case M28 (1980) 80 ATC 187, the Board of Review did not
permit the taxpayer a deduction for the dry-cleaning costs of suits. The
taxpayer was a lecturer who argued that the dry-cleaning costs were an
abnormal expense due to the taxpayer’s work environment of chalk dust.
The Board of Review found that the expenses, while coming close to
deductibility, were not sufficiently abnormal as chalk dust is readily brushed
out of suits and would not require the suits to be dry-cleaned any more often
than they would otherwise need.
On the other hand, in Westcott v FCT (1997) 37 ATR 1017, where the
taxpayer was a manager and head waiter at a restaurant and was denied a
deduction for the cost of black trousers purchased in order to perform his
employment duties, the taxpayer was permitted a deduction for his dry-
cleaning costs as this was an “abnormal cost” related to his income-
producing activities. As a result of his employment as a manager and head
waiter of a restaurant, the taxpayer was required to handle food and wine,
which frequently spilled on his clothing. The spills had to be removed by dry-
cleaning and the clothes sometimes needed to be dry-cleaned as often as
every second day. The AAT accepted that this was an abnormal cost which
was caused by the taxpayer’s income-producing activities and therefore the
dry-cleaning expenses were sufficiently connected to the production of the
taxpayer’s assessable income (satisfying the positive limbs of the
predecessor to s 8-1) and were not a private or domestic expense (thereby
not attracting the second negative limb of the predecessor to s 8-1).

In FCT v Edwards (1994) 28 ATR 87, it was accepted by the Commissioner

and the taxpayer that, if the expenses were found to be deductible, only a
portion of those expenses would be deductible. In other words, some portion
of the taxpayer’s clothing expenditure would be attributable to private
purposes, and therefore not deductible, while the portion that constituted
the “additional expenditure” would be for income-producing purposes, and
therefore deductible. As discussed at [12.270], there is no precise formula
for apportionment which should be done on a case-by-case basis depending
on the taxpayer’s particular circumstances. In FCT v Edwards, it was
accepted that a comparison between the taxpayer’s current year
expenditure and her average expenditure in the previous two years was an
accurate basis for determining the proportion of the taxpayer’s expenditure
that constituted “additional expenditure”.
Expenditure caused by taxpayer’s work conditions [12.780]
Expenses incurred by a taxpayer on conventional clothing or related items
may also be deductible where the need for the items is created by the
taxpayer’s working conditions or environment: Mansfield v FCT (1995) 31
ATR 367; Morris v FCT (2002) 50 ATR 104; Ruling TR 2003/16.
Case study 12.39: Expenses on conventional clothing deductible
In Mansfield v FCT (1995) 31 ATR 367, the taxpayer was a flight attendant
who incurred expenditure on stockings, shoes, moisturiser, cosmetics and
hairdressing. The taxpayer argued that the expenses were incurred in
gaining or producing assessable income since she was required to be well
groomed as part of her job. Further, the taxpayer showed that her shoes
were a half-size bigger than her ordinary shoes due to the swelling caused
by cabin pressure and the moisturiser was required due to the dry cabin air.
The Commissioner denied the taxpayer’s deductions on the basis that the
expenses related to conventional clothing items, which could be used
outside of work.
The Federal Court permitted the taxpayer a deduction for the expenses
relating to the shoes and moisturiser as the need for them was created by
the taxpayer’s working conditions, that is, the cabin pressure and dry air of
an aeroplane. The Court also permitted the taxpayer a deduction for the
stockings on the basis that this was part of the taxpayer’s uniform. However,
the Court did not permit the taxpayer a deduction for the cosmetics and
hairdressing costs as this was considered to be a private expense as a result
of the taxpayer’s personal choice and not due to the taxpayer’s working
environment.

Case study 12.40: Expenses on conventional clothing deductible

Morris v FCT (2002) 50 ATR 104 involved 10 different taxpayers, all of whom
worked in occupations which required them to work outdoors in the sun. The
taxpayers incurred expenditure on sun protection items, such as sunscreen,
hats and sunglasses. The taxpayers claimed a deduction for expenses
relating to the sun-protection items on the basis that the expenses were
incurred in gaining or producing assessable income. The Commissioner
denied the deductions on the basis that the items were conventional and
could be used outside work and that the costs of obtaining them were
therefore private or domestic outgoings.
The Federal Court allowed all of the taxpayers a deduction for the sun-
protection items as the expenses clearly arose out of their working
conditions (in the sun) and were therefore incurred in the course of gaining
or producing the taxpayers’ assessable income. The Court rejected the
Commissioner’s argument that, to be deductible, the expenses must relate
to artificial work conditions. The expenses satisfied the first positive limb of s
8-1 and did not fall within the second negative limb of s 8-1 as they were not
private or domestic expenses.
In these situations, the expenses arise due to the taxpayer’s work conditions
and are incurred in the course of gaining or producing the taxpayer’s
assessable income. As such, the expenses are sufficiently connected to the
taxpayer’s production of assessable income and satisfy the positive limbs of
s 8-1. The expenses are not considered private or domestic in nature and the
negative limbs of s 8-1 do not apply to deny a deduction.
Occupation-specific clothing, protective clothing and uniforms
[12.790]
Occupation-specific clothing and protective clothing are generally deductible
under s 8-1 of the ITAA 1997 as they are incurred in the course of gaining or
producing assessable income and are not a private or domestic outgoing:
Morris v FCT (2002) 50 ATR 104; Rulings TR 2003/16 and TR 97/12. There is
sufficient connection to the taxpayer’s income-producing activities and the
positive limbs of s 8-1 are satisfied. The expenses are not private or
domestic and none of the negative limbs of s 8-1 apply to deny a deduction.
Occupation-specific clothing identifies the wearer as a person associated
with a particular profession, trade, vocation, occupation or calling: s 34-
20(1).

Examples of occupation-specific clothing include barrister’s robes, a white

dress worn by nurses and black-and-white chequered trousers worn by chefs.
Protective clothing will be sufficiently connected to the taxpayer’s production
of assessable income where, for instance, there is a real risk of their being
exposed to illness or injury in the course of carrying out their income-
producing activities: s 34-20(2). Examples of protective clothing items
include sun-and rain-protection items for taxpayers required to work
outdoors (e.g., sunglasses, hat, raincoat, umbrella), white coat and goggles
for laboratory technicians or assistants, hard hat for construction workers,
and gloves for mechanics or gardeners. Ruling TR 2003/16 contains further
guidance as to when a deduction will be allowed for protective clothing.
The deductibility of uniforms will depend on the taxpayer’s specific
circumstances. As we have seen at [12.750], expenses on conventional
clothing are generally not deductible even though the taxpayer may be
required to wear specific items of clothing for work purposes. As stated by
Hill J in Mansfield v FCT (1995) 31 ATR 367 at 375, “a uniform is not merely a
set of clothes reserved for the occasion of work”. A uniform is usually
sufficiently distinctive so that the casual observer can clearly identify the
employee as working for the particular employer: s 34-15.
Where the taxpayer is required to wear a uniform to perform their duties, the
uniform will be deductible under s 8-1 as the expense is incurred in the
course of gaining or producing the taxpayer’s assessable income and the
positive limbs of s 8-1 are satisfied. The expenses are not considered a
private or domestic outgoing and, as such, the negative limbs of s 8-1 do not
operate to deny deductibility. Note that for the expenses to be deductible,
the whole uniform must be worn: Ruling TR 97/12.
Expenditure on non-compulsory uniforms is not deductible under s 8-1
unless the employer has registered the design of the uniform in accordance
with the provisions of Div 34: s 34-10. However, this limitation does not
apply to occupation-specific or protective clothing: s 34-10(3).
Capital expenses [12.800]
Although certain clothing expenses may not be treated as a private or
domestic outgoing, the expenses may still not be deductible under s 8-1 of
the ITAA 1997 if they are capital in nature: see [12.170]–[12.210]. For
example, this would be the case where the clothing items are expected to
last the taxpayer for a number of years. However, the taxpayer may be
entitled to deduct the expense over a number of years under Div 40: see
Chapter 14.

Example 12.27: Clothing expenses that are capital in nature

Chris is a barrister. He had to purchase a wig to wear when he appears in
court. Chris does not go to court very often and looks after his wig very well.
He expects that the wig will last him for at least five years. The wig is
occupation-specific clothing and is therefore not a private or domestic
expense. However, it is not deductible under s 8-1 of the ITAA 1997 as Chris
expects it to last for at least five years and therefore it is capital in nature.
The cost of the wig may be deductible over a number of years, as discussed
in Chapter 14.
Interest expenses [12.810]
Interest expenses are one of the most common types of expenses incurred
by taxpayers. Interest expenditure may be deductible under s 8-1 of the ITAA
1997 where there is sufficient connection to the production of assessable
income and none of the negative limbs of s 8-1 are satisfied. “Interest” has
been defined as “compensation paid by the borrower to the lender for
deprivation of use of his money”: Riches v Westminster Bank Ltd [1947] 1 All
ER 469 at 472. In essence, “interest” is the cost of borrowing money and can
include interest on interest (i.e., compound interest).
As a general rule, the deductibility of interest expenses will depend on the
taxpayer’s use of the borrowed funds: FCT v Munro (1926) 38 CLR 153.
Where the taxpayer uses the borrowed funds to gain or produce assessable
income (e.g., by purchasing an income-producing asset or in a business),
any interest arising in relation to the borrowing may be deductible under s 8-
1. For example, interest incurred on a home loan may be deductible where
the loan is used to purchase an investment property that produces rental
income. On the other hand, the interest would not be deductible where the
loan is used to purchase a property that is the taxpayer’s residence and is
not used to produce any assessable income. As we have seen in Steele v
DCT (1999) 41 ATR 139 (see Case Study [12.8]), interest expenses can be
sufficiently connected to the production of assessable income even where
the income is only gained or produced in a future income year. The
Commissioner’s guidance on the deductibility of interest incurred prior to or
after the production of assessable income is contained in Ruling TR 2004/4.
The deductibility of “penalty interest payments” (i.e., an amount payable by
a borrower in consideration for the lender agreeing to an early repayment of
a loan) will also depend on the taxpayer’s use of the borrowed funds (for
gaining
or producing assessable income or in a business carried on for that purpose)
and whether the recurring interest liability on the terminated loan would
have been deductible if incurred: see Taxation Ruling TR 2019/2.
Gearing [12.820]
Gearing refers to the borrowing of money in order to invest, commonly in the
property or share markets. Positive gearing refers to the situation where the
income from the investment exceeds the costs, both interest and other
deductions, of the investment.
Negative gearing refers to the borrowing of money to make an investment
where the interest on those borrowings, along with other deductions,
exceeds the income from the investment. Provided the investments are
genuine, the excess can then be claimed as a deduction against a taxpayer’s
other income. Negative gearing is a strategy often used by high-income
taxpayers to reduce their annual income tax payable – they hope that
obtaining long-term capital gains will at least compensate for the annual loss
from negative gearing.
In relation to the general deductibility of interest under s 8-1 of the ITAA
1997, the courts will consider whether an expense is appropriate and
adapted towards the production of assessable income, rather than whether
the expense is warranted from a commercial perspective. In other words,
interest will be deductible if it satisfies one of the two positive limbs of s 8-1
regardless of whether the total deductible costs (including interest) exceed
the assessable income from the investment.
Example 12.28: Negative gearing and tax
Natasha has been closely watching the property market over the last few
months and she is of the view that it is likely to rise significantly over the
next three years. Even though Natasha has a very secure and highly paid
job, she does not have any spare cash, so she decides to borrow $200,000 to
invest in a rental property. Natasha is able to borrow the money at a rate of
10% pa on an interest-only basis and purchases a suitable property. During
the current tax period, Natasha incurred interest and other running costs of
$25,000 but only received assessable income in the form of rent of $15,000.
The interest and other running costs are incidental and relevant to the
production of assessable income (rent) and therefore will be fully deductible
under s 8-1 of the ITAA 1997. The rental income of $15,000 is assessable
under s 6-5, which results in a net tax loss of $10,000 from the investment.

If Natasha is on the top marginal tax rate of 47% (including the Medicare
levy of 2%), the $10,000 tax loss will reduce her total taxable income from
her salary and save her $4,700 ($10,000 × 47%) in tax. However, the tax
saving has not made this investment profitable; it has only reduced the loss
from $10,000 to $5,300 ($10,000 − $4,700). To justify this investment, there
would still need to be an expectation that either rents will rise and the
investment will become positively geared or the after-tax capital gain on
disposal of the property would be sufficient to cover the annual loss and
warrant the risk associated with the investment.
Capital expenses [12.830]
Although interest expenses are generally treated as revenue expenses, they
may be considered a capital expense in certain circumstances. In St George
Bank Ltd v FCT (2009) 73 ATR 148, the Full Federal Court held that interest
expenses incurred by the taxpayer were capital in nature. The case involved
a complex financing arrangement which came about because the taxpayer
was required by the Reserve Bank of Australia to increase its capital. The
Court found that the arrangement related to the acquisition of permanent
capital for the business and thus the interest expenses were for a structural
advantage of a lasting character, which is a capital expense according to
Sun Newspapers Ltd and Associated Newspapers Ltd v FCT (1938) 61 CLR
337 (see Case Study [12.10]). The taxpayer tried to argue that the interest
expenses were a revenue expense because they were recurrent, but this
argument was specifically rejected by the Court. The Court stated that the
recurrence of a payment may be a relevant factor but is certainly not
decisive. The High Court refused the taxpayer special leave to appeal from
the decision of the Full Federal Court. Whether or not interest expenses are
capital in nature will depend on whether the expenses relate to the
taxpayer’s income-producing structure (capital) or their income-producing
process (revenue): see [12.170]–[12.210].
Legal expenses [12.840]
As discussed at [12.170]–[12.210], distinguishing between capital and
revenue expenses is often a difficult issue in practice. Legal expenses are a
prime example of the difficulty in characterising an expense as either capital
or revenue.
Case study 12.41: Legal expenses not capital in nature
In Hallstroms Pty Ltd v FCT (1946) 72 CLR 634, the taxpayer was a
manufacturer of fridges which incurred legal expenses in successfully
blocking a competitor’s application to extend a patent. Utilising the
“enduring benefit” test discussed at [12.180], a majority of the High Court
found that the expenses were deductible under the predecessor to s 8-1 of
the ITAA 1997 as they were not capital in nature. In reaching this conclusion,
the majority found that the expenses were incidental to the taxpayer’s
production of assessable income.

This was because the legal expenses were incurred to protect the taxpayer’s
existing rights (to manufacture its refrigerators in the way it wished) and did
not result in the acquisition of any new rights or benefits. Dixon J
(dissenting), who set out the test and factors in Sun Newspapers Ltd and
Associated Newspapers Ltd v FCT (1938) 61 CLR 337 (see Case Study
[12.10]), concluded that the legal expenses were capital in nature as they
related to the taxpayer’s income-producing structure and not to its income-
producing processes. This opinion was referred to by the Court in Broken Hill
Theatres Pty Ltd v FCT (1952) 85 CLR 423 (see Case Study [12.42]).
Following the importance of the income-producing structure versus the
income-producing process distinction adopted in Broken Hill Theatres and
subsequent cases, Hallstroms is now mainly relevant for Dixon J’s dissenting
opinion.
Case study 12.42: Legal expenses of a capital nature
In Broken Hill Theatres Pty Ltd v FCT (1952) 85 CLR 423, the taxpayer was
the sole cinema operator in Broken Hill. The taxpayer incurred legal
expenses in successfully blocking a competitor’s application to operate a
cinema. Such applications were conducted annually and therefore the
taxpayer argued that the expenses were not capital in nature as they did not
provide the taxpayer with a lasting benefit.

The taxpayer also argued that as it had already successfully blocked five
such applications, the expenses were recurrent. The Full High Court (now
under the leadership of Dixon CJ) found that the expenses were not
deductible under the predecessor to s 8-1 of the ITAA 1997 because the
advantage of being free from competition, even if only for 12 months, was
regarded as “just the very kind of thing which has been held in many cases
to give to moneys expended in obtaining it the character of capital outlay”
(at 434).

The Court did not accept the argument that, where no new right or tangible
asset was acquired by the expenditure, it must be on revenue account. In
relation to the argument that the expenditure was recurrent, the Court
stated that it was not recurrent in the relevant sense because it was made
on a particular and isolated occasion and it could not be known for certain
whether another application would be made by a competitor in future. The
Court focused on the distinction between expenses related to the taxpayer’s
income-producing structure (i.e., the preservation and protection of that
structure), as opposed to its income-producing activities or processes.
Case study 12.43: Legal expenses of a capital nature
In John Fairfax & Sons Pty Ltd v FCT (1959) 101 CLR 30, the taxpayer, a
newspaper publisher, acquired control of another newspaper company,
Associated, through a share allotment. An existing shareholder of Associated
brought an action in the Supreme Court of NSW arguing that the share
allotment was improper and seeking a declaration that the issuance was
void and the taxpayer should be removed from Associate’s share register.
The taxpayer incurred legal expenses in relation to the court action (which
was dismissed after several court hearings). The Full High Court rejected the
taxpayer’s argument that the expenses were revenue in nature as they were
incurred in protecting its existing rights and that no new rights or benefits
were acquired. However, their Honours adopted different reasons in reaching
their conclusion that the expenses were capital in nature. Dixon CJ,
continuing his approach established in Sun Newspapers Ltd and Associated
Newspapers Ltd v FCT (1938) 61 CLR 337, found that the expenses related
to the taxpayer’s income-producing structure and were thus capital
expenses. Menzies J similarly held that the expenses “were affairs of capital,
relating as they did to the profit making subject rather than its operation”.
Fullager J, on the other hand, found that the expenses were capital in nature
because they were part of the acquisition cost. Kitto J agreed with all three,
while Taylor J concurred with Fullager and Menzies JJ.
Case study 12.44: Legal expenses held to be revenue in nature
In FCT v Consolidated Fertilizers Ltd (1991) 22 ATR 281, the taxpayer was a
manufacturer of pesticides and fertilisers. The taxpayer had obtained a
licence from a US company to sell particular products, incorporating specific
technology, in Australia. The developer of the technology commenced an
action against the US company which could potentially affect the taxpayer’s
rights under the licensing agreement. The taxpayer incurred legal expenses
in joining the defence of the US company.

The Full Federal Court held that the legal expenses were not capital in
nature. The taxpayer was already the possessor of a “profit-yielding subject”
and the legal expenses were incurred to protect that source of income. The
Court drew a distinction between this case and Broken Hill Theatres Pty Ltd v
FCT (1952) 85 CLR 423 (see Case Study [12.42]) and John Fairfax & Sons Pty
Ltd v FCT (1959) 101 CLR 30 (see Case Study [12.43]). The Court suggested
that expenses to protect a business will be capital in nature where they are
incurred on an isolated occasion for that purpose, while such expenditure
incurred in the course of the prudent management of the business would be
a revenue expense. Here, the taxpayer’s licensed technology could be
threatened by a number of parties and the protection of the technology was
a regular incident of the taxpayer’s business. Thus, the legal expenses were
a revenue expense.
[12.850] Following Broken Hill Theatres Pty Ltd v FCT (1952) 85 CLR 423
(see Case Study [12.42]) and John Fairfax & Sons Pty Ltd v FCT (1959) 101
CLR 30 (see Case Study [12.43]) and similar cases, it is generally accepted
that legal expenses incurred to protect the taxpayer’s title in an asset or to
protect its existing business structure will be classified as a capital expense.
This will be the case even where the taxpayer has not acquired any new
rights or benefits and is merely protecting its existing position. The key
distinction is that expenses incurred to protect the taxpayer’s business
structure will be capital, while expenses incurred to protect the taxpayer’s
business processes will be revenue. FCT v Consolidated Fertilizers Ltd (1991)
22 ATR 281 (see Case Study [12.44]) suggests that legal expenses to protect
the taxpayer’s business will be for the protection of the taxpayer’s income-
producing processes (and therefore a revenue expense) where it is a regular
incident of the taxpayer’s business.

Where the legal expenses relate to defending charges and allegations made
against a business taxpayer, Dixon CJ in FCT v Snowden & Willson Pty Ltd
(1958) 99 CLR 431 (see Case Study [12.4]) suggested that the expenses
would not be of a capital nature if the taxpayer’s business structure or
capital assets were not imperilled or the investigating authority did not have
the authority to put the taxpayer out of business. Where the investigations
are conducted by an authority with the power to put the taxpayer out of
business (e.g., deregister a company), expenses incurred in defending the
investigations may be capital in nature.
Note that the success or failure of the legal proceedings has no impact on
the deductibility of legal expenses related to those proceedings.
Where the expenses are capital in nature, the taxpayer may be entitled to
take the expense into account for tax purposes through the capital
allowances provisions (see Chapter 14), the capital gains provisions (see
Chapter 11) or the “black hole expenditure” provisions: see Chapter 14. Note
that some legal expenses, such as costs related to obtaining tax advice,
preparing leases and discharging mortgages, may be deductible under a
specific deduction provision: see Chapter 13.
Questions [12.860]
12.1 Melissa is a mechanic. She runs her own business specialising
in repairing electric cars. During the year, Melissa incurred the
following expenses:
(a) salary costs to her two regular employees of $100,00 (paid
electronically through the business’s payroll system which
automatically applies the relevant tax withholding and pays the
amount to the ATO);
(b) salary costs to casual employees of $10,000 (these employees
are only required during busy periods and are paid in cash “of the
books”);
(c) salary costs of $2,000 to her brother who is a university student
(paid electronically through the business’s payroll system; Melissa
knows the amount is excessive, but she wants to support him in his
studies);
(d) travel costs of $3,000 for travel from her home to her repair
shop; (e) $5,000 on special overalls and eye goggles for Melissa and
her employees to use when they are repairing cars;
(f) childcare costs of $22,000 so that Melissa is able to go to work
every day;
(g) $1,000 on a one-day course on a new accounting software
program that Melissa wants to use in the business to better comply
with new tax reporting requirements.
Advise Melissa as to whether the above expenses would be
deductible for income tax purposes.
12.2 Jurgen is a teacher at a German-language school in Australia.
As part of a competitive process, he was selected to participate in a
prestigious two-week education conference in Germany. His
employer supported Jurgen’s participation by allowing him to travel
to the conference without leave but did not pay for the travel
expenses. Jurgen incurred expenses of $2,000 on a return plane
ticket between Germany and Australia and $300 on travel
insurance. His hotel costs during the conference were covered by
the conference organiser, but Jurgen
stayed an additional five days at the hotel so that he could do some
sightseeing. The extra nights at the hotel cost him $1,000. Advise
Jurgen as to whether the above expenses would be deductible for
income tax purposes.
12.3 Sanjay was employed at a large telecommunications firm. He
was terminated from his job and was not paid his entitlements
(annual leave and long service leave) at this time. He incurred legal
expenses in taking his employer to the Fair Work Commission to
claim his entitlements. He also sued his employer for loss of future
earnings. Advise Sanjay as to the deductibility of the legal
expenses.
12.4 Michael is a scientist. He uses his own car to travel to various
locations to conduct experiments. He acquired the car on 1 October
2020 for $60,000. The acquisition cost was funded entirely by a loan
at an interest rate of 15%. He has determined that the depreciation
deduction on the car would be $2,300 for the year. In addition,
Michael incurred the following expenses during the year: •
Registration and insurance = $2,000; • Repairs and maintenance =
$1,000; and • Oil and fuel costs = $1,500.
For the period 1 October 2020 to 30 June 2021, Michael estimates
that the car travelled a total of 15,000 kilometres, 12,000 of which
were for business purposes. You may assume that Michael has
maintained all necessary records and a logbook.
Calculate Michael’s deduction for car expenses under the two
methods in Div 28 of the ITAA 1997. Assume that depreciation has
been adjusted for part year use and the impact of the car limit.
12.5 Alison is an interior designer with her own business. She does
not have an office as she thinks it would just be a waste of money
as her clients do not come to her, but she goes to the clients. It is
crucial to her business that she be able to visit her client’s premises
to view their homes before providing her services. Alison has set
aside one room in her home as her office and uses it exclusively for
her interior designing work. During the year, Alison incurred
expenses in travelling to meet her clients at their home and
sustained increased expenditure on electricity, gas and cleaning in
relation to her office. Alison owns her home and pays interest on
her mortgage monthly. Last month, Alison was late in paying her
monthly interest charge and had to pay a penalty of $150.
Advise Alison as to the deductibility of the abovementioned
expenses.
12.6 Olivia is an investment banker. She owns her own home and
has decided to invest in the property market. As this would be her
first property investment in a personal capacity, she hired a
property broker to assist her in finding a suitable investment
property. The broker charged her a fixed fee of $11,000 upfront for
his assistance. Olivia also attended a two-day course on successful
property investment. The course cost $3,300.
The broker has found a suitable investment property and Olivia
borrowed the funds from her bank to purchase the property. She
used her own home as security for the loan. The purchase is for a
vacant block of land and Olivia will build two homes on the land and
sell them for a profit (hopefully) in two years. Advise Olivia as to the
deductibility of the fee to the property broker, course fees and the
interest charges to the bank.

Chapter 13 - Specific deductions

Key
points ............................................................................................
....... [13.00]
Introduction...................................................................................
............. [13.10]
Tax-related
expenses ................................................................................
[13.20]
Repairs ..........................................................................................
.............. [13.30]
Meaning of
repair ......................................................................................
[13.33]
Income-producing
purpose ...................................................................... [13.35]
Capital
expenses .......................................................................................
. [13.37]
Initial
repairs ..........................................................................................
.... [13.40]

Improvements ................................................................................
........... [13.50]
Replacements ................................................................................
............ [13.60]
Notional repairs not
deductible ................................................................ [13.70]
Bad
debts .............................................................................................
...... [13.80]
Determining that a debt is
“bad” .............................................................. [13.83]
Money-lending
business............................................................................ [13.85]
Corporate
taxpayers..................................................................................
[13.90]
Payments to
associations .........................................................................
[13.100]
Travel between
workplaces .................................................................... [13.110]
Gifts ..............................................................................................
............. [13.130]
Limitations on deductions for gifts or
donations...................................... [13.140]
Political contributions and
gifts ................................................................ [13.150]
Deductibility of gifts or donations under s 8-
1 ........................................ [13.160]
Prior year
losses.........................................................................................
[13.180]
Corporate
taxpayers..................................................................................
[13.190]
Limitations on
losses ................................................................................
[13.200]
Other specific deduction
provisions ........................................................ [13.210]
Questions ......................................................................................
............ [13.220]

Key points [13.00]

• In addition to the general deduction rule, discussed in Chapter 12,
taxpayers may claim a deduction for various expenses under a specific
deduction provision.
• A specific deduction provision provides taxpayers with a deduction for a
specific type of expense.
• Where a taxpayer is entitled to deduct an expense under both the general
deduction provision (s 8-1 of the Income Tax Assessment Act 1997 (Cth)
(ITAA 1997)) and a specific deduction provision, the taxpayer should deduct
the expense under the specific deduction provision as it is the most
appropriate provision.
• Most specific deduction provisions are contained in Div 25 of the ITAA
1997, but a number of specific deduction provisions are contained in other
Divisions of the legislation, such as Div 30 and Div 36.
• Examples of expenses which may be deducted under a specific deduction
provision include: – the cost of managing one’s tax affairs; – non-capital
expenses incurred in repairing property used for income-producing purposes;
– bad debt write-offs where certain conditions are satisfied; – payments for
membership of a trade, business or professional association;
– expenditure incurred by a taxpayer in travelling directly between two
workplaces;
– gifts or donations to qualifying recipients; and – tax losses incurred in prior
income years.
Introduction [13.10]
As discussed in Chapter 12, there are two categories of deductions: general
deductions and specific deductions. The general deduction rule is in s 8-1 of
the Income Tax Assessment Act 1997 (Cth) (ITAA 1997). Specific deductions
arise where a specific provision in the legislation, outside Div 8, provides the
taxpayer with a deduction for an expense: s 8-5.
A specific deduction provision may relate to an expense that is otherwise
deductible under s 8-1 or it may apply to an expense that is not deductible
under s 8-1 either because it does not satisfy the positive limbs of s 8-1 or
because it is denied by one of the negative limbs of s 8-1. An expense that is
deductible under both a specific deduction provision and the general
deduction provision should be deducted under the “most appropriate”
provision: s 8-10.

As a general rule of statutory construction, the specific deduction provision

would usually be the most appropriate provision. Where an expense is not
deductible under a specific deduction provision, because either the expense
does not satisfy the requirements of the specific deduction provision or there
is no applicable specific deduction provision, the taxpayer should consider
the deductibility of the expense under the general deduction rule in s 8-1.
Section 12-5 lists the specific deduction provisions in the income tax
legislation. Most specific deduction provisions are contained in Div 25, but a
number of specific deduction provisions are contained in other Divisions of
the legislation. Only some of the more common specific deduction provisions
are discussed in this chapter.

Tax-related expenses [13.20]

Section 25-5 of the ITAA 1997 provides taxpayers with a deduction for any
expenditure incurred in managing their “tax affairs”. The definitions of “tax
affairs” and “tax” in s 995-1 limit the deduction to expenses incurred in
relation to the taxpayer’s income tax obligations. While business taxpayers
may be able to deduct such expenses under s 8-1, non-business taxpayers
are unlikely to be able to deduct the expenses under s 8-1 as they would be
classified as private or domestic expenses. Expenses relating to compliance
with other taxes, such as fringe benefits tax (FBT) and goods and services
tax (GST), are not deductible under s 25-5 but are likely to be deductible
under s 8-1 as the expenses incurred in fulfilling the taxpayer’s obligations in
relation to those taxes would generally be incurred in the carrying on of a
business.
The section also provides taxpayers with a deduction for any expenses
incurred in complying with an obligation imposed on the taxpayer by a
Commonwealth law, where the obligation relates to the taxpayer’s tax
affairs, the general interest charge (e.g., on underpayment or late payment
of tax), a penalty payable because the taxpayer’s varied GST instalments are
too low and certain valuation expenses (e.g., in relation to a gift of property).

The payment of income tax, amounts withheld or payable under the Pay As
You Go (PAYG) system, interest incurred in borrowing money to pay income
tax or PAYG amounts and expenditure related to the commission or possible
commission of an offence under Australian or foreign law are not deductible
under s 25-5: s 25-5(2). Note that fees or commissions paid in obtaining
advice in relation to the operation of a Commonwealth law relating to
taxation are only deductible when the advice is provided by a “recognised
tax adviser”: s 25-5(2) (e). “Recognised tax adviser” is defined in s 995-1 as
a registered tax or GST agent or a legal practitioner. Any expenses that are
not deductible under s 8-1 due to the operation of a specific provision that
denies the deduction are also not deductible under s 25-5: s 25-5(3).
Tax-related expenses are also not deductible if the expenses are capital
expenditure: s 25-5(4). For example, the cost of acquiring a computer used
solely in completing tax returns is not deductible under s 25-5 as it is capital
expenditure. However, the cost of the computer may be deducted over a
number of years in accordance with the capital allowances provisions
discussed in Chapter 14. As we will see, the capital allowances provisions
only provide a deduction for property used for an income-producing purpose.
The use of property in complying with tax affairs is taken to be for income-
producing purposes under s 25-5(5). Note that the subsection specifies that
an expense will not be a capital expense simply because the tax affairs
concerned relate to matters of a capital nature.
Example 13.1: Cost of managing tax affairs
Robin uses a tax agent to complete his income tax return every year. This
year, Robin paid his tax agent $110 to complete his tax return. He also paid
his tax agent $300 for advice in relation to the disposal of property which
was subject to the capital gains provisions. Robin is entitled to a deduction of
$410 under s 25-5 as the fees are a cost of managing his tax affairs. The
$300 is deductible even though the advice relates to a capital transaction.
In Determination TD 2017/8, the Commissioner confirms that the cost of
travelling to have a tax return prepared by a “recognised tax adviser” is
deductible under s 25-5.
Repairs [13.30]
Under s 25-10 of the ITAA 1997, taxpayers are permitted a deduction for
expenditure incurred on repairs to premises or depreciating assets used for
income-producing purposes. The term “property” is used in this chapter to
refer to both premises and depreciating assets.

There is some question as to the necessity for s 25-10 as a specific

deduction provision as any expenses that are deductible under this section
are likely to be deductible under s 8-1. Regardless, if applicable, repairs
should be deducted under s 25-10, rather than s 8-1, as it is the most
appropriate provision: s 8-10.
To claim a deduction for repairs under s 25-10(1), it is necessary to show
that:
• the expenditure relates to a repair;
• the property is used for income-producing purposes; and
• the expense is not a capital expense.
Meaning of repair [13.33]
The word “repair” is not defined in the income tax legislation and takes on its
ordinary meaning. “Repair” generally refers to the remedying of a defect in a
property. In Lurcott v Wakely and Wheeler [1911] 1 KB 905, Buckley LJ
provided the following examples of “repair”: A skylight leaks; repair is
effected by hacking out the putties, putting in new ones, and renewing the
paint. A roof falls out of repair; the necessary work is to replace the decayed
timbers by sound wood; to substitute sound tiles or slates for those which
are cracked, broken, or missing; to make good the flashings, and the like.
Part of a garden wall tumbles down; repair is effected by building it up again
with new mortar, and, so far as necessary, new bricks or stone.
The property must be in need of restoration for the work to constitute a
“repair” (Case J47 (1958) 9 TBRD 244) and pure maintenance work will
generally not be considered a repair. For example, painting a wall which has
deteriorated would be considered a repair, whereas oiling a part which is in
perfect working condition would constitute maintenance, and not a repair.
Expenses for maintenance work which are not deductible under s 25-10 of
the ITAA 1997 may be deductible under the general deduction provision, s 8-
1.

Example 13.2: Expenses not for repairs

A shopkeeper, Sam, decides to replace his shop’s awning with a more
modern and aesthetically pleasing equivalent. The old awning is in good
condition before the work is done – there is nothing to be restored, there are
no decayed or worn-out parts to be replaced and nothing loose or detached
that needs to be fixed.
The expenditure involved is not for repairs because the awning was in good
repair before the work was done, so the expenses are not deductible under s
25-10. Source: Adapted from Example 1, Ruling TR 97/23.

In Ruling TR 97/23, the Commissioner suggests that work done solely to

meet the requirements of regulatory bodies will not be a repair unless the
work remedies defects in the property. For example, the cost of removing
asbestos insulation from factory walls and replacing it with modern insulation
material would not be considered a repair if the insulation is not in need of
repair.
Income-producing purpose [13.35]
The property must be used for an income-producing purpose for repairs to
be deductible under s 25-10 of the ITAA 1997. Examples of the use of
property for income-producing purposes include property used to earn rental
income or to carry on a business.
Section 25-10(2) ensures that a partial deduction is available, where the
taxpayer only partly held or used the property for income-producing
purposes during the income year. In this case, the taxpayer is entitled to a
deduction for the amount of the expense that is considered “reasonable”. In
Ruling TR 97/23, the Commissioner suggests that “reasonable” would be in
proportion to the part of the property or period used for income-producing
purposes.
Example 13.3: Repairs on premises partly used for income-
producing purposes
Emma owns a two-bedroom house. She lives in one bedroom and she rents
out the other bedroom. Emma incurred $100 of expenses on repairs to the
house. Emma is entitled to a deduction of $50 under s 25-10(2) as 50% of
the house is used for income-producing purposes.
Where the repairs are undertaken after the property ceases to be held,
occupied or used for income-producing purposes, the cost of the repairs will
be deductible if the necessity for the repairs can be related to the use of the
property for income-producing purposes and the property did produce
assessable income during the year when the expenses were incurred: Ruling
IT 180.
Capital expenses [13.37]
Once it is determined that the property is used for income-producing
purposes, the main issue in claiming a deduction for repairs is to determine
whether the expenditure constitutes a capital expense. As with s 8-1 of the
ITAA 1997, s 25-10(3) denies taxpayers a deduction for repairs that
constitute capital expenditure.
Whether or not a repair constitutes a capital expense is determined in
accordance with the test and factors outlined in Sun Newspapers Ltd and
Associated Newspapers Ltd v FCT (1938) 61 CLR 337: see [12.180]. A repair
that relates to the business structure is likely to constitute a capital expense,
whereas a repair that is a working or operating expense will be deductible
under s 25-10.
Broadly, case law has developed three categories of expenditure on repairs
which may be classified as capital expenditure:
• initial repairs: see [13.40];
• improvements: see [13.50]; and
• replacements: see [13.60].
Initial repairs [13.40]
Initial repairs are repairs undertaken to remedy defects which exist at the
time the property is acquired. The courts have held that such repairs are not
deductible as they are capital expenses: Law Shipping Co Ltd v Inland
Revenue Commissioners (1923) 12 TC 621; W Thomas & Co Pty Ltd v FCT
(1965) 115 CLR 58. It is considered likely that the taxpayer would have
received a reduction in the purchase price of the property to take into
account the cost of the repairs and it is therefore appropriate to treat the
expenditure as a part of the cost of acquisition. However, even where the
taxpayer may not have been aware of the defects at the time of acquisition,
initial repairs are still not deductible: W Thomas & Co Pty Ltd v FCT (1965)
115 CLR 58.
Note that the test is that the defects must have existed at acquisition time
and not that the repairs have to be undertaken at that time. Repairs
undertaken at a later point in time may still be treated as initial repairs if the
defects existed at the time of acquisition. Similarly, repairs made soon after
the property is acquired may not necessarily be initial repairs and it would
depend on whether the defects existed at the time of the acquisition.
Example 13.4: Initial repairs – possible partial deduction
Micah purchased a house close to the local university with the intention of
renting the house out to students. At the time of the acquisition, the house
desperately required repainting but Micah did not have sufficient money to
do so. He managed to rent it out to some students for a year at lower rent
and then repainted the house once they left, 12 months later. The repainting
cost Micah $2,000.

The $2,000 would generally be deductible under s 25-10 as it relates to the

repair of premises used for an income-producing purpose (to gain or produce
rental income). However, in this case, the $2,000 may not be fully deductible
under s 25-10 as the repainting is to remedy a defect which existed at the
time of acquisition and is therefore an “initial repair” which constitutes a
capital expense.
Micah may be able to claim a deduction for some portion of the $2,000 if it
could be argued that the expense is attributable to the one year when the
house was rented out to the students.
Example 13.5: Initial repairs capital in nature and not deductible
William purchased a house that was in good repair, but to make it more
attractive to prospective tenants he undertook minor repairs and
renovations. The minor repairs and renovations were initial repairs and their
cost is of a capital nature and is not deductible under s 25-10. During the
course of the repairs and renovations, William discovered that the woodwork
was seriously affected by white ants. He incurred substantial expenditure to
remedy the white-ant-related problems in order to restore the house to a
state suitable for occupation by tenants. The white-ant-related problems
existed at the date of purchase and the expenditure incurred to fix those
problems constitutes initial repairs which are capital in nature and not
deductible under s 25-10. The facts that William was unaware of the problem
when he purchased the house and would have paid a lower purchase price if
he had known of the need for repairs do not alter the capital nature of the
expense: Case 64 (1944) 11 TBRD (OS) 202; W Thomas & Co Pty Ltd v FCT
(1965) 115 CLR 58. Source: Adapted from Example 13, Ruling TR 97/23.
Improvements [13.50]
As stated by Windeyer J in W Thomas & Co Pty Ltd v FCT (1965) 115 CLR 58
at 72, “repair involves restoration of a thing to a condition it formerly had
without changing its character”. In some cases, the work done to property
may surpass being a repair and constitute an improvement, in which case
the expenditure will be capital in nature. Generally, repairs remedy a defect
due to wear and tear, whereas an improvement enhances the efficiency or
character of the property.
Distinguishing between a repair and an improvement is a question of fact
and will depend on the exact work done. A repair may constitute an
improvement if the materials used to repair the property are different to the
original materials or where the work done to the property involves
technological advancements. Generally, a repair should only restore the
property to its previous condition (ie, before wear and tear due to the
taxpayer’s income-producing activities, which will generally be its condition
when acquired by the taxpayer) and not change the character or efficiency
of the property.
Case study 13.1: Improvements not deductible due to change of
character of property
In FCT v Western Suburbs Cinemas Ltd (1952) 86 CLR 102, the taxpayer
wanted to repair a damaged ceiling at its cinema but the existing materials
were no longer available and therefore the taxpayer “repaired” the ceiling
with newer, better material. The new material, fibrous plaster, had a much
longer life than the old material, was harder and was also better decorative
material as it could be moulded. The High Court denied the taxpayer a
deduction for the cost of repairing the ceiling with the new material on the
basis that the use of the new material was an improvement and the
purported repair changed the character of the property and did not merely
restore it to its previous condition. This is despite the fact that the existing
material was no longer available and the taxpayer did not have a choice in
using the new material. The Court stated that the test was whether the
actual expenditure incurred by the taxpayer constituted a repair.
Example 13.6: Repair constitutes improvement – not deductible
Elle uses her truck for income-producing purposes. She replaces the truck’s
worn-out petrol engine with a diesel engine, which improves the economy of
operation of the truck. Due to the significantly greater efficiency in the
truck’s function, the costs relate to improvement of the truck and not just a
repair. The engine, being a major and important part of the truck, is a new
and better engine with considerable advantages over the old one, including
reducing the likelihood of future repair bills. The costs are capital in nature
and are not deductible under s 25-10. Source: Adapted from Example 3,
Ruling TR 97/23. See also Case 82 (1953) 3 CTBR (NS).
Example 13.7: Repair not an improvement – deductible
Mary owns a factory and she needs to repair its floor, which is made of
bitumen laid on a gravel base. She replaces it with a new floor consisting of
an underlay of concrete topped with a paving stone made of crushed granite
and cement. The new floor, from a functional efficiency (rather than
aesthetic) point of view, is not superior in quality to the old floor and it
performs exactly the same function as the old floor. In fact, the new floor will
be more expensive to repair than the old floor. Because the new floor is not a
substantial improvement, it is a repair and its cost is deductible under s 25-
10. Source: Adapted from Example 8, Ruling TR 97/23. See also Case T75
(1968) 18 TBRD 377; Case 40 (1968) 14 CTBR (NS).
Where repairs and improvements are done concurrently, the taxpayer may
be entitled to a deduction for the expenses which constitute a repair if the
expenses can be separately identified and quantified.
Example 13.8: Repairs and improvements done concurrently –
partial deduction
Tracy owns a factory, for which the council has advised her to repair faulty
wiring, reposition existing electrical outlets and install new power points,
mains and switchboards.
The cost of the work relating to repairing the faulty wiring only is deductible
under s 25-10 provided Tracy can separate the costs of repairing the wiring
from the (capital) costs of the electrical improvements. Tracy should seek
separate quotes and maintain separate accounts in relation to the costs of
repairing the wiring and the cost of the electrical improvements. Source:
Adapted from Example 12, Ruling TR 97/23.
Replacements [13.60]
Finally, where the repair to property involves a replacement, it is necessary
to ascertain whether the replacement is of part of an asset (which is a repair
and therefore deductible) or the whole of an asset (which is a replacement
and therefore capital): Lindsay v FCT (1960) 106 CLR 377.
Distinguishing between replacements of a part of an asset, as opposed to
the whole of an asset, can be a difficult issue and depends on the individual
facts of a case. Essentially, an asset will be an asset in itself, where it is
separately identifiable from the entire asset and is capable of independent
use.
For example, in Samuel Jones & Co (Devondale) Ltd v IRC (1951) 32 TC 513,
the Court accepted that the replacement of a chimney in need of repair with
a new chimney of similar dimensions and quality was a repair and not a
replacement as the chimney was an inseparable part of the entire asset,
being the factory.

In FCT v Western Suburbs Cinemas Ltd (1952) 86 CLR 102, although the
taxpayer changed the entire roof of the cinema, the replacement of the roof
was the replacement of part of an asset only and not the whole of the asset,
being the cinema. The roof was not a separately identifiable asset in itself
and had no independent use. Similarly, in W Thomas & Co Pty Ltd v FCT
(1965) 115 CLR 58, a building was held to be the entire asset with the floor
and walls being parts of the asset.
Example 13.9: Replacement of part of asset – deductible
Micah owns an investment property which is rented out to students. He
recently had an electrician attend the premises to fix the air conditioner in
the property as the tenants complained that it was leaking. The electrician
changed the compressor in the air conditioning unit, which solved the
problem.
The changing of the compressor is a repair as the compressor is part of the
asset (the air conditioner) and does not have any independent use. As such,
the costs incurred in changing the compressor are deductible under s 25-10
of the ITAA 1997 as a repair. On the other hand, if the electrician had
changed the air conditioning unit, installing a new, identical unit, that would
have been the replacement of an entire asset and the costs incurred would
not be deductible under s 25-10, as they would be a capital expense.
Example 13.10: Replacement of part of an asset and whole asset –
partial deduction
Stuart and Jeff are neighbouring farmers affected by a severe bushfire.
Stuart restores his existing fencing to good condition by mending it and
replacing damaged sections, for example, the fence on the northern
boundary. Jeff replaces the entire fence surrounding his property. Stuart is
entitled to claim a deduction for the cost of repairing his fence under s 25-
10. The entirety is the total fencing, so replacing the fences on the northern
boundary is a replacement of a subsidiary part of the whole fencing.
However, Jeff’s expenditure is not deductible under s 25-10 because the
whole fence was replaced, making it a reconstruction of the entirety. The
total fence is not a subsidiary part of the rural property or of anything else.
To replace entire fencing with new fencing is to replace one capital asset
with another capital asset. The cost is therefore of a capital nature. Source:
Adapted from Example 4, Ruling TR 97/23. See also Case 58 (1962) 10 CTBR
(NS); Case 44 (1963) 11 CTBR (NS).
Example 13.11: Replacement of separately identifiable asset not
deductible
Mr Bowser owns a service station that is not connected to the mains power
supply. He has meters and a pumping plant to supply power to the service
station, both of which he needs to replace due to old age. The meters and
the pumping plant are entireties in their own right, separate and distinct
from the service station. Their replacement is not a repair and the cost is not
deductible under s 25-10. Source: Adapted from Example 6, Ruling TR 97/23.
See also Case 36 (1949) 15 TBRD (OS) 287.
Expenditure incurred in repairing an asset which is not deductible because it
constitutes the replacement of the entire asset may be deductible under the
capital allowances provisions if the asset is a depreciating asset (see Chapter
14) or it may be added to cost base if the asset is a CGT asset (see Chapter
11).
Notional repairs not deductible [13.70]
Consistent with the provisions of the tax legislation generally, taxpayers are
only entitled to a deduction under s 25-10 for the actual expenditure
incurred by the taxpayer on repairs and not some notional (i.e., theoretical
or estimated) amount. For example, where the taxpayer’s expenditure on
repairs is not deductible because the expenditure is capital in nature, the
taxpayer is not entitled to claim a deduction for “notional repairs”: FCT v
Western Suburbs Cinemas Ltd (1952) 86 CLR 102. “Notional repairs” refers
to the cost that would have been incurred by a taxpayer had he or she
merely repaired the property, rather than improved it or replaced the
entirety. The taxpayer also cannot argue that expenses should be deductible
as the improvement or replacement would save on future expenditure for
repairs which would be deductible.
Case study 13.2: Notional repairs not deductible
As discussed in Case Study [13.1], the High Court in FCT v Western Suburbs
denied the taxpayer a deduction for expenditure on repairs to a ceiling on
the basis that the repairs undertaken constituted an improvement due to the
use of new material. In the alternative, the taxpayer sought to claim a
deduction for £603, being the architect’s estimate of the cost that would
have been incurred by the taxpayer had the ceiling been repaired using the
old material instead of the new material.
The Court denied the taxpayer a deduction for the £603 as well on the basis
that the deduction was for “notional repairs” and there was no basis in law
for a deduction for repairs that could have been undertaken by the taxpayer.
Again, the test of deductibility depends on the actual cost incurred by the
taxpayer.
Example 13.12: Notional repairs not deductible
Ken runs a factory in a building, where the wooden floor needs repairing. He
has two options. He can either repair the old floor or replace it with an
entirely new one made of steel and concrete. Ken chooses the second option
because it will save on future expenditure on repairs and because it has
distinct advantages over the old wooden floor. Ken cannot claim a deduction
for the costs incurred in replacing the floor or the costs he would have
incurred if he had simply repaired the wooden floor. The replacement of the
floor with the new material constitutes an improvement and his actual
expenditure is capital, so none of it is deductible as a repair under s 25-10.
Source: Adapted from Example 7, Ruling TR 97/23.
Bad debts [13.80]
Taxpayers who account for their income on an accruals basis rather than on
a cash basis (see Chapter 16) include their business income in their
assessable income at the time it is derived, rather than when it is received.
However, in some cases, the taxpayer may find that it is unable to recover
moneys owed and has a bad debt. In this situation, s 25-35(1)(a) of the ITAA
1997 provides taxpayers with a deduction for the write-off of a bad debt,
where the debt was previously included in the taxpayer’s assessable income.
Where the taxpayer is carrying on a money-lending business, s 25-35(1)(b)
provides the taxpayer with a deduction for the write-off of a bad debt.
In order for a taxpayer to claim a deduction under s 25-35, it is important
that in the income year when the taxpayer claims the deduction:
• there is an existing debt (i.e., the taxpayer is legally or equitably entitled
to receive an amount from another entity);
• the debt is bad; and
• the debt was actually written off – merely creating a provision for bad
debts will not constitute a write-off; there must be some written record, for
example, board minutes, memo from financial controller or accounting
entries, to evidence the taxpayer’s decision to write off the debt.
The taxpayer will not be entitled to a deduction for a bad debt under s 25-
35, where all of these elements are not satisfied: Point v FCT (1970) 119 CLR
453.
Case study 13.3: Bad debt deductions denied – write-off in wrong
year
In Point v FCT (1970) 119 CLR 453, the taxpayer entered into an agreement
to release a debtor from its obligations to the taxpayer in one income year
and the debt was written off in the taxpayer’s accounts in the following
income year.
The High Court found that the taxpayer was not entitled to a bad debt
deduction under the former equivalent provision of s 25-35 in either income
year. In the first year, the taxpayer was not entitled to a deduction as the
debt had not actually been written off, while a deduction was not available in
the following year, as there was no debt in existence at that time. This was
because the debtor had been released from its obligations in the previous
income year.
Example 13.13: Bad debt deductions
Company R sells goods on credit. It includes the amount of a sale in its
assessable income at the time of sale. As of 30 June, Company R had
$10,000 in debts relating to past sales. The company created a provision for
bad debts of $2,000 for debts that remained unpaid after three months and
also wrote off debts of $1,000, which were still unpaid after six months.
Company R is entitled to a deduction of $1,000 under s 25-35 of the ITAA
1997 in respect of the write-off as the $1,000 had previously been included
in Company R’s assessable income at the time of sale, and all of the other
conditions in s 25-35 are satisfied. The provision for bad debts of $2,000 is
not deductible as it does not constitute a “write-off”.
Determining that a debt is “bad”[13.83]
Taxpayers are only entitled to a deduction for a debt that is “bad” under s
25-35 of the ITAA 1997. In Ruling TR 92/18, the Commissioner suggests that
it is not necessary that the taxpayer take all available legal steps to recover
a debt before it can be classified as “bad”. It is sufficient that the taxpayer
make a bona fide assessment based on sound commercial considerations
that the debt is bad. In Ruling TR 92/18, the Commissioner states:
31. A debt may be considered to have become bad in any of the following
circumstances:
(a) the debtor has died leaving no, or insufficient, assets out of which the
debt may be satisfied;
(b) the debtor cannot be traced and the creditor has been unable to
ascertain the existence of, or whereabouts of, any assets against which
action could be taken;
(c) where the debt has become statute barred and the debtor is relying on
this defence (or it is reasonable to assume that the debtor will do so) for
non-payment;
(d) if the debtor is a company, it is in liquidation or receivership and there
are insufficient funds to pay the whole debt, or the part claimed as a bad
debt;
(e) where, on an objective view of all the facts or on the probabilities existing
at the time the debt, or a part of the debt, is alleged to have become bad,
there is little or no likelihood of the debt, or the part of the debt, being
recovered.
32. While individual cases may vary, as a practical guide a debt will be
accepted as bad under category (e) above where, depending on the
particular facts of the case, a taxpayer has taken the appropriate steps in an
attempt to recover the debt and not simply written it off as bad. Generally
speaking such steps would include some or all of the following, although the
steps undertaken will vary depending upon the size of the debt and the
resources available to the creditor to pursue the debt:
(i) reminder notices issued and telephone/mail contact is attempted;
(ii) a reasonable period of time has elapsed since the original due date for
payment of the debt. This will of necessity vary depending upon the amount
of the debt outstanding and the taxpayers’ credit arrangements (e.g. 90, 120
or 150 days overdue);
(iii) formal demand notice is served; (iv) issue of, and service of, a summons;
(v) judgment entered against the delinquent debtor; (vi) execution
proceedings to enforce judgment;
(vii) the calculation and charging of interest is ceased and the account is
closed (a tracing file may be kept open; also, in the case of a partial debt
write-off, the account may remain open);
(viii) valuation of any security held against the debt; (ix) sale of any seized
or repossessed assets.
While the above factors are indicative of the circumstances in which a debt
may be considered bad, ultimately the question is one of fact and will
depend on all the facts and circumstances surrounding the transactions. All
pertinent evidence including the value of collateral securing the debt and
the financial condition of the debtor should be considered. Ultimately, the
taxpayer is responsible for establishing that a debt is bad and bears the onus
of proof in this regard.
Money-lending business [13.85]
The determination as to whether a taxpayer is carrying on a business of
money-lending is a factual one to be made on a case-by-case basis in
accordance with the principles discussed in Chapter 8. In the case of banks
and finance companies, it will generally be clear that they are carrying on a
business of money-lending. One issue that sometimes arises in practice is
whether an in-house finance company is in the business of money lending:
see, for example, FCT v BHP Billiton Finance Ltd [2010] FCAFC 25 (note that
the case was appealed to the High Court but on a different issue: FCT v BHP
Billiton Ltd [2011] HCA 17). This is a factual question to be determined based
on the taxpayer’s circumstances and it has been accepted that a taxpayer
can be in the business of money-lending, even if it only lends to a particular
class of borrowers, as long as it does so in a business-like manner with a
view to making a profit: Fairway Estates Pty Ltd v FCT (1970) 1 ATR 726.
In FCT v National Commercial Banking Corp of Australia Ltd (1983) 15 ATR
21, the Full Federal Court confirmed that a taxpayer that is in the business of
money-lending is entitled to a bad debt deduction even where an amount
has not been previously included in the taxpayer’s assessable income in
relation to the debt. The deduction is not only limited to the unpaid loan
principal but also includes any capitalised interest and associated costs, such
as fees and charges.
Corporate taxpayers [13.90]
Companies are only entitled to a deduction for bad debts, where the
company satisfies the loss recoupment tests discussed in Chapter 21.
Essentially, a company must have the same owners or the same or similar
business from the time the debt was incurred to the time when a bad debt
deduction is claimed for the debt.
Payments to associations [13.100]
Section 25-55 of the ITAA 1997 provides taxpayers with a deduction for
payments for membership of a trade, business or professional association.
However, the maximum amount deductible under this section is $42.
Therefore, as the note to s 25-55 points out, a taxpayer would be better
advised to claim a deduction for payments to associations under s 8-1 if the
taxpayer satisfies the requirements of that section. The difference between
the two sections is that s 8-1 requires a connection between the expense
and the production of income, whereas there is no such nexus requirement
in s 25-55.
Example 13.14: Payments to associations deductible under ss 8-1
and 25-55
Talil is an accountant and is a member of the Accounting Institute of
Australia. His membership fees for the year were $700. Talil would claim a
deduction of $42 under s 25-55 of the ITAA 1997 and a deduction of $658
under s 8-1 as the expense was incurred in gaining or producing his
assessable income.
Example 13.15: Payments to associations deductible under s 25-55
only
Following on from Example 13.14, assume that Talil has decided to pursue
his true passion for cooking and works as a chef instead of as an accountant.
Talil would claim a deduction for $42 under s 25-55 for his accounting
membership fees but would not be entitled to a deduction under s 8-1 for
the remaining $658 as the membership fees are not incurred in gaining or
producing his assessable income.
Travel between workplaces [13.110]
As discussed in Chapter 12, in FCT v Payne (2001) 202 CLR 93, the Full High
Court found that expenses incurred by a taxpayer in travelling between two
unrelated places of work are not deductible under s 8-1 of the ITAA 1997 as
the expenses are not incurred in the course of gaining or producing
assessable income but rather in putting the taxpayer in a position to gain or
produce assessable income. As such, the expenses do not satisfy the
positive limbs of s 8-1. A workplace is a place where the taxpayer is engaged
in activities which gain or produce assessable income (e.g., place of
employment or place of business).

The Government subsequently introduced s 25-100, which provides

taxpayers with a deduction for travel directly between two workplaces,
where the taxpayer is engaged in income-producing activities at each
workplace (e.g., employment or business). However, the expenses are not
deductible under s 25-100, where one of the workplaces is also the
taxpayer’s residence. The taxpayer in FCT v Payne, for example, would not
be assisted by s 25-100 as the location of his deer-farming business activity
was also his residence.
Example 13.16: Travel between workplaces
Nash works as an accountant at a large accounting firm. He also works in his
family business. Under an arrangement with the accounting firm, he leaves
the accounting firm at 3 pm each day to go and work in the family business
(where he receives salary income). Nash takes a train from the accounting
firm to the family business.
Nash would be entitled to a deduction for the cost of his train ticket for the
travel between the accounting firm and his family business under s 25-100
of the ITAA 1997. The travel is directly between two workplaces, where he
gains or produces assessable income and neither is his residence.
Gifts [13.130]
Division 30 of the ITAA 1997 provides taxpayers with a deduction for gifts or
contributions made to particular recipients. The gift or contribution can be of
money or property. Note that the amount of the deduction is generally
limited to the amount “paid” or “contributed” and does not include the
incurring of a liability: s 30-15; Arnold v FCT [2017] AATA 1318.
Broadly, a gift or contribution must be made to a “deductible gift recipient”
(DGR) to qualify for a deduction under Div 30. A “deductible gift recipient” is
an entity which meets the requirements to be registered as such by the
relevant body, for example, public universities, public hospitals, charities
(such as World Vision) or research organisations (such as Cancer Council
Australia). Most organisations would generally publicise the fact that they
are a registered DGR so that potential donors are aware that any gifts or
contributions to the organisation would be deductible for tax purposes.
The issue in relation to the deductibility of gifts or contributions is that the
payment must be a “true” gift and made with no expectation of material
advantage in return: FCT v McPhail (1968) 117 CLR 111. In Ruling TR
2005/13, the Commissioner suggests that a deductible gift must be one that
is voluntary, transfers the taxpayer’s beneficial interests in the property to
the recipient and is made without the expectation of a material advantage in
return.
Case study 13.4: Gift not deductible due to receipt of material
advantage in return
In FCT v McPhail (1968) 117 CLR 111, the taxpayer made a contribution to a
building fund for the school attended by his son. The school charged
different fees depending on whether a contribution was made to the building
fund. As such, the taxpayer was charged lower school fees for his son than
he would have otherwise paid.
The High Court denied the taxpayer a deduction for the contribution to the
building fund on the basis that it was not a true gift as the taxpayer received
a material advantage in return, being the lower school fees for his son’s
education.
Example 13.17: Deductibility of charitable donations
Sam is a strong supporter of Cancer Council Australia. He makes a monthly
donation of $10 to the organisation. In addition, he purchased 20 raffle
tickets which cost him $2 each. The raffle prize was the latest model BMW
car which was Sam’s dream to own. Cancer Council Australia is a registered
DGR.
Sam would be entitled to a deduction for the $10 monthly donation to
Cancer Council Australia under Div 30 of the ITAA 1997 as it is a donation to
a DGR. However, Sam would not be entitled to a deduction for the purchase
of the raffle tickets ($40) as it is not a “true” gift. Sam has received a
material advantage in return for the $40, being his entry into the raffle
competition and the opportunity to win the BMW car. Further, the payment is
not “voluntary” as it is in effect a payment for the right to enter a
competition.
Whether or not the taxpayer has received a material advantage from the gift
or donation is a question of fact, and the Commissioner provides a number
of examples in Ruling TR 2005/13 on this issue. For example, where the
taxpayer receives items such as chocolates, calendars, pens or mugs in
return for a gift or donation, the Commissioner considers it likely that the
taxpayer has received a material advantage in return for the gift or donation
as these are utility items which benefit the taxpayer. On the other hand,
where the taxpayer receives token items, such as a lapel badge, bumper
sticker, red nose or daffodils, the items are not considered to provide the
taxpayer with a material advantage as they are not utility items and
primarily serve as promotional or advertising material for the recipient.
Public recognition of a gift or donation (e.g., on a telethon or in a publication)
generally does not constitute a material advantage. However, public
recognition that is used in the donor’s advertising or marketing may
constitute a material advantage.
Limitations on deductions for gifts or donations [13.140]
A taxpayer’s deduction for a gift or donation may be limited or disallowed in
certain circumstances.
Under s 26-55(1) of the ITAA 1997, a taxpayer is not entitled to a deduction
for a gift or contribution under Div 30 if the deduction would result in the
taxpayer incurring or increasing a tax loss for the year.

Example 13.18: Charitable donations and losses

Jasper has assessable income of $100,000 and deductions of $120,000. His
deductions of $120,000 include donations of $30,000, which satisfy the
requirements in Div 30 of the ITAA 1997.
Jasper is only entitled to a deduction of $10,000 in respect of his donations,
which would result in his taxable income for the year being nil. Jasper is not
entitled to a deduction for the remaining $20,000 of donations under Div 30
as that would result in him incurring a loss in the current year: s 26-55(1).
However, s 26-55 does not limit deductions for gifts or donations that satisfy
the general deduction rule in s 8-1 and Jasper may be able to deduct the
remaining $20,000 of donations under s 8-1 if the requirements of that
provision are satisfied (see [13.160]).
In addition, an anti-avoidance rule in s 78A of the Income Tax Assessment
Act 1936 (Cth) does not permit a deduction for gifts or donations under Div
30 in certain circumstances. A gift or deduction may not be deductible,
where:
• the amount or value of the benefit derived by the DGR as a consequence
of the gift is, or will be, or may reasonably be expected to be, diminished
subsequent to the receipt of the gift: s 78A(2)(a);
• another fund, authority or institution, other than the recipient DGR makes,
or becomes liable to make, or may reasonably be expected to make a
payment, or transfer property to any person or incur any other detriment,
disadvantage, liability or obligation: s 78A(2)(b);
• the giver or the giver’s associate obtains, or will obtain, or may reasonably
be expected to obtain any benefit, advantage, right or privilege apart from
the benefit of a tax saving associated with the gift deduction: s 78A(2)(c); or
• the recipient DGR or another fund, authority or institution acquires
property, directly or indirectly, from the giver or the giver’s associate: s
78A(2)(d).

Under s 78A(3), a donation of property may not be deductible, where the

donor retains the right to use the donated property. In essence, s 78A
addresses situations, where the gift or donation is not in fact a “true” gift or
donation.
Political contributions and gifts [13.150]
Section 26-22 denies business taxpayers a deduction for political gifts or
donations. A political gift or donation can be a contribution to a registered
political party or an individual who is a candidate in a government election
(federal, state or local) or a current member of government. Individuals can
claim a maximum deduction of $1,500 for political gifts or donations but not
if the gift or donation is made in the course of carrying on a business: ss 30-
242 and 30-243. Where an individual makes a political gift or contribution in
the course of carrying on a business, the amount is not deductible under s
26-22.
Deductibility of gifts or donations under s 8-1 [13.160]
Where a gift or donation, other than a political gift or donation, is not
deductible under Div 30 of the ITAA 1997, the gift or donation may
nonetheless be deductible under the general deduction provision, s 8-1: see
Chapter 12. The key issue is that the gift or donation must be sufficiently
connected to the production of the taxpayer’s assessable income. The
limitation on the deductibility of political gifts and donations in s 26-22 also
applies to deductions under s 8-1. However, the limitations in s 26-55 and s
78A apply to deductions for gifts or donations under Div 30 only.
The following examples illustrate when gifts or donations that are not
deductible under Div 30 may be deductible under s 8-1.
Example 13.19: Gift or donation incurred in gaining or producing
assessable income
Lucas runs his own advertising agency. During the month of July, he agrees
to donate a percentage of his fees from any new clients to a DGR nominated
by the client.
The donation to the DGR by Lucas is unlikely to be deductible under Div 30
as Lucas has received a material advantage in return – that is, the custom of
the new client. However, Lucas is likely to be able to claim a deduction for
the donation under s 8-1 as the donation is incurred in the course of gaining
or producing Lucas’ assessable income, thereby satisfying the positive limbs
of s 8-1. None of the negative limbs of s 8-1 apply to deny a deduction.
Example 13.20: Gift or donation incurred in gaining or producing
assessable income
Robert owns a costume shop. He makes a payment of $20,000 to a cultural
DGR on the basis that it will place a prominent sign at the entrance to its
complex thanking Robert’s Costume Shop for its generous support. The
$20,000 payment is not a gift, as Robert receives a material benefit, namely
advertising for his shop, in return for it. In addition, the payment would not
be deductible because of s 78A(2)(c). However, Robert may be entitled to a
deduction under s 8-1 for the contribution as a business expense. Source:
Adapted from Example 66 in Ruling TR 2005/13.
Example 13.21: Gift or donation incurred in gaining or producing
assessable income
As part of its “corporate philanthropy” program, a large retailer sponsors a
local symphony orchestra (a DGR). The retailer’s business name is to be
included in the name of all concerts, all advertising and displays at concerts
are to feature the retailer’s logo and name in the dimensions it specifies, and
such advertising and displays are to emphasise the retailer’s support and
commitment to the symphony orchestra. The retailer will give the orchestra
$400,000 for the year. The payment will not be a gift. The retailer receives
material benefits from the advertising. However, the retailer may be entitled
to a deduction under s 8-1 for the payment as a business expense. Source:
Adapted from Example 68 in Ruling TR 2005/13.
In Ruling TR 1999/10, the Commissioner suggests that donations of trophies,
books and sporting equipment or gifts such as flowers and cards for
birthdays and other occasions by a parliamentarian to their constituents may
be deductible under s 8-1, even though the recipients are not DGRs. In
Determination TD 2016/14, the Commissioner suggests that gifts to former
or current clients may be deductible under s 8-1 if the gift is made for the
purpose of producing future assessable income.
Prior year losses [13.180]
A taxpayer incurs a tax loss in an income year, where the taxpayer’s
deductions exceed his or her assessable income. As a result, the taxpayer
does not pay any income tax in that income year. In addition, the taxpayer is
entitled to carry forward the loss and utilise it as a deduction against
assessable income in subsequent income years under Div 36 of the ITAA
1997. Unutilised losses can be carried forward indefinitely until death in the
case of an individual taxpayer or for as long as the loss recoupment tests
(see [13.190]) are satisfied in the case of a corporate taxpayer. Note that
these rules are in relation to a taxpayer’s non-capital losses, whereas the
application of prior year capital losses is governed by the capital gains
provisions discussed in Chapter 11.
The amount of a taxpayer’s tax loss in a particular income tax year is
calculated by reference to s 36-10 as follows:
Deductions (excluding prior year tax losses) − Assessable income − Net
exempt income where Net exempt income = Exempt income − Losses or
outgoings incurred in producing exempt income − Any foreign tax paid
Example 13.22: Current year loss amount
Ambrose determined that his assessable income for Year 1 was $100,000,
while his total deductions for the year were $150,000. Ambrose also had
$20,000 of exempt income in that year.
Ambrose has incurred a tax loss of $30,000 for the income year ($150,000 −
$100,000 − $20,000). He is entitled to carry forward the tax loss of $30,000
and utilise it as a deduction against future assessable income.
The relevant provisions regarding the deductibility of prior year losses are ss
36-15 (for entities other than corporate entities, ie, individuals, partnerships
and trusts) and 36-17 (for companies). The sections provide that the
taxpayer is entitled to a deduction against assessable income for prior year
losses. However, where the taxpayer has any exempt income, any prior year
losses must be applied against the taxpayer’s exempt income first and any
remaining amount then applied to the taxpayer’s assessable income. Where
the taxpayer has losses from more than one year, the losses are deducted in
the order in which the taxpayer incurred them, that is, on a first-in-first-out
basis: ss 36-15(5) and 36-17(7).
Example 13.23: Losses in consecutive years
Following on from Example 13.22, Ambrose has carried-forward losses of
$30,000 from Year 1. In Year 2, Ambrose again makes a tax loss of $30,000.
Ambrose does not have any excess assessable income in Year 2 and
therefore he cannot claim a deduction for the prior year loss. His Year 2 loss
is added to the Year 1 loss and carried forward for deduction against future
assessable income.
Example 13.24: Utilisation of prior year losses
Following on from Examples 13.22 and 13.23, Ambrose has carried-forward
losses of $30,000 from Year 1 and $30,000 from Year 2. In Year 3, Ambrose
has assessable income of $200,000, exempt income of $10,000 and
deductions of $160,000.
In working out his tax liability for Year 3, Ambrose must first deduct his
carried-forward losses of $60,000 against his exempt income (if any). In this
case, Ambrose has exempt income of $10,000, which leaves him with
carried-forward losses of $50,000.
The $50,000 of carried-forward losses is then deducted against the excess of
Ambrose’s assessable income over his deductions, which in this case is
$40,000, and leaves Ambrose with carried-forward losses of $10,000, which
can be applied against his future assessable income. Note that the losses are
assumed to be utilised on a first-in-first-out basis and therefore the
remaining $10,000 carried-forward loss is assumed to have been incurred in
Year 2.
Corporate taxpayers [13.190]
The key difference between s 36-15 of the ITAA 1997 for non-corporate
entities and s 36-17 for companies is that companies can choose how much
of their carried-forward losses they want to apply against their current year
assessable income after applying the losses against any exempt income.
Individuals, on the other hand, are not entitled to choose the amount of a
prior year loss that they wish to deduct and instead must apply as much of
the loss as is available to reduce their taxable income.
Companies can choose how much of their carried-forward losses to deduct in
the current year due to the operation of the imputation system, which is
discussed in Chapter 21. In some cases, a company may want to pay tax in
order to receive a credit to its franking account so that it can distribute
franking credits to shareholders upon payment of a dividend.
Example 13.25: Prior year losses – company
Assume that in Examples 13.22, 13.23 and 13.24 the taxpayer was not
Ambrose but Company R.
In working out its tax liability for Year 3, Company R must still deduct its
carried-forward losses of $60,000 against its exempt income first. In this
case, Company R has exempt income of $10,000, which leaves it with
carried-forward losses of $50,000.
Instead of deducting $40,000 of carried-forward losses against its excess of
assessable income over deductions of $40,000 in the current year, Company
R can choose to deduct any amount (or none) of its carried-forward losses in
the current year.
For example, if Company R chose to deduct $10,000 of prior year losses, it
would have taxable income of $30,000 in Year 3 on which it must pay tax
and $40,000 of losses to be carried forward and utilised in future income
years.
Limitations on losses [13.200]
All taxpayers are entitled to carry forward prior year losses indefinitely for
use against future assessable income. However, a taxpayer’s entitlement to
utilise prior year losses in future years may be restricted by the following
rules in relation to:
• companies: the continuity of ownership and same or similar business loss
recoupment tests (discussed in Chapter 21); and
• individuals: the non-commercial losses rules in Div 35 of the ITAA 1997
(discussed in Chapter 23).
Other specific deduction provisions [13.210]
There are many specific deduction provisions in Div 25 of the ITAA 1997 and
it is beyond the scope of this book to discuss all of them here. As a specific
deduction provision takes precedence over the general deduction provision
(s 8-10), it is necessary to first check whether there is an applicable specific
deduction provision before considering the deductibility of an expense under
s 8-1. The following specific deduction provisions are worth noting but are
not discussed in detail:
• Expenditure incurred in preparing, registering or stamping a lease of
property or an assignment or surrender of a lease of property, where the
property is used for an income-producing purpose: s 25-20.
• Any expenses incurred by a taxpayer in borrowing money are deductible,
where the loan amount is used for an income-producing purpose: s 25-25.
This provision captures borrowing costs such as loan establishment fees,
valuation fees or loan guarantee insurance which would not be deductible
under s 8-1 as they constitute capital expenses. The expenses are generally
deductible over the term of the loan or five years. Interest expenses, which
are deductible under s 8-1, are not considered borrowing expenses.
• A loss from a profit-making undertaking or plan is deductible under s 25-40
if any profit from that plan would have been assessable under s 15-15.
However, this provision does not apply to property acquired on or after 20
September 1985.
• A deduction is available for a loss of money caused by theft, stealing,
embezzlement, larceny, defalcation or misappropriation by the taxpayer’s
employee or agent (but not an individual employed solely for private
purposes) where the money was included in the taxpayer’s assessable
income in the current year or an earlier income year: s 25-45. The deduction
is available in the year when the taxpayer discovers the loss. Any amount
received by the taxpayer in relation to the loss may be included in the
taxpayer’s assessable income under subdiv 20-A. A deduction is also
available, where a balancing adjustment event (e.g., a disposal) happens to
a depreciating asset and the loss relates to an amount that was included in
the termination value of the asset: s 25-47.
• Payments of a pension, gratuity or retiring allowance to an employee,
former employee or dependant of an employee or former employee are
deductible under s 25-50, where the payments are made in good faith in
relation to the past services provided by the employee or former employee
in relation to the taxpayer’s business. However, the payments are only
deductible under s 25-50 if they are not deductible under another provision
(e.g., s 8-1): s 25-50(3).
Questions [13.220]
13.1 Beatrice owns a lavender farm in regional Victoria. She is
concerned about “dodgy” tax advisers and so she uses a tax adviser
in the
Melbourne CBD who is highly recommended and registered with the
Tax Practitioners Board. She recently received an invoice for $3,300
from her tax adviser. The invoice related to assistance with her
current year income tax return ($1,100) and upcoming sale of her
lavender farm ($2,200). Beatrice was a little late in paying her tax
liability last year and had to pay a general interest charge of $500.
She also incurred $70 in travelling expenses to see her tax adviser.
Advise Beatrice as to the tax deductibility of the abovementioned
expenses.
13.2 Ronald owns a cronut shop. He undertakes the following
activities: (a) Repainting the ceiling which was turning yellow due
to the baking in the shop.
(b) Redoing the floor of the shop with tiles. The floor needed to be
redone as it was timber and had been so well used that it was very
slippery. Ronald decided to use tiles this time so the floor could
have a non-slip surface.
(c) Repainting the sales counter to make it more appealing to
customers. There was nothing wrong with the existing counter, but
Ronald felt that the new colour would be more attractive.
(d) Replastering and repainting a wall in the kitchen. The wall
required work when Ronald bought the shop, but as it was in the
kitchen and could not be seen by customers, Ronald did not bother
getting the work done until now.
Advise Ronald as to his income tax consequences in relation to the
above information.
13.3 Penelope is a surgeon at the local hospital. However, the long
hours have been very draining, and she has decided to take a leave
of absence from the hospital and pursue her interest in blending
coffee beans to find the perfect taste. She has incurred the
following expenses: (a) payment of $5,000 to the Australian Society
of Plastic Surgeons (Penelope has decided to maintain her
membership during her leave of absence in case she decides to go
back to work as a surgeon);
(b) donation of $500 to Médecins Sans Frontières (a registered
DGR); and
(c) donation of $1,000 to her local neighbourhood community house
(a registered DGR). All donors are permitted to book the function
room in the house for free up to three times per year. The normal
booking fee would be $250.
Advise Penelope as to her income tax consequences arising out of
the above information.

13.4 Chantal has provided you with the following information: Year
1:
Assessable income = $100,000; Deductions = $500,000 Year 2:
Assessable income = $500,000; Exempt income = $100,000;
Deductions = $300,000 Year 3:
Assessable income = $100,000; Exempt income = $200,000;
Deductions = $100,000
Advise Chantal as to her taxable income/loss each year. Would your
advice be any different if the taxpayer was Chantal Pty Ltd?
13.5 Big Shoes Pty Ltd sells shoes exclusively online. Customers are
invoiced for the shoes when they are shipped and are only required
to pay for the shoes once they have been received and deemed
satisfactory. Big Shoes includes the invoice amount in its assessable
income when the invoice is issued. As of 30 June, Big Shoes
determined that it had $10,000 in unpaid invoices. Its records
indicated that 70% of the invoices related to shoes sold within the
last month, which was considered acceptable. However, of the
remaining $3,000, $1,000 related to invoices which were more than
three months overdue. In accordance with its customary practice,
Big Shoes wrote off the $1,000 of outstanding invoices. Its standard
practice is to issue payment reminders before writing off the debt
and turning it over to a debt collector. Big Shoes also created a
provision for bad debts of $2,000 at this time.
Advise Big Shoes as to what amount (if any) it can deduct in
relation to the unpaid invoices.
13.6 Jeremy is a personal trainer. He works at a local gym providing
personal training services to members of the gym. Jeremy works at
the gym until 3 pm each day. He then takes the train home. He has
to be home by 4 pm as he trains clients at his home gym from 4 pm
to 7 pm. Advise Jeremy as to the tax deductibility of his train fare.
Would your answer be any different if Jeremy took the train to
another gym, where he trained clients from 4 pm to 7 pm?

Chapter 14 - Capital allowances

Key
points ............................................................................................
....... [14.00]
Introduction...................................................................................
............. [14.10]
Depreciation
deductions ...........................................................................
[14.20]
Depreciating
asset......................................................................................
[14.30]
Composite
items ........................................................................................
[14.35]
Claiming a
deduction .................................................................................
[14.40]
Held ..............................................................................................
.............. [14.50]
Decline in
value ..........................................................................................
[14.70]
Taxable
purpose .........................................................................................
[14.100]
Balancing
adjustments ...............................................................................
[14.110]
Depreciating asset used for non-taxable
purpose .................................... [14.115]
Interaction with capital gains
provisions ................................................... [14.118]
Roll-over
relief ............................................................................................
[14.120]
Cars ..............................................................................................
............... [14.125]
Pooling of
assets .........................................................................................
[14.130]
Low-value
pool ...........................................................................................
[14.140]
Software development
pool ....................................................................... [14.160]
Small business entity
concessions............................................................... [14.165]
Capital works
deductions ............................................................................
[14.170]
Black hole
expenses ....................................................................................
[14.180]
Project
pools..............................................................................................
.. [14.190]
Business-related
costs ................................................................................ [14.200]

Start-up
expenses .......................................................................................
[14.215]
Questions ......................................................................................
.............. [14.220]

Key points [14.00]

• Expenses that are not immediately deductible under the general deduction
provision or a specific deduction provision because they are capital or capital
in nature may be deductible over a number of years under the capital
allowances regime.
• The cost of acquiring a depreciating asset used for income-producing
purposes is one of the main categories of capital expenditure which is
deductible under the capital allowances regime: Div 40 of the Income Tax
Assessment Act 1997 (Cth) (ITAA 1997).
• The holder of a depreciating asset used for income-producing purposes is
entitled to a deduction in an income year for the decline in value of the
depreciating asset for that year.
• The decline in value of a depreciating asset is calculated in accordance
with either the diminishing value method or the prime cost method.
• The disposal of a depreciating asset may give rise to an assessable income
or deduction amount.
• Taxpayers may choose to calculate the depreciation deduction for certain
depreciating assets on a pooled basis.
• Capital expenses incurred in constructing a building used for income-
producing purposes may be deductible under the capital works provisions in
Div 43 of the ITAA 1997.
• Business taxpayers may be entitled to deduct certain capital expenses
which are not otherwise taken into account under the income tax legislation
over a period of five years under s 40-880 of the ITAA 1997.
• Small business taxpayers may be entitled to accelerated deductions in
certain situations.
Introduction [14.10]
As discussed in Chapters 12 and 13, most expenses are not immediately
deductible under s 8-1 of the Income Tax Assessment Act 1997 (Cth) (ITAA
1997) or a specific deduction provision, such as s 25-10 for repairs, where
the expense is a capital expense. However, taxpayers may still be entitled to
a deduction for capital expenses under the capital allowances regime.
Essentially, the capital allowances regime provides taxpayers with a
deduction for the expense over the period of time that the expense is
expected to benefit the taxpayer. This approach aligns the timing of the
deductions with the corresponding income expected to be generated by the
expense.
Note that, in the 2020 Federal Budget, it was announced that businesses
with aggregated annual turnover of less than $5 billion will be able to deduct
the full cost of eligible assets acquired from 7:30 pm AEDT on 6 October
2020 (i.e., Budget night) and first used or installed by 30 June 2022. The
immediate deduction is available for new depreciable assets and the cost of
improvements to existing assets. Small and medium-sized businesses
(aggregated annual turnover of less than $50 million) can also fully deduct
the cost of second-hand assets. The capital allowances regime discussed in
this chapter will not be relevant for assets acquired during that period. The
measure was one of many initiatives introduced to boost business
investment and stimulate the economy in response to the economic impacts
of the global COVID-19 pandemic.
In this chapter, we consider the three categories of deductible capital
expenditure set out in Figure 14.1.
Depreciation deductions [14.20]
One of the most common categories of capital expenditure that is effectively
deductible for tax purposes is capital expenditure which relates to a
depreciating asset used for income-producing purposes. Division 40 of the
ITAA 1997 provides taxpayers with a deduction over a period of years for
capital expenses related to such depreciating assets (e.g., acquisition cost).
The deduction is only available for the time the taxpayer held the
depreciating asset and to the extent that the asset was used for the purpose
of gaining or producing assessable income. The legislation does not use the
term “depreciation” but that is essentially what Div 40 addresses by
providing a deduction for the decline in value of the asset over its estimated
useful life.
The general depreciation rules do not apply in the following circumstances:
• The asset is an eligible work-related item for the purposes of s 58X of the
Fringe Benefits Tax Assessment Act 1986 (Cth) (FBTAA) and is provided as an
expense payment fringe benefit or property fringe benefit: s 40-45(1). The
measure was introduced as it was considered inappropriate that employees
could claim depreciation deductions for such assets, while employers could
claim a deduction in respect of the provision of the fringe benefit and, under
s 58X, avoid paying fringe benefits tax. Following the amendment,
employees are not entitled to claim depreciation deductions in relation to
such items as employees have effectively not borne the cost of the asset
where it is provided as a fringe benefit.
• Expenditure on capital works (i.e., on buildings): s 40-45(2). Capital works
expenditure is deductible under Div 43: see [14.170].
• Expenditure on assets related to investments in Australian films: s 40-
45(5). Such expenditure is generally dealt with under Divs 10BA and 10B of
Pt III of the Income Tax Assessment Act 1936 (Cth) (ITAA 1936).
• Expenditure which is deductible under another subdivision, such as
expenditure on primary production assets (subdiv 40-F); expenditure of
primary producers or other landlords (subdiv 40-G); capital expenditure for
the establishment of trees in carbon sink forests (subdiv 40-J) and
expenditure allocated to a software development pool (subdiv 40-E): s 40-50.
• Expenditure on a car where the deduction for car expenses has been
calculated in accordance with the cents per kilometre method (see Chapter
12) in that year: s 40-55.
• Second-hand depreciating assets used or installed in residential rental
premises: s 40-27. Deduction is not available for the decline in value of such
depreciating assets unless the asset is used in carrying on a business or, the
taxpayer is a corporate tax entity, superannuation fund that is not a self-
managed super fund, managed investment trust, public unit trust, or, a unit
trust or partnership if each member of the trust or partnership is one of
these entities.
Note that “small business entities” can choose not to apply the general
depreciation rules and use the simpler depreciation rules in subdiv 328-D
(see [14.165]) instead.
Depreciating asset [14.30]
The first key issue is to determine whether the expense relates to a
depreciating asset. “Depreciating asset” is defined in s 40-30(1) of the ITAA
1997 as an asset which has a limited effective life (i.e., limited usefulness)
and can reasonably be expected to decline in value over the time that it is
used. Common examples of depreciating assets include computers,
furniture, cars, machinery, telephones, etc.
Land is specifically excluded from the definition of “depreciating asset” as it
is generally not expected to decline in value. Intangible assets are also
excluded from being depreciating assets unless they are specifically listed in
s 40-30(2). Examples of intangible assets that are treated as depreciating
assets include mining, quarrying or prospecting rights or information, items
of intellectual property (copyright, patents and registered designs) and in-
house software. Buildings are effectively treated as not being depreciating
assets as expenditure relating to buildings is considered capital works and is
dealt with under Div 43: s 40-45(2).
Note that:
• the trading stock rules (discussed in Chapter 17) take precedence over the
depreciating asset rules as items of trading stock are excluded from the
definition of “depreciating asset”: s 40-30(1); and
• the depreciating asset rules take precedence over the capital gains tax
(CGT) rules (discussed in Chapter 11) as s 118-24 states that any capital
gains or losses on depreciating assets are disregarded.
Composite items [14.35]
Where a depreciating asset is made up of a number of individual items, it
may be necessary to determine whether each component is a separate
depreciating asset or whether the item as a whole is the depreciating asset.
This is a question of fact and degree which can only be determined in light of
all of the circumstances of the particular case: s 40-30(4). In Draft Ruling TR
2017/D1, the Commissioner suggests, based on case law, that the following
principles should be taken into account in determining whether a composite
item is a single depreciating asset or more than one depreciating asset:
• identifiable function – the depreciating asset will tend to be the item that
performs a separate identifiable function, having regard to the purpose or
function it serves in its business context;
• use – a depreciating asset will tend to be an item that performs a discrete
function. However, the item need not be self-contained or able to be used on
a stand-alone basis;
• degree of integration – the depreciating asset will tend to be the composite
item where there is a high degree of physical integration of the components;
• effect of attachment – the item, when attached to another asset having its
own independent function, varies the performance of that asset;
• system – a depreciating asset will tend to be the multiple components that
are purchased as a system to function together as a whole and which are
necessarily connected in their operation.
For example, the motherboard in a laptop computer will not be a separate
depreciating asset as it is not separately identifiable and has no independent
use. The monitor or screen of a laptop is also not a separate depreciating
asset. Although it can be separately identified, it has no independent use. A
printer will be a separate depreciating asset as it is separately identifiable
and has an independent use.
As mentioned earlier, buildings are effectively treated as not being
depreciating assets since capital expenditure in relation to buildings is
deducted under Div 43, not Div 40. However, it may be necessary in some
cases to identify whether the expenditure relates to a separate depreciating
asset (which is deductible under Div 40) or the building itself (which is
deductible under Div 43). Again, the question is one of fact and degree
which will be determined in accordance with the individual circumstances of
a case. In Rulings TR 2007/9 and TR 2004/16, the Commissioner suggests
the following factors as being relevant in making that determination: •
whether the item appears visually to retain a separate identity;
• the degree of permanence with which it has been attached;
• the incompleteness of the structure without it; and
• the extent to which it was intended to be permanent or whether it was
likely to be replaced within a relatively short period.
Example 14.1: Separate depreciating assets
A retail camping equipment shop specialising in speleological equipment
(i.e., equipment used in cave exploration) has a fibreglass facade attached
to its shopfront. The facade was designed and constructed so that in
colour, texture and shape the doorway has the appearance of a cave
entrance which customers walk through to enter the shop. The interior of the
shop is decorated with various items to continue the cave theme. The
fibreglass facade does not form part of the premises. The facade has a
separate visual identity and is not necessary to complete the premises.
These factors outweigh considerations of the degree of permanence with
which the facade is attached and any intention that it remain in place for a
considerable period of time. The sole purpose of the facade is to create a
cave-like atmosphere or ambience that is intended to attract caving
equipment customers. Given the nature of the equipment in which the
business specialises, the presentation of the cave-like atmosphere is a
definable element in the service the business provides and for which its
customers are prepared to pay. The facade’s function is not as part of the
premises and is so related to the business to warrant it being a separate
depreciating asset. The shopfront to which the fibreglass facade is attached
merely forms part of the premises and is not a depreciating asset. Source:
Adapted from Example 5 in Ruling TR 2007/9.
Example 14.2: Separate depreciating assets
Liam owns an investment property which he rents out to students. He
recently spent $5,000 installing new kitchen cupboards. Kitchen cupboards
form part of the premises and therefore are part of the setting of Liam’s
rental income-producing activities. Kitchen cupboards form part of the
premises as they are fixed to the premises, intended to remain in place
indefinitely and are necessary to complete the premises. Any separate visual
identity is outweighed by the other factors. Since kitchen cupboards form
part of the premises, they are not depreciating assets. Source: Adapted from
Example 1 in Ruling TR 2004/16.
Claiming a deduction [14.40]
The main provision that provides taxpayers with a deduction in relation to
depreciating assets is s 40-25 of the ITAA 1997. According to s 40-25(1), the
amount of the deduction is equal to the decline in value for an income year
of a depreciating asset that is held by the taxpayer any time during the year.
The amount of the deduction is reduced for any use of the asset for a non-
taxable purpose: s 40-25(2).

Where the cost of the depreciating asset is less than $300 and the asset is
used predominantly in gaining or producing assessable income that is not
income from business (e.g., an asset used by an employee for work purposes
or an asset used to gain or produce income from property), the cost of the
depreciating asset is immediately deductible under s 40-80(2). Business
assets are not included in this exception but may be subject to pooling or an
immediate deduction in the case of small businesses: see [14.130] and
[14.165] respectively. An immediate deduction is also available for the cost
of assets used for exploration or prospecting for minerals in certain
circumstances: s 40-80(1).
The immediate deduction is not available, where:
• the asset is part of a set and the taxpayer started to hold the set in that
income year and the set costs more than $300: s 40-80(2)(c); or
• the total cost of the asset and any other identical or substantially identical
assets that the taxpayer starts to hold in that income year exceeds $300: s
40-80(2)(d).
Example 14.3: Depreciating assets costing less than $300
Kieran purchased a table for an investment property which he rents out to
students. The table cost $200. The cost of the table is immediately
deductible to Kieran as it cost less than $300 and is used to produce
assessable income which is not business income (i.e., rental income).
In order to claim a deduction under s 40-25, it is necessary to understand
when a taxpayer has “held” a depreciating asset, the “decline in value” of
the asset and the “taxable purpose” of the asset. We will now consider each
of these elements in detail.

Held [14.50]
Under s 40-25 of the ITAA 1997, it is the holder of an asset who is entitled to
a deduction for the decline in value of a depreciating asset. The table in s
40-40 outlines who will be the holder of an asset in specified circumstances.
Generally, the holder of an asset is its legal owner.
However, in certain circumstances, it may be the economic owner of an
asset, and not the legal owner, who is the holder of the asset and therefore
entitled to the depreciation deductions. For example, in a hire-purchase
arrangement, it is the lessee who is entitled to depreciation deductions as
the economic owner of the asset, and not the lessor, who is the legal owner
of the asset. Broadly, the economic owner of an asset is the person who
bears all the risks and benefits associated with the asset.
Example 14.4: Holder of a depreciating asset
Kieran purchased an air conditioner for his rental property which is rented
out to students. The decline in value of the air conditioner for the year was
$1,000.
Kieran is entitled to a deduction of $1,000 for the depreciation of the air
conditioner as it is used for income-producing purposes. Although the asset
is being used by the students, Kieran is the holder of the asset as he is the
legal and economic owner of the asset. He continues to bear all of the risks
and benefits associated with the asset.
Example 14.5: Holder of a depreciating asset
Big Accounting Pty Ltd acquires a car under a hire-purchase agreement from
Big Cars Pty Ltd. Under the terms of the agreement, Big Accounting is
required to pay monthly instalments for a period of three years at the end of
which legal ownership will be transferred to Big Accounting. During the three
years, Big Cars maintains legal ownership of the cars. However, the costs
and risks of ownership are borne by Big Accounting during this period. The
decline in value of the car is $3,000 per year. Big Accounting is entitled to a
deduction of $3,000 in respect of the depreciation of the car. Although Big
Accounting is not the legal owner of the car, it bears all of the risks of
ownership and is the economic owner of the car. As such, it is the “holder” of
the car under s 40-40.
[14.60] Jointly held depreciating assets. Section 40-35 of the ITAA 1997
ensures that a taxpayer is still entitled to a deduction for the decline in value
of a depreciating asset where the asset is held by more than one person. In
this situation, each person is entitled to a deduction for the decline in value
of his or her interest in the asset.
Example 14.6: Jointly held depreciating assets
Kieran and Rowan purchased a computer together for $5,000 in equal
proportions. They both use the computer for their respective income-
producing purposes only (i.e., no private use). The decline in value of the
computer this year was $1,000.
Kieran and Rowan would each be entitled to a deduction of $500 in relation
to the decline in value of the computer as each has a 50% interest in the
computer, and each has used his interest in the computer for income-
producing purposes only.
However, in the case of depreciating assets held by partnerships, the
depreciating assets are deemed to be held by the partnership and not the
individual partners: s 40-40. Therefore, the partnership includes depreciation
deductions in calculating the partnership’s net income for the year. This is
contrary to the rules regarding CGT assets, where the partner, and not the
partnership, reports the CGT consequences in relation to an asset.
Decline in value [14.70]
Broadly, the decline in value of a depreciating asset is worked out by
apportioning the cost of the asset over the number of years that the asset is
expected to be of use.
The decline in value of a depreciating asset is calculated from the start time,
which is the time the asset is first used or is installed ready for use for any
purpose: s 40-60 of the ITAA 1997. Where the asset is acquired for use in a
business that has not yet commenced, the asset does not start to decline in
value until the business commences: Determination TD 2007/5.
Taxpayers have the option of calculating the decline in value of a particular
depreciating asset using either the diminishing value method or the prime
cost method: s 40-65. The choice of method is made on an asset-by-asset
basis and taxpayers can choose a different method for each of their assets.
However, once the choice of method is made, it cannot be changed: Note 1
to s 40-65; s 40-130. The taxpayer can change the method if the asset is
replaced (i.e., a replacement asset does not have to use the same method
as the original asset). The taxpayer does not have a choice of method in the
following circumstances:
• Assets acquired from an associate: s 40-65(2). The definition of “associate”
is found in s 318 of the ITAA 1936 and is discussed at [7.55]. In this situation,
the taxpayer must use the same method as was used by the associate.
Section 40-140 specifies how the taxpayer is to obtain the relevant
information from the associate. See Example 14.9.
• The holder of the asset has changed but the user is the same or an
associate of the former user: s 40-65(3). The taxpayer is required to use the
same method as the former holder. Where the taxpayer does not know or
cannot readily find out the former holder’s method, the diminishing value
method must be used.
• Assets allocated to a low-value pool (see [14.140]): s 40-65(5). The method
is specified by subdiv 40-E.
• Research and development expenditure deductible under s 73BA of the
ITAA 1936: s 40-65(6). The taxpayer is required to use the same method as
was used under that section.
• The asset is in-house software, an item of intellectual property (except
copyright in a film), a spectrum licence, a datacasting transmitter licence or
a telecommunications site access right: ss 40-70(2) and 40-72(2). The prime
cost method must be used for these assets. The diminishing value method
(known as the “reducing-balance method” in accounting) provides the
taxpayer with greater deductions in the early years of the asset’s life and is
considered more appropriate for assets which wear out more rapidly in the
early years of use. The prime cost method (known as the “straight-line
method” in accounting) provides the taxpayer with equal depreciation
deductions each year (where there are no second element costs incurred
after acquisition) and is more appropriate for assets which wear out evenly
over time.
[14.80] The diminishing value method is set out in ss 40-70 and 40-72 of
the ITAA 1997 as follows:
Assets held pre-10 May 2006:
The percentage in each of the formulas represents the diminishing value
factor. The higher factor does not increase the overall depreciation
deductions for the asset or change the effective life of the asset. The higher
factor provides for greater deductions in the early years of an asset. The
200% rate was introduced in 2006 as it was thought to more closely
approximate the actual decline in the economic value of assets generally
due to rapidly advancing technology.

[14.90] The elements in the above formulae are broadly explained as

follows:
• The base value of an asset is its “opening adjustable value” plus any
second element costs incurred in the current year: s 40-70(1) of the ITAA
1997. The “opening adjustable value” is the cost of the asset less the decline
in value of the asset in previous years: s 40-85. In the first year that the
asset is held, its base value will be its “cost”. Note that the depreciation
deduction for a particular year cannot exceed the asset’s base value in that
year: ss 40-70(3) and 40-72(3).
• The cost of a depreciating asset is outlined in detailed rules in subdiv 40-C.
It is generally equal to the amount paid to acquire the asset (the “first
element” of cost: s 40-180) which can also include acquisition costs such as
customs duty, delivery and installation costs: Ruling IT 2197. Any costs
incurred after the acquisition of the asset which contribute to bringing the
asset to its present condition and location (the “second element” of cost: s
40-190) can also be included in the asset’s cost.
Note that:
– The cost of an asset is not limited to amounts paid by the taxpayer and can
include the value of any non-cash benefits or the amount of a liability: s 40-
185.
– Any expenses that are deductible under another provision of the tax
legislation (eg, repairs that are deductible under s 25-10) cannot be included
in the asset’s cost: s 40-215.
– Goods and Services Tax (GST) is not included in the cost to the extent that
the taxpayer is entitled to “input tax credits” (a refund of GST paid on the
acquisition: see [25.190]): s 27-80.
– Where the asset is acquired from a non-arm’s length party and the amount
paid for the asset exceeds market value, cost is deemed to be market value:
s 40-180(2) Item 8. Whether or not parties are at arm’s length is a question
of fact depending on any connection between the parties and any other
relevant factors: s 995-1. The terms “arm’s length” and “market value” are
discussed at [17.70].
– Where the depreciating asset is a car, the cost of the car for the purposes
of calculating the depreciation deduction is limited to the amount specified
as the “car limit” for the income year when the taxpayer first started to hold
the car: s 40-230. The car limit is $59,136 for the 2020–2021 income year.
See [14.125].
– Where the asset’s effective life is recalculated per s 40-110 (due to
changed circumstances) and the prime cost method is used, the asset’s
“cost” is its opening adjustable value for the change year plus any second
element costs incurred that year: s 40-75(2) and (3). See Example 14.11.
• The days held are the number of days in the year that the asset is used or
installed ready for use for any purpose: s 40-70(1).
• The effective life is the number of years that the asset is expected to be of
use to any taxpayer for a taxable purpose (i.e., it is the “life” of the asset,
not its expected “life” for the particular taxpayer). For example, a car rental
company may trade-in its cars after two years, but the useful life of these
cars is five years. The effective life of the car in calculating the car rental
company’s depreciation deductions is five years. In most cases, the taxpayer
has the option of either estimating the effective life of an asset themselves
or using the Commissioner’s determination of effective life: s 40-95(1). The
Commissioner’s determination of effective life is listed in Ruling TR 2020/3
and Income Tax (Effective Life of Depreciating Assets) Determination 2015
(as amended by subsequent Amendment Determinations). The
Commissioner provides the effective lives for a large number of assets and
industries. Some examples of the Commissioner’s determination of effective
life of assets are included in the Appendix. Taxpayers who choose to use
their own estimates of effective life may be at greater risk of audits or
penalties if the estimates are found to be unrealistic, while taxpayers who
rely on the Commissioner’s determination of effective life will not be subject
to penalties even if the effective life is later determined to be incorrect or
overly-generous.
Taxpayers must determine the effective life of an asset (whether through
self-assessment or using the Commissioner’s estimate) in the income year in
which the asset’s start time occurs: s 40-95(3).
However, taxpayers do not have a choice regarding effective life in the
following situations: • The asset was acquired from an associate: s 40-95(4).
The definition of “associate” is found in s 318 of the ITAA 1936 and is
discussed at [7.55]. The taxpayer’s effective life will depend on the
associate’s choice of method and effective life. Where the associate used the
diminishing value method, the taxpayer must continue to use the same
effective life. Where the associate used the prime cost method, the taxpayer
must use an effective life equal to any period of the asset’s effective life the
associate was using that is yet to elapse at the time the taxpayer started to
hold the asset. See Example 14.9.
• The holder of the asset has changed but the user is the same or an
associate of the former user: s 40-95(5). The taxpayer’s effective life will
depend on the former holder’s choice of method and effective life. Where the
former holder used the diminishing value method, the taxpayer must
continue to use the same effective life. Where the former holder used the
prime cost method, the taxpayer must use an effective life equal to any
period of the asset’s effective life the former holder was using that is yet to
elapse at the time the taxpayer started to hold the asset: s 40-95(5)(c) and
(d). Where the taxpayer is unable to obtain the relevant information from the
holder, the taxpayer cannot self-assess the effective life and must use the
Commissioner’s determination of effective life: s 40-95(6).
• The asset is an intangible depreciating asset listed in s 40-95(7). The
section specifies the effective life of those assets. Where the intangible asset
is acquired from a former holder of the asset, the effective life of the asset
for the new holder is the number of years remaining in the effective life
specified in s 40-95(7) at the start of the income year in which the new
holder acquires the asset: s 40-75(5). See Example 14.10.
Note that:
• Certain assets have a statutory “capped life” (i.e., a maximum effective
life) and taxpayers who use the Commissioner’s determination of effective
life cannot exceed the cap even though the Commissioner may provide a
longer effective life in the determination than the “capped life”: s 40-102.
Taxpayers who self-assess the effective life of an asset may use a longer
effective life than the “capped life”.
• If a taxpayer chooses to self-assess the effective life of an asset, they must
estimate the number of years that the asset is expected to be of use for any
taxpayer for income-producing purposes (i.e., it is the “life” of the asset, not
its expected “life” for the taxpayer): s 40-105. In making this determination,
the taxpayer is expected to do so having regard to the wear and tear they
reasonably expect from their expected circumstances of use and assuming
that the asset will be maintained in reasonably good order and condition. A
shorter effective life may be used where it is estimated that the asset is
likely to be scrapped, sold for no more than scrap value or abandoned at the
end of a period: s 40-105(2).
• A taxpayer is entitled to recalculate the effective life of a depreciating
asset in a later income year if the effective life that the taxpayer has been
using is no longer accurate because of changed circumstances relating to
the nature of the use of the asset: s 40-110(1). There are also certain
circumstances when the taxpayer is required to recalculate the effective life
of an asset: ss 40-110(2) and (3) (e.g., the asset’s cost is increased by at
least 10%). Where the asset’s effective life is recalculated and the prime
cost method is used, the effective life of the asset for the purposes of
working out the decline in value is the number of years remaining under the
new effective life: s 40-75(2) and (3). For example, if a taxpayer has
calculated the decline in value of an asset for four years using an effective
life of 10 years but then recalculates the effective life to be eight years, the
effective life of the asset for the purposes of calculating the decline in value
going forward will be four years. See Example 14.11.
The prime cost method provides for equal deductions in each year and the
cost is fully depreciated at the end of the asset’s effective life. The
diminishing value method provides for much higher depreciation deductions
in the early years of the asset’s effective life but tapers off towards the end
of the asset’s effective life. The taxpayer can continue to claim a
depreciation deduction for the asset in accordance with the diminishing
value method until the asset’s cost is fully deducted. If the taxpayer uses a
low-value pool (see [14.140]), the asset can be added to the low-value pool
once it has an opening adjustable value of less than $1,000.
Example 14.8: Calculating the decline in value of a depreciating
asset
Kieran purchased a new refrigerator for his rental property on 15 June of Year
1 for $2,000. The refrigerator was delivered to the premises on 20 July. The
effective life of a refrigerator is 12 years. Kieran’s depreciation deductions in
respect of the refrigerator under both methods are as follows (assume that it
is not a leap year):
Kieran is not entitled to any depreciation deductions in the first income year
as the refrigerator is not used or installed ready for use in that income year.
In the second income year Kieran is entitled to depreciation deductions from
20 July when the refrigerator was first used or installed ready for use.
Therefore:
Days held = 347 Cost = $2,000 Effective life = 12 years

In the third income year the depreciation deduction is calculated as follows:

Diminishing value method: = $1,683 × (365/365) × (200%/12) = $281
Where:
Base value = Opening adjustable value = Cost − Decline in value = $2,000
− $317 = $1,683 Prime cost method: = $2,000 × (365/365) × (100%/12) =
$167

Example 14.9: Decline in value of asset acquired from associate

Big Toes and Big Hands are wholly owned by Big Head. On 1 January,
Big Toes acquired a machine from Big Hands for $100,000. The
market value of the machine at the time of transfer was $80,000.
Prior to the sale, Big Hands had been depreciating the machine for
a period of five years under the prime cost method using an
effective life of 15 years. Big Toes and Big Hands are “associates”
per s 318 of the ITAA 1997. As such, Big Toes does not have a choice
of method in calculating its depreciation deductions for the asset: s
40-65(2). It must calculate the decline in value of the machine using
the prime cost method. The effective life of the machine for Big Toes
will be the remaining years of the effective life used by Big Hands
(ie, 10 years): s 40-95(4). Further, the “cost” of the asset will be
limited to its market value under s 40-180(2) Item 8. Therefore,
assuming it is not a leap year, Big Toes’ depreciation deduction will
be calculated as follows:
$80,000 × (181/365) × (100%/10) = $3,967

Example 14.10: Decline in value of intangible asset

On 1 July, Rosheen acquired a standard patent from Linda (the
original holder) for $30,000. Prior to the sale, Linda had held the
patent for five years.
As the relevant asset is an item of intellectual property, Rosheen
does not have a choice of method in calculating the decline in value
of the asset. The decline in value must be calculated using the
prime cost method per ss 40-70(2) and 40-72(2). The effective life of
the asset is specified under s 40-95(7) as 20 years and Rosheen
cannot self-assess the effective life of the patent. As Rosheen is not
the original holder of the asset, her effective life will be the
remaining years of the effective life specified in s 40-95(7) (ie, 15
years): s 40-75(5). Therefore, assuming it
deduction will be calculated as follows: $30,000 × (365/365) ×
(100%/15) = $2,000
Example 14.11: Impact of recalculation of effective life on decline in
value
Big Shoes Pty Ltd acquired a printing machine for $30,000 on 1 July
of the previous year. On 1 July this year, Big Shoes incurred
expenses of $5,000 in upgrading the machine to take advantage of
the latest available technology. The costs qualify as “second
element costs”. Last year, Big Shoes depreciated the machine using
the prime cost method and an effective life of eight years.
As the cost of the asset has increased by more than 10%, Big Shoes
is required to recalculate the effective life of the machine per s 40-
110(2). Big Shoes assesses the new effective life of the machine to
be 15 years. The effective life of the machine for the purposes of
the decline in value calculation going forward will be 14 years per s
40-75(2) and (3). The cost of the asset will be its opening adjustable
value plus any second element costs incurred this year: s 40-75(2)
and (3).
Opening adjustable value = Cost − Decline in value in previous
years = $30,000 − ($30,000 × 365/365 × 100%/8) = $30,000 −
$3,750 = $26,250.
Decline in value this year = ($26,250 + $5,000) × 365/365 ×
100%/14 = $2,232 (assuming it is not a leap year).

Taxable purpose [14.100]

Section 40-25(2) of the ITAA 1997 ensures that a depreciation deduction can
only be claimed in relation to depreciating assets used for a taxable purpose.
Under that section, the depreciation deduction must be reduced by an
appropriate percentage for any decline in value that is attributable to the
use of the asset for non-taxable purposes.
Generally, an asset will be used for a taxable purpose where it is used in the
production of assessable income or in exploration or prospecting, mining site
rehabilitation and environmental protection activities: s 40-25(7).

Example 14.12: Depreciating assets partly used for a taxable

purpose
Naresh is a chef. He purchased a mobile phone on 1 July for $3,000.
He estimates that he uses the mobile phone for his own purposes
70% of the time and for work purposes 30% of the time. The
Commissioner has assessed the effective life of mobile phones as
three years. Naresh uses the Commissioner’s determination of
effective life and the prime cost method to calculate all depreciation
deductions. Assume that it is not a leap year.
Decline in value = $3,000 x 365/365 x 100%/3 = $1,000
Naresh must reduce the $1,000 depreciation deduction by 70% as
that is the percentage of the asset’s decline in value which is
attributable to his use of the mobile phone for a non-taxable
purpose (ie, not in the production of his assessable income).
Therefore, Naresh’s deduction for the year in relation to the mobile
phone would be:
$1,000 − (70% × $1,000) = $300.
Balancing adjustments [14.110]
Under subdiv 40-D of the ITAA 1997, taxpayers must make an adjustment to
their taxable income if there is a balancing adjustment event. A balancing
adjustment event occurs under s 40-295, where:
• the taxpayer stops holding the depreciating asset;
• the taxpayer stops using the depreciating asset or having it installed ready
for use for any purpose and expects never to use it or have it installed ready
for use again;
• the taxpayer has not used the depreciating asset and either stops having it
installed ready for use or decides never to use it; or
• there is a change in the interests or holding of the depreciating asset and it
was a partnership asset before the change or becomes one as a result of the
change.
A balancing adjustment event does not occur simply because the taxpayer
splits or merges a depreciating asset: s 40-295(3). The most common
balancing adjustment event is the disposal of a depreciating asset but there
can also be a balancing adjustment for assets that become redundant.
Balancing adjustments effectively adjust for the over or under depreciation
of an asset which has been calculated using the asset’s estimated effective
life.

The balancing adjustment amount is calculated under s 40-285 by

comparing the asset’s “termination value” with its “adjustable value”.
Where, broadly:
• Termination value = Amount received by the taxpayer in relation to the
balancing adjustment event or its market value at the time of the event in
the case of redundant assets and non-arm’s length transactions: s 40-300;
and
• Adjustable value = Cost of the asset minus prior year decline in value
minus decline in value for the current year up to the date of the balancing
adjustment event: s 40-85. Note that the cost of the asset is reduced by its
decline in value over the relevant period, not the depreciation deductions
claimed by the taxpayer thus far. Any use of the asset for non-taxable
purposes is taken into account under s 40-290: see [14.115].
Where:
• Termination value > Adjustable value, the difference is included in the
taxpayer’s assessable income for the year: s 40-285(1); and
• Termination value < Adjustable value, the difference is a deduction for the
taxpayer that year: s 40-285(2).
Example 14.13: Disposal of a depreciating asset
Following on from Example 14.8, assume that Kieran sold the refrigerator on
30 September Year 3 for $1,500.
Decline in value calculated using the diminishing value method:
Termination value = $1,500 (amount received on disposal)
Adjustable value = $2,000 − $317 − $71 = $1,612
Where:
Depreciation for Year 2 = $317 (as calculated in Example 14.8)
Depreciation from 1 July to 30 September Year 3 = ($2,000 − $317) ×
(92/365) × (200%/12) = $71
Termination value ($1,500) < Adjustable value ($1,612). Therefore,
Kieran is entitled to a deduction of $112 in relation to the disposal of the
refrigerator.
Decline in value calculated using prime cost method:
Termination value = $1,500 (amount received on disposal)
Adjustable value = $2,000 − $158 − $39 = $1,803
Where:
Depreciation for Year 2 = $158 (as calculated in Example 14.8)

Depreciation for 1 July to 30 September Year 3 = ($2,000 − $158) × (92/

365) × (100%/12) = $39
Termination value ($1,500) < Adjustable value ($1,803). Therefore, Kieran is
entitled to a deduction of $303 in relation to the disposal of the refrigerator.
In either case, Kieran is entitled to a deduction in relation to the disposal of
the refrigerator. However, the amount of the deduction will depend on which
method Kieran used to calculate his depreciation deductions.
Depreciating asset used for non-taxable purpose [14.115]
Where the depreciation deductions have been reduced because the taxpayer
used the depreciating asset for non-taxable purposes, s 40-290 of the ITAA
1997 reduces the balancing adjustment amount calculated under s 40-285.
The reduction is calculated as follows:
Sum of reductions / Total decline × Balancing adjustment amount
Broadly:
• The sum of reductions is the sum of the reductions to depreciation
deductions due to the use of the depreciating asset for non-taxable
purposes; and
• The total decline is the total decline in value of the depreciating asset
since the taxpayer started to hold it.
Example 14.14: Disposal of a depreciating asset partly used for
income-producing purpose
Following on from Example 14.12, assume Naresh bought the mobile phone
on 1 July and sold it on 30 June of the following year for $1,500.
Termination value = $1,500 (amount received on disposal) Adjustable value
= $3,000 (cost) − $1,000 (depreciation until date of disposal from Example
14.12) = $2,000
As Termination value ($1,500) < Adjustable value ($2,000), Naresh is entitled
to a deduction of $500 in relation to the disposal of the mobile phone.
However, as Naresh used the mobile phone only partly for income-producing
purposes, the balancing adjustment amount must be reduced under s 40-
290 as follows:
$700 (the total reduction in depreciation deductions)
$1000 (the total decline in values since Naresh started to hold the mobile
phone) × $500 = $350
Therefore, Naresh is entitled to a deduction of $150 on the disposal of the
mobile phone.

Interaction with capital gains provisions [14.118]

In some cases, a balancing adjustment event may also give rise to a CGT
event: see [11.40]. As mentioned earlier, the capital allowances provisions
take precedence over the capital gains provisions and any capital gain or
loss on a depreciating asset is disregarded under s 118-24 of the ITAA 1997.
However, where the asset is only partly used for a taxable purpose, the
asset is only partly accounted for under the capital allowances provisions (as
we have seen, the decline in value deduction and balancing adjustment
amount are reduced for any use of the asset for a non-taxable purpose). In
this case, the capital gains provisions have residual operation in relation to
the part of the asset that is not used for a taxable purpose and CGT event K7
(see [11.150]) may happen to the asset at the time of the balancing
adjustment event.
Roll-over relief [14.120]
Taxpayers may be entitled to roll-over relief in relation to a balancing
adjustment amount in certain circumstances.
Automatic roll-over relief applies where there is a disposal of a depreciating
asset that involves a CGT event and one of the following items applies:
• the asset is disposed to a wholly owned company;
• the asset is disposed by a partnership to a wholly owned company;
• the asset is transferred from a trust to a company under a trust
restructure;
• the disposal occurs because of a marriage or relationship breakdown; or
• the asset is disposed of to another member of the same wholly owned
group.
In this situation, the relief depends on the relevant event and is specified in s
40-340(1) of the ITAA 1997.

Taxpayers may choose roll-over relief where the balancing adjustment event
happens under s 40-295(2) (i.e., a change in the holding or interests of a
partnership asset) and the transferor and the transferee choose for roll-over
relief to apply: s 40-340(3). The roll-over relief is that the balancing
adjustment event does not happen and the transferee deducts the decline in
value of the asset using the same method and effective life that the
transferor was using: s 40-345.
Where there is an involuntary disposal of a depreciating asset for one of the
reasons specified in s 40-365(2) (e.g., the asset is lost or destroyed) and the
taxpayer has a replacement asset, the taxpayer can choose to reduce some
or all of any amount that is included in the taxpayer’s assessable income
(i.e., the balancing adjustment amount) as a result of the balancing
adjustment event. The amount that is not included in the taxpayer’s
assessable income must be applied to reduce the cost of the replacement
asset: s 40-365(1).
Cars [14.125]
There are a number of special rules for “cars” which may deny a deduction
for depreciation or limit the amount of the deduction. “Car” is defined in s
995-1 of the ITAA 1997 as a motor vehicle (except a motor cycle or similar
vehicle) designed to carry a load of less than one tonne and fewer than nine
passengers.
As mentioned earlier, taxpayers cannot claim a deduction for depreciation in
relation to a car where the deductions for car expenses have been calculated
in accordance with the cents per kilometre method (see Chapter 12) in that
year: s 40-55.
Under s 40-230, the cost of a car for the purposes of calculating the decline
in value is limited to the “car limit” for the financial year in which the
taxpayer started to hold the car. The limit does not apply to cars fitted out
for transporting disabled people in wheelchairs: s 40-230(2). The “car limit”
is specified by the Commissioner each year and, for the 2020–2021 income
year, the car limit is $59,136. The car limit is applied after taking into
account any GST input tax credits (see [25.230]) that the taxpayer may be
entitled to in relation to the car: Determination TD 2006/40.
Example 14.15: Calculating the decline in value of a car
Hoong purchased two new cars on 1 January 2021 for $110,000
(including GST) and $60,000 (including GST) each. He uses the cars
entirely for income-producing purposes. The effective life of a car is
eight years. Hoong is entitled to input tax credits of $5,376 in
respect of the acquisition of each car. As we will see in Chapter 25,
the input tax credits for a car are also limited by the car limit and
are therefore equal to $59,136/11. In the 2020–2021 income year,
Hoong would calculate his depreciation deductions as follows:

Car 1: The cost of the car is reduced by the input tax credits of
$5,376 to $104,624. As this amount exceeds the car limit, the cost
of the car is further reduced to the car limit of $59,136. Hoong’s
depreciation deduction in relation to the car is calculated as
follows:
Car 2: The cost of the car is reduced by the input tax credits of
$5,376 to $54,624. As this amount does not exceed the car limit,
the cost of the car will not be further reduced under s 40-230.
Hoong’s depreciation deduction in relation to the car is calculated
as follows:

Finally, the calculation of the balancing adjustment amount for a car

will depend on the method used for calculating car expenses (see
Chapter 12) s 40-285(2) Note 1 and s 40-370. The termination value
of the car is adjusted under s 40-325 where the cost of the car was
limited to the “car limit”.
Pooling of assets [14.130]
Taxpayers have the choice of claiming deductions for the decline in value of
certain assets on a group basis under subdiv 40-E of the ITAA 1997. The
pooling of assets reduces compliance costs for taxpayers as individual
depreciation calculations are not required for each asset. There are two asset
pools in subdiv 40-E which may be utilised by taxpayers:
• low-value pool: see [14.140]; and
• software development pool: see [14.160].
Low-value pool [14.140]
Under s 40-425 of the ITAA 1997, taxpayers have the option of establishing a
low-value pool for any “low-cost” or “low-value” assets.
A “low-cost” asset is a depreciating asset (except a horticultural plant)
whose cost at the end of the income year in which the taxpayer started to
use it, or have it installed ready for use, for a taxable purpose is less than
$1,000: s 40-425(2). We have already discussed “cost” at [14.90] and
“taxable purpose” at [14.100].
A “low-value” asset is a depreciating asset (except a horticultural plant) held
by the taxpayer that has been depreciated using the diminishing value
method and has an opening adjustable value of less than $1,000: s 40-
425(5). “Opening adjustable value” is discussed at [14.90].

However, the following assets cannot be added to the low-value pool:

• Assets that qualify for an immediate deduction under s 40-80(2) – that is
assets that cost less than $300 and are used for an income-producing
purpose other than in a business: s 40-425(4).
• Assets that are deductible under subdiv 328-D – that is in respect of capital
allowances for small business entities (see [14.165]): s 40-425(7).
• Assets used in research and development activities which qualify for a
deduction under s 73BA of the ITAA 1936: s 40-425(8).
Note that although taxpayers have the option of using a low-value pool, once
a taxpayer creates a low-value pool (i.e., by allocating a low-cost asset to a
low-value pool), all low-cost assets held by the taxpayer in that year and
future years must be added to the pool: s 40-430(1). The taxpayer continues
to have an option as to whether or not to add low-value assets to the pool on
an individual asset basis.
Example 14.16: Allocating assets to a low-value pool
Tanya runs her own bakery in Perth. Assume that it is not a “small business
entity”. Tanya is depreciating her oven and refrigerator using the diminishing
value method due to their substantial cost. She depreciates all other assets,
such as tables and chairs, using the prime cost method as it is easier. Tanya
has also chosen to use a low-value pool. This year, Tanya acquired a new
display rack for $200 and a television for customers for $700. She has also
determined that the opening adjustable value (i.e., the cost less the decline
in value in previous years) of the refrigerator is $1,500 and the oven is $900.
Tanya must add the display rack and television to her low-value pool as they
are low-cost assets. Although the display rack costs less than $300, it is not
immediately deductible as Tanya uses it in her business. The oven is a low-
value asset as it has been depreciated using the diminishing value method
and has an opening adjustable value less than $1,000. Tanya can choose
whether or not to add the oven to the low-value pool. The refrigerator does
not qualify as a low-value asset and cannot be added to the low-value pool
this year, although it may qualify in future years once its opening adjustable
value is less than $1,000. The other assets must continue to be depreciated
in accordance with the prime cost method and can never be added to the
low-value pool as they will not qualify as low-cost or low-value assets.
[14.145] Taxable purpose.
As with the general depreciation provisions, depreciation deductions are only
available in respect of low-value pool assets to the extent that the assets are
used for a taxable purpose. Taxpayers are required to make a reasonable
estimate of the taxable use percentage of the asset when the asset is
allocated to the low-value pool: s 40-435 of the ITAA 1997. The taxable use
percentage is the extent to which the asset will be used for taxable purposes
over its remaining effective life. The amount that is allocated to the low-
value pool in relation to an asset is its cost multiplied by the taxable use
percentage.
Example 14.17: Taxable use percentage of low-cost and low-value
assets
Paul uses a low-value pool for depreciating assets. This year he
purchased a printer for $550. Paul must allocate the printer to the
low-value pool as it is a low-cost asset. The effective life of a printer
is three years. Paul estimates that he will use the printer 50% for
income-producing purposes in the first year, 70% for income-
producing purposes in the second year and 30% for income-
producing purposes in the third year. The taxable use percentage of
the printer will be 50% ((50 + 70 + 30)/3). Paul will allocate $275 to
his low-value pool this year in relation to the printer. Paul has also
reviewed all of his assets that are being depreciated using the
diminishing value method. He determined that the opening
adjustable value of two of the assets is less than $1,000. Paul has a
choice whether to allocate the assets to the low-value pool as they
are low-value assets. He decides to allocate one of the assets, a
mahogany table, to the low-value pool. The opening adjustable
value of the table is $700. Paul determines that the remaining
effective life of the table is two years. He will use the table 30% for
income-producing purposes in the first year and 100% for income-
producing purposes in the second year. The taxable use percentage
of the table will be 65% ((30 + 100)/2). Paul will allocate $455 (65%
× $700) to the low-value pool this year in respect of the table.
Note that the determination of taxable use percentage is done at
the time that the asset is allocated to the low-value pool and the
legislation does not allow for any change to the value of the asset
once it is in the pool to take into account any change of purpose.
Example 14.18: Taxable use percentage of low-cost assets
Kerry owns an investment property in Melbourne. She purchased a
clothes dryer for the property for $990. She maintains a low-value
pool and must allocate the clothes dryer to the low-value pool as it
is a low-cost asset. At the time of allocating the asset to the low-
value pool, Kerry estimated that the dryer would be 100% used for
income-producing purposes over
its effective life as the property would be rented out to tenants.
Kerry allocated $990 to the low-value pool in relation to the dryer.
Due to unforeseen circumstances, Kerry was forced to move into
the property the following year and could no longer rent it out to
tenants. Kerry must continue to work out the decline in value of the
dryer based on her original reasonable estimate of the taxable use
percentage of the asset under s 40-435 even though the taxable use
percentage has changed. Source: Adapted from former ATO ID
2004/940.
[14.150] Decline in value.
The decline in value of low-value pool assets is calculated in accordance with
s 40-440(1) of the ITAA 1997 as follows:
• Step 1: Multiply the taxable use percentage cost of any low-cost assets
allocated to the low-value pool in the current year by 18.75%.
• Step 2: Multiply the taxable use percentage of any second element costs
incurred that year relating to low-value assets added to the pool in that year
or an earlier year by 18.75%.
• Step 3: Multiply the closing pool balance for the previous year and the
opening adjustable values of low-value assets added to the pool that year by
37.5%.
• Step 4: Sum up the amounts in Steps 1, 2 and 3. The result is the decline in
value of the low-value pool.
The closing pool balance for the current income year is the sum of the
closing pool balance for the previous year plus the taxable use percentage of
any low-cost and low-value assets added to the pool in the current year, less
the decline in value of the pool calculated under s 40-440(1): s 40-440(2).
Example 14.19: Decline in value of low-value pool
Nicholas runs his own personal training business. He chooses to use a low-
value pool for qualifying assets. In Year 1, he purchased a table for $700 and
a printer for $600. He estimates that he will use both of these assets 100%
for income-producing purposes over their effective lives. In Year 1, the
decline in value of Nicholas’ low-value pool is 18.75% × $1,300 = $244. The
full cost of both assets is added to the pool as their taxable use percentage
is 100%.
The closing pool balance is $1,056 (i.e., $1,300 − $244). In Year 2, Nicholas
purchases a fancy new phone for the business for $750. He also determines
that the opening adjustable value of a piece of equipment depreciated using
the diminishing value method is $900.

Nicholas estimates that the taxable use percentage of the phone over its
effective life is 90%. He estimates that the taxable use percentage of the
equipment for the remainder of its effective life is 100%. In Year 2, the
decline in value of Nicholas’ low-value pool is:
• Step 1: $750 × 90% × 18.75% = $127
• Step 2: Not applicable.
• Step 3: ($1,056 × 37.5%) + ($900 × 37.5%) = $396 + $337.50 = $733.50
• Step 4: Decline in value = $127 + $733.50 = $860.50 The closing pool
balance in Year 2 is [$1,056 + ($750 × 90%) + $900] − $860.50 =
$1,770.50.
[14.155] Balancing adjustment events.
Where a balancing adjustment event (see [14.110]) happens to an asset in a
low-value pool, the taxable use percentage of the asset’s termination value
(see [14.110]) is deducted from the closing pool balance: s 40-445(1) of the
ITAA 1997.
Example 14.20: Disposal of low-value pool asset
Following on from Example 14.19, Nicholas disposed of the printer in Year 2
for $300. The decline in value of the low-value pool in Year 2 is calculated as
above. However, the closing pool balance in Year 2 will be $1,470.50
($1,770.50 − $300) to take into account the disposal of the printer. The full
$300 is deducted from the closing pool balance as the taxable use
percentage of the printer was 100%.
Where the taxable use percentage of the asset’s termination value is greater
than the closing pool balance, the closing pool balance is reduced to zero
and the excess is included in the taxpayer’s assessable income in that year:
s 40-445(2).
Example 14.21: Disposal of low-value asset
Following on from Example 14.19, assume that Nicholas disposed of the
printer in Year 2 for $2,000 to a collector who was willing to pay such a high
price. The decline in value of the low-value pool in Year 2 is calculated as per
Example 14.19. However, the closing pool balance in Year 2 will be 0
($1,770.50 − $2,000) to take into account the disposal of the printer. The full
termination value of the printer is deducted from the closing pool balance as
the taxable use percentage of the printer was 100%. However, the deduction
cannot take the pool balance below 0. The excess of $229.50 ($2,000 −
$1,770.50) is added to Nicholas’ assessable income per s 40-445(2).
Software development pool [14.160]
Taxpayers who develop software are generally required to capitalise any
expenditure associated with the development of the software. Once the
project is completed and the software is used or ready for use in the
business, the taxpayer is entitled to claim a deduction for the decline in the
value of the asset over the period of its effective life. Tracking all expenditure
related to the development of software can be quite onerous and
significantly increase taxpayers’ compliance costs. As such, taxpayers have
the option of allocating any expenditure incurred in developing “in-house
software” to a pool under s 40-450 of the ITAA 1997. “In-house software” is
defined in s 995-1 as computer software or a right to use computer software
that the taxpayer acquires, develops or has another entity develop that is
used mainly in performing the functions for which the software was
developed and which is not deductible under another provision of the tax
legislation outside Div 44 (e.g., the general deduction provision in s 8-1) and
Div 328 (the small business provisions). Only expenditure incurred by the
entity in developing or having another entity develop in-house software can
be added to a software development pool – that is the costs of acquiring in-
house software cannot be added to the pool: s 40-450(1). Further, in-house
software expenses can only be added to a pool where the software is used
solely for a taxable purpose: s 40-450(3).
Once a taxpayer chooses to use an in-house software development pool, all
such expenditure must be allocated to the pool: s 40-450(2). The taxpayer
must create a separate pool in each income year that the taxpayer incurs
expenditure on in-house software development: s 40-450(4).
The decline in value of in-house software development pool expenditure is
calculated per s 40-455 as follows:
• first year expenditure allocated to the pool – no deduction;
• second year expenditure in pool – 30%;
• third year expenditure in pool – 30%;
• fourth year expenditure in pool – 30%; and
• fifth year expenditure in pool – 10%.
This calculation applies to income years starting on or after 1 July 2015. Prior
to that date, the decline in value of in-house software development pool
expenditure was deducted over four years – no deduction in the first year,
40%
deduction in the second and third years and 20% deduction in the fourth
year. The taxpayer is required to include in its assessable income any
consideration received in respect of the software if the expenditure relating
to the software was added to a software development pool: s 40-460.
Small business entity concessions [14.165]
Finally, it should be noted that subdiv 328-D of the ITAA 1997 contains a
number of concessions in the form of simpler depreciation rules for small
business entities. In this context, a “small business entity” is a sole trader,
partnership, company or trust that operates a business for all or part of the
income year and has an aggregated turnover of less than $10 million.
Broadly, “aggregated turnover” is the entity’s turnover plus the annual
turnover of any business that is connected or affiliated to the entity. Instead
of calculating depreciation deductions under the general depreciation
provisions in Div 40, small business entities can choose to claim depreciation
deductions in accordance with the provisions of subdiv 328-D: s 328-175(1).
Subdivision 328-D does not apply to a depreciating asset to which Div 40
does not apply because of s 40-45 (see [14.20]) although there are some
exceptions to this general rule (e.g., primary production business assets): s
328-175(2)–(10).
Under subdiv 328-D, small business entities can:
• claim an immediate deduction for assets costing less than $1,000: s 328-
180; and
• put all other assets into a general small business pool and treat them as if
they are a single asset subject to one rate: s 328-185. The threshold for
immediate deduction was increased between 12 May 2015 and 31
December 2020 and also expanded to medium and large businesses. For the
period 1 July 2020 to 31 December 2020, the threshold for immediate
deduction was $150,000 and applied to businesses with a turnover less than
$500 million.
The general small business pool is effectively treated as a single asset and
under s 328-190, small business entities are entitled to a deduction of:
• 30% of the value of the assets already in the general small business pool
(i.e., 30% × opening pool balance); and
• 15% of the value of general small business pool assets acquired in the
current income year.
The opening pool balance is determined in accordance with s 328-195. Note
that only the taxable use proportion of the asset’s cost is added to the pool:
s 328-205. However, unlike the general low-value pool discussed earlier,
small business entities are required to make a reasonable estimate of the
taxable purpose of any pooled assets each income year and make an
adjustment to the opening pool balance to take into account any change of
taxable purpose if necessary: s 328-225.
The closing pool balance is determined in accordance with s 328-200 and
takes into account the disposal of pool assets by deducting the asset’s
termination value from the pool balance. If the reduction results in the pool
balance being less than 0, the pool balance is taken to be 0 and the excess is
included in the taxpayer’s assessable income: s 328-215(2). In the case of
the disposal of an asset which qualified for an immediate deduction, the
termination value is included in the taxpayer’s assessable income: s 328-
215(4).
Where the general small business pool value is low, the deduction is
determined in accordance with s 328-210 rather than s 328-190. This is
determined by calculating the following amount:
• Opening pool balance + Taxable use % of cost of new assets − Taxable use
% of termination values of depreciating assets allocated to the pool for which
a balancing adjustment event occurred during the year. Where that amount
is less than $1,000 but more than 0, the taxpayer can claim an immediate
deduction for the total amount and where that amount is less than 0, the
taxpayer must include the amount by which that amount is less than 0 in
assessable income: ss 328-210 and 328-215. For income years ending on or
after 12 May 2015 and on or before 31 December 2020, the threshold for
immediate deduction is increased to $20,000, $25,000, $30,000 or $150,000
as applicable (see above): Note 2 to s 328-210(1).
Taxpayers may choose not to use subdiv 328-D or may cease to qualify as a
small business entity in a particular year. In such situations, any pooled
assets continue to remain in the pool and deductions are claimed in
accordance with subdiv 328-D: s 328-220(1). However, any depreciating
assets that the taxpayer starts to hold in that year are not added to the pool
and depreciation deductions in relation to those assets are calculated in
accordance with the general capital allowances provisions in Div 40: s 328-
220(2).
Capital works deductions [14.170]
Division 43 of the ITAA 1997 provides taxpayers with a deduction for certain
capital expenditure on buildings used for income-producing purposes and
other capital works. Section 43-20 specifies the capital works to which the
division applies as follows:
• A building or an extension, alteration or improvement to a building begun
in Australia after 21 August 1979 or begun outside Australia after 21 August
1990.
• Capital works begun after 26 February 1992 (that do not fall within the first
category) that are structural improvements or extensions, alterations or
improvements to structural improvements in or outside Australia. Examples
of structural improvements include sealed roads, sealed driveways, sealed
car parks, bridges, pipelines, retaining walls, fences, concrete or rock dams
and sports fields.
• Capital works being earthworks or extensions, alterations or improvements
to earthworks if they are constructed as a result of environmental protection
activities can be economically maintained in reasonably good order and
condition for an indefinite period, are not integral to the construction of
capital works and the expenditure was incurred after 18 August 1992.
Very broadly, the expenditure is deductible over a specified period at a rate
of either 4% or 2.5% per annum: s 43-25. The exact calculation is complex
and depends on the type of capital works, the use of the “construction
expenditure area” (e.g., residential or non-residential buildings) and when
the capital works commenced. The Commissioner’s guidance in relation to
the operation of Div 43 is in Ruling TR 97/25.
Note that deductions are only available once construction is completed: s 43-
30. The amounts that are deductible must be “construction expenditure”: s
43-15. “Construction expenditure” is capital expenditure incurred in respect
of the construction of capital works but does not include expenses such as
expenditure on acquiring land, demolishing existing structures, landscaping
or expenditure on plant: s 43-70. Deductions must be claimed within a
period of 25 years (where the 4% rate is used) and 40 years (where the 2.5%
rate is used).
Unlike the capital allowances regime in Div 40, Div 43 does not address the
disposal of a building that has been the subject of capital works deductions –
that is there is no “balancing adjustment”. The disposal of buildings is
captured by the capital gains provisions and any capital works deductions
are taken into account by adjusting the cost base or reduced cost base of the
building: see Chapter 11. Cost base or reduced cost base is reduced by any
Div 43 deductions. Therefore, the taxpayer will have a capital gain if the
building is sold for more than its written down value and a capital loss if it is
sold for less than its written down value. Additional deductions may be
available under s 43-250 where the building is destroyed rather than sold.
Where the building is not a capital asset of the taxpayer, no adjustment is
made for the capital works deductions claimed (MLC Ltd v DCT (2002) 51
ATR 283) and any undeducted capital works expenditure is transferred to the
purchaser who is allowed the deductions under s 43-10.
Black hole expenses [14.180]
In Chapter 12, we saw that non-personal expenses may not be deductible
under s 8-1 of the ITAA 1997 if they are incurred before the commencement
of a business or production of assessable income, or if they are capital
expenses. Some of these expenses may be deductible over a number of
years under the capital allowances provisions discussed in this chapter or
they may be taken into account when an event happens to the relevant
asset under the capital gains provisions discussed in Chapter 11. However,
many expenses did not fall within these regimes and were not recognised for
tax purposes, which resulted in them being labelled “black hole” expenses.
In 2001, subdiv 40-I was introduced to capture these so-called “black hole”
expenses for tax purposes. Subdivision 40-I captures two categories of
expenses that may not otherwise be recognised by the tax legislation.
Project pools [14.190]
Section 40-830 of the ITAA 1997 provides a deduction for capital expenditure
associated with a project that the taxpayer carries on for a taxable purpose
(ie, to produce assessable income) and mining or transport capital
expenditure. Broadly, the expenses are allocated to a “project pool” and are
deductible over the life of the project. Only expenses that do not form part of
the cost of a depreciating asset held by the taxpayer or are not deductible
under another provision can be added to the project pool: s 40-840.
Examples of capital expenses that can be added to a project pool include
feasibility studies, environmental studies, site preparation costs, amounts
incurred in seeking to obtain a right to intellectual property and amounts
related to creating or upgrading community infrastructure for a community
associated with the project: s 40-840(2)(d). “Mining capital expenditure” and
“transport capital expenditure” are defined in ss 40-860 and 40-865
respectively. The Commissioner’s guidance on project pools is contained in
Ruling TR 2005/4.
Business-related costs [14.200]
The second category of “black hole” expenses captured by subdiv 40-I of the
ITAA 1997 is “business-related costs”. Section 40-880 provides taxpayers
with a deduction for business expenses that are not deductible because they
are capital in nature. Any expenses that are not deductible because they are
private or domestic expenses, incurred in gaining or producing exempt or
non-assessable non-exempt income, or specifically denied deductions under
a particular provision of the legislation (see Chapter 12) are not deductible
under s 40-880: s 40-880(5)(h)–(j).
Taxpayers are entitled to deduct qualifying capital expenses over a period of
five years, where the expense relates to the taxpayer’s business that is
carried on for the purpose of gaining or producing assessable income. The
expenditure is deducted in equal proportions over the five years: s 40-
880(2).
The key limitation of s 40-880 is that it only applies to expenses that are not
otherwise taken into consideration under the income tax legislation. For
example, if the expense relates to a depreciating asset, can be deducted
under another legislative provision, forms part of the cost of land or is taken
into account in calculating the capital gain or loss on a CGT asset, the
expense cannot be deducted under s 40-880: s 40-880(5). In this case, the
CGT rules take precedence over s 40-880.
Example 14.22: Capital expenditure related to depreciating asset
Hamish wants to buy a computer that is not available in Australia for his
business. After extensive research, he travels to Germany to purchase the
computer. Hamish travels to Germany for the sole purpose of purchasing the
computer. The travel costs would not be immediately deductible as they
constitute a capital expense but would be included as part of the first
element of the cost of the computer because they are directed to and result
in the purchase of the computer, which is a depreciating asset. The travel
costs cannot be deducted under s 40-880 due to the operation of s 40-
880(5)(a). Source: Adapted from Example 2.23 in Explanatory Memorandum
to the Tax Laws Amendment (2006 Measures No 1) Act 2006.
[14.210] Examples of capital expenditure that may be deducted under s 40-
880 of the ITAA 1997 include:
• expenditure to establish a business structure – for example, legal expenses
or registration costs associated with the formation of a company;
• expenditure to change from one business structure to another – for
example, legal expenses to change from partnership to company;
• expenditure to raise equity for a business – for example, costs of issuing a
prospectus, legal costs, advertising costs;
• expenditure to defend a business against a takeover – for example, legal
expenses, advertising costs, mailing costs, consultancy fees; and
• costs to stop carrying on a business, including liquidation and
deregistration costs.
These expenses would not be deductible under s 8-1 as they are capital
expenses (relating to the taxpayer’s business structure rather than business
process). They do not relate to a depreciating asset and would not form part
of the cost base of a CGT asset (see Chapter 11) and therefore s 40-880 is
applicable. Note that the business may be a previous or future business of
the taxpayer. Section 40-880(7) states that where the expenditure relates to
a proposed business, it must be reasonable to conclude that the business is
proposed to be carried on within a reasonable time. This is an objective test
that is to be determined on a case-by-case basis. The taxpayer may
demonstrate their commitment by having a business plan, establishing
business premises, undertaking research on the business and investing in
assets.
Example 14.23: Capital expenditure relating to proposed business
Brewster Pty Ltd carries on a mobile ice cream business. The company spent
$5,000 on research into the market for soft drinks with the purpose of
establishing a new business. The research indicated that a mobile soft drink
business is unlikely to be profitable and, consequently, the new business was
not established.
Brewster Pty Ltd is entitled to a deduction of $1,000 per year over the next
five years as the expenses are capital expenditure relating to a proposed
business to be carried on for the purpose of gaining or producing assessable
income. Source: Adapted from Example 2.3 in Explanatory Memorandum to
the Tax Laws Amendment (2006 Measures No 1) Act 2006.
Example 14.24: Capital expenditure relating to proposed business
June Pty Ltd incurred expenditure on due diligence into a business that it
proposed to acquire and carry on. However, the vendor withdrew from the
sale before it could be finalised.
The expenditure is deductible over five years as a business-related cost.
Source: Adapted from Example 2.4 in Explanatory Memorandum to the Tax
Laws Amendment (2006 Measures No 1) Act 2006.
The Commissioner’s views as to the operation and scope of s 40-880 are
contained in Ruling TR 2011/6.
Start-up expenses [14.215]
From 1 July 2015, qualifying individuals and small business entities (see
[14.165]) can claim an immediate deduction for expenditure related to a
proposed business or proposed structure that would otherwise be deductible
over five years under s 40-880: s 40-880(2A). Expenses that may be
immediately deductible under this provision include certain government fees
and charges, costs associated with raising capital and cost of advice or
services related to the proposed business or proposed structure. Individuals
can claim an immediate deduction for start-up expenses if they are not
carrying on a business and are not connected with, or an affiliate of, an
entity that carries on a business that is not a small business entity.
Questions [14.220]
14.1 On 1 June 2019, Rogan purchased a new scooter for $6,000 for
use in his business. The Commissioner has assessed the effective
life of scooters as three years. Rogan decided to upgrade to a new
scooter and sold the old one to a reputable second-hand dealer for
$3,000 on 31 August 2020. Rogan estimates that he used the
scooter for business purposes 90% of the time. Advise Rogan of his
income tax consequences arising on the disposal of the scooter
under both the diminishing value method and the prime cost
method. Assume that Rogan does not qualify as a small business
entity.
14.2 Jerry and Elaine own and run a diner together. The diner is run
through their partnership, Tom’s Diner. Jerry and Elaine also own a
residential investment property together which they purchased in
equal proportions. During the year, they undertook the following
transactions:
• Purchased a new dishwasher machine for the diner for $15,000 on
1 December 2020. The Commissioner has assessed the effective life
of dishwashers as eight years.
• Installed a new kitchen exhaust fan on 27 April 2021. The kitchen
fan cost $1,100 and it cost an additional $500 to install it. The
Commissioner has assessed the effective life of kitchen exhaust
fans as five years.
• Installed a new ducted vacuum cleaner in the investment property
on 1 February 2021. The ducted vacuum cleaner cost $5,000. The
Commissioner has assessed the effective life of residential ducted
vacuum cleaners as 10 years.
Advise Jerry and Elaine of their income tax consequences arising out
of the above information under both the diminishing value method
and the prime cost method (if relevant) for the year ended 30 June
2021. Assume that an immediate deduction is not available for the
assets.
14.3 On 1 October, Meghan acquired a standard patent from Kate
(the original holder) for $85,000. Prior to the sale, Kate had held
the patent for 12 years. Advise Meghan as to her depreciation
deduction in relation to the standard patent. You may assume that
it is not a leap year.
14.4 Acme Pty Ltd acquired a machine from its parent company for
$500,000 on 1 January of this year. The market value of the machine
at that time was $300,000. The parent company has owned the
machine for three years and calculated its depreciation deductions
using the prime cost method and an effective life of eight years.
Calculate the decline in value of the machine for Acme this income
year. Assume that it is not a leap year and Acme is not a small
business entity.
14.5 Following on from 14.4, Acme sold the machine to an unrelated
party for $400,000 on 1 December of this year. Advise Acme of its
tax consequences on disposal of the machine.
14.6 An extract of the asset register of Alpha Pty Ltd (Alpha) for the
2019–2020 income year is as follows:

All depreciable assets are for 100% business use and Alpha uses a
low-value pool for all eligible assets. The closing value of the low-
value pool at 30 June 2020 was $5,300. Alpha purchased a printer
on 5 June 2021 for $700.
Advise Alpha of the income tax consequences arising out of the
above information for the 2020–2021 income year assuming an
immediate deduction is not available.
14.7 Jacaranda Pty Ltd is a new company operating in Perth, West
Australia. The company signed a commercial lease for a period of
several years with an option to further extend the lease at its
discretion. The company incurred various expenses in making the
leased premises suitable for its business. The expenses relate to
the leased premises and are considered a capital expense.
Advise Jacaranda as to its income tax consequences arising out of
the above information.

Chapter 16 – Tax Accounting

Key
points ............................................................................................
....... [16.00]
Introduction...................................................................................
............. [16.10]
Derivation of
income .................................................................................
[16.20]
Meaning of
“derive” ..................................................................................
[16.20]
Timing of
derivation ..................................................................................
[16.30]
Cash vs accruals
accounting ...................................................................... [16.40]
SBE
taxpayers ......................................................................................
....... [16.50]
Large firms and
businesses ........................................................................ [16.60]
Switching between cash and accruals
basis .............................................. [16.70]
Payment before earning activity has
commenced .................................... [16.90]
Sales under a “lay-by
method” ................................................................... [16.95]
Dividend income – when
derived.............................................................. [16.100]
Derivation of income – delay because of
dispute..................................... [16.110]
Timing – deductions and
deductibility....................................................... [16.120]
Expenses .......................................................................................
............. [16.120]
Expense of an earlier income
year ............................................................ [16.140]
Incurred after business ceases to
operate ................................................ [16.150]
Relevant to reduction of future
expenses ................................................. [16.160]
When no income is being
generated ......................................................... [16.170]
Prepaid
expenses .......................................................................................
. [16.180]
Amounts specifically
excluded .................................................................... [16.182]
SBE
taxpayers ......................................................................................
........ [16.185]
Not satisfying the 12-month rule – non-business
expenditure ................. [16.186]
Provisions ......................................................................................
............... [16.190]
Long service leave and annual
leave ........................................................... [16.190]
Bad
debts .............................................................................................
........ [16.220]
Insurance
companies ...................................................................................
[16.230]
Questions ......................................................................................
............... [16.250]
Key points [16.00]
• Financial accounts, such as profit and loss statements and balance sheets,
are prepared according to the relevant accounting standards. When a tax
return is being prepared, the accounting reports need to be reconciled with
taxation requirements.
• Taxpayers are required to use either accruals accounting or cash
accounting for taxation purposes, and there are taxation implications of
changing between cash and accruals accounting.
• Small business entity taxpayers have a choice in recognising the derivation
of income on the cash or accruals basis.
• The term “derivation of income” is not defined in the Income Tax
Assessment Acts.
• Taxpayers are taken to have received the derived amount as soon as it is
applied or dealt with in any way on their behalf or as they direct.
• Dividend income is derived by the shareholder and treated as income
when it is actually paid.
• The taxation treatment of an expense differs from the financial accounting
treatment of the deductibility of the expense.
• Taxpayers accounting on a cash basis can still claim a deduction for
expenses that have been incurred but not paid for by the end of the financial
year. On an accruals basis, once the liability to pay the expense or outgoing
has been incurred, it can be deducted from assessable income.
• A deduction is not available for a provision for bad debts, long service
leave and holiday pay. Bad debts are covered by a specific deduction
provision: s 25-35 of the Income Tax Assessment Act 1997 (Cth). Section 26-
10 confirms that a deduction for long service leave may only be claimed in
the year paid.
• Deductions by an insurance company for a provision to meet future claims
may be based on an estimate of claims likely to be made and is deductible
from assessable income.
• There are legislative provisions that regulate the timing of the deductibility
of prepaid expenses and prevent a taxpayer claiming a deduction for the
prepayment of expenses in certain circumstances.
Introduction [16.10]
Tax accounting is based on financial events happening over a financial year.
It is quite different to financial accounting. One of the most important tasks
that an accountant undertakes is to reconcile the financial statements to tax
requirements contained in both the statutory and common law. Many
financial accounting treatments for recognising income and deductions are
not acceptable for taxation purposes. Those items of difference are
discussed in this chapter. For taxation purposes, what has happened
between 1 July and 30 June the next year is taken into account when
determining the taxation liability for the individual or entity. This means that
questions arise as to what happens when the taxpayer is due to be paid
assessable income on 30 June, but it is not actually received until 1 July. The
question also arises as to what financial year income is said to have been
“derived”, that is, taken into account as assessable income. Tax accounting
rules are different to financial accounting principles and this, coupled with
the concept of a financial year, leads to laws that must be followed.
Income tax payable must be determined according to the provisions of the
Income Tax Assessment Act 1997 (Cth) (ITAA 1997). As a starting point, s 4-
10 of the ITAA 1997 states:
4-10 How to work out how much income tax you must pay (1) You must pay
income tax for each financial year.
(2) Your income tax is worked out by reference to your taxable income for
the income year. The income year is the same as the financial year, except
in these cases:
(a) for a company, the income year is the previous financial year; (b) if you
have an accounting period that is not the same as the financial year, each
such accounting period or, for a company, each previous accounting period
is an income year.
There are many areas in taxation law where the method used to account for
income or deductions differs from the Generally Accepted Accounting
Principles (GAAP). The important areas of difference are examined in this
chapter and outlined in Figure 16.1.

Derivation of income - Meaning of “derive” [16.20]

Division 6 of the ITAA 1997 uses the term “derived” to refer to income of the
taxpayer. However, the term “derived” is not defined in either Income Tax
Assessment Acts. As such, it is left to the common law to determine the
meaning of “derived”. The following quote from Gibbs J in Brent v FCT (1971)
125 CLR 418 at 570 provides an excellent definition:
The Act does not define the word “derived” and does not establish a method
to be adopted as a general rule to determine the amount of income derived
by a taxpayer, although particular situations not relevant to the present case
are dealt with. The word “derived” is not necessarily equivalent in meaning
to “earned”. “Derive” in its ordinary sense, according to the Oxford English
Dictionary, means “to draw, fetch, get, gain, obtain (a thing from a source)”.
It has become well established that unless the Act makes some specific
provision on the point the amount of income derived is to be determined by
the application of ordinary business and commercial principles and that the
method of accounting to be adopted is that which “is calculated to give a
substantially correct reflex of the taxpayer’s true income” (Commissioner of
Taxes (South Australia) v Executor, Trustee and Agency Company of South
Australia Limited (Carden’s Case) (1938) 63 CLR 108 at 152-4; 1 AITR 416 at
441-2).
Timing of derivation [16.30]
An important step in calculating the taxpayer’s assessable income is
determining when that income has been “derived” in a tax year. There are
two possible scenarios for a business: when it renders an account or tax
invoice or when the customer or client actually pays the money.
Sections 6-5(4) and 6-10(3) of the ITAA 1997 state that in working out
whether you have derived an amount of ordinary income or statutory
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.
The two cases, Henderson v FCT (1970) 119 CLR 612 (see Case Study [16.2])
and Arthur Murray (NSW) Pty Ltd v FCT (1965) 114 CLR 314 (see Case Study
[16.3]), provide excellent examples of how the courts have dealt with the
issue of derivation of income. The timing of the derivation of income will be
dependent on whether the taxpayer is operating on a cash basis or an
accruals basis.
Cash vs accruals accounting [16.40]
Sections 6-5 and 6-10 of the ITAA 1997 leave it open to taxpayers to
calculate their assessable income on a cash basis or an accruals basis. The
distinction is also referred to as the “receipts method” or the “earnings
method”. For accounting purposes, all financial statements are prepared on
an “accruals” basis, but for taxation purposes tax returns can be prepared
on an accruals basis or on a “cash” basis.
The assumption is that individuals will account on a cash basis. In relation to
business, it is a question of fact. However, case law supports the proposition
that only professional practices and small-to medium-sized businesses
should account on a cash basis if it is considered to be appropriate from a
cashflow perspective.

If you are taken to have received an amount of income as soon as it is

applied or dealt with on your behalf or as you direct (s 6-5(4) of the ITAA
1997), the question we ask is whether it is derived when received in cash or
on an accruals basis.

Example 16.1: Cash vs accruals basis – timing

Marieke places $10,000 with her bank in a term deposit for one year at 4.5%
interest. The term deposit matures on 1 July and $450 is paid in interest by
the bank by crediting Marieke’s account with the money. If Marieke
accounted for the interest of $450 on a cash basis, it would be included in
the current year, but if she accounted on an accruals basis, then it would be
included in the previous year as the interest accrued to her.
There is nothing in the statutory law that compels taxpayers to adopt an
accruals method or cash method to calculate the amount of taxable income
they have gained in a particular tax year. However, from a practical
perspective, accountants and lawyers should have regard to the Australian
Taxation Office (ATO) public ruling, TR 98/1. The approach taken by the ATO
in the ruling is that trading income should be returned on an accruals or
earnings basis and income from non-trading activities such as specialised
knowledge and skill, investment income, and rent and royalties could be
returned on a cash or receipts basis.
Case study 16.1: Recoverable debt
The issue of using the correct method of accounting arose in the case of
Barratt v FCT (1992) 23 ATR 339 where the taxpayer was not able to sue for
the recovery of a bad debt until six months after the service had been
provided to the customer. The taxpayer was carrying on the business of a
pathology practice and the Medical Practitioners Act 1938 (NSW) had the
effect of rendering fees not recoverable as a debts for a period of at least six
months after the service. The taxpayer used the cash method of accounting
on the basis that they could not recover the non-payment of fees for at least
six months after the provision of the service. The ATO contended that due to
the size of the practice and the case law on this point that the most
appropriate method of accounting was the accruals method. The Full Bench
of the Federal Court held that the appropriate method was indeed the
accruals method and that the concept of a “recoverable debt” did not justify
the use of a cash basis of accounting.
SBE taxpayers [16.50]
Any business that is an eligible small business entity (SBE) may account on
either a cash or accruals basis. The test to be applied is that the entity must
have an average turnover of less than $10 million (previously $2 million).
The Government encourages small businesses to account on a cash basis as
this is better for cashflow purposes when calculating income tax payable and
GST owing to the ATO.
Large firms and businesses [16.60]
In Henderson v FCT (1970) 119 CLR 612 (see Case Study [16.2]), the High
Court established the legal principle that with large professional firms the
appropriate method to be used in calculating taxable income is the accruals
basis. It is however acceptable for small professional practices and small
businesses to use the cash basis as it provides a cashflow advantage when
businesses first start because their assessable income is based only on cash
received. Any income tax payable can then be met from the cash received.
Switching between cash and accruals basis [16.70]
If a small business grows into a large business, then it may be appropriate
for that business to change from accounting on a cash basis to an accruals
basis for taxation purposes. The change would occur at the start of a new
financial year.
Example 16.2: Impact of changing from cash to accruals basis
In Year 1, ABC Pty Ltd accounted on a cash basis and its taxable income was
$200,000. In Year 2, ABC Pty Ltd accounted on an accruals basis and its
taxable income was $600,000.
Cash ($) Invoice/accruals ($)
Year 1 200,000 500,000
Year 2 800,000 600,000
What is the effect of the $200,000 of cash that is not included in ABC’s Year
2’s taxable income? Is this amount subject to income tax and, if so, how?
Case Study [16.2] provides the answer.
Case study 16.2: Changing from cash to accruals basis
Henderson v FCT (1970) 119 CLR 612 illustrates what happens when
taxpayers change the method they use to calculate their taxable income. In
this case, the change was from a cash basis to an accruals basis. The
taxpayer, Mr Henderson, was a partner in an accounting practice and
calculated the partnership income for the year ended 30 June 1964 on a
cash basis, then prepared the partnership’s tax return on that footing. Mr
Henderson returned his income on the same basis.

The Commissioner accepted these returns and assessed Mr Henderson for

income tax on the basis of them. Fees outstanding at the end of that year
were not brought in as assessable income in that year.

If the partnership income were computed for the year ending 30 June 1965
upon an earnings (accruals) basis and the relevant earnings were confined to
the earnings of that tax year, those fees outstanding, which amounted to a
considerable sum in the order of $179,000, if no other action was taken,
would be collected without ever being subject to income tax.
The High Court held that where the professional accounting practice
employed more than 295 people, the correct method was the accruals basis
of accounting and not the cash basis. The cash basis was accepted as
appropriate for small professional practices, as was the situation in
Commissioner of Taxes (South Australia) v Executor, Trustee and Agency
Company of South Australia Limited (Carden’s Case) (1938) 63 CLR 108,
where a single doctor was conducting a medical practice. The fact that
changing from a cash to an accruals method resulted in income from an
earlier year that had not been collected in that year, and was not subject to
income tax in the current year, made no difference to the finding of the High
Court.

According to Barwick CJ at 647: [T] he whole purpose of calculating your

taxable income each year is to provide a true “reflex of income” for that
period. It is not a two year period or any other period. The earnings of a prior
year are subject to income tax in that year. In this case the earnings on a
cash basis that are not included in the next year because of calculating
assessable income on an accruals basis is not subject to income tax. The
uncollected fees earned in a prior year cannot be included in the assessable
income of the next year. They are simply untaxed earnings.
For the Commissioner’s views on the treatment of the outstanding debts and
the CGT consequences: see ID 2014/1.
[16.80] If a taxpayer kept changing from a cash to accruals basis and then
back again in order to derive tax-free income, then the ATO could assert that
the taxpayer was engaged in tax avoidance under Pt IVA of the Income Tax
Assessment Act 1936 (Cth) (ITAA 1936) and could impose penalties for such
conduct.
Payment before earning activity has commenced [16.90]
The question of recognising income may arise when a business receives a
prepayment for goods or services and the goods or services which will be
provided over a period of time and over more than one financial year. Arthur
Murray (NSW) Pty Ltd v FCT (1965) 114 CLR 314 illustrates the way in which
the income is said to have been derived in these circumstances. Generally,
amounts received in advance will not be regarded as income and will only be
recognised when the goods or services are provided.
Case study 16.3: Derivation of income where prepayment occurs
In Arthur Murray (NSW) Pty Ltd v FCT (1965) 114 CLR 314, the taxpayer,
Arthur Murray, was in the business of providing dancing lessons to the
public. Students would pay for five, 15 or 30 hours of tuition over a period of
time but not exceeding one year unless they paid for a lifetime of lessons.
Payment was to be made by instalments or a lump sum and the contract did
not provide for a refund in the case of students not wanting to complete
their course of classes, but, in some instances, refunds were made to
students. The company, on receipt of payment, would credit the amount to
an account styled “Unearned Deposits – Untaught Lessons Account”. When
the lessons were given, amounts were then transferred to an account styled
“Earned Tuition Account”. The company would not include amounts that
represented fees in advance in its assessable income for tax return
purposes. Income was only recognised when the lesson had been given and
the income had been earned. The Commissioner assessed the taxpayer on
the total of the income received prior to the end of the financial year.
In the joint judgment of Barwick CJ, Kitto and Taylor JJ at 318: [A]ccording to
established accounting and commercial principles, in the case of a business
either selling goods or supplying services, amounts received in advance of
the goods being delivered or the services being supplied are not regarded as
income. We have not been able to see any reason which should lead the
courts to differ from accountants and commercial men on the point.
Nothing in the Act [ITAA 1936] is contradicted or ignored when a receipt of
money as a prepayment under a contract for future services is said not to
constitute by itself a derivation of assessable income. On the contrary, if the
statement accords with ordinary business concepts in the community – and
we are bound by the case stated to accept that it does – it applies the
provisions of the Act according to their true meaning.
Sales under a “lay-by method” [16.95]
The situation may also arise where retail stores “sell” goods on an
instalment basis and the legal title to the goods is not transferred nor the
physical possession until full payment has been received. These
arrangements
are referred to as “lay-by sales”. The question arises as to what stage the
taxpayer derives the income. In this case, the income is only derived when
legal title passes to the customer and not when the contract is entered into.
In the meantime, the income is held in a suspense account and only
recognised as income when the full payment has been made and the goods
delivered or the customer defaults on the arrangement.
Dividend income – when derived [16.100]
Dividends are assessable income pursuant to s 44(1) of the ITAA 1936
leading to the question of when dividends are recognised as income.
Dividends are treated as income in the hands of the shareholder when
actually paid, not when declared by the directors. The directors can rescind
the decision to pay the dividend at any time up until payment, so the
shareholders are not absolutely entitled to the dividends until they are paid.
Authority for this statement is Brookton Co-operative Society v FCT (1981)
147 CLR 441.
Example 16.3: Derivation of dividend income
Company XYZ Ltd declares a dividend of 25 cents per share on 4 May 2020.
Your client is due to receive a dividend of $550. The dividend is paid on 15
July 2020. The question is whether the client has derived the $550 in the
2019–2020 financial year or the 2020–2021 financial year.

According to the decision in Brookton Co-Operative Society v FCT, the

dividend is regarded as income when paid and not when it is declared. The
income is derived in the 2020–2021 financial year. The income is recognised
on a cash basis, not an accruals basis.
Derivation of income – delay because of dispute [16.110]
If a taxpayer is owed money for goods sold, but the amount of money is
subject to a dispute, then the question arises as to what stage that money
should be brought to account as assessable income: when the dispute has
been resolved or when the goods have been sold. In the case of BHP Billiton
Petroleum v FCT (2002) 51 ATR 520, this exact issue was decided by a Full
Bench of the Federal Court. The main legal issue decided in this case is set
out in Case Study [16.4]. In that case, the Court held that income is only
derived when a dispute is settled.

Case study 16.4: Income derived in the case of a legal dispute

In BHP Billiton Petroleum v FCT (2002) 51 ATR 520, the two taxpayers, BHP
Billiton and Esso Australia, were involved in the production of petroleum
products in the Bass Strait. The taxpayers entered into contracts for the sale
of gas (or ethane) to six buyers. The buyers agreed to pay an annually
determined amount for the gas. Monthly statements were to be issued and
payment was to be made within 15 days of receipt by the buyer. There was
provision in the 12th month for an adjustment to be made to ensure that the
amount to be paid reflected the annual contract amount. Following the
replacement of the royalty and excise regime with the petroleum resource
rent tax (the PRRT) from 1 July 1990, the sellers notified the buyers that they
intended to pass on the effect of the PRRT directly to the buyers (the pass-on
amount).

The pass-on amount could only be determined some time after gas was
delivered. The buyers did not pay the pass-on amounts. The matter was
subject to dispute and arbitration, including a (lapsed) appeal to the
Supreme Court of Victoria. It was eventually settled, with the parties
agreeing not only to settle the claim for the pass-on amounts for the past,
but also to settle claims that would arise in the future. The settlement thus
involved the payment of two lump sums, one for the past claim and one for
the future claim. The assessability of the second lump sum payable (i.e., that
paid for release for future pass-on amounts) was not the subject of dispute.
The Commissioner assessed the taxpayers on the basis that they had
derived the additional income, namely the pass-on amounts at the time the
gas was invoiced monthly, even though the amounts were in dispute. The
Federal Court, per Hill and Heerey JJ at 539, held that the additional amounts
of income were only derived when the dispute had been settled. Their
conclusion was:
It is clear that there is no Australian authority which requires the conclusion
that where there is a bona fide dispute a taxpayer on an accrual basis is
obliged to account for trading income that is the subject of dispute in the
year where goods are sold, if the taxpayer is a trader in goods or in the year
when services are rendered, if the taxpayer derives income from services
performed.
As should by now be clear a principle which requires the taxpayer to account
for disputed income in the year goods are sold conflicts with accounting
practice. That practice regards income to be derived when the dispute is
concluded, whether through arbitration, litigation or settlement. The only
justification for the principle for which the Commissioner here contends is
one that proceeds on the fiction that a successful litigant was always going
to be successful and was always going to receive the amount
which the arbitral or litigation result achieves. The court should be slow to
adopt a fiction in preference for reality in a case such as the present. The
deferral of derivation until the conclusion of the dispute (or perhaps receipt if
that occurs earlier) avoids the difficulties which arise where the accounts of
the year in which the trader sells goods cannot be reopened and where the
availability of a deduction for a bad debt may be the subject of doubt. It
avoids too the unfairness to a taxpayer in being required to pay tax
immediately where recoverability of what is owed to the taxpayer and which
is the fund out of which the tax might be expected to be paid, is, as a result
of a bona fide dispute, outside the control of the taxpayer. It accords with the
common sense solution arrived at in both the United States and Canada
where the tax law does not permit reopening of the tax accounts.
The Commissioner’s submission that in the present case the taxpayer’s
derived income at the time gas was delivered to purchasers for the purpose
of the ITAA 1936 should be rejected. Because the parties accept that no
different result flows from the Petroleum Resource Rent Tax Assessment Act
1987 (Cth), it follows that the taxpayer likewise derived the consideration
receivable from the sale of gas only when the dispute between the buyers
and the taxpayers themselves was settled. The appeals should accordingly
be allowed with costs.
Timing – deductions and deductibility Expenses [16.120]
In order to claim an expense or outgoing as a deduction pursuant to s 8-1 of
the ITAA 1997, the question arises as to whether it is necessary to have paid
for that expense or whether it is sufficient that the liability to pay has been
incurred. Another consideration is whether an expense that relates to a
previous financial year or a future financial year can still be claimed as a
deduction in the current financial year. The taxation treatment of the
recognition of an expense even when not paid or the timing of the deduction
of that expense differs from the financial accounting treatment of the
deductibility of the expense. These differences are discussed in detail below.
The starting point for deductions is s 8-1. 8-1 General deductions
(1) You can deduct from your assessable income any loss or outgoing to the
extent that:
(a) it is incurred in gaining or producing your assessable income; or
(b) it is necessarily incurred in carrying on a business for the purpose of
gaining or producing your assessable income.

(2) However, you cannot deduct a loss or outgoing under this section to the
extent that:
(a) it is a loss or outgoing of capital, or of a capital nature; or
(b) it is a loss or outgoing of a private or domestic nature; or
(c) it is incurred in relation to gaining or producing your exempt income or
your non-assessable non-exempt income; or
(d) a provision of this Act prevents you from deducting it.
The term “incurred” does not have the opposite meaning to “derived” when
looking at income. If a taxpayer is accounting on a cash basis, then he or she
can still claim a deduction for expenses that have been incurred but not paid
for, a hybrid approach and, similarly, if accounting on an accruals basis, then
once the liability to pay the expense or outgoing has been incurred, it can be
deducted from assessable income.
The loss or outgoing must be incurred in gaining or producing the taxpayer’s
assessable income. It is not necessary to match the loss or outgoing with the
income earned in the same income year, at least where a continuing
business is involved. The financial accounting “matching principle” has no
relevance to the taxation treatment of the deductibility of expenses. The
expense may be relevant to any of the following circumstances:
• an earlier income year;
• when a business has ceased to be owned by the taxpayer;
• the reduction of future expenses; or
• deductible when no income is generated but may be in the future.
[16.130] Ruling TR 97/7 is relevant to understanding what is meant by the
term “incurred” as well as timing of the deductibility of expenses. Taxation
Ruling – TR 97/7 – Income tax: section 8-1 – meaning of “incurred” – timing
of deductions ...
Incurred 4. There is no statutory definition of the term “incurred”. 5. As a
broad guide, you incur an outgoing at the time you owe a present money
debt that you cannot escape. But this broad guide must be read subject to
the propositions developed by the courts, which are set out immediately
below.
6. The courts have been reluctant to attempt an exhaustive definition of a
term such as “incurred”. The following propositions do not purport to do this,
they help to outline the scope of the definition. The following general rules,
settled by case law, assist in most cases in defining whether and when a loss
or outgoing has been incurred:

(a) a taxpayer need not actually have paid any money to have incurred an
outgoing provided the taxpayer is definitively committed in the year of
income. Accordingly, a loss or outgoing may be incurred within section 8-1
even though it remains unpaid, provided the taxpayer is “completely
subjected” to the loss or outgoing. That is, subject to the principles set out
below, it is not sufficient if the liability is merely contingent or no more than
pending, threatened or expected, no matter how certain it is in the year of
income that the loss or outgoing will be incurred in the future. It must be a
presently existing liability to pay a pecuniary sum;
• ... Accounting practice
8. The principles set out above relating to the interpretation of the word
“incurred” derive from cases where taxpayers operated on an earnings
basis. However, the cases have not generally sought to limit the meaning of
the word “incurred” by reference to the nature of a taxpayer’s accounting
system.
9. In these circumstances, subject to the propositions outlined above, a
taxpayer who uses a cash receipts based accounting system need not
necessarily have paid or borne a loss or outgoing in order for that loss or
outgoing to have been “incurred” for the purposes of section 8-1.
The Commissioner recently released Taxation Ruling TR 2020/1 explaining
the circumstances in which employees incur deductions for work expenses
but refers the reader back to TR 97/7 for guidance on the timing of the
deduction under s 8-1.
Expense of an earlier income year [16.140]
Placer Pacific Management Pty Ltd v FCT (1995) 31 ATR 253 illustrates the
taxation principle that an expense is deductible in a later year when the
event that gave rise to the expense occurred in an earlier year.
Case study 16.5: Expense of earlier year deductible in later year
In Placer Pacific Management Pty Ltd v FCT (1995) 31 ATR 253, the taxpayer,
a manufacturer of conveyor belts, installed a conveyor belt for NWCC. In July
1981, it sold its business. In August 1981, NWCC sued the taxpayer, claiming
that the conveyor belt was defective. In 1989, the taxpayer settled the
action by paying NWCC $325,000 and claimed the amount as a deduction in
the year of income ending 1989. The Federal Court held that the expense
was deductible and followed the decision in AGC (Advances) Ltd v FCT
(1975) 132 CLR 175.

The Federal Court held a great deal of injustice would follow if in the present
case Placer was unable to claim a deduction for the cost of the
compensation and legal fees payable as a result of having sold a defective
conveyer belt some years before the business ceased to operate. The
expenses were deductible and the High Court decision in AGC (Advances) Ltd
v FCT was followed and the High Court’s view of the decision in
Amalgamated Zinc (De Bavay’s) Ltd v FCT (1935) 54 CLR 295 was accepted
as correct.
The following quote from the joint judgment of Davies, Hill and Sackville JJ at
258 provides an excellent statement of the taxation law as it currently
stands:
On the facts of the present case the occasion of the loss or outgoing
ultimately incurred in the year of income was the business arrangement
entered into between Placer and NWCC for the supply of the conveyor belt
which was alleged to be defective. The fact that the division had
subsequently been sold and its active manufacturing business terminated
does not deny deductibility to the outgoing. A finding to the contrary would
lead to great inequity. Many businesses generate liabilities which may arise
in the considerable future. Such liabilities are sometimes referred to as “long
tail liabilities”. To preclude deductibility when those liabilities come to fruition
on the basis that the active trading business which gave rise to them had
ceased would be unjust.
Incurred after business ceases to operate [16.150]
It is possible to claim, as a deduction in the current financial year, expenses
that were committed to many years prior and for a business that is no longer
owned by the taxpayer. In FCT v Jones (2002) 49 ATR 188, the High Court
held that the interest expense on a loan taken out when a business was
operational was still deductible even when the business was no longer
owned by the taxpayer.
Case study 16.6: Expense incurred in earlier year by former
business owner
In FCT v Jones (2002) 49 ATR 188, a loan was taken out to finance a business
owned by Mr and Mrs Jones. When the taxpayer’s husband became ill and
eventually died, the proceeds from the sale of the business did not cover the
loan and Mrs Jones had an ongoing liability to the financial institution. The
loan was secured against the family home and at one stage was refinanced
in order to take advantage of a lower interest rate. The taxpayer, Mrs Jones,
continued to pay the interest on the loan out of her salary as a nurse and
claimed a deduction pursuant to s 8-1 of the ITAA 1997. The ATO denied the
deduction on the basis that the business was no longer owned by the
taxpayer.
The Federal Court held that the interest expense was deductible even
though the business was not still owned by the taxpayer. They followed the
precedent of both AGC (Advances) Ltd v FCT (1975) 132 CLR 175 and Placer
Pacific Management Pty Ltd v FCT (1995) 31 ATR 253 in that expenses are
still deductible even when the business ceases to operate. The fact that the
loan was refinanced did not break the nexus between the expense and the
business operations that were used to gain the assessable income in the first
place. Mrs Jones had an obligation to keep paying the interest on the loan
until the loan had been fully repaid, otherwise she would have lost the family
home.

Relevant to reduction of future expenses [16.160]

W Nevill & Co Ltd v FCT (1937) 56 CLR 290 illustrates the taxation law
principle that an expense is still deductible in the current financial year even
though it results in a reduction of expenses in future years. There is no need
in tax accounting to match the expense to the benefit derived by the action
of the taxpayer which may only occur in a future financial year.
Case study 16.7: Current-year deduction where expense reduces
future expenses
In W Nevill and Co Ltd v FCT (1937) 56 CLR 290, Mr William Nevill was
managing director of the taxpayer company. Due to his bad health, he
thought it advisable that someone should be brought into the business to
help him in its management. On 11 July 1930, the company employed Mr
King as joint managing director of the company with Mr Nevill for a term of
five years from 1 July 1930 at a remuneration of £1,500 per annum together
with a certain percentage of the profits. When the joint managing director
arrangement did not work efficiently, Mr King was asked to resign. He was
prepared to resign from the ninth day of March 1931, on the basis that the
company pay him the sum of £2,500 as follows: £1,500 cash and the
balance of £1,000 by 10 equal monthly instalments of £100 terminating
December 1931 to be covered by 10 promissory notes of the company. The
money and promissory notes were paid and the company claimed a
deduction for the total amount in the year in which the expense was
incurred.

The High Court held that the expense was deductible, even though it was
incurred to reduce future deductions. The wording of s 8-1 of the ITAA 1997
does not discuss taxable income but assessable income and a reduction in
expenses increases assessable income. The payment to the retiring
managing director was not of a capital nature as it was not used to buy plant
or equipment or provide a permanent improvement to the business. The
payment should be apportioned between the two financial years and not
deducted in the year in which the obligation to pay was incurred.
When no income is being generated [16.170]
Steele v DCT (1999) 197 CLR 459 is an important precedent for finding that
expenses may be deductible even though no income is derived at the time
the expense is incurred but where, as a result of the expense, the taxpayer
may generate income in the future. The High Court decision reinforces the
fact that the “matching” of expenses to the gaining of assessable income is
not required for taxation purposes before an expense is deductible pursuant
to s 8-1 of the ITAA 1997.
Case study 16.8: Expenses deductible where no income generated
Mrs Steele purchased a large area of land to be used as the site of a motel. A
large amount of money was borrowed to buy the land and the interest
expense was claimed by Mrs Steele even though the motel had not been
built many years after the land had originally been purchased. A small
amount of income was generated from agisting horses on the land. The main
question was whether the interest expenses could be deductible pursuant to
s8-1 of the ITAA 1997 (s 51(1) of the ITAA 1936), even though the interest
was incurred in purchasing a capital asset that did not generate the volume
of assessable income that was originally contemplated by the taxpayer.

The High Court held that the interest expense was deductible even though
the capital asset was not used as intended and the volume of assessable
income was not produced as originally intended. The High Court was of the
opinion that the positive limbs must be applied to the expense before the
Court then looks at the application of the negative limbs. Finally, the High
Court dismissed the notion that the expense must be contemporaneous to
the gaining of the assessable income.

Prepaid expenses [16.180]

Sections 82KZL–82KZMG of the ITAA 1936 regulate the timing of the
deductibility of advance expenditure. These provisions were introduced to
prevent a taxpayer claiming a deduction for the prepayment of expenses in
a current financial year for several years’ worth of expenses. For example,
prior to these provisions being introduced, a business could have prepaid a
five-year lease of a motor vehicle for a business with one payment and
claimed a deduction for the entire amount. If the annual lease cost was
$12,000, then instead of claiming only this amount, if the entire lease
payments were paid at once ($12,000 × 5 = $60,000), then a deduction for
$60,000 could be claimed in year 1.
Where expenditure covers a period of more than one tax year, the general
principle is that the taxpayer must apportion that expenditure over the
eligible service period of the expenditure. There are, however, exceptions to
this general principle. The two main exceptions are amounts of expenditure
which are specifically excluded from the apportionment rule and certain
payments made by SBEs and non-business taxpayers.
Amounts specifically excluded [16.182]
In some situations, it is necessary to pay for expenses, such as insurance
premiums, and annual fees, such as licences and registration fees, over a
12-month period. These types of expenses are excluded from the 12-month
rule by virtue of s 82KZL(1).
Section 82KZL(1) states that the following types of expenditure are excluded
from the 12-month prepayment rules:
• amounts of less than $1,000;
• amounts required to be incurred by a court order or law of the
Commonwealth, State or Territory;
• payments of salary or wages (under a contract of service);
• amounts that are capital, private or domestic in nature; and
• certain amounts incurred by a general insurance company in connection
with the issue of policies or the payment of reinsurance premiums.
Example 16.4: Amount required to be incurred under a State law
John operates a cartage business and paid $1,200 on 31 December 2019 to
register his truck for 12 months from 1 January 2020 to 31 December 2020.
The truck is used exclusively for business purposes. Although the registration
fee is over $1,000 and it covers a period spreading across more than one
income year, it is excluded expenditure. This is because it is required to be
incurred under a State or Territory law. The prepayment rules do not apply to
this type of expenditure and the fee is deductible in the year it is incurred.

SBE taxpayers [16.185]

SBE taxpayers and non-business taxpayers, such as passive investors, can
pay for a service up to 12 months and obtain an immediate deduction: s
82KZM of the ITAA 1936.
Example 16.5: Prepaid expense that is immediately deductible
The Jacobs Trust is a small business entity. On 1 June 2020, it made a
payment of $24,000 to cover the lease of its business premises for a 12-
month period commencing on 1 July 2020 and ending on 30 June 2021. As
the eligible service period for the expenditure does not exceed 12 months
and ends on or before the last day of the income year following the year in
which the payment was made, the prepayment satisfies the 12-month rule.
The Jacobs Trust can therefore choose to claim an immediate deduction of
$24,000 in the 2019–2020 income year.
Not satisfying the 12-month rule – non-business expenditure
[16.186]
If the non-business expenditure’s eligible service period is more than 12
months or it ends after the last day of the next income year, it is necessary
to use the following formula to work out the amount of the deduction:
Expenditure × Number of days of eligible service period in the income year
Total number of days of eligible service period
Example 16.6: Deduction for non-business expenditure with eligible
service period >12 months
Tom Pty Ltd is a small business entity. On 31 May 2019, it paid $15,000 for
business advertising to cover the period 1 June 2019 to 30 June 2020 (396
days). Because the eligible service period is longer than 12 months, the
prepayment does not satisfy the 12-month rule. Tom Pty Ltd cannot claim an
immediate deduction for the prepayment. Instead, the deduction for the
expenditure must be apportioned over the eligible service period as follows:
2019 (1 June 2019 to 30 June 2019)
$15,000 × 30/396 = $11,36

2019–2020 (1 July 2019 to 30 June 2020)

$15,000 × 366/396 = $13,864
The total deduction allowed proportionately over the 2018–2019 and 2019–
2020 income years will be $15,000.
Provisions Long service leave and annual leave [16.190]
The two cases, FCT v James Flood Pty Ltd (1953) 88 CLR 492 and Nilsen
Development Laboratories Pty Ltd v FCT (1981) 11 ATR 505, relate to the
deductibility of provisions for future expenses, such as long service leave
and annual leave for employees. In both cases, the High Court held that the
provision for these future expenses was not deductible as there was no
actual liability at the time of making the provision.
Case study 16.9: Holiday and sick pay as future expenses
In FCT v James Flood Pty Ltd (1953) 88 CLR 492, the taxpayer carried on
business as a motor-body builder and general engineer. The company was a
party to the variation of an award made by the Commonwealth Court of
Conciliation and Arbitration. The award as varied provided: Annual Leave.
Period of Leave. 13A. (a) Except as hereinafter provided a period of fourteen
consecutive days’ leave shall be allowed annually to an employee after
twelve months’ continuous service (less the period of annual leave) as an
employee in any one or more of the occupations to which this award applies.
When the company lodged its tax return for the year ending 30 June 1947,
the return was accompanied by a manufacturing account which
showed, under the heading “Manufacturing overhead”: “holiday and sick pay
etc. £1,888 8s 2d”. In answer to a request for further information by the
Commissioner, the company stated that, of the sum of £1,888 8s 2d, £578
10s 2d represented holiday and sick pay which had accrued, but which had
not been paid in the year of income. The Commissioner disallowed the sum
of £579 as a deduction from assessable income.
The High Court held that in order for an expense, loss or outgoing, to be
incurred (pursuant to s 8-1 of the ITAA 1997), it does not require the amount
to be actually paid, but it does require a liability to meet the payment that is
fixed and cannot be changed. In this case, the liability to pay holiday pay
was subject to contingencies, such as an employee leaving before 12
months of service. The time to claim a deduction is when the employee
takes his or her holiday leave and the money is paid and that usually occurs
in the later financial year.
[16.200] In Nilsen Development Laboratories Pty Ltd v FCT (1981) 11 ATR
505, the High Court confirmed its earlier decision in FCT v James Flood Pty
Ltd (1953) 88 CLR 492 that provisions for leave were not deductible until
actually paid in a particular financial year.
The situation relating to the deductibility of a provision for long service leave
and annual leave has subsequently been legislated by virtue of s 26-10 of
the ITAA 1997.
[16.210] Statutory solution. Section 26-10 of the ITAA 1997 confirms that a
deduction for leave, such as long service leave, annual leave and sick leave,
may only be claimed in the year paid. Section 26-10 states: 26-10 Leave
payments (1) You cannot deduct under this Act a loss or outgoing for long
service leave, annual leave, sick leave or other leave except: (a) an amount
paid in the income year to the individual to whom the leave relates (or, if
that individual has died, to that individual’s dependant or legal personal
representative); or
(b) an accrued leave transfer payment that is made in the income year. A
provision or an allowance for the anticipated expense is not deductible.
Bad debts [16.220]
Provisions for bad debts are not allowable deductions. Provisions are usually
book entries, for financial accounting purposes, made in respect of
anticipated or possible future loss contingencies. At the time of making the
provision, it is not yet possible to say that a loss or outgoing has been
“incurred” as the relevant “triggering” event has not yet occurred.
Bad debts are now covered by a specific deduction, s 25-35 of the ITAA
1997.
Insurance companies [16.230]
Insurance companies incur liabilities at the time that certain events occur
but of which the insurance company may not become aware until some time
in the future. It has been necessary for insurance companies to make an
estimate of future liability, usually by reference to historical experience or
educated estimates. Insurance companies are allowed a deduction for
estimated costs associated with future claims.
Case study 16.10: Insurance companies – estimated future
deductions
In RACV Insurances Pty Ltd v FCT (1974) 4 ATR 610, the taxpayer set aside
amounts to cover unreported third party claims. These amounts were
estimates of the likely cost of claims arising out of accidents occurring before
the end of the income year, but not yet reported. The Commissioner
disallowed the deduction. The Supreme Court of Victoria held that the
estimated cost was deductible. The fact that the amount was estimated and
that it may have to be adjusted in light of later events does not bar the claim
for a deduction. Once the event had occurred, the accident out of which
absolute liability arose, s 8-1(1) of the ITAA 1997 applied, which was not
dependant on a notice of the claim.
[16.240] Commercial Union Assurance v FCT (1977) 7 ATR 435 was similar
to RACV Insurances Pty Ltd v FCT (1974) 4 ATR 610 and affirmed the right to
be able to claim a deduction based on an estimate of claims likely to be
made. In this case, the provision was deductible even though it included an
estimate of damages to be paid by policy holders that had not notified the
insurance company within the stipulated time limit.
Case study 16.11: Deduction for an insurance provision for future
claims
As was the situation in RACV Insurances Pty Ltd v FCT (1974) 4 ATR 610 (see
Case Study [16.10]), the taxpayer, Commercial Union Assurance Co of
Australia Ltd, claimed a deduction for the provision of insurance claims that
had not been notified but would have to be met, even though, as a condition
precedent of the policy, the insured was required to notify the taxpayer
company within a specified time. The Commercial Union Assurance Company
did pay claims even if they were not notified within the time limit. The
Commissioner accepted the provision that was based on notified claims as a
deduction, but disallowed this extra provision on the basis that it did not
follow the situation in RACV Insurances Pty Ltd v FCT.
The Victorian Supreme Court confirmed the correctness of the decision in
RACV Insurances Pty Ltd v FCT and held that a provision for future claims,
even where the insurance policy document required notification of a claim
within a time limit, was also deductible. The issue of whether a provision
could include potential claims from earlier years when the premiums had
been paid was also held to be deductible, based on the authority of AGC
(Advances) Ltd v FCT (1975) 132 CLR 175.

Questions [16.250]
16.1 Your client is a small IT consulting business consisting of a
husband and wife as the principals and two employees. From the
time the business was established, 1 July 2015, it has been
accounting for tax purposes on a cash basis. For the current
financial year, your client has decided to account on an accruals
basis as the size of the business is increasing. As at 30 June it has
$40,000, which was paid to it from the previous financial year, and
this amount was not included in its assessable income for that year.
Must it be included in the current financial year? Would your answer
be different if your client had deliberately told the customer not to
pay its account for $40,000 until after 30 June?
16.2 Your client is a medium-sized building company and has
provided you with its accounting records for the current financial
year. Included in the accounting figures are the following amounts.
How would you treat them for tax purposes?
(a) Provision for long service leave for 10 employees – $25,000. The
actual amount paid during the year was $12,000.
(b) Insurance premium on the plant and equipment – $22,500, paid
on 1 June for 12 months.
(c) As at 30 June, there is an outstanding electricity account for
$1,500 and telephone account for $4,500.
(d) A maintenance contract on the computer equipment for 12
months – $12,000. The payment was made in the current year but
ends in May of the following year.
(e) The sum of $165,000 was paid to the sales manager on 30 June
as compensation for the early termination of his employment
contract. The employment contract had one year to go; it would
have ended on 30 June of the following year.
(f) Interest expense of $56,000 on a loan that has five years to run
that was originally used to purchase a computer repair business
which ceased to operate on 30 June 2019.
16.3 For the year ended 30 June, BBNT Pty Ltd, a lawn mower
manufacturer, reported an operating (accounting) profit of
$750,000. The company does not elect to be taxed as a SBE
taxpayer.
In coming to this profit figure, the financial accountant had taken
into account the following items:
(a) $30,000 has been claimed as a deduction being the amortisation
of goodwill arising from the acquisition of a business two years
earlier.
(b) A provision has been raised for future warranties equal to 2% of
sales. During the year, the sales amounted to $5 million.
(c) Depreciation on the buildings was $50,000. However, for tax
purposes, only $25,000 is tax deductible.
(d) The company spent $75,000 on legal expenses opposing an
application by Heavy Mowers Pty Ltd to extend its patent on a
brand of mower. If the patent was not extended, then BBNT could
produce a similar mower.
(e) The company borrowed $200,000 on 1 January of the current
year to cover the purchase of new plant. The loan is repayable in 10
years. The cost of borrowing was $2,500, and this amount was
written as a deduction in the company financial accounts when it
was paid.
(f) Because of a shortage of working capital, the company was
forced to sell off some land for $300,000 in February of the current
year. The land had been bought in October 1995 at a cost of
$180,000. The company only brought to account in its financial
statements the difference between the current market value of
$220,000 and the proceeds, namely $300,000, as their accounting
gain on sale.
(g) The directors also advised the financial accountant to make a
provision for:
(i) bad and doubtful debts of $30,000;
(ii) annual leave and long service leave of $60,000.
(h) The company also purchased for the managing director a new
car at a cost of $120,000. The car was purchased by the company on
1 July of the current year. The effective life of the car is 7.5 years.
For accounting purposes, the financial accountant has claimed
depreciation in the accounts of $12,000 being 10% of the cost. (i)
The company also needed to acquire a series of parts to hold as
stock on hand. At the end of the year, the company had closing
stock of $146,000. Of this figure, the directors believed that
$85,000 represented obsolete stock and wished to write off this
amount. The financial accountant had not done this in deriving the
profit of $750,000 as he was unsure of how to account for it in the
financial accounts. The obsolete stock had been scrapped at the end
of the year and taken to a metal recycler.
The company has carry forward losses of $150,000. There has been
no change in the ownership of the company between the start of
the loss year and the end of the current year other than 35% of the
shares were sold year to a Perth-based (unrelated) company. The
company received the following dividends:
• Cash dividend from BHP Ltd of $23,000 fully franked. • Dividend
from Intergroup Ltd of $7,800 which was 75% franked. The company
had elected to reinvest the dividend and receive shares instead of
cash.
• Cash dividend from Microsoft Inc, a US company, of A$8,200. An
amount of A$1,447 had been withheld as tax by the US Internal
Revenue Service.
• Dividend of $3,000 unfranked from Golden Beach Pty Ltd which
was declared on 5 May of the previous year by the directors but not
actually paid until 5 July of the current year.
The company accountant had only brought to account as income the
actual cash when received in respect of the above dividends. It did
not account for any dividends due.
The company directors come to you as the taxation adviser of the
company and wish to know what the taxable income is for the
company and the tax payable. The company wishes to maximise its
tax deductions.
16.4 You are the tax accountant for Computer Consultants Pty Ltd, a
large company with a turnover of $24 million. You have been asked
to review the 30 June accounts for the company. After you
conducted your review, you notice the following items had been
claimed as a tax deduction in the financial reports:
• Provision for long service leave $60,000 (an amount of $21,000
was actually paid).
• Maintenance contract fee of $60,000 (this related to the period
May of the current year to May in the following year).
• Provision for bad debts $40,000 (this was an estimate only by the
marketing staff and no legal action has been taken). You are
required to write a report to the directors explaining the correct
taxation treatment of the above items. In your report, you should
refer to the sections of the Act and any relevant case law.
16.5 When are taxpayers allowed to account for their taxable
income on a cash basis and when are they required to account for
their taxable income on an accruals basis? Could a business with a
turnover of $20 million account on a cash basis?
16.6 If your client is required to pay interest on a loan that was
used in a business that was sold last year, are they still entitled to
claim a deduction for the interest expense even though they are not
able to match the expense to the derivation of assessable income
from the business?
16.7 Would it be tax effective if your client paid for the lease
payments on their photocopier for the next two years in one lump
sum just before the end of the financial year?
16.8 If you are accounting on a cash basis in your accounting
practice and a client came in to pay their account on 30 June, but
you did not bank it until the next day, namely 1 July, when are you
taken to have derived that income? Would it make any difference if
you were accounting on an accruals basis?
16.9 If your client owns a small business selling designer clothes
and sells dresses on a “lay-by” system, when are they said to have
derived their income? Is it when the final payment is made or when
the first payment has been made?
16.10 Emily has a sickness insurance policy that will pay a weekly
benefit and is renewable in advance each July. She receives the
renewal notice each June and pays it in July. It what year will Emily
be able to deduct the payment for the policy?
16.11 Ms Lei is a sole practitioner accountant. Her practice also acts
as an agent for a local energy supplier accepting payments. The
income is small with five regular employees, including her son and
daughter who each work 30 hours a week. The regular employees
do not have professional accounting qualifications, so Ms Lei takes
responsibility for all work that is completed. Occasionally, where
there are difficult tax questions, Ms Lei hires an accountant to do
work for the practice.

Except for three regular clients who are billed on a quarterly basis,
all others are billed when work is complete.
Should Ms Lei account for her income on a cash or accruals basis?
16.12 Samuel is the sole shareholder, director and employee of a
company. Samuel’s company owns and hires out a digger and truck.
The business rents the digger and truck out at a fixed rate per hour.
The rate is for the backhoe, the truck and Samuel’s labour. The
business never rents the backhoe or truck out without Samuel’s
labour. For the purposes of taxation, the company has always
returned the income from its business on the basis of cash received.
The business does not usually extend credit and requests payment
on completion of a job. The company maintains simple books of
account, recording income when received. For purposes other than
taxation, the business records income on a receipts basis, although
the business accounts do record debtors and creditors.
For taxation purposes, should the business account for the income
on a cash or accruals basis?

Chapter 17 - Trading stock

Key
points ............................................................................................
....... [17.00]
Introduction...................................................................................
.............. [17.10]
Meaning of trading
stock ........................................................................... [17.20]
Common items of trading
stock ................................................................ [17.30]
Accounting for trading
stock ...................................................................... [17.50]
Acquisitions ...................................................................................
............. [17.60]
Non-arm’s length
transactions .................................................................. [17.70]
Disposals .......................................................................................
.............. [17.80]
Disposals in the ordinary course of the taxpayer’s business
……............... [17.90]
Disposals outside the ordinary course of the taxpayer’s business
…….... [17.110]
Year-end
adjustments ...............................................................................
[17.120]
Value of trading stock at start of
year ...................................................... [17.130]
Value of trading stock at end of
year ....................................................... [17.140]
Comprehensive
example .......................................................................... [17.210]
Trading stock on
hand............................................................................... [17.220]
Special
rules ..............................................................................................
[17.240]
Asset of taxpayer becomes trading
stock................................................. [17.250]
Item ceases to be trading stock but
continues to be owned by
taxpayer ........................................................ [17.260]
Lost or destroyed
stock ............................................................................ [17.270]
Small business
entities .............................................................................
[17.280]
Interaction with other income tax
rules ................................................. [17.290]
Questions ......................................................................................
............ [17.300]
Key points [17.00]
• Taxpayers who are carrying on a business may have a class of assets
known as trading stock which are subject to a special statutory tax
accounting regime in Div 70 of the Income Tax Assessment Act 1997 (Cth).
• The trading stock provisions outline what constitutes trading stock and the
timing and quantum of any assessable income or deduction amounts in
relation to trading stock.
• The definition of “trading stock” is very broad, and it is necessary to
determine the taxpayer’s purpose in holding an item to determine whether it
is trading stock of the taxpayer.
• The timing of income and deductions in relation to trading stock will
generally depend on whether the stock is “on hand” for the taxpayer.
• The assessable income or deduction amount in relation to trading stock
may be altered by special rules, where the taxpayer and the other party to
the transaction do not deal with each other at arm’s length.
• Taxpayers will have an assessable income amount or a deduction amount
at the end of the financial year, depending on the value of trading stock at
year-end as compared to the value of trading stock at the start of the year.
• Taxpayers have a choice of three methods in valuing trading stock at year-
end unless the stock is obsolete.
• Special rules govern the tax consequences for a taxpayer, where assets
owned by the taxpayer become trading stock or an item of trading stock
ceases to be trading stock but continues to be owned by the taxpayer.
Introduction [17.10]
Chapter 16 discusses how income and deductions are generally taken into
account for tax purposes, that is, on a cash or accruals basis. In this chapter,
we look at the statutory tax accounting regime for a particular class of
assets known as “trading stock”. If an asset is classified as trading stock, the
timing and quantum of income and deductions relating to trading stock are
governed by Div 70 of the Income Tax Assessment Act 1997 (Cth) (ITAA
1997).
The trading stock provisions essentially match the cost of trading stock with
the revenue from its sale. Where the stock remains unsold at year-end, the
taxpayer has simply converted one asset (cash) to another (stock). The
taxpayer should not be entitled to a deduction in this case as there has been
no change in the taxpayer’s economic position. The trading stock provisions
provide for an adjustment at year-end to take into account any unsold stock
at that time. The trading stock provisions in Div 70 are very similar to the
accounting treatment of trading stock. However, there are some differences,
such as the methods for valuing stock at year-end.

Note that there are concessional trading stock rules for small business
entities under Div 328. These rules are discussed at [17.280].
Figure 17.1 provides an overview of the tax rules applicable to transactions
involving trading stock.

Meaning of trading stock [17.20]

“Trading stock” is defined in s 70-10 of the ITAA 1997 as follows: Trading
stock includes: (a) anything produced, manufactured or acquired that is held
for purposes of manufacture, sale or exchange in the ordinary course of a
business; and
(b) livestock; but does not include a Div 230 financial arrangement.
Note that:
• It is clear from the expression “includes” that this is not an exhaustive
definition as to what constitutes trading stock. There may be items which do
not satisfy this definition but are nonetheless treated as trading stock for tax
purposes. However, given the wide definition of “trading stock” in para (a), it
is likely that this would only occur in rare instances.
• “Anything” can be trading stock. In FCT v St Hubert’s Island Pty Ltd (1978)
8 ATR 452, the High Court suggested that the term “anything” should have
the widest possible meaning and includes intangibles. The definition is
certainly wide enough to encompass the accounting concept of “inventory”
and the ordinary commercial meaning of trading stock.
• As “anything” can be trading stock, the key to determining when an item
will constitute trading stock is in the purpose for which it is held. An item
must be held for the purpose of manufacture, sale or exchange to constitute
trading stock. The test is focused on the holding of the asset and will
therefore depend on the individual taxpayer at a particular point in time and
on the individual asset.
• An item does not have to be held directly for manufacture, sale or
exchange and items held indirectly for this purpose (e.g., spare parts or
consumables) can constitute trading stock.
• Items held for hire to customers will not be trading stock as they are not
held for “manufacture, sale or exchange”: Cyclone Scaffolding Pty Ltd v FCT
(1987) 19 ATR 674; Ruling TR 98/8.
• An item can be trading stock of a taxpayer even if the taxpayer is not its
legal owner: see [17.220].

Example 17.1: Meaning of “trading stock”

Tom is a chair manufacturer. He holds chairs in his factory for sale to retail
customers. He takes one of the chairs for use in his office. Simon is Tom’s
accountant. He purchases one of Tom’s chairs for use in his office. The chairs
held at the factory are trading stock for Tom as they are being held for the
purpose of sale. However, the chair which Tom takes for use in his own
office, while trading stock at one time, ceases to be trading stock as it is not
held for the purpose of manufacture, sale or exchange once Tom uses it for
other purposes.
The chair purchased by Simon, although trading stock for Tom, is not trading
stock for Simon as it is not held by Simon for the purpose of manufacture,
sale or exchange.
For an item to constitute trading stock, it must be held for the relevant
purpose in the ordinary course of the taxpayer’s business. It is therefore
necessary to determine whether the taxpayer is carrying on a business and
the nature of that business: see Chapter 8.
Example 17.2: Meaning of “trading stock”
TS Pty Ltd builds houses which it rents to residential customers. Due to
cashflow problems, it decides to sell 10% of the houses in its latest
development project. The houses are not trading stock for TS Pty Ltd.
Although they are held for the purpose of sale, this is not in the ordinary
course of TS’s business. TS’s ordinary business is to build houses to produce
rental income: see ARM Constructions Pty Ltd v DCT (1987) 18 ATR 407.
The only item that is clearly trading stock per the definition is livestock.
“Livestock” is defined in s 995-1(1) as not including animals used as beasts
of burden or working beasts in a business other than a primary production
business. Generally, all animals used in a primary production business will be
trading stock: FCT v Wade (1951) 84 CLR 105. “Primary production business”
is defined in s 995-1 and includes activities such as maintaining animals for
the purpose of selling them or their bodily produce and taking or culturing
pearls or pearl shell. Examples of livestock include bees kept for use in a
honey production business (Determination TD 2008/26) and horses owned
by a horse breeder: Ruling TR 2008/2. Examples of livestock that are not
trading stock include birds for display in a tourist park (ATO ID 2009/25) and
dogs used as guard dogs in business premises (ATO ID 2011/18).

The only item that is definitely not trading stock per the definition is a Div
230 financial arrangement.
Common items of trading stock [17.30]
In FCT v St Hubert’s Island Pty Ltd (1978) 8 ATR 452, the High Court found
that land constituted trading stock, where the land is held by a land
developer for the purpose of sale in the ordinary course of business. In that
case, the taxpayer was in the business of land development, and the Court
found that the taxpayer’s undeveloped land constituted trading stock as it
was held for the purpose of sale in the ordinary course of business. It did not
matter that the land was not in a condition ready for sale at that time.
In FCT v St Hubert’s Island, the High Court also confirmed that raw materials
(items which are used to make something else) and partly finished goods
would constitute trading stock of a manufacturer. However, a distinction has
been drawn between goods and services. Unbilled work in progress of a
professional services firm generally does not constitute trading stock:
Henderson v FCT (1970) 119 CLR 612.
Example 17.3: Work in progress not trading stock
Tom’s accountant, Simon, has been assisting Tom with the preparation of his
monthly accounts. As at 30 June, Simon had spent approximately 10 hours
working on Tom’s accounts, but had yet to bill Tom for this work. The unbilled
work is “work in progress” for Simon, but does not constitute trading stock.
Intangibles (non-physical items), such as shares, may also constitute trading
stock if they are held with the relevant purpose: Investment & Merchant
Finance v FCT (1971) 2 ATR 361; Patcorp Investments Ltd v FCT (1976) 6 ATR
420.
Spare parts held by a business for performing repairs will also generally
constitute trading stock as they are held for the purpose of exchange in the
ordinary course of business. However, spare parts would not constitute
trading stock, where they are used to repair items used by the taxpayer in
his or her business or are used in the repair of goods which are still owned
by the taxpayer (e.g., goods leased to customers).
Example 17.4: Spare parts as trading stock
Tom, the chair manufacturer, includes a complex spring system which he
acquires from another business in the chairs that he manufactures. He
offers a one-year warranty on the spring systems as they can sometimes
prove problematic. He holds some extra spring systems in stock for
performing repairs. He uses these spring systems for repairs on chairs sold
to customers, whether or not they are still under warranty. If they are no
longer under warranty, he charges the customer for the cost of the new
spring system. He also uses the spring systems to repair chairs used in his
own business and to repair chairs that are leased to customers.
The spring systems used to repair the chairs owned by customers constitute
trading stock.
The spring systems used to repair the chairs owned by Tom, that is, the
chairs used in his own business, and the chairs leased to customers, will not
constitute trading stock as the chairs are still owned by Tom.
The Commissioner provides some guidance in Ruling TR 93/20 on when
computer spare parts will constitute trading stock. In this Ruling, he suggests
that if it is possible to track the use of each spare part individually, this
should be done to determine whether the part constitutes trading stock.
However, where it is not possible to track spare parts individually, the
Commissioner suggests that taxpayers may treat a whole pool of spare parts
as trading stock if at least 80% of the pool is used as trading stock.
There are limits as to the amount of spare parts that can be accumulated by
a taxpayer and treated as trading stock. The taxpayer should only hold a
sufficient amount of spare parts for the business to continue operating
efficiently and any excess would be treated as a capital asset: Ruling IT 333;
Guinea Airways v FCT (1950) 83 CLR 584.
Case study 17.1: Spare parts as trading stock
In Guinea Airways v FCT (1950) 83 CLR 584, the taxpayer had accumulated a
large stockpile of spare parts in order to avoid shipping delays. The High
Court found that the excessive amount was not trading stock, but capital
assets.
[17.40] Items used by a service provider in the course of providing services
(consumables) will also constitute trading stock in certain circumstances. In
Ruling TR 98/8, the Commissioner suggests that such items would constitute
trading stock, where:
• the taxpayer is carrying on a business;
• the items are supplied in the course of providing services;
• the items are separately identifiable things before and after the services
are provided (i.e., the items are not used up or significantly changed in the
provision of the services); and
• ownership of the items passes to the customers. Example 17.5:
Consumables as trading stock
Tom has a chair repair business. He holds timber, springs and glue which he
uses to repair chairs.
The timber and springs would constitute trading stock as they are separately
identifiable items before and after Tom repairs a chair. The glue would not
constitute trading stock as it is no longer separately identifiable after Tom
uses it to repair a chair.
Packaging materials held by a taxpayer may also constitute trading stock in
certain circumstances. In Ruling TR 98/7, the Commissioner suggests that
packaging items would constitute trading stock, where they are disposed of
in conjunction with “core goods” (what the taxpayer sells) and are so closely
associated with the core goods that they form part of the core goods or are
necessary to bring the core goods into the form, state or condition in which
they are sold.
Example 17.6: Packaging materials as trading stock
Lee owns a takeaway shop selling fried rice and noodles. He holds plastic
containers, forks, chopsticks and serviettes, which he provides to customers
at the time of sale.
The plastic containers constitute trading stock as they are related to the
“core good” (the rice or noodles) and are a necessary part of the sale. The
forks, chopsticks and serviettes are not trading stock as they are not related
to the core goods and are not a necessary part of the sale. Source: Adapted
from Example 2, Ruling TR 98/7.
Accounting for trading stock [17.50]
A taxpayer will have tax consequences arising:
• from the acquisition of trading stock: see [17.60];
• from disposals of trading stock: see [17.80]; and • at year-end: see
[17.120].

Acquisitions [17.60]
The acquisition of trading stock by a taxpayer is a deduction under s 8-1 of
the ITAA 1997 as the expense of acquiring trading stock is “necessarily
incurred in carrying on a business to gain or produce assessable income”.
Although the taxpayer is acquiring a business asset, the expense is not
treated as a capital expense due to the operation of s 70-25.
Although the cost of acquiring trading stock is deductible under s 8-1, the
timing of that deduction is governed by s 70-15. The cost of acquiring
trading stock will be deductible: • when the trading stock is “on hand”: see
[17.220]; or
• when an amount is included in the taxpayer’s assessable income in
relation to the disposal of the trading stock.
Non-arm’s length transactions [17.70]
Where the buyer and the seller do not deal with each other at “arm’s length”
and the amount of the expense is greater than the “market value” of the
trading stock, the amount of the deduction for the acquisition of the trading
stock is taken to be market value: s 70-20 of the ITAA 1997.
Section 995-1 does not provide a definition of “arm’s length” but suggests
that in determining whether a transaction is at arm’s length, any connection
between the parties and any other relevant circumstances must be taken
into account. It has been suggested that in determining whether a
transaction is at arm’s length, it is necessary to consider whether the
outcome of the dealings between the parties is a matter of real bargaining:
Granby Pty Ltd v FCT (1995) 30 ATR 400; Trustee for the Estate of the late
AW Furse No 5 Will Trust v FCT (1990) 21 ATR 1123. For example, a
transaction between members of the same corporate group may be a non-
arm’s length transaction, but whether or not it is actually a non-arm’s length
transaction will depend on the individual circumstances. If the transaction is
conducted on the same terms as a transaction with unrelated entities, it is
unlikely to be a non-arm’s length transaction.
The term “market value” is also not defined in the tax legislation. A generally
accepted definition of “market value” is the price that would be agreed to in
an open and unrestricted market by a willing but not anxious purchaser and
seller who are aware of current market conditions: Spencer v Commonwealth
(1907) 5 CLR 418.
Note that where the non-arm’s length transaction is not caught by s 70-20
(eg, where the transaction amount is below market value), the purchaser
may be deemed to acquire the trading stock at market value if it is a
disposal of trading stock for the vendor which is considered to be a disposal
outside the ordinary course of its business: see [17.100]–[17.110].
Figure 17.2 provides a guide to the tax consequences that arise upon the
acquisition of trading stock.
Disposals [17.80]
The tax consequences of a disposal of trading stock will depend on whether
the disposal is in or outside the ordinary course of the taxpayer’s business.
Disposals in the ordinary course of the taxpayer’s business [17.90]
Gross receipts received by a taxpayer will be assessable as ordinary
business income under s 6-5 of the ITAA 1997. The timing as to when the
gross receipts must be included in the taxpayer’s assessable income is
stipulated by s 70-5(2)(b). The gross receipts from the disposal of trading
stock will be assessable when the trading stock ceases to be “on hand”: see
[17.220].
[17.100] Non-arm’s length transactions. Where there is an adjustment
to the purchaser’s deduction under s 70-20, because the transaction was not
at arm’s length (see [17.70]), s 70-20 provides that the amount that is
included in the taxpayer’s assessable income will also be market value. Note
that where the non-arm’s length transaction is not captured by s 70-20 (eg,
where the purchaser is not acquiring trading stock or the transaction amount
is less than market value), the non-arm’s length transaction may be treated
as a disposal outside the ordinary course of the taxpayer’s business: see
[17.110]. The terms “arm’s length” and “market value” are discussed at
[17.70].
Disposals outside the ordinary course of the taxpayer’s business
[17.110]
The tax consequences of a disposal of trading stock outside the ordinary
course of the taxpayer’s business are governed by s 70-90 of the ITAA 1997.
A common example of a disposal of trading stock outside the ordinary course
of a taxpayer’s business is where trading stock is disposed of as part of the
sale of a business. In Pastoral & Development Pty Ltd v FCT (1971) 2 ATR
401, the Federal Court suggested that a sale of trading stock between
related parties at an extremely low or high price (a non-arm’s length
transaction) may also be considered a disposal outside the ordinary course
of business. A gift or donation of trading stock will also be a disposal outside
the ordinary course of business (a deduction may be allowed under s 30-15,
where the conditions for deductibility in that section are satisfied: see
Chapter 13).
Where trading stock is disposed of outside the ordinary course of the
taxpayer’s business, the taxpayer must include the market value of the
trading stock on the day of disposal in assessable income. Any amount
actually received by the taxpayer is treated as non-assessable, non-exempt
income under s 70-90(2). Under s 70-95, the purchaser is deemed to acquire
the trading stock for the same value, that is, market value. “Market value” is
discussed at [17.70].
Under s 70-105, disposals of trading stock due to the death of the taxpayer
are treated in a manner which gives rise to similar tax consequences as a
disposal outside the ordinary course of a business.
Figure 17.3 provides a guide to the tax consequences arising upon the
disposal of trading stock.
Year-end adjustments [17.120]
As the cost of acquiring trading stock is deductible once the trading stock is
on hand for the taxpayer, an adjustment is required at year-end to take into
account any unsold trading stock which is held by the taxpayer at that time.
The year-end adjustment ensures that taxpayers are only allowed a
deduction for the cost of acquiring trading stock when there is an actual
economic decline or “outgoing”. Where the trading stock is “on hand” at
year-end, the taxpayer has simply converted one asset (cash) to another
(trading stock).
Under s 70-35 of the ITAA 1997, taxpayers are required to compare the
“value” of trading stock on hand at the start of the year and at the end of
the year.
Where the:
• value of trading stock at year-end is greater than the value of trading stock
at the start of the year, the difference is included in the taxpayer’s
assessable income; or
• value of trading stock at year-end is less than the value of trading stock at
the start of the year, the difference is a deduction for the taxpayer.

The “value” of stock at year-end is ascertained by working out which items

of trading stock are on hand at year-end and prescribing an amount to each
item of trading stock in accordance with one of three methods set out in the
legislation (see [17.140]). The legislation does not require that taxpayers
undertake a physical stocktake, but this is generally the best method for
accurately determining what items of trading stock are on hand at year-end.

Taxpayers who maintain accurate records of all purchases and disposals and
undertake regular checks throughout the year to account for any losses or
errors will not need to perform a year-end stocktake. See further
Determination TD 93/125. Small business taxpayers can choose not to
perform a stocktake under the concessions discussed at [17.280].
Value of trading stock at start of year [17.130]
Under s 70-40 of the ITAA 1997, the value of a taxpayer’s trading stock on
hand at the start of the year must equal the value of its trading stock at the
end of the previous income year. In Hua Wang Bank Berhad v FCT (No 19)
[2015] FCA 454, the Federal Court confirmed that the value of trading stock
at the end of the previous income year must have been taken into account
for tax purposes to be used as the value of trading stock at the start of the
following year. For example, if the taxpayer did not lodge a tax return for a
particular year, the value of trading stock at the start of the following year
will be nil as the trading stock value at the end of the previous year has not
been taken into account for tax purposes.

Value of trading stock at end of year [17.140]

The taxpayer has three choices when determining the value of trading stock
on hand at the end of the year. Under s 70-45 of the ITAA 1997, the stock
can be valued at:
• cost: see [17.150];
• market selling value: see [17.170]; or
• replacement value: see [17.180].
The taxpayer can use a different method for valuing different items of
trading stock with the only restriction being that the year-end value must be
used for the value of the particular item of trading stock at the start of the
following year. There is also no restriction on the taxpayer changing
valuation methods from year to year. The taxpayer does not have to use one
of these three methods in valuing obsolete stock: see [17.190].
The amount of any GST input tax credits (see Chapter 25) is excluded from
the value of stock under all three methods: s 70-45(1A).
[17.150] Cost. The meaning of “cost” in this context is not provided in the
legislation, and the courts have held that cost should be determined in
accordance with relevant accounting principles: Philip Morris Ltd v FCT
(1979) 10 ATR 44; FCT v Kurts Development Ltd (1998) 39 ATR 493.
In the case of manufacturers, the courts in Philip Morris Ltd v FCT (1979) 10
ATR 44 and FCT v Kurts Development Ltd (1998) 39 ATR 493 suggested that
the “direct cost method” is not appropriate and taxpayers should use the
“absorption cost method” to determine the cost of trading stock. In IT 2350,
the Commissioner states that under the “absorption cost method”, the
following three elements should be taken into account in determining the
cost of trading stock manufactured by a taxpayer:
• material costs (the cost of materials used to manufacture the particular
item of trading stock);
• direct labour costs (the cost of labour used directly in the manufacturing
operations); and
• production overhead costs (all production costs excluding material costs
and direct labour costs).
The “direct cost method” would only include the first two elements in the
cost of an item of trading stock.
Production overhead costs are also known as factory overheads, indirect
manufacturing costs, manufacturing overheads or manufacturing expenses.
These costs fall into two categories – variable production overheads which
vary with the volume of production (e.g., factory light and power, stores and
most indirect labour) and fixed production overheads which remain constant
and do not vary with the volume of production (e.g., factory rent, insurance
and depreciation). It is necessary to determine the extent to which
production overhead costs relate to manufacturing and non-manufacturing
purposes and only the portion relating to the manufacturing operations
should be included in the product cost under the absorption cost method.
Expenses on marketing, storage, advertising, selling, distribution, finance,
research and development, general administration, employee benefits (e.g.,
cafeteria, training, recreational facilities) and income tax are generally not
considered production overhead costs. Costs associated with strikes, rework,
scrap and spoilage are also not considered to be production overhead costs.
The determination as to which expenses are to be included as production
overhead costs is not a straightforward issue. In FCT v Kurts Development
Ltd (1998) 39 ATR 493, for example, the Full Federal Court held that
infrastructure and external costs of the subdivision formed part of the cost of
individual allotments of land.
In the case of retailers and wholesalers, the Commissioner adopts the view
in Ruling TR 2006/8 that the “absorption cost method” is the appropriate
methodology for determining the “cost” of trading stock. As such, the cost of
each item of trading stock includes all direct and indirect expenditure
incurred in bringing the item to its present location and condition up to the
time that the item is located in its final selling location. Examples of
expenses that would be included in the “cost” of trading stock under this
method include the purchase price of the stock; any import duties and taxes
that are not subsequently recoverable; inwards transport and handling
charges; adjustments and assembly costs incurred in preparing the trading
stock for sale; costs incurred in operating a purchasing department; and
administrative costs associated with receiving and inspecting the trading
stock. Any distribution centre and off-site storage costs should also be
apportioned and included as relevant.
Where the deduction for the acquisition of trading stock is taken to be
market value under s 70-20 of the ITAA 1997 (i.e., a non-arm’s length
transaction), the “cost” of the trading stock for the purposes of the year-end
valuation will also be taken to be its market value: s 70-20, Note 1.
[17.160] Where it is not possible for the taxpayer to determine which
individual item of trading stock is on hand and which item has been disposed
of, the High Court in Australasian Jam v FCT (1953) 88 CLR 23 held that
taxpayers should use the first-in-first-out (FIFO) method for determining cost.
Other methods, such as the last-in-first-out method (LIFO), are not
acceptable in determining cost.

Example 17.7: Cost of trading stock

A retail company purchases 1,000 cans of soup for sale to customers. It
purchased the cans as follows:
• 1 July: 200 cans for $0.50 each;
• 1 December: 700 cans for $0.60 each;
• 1 March: 100 cans for $0.55 each.
At 30 June, 600 cans of soup were still on hand. Assume that there were no
cans of soup on hand at the start of the year. The taxpayer is unable to
accurately determine which cans of soup have been sold and which have
not.
The value of the remaining cans of soup (trading stock on hand at year-end)
using the cost method would be (100 × $0.55) + (500 × $0.60) = $355.
Under the FIFO method, it is assumed that all of the cans purchased for
$0.50 and 200 of the cans purchased for $0.60 have been sold.
In Australasian Jam v FCT (1953) 88 CLR 23, the High Court also accepted
that taxpayers could use a “standard or average cost” method for
determining the cost of trading stock. However, the standard or average cost
must be determined using reasonable values.
Case study 17.2: Cost of trading stock
In Australasian Jam v FCT (1953) 88 CLR 23, the taxpayer had determined
the standard cost of its trading stock (jars of jam) in one income year and
continued to use that standard cost for valuing its trading stock over the
next 30 years. The High Court accepted the method used by the taxpayer,
but found that the values used were not reasonable. The Court accepted the
Commissioner’s valuation of the taxpayer’s trading stock, which had also
been determined using the standard cost method, although the standard
cost had been calculated using updated amounts.
Example 17.8: Average cost of trading stock
Following on from Example 17.7, the taxpayer could also determine the cost
of the cans of soup on hand at year-end using the average cost. The average
cost of the cans of soup would be:

[(200 × $0.50) + (700 × $0.60) + (100 × $0.55)]/1,000 = $0.58. The value

of the taxpayer’s stock at year-end would be 600 × $0.58 = $348.

Note that the FIFO basis or average cost method should only be used, where
the taxpayer is unable to determine which items of trading stock have been
sold and which items remain on hand: Ruling IT 2289. Where the taxpayer is
able to make that determination, the actual cost of the item should be used.
[17.170] Market selling value.
Market selling value is the amount for which the taxpayer could sell the
trading stock in the ordinary course of its business in its ordinary market:
Australasian Jam v FCT (1953) 88 CLR 23. For example, the market selling
value of a wholesaler would be the amount for which it could sell the stock in
the wholesale (not retail) market. Further, the value is to be determined in
accordance with the taxpayer’s normal selling arrangements and not, for
example, under sale conditions.
The note to s 70-45 of the ITAA 1997 confirms that “market selling value”
may not be the same as “market value”. “Market value” is discussed at
[17.70].
[17.180] Replacement value.
The replacement value of trading stock is the amount the taxpayer would
have to spend to replace the stock. Again, the amount must be the relevant
amount for the taxpayer: Parfew Nominees Pty Ltd v FCT (1986) 17 ATR
1017. For example, the replacement value for a wholesaler would be the
amount for which it could purchase the stock, and not, for example, the
amount it would pay if it acquired the stock in the retail market.
In Parfew Nominees Pty Ltd v FCT (1986) 17 ATR 1017, the Court stated that
while actual replacement is not necessary and only notional replacement is
required, there may be situations where replacement value is not an option
for the taxpayer as replacement must be possible and not defy business
reality. The Commissioner suggests that taxpayers can only use replacement
value, where the items are available in the market and are substantially
identical to the replaced items: Determination TD 92/198. For example, an
antiques dealer is unlikely to be able to take into consideration replacement
value in valuing its year-end trading stock as antiques are unique and not
readily available in the market.
[17.190] Obsolescence.
Under s 70-50 of the ITAA 1997, taxpayers may value trading stock at a
value lower than the three methods provided by s 70-45, where:
• the stock is obsolete; and
• the value used by the taxpayer is reasonable. In Ruling TR 93/23, the
Commissioner suggests that stock will be obsolete, where it is or it is going
to be out of use, out of date, unfashionable or outmoded. In para 5 of the
Ruling, the Commissioner suggests the following factors as being relevant in
making that determination:
(a) the age of the stock on hand;
(b) the quantities of the stock on hand which, according to the operating and
sales budgets, are expected to be used or sold during the year and in the
future;
(c) the length of time since the last sale, exchange or use of an item of the
stock;
(d) industry experience/taxpayer expertise in relation to the same kind or
class of trading stock;
(e) the price at which the last sale of the stock was made, the price of the
stock on the taxpayer’s price list and the price at which the taxpayer is
prepared to sell the stock; and
(f) if the stock is spare parts:
(i) the past movements of the stock and the expected future movements of
the stock compared with the total number of units in existence which might
require that stock; and
(ii) the approximate date by which the last of those units can be expected to
have gone out of use.
The Commissioner suggests that the accurate value of obsolete stock will
generally be the value of the stock at which it is reasonable to assume that it
will be sold in the future, or its scrap value if the stock will not be sold. The
stock may have a nil valuation, where it cannot be sold or be used for any
other purpose.
[17.200] New livestock from reproduction.
Where the taxpayer has new livestock through natural reproduction, the cost
of the livestock is, of course, zero. Section 70-55 of the ITAA 1997 allows
taxpayers to value such livestock at any cost up to their market value
subject to prescribed minimum values.
Comprehensive example [17.210]
The following example illustrates the application of the rules regarding the
acquisition, disposal and year-end adjustments of trading stock.
Tom’s income tax consequences in relation to the chairs are as follows: • The
chairs are trading stock as Tom holds them for the purpose of sale in the
ordinary course of his business: s 70-10 of the ITAA 1997.
• The partly completed chairs and the timber and springs are also trading
stock under s 70-10, as confirmed by FCT v St Hubert’s Island Pty Ltd (1978)
8 ATR 452.
• The acquisition of timber and springs during the year is a deduction under
s 8-1 and the expenses are deductible when the springs and timber are on
hand or an amount is included in Tom’s assessable income in relation to their
disposal: s 70-15.
• The $20,000 received for the sale of chairs must be included in Tom’s
assessable income under s 6-5 once the chairs are no longer “on hand”: s
70-5(2)(b).
• Tom has a year-end adjustment under s 70-35 of $1,100, being the
difference between the value of his stock on hand at year-end and the value
of his stock on hand at the start of the year. The difference is a deduction as
the value of Tom’s stock at year-end is less than the value at the start of the
year.
Trading stock on hand [17.220]
It is very important for a taxpayer to determine when trading stock is “on
hand”. Whether or not trading stock is on hand determines:
• when a taxpayer includes gross receipts on sale of trading stock in
assessable income;
• when a taxpayer can claim a deduction for the acquisition of trading stock;
and
• the value of trading stock at year-end.
There is no guidance in the legislation as to when trading stock is “on hand”.
It is generally accepted that trading stock will be on hand, where the
taxpayer has dispositive power over the stock: Farnsworth v FCT (1949) 78
CLR 504; FCT v Suttons Motors (Chullora) Wholesale Pty Ltd (1985) 157 CLR
277; All States Frozen Foods Pty Ltd v FCT (1990) 20 ATR 1874; see also
Ruling IT 2670.
A taxpayer has dispositive power, where the taxpayer has the power to
dispose of the stock. Generally, legal ownership will provide dispositive
power, but this is not always the case. Whether or not a taxpayer has
dispositive power will depend on the individual facts of a case and no single
factor (e.g., possession, the taxpayer received progressive payments based
on estimated sales. The High Court found that the fruit that had been
delivered to the packing house was no longer trading stock on hand of the
taxpayer. The Court noted that the taxpayer no longer had direct power or
control over the disposal of her fruit.
The fact that the taxpayer no longer had possession, control and risk in
relation to her trading stock meant that she no longer had dispositive power
over the trading stock. As the taxpayer did not have dispositive power over
the stock, it was no longer “on hand”.
Case study 17.4: Trading stock “on hand”
In FCT v Suttons Motors (Chullora) Wholesale Pty Ltd (1985) 157 CLR 277,
the taxpayer was a car dealer who had cars from the manufacturer under a
floor-plan arrangement. Under the arrangement, the taxpayer had
possession of the cars, risk and control over the cars and the right to sell
them. However, the taxpayer did not actually have ownership of the cars. It
only had the right to acquire the cars, which it did once it had found a buyer
for a car.
The High Court found that the cars were trading stock of the taxpayer, even
though it did not have ownership of the cars because, under the terms of the
floor-plan arrangement, the taxpayer had the power to dispose of the cars
even though it did not have ownership over them.
Case study 17.5: Trading stock “on hand”
In All States Frozen Foods Pty Ltd v FCT (1990) 20 ATR 1874, the taxpayer
was a wholesaler of frozen goods. At year-end, some of its frozen goods were
on ships at sea en route to Australia. The Full Federal Court found that the
frozen goods were trading stock on hand of the taxpayer as the taxpayer
had dispositive power over the goods.
In this case, the fact that the taxpayer did not have possession of the goods
did not matter because, under the terms of the shipping agreement, the
taxpayer had control, risk and ownership of the goods once they were placed
on the ship (Cost, Insurance and Freight contract). Therefore, the taxpayer
had the power to sell the goods even while they were still at sea.
[17.230] Where the trading stock is land or buildings on land, the Full
Federal Court in Gasparin v FCT (1994) 28 ATR 130 held that the time when
the land or buildings cease to be trading stock is the date of settlement of
the contract of sale as that is the time when dispositive power over the land
or buildings is lost.
The Commissioner has issued a number of rulings and determinations as to
when a particular item of trading stock is “on hand”. The Commissioner
suggests that: • goods sold under a lay-by arrangement which are still in the
seller’s possession are trading stock on hand of the seller: Ruling TR 95/7;
• goods sold under a conditional contract are trading stock on hand of the
buyer if they are in the buyer’s possession at year-end. However, they revert
to being trading stock of the seller if they are returned: Ruling TR 97/15; and
• goods provided to prospective purchasers or retailers for display purposes
only remain trading stock of the wholesaler until the purchaser or retailer
enters into a contract of sale or consignment for the goods: Determination
TD 95/48.
Special rules [17.240]
Whether an item constitutes trading stock of the taxpayer depends on the
taxpayer’s purpose in holding the asset. Therefore, the characterisation of
an asset can change over time depending on the taxpayer’s purpose in
holding that asset, even though there is no change in ownership.
There are special rules that govern the tax consequences for a taxpayer,
where an asset which was previously owned by the taxpayer becomes
trading stock (see [17.250]) or where an item of trading stock ceases to be
trading stock, but continues to be owned by the taxpayer: see [17.260].
Asset of taxpayer becomes trading stock [17.250]
Where an asset that is owned by a taxpayer becomes trading stock, the
taxpayer is deemed to have disposed of the asset and re-acquired an item of
trading stock under s 70-30 of the ITAA 1997. The taxpayer has a choice
under the section as to whether the deemed disposal and re-acquisition is
done at “cost” or at “market value”. “Cost” is determined in accordance with
s 70-45 (see [17.150]): s 70-30(3). Where the item was originally acquired
for no consideration, its cost is determined in accordance with s 70-30(4).
The tax consequences arising upon the deemed disposal will depend on the
taxpayer’s holding of the asset prior to the change. Where the asset was
held as a depreciating asset prior to becoming trading stock, a balancing
adjustment may be required under Div 40 to account for the deemed
disposal: see Chapter 14.
Where the asset was held as a CGT asset prior to becoming trading stock,
the tax consequences will depend on whether the deemed disposal was
done at “cost” or “market value”. Where the taxpayer elects for the deemed
disposal to be done at “cost”, any CGT consequences arising on the deemed
disposal are disregarded: s 118-25. Where the taxpayer elects for the
deemed disposal and re-acquisition to take place at “market value”, CGT
Event K4 happens to the taxpayer at that time under s 104-220. The tax
consequences for the taxpayer will be:
• a capital gain where the market value of the asset on the day it becomes
trading stock is greater than the cost of the asset; or
• a capital loss where the market value of the asset on the day it becomes
trading stock is less than the cost of the asset.
Upon the deemed re-acquisition of the asset, the taxpayer will be entitled to
a deduction under s 8-1 for the cost of acquiring the trading stock – this will
either be “cost” or “market value” depending on the taxpayer’s election in
relation to the deemed disposal. If the stock is still on hand at the end of the
year, the taxpayer will have to include the value of the trading stock in the
value of its trading stock on hand at year-end.
Example 17.10: Asset of the taxpayer becomes trading stock
Declan owns a block of land, Blackacre, which he purchased in Year 1 for
$200,000. Since that time, Declan has become involved in a number of land
development activities and in Year 3 he decided to venture Blackacre into
the business. The value of Blackacre at that time was $500,000. In Year 4,
Declan sold Blackacre for $700,000.
In Year 3, a capital asset of Declan’s became trading stock. At that time,
Declan is deemed to have disposed of Blackacre for either cost or market
value and is deemed to re-acquire it on the same day for the same value.
Declan’s tax consequences on the disposal of Blackacre in Year 4 will depend
on his choice of method in Year 3.

Option 1: Declan chooses “cost” Year 3

Declan would claim a deduction under s 8-1 for the cost of acquiring trading
stock ($200,000). However, that amount would be reflected in the value of
Declan’s trading stock at year-end as Blackacre is still on hand at that time.
Therefore, under the trading stock rules, Declan effectively has no tax
consequences from the asset becoming trading stock in Year 3. (The capital
gains tax provisions may give rise to separate tax consequences for Declan.)
Year 4
Declan includes the $700,000 received for the sale of Blackacre in his
assessable income. As Blackacre is no longer on hand at year-end, Declan
will effectively receive a deduction of $200,000 in that year as that amount
is included in the value of his trading stock on hand at the start of the year,
but not in the value of his trading stock on hand at the end of the year.
Therefore, Declan is in a net income position of $500,000 in Year 4. Option 2:
Declan chooses “market value” Year 3 Declan would have a capital gain of
$300,000 under s 104-220 as the cost of the asset ($200,000) is less than its
market value on the day of the deemed disposal ($500,000).
Declan would claim a deduction of $500,000 under s 8-1 for the “cost” of
acquiring trading stock (Declan is deemed to have reacquired Blackacre for
$500,000 which is the market value at that time). However, that amount
would be reflected in the value of his trading stock at year-end as Blackacre
is still on hand at that time.
Therefore, Declan has a capital gain of $300,000 on the asset becoming
trading stock in Year 3 and no further tax consequences under the trading
stock provisions. Year 4
Declan includes the $700,000 received for the sale of Blackacre in his
assessable income. As Blackacre is no longer on hand at year-end, Declan
will effectively receive a deduction of $500,000 in that year as that amount
is included in the value of his trading stock on hand at the start of the year,
but not in the value of his trading stock on hand at the end of the year.
Therefore, Declan is in a net income position of $200,000 in Year 4.
Essentially, the two options merely result in a timing difference. However, as
an individual who has owned the CGT asset for more than 12 months, Declan
would be entitled to discount the $300,000 capital gain on Blackacre to
$150,000 (assuming he has no capital losses) and Option 2 would therefore
provide Declan with a better overall tax outcome. Where the taxpayer is a
company, the two options only result in a timing difference as companies
cannot discount a capital gain: see Chapter 11.

Item ceases to be trading stock but continues to be owned by

taxpayer
[17.260] Where a taxpayer ceases to hold an item as trading stock, but
continues to own it, the taxpayer is deemed to have disposed of the item
and re-acquired it for “cost” under s 70-110 of the ITAA 1997. An item of
trading stock would generally cease to be trading stock when the taxpayer’s
purpose in holding the asset changes. Section 70-110 provides the example
of a sheep grazier who takes a sheep from stock for personal consumption.
The taxpayer will have to include the “cost” of the trading stock in
assessable income under s 6-5 in the income year in which he or she ceases
to hold the asset as trading stock.
Upon re-acquisition, the cost of the trading stock will become the asset’s
cost base if the taxpayer holds it as a CGT asset or its cost under Div 40 if
the taxpayer holds it as a depreciating asset.
Example 17.11: Item ceases to be trading stock of taxpayer
Michael owns a bookstore specialising in first-edition books. He purchased a
first-edition copy of The Chronicles of Narnia by CS Lewis for $12,000 for the
store. The book did not sell and, after a few months, he decided to remove
the book from the shelf and keep it for himself. The acquisition of the book is
the acquisition of an item of trading stock as Michael sells books in the
ordinary course of his business. Therefore, the $12,000 is deductible under
ss 8-1 and 70-15 as the book is on hand. When Michael takes the book from
the store for himself, it ceases to be trading stock and Michael is deemed to
have disposed of it for cost under s 70-110. As such, Michael must include
$12,000 in his assessable income for the year.
Although Michael is also deemed to have acquired the book for its cost
($12,000), the $12,000 is not deductible as the book is for Michael’s private
or domestic use (see Chapter 12). The $12,000 may form part of the cost
base of the book should there be capital gains tax consequences at a later
point in time.

Each year the Commissioner publishes a Taxation Determination, which

provides the amounts that the Commissioner will accept as reasonable
estimates of the value of goods taken from trading stock for private use by
taxpayers in certain businesses such as a bakery, butcher and restaurant.
The relevant Determination for the 2019–2020 income year is TD 2020/1. At
the time of writing, the relevant Determination for the 2020–2021 income
year had yet to be published.
Lost or destroyed stock [17.270]
Any lost or destroyed stock is effectively taken into account through the
year-end adjustment as the stock is not “on hand” at that time and is not
included in the value of the trading stock at year-end. Any amount received
as compensation for lost or destroyed stock (eg, insurance proceeds) is
included in the taxpayer’s assessable income under s 70-115 of the ITAA
1997.
Small business entities [17.280]
A “small business entity” can choose not to account for changes in the value
of stock for an income year, where the difference between the opening value
of stock on hand and a reasonable estimate of stock on hand at year-end is
less than $5,000: s 328-285. As with other taxpayers, the value of trading
stock at year-end becomes the value of trading stock at the start of the
following year: s 328-295. In this context, a “small business entity” is a sole
trader, partnership, company or trust that operates a business for all or part
of the income year and has an aggregated turnover of less than $10 million:
s 328-110. In the 2020 Federal Budget, it was announced that entities with
an aggregated annual turnover of less than $50 million will be able to access
these concessions from 1 July 2021. Broadly, “aggregated turnover” is the
entity’s turnover plus the annual turnover of any business that is connected
or affiliated to the entity. Taxation Ruling TR 2019/1 provides guidance as to
when a company carries on a business for the purposes of s 328-110.
Where the “small business entity” chooses to account for changes in the
value of trading stock, the general trading stock rules discussed in this
chapter apply.
Interaction with other income tax rules [17.290]
An asset that is trading stock may also qualify as a CGT asset and be subject
to tax under the CGT rules discussed in Chapter 11. This is prevented from
happening by s 118-25 of the ITAA 1997, which provides that any capital
gain or loss arising is disregarded if, at the time of the CGT event, the CGT
asset is classified as trading stock.
Similarly, an item of trading stock may also qualify as a depreciating asset
and be subject to the capital allowances regime discussed in Chapter 14.
This is prevented from happening by s 40-30(1)(b), which excludes an item
of trading stock from the definition of “depreciating asset”.
However, an item of trading stock that is a financial arrangement under Div
230 will be subject to tax under those provisions and not the trading stock
provisions: s 70-10.

Questions [17.300]
17.1 Consider whether the following are trading stock:
(a) Bees kept for use in a honey production business.
(b) Horses used in the city horse carriage tour business.
(c) Horses owned by a horse-training business competitions.
(d) Horses owned by a racehorse breeder.
(e) Undeveloped land owned by a land developer.
(f) Motherboards owned by a computer manufacturer for making
computers.
(g) Partly finished computers of a computer manufacturer.
(h) Lemon trees on a lemon farm.
(i) Lemons which have been picked from the trees on a lemon farm
and are ready for sale.
(j) Car oil used by a mechanic when servicing cars.
17.2 Alex is an ardent movie watcher. He believes that the quality of
the movie watching experience is much better on a DVD instead of
via a streaming service. He is also an active environmentalist and
likes to reduce consumption. He has combined his two loves by
running a DVD rental business and has a collection of more than
1,000 DVDs available for rental. Are the DVDs held in Alex’s DVD
rental business trading stock?
17.3 Best Juice is a juice retail company in Australia. The company
purchases exotic juices from various wholesalers and sells the
juices to the public through various pop-up outlets. The company
started operations during the last financial year and had no stock
on hand at the start of the year. During the year, the company
undertook the following transactions:
• 1 August: Purchased 3,000 bottles of juice for $1 each;
• 1 December: Purchased 5,000 bottles of juice for $1.50 each;
• 1 February: Purchased 3,000 bottles of juice for $1.10 each.

The company has determined that at 30 June, it has 1,000 bottles of

juice in stock. However, it is unable to determine when these bottles
were purchased. At 30 June, the bottles of juice could be purchased
by the company for $1.30 each and the company sells the bottles
for $2.50 each. Advise Best Juice as to how it should value its stock
on hand at 30 June if it wishes to minimise its tax liability for the
year.
17.4 Isabelle lives in Melbourne, Australia. She has a little shop in
the city selling colourful umbrellas. Isabelle only sells colourful
umbrellas because she thinks that people need to see lots of
colours on a rainy day. She purchases these umbrellas from various
suppliers in other countries. During the year, Isabelle had the
following transactions:
(a) Purchased $7,500 worth of umbrellas on 20 June from an
overseas supplier. The umbrellas were loaded on to a ship the next
day and under the terms of Isabelle’s agreement, she takes
ownership, control and risk of the umbrellas only once they are
delivered to her in Melbourne and she deems them to be of
acceptable quality. Isabelle received the umbrellas on 2 July and
returned $500 worth of umbrellas the same day.
(b) Gave away 10 umbrellas to family and friends as gifts. The
umbrellas cost $10 each and Isabelle sells them for $100 each.
(c) Took an umbrella home for her own use as it was raining heavily,
and she had forgotten to bring her umbrella to work. The umbrella
cost $10 and Isabelle would have sold it for $100.
(d) On 15 June, Isabelle decided to have an “all stock must go” sale
so that she could buy new umbrellas for the new financial year. She
sold all of her remaining stock (100 umbrellas) for $50 each. The
umbrellas had cost $10 each.
Advise Isabelle as to her income tax consequences arising from the
above information.
17.5 Bad Backs Be Gone manufactures and sells ergonomic office
chairs and desks to the general public. The company’s books of
account provide the following information:
Advise Bad Backs Be Gone of its income tax consequences arising
from the above information.

Part 5 - Investment and Business Entities

To this point, the book has focused on the tax formula as it applies to
individual taxpayers, whether they are an employee or a sole trader.
However, once a student is able to determine income tax payable for an
individual taxpayer, it is then possible to understand the basic concepts
which apply to other entities, such as superannuation funds, partnerships,
companies and trusts. In addition to the unique issues raised by various
structures, taxpayers may undertake international transactions. Both the
structure adopted and the types of transactions undertaken, whether
domestic or international, add a new level of complexity to income tax. Part
5 of this book considers the various structures recognised for tax purposes,
some of which pay tax as a separate entity while others are treated as
having distributed the taxable income to the underlying taxpayers. It also
considers the international tax rules which may affect taxpayers, whether
individuals or other types of entities.
The taxable income of the various structures will be determined in the same
way as an individual. However, in addition to applying the taxation formula,
there are unique rules which apply to specific entities recognised for taxation
purposes. Part 5 discusses these rules.
Chapter 18 examines superannuation and other retirement savings and
explains that, while a superannuation fund is a type of trust, there are
specific tax rules which apply. In particular, complying superannuation funds
are taxed concessionally as well as having their own legislative regime.

Chapter 19 considers partners and partnerships and explains that while a

partnership lodges a separate tax return, it does not pay income tax. Rather,
the net income or loss of a partnership is taken into account at partner level,
with the partner including the net income of the partnership in his or her
taxable income or offsetting the loss against other income. In addition to this
basic principle, Chapter 19 explains that there are special rules in relation to
salaries paid to partners, interest on capital contributions, superannuation
payments, trading stock, capital gains and dividends.
Another structure often adopted by taxpayers is a trust. Chapter 20
examines the taxation of trusts and beneficiaries. Like partnerships, trusts
are also required to lodge a separate tax return but do not pay income tax.
Rather, it is the beneficiaries, where presently entitled, who pay the income
tax or, where the beneficiaries are not presently entitled, the trustee pays
the income tax on the beneficiary’s share of the net trust income. Again,
there are special rules which need to be considered in relation to trusts and
beneficiaries and Chapter 20 discusses these. In particular, it outlines the
different status of beneficiaries, the different types of trusts, the
consequences of a trust receiving dividends or capital gains, the distribution
of trust income to minors and differences between the taxation laws and
accounting principles in determining the net income of a trust.
The final structure considered is that of companies. Chapter 21 looks at the
taxation of companies and shareholders. Companies are treated as a
completely separate entity and taxed as such. In other words, a company
pays tax on its net income at a flat rate. Further, a company cannot
distribute net losses but instead carries them forward to later years. A
company distributes its net income to its shareholders by way of dividends.
Dividends are subject to the dividend imputation regime. An imputation
regime is contrasted with a classical regime, which taxes the company on its
net profits and then taxes the shareholders on the dividends. The imputation
system does not impose double taxation on the company’s net income but
rather provides a grossing up and credit mechanism to ensure that the
profits are effectively taxed at the shareholder’s marginal tax rate.
International transactions add a further layer of complexity to the simple
income tax payable formula. Chapter 22 considers the principles which
govern cross-border transactions. It looks at foreign income of Australian
residents, taking into account the ways in which double taxation is avoided
either via an exemption or a credit. It also examines the accruals regime
which prevents the deferral of tax where income is not repatriated to
Australia. Chapter 22 further looks at Australian source income of reign
residents, particularly the withholding tax regime. In addition to the
allocation and taxing rules, the international tax regime contains anti-
avoidance provisions which prevent non-arm’s length transfer pricing and
appropriate debt-to-equity levels under the thin capitalisation regime.
Finally, the overriding effect of the tax treaties (also known as double tax
agreements) to which Australia is a party is considered.
Chapter 19 - Partners and partnerships
Key
points ............................................................................................
....... [19.00]
Introduction...................................................................................
.............. [19.10]
What constitutes a
partnership? ................................................................ [19.20]
Taxation law
definition ..............................................................................
[19.30]
Compliance obligations of a
partnership ................................................... [19.40]
Taxation of
partnerships .............................................................................
[19.50]
Net income of a
partnership ...................................................................... [19.60]
Partnership
losses ......................................................................................
[19.70]
Treatment of special partnership
items .................................................... [19.80]
Partners’
salaries ........................................................................................
[19.90]
Interest payments between a partnership and its
partners ................... [19.100]
Superannuation for
partners ................................................................... [19.110]
Dividends received by a
partnership ....................................................... [19.120]
Capital gains
tax .......................................................................................
[19.130]
Uncontrolled partnership
income ............................................................ [19.140]
Alienation of share of partnership
income .............................................. [19.150]
Variation or dissolution of
partnership.................................................... [19.160]
Work in
progress .......................................................................................
[19.170]
Trading stock and depreciating
assets...................................................... [19.180]
Limited
partnerships ..................................................................................
[19.190]
Questions ......................................................................................
............. [19.200]

Key points [19.00]

• The tax definition of “partnership” is wider than the general law definition
and includes joint ownership of assets without the need for a business
venture.
• Partnerships are in general taxed under the attribution or look through
model under which a partnership is not a taxpayer; instead, the partners are
assessed on the net income of the partnership.
• The attribution model dictates that: (i) the nature of income derived by a
partnership is preserved when assessed in the hands of the partners and (ii)
losses made in a partnership flow through to the partners.
• “Salaries” paid to partners are not deductible to the partnership as the
partners cannot employ themselves. Superannuation payments for partners
are not deductible to the partnership.
• Interest on initial capital contributed to the partnership is not deductible to
the partnership.
• Capital gains and losses on assets held in a partnership are taken to be
made by the partners individually.
• The death, retirement of an existing partner or introduction of a new
partner are in general treated as the termination of the partnership for
taxation purposes and require the preparation of a tax return up until the
date of the variation of the partnership.
• Payment for work in progress made to a retiring partner is treated as
assessable income of the partner and is deductible for the paying partners.
• Limited partnerships are in general taxed as companies. Introduction
[19.10] Partnerships are not separate legal entities, and the partners retain
personal liability even though they operate their business through a
partnership. In Australia, the largest proportion of partnerships is in the
agriculture, forestry and fishing industry. A partnership can exist for taxation
purposes with companies or even trusts as the partners.
The general taxation rules of partnerships are stipulated in Div 5 of Pt III of
the Income Tax Assessment Act 1936 (Cth) (ITAA 1936). In general,
partnerships are taxed under the attribution or look through model, under
which partnerships are not taxpayers. Instead, the partners are assessed on
the net income of the partnerships. The main tax advantages of conducting
business through partnerships are twofold. First, losses incurred by a
partnership are shared by the partners immediately and can be used to
offset the partners’ other assessable income. In contrast, losses incurred by
a company or a trust are in general trapped at the entity level. Second, the
character of income derived by a partnership is preserved when assessed in
the hands of the partners. For example, exempt income derived by a
partnership remains as exempt income in the hands of the partners. This is
in general not the case for companies.

What constitutes a partnership?[19.20]

Basically, a partnership is a contractual relationship between two or more
people who wish to conduct a business in common with a view to profit. In
general, partners in a partnership are liable jointly for the debts and
obligations of the partnership. The partnership agreement stipulates the
partners’ rights and duties, and interest in partnership property. The
agreement can be in writing or merely an oral arrangement. A partnership
can exist without a written agreement (Re Lance; Ex parte Nilant (1996) 34
ATR 573), and a partnership may be found not to exist even though there is
a written agreement to that effect: Case 95 (1968) 14 CTBR (NS) 553.
Partnership law is found in State statutory law and the general law, and all
States have similar legislation relating to partnerships. For example, in
Victoria, the Partnership Act 1958 (Vic) provides, among other things, the
legal basis for the creation of a partnership, the rules that govern the liability
of the partners and the procedure for the dissolution of a partnership.
Section 5 of the Partnership Act 1958 provides a definition of “partnership”
and requires the following elements to be present:
1. two or more people enter into a contract;
2. to carry on a business in common;
3. with a view to make a profit.
This definition requires sufficient activity to constitute a business, an
acceptance of the liability of each partner for the debts of the partnership, a
joint and severable liability for the actions of the partners and a sharing of
net returns. Persons wishing to avoid the inference of partnership generally
exclude joint and severable liability of the partners and provide for the
sharing of gross returns which are netted at individual level. Although it is
unnecessary to have a written contract, it is extremely advisable to do so.
In TR 94/8, the Commissioner lists the factors in deciding whether a
partnership exists between two or more persons:
• mutual assent and intentions of the parties;
• joint ownership of business assets;
• registration of business name;
• joint business account and the power to operate it;
• extent to which the parties are involved in the conduct of the business;
• extent of capital contributions;
• entitlement to a share of net profits;
• business records; and
• trading in joint names and public recognition of the partnership.

The Australian Taxation Office (ATO) states that the above list of factors is
not exhaustive, and the weight given to each factor will depend on the
individual circumstances. Although no single factor is decisive, an
entitlement to a share of net profits is considered essential.
Taxation law definition [19.30]
Section 995-1 of the Income Tax Assessment Act 1997 (Cth) (ITAA 1997)
defines a partnership as:
(a) an association of persons (other than a company or a limited partnership)
carrying on business as partners or in receipt of ordinary income or statutory
income jointly; or
(b) a limited partnership.
The tax law definition is wider than that of the general law. While the first
limb in paragraph (a) of the definition is similar to the Partnership Acts in
various states and territories, the second limb covers passive investment
income from, for example, jointly owned investment properties and joint
bank accounts even though the parties involved do not conduct a business.
TR 93/32 considers the position of co-ownership of an investment property
and contends that it satisfies the second limb of the tax definition of
“partnership”. It will not satisfy the general law definition of a partnership
and the first limb definition under s 6(1) of the ITAA 1936 because the
partners are not carrying on a business. Therefore, an agreement as to the
sharing of the profit or loss other than in accordance with the percentage of
ownership by the individual
partners will have no effect for income tax purposes because no partnership
exists outside the second limb of the tax definition. This position is based on
the decision by Beaumont J in FCT v McDonald (1987) 18 ATR 957, where his
Honour found that the parties were co-owners and not partners under the
first limb of s 6(1) of the ITAA 1936.
Case study 19.1: Partnership vs co-ownership
FCT v McDonald (1987) 18 ATR 957 concerns a partnership between a
husband and wife, Mr and Mrs McDonald, who jointly owned a number of
investment properties. Mr McDonald claimed a tax deduction in the sum of
$1,941 as a loss on the partners’ property investments. Mr and Mrs
McDonald owned a number of properties as joint tenants but the husband
and wife agreed to share the net profit of the partnership on the basis of the
wife receiving 75% and the husband 25% and any loss being borne solely by
the husband. The Commissioner allowed only 50% of the loss as a deduction.
The Federal Court found that no general law partnership existed as Mrs
McDonald was merely a passive investor and had no commercial expertise to
contribute to the business. Mr McDonald could only claim half of the loss as a
tax deduction against his own personal income.

In the words of Beaumont J (at 967): “In my opinion, no partnership under

the general law subsisted between the respondent and his wife. Their
relationship was one of co-ownership, and even if they were deemed to be
partners by reason of subsection 6(1) of the Act [ITAA 1936], this
circumstance is immaterial for our purposes”. In order to satisfy the general
law definition of a partnership, the partners must be engaged in the conduct
of a business, not just joint ownership of property as joint tenants.
As a result of FCT v McDonald, the ATO released Ruling TR 94/8 to provide a
set of guidelines to determine whether a partnership exists for a husband
and wife according to general law concepts and, in particular, what is
required in terms of carrying on a business. If these guidelines are not
satisfied, a partnership only exists under the second limb of the taxation law
definition, and the partners share profits and losses equally. In practice, in
these cases, the ATO does not require the husband and wife to file a
partnership return, and allows them to include the income and deductions in
their individual tax returns.
Limited partnerships are discussed in [19.190].

Compliance obligations of a partnership [19.40]

A partnership does not pay tax, but must lodge a tax return: s 91 of the ITAA
1936. A partnership has its own tax file number (TFN), and the schedule at
the end of the return sets out the amount of net income or loss attributed to
each partner. The schedule also shows the breakup of each item of income,
such as exempt income or non-assessable non-exempt income. With the
partnership return, the ATO can then match the data with the partners’ own
tax returns.
As a partnership is carrying on a business, it must:
• obtain a TFN for the partnership, even though it is not a separate legal
entity;
• obtain an Australian Business Number (ABN);
• register for goods and services tax (GST) if required; and
• find out if it needs to obtain a registered business name from the State or
Territory Government small business office, especially if the individual
partners are not using their own names in the business.
Taxation of partnerships [19.50]
As stated at [19.40], a partnership does not pay tax, and any partnership
income or loss is included in the tax returns of the individual partners. Figure
19.2 provides a guide to determine a partner’s share of partnership income
or loss.
Net income of a partnership [19.60]
Section 90 of the ITAA 1936 defines “net income” of a partnership as:
[T] he assessable income of the partnership, calculated as if the partnership
were a taxpayer who was a resident, less all allowable deductions except
deductions allowable under section 290-150 or Division 36 of the Income Tax
Assessment Act 1997.
It is important to note that the net income of a partnership does not include
net capital gains. Capital gains are included in the assessable income of the
partners: see [19.130] for more detail.
Though assets of a partnership are legally owned by the partners, the
computation of the net income of a partnership takes into account
transactions with respect to certain assets. For instance, sales and purchases
of trading stock are treated as income and deductions at the partnership
level. The difference between the opening and closing stock values is also
taken into account in the partnership accounts. Similarly, capital allowance
on plant and equipment pursuant to Div 40 and capital works deductions
pursuant to Div 43 are also claimed as deductions at the partnership level.
The assessable income of a partner in a partnership includes a share of the
net income of the partnership, as s 92 of the ITAA 1936 stipulates that the
assessable income of a partner in a partnership shall include:

1. so much of the individual interest of the partner in the net income of the
partnership of the year of income as is attributable to a period when the
partner was a resident; and
2. so much of the individual interest of the partner in the net income of the
partnership of the year of income as is attributable to a period when the
partner was not a resident and is also attributable to sources in Australia.
Case study 19.2: Calculation of net income
Fred and Bill conduct a partnership providing IT consulting, sharing profits
and losses equally. In this income year, the partnership derived fees of
$180,000 (excluding GST) and incurred expenses of $40,000.

The net income of the partnership is $180,000 − $40,000 = $140,000.

Fred and Bill have to include in their tax returns assessable income from the
partnership of $70,000 each.

Partnership losses [19.70]

Section 90 of the ITAA 1936 defines “partnership loss” as:
the excess (if any) of the allowable deductions, other than deductions
allowable under section 290-150 or Div 36 of the ITAA 1997, over the
assessable income of the partnership calculated as if the partnership were a
taxpayer who was a resident.
Partnership losses are shared by the partners who can deduct the losses in
their own tax returns pursuant to ss 90 and 92(2) of the ITAA 1936. Section
92(2) of the ITAA 1936 states that:

[I] f a partnership loss is incurred by a partnership in a year of income, there

shall be allowable as a deduction to a partner in the partnership:
(a) so much of the individual interest of the partner in the partnership loss as
is attributable to a period when the partner was a resident; and
(b) so much of the individual interest of the partner in the partnership loss as
is attributable to a period when the partner was not a resident and is also
attributable to sources in Australia.
Exempt income derived by a partnership is similarly attributed to the
partners and thus may affect the amounts of loss deductions available to the
partners (see [3.170] for detail): s 92(3) of the ITAA 1936.
Case study 19.3: Calculation of partnership loss
Same facts as in Case Study [19.2], except that the partnership incurred
expenses of $200,000. The net loss of the partnership is calculated as
$200,000 − $180,000 = ($20,000).
Fred and Bill can deduct a loss from the partnership of $10,000 each in their
own individual tax returns.
[19.80] Certain transactions with respect to partnerships are subject to
specific taxation treatments, including:
• partners’ “salaries”;
• interest payments between a partnership and its partners;
• superannuation deduction for partners;
• dividends received by a partnership;
• capital gains and losses made on partnership assets;
• uncontrolled partnership income; and
• alienation of share of partnership income.

These items are discussed in the following paragraphs.

Partners’ salaries [19.90]
As a partnership is not a separate legal entity, partners cannot be employed
by themselves. It is sometimes the case that, as a means of recognising the
extra value of a partner to the partnership, one partner is paid an extra
amount of money over and above the share of partnership profits. This may
be described as a “salary”. However, a partner’s salary is not regarded as an
expense to the partnership and thus not deductible for income tax purposes.
Instead, it is treated as part of the allocation of profits and losses of a
partnership to the partners. The ATO position on the issue of partners’
salaries is explained in TR 2005/7. The following two case studies illustrate
the operation of the rules.
Case study 19.4: “Salary” paid to a partner
Andy and Ben are partners in a partnership, sharing profits and losses
equally. Andy has special skills which are rewarded by the partnership in the
form of a “salary” of $40,000. In this income year, profit of the partnership
after deduction of the salary is $100,000. As the salary is not deductible for
income tax purposes, the net income of the partnership is $100,000 +
$40,000 = $140,000. Out of this amount, Andy shared (1) $40,000 which is
received as “salary”; and (2) 50% of what remains, namely 50% of
$100,000, or $50,000. Therefore, Andy has to include a total of $90,000 as
assessable income in his tax return. Ben shared $50,000 out of the $140,000
net income of the partnership.
Case study 19.5: Partnership makes loss after deducting partner
“salary”
Same facts as Case Study [19.4], except that the partnership incurred a net
loss of $30,000 after deducting the “salary” to Andy. Again, the salary is
added back, resulting in a net income of the partnership of $10,000.
According to TR 2005/7, Andy is treated as having the sole entitlement to the
whole of the net income, as he is entitled to receive the “salary” before any
allocation of the partnership’s profits or losses. He has to include the
$10,000 as assessable income in his tax return.

Ben did not share any of the net income of the partnership in this income
year.
The non-deductibility of salaries paid to partners in a partnership was
confirmed in Re Scott v FCT (2002) 50 ATR 1235.
Case study 19.6: Partners’ salaries not deductible
Re Scott v FCT (2002) 50 ATR 1235 concerns a partnership between a
husband and wife, Mr and Mrs Scott, and their four sons. The partnership
conducted a business involved in preparing tax returns, with Mrs Scott as the
registered tax agent. Mr Scott was employed in the business, as well as their
son, Andrew. The other three sons, while partners, were engaged in other
professional activities not associated with the partnership. As a result of Mr
Scott and Andrew being paid tax-deductible “salaries”, the partnership
incurred a loss which was distributed to the other partners who then claimed
the loss as a tax deduction against their other income.

The Commissioner disallowed the payment of the “salaries” as a deduction.

The AAT held that under the general law a partnership is not a separate legal
entity and, as such, the partners cannot employ themselves and pay
themselves a salary. The taxpayers relied in part on Ruling IT 2218, which
allowed partnerships to take into account the contribution that a particular
partner may make to the partnership by receiving an additional payment, a
notional “salary”, but at no time did the ruling state that the “salary” was
deductible to the partnership. As a result of this case, the ATO withdrew the
ruling.
Interest payments between a partnership and its partners [19.100]
Similar to the treatment of salaries paid by a partnership to its partners,
interest paid to a partner on capital contributed to a partnership is not
regarded as an expense to the partnership and thus not deductible. Instead,
it is treated as part of the allocation of profits of the partnership to the
partner. For the same rationale, interest credited to a partner’s current
account is not deductible to the partnership, while interest debited to that
account is not taxable to the partnership: FCT v Beville (1953) 10 ATD 170.
Different tax implications apply to interest on a loan made by a partner to a
partnership. As the loan is distinct from the capital introduced to the
partnership, interest expenses on the loan are deductible to the partnership:
Leonard v FCT (1919) 26 CLR 175.

Interest expenses on external borrowings by a partnership as working capital

are deductible to the partnership. This is so even if the loan is used to repay
capital contributions of partners, provided the borrowings are used to
refinance funds employed in the partnership business: FCT v Roberts and
Smith (1992) 23 ATR 957; and Ruling TR 95/25.
Case study 19.7: Interest expenses and the refinancing principle
In FCT v Roberts and Smith (1992) 23 ATR 957, a partnership of lawyers
claimed interest at the partnership level on a loan of $125,000 pursuant to s
51(1) of the ITAA 1936 (now s 8-1 of the ITAA 1997). The partnership used
the money to pay each existing partner the sum of $25,000, representing a
repayment of capital to each of the five partners. The Commissioner
disallowed the expense as a deduction. Smith was an original partner and
Roberts became a new partner some three years later. In the words of Hill J
at 507:
The making of the regular interest payments was part of the cost to the new
partner of becoming a partner. It in no way differed in substance from
interest that would need to be paid had the incoming partner borrowed from
an external financier to finance the purchase from the other partners of the
partnership share. Nor in substance did it differ from a case where the
incoming partner was financed into the partnership by the other partners
and was required to pay interest to them. Nor would the case have been
different if the arrangement had been to indemnify the other partners in
respect of a proportionate share of the principal and to assume the liability
for interest attaching to that share. In each of these cases the interest
liability incurred has the necessary connection with the assessable income of
the new partner to be thereafter derived under s 92 of the Act. It is relevant
and incidental to that end.
As a result of FCT v Roberts and Smith, the ATO released Ruling TR 95/25,
which sets out a series of guidelines to determine whether a partnership can
deduct interest expense on funds borrowed to repay the initial capital
contributions by the partners.
Superannuation for partners [19.110]
Concessional superannuation contributions for partners are not deductible to
the partnership because partners cannot employ themselves and therefore
cannot make employer superannuation contributions. Partners are regarded
as self-employed and, as a result of the simplified superannuation rules, they
can make concessional contributions (see Chapter 18 for details). The
individual partners then claim the superannuation expenses as deductions in
their own tax returns. In contrast, concessional superannuation contributions
for employees, including the superannuation guarantee surcharge, are
deductible to the partnership.
Dividends received by a partnership [19.120]
Pursuant to s 207-35 of the ITAA 1997, if a partnership receives a franked
dividend, the amount of the dividend as well as the imputation credit must
be included in the assessable income of the partnership.
When the dividend income is distributed to the partners as part of the share
of the net income of the partnership, it retains its character in the hands of
the partners. The individual partners can then claim as a tax offset in their
individual tax returns the amount of the imputation credit attached to the
dividend. Unlike a trust, even if a partnership has made a loss, the partners
can still share the franking credit attached to the dividend (see [21.250] for
detail).
Capital gains tax [19.130]
Section 106-5 states that “any capital gain or capital loss from a CGT event
happening in relation to a partnership or one of its CGT assets, is made by
the partners individually”. In other words, a capital gain on a partnership
asset is not included in the partnership’s assessable income. Instead, it is
included in the partners’ own tax returns. Each partner’s capital gain or loss
is determined by reference to the partnership agreement or partnership law
if there is no agreement.
Each partner has separate cost base and reduced cost base for the partner’s
interest in the asset. It follows that upon the retirement of a partner from a
partnership, the remaining partners are treated as acquiring a share of the
departing partner’s interest in the partnership assets. Similarly, when a new
partner is admitted to a partnership, the existing partners are regarded as
disposing a part of their interest in the partnership assets.
The following two case studies illustrate how the CGT rules apply to
partnerships and their partners.

Case study 19.8: CGT implications of a new partner

Gary and George formed a partnership as equal partners and each
contributed $30,000. The partnership bought land for $60,000 ten years ago,
which increased in value to $600,000. Matt was introduced into the
partnership as an equal partner and acquired one-third share in the land by
paying Gary and George $100,000 each.
For CGT purposes, Gary and George have each disposed of one-third of their
interest in the land to Matt. Each has a cost base for that interest of $10,000
and capital proceeds of $100,000, resulting in a capital gain of $90,000 each
before discount. Matt’s cost base of his interest in the land is $200,000.
Source: Adapted from s 106-5(4) of the ITAA 1997.
Case study 19.9: Disposal of partnership assets
An investor and her spouse, Jacqui and Evan, created a partnership five
years ago, sharing profits and losses equally. Jacqui contributed an
investment property with a value of $300,000 to the partnership. Evan
contributed cash of $300,000.
The investment property was sold in the current income year for $400,000.
Each partner has a cost base of $150,000 (i.e., 50% of $300,000) in the
property. Capital proceeds for each partner is $200,000 (i.e., 50% of
$400,000). Therefore, each partner made a capital gain of $50,000 before
discount on the disposal of the property. If a partner had a carry-forward
capital loss, that partner can offset the capital gain by the amount of the
capital loss.
Uncontrolled partnership income [19.140]
In the absence of specific anti-avoidance provision, it would be relatively
easy for a high-income earner to shift income to another person with lower
marginal tax rate by forming a partnership between the two persons. For
example, a husband who is carrying on a business may form a partnership
with his wife who is a housewife with no income, while the husband
maintains total control over the partnership business and income.
Section 94 of the ITAA 1936 is the specific anti-avoidance provision designed
to deal with this kind of income-splitting arrangements. In particular, if a
partner of a partnership has no real and effective control of his/her share of
the net income of the partnership, that amount is regarded as “uncontrolled
partnership income”. The provision imposes a penalty tax rate on the
uncontrolled partnership income in the hands of the partner. The penalty tax
rate is generally the top marginal tax rate less the average rate of tax of the
partner. In other words, the uncontrolled partnership income is effectively
taxed at the top marginal tax rate. The specific anti-avoidance provision
does not apply to a partner that is a company, a trustee or a minor.

Alienation of share of partnership income [19.150] As an income-splitting

strategy, a partner may assign his share of partnership income to another
person with a lower marginal tax rate: FCT v Everett (1980) 143 CLR 440. As
a result of this case, this kind of assignment of interest in a partnership was
known as an Everett assignment. However, since the introduction of the CGT
provisions in 1985, these assignments in most cases may no longer provide
any substantial tax benefit unless the relevant interest is a pre-CGT asset.
Therefore, they are not discussed in detail here.

Variation or dissolution of partnership [19.160]

It is a good practice to draft a partnership agreement whereby on admission
of a new partner or the death or retirement of a partner the partnership
business will continue. Otherwise the old partnership ceases to operate and
a new partnership would need to be started. This would result in an
accounting of the partnership profit or loss at the date of death, retirement
or admission of a new partner and the lodgement of a tax return. If this
happened during the financial year, a further tax return is required at the
end of the financial year. This situation creates problems with the value of
the work in progress, bad debts, trading stock and depreciating assets that
were owned by the partners and partnership at the date of the death,
retirement or admission of a new partner.
For large professional partnerships, the Commissioner allows the partnership
to lodge a single tax return at the end of the financial year that shows the
allocation of profit or loss among the existing partners, new partners and
retiring partners.
For the CGT implications on partnership assets when a partner retires or a
new partner is admitted, see [19.130].
Work in progress [19.170]
When a partner retires from the partnership, the outgoing partner may sell
the work in progress to the remaining partners or a new partner. The
payment is income according to ordinary principles (Crommelin v FCT (1998)
39 ATR 377) and is now statutory income pursuant to s 15-50 of the ITAA
1997.
At general law, the partners purchasing the work in progress could not
obtain a deduction because the outlay was on capital account. However,
symmetric treatment is now achieved under the tax law by allowing a
specific deduction for the purchase of work in progress: s 25-95 of the ITAA
1997.

Trading stock and depreciating assets [19.180]

When there is a change in the composition of a partnership, specific
provisions apply to both trading stock and depreciating assets of the
partnership. In broad terms, the trading stock is deemed to have been
notionally disposed of at market value outside the ordinary course of
business: s 70-100 of the ITAA 1997. For depreciating assets of the
partnership, s 40-340 of the ITAA 1997 provides a roll-over relief so that no
tax liability arises on a change in the partnership.
Limited partnerships [19.190]
Limited partnerships are defined in s 995-1 of the ITAA 1997 to mean, among
other things: an association of persons (other than a company) carrying on
businesses as partners ... where the liability of at least one of those persons
is limited. They are in general taxed as companies: Div 5A of Pt III of the ITAA
1936.

Questions [19.200]
19.1 Peter and Jill are in a partnership as retailers of electrical
goods. The partnership records, exclusive of GST, for this income
year disclose:
Other details:
• Peter and Jill share partnership profits equally;
• Trading stock on hand 1 July: $10,000;
• Trading stock on hand 30 June: $20,000;
• Peter’s personal records disclose:
– Gambling winnings: $2,000;
– Net salary as a part-time instructor (excluding PAYG tax
instalments of $2,000): $5,000;
– Subscription to professional journals: $500; – Peter is a member of
a private health fund.
Calculate Peter’s taxable income for the income year explaining
your treatment of each item in this question.
19.2 Alasdair is a retired solicitor. His wife Tracy is a retired school
teacher. Both wish to remain active and they invest in a gift shop
that is to be managed by their daughter Carol, who is aged 35. They
form a partnership of three called “Carol’s Gift Shop”.
Alasdair and Tracy contributed $40,000 each to fund the purchase
of the shop. The partnership agreement provides:
• Both Alasdair and Tracy are to receive interest at the rate of 10%
pa on their capital contribution of $40,000.
• Carol will receive a salary of $25,000 for the management of the
shop, as well as superannuation contributions of $6,000.
• A car will be leased by the business and provided to Carol. • All
profits and losses are to be shared equally between the three
partners.
• The accounts for this income year show the following:
The leased car was used 80% of the time for business and 20% of
the time for private purposes. With reference to the facts above:
1. Calculate the net income of the partnership. Show the allocation
of net income to each of the three partners.
2. Explain if the provision of the motor vehicle by the partnership to
Carol imposes any fringe benefits tax liability on the partnership.

19.3 Johnny and Leon are adult partners in a business selling

sporting goods. The partnership records, excluding GST, for the
current income year disclose the following:
Calculate the net income for the partnership for the income year.
19.4 Gary and Matt are partners in a partnership running a Thai
restaurant. They share profits and losses equally under the
partnership agreement. In addition, Gary receives salaries of
$30,000 every year from the partnership for taking on the daily
management role in the restaurant. In this income year, the
partnership makes a loss of $45,000 after deducting the salaries
paid to Gary.
Explain the tax implications of Gary and Matt in this income year.
19.5 Peter and Paul are partners in a partnership. Their shares of
the partnership profits and losses are 60% and 40% respectively.
Peter is a resident and Paul is a non-resident. In this income year,
the partnership derived the following income:
• interest income from an Australian bank account: $30,000;
• interest income from an overseas bank account: $18,000.
Calculate the net income of the partnership and explain how that
amount will be allocated and assessed in the hands of Peter and
Paul.
Chapter 20 - Trusts and beneficiaries
Key
points ............................................................................................
....... [20.00]
Introduction...................................................................................
............. [20.10]
What is a
trust? ..........................................................................................
[20.20]
Fixed
trusts ............................................................................................
.... [20.30]
Discretionary
trusts ....................................................................................
[20.40]
Testamentary
trusts ...................................................................................
[20.50]
Taxation of
trusts ........................................................................................
[20.60]
Beneficiary presently entitled and not under a legal
disability .................. [20.70]
Income of the trust estate vs net
income.................................................. [20.80]
Proportionate and quantum
views ............................................................. [20.90]
Interim measures in response to Bamford
case...................................... [20.100]
Presently
entitled.....................................................................................
[20.110]
Statutory present
entitlement ................................................................. [20.120]
Character of income
preserved ............................................................... [20.130]
Beneficiary presently entitled but under a legal
disability ...................... [20.140]
No beneficiary is presently
entitled ........................................................ [20.150]
Minor
beneficiaries..................................................................................
[20.160]
Non-resident
beneficiaries ......................................................................
[20.170]
CGT events for
trusts ................................................................................
[20.180]
Questions ......................................................................................
............ [20.190]
Key points [20.00]
• Trusts are not separate legal entities. They can be classified as either a
fixed trust or a discretionary trust. Each beneficiary of a fixed trust is entitled
to a fixed proportion of the trust income. A common example of a fixed trust
is a unit trust. In contract, the entitlement of a beneficiary of a discretionary
trust is at the discretion of the trustee who determines the amount of
distribution to each of the beneficiaries.
• If a beneficiary of a trust is presently entitled to a share of the trust
income, his or her assessable income includes that share of the net income
of the trust.
• In practice, net income of a trust calculated according to the tax law is
often different from the trust income determined under the trust law. Case
law suggests that the proportionate view is preferable to the quantum view
in determining the amount of assessable income of the beneficiaries.
• If a beneficiary is under a legal disability, the trustee pays income tax on
behalf of the beneficiary.
• The character of income of a trust in general is preserved upon distribution
to beneficiaries. In particular, dividends and capital gains of a trust retain
these characters in the hands of beneficiaries to whom they are entitled.
• If no beneficiary is presently entitled to an amount of net income of a trust,
the trustee is subject to tax on that amount at a penalty rate, namely the top
marginal individual tax rate plus Medicare levy.
• Trust distributions to minors in general are subject to the same penalty
rate.

Introduction [20.10]
A trust is not a separate legal entity. In broad terms, a trust refers to a
relationship between a trustee and beneficiaries, under which the trustee is
obliged to manage the trust assets and activities for the benefit of the
beneficiaries.
Trusts are commonly used in Australia not only for asset protection purposes,
but also for carrying on businesses. Trusts typically account for
approximately 3% of the number of taxpayers in Australia. Discretionary
trusts are the most common type of trusts used in Australia. One of the main
motivations for using a discretionary trust to hold assets or conduct a
business is to shield the assets from claims against a taxpayer upon
bankruptcy or for negligence and other legal liability. While the trustee is the
legal owner of the assets of the trust, beneficiaries of a discretionary trust in
general do not have any interest in the assets.
The key legislative provisions relating to the taxation of trusts are stipulated
in Div 6 of the Income Tax Assessment Act 1936 (Cth) (ITAA 1936). While a
trust itself does not have to pay tax, its trustee must lodge a tax return each
year reporting the net income or loss of the trust.
The current taxation regime of trusts in Australia is complex and can produce
anomalous outcomes. The government announced in 2010 that it would
rewrite the provisions and has proposed reform options to improve the
regime. However, no progress has been made at the time of writing this
book.

What is a trust?
[20.20] A “trust” is defined in HA Ford and WA Lee, Principles of the Law of
Trusts (2nd ed, Lawbook Co, Sydney, 1990) at [101] as follows: A trust may
be defined as an obligation enforceable in equity which rests on a person
(the trustee) as owner of some specific property (the trust property) to deal
with that property for the benefit of another person or persons (the
beneficiaries) or for some object or purpose.
A “bare trust” can be established verbally by simply asking a person to hold
property in his or her name as the trustee for another person when the true
ownership of the property is concealed. An example of a bare trust is when a
nominee owns shares on behalf of the true owner so that the ownership can
be hidden from other parties.
In practice, an express trust that is established formally with a trust deed is
more common. An important and widely used form of a trust is a
superannuation fund. Many financial investments are held in a trust, such as
a managed investment fund or a property trust, where the investor owns
units in the trust.
Trusts can be categorised as either fixed trusts or discretionary trusts. In
fixed trusts, the trustee is obligated to pay the income or capital of the trust
in precise fixed proportions to specified beneficiaries. In contrast, the trustee
of
a discretionary trust has the power and discretion to determine the amount
of income and capital distributions to each of the beneficiaries. These two
types of trusts are discussed in more detail below.
Fixed trusts [20.30]
In fixed trusts, the entitlements of beneficiaries to income and corpus
(capital) are predetermined, or fixed, by the terms of the trust deed. A
typical example of a fixed trust is a unit trust. Many managed or collective
investment schemes are structured as unit trusts and the values of the units
are published in the financial part of the newspapers every week. They are a
popular form of investment for superannuation funds.
The case of Charles v FCT (1954) 90 CLR 598 is important because it
provides an explanation of what it means to be a unit holder in a unit trust
and this is compared with being a shareholder in a company. Dixon CJ, Kitto J
and Taylor J provided the following distinction in their joint judgment (at
609): ... for a unit held under this trust deed is fundamentally different from
a share in a company. A share confers upon the holder no legal or equitable
interest in the assets of the company; it is a separate piece of property; and
if a portion of the company’s assets is distributed among the shareholders
the question whether it comes to them as income or capital depends upon
whether the corpus of the property (their share) remains intact despite the
distribution. But a unit under the trust deed before us confers a proprietary
interest in all of the property which for the time being is subject to the trust
of the deed. The beneficiaries of a unit trust are entitled to a fixed proportion
of the net income or capital under the trust deed, and the trustee has no
discretion to change the fixed entitlement. In particular, the share of net
income and capital of a unit trust is determined by the number of units held
by the beneficiary. The number of units held by each beneficiary typically
corresponds to the contribution made to the trust by the beneficiary.
Units in a unit trust are similar to shares in a company but without the
statutory compliance requirements contained in the Corporations Act 2001
(Cth), as that Act has no bearing on trusts. However, if the unit trust is a
public trading trust, then the offering of units to the public would constitute
a financial product for the purposes of the Corporations Act 2001 (Cth).
Figure 20.2 illustrates how a fixed trust may be structured.
Certain unit trusts are taxed as companies, including corporate unit trusts
and public trading trusts pursuant to, respectively, Divs 6B and 6C in Pt III of
the ITAA 1936. The government announced in 2010 that it would repeal Div
6B and modify Div 6C. Detailed discussion of these rules is beyond the scope
of this book.

Discretionary trusts [20.40]

Under a discretionary trust, the trustee has an absolute discretion in
allocating trust income or capital to a beneficiary each year. As the
beneficiaries of a discretionary trust have no entitlement to trust property
until the trustee determines otherwise, the trust provides asset protection in
the case of beneficiaries becoming bankrupt. In addition, as CGT event E4
(see discussion in [20.180]) does not apply to discretionary trusts in practice,
tax concessions at trustee level flow through to the individual beneficiaries.
For example, where accounting profit exceeds net income of the trust, this
excess can often be passed through to the individual beneficiaries in a
discretionary trust. These are the main reasons why discretionary trusts are
used extensively to operate small-to-medium businesses.
In a typical family trust, the main beneficiary would appoint the trustee in its
capacity as an “appointor”. The appointor is noted in the trust deed and has
the power to remove the trustee or to appoint a new trustee if required. If
the trustee is a company, then the directors of the company are responsible
for the management of the trust fund and owe a duty to the company to
conduct the affairs of the company in accordance with their statutory and
common law duties as directors. The shareholders have the role of voting for
the directors at the annual general meeting so that if the shareholders
change, it is likely that the directors will change.
The trust deed is often referred to as a “deed of settlement” and the
“settlor” provides an initial amount of cash to the trustee to invest on behalf
of the beneficiaries. It is important that the settlor is independent from the
beneficiaries. In most cases, it is the family solicitor or accountant or a
family friend that is chosen as the settlor. Figure 20.3 illustrates the way in
which a discretionary trust is established.
The issue of who should be the settlor is important if there are minor
beneficiaries, as s 102 of the ITAA 1936 may be applied by the Australian
Taxation Office (ATO) to tax the trustee on the net income of a minor
beneficiary. This issue is discussed in [20.160].
Once the settlor has established the trust by making the initial contribution
of cash (usually $20) and executing the deed of settlement, the trustee is
able to conduct the business of the trust. The deed of settlement has a
vesting date, usually 80 years from the date of establishment. Eventually,
the trust is wound up either on the vesting date or earlier by distributing all
of the income and capital of the trust estate to the beneficiaries.
The trustee is the legal owner of the trust property and has a range of
statutory and common law obligations regarding how the trust fund is
managed. The trust property is administered on behalf of the beneficiaries.
In a family trust, the class of beneficiaries is identified in the deed of
settlement, which allows for new family members to be included at a later
time, such as grandchildren.
As mentioned above, one of the advantages of discretionary trusts is the
ability to split income between beneficiaries taking into consideration the tax
profiles
of the beneficiaries. For example, if a beneficiary has carried forward capital
losses, the trustee may decide to distribute more capital gains to that
beneficiary to minimise the tax liability of the capital gain. Of course, these
arrangements are subject to the challenge of the Commissioner who may
attempt to apply the general anti-avoidance provisions in Pt IVA of the ITAA
1936 if he or she is of the opinion that the dominant purpose of entering into
the arrangement is for the tax benefits (for a discussion of the general anti-
avoidance provisions, see Chapter 23 on tax avoidance).
Testamentary trusts [20.50]
A testamentary trust is a trust created under a will and can be either a fixed
trust or a discretionary trust. The beneficiaries can be the widow or widower,
and children or grandchildren. Testamentary trusts provide a vehicle for
wealthy individuals who want to preserve their wealth. For example, if the
offspring are not in a position to preserve the assets due to say a bad
marriage, impending bankruptcy or a social problem such as drugs or
gambling, the income and capital can be held at the trust level and
eventually distributed to grandchildren.
Taxation of trusts [20.60]
The taxation of trusts depends on, among other things, who is entitled to the
trust income and whether or not they are under a legal disability. Figure 20.4
summarises how a trust is taxed.
The first step is to calculate the net income or loss of a trust. Trust losses
cannot be distributed to the beneficiary. Instead, subject to specific anti-loss
trafficking provisions, they may be carried forward in the trust to offset
against future income derived by the trust.
If a trust has net income, the next step is to determine who should be the
taxpayers for the amount. There are in general three possible scenarios
under which the net income of a trust is subject to income tax in the hands
of a beneficiary or the trustee: • the beneficiary is presently entitled to the
trust income and is not under a legal disability;
• the beneficiary is presently entitled to the trust income and is under a legal
disability; and
• no beneficiary is presently entitled to the trust income.
Beneficiary presently entitled and not under a legal disability
[20.70]
Section 97 of the ITAA 1936 is a key provision in the taxation regime for
trusts. It stipulates that: [W] here a beneficiary of a trust estate who is not
under any legal disability is
presently entitled to a share of the income of the trust estate ... the
assessable income of the beneficiary shall include ... that share of the net
income of the trust estate ... (emphasis added)
The meanings of “the income of the trust estate”, “net income”, “presently
entitled” and the word “share” in s 97 are critical for the taxation of trusts
and are discussed in the following paragraphs.

Income of the trust estate vs net income [20.80]

The net income of a trust is defined in s 95(1) of the ITAA 1936 as, among
other things, the total assessable income of the trust estate calculated under
the tax law as if the trustee were a resident, less allowable deductions. In
other words, net income of a trust is broadly its taxable income calculated
according to the tax law. In particular, capital gains made by a trust are
typically included in its net income.
In contrast, the “income of the trust estate” is not defined in the tax law. In
the absence of specific definitions in the trust deed, the term may refer to
the general concept of trust income under trust law, which typically excludes
capital items. In this case, the income of a trust estate is likely to exclude
capital gains.
Case study 20.1: Concepts of trust income and net income
A discretionary trust derived rental income of $100 and capital gain of $200
in the current income year. The trust adopts the general concept of income
for trust law purposes. In this case, the net income of the trust is $300, while
the trust income for trust law purposes is $100.
The discrepancies between the net income of a trust under the tax law and
the trust income under trust law have been problematic for many decades.
For example, if a beneficiary of the trust in Case Study [20.1] is an income
beneficiary (i.e., a beneficiary that can only receive distribution of trust
income but not capital from the trust), what is the amount of his or her
assessable income under s 97? The answer depends on the meaning of the
word “share” in the section and is discussed in the next section.
Proportionate and quantum views [20.90]
There are two alternative approaches to interpret the word “share” in s 97 of
the ITAA 1936: the proportionate view and the quantum view. The best way
to explain the difference between the two approaches is to use an example.
Case study 20.2: Proportionate vs quantum views – income and
capital beneficiaries
Going back to the discretionary trust in Case Study [20.1], assume the trust
has two beneficiaries, Gary and George. Gary is an income beneficiary who
can only receive distribution of trust income. George is a capital beneficiary
who can only receive capital distribution from the trust. Assume further that
the trustee decides to distribute the trust income of $100 to Gary.
In this case, Gary is presently entitled to $100, representing all the trust
income according to the trust law. Literal reading of s 97 suggests that there
are two alternative interpretations of the word “share”:
1. Proportionate view: Under this view, the word “share” refers to the
proportion or percentage. In other words, as Gary is presently entitled to
100% of the trust income, his assessable income has to include 100% of the
net income, that is $300. This is so even though Gary cannot and will never
receive the $200 capital gain.
2. Quantum view: Under this view, the word “share” refers to the amount. In
other words, as Gary is presently entitled to $100 out of the trust income, his
assessable income has to include $100 out of the net income of the trust.
Both interpretations are problematic. Under the proportionate view, Gary is
taxed on the $200 capital gain that he will never receive. This case study
shows that the proportionate view can tax the wrong taxpayer for the wrong
amount.
The quantum view, unfortunately, may not be appropriate either. Under that
view, while Gary is taxed on the $100 out of the $300 net income, s 97 fails
to identify who should be the taxpayer for the remaining $200. In that case,
the trustee would be taxed on the $200 at the top marginal rate plus
Medicare levy pursuant to s 99A of the ITAA 1936 (see [20.150]). This tax
outcome contradicts the reality that George as the capital beneficiary
received the $200. He should be the taxpayer paying tax on the $200 at his
marginal tax rate. In other words, the quantum view also taxes the wrong
taxpayer for the wrong amount.
The problems of the two conflicting views can also arise if a deduction
originally claimed by a trust is disallowed by the ATO some years later,
resulting in additional net income. The issue is who should pay tax on the
additional net income, the beneficiaries or the trustee?
Case study 20.3: Proportionate vs quantum views – adjustment of
net income
In Year 1, the ABC trust had a net income of $100 and distributed $20 to
beneficiary A and $80 to beneficiary B. Each of the beneficiaries paid income
tax on their distributions. In Year 2, the ATO disallowed a deduction for $30
so that the net income of the trust according to the tax law was adjusted to
$130. Who should pay tax on the extra $30?

If the proportionate view is accepted, each beneficiary is liable to pay tax on

the additional amount in proportion to their original distribution: 20% to A,
being $6, and 80% to B, being $24. If, on the other hand, the quantum view
is adopted, the additional $30 would be assessed in the hands of the trustee
at the top marginal tax rate. The reason for this is that, under the quantum
approach, the specific dollar amount distributed to the beneficiaries is
considered to be the correct share of the net income of the trust and no
additional amounts can be distributed once the trustee has made its
decision.
The proportionate view is the prevailing view, as confirmed in the High Court
case FCT v Bamford (2010) 240 CLR 481; [2010] HCA 10.
Case study 20.4: Bamford case In Bamford v FCT, the trustee distributed
the net income of the trust of $187,530 to the following beneficiaries:
Interim measures in response to Bamford case [20.100]
Despite the long-standing consensus that the character of income is
preserved through trusts (see [20.130]), the Bamford case created
uncertainties with respect to the ability of trusts to stream capital gains and
franked distributions to beneficiaries. In response to the uncertainties, the
government enacted interim measures to specifically allow streaming of
these two items: subdivs 115-C and 207-B of the Income Tax Assessment Act
1997 (Cth) (ITAA 1997). Detailed discussion of these provisions is outside the
scope of this book.
Presently entitled [20.110]
The concept of a beneficiary being presently entitled to the income of the
trust is a key element to the taxation of trusts. In order for beneficiaries to
be presently entitled to a share of the trust income, they must have a right
to be paid that share by the trustee. The High Court confirmed that the
words “present entitlement” in s 97 have their general trust law meaning:
Commissioner of Taxation v Bamford [2020] HCA 10. The following two case
studies explain further the meaning of the term “presently entitled”.
Case study 20.5: Meaning of “presently entitled”
In Harmer v FCT (1991) 173 CLR 264, three solicitors agreed to hold a
certain amount of money on trust until a dispute as to the rightful owner of
the money had been resolved in court proceedings. The Commissioner
assessed the solicitors on the interest earned on the money in dispute they
were the trustees and liable to pay income tax pursuant to s 99A of the ITAA
1936 at the penalty rate of 48.5% (now 46.5%). The applicant contended
that they were not trustees or, if they were, there were taxpayers presently
entitled pursuant to s 95A(2), and they should pay income tax at the
individual rates and not the penalty rate. The High Court held that there
were no beneficiaries that were presently entitled and, at best, their
entitlement to the money was contingent on the outcome of the court case.
The High Court stated (at 271) that a beneficiary has a present entitlement
if:
• the beneficiary has an interest in the income which is both vested in
interest and vested in possession; and
• the beneficiary has a present legal right to demand and receive payment
of the income, whether or not the precise entitlement can be ascertained
before the end of the relevant year of income and whether or not the trustee
has the funds available for immediate payment.
The term “vested” in this context means that the beneficiary has a legal
right to the money held in the trust.
Beneficiaries can be presently entitled to trust income even if they have no
knowledge of the distribution, as the Vegners case illustrates.
Case study 20.6: Beneficiary has no knowledge of distribution
In Vegners v FCT (1991) 21 ATR 1347, Ray Vegners Pty Ltd conducted a
business of consulting engineers in its capacity as trustee of the Vegners
Family Trust. The trust was a discretionary trust established by a deed of
settlement dated 29 April 1980. The income and capital beneficiaries under
the trust included Raymond Vegners and Helena Vegners. In 1982, Raymond
Vegners and Helena Vegners, who had earlier separated, entered into a
matrimonial agreement dated 2 July 1982, which provided that the wife
receive payment from the trustee of the Vegners Family Trust by way of
further property settlement, the lump sum of $39,128 by 134 equal calendar
monthly instalments of $292 per month, the first of such instalments to be
paid on 9 April 1981 and thereafter on the ninth day of each and every
succeeding month. In 1982, the trustee resolved that out of the net income
of the trust, $4,042 should be distributed to Mrs Helena Vegners for her own
benefit. In 1983, a similar resolution was passed in respect of a distribution
of $4,004 and
in 1984, the sum was $3,504. During those years, payments totalling $3,504
were actually made by the trustee to Mrs Helena Vegners. Helena Vegners
was assessed on the above amounts. They had not been included in her tax
return as she had no knowledge that they were distributions from a trust.
The Federal Court held (at 1349):
The sole question is whether Mrs Vegners was personally entitled to trust
income and assessable to tax under the provisions of s 97 and 101 of the
Income Tax Assessment Act 1936 ... The trial judge was correct in holding
that the income which Mrs Vegners received and to which she was presently
entitled was assessable as part of her income.
It was not necessary that Mrs Vegners knew that the money was a
distribution from the trust before it was assessable.
The Full Federal Court in Carter v Commissioner of Taxation [2020] FCAFC
150 held that a disclaimer of entitlement to trust income executed by a
beneficiary of a discretionary trust was effective and denied the application
of s 97 on the beneficiary, even though the disclaimer was executed 30
months later retrospectively. In other words, the effect of the disclaimer is
that the beneficiary was regarded as never entitled to the trust income for
the purposes of s 97 in respect of the relevant income year.
Statutory present entitlement [20.120]
A beneficiary under a discretionary trust is not presently entitled until the
trustee exercises its discretion in the beneficiary’s favour. Section 101 of the
ITAA 1936 clarifies that once a trustee of a discretionary trust has resolved
to exercise its discretion in favour of a beneficiary, that beneficiary is
deemed to be presently entitled to the amount paid or applied to him or her.
The concept of present entitlement is extended by s 95A(2), which stipulates
that: ... where a beneficiary has a vested and indefeasible interest in any of
the income of a trust estate but is not presently entitled to that income, the
beneficiary shall be deemed to be presently entitled to that income of the
trust estate.
Character of income preserved [20.130]
The character of an item of income is preserved when it is distributed to a
beneficiary. For instance, if dividends received by a trust are distributed to a
beneficiary, the amount remains as dividends in the hands of the beneficiary
and the imputation credits can be attached to the distribution. In particular,
the dividends are grossed up to determine the net income of the trust estate
by the value of the imputation credit. When the dividend income is
distributed to the beneficiaries, the beneficiary can claim the imputation
credit attached to the dividend as an offset in his or her individual tax return.
However, if the trust is in loss, the dividend income cannot be distributed
and the tax offsets are lost.
Similarly, a capital gain derived by the trust can be distributed to an
individual beneficiary who may be eligible to claim a 50% discount on the
capital gain. In particular, if a trust makes a capital gain on the realisation of
a trust asset, the capital gain can be distributed to a specific beneficiary and
the 50% discount for the individual may be claimed, provided among other
things the trust has held the asset for more than 12 months. According to s
115-10 of the ITAA 1997, the 50% discount applies to the trust and the trust
would include a discounted capital gain in its net trust income calculation.
When it distributes the capital gain to an individual beneficiary, the gain is
grossed up to its non-discount amount and the individual (if eligible) then
claims the 50% discount in his or her own tax return. The trustee needs to
ensure that the capital gain is identified in the accounts of the trust and that
the specific distribution is clearly identified in the distribution process.
Beneficiary presently entitled but under a legal disability [20.140]
Where the beneficiary is presently entitled but under a legal disability, s 97
of the ITAA 1936 does not apply to tax the beneficiary. Instead, the trustee
will be required to pay income tax on behalf of the beneficiary at the rate of
tax that the beneficiary would have paid: s 98 of the ITAA 1936. Under
general law, a person is under a legal disability if they are unable to give a
valid discharge for a payment made to them. Common examples include
minors, undischarged bankrupts and intellectually impaired persons.
The amount of income tax is calculated as if the share of the net income was
the only income of the beneficiary and no deductions are available. If the
beneficiary derives other income, the total income is computed and the
beneficiary is taxed on the total. The beneficiary is entitled to a deduction for
the tax paid by the trustee: s 100(2) of the ITAA 1936.
No beneficiary is presently entitled [20.150]
In general, if all or part of the net income of a trust is not included in the
assessable income of a beneficiary or the trustee under ss 97 or 98 of the
ITAA 1936, that amount is taxed in the hands of the trustee at the top
marginal individual tax rate plus Medicare levy: s 99A of the ITAA 1936. This
penalty rate is designed to discourage accumulation of income in trusts in
Australia.

An exception applies to the penalty rate under s 99A. If a trust resulted from
a will and the Commissioner is of the opinion that it is unreasonable to apply
the penalty rates, the trustee will be taxed on that share of net income at
the normal individual progressive tax rates: s 99 of the ITAA 1936. This
situation often arises in the case of a testamentary trust.
To avoid the application of the penalty rate under s 99A, trust deeds of
discretionary trusts generally contain a “default beneficiary” provision
whereby if the trustee fails to distribute all trust income by the year end, the
income will be automatically distributed to, for example, a corporate
beneficiary to cap the tax liability at 30% before midnight on 30 June.
Minor beneficiaries
[20.160] The tax law has a specific anti-avoidance provision designed to deal
with the splitting of income from a high-income earner (e.g., a father) to his
children under 18 through a trust: s 102 of the ITAA 1936. However, the
provision has proved to be totally ineffective in most cases, as it can be
easily circumvented by having someone other than the father (e.g., the
grandfather of his children) establish the trust. The response of the
government to this ineffective provision is the introduction of a new regime
for income of minors, namely Div 6AA of the ITAA 1936.
Income of minors, including distributions from trusts, are in general taxed at
the top marginal rate plus Medicare levy: Div 6AA of the ITAA 1936. In
particular, minors are eligible for a tax-free threshold of $416, which is
progressively clawed back as shown below:
Table 20.1 2018–2019 tax rates for Div 6AA income of resident minor
beneficiaries

Income amount ($) Tax payable

0–416 Nil
417–1,307 66% of the excess over $416
1,308+ 45% of the total Div 6AA income
Case study 20.7: Income of minor
A trustee distributed $6,000 of trust income to a minor beneficiary aged 10
years. The beneficiary is treated as being presently entitled but under a legal
disability. The trustee will pay tax on behalf of the beneficiary at the rates
shown in Table 20.1. The tax payable is:

$6,000 × 45% = $2,700

Certain minors are not subject to Div 6AA, including minors in full-time
employment and disabled children: s 102AC(2) of the ITAA 1936. Certain
income items are also exempt from the penal rates, including employment
income and income from deceased estates: s 102AE(2) of the ITAA 1936.
Non-resident beneficiaries [20.170]
If a non-resident beneficiary is presently entitled to a share of the trust
income and is not under legal disability, in broad terms, his or her share of
the net income (excluding foreign-sourced income) is taxed in the hands of
the trustee at the rates applicable to non-residents: ss 98(2A) and (3) of the
ITAA 1936.
CGT events for trusts [20.180]
The tax law stipulates nine CGT events relating to trusts, including creation
of a trust over a CGT asset (CGT event E1), transfer of a CGT asset to a trust
(CGT event E2), beneficiary becoming entitled to a trust asset (CGT event
E5), etc. The full list of CGT events concerning trusts can be found in Chapter
11. Detailed discussion of these events is beyond the scope of this book.
However, CGT event E4 is worth some discussion in the context of the
taxation of distributions to beneficiaries.
CGT event E4 happens if in general:
1. a beneficiary receives a payment (“non-assessable payment”) from the
trustee with respect of his or her interest in the trust; and
2. the non-assessable payment is not regarded as assessable income in the
hands of the beneficiary.
The time of the event is defined, among other things, to be the time just
before the end of the income year in which the trustee makes the non-
assessable payment. The ATO is of the opinion that this CGT event is not
applicable to discretionary trusts: TD 2003/28. A typical example of CGT
event E4 is the distribution of certain exempt income derived by a unit trust
to its unit holders.
In broad terms, the effect of CGT event E4 depends on the amount of the
non-assessable payment relative to the cost base of the units held by the
beneficiary. If the non-assessable payment is less than the cost base of the
units, the cost base and reduced cost base of the units are reduced by the
amount of the payment. Otherwise, the cost base and reduced cost base are
reduced to zero, and the excess of the non-assessable payment over the
cost base is the capital gain arising from the CGT event.
Case study 20.8: CGT event E4
Gary bought one unit in a unit trust for $10,000 in 2010. During the current
income year, the trustee made non-assessable payments of $6,000 per unit.
Just before the end of the current income year, CGT event E4 occurs with the
effect of reducing the cost base and reduced cost base of the unit from
$10,000 to $4,000.
If in the following income year, the trustee made another non-assessable
payment of $6,000 per unit, CGT event E4 occurs again just before the year
end. In this case, the cost base and reduced cost base of the unit are
reduced to zero, and Gary made a capital gain of $2,000, which is eligible for
CGT discount.
Questions [20.190]
20.1 Lawless Trust is a discretionary trust, with an Australian
incorporated company as trustee. The trust derived the following
income in this income year: • $600,000 profits from running a
restaurant in Sydney; • $90,000 interest from an Australian bank
account; and • $18,000 interest from a Hong Kong bank account.
The trust has the following three beneficiaries who are entitled to
receive both income and capital distributions from the trust: • Gary,
50-year-old Australian resident, a tax manager earning $200,000
salary in the year;
• George, 40-year-old non-resident; and
• Matt, 12-year-old Australian resident, with no other income.

What are the tax implications of the three beneficiaries if the

trustee distributes the above income equally to each of them? You
are not required to compute the tax liabilities of the beneficiaries.
20.2 The Li Family Trust is a discretionary family trust with two
adult resident beneficiaries, Emma and Peter. During this income
year, the activities of the trust gave rise to the following:
$
Loss from rental property
(6,000)
Interest income from term deposits
4,000
Cash received from fully franked dividends
14,000
A capital gain from the sale of BHP shares that had been held for
two years 10,000
The trustee of the trust resolved to distribute 100% of the trust
income to Emma.
Emma also has the following income:
• Salary of $200,000 from which PAYG withholding tax instalments
of $60,000 have been deducted.
• Work-related expenses of $275. Emma has private hospital cover.
Based on the facts above: 1. Calculate the taxable income and tax
payable or refundable for Emma for the income year.
2. Would your answer differ if the Li Family Trust made a rental loss
of $40,000?
20.3 Bruce Whelan established the “Whelan Family Trust” in 1990
with ABC Pty Ltd as the corporate trustee. Bruce and his wife May
are the directors of the trustee company. The trust holds a variety
of investments in property and cash. The trust was established to
protect the investments as Bruce is always concerned that he could
be sued for negligence. The trust records for this income year
disclose the following:

Receipts ($)
80,000 Rent from investment properties
6,000 Interest from a bank account
Payments ($)
2,000 Accounting expenses for tax return
10,000 Repairs to investment properties
4,000 Interest on a loan for the investment property
1,000 Legal expenses incurred in defending a claim by a
tenant

May does not work. Bruce is a senior tax manager and received a
salary of $160,000 in this income year. He has three children:
• a son, John, aged 21 years, a student at university who earned
$12,000 for the year;
• a daughter, Kim, aged 19, also a university student who earned
only $2,000 for the year; and
• a second daughter, Amy, aged 16 years, a full-time high school
student with no other income.
Bruce has his grandmother living with him, and she had no income
for the year. All family members are beneficiaries of the trust. Bruce
also established a corporate beneficiary, and this is available to
receive trust distributions. Calculate the net income of the Whelan
Family Trust for this income year and advise Bruce as to how he can
distribute the net income in the most tax-effective way.
20.4 Tom runs a small retail business selling men’s clothing in the
suburb of Glen Waverley, Melbourne. The business is structured as a
discretionary trust – the “Jones Family Trust” – with his company,
Glen Waverley Clothing Pty Ltd, as the trustee. Tom and his wife,
Mary, are the two directors of the trustee company. The trust has an
ABN and TFN and is registered for GST.
The trust had the following transactions in this income year:

Receipts ($)
198,000 Retail sales
17,000 Rental income from an income-producing investment
apartment
1,000 Interest on bank deposits
Payments ($)
15,000 Body corporate fees on income-producing property
66,000 Purchase of trading stock
5,000 Interest on money borrowed to purchase the
income-producing investment
apartment
5,000 Borrowing expenses relating to a new loan to
acquire the investment apartment. The loan is for 10 years
and began on 1 July 2012
1,100 Fees paid to a registered tax agent
11,000 New equipment wholly used in business with an
estimated life of 20 years
1,080 New equipment wholly used in business with an
estimated life of three years
1,000 Travel to and from work

Additional information:
(a) The trust has a carry forward tax loss of $10,000.
(b) The trust is a small business entity (SBE) and prepares accounts
on that basis.
(c) Stock at beginning of the year was valued at $20,000.

Stock at year end was:

Cost $16,000
Market selling value $19,000
Replacement $18,000
The trust does make an election under s 328-285(2) of the ITAA
1997.
(d) The opening depreciation pool balance for the general SBE pool
was $30,000.
(e) The trust purchased an investment apartment in a hotel complex
brand new on 1 July this income year for a cost of $400,000. The
quantity surveyor advised Tom that the construction cost of the
apartment was $167,000.
Calculate the net income of the trust for the income year. Note that
the above figures include GST.
20.5 A unit trust has two unit holders, John and Mary, both are
residents of Australia. John holds 300 units which he acquired in
1983 for $300,000. Mary acquired her 100 units in 2001 for
$400,000. In this income year, the unit trust derived $700,000
capital gain from disposing a pre-CGT asset and distributed the
amount to the unit holders. Explain the tax implications of the unit
trust, and the unit holders John and Mary.
Chapter 21 - Companies and shareholders
Key
points ............................................................................................
....... [21.00]
Introduction...................................................................................
............. [21.10]
Definition of a
company ............................................................................ [21.20]

Public
officer.............................................................................................
.. [21.30]
Dividends.......................................................................................
............. [21.40]
Taxation of
dividends.................................................................................
[21.40]
Meaning of
“shareholders” .......................................................................
[21.50]
Meaning of
“dividends” ............................................................................
[21.60]
Share capital
account................................................................................
[21.70]
Non-share
dividends ................................................................................
[21.80]
Meaning of
“paid” ....................................................................................
[21.90]
Meaning of
“profits” ...............................................................................
[21.100]
Deemed dividends for private
companies .............................................. [21.110]
Introduction ...................................................................................
.......... [21.110]
Private
companies....................................................................................
[21.120]
Deemed
dividends ...................................................................................
[21.130]
Deemed dividends for distributions by
liquidator .................................. [21.140]
Imputation
system...................................................................................
[21.150]

Introduction ...................................................................................
......... [21.150]
Implications for
companies ..................................................................... [21.160]
Franking a
distribution .............................................................................
[21.160]
Franking credit attached to
dividends ..................................................... [21.170]
Franking
account ......................................................................................
[21.180]
Franking deficit
tax .................................................................................. [21.190]
Implications for
shareholders .................................................................. [21.200]
Resident individual
shareholders ............................................................. [21.210]
Resident corporate
shareholders ............................................................ [21.220]
Excess franking offset: carried forward
losses ........................................ [21.230]
Excess franking offset: current year
loss ................................................. [21.240]
Resident partnerships and trusts as
shareholders .................................. [21.250]
Non-resident
shareholders ......................................................................
[21.260]
Measures protecting the imputation
system .......................................... [21.270]
The benchmark
rule ................................................................................. [21.270]
Qualified
person .......................................................................................
[21.280]
45-day holding period
rule ...................................................................... [21.290]
Related payment
rule .............................................................................. [21.300]
Company
losses .......................................................................................
[21.310]

Introduction ...................................................................................
......... [21.310]
Carried forward realised
losses ............................................................... [21.320]
Continuity of ownership
test ................................................................... [21.330]
Business continuity
test ........................................................................... [21.335]
Same business
test ...................................................................................
[21.340]
Similar business
test ................................................................................ [21.345]
Unrealised
losses ......................................................................................
[21.350]
Multiplication of
losses ............................................................................ [21.360]
Consolidation .................................................................................
.......... [21.370]

Introduction ...................................................................................
......... [21.370]
Policy
objectives ......................................................................................
. [21.380]
Membership
requirements .....................................................................
[21.390]
Multiple entry consolidated
groups ........................................................ [21.400]
Implications of electing to
consolidate .................................................... [21.410]
The single entity
rule................................................................................ [21.410]
The entry and exit history
rules .............................................................. [21.420]
Liability to
tax .........................................................................................
[21.430]
Pre-consolidation
losses ......................................................................... [21.440]
The tax cost setting
rules ........................................................................ [21.450]

Questions ......................................................................................
........... [21.460]
Key points [21.00]
• Companies are in general treated as separate taxpayers from their
shareholders. A major exception is the consolidation regime under which a
wholly owned resident corporate group can elect to be taxed as one single
taxpayer.
• Companies may be public or private. Public companies are generally those
listed on the stock exchange.
• Certain distributions by private companies may be deemed to be
assessable dividends, including excessive salaries, payments, loans and
forgiveness of loans to shareholders or associates.
• Dividends paid out of profits of a company are in general assessable
income to its shareholders. This is so even if the profits include exempt
income at the company level.
• Under imputation, a company may distribute a dividend with franking
credits to its shareholders. Companies are required to maintain a franking
account which records the amount of income tax paid by the company and
other companies paying dividends to the company.
• A resident shareholder receiving a franked dividend is subject to tax on a
“gross up and tax offset” basis. The assessable income includes not only the
amount of dividend but also the “gross up” amount representing the
franking credit attached to the dividend. The shareholder’s tax liability is
then reduced by the amount of tax offset equal to the gross up.
• Excess tax offset for a resident individual shareholder is refundable.
However, such amount is not refundable to resident corporate shareholders;
instead, they are subject to specific rules dealing with the excess tax offset
issue.
• Unlike partnerships, companies cannot distribute losses which are trapped
at the company level. The losses can be carried forward indefinitely to later
years, provided the company satisfies either the continuity of ownership test
(COT) or the business continuity test (BCT).
• A wholly owned resident corporate group may elect to be taxed as one
single taxpayer under the consolidation regime. The advantages of electing
to consolidate include the ability to offset taxable income and tax losses
among group members and tax-free transfers of assets within a consolidated
group. However, the consolidation regime in Australia is notoriously complex.
Introduction [21.10]
The income tax law in general treats a company as a separate taxpayer
from its shareholders. In particular, the tax law stipulates that income tax is
“payable by each individual and company ...” (emphasis added): s 4-1 of the
Income Tax Assessment Act 1997 (Cth) (ITAA 1997).
The general principle of treating a company as a separate taxpayer from its
shareholders implies that, when income flows through a company to its
shareholders, income tax may be imposed at two levels: first at the company
level upon its derivation of the income and then at the shareholder level
upon receiving distribution from the company. Potentially, the same
economic income may be subject to double taxation. Countries have
introduced different regimes attempting to deal with this issue. Australia’s
imputation system aims to eliminate this double taxation by providing a tax
offset to the shareholder, representing the amount of income tax already
paid on those profits at the company level. Pursuant to the neutrality
principle, the total income tax paid on the income by the company and the
shareholders should equal the amount of income tax payable if the
shareholders receive the income directly without passing through the
company. However, the imputation system fails to achieve this neutral effect
in many circumstances, including tax-preferred income and non-resident
shareholders.
Companies in general are subject to income tax at a standard flat rate of
30%. However, companies that are small business entities are subject to a
reduced rate of 26% in 2020–2021. This small business company tax rate is
scheduled to be reduced to 25% in 2021–2022. For clarity purposes, the
applicable tax rate for companies in the discussion in this chapter is
assumed to be 30%, unless specifically stated otherwise.
Compared to the top marginal tax rate for individuals, the lower tax rate of
companies offers tax arbitrage opportunities to defer income tax for high-
income earners. Specific anti-avoidance provisions are designed to deem
certain payments from private companies to their shareholders to be
assessable dividends.
Losses incurred by a company can be carried forward indefinitely to offset
future taxable income of the company, subject to specific anti-avoidance
provisions dealing with trafficking of losses.
One major exception to the general rule of the separate entity treatment for
companies is the consolidation regime, under which a consolidated group is
treated as one single taxpayer for income tax purposes.

Definition of a company [21.20]

Section 995-1 of the ITAA 1997 defines “company” as:
1. a body corporate; or
2. any other unincorporated association or body of persons; but does not
include a partnership or a non-entity joint venture.
Under the definition, a non-profit-making club is treated as a company under
income tax law. The taxation treatment for companies is extended to other
“corporate tax entities”, namely corporate limited partnerships, corporate
unit trusts and public trading trusts: s 960-115 of the ITAA 1997. This
chapter focuses on the taxation of incorporated companies limited by
shares.
Public officer [21.30]
Every company carrying on business or deriving property income in Australia
must appoint a public officer: s 252 of the Income Tax Assessment Act 1936
(Cth) (ITAA 1936). The public officer must be a resident and a natural person
aged at least 18.
Service of any document on the public officer is sufficient service upon the
company for all the purposes of the income tax law. The public officer is
answerable for all obligations imposed on the company by the income tax
law. If the company defaults, the public officer shall be liable to the same
penalties as the company.
Dividends Taxation of dividends [21.40]
Section 44 of the ITAA 1936 stipulates that the assessable income of a
resident shareholder in a company includes:

1. dividends paid to the shareholder by the company out of profits derived

by it from any source; and
2. all non-share dividends paid to the shareholder by the company.

The provision applies to both resident and non-resident companies. The

section further provides that the scope of taxation on dividends paid to non-
resident shareholders is basically limited to the amounts attributable to
sources in Australia. However, dividends subject to withholding tax, and
franked dividends that are exempt from withholding tax, are specifically
deemed to be non-assessable non-exempt income: s 128D of the ITAA 1936.
For more discussions on withholding tax, see Chapter 22.
Issues arising from s 44 include:
1. Who is a shareholder? See [21.50].
2. What are “dividends” and “non-share dividends”? See [21.60]–[21.80].
3. When is it paid? See [21.90].
4. What is the meaning of “profits”? See [21.100].
Meaning of “shareholders” [21.50]
Section 6 of the ITAA 1936 defines “shareholder” to include “member or
stockholder”. Entry on the company’s register of members is necessary to
constitute membership of a company: Patcorp Investments Ltd v FCT (1976)
6 ATR 420. A person with beneficial ownership of shares, but without
registration, generally would not be a shareholder.
Since 1 July 2001, for the purpose of s 44 of the ITAA 1936, the meaning of
“shareholder” has been extended by the debt/equity regime. In particular,
holders of “equity interest” are treated in the same way as shareholders: s
43B(1)(b) of the ITAA 1936. The debt/equity regime in general aims to
classify interests in a company into either “equity interest” or “debt interest”
according to their economic substance: s 974-10(1) of the ITAA 1997. For
example, a financial arrangement may be a loan in legal form but may be
classified as an “equity interest” under the debt/equity rules. One of the
consequences is that payments made under the arrangement would not be
deductible as interest expenses. Instead, in general, they would be treated
as dividends.
Meaning of “dividends”[21.60]
“Dividend” is defined in s 6(1) of the ITAA 1936 to include: 1. any distribution
made by a company to its shareholders, whether in money or other property;
and
2. any amount credited by a company to its shareholders as shareholders.
The definition is potentially very broad, including any distribution of money
or property to shareholders.
One important exception in the definition is distribution representing return
of capital. In particular, the definition of “dividend” excludes “moneys paid
or credited by a company to a shareholder ... where the amount ... is debited
against ... the share capital account of the company”. Such amounts should
not be taxable to shareholders as they are payments made by a company to
return the capital contributed by the shareholders.
The “debit against share capital account” exception may, in the absence of
specific anti-avoidance provision, provide opportunities to avoid or defer
income tax liability by designating a distribution to be a return of capital.
However, there are capital gains tax (CGT) consequences. The non-
assessable payment would reduce the cost base and reduced cost base of
the shares. If such payment exceeds the cost base, the excess is taxed as
capital gain under CGT event G1: s 104-135 of the ITAA 1997.

Case study 21.1: Return of capital

Mr Bond bought one share in Company A for $100 two years ago. The
company made a distribution of $20 to Mr Bond from its share capital
account this year. The $20 received by Mr Bond is not dividend, and thus not
taxable under s 44 of the ITAA 1936. Instead, the distribution triggers CGT
event G1. The cost base and reduced cost base of the share is reduced to
$80. If Mr Bond now sells the share for $120, he will have a capital gain of
$40 (ignoring CGT discount).
Share capital account [21.70]
“Share capital account” of a company is in general defined as “an account
which the company keeps of its share capital”: s 975-300 of the ITAA 1997.
In the absence of anti-avoidance provision, it would be possible for a
company to convert otherwise taxable distribution of profits into non-taxable
amount by capitalising profits into its share capital account. The tax law has
a specific anti-avoidance provision to deal with this issue. A share capital
account is tainted if it includes amounts transferred from other accounts of
the company: s 197-50 of the ITAA 1997. A “tainted” share capital account is
in general not regarded as a share capital account for the purposes of the
tax law: Div 197 of the ITAA 1997. In other words, a shareholder’s
distribution that is debited against a “tainted” share capital account would
still fall under the definition of “dividend”. Furthermore, the distribution is
also deemed to be paid out of profits derived by the company: s 44(1B) of
the ITAA 1936 and s 975-300(3)(d) of the ITAA 1997. This is to ensure that
such a distribution would be assessable income to the shareholder under s
44 of the ITAA 1936.
There are two other implications of tainting a share capital account. First, a
franking debit arises in the company’s franking account when an amount is
transferred to its share capital account that results in tainting the account: s
197-45 of the ITAA 1997. Second, distributions coming out of a tainted share
capital account are unfrankable distribution: ss 202-45(e) and 975-300(3)
(ba) of the ITAA 1997.
Another anti-avoidance provision to protect the integrity of the tax policy on
return of capital is s 6(4) of the ITAA 1936. The section applies if, under an
arrangement, a person subscribes shares in a company which credits the
amount to its share capital account, and the company makes distributions to
another person by debiting the share capital account. An example of such an
arrangement is when a company issues new shares to new shareholders and
uses the funds raised to make distributions to existing shareholders. If s 6(4)
applies, the “return of capital” exclusion in the definition of “dividend” would
not apply and the distributions would still be regarded as dividends.
Non-share dividends [21.80]
“Non-share dividends” are defined in broad terms as distributions made by a
company to holders of its “non-share equity interest”: ss 974-115 and 974-
120 of the ITAA 1997. “Non-share equity interest” in a company means
basically an interest in a company that is not a share in the company per se
but is classified as “equity interest” under the debt/equity rules: s 995-1 of
the ITAA 1997.
The definition of “non-share dividends” is subject to an exclusion similar to
the “return of capital” exclusion under the definition of “dividends” discussed
at [21.60]. In particular, a distribution made to a holder of a non-share equity
interest in a company is not a “non-share dividend” to the extent that the
company debits the distribution against its share capital account or non-
share capital account: s 974-120(2) of the ITAA 1997.
Meaning of “paid” [21.90]
The definition of “paid” in relation to dividends includes credited or
distributed: s 6(1) of the ITAA 1936. The meaning of “paid” was considered
in the High Court case of Brookton Co-operative Society Ltd v FCT (1981)
147 CLR 441, which held that a dividend was still paid if it is credited and the
crediting could not be revoked.
Meaning of “profits” [21.100]
Dividends (other than non-share dividends) would be assessable income of a
shareholder provided, among other things, they are paid out of profits
derived by the company: s 44(1) of the ITAA 1936. What is the meaning of
“profits” in this context? In the High Court case FCT v Slater Holdings Pty Ltd
(1984) 156 CLR 447, it was held that dividends paid out of exempt income of
a company were paid out of profits and thus assessable under s 44 of the
ITAA 1936. The important implication of this meaning of profits is that
income passing through a company will lose its character and in general is
taxed as dividends when distributed to the shareholders. The Corporations
Act 2001 (Cth) was changed in 2010 in respect of the requirements for
paying dividends. The original “profits test” – that is, dividends might only be
paid out of company profits – was replaced with a more flexible requirement
that allows a company to pay dividends if, among other things, the
company’s assets exceed its liabilities before the dividend is declared: s
254T of the Corporations Act 2001 (Cth). In response to the change of the
company law, “a dividend paid out of an amount other than profits” is now
deemed to be a dividend paid out of profits for income tax purposes: s
44(1A) of the ITAA 1936.
Deemed dividends for private companies Introduction [21.110]
The difference between the corporate tax rate of 30% and the top individual
marginal tax rate provides incentive for taxpayers to accumulate profits at
the company level, instead of making distributions to shareholders. Various
schemes have been devised to pass benefits to shareholders and, at the
same time, avoid being regarded as dividends. Examples include loans to
shareholders, excessive salaries paid to shareholders and transfer of
property between a company and its shareholders at non-arm’s length
prices.
Case study 21.2: Avoidance opportunity for private companies
Mr Solo, an Australian resident subject to the top marginal tax rate, owns all
the shares in a company incorporated in Australia. The company derives
$200,000 net investment income in the current income year. The company’s
tax liability would be 30% of $200,000, that is, $60,000. This is less than the
tax liability of Mr Solo if he receives the income directly. If the company
distributes the income after tax of $140,000 to Mr Solo as dividends, the
amount would be taxable to Mr Solo (under the imputation system discussed
in [21.150]) at his marginal tax rate. Assuming no specific anti-avoidance
provisions, Mr Solo would be able to avoid the tax if the payment made to
him is disguised as say a loan to the company’s shareholder.
The tax law contains specific anti-avoidance provisions to tackle this kind of
scheme involving private companies. The general effect of the provisions is
to deem such transactions to be assessable dividends. Such deemed
dividends are unfrankable under the imputation system: s 202-45(g) of the
ITAA 1997.
Private companies [21.120]
“Private company” is defined as a company that “is not a public company”: s
103A(1) of the ITAA 1936. “Public company” is defined broadly to include a
listed company and a subsidiary of a public company: s 103A(2) of the ITAA
1936. However, a listed company in general is not a public company
if control over the company is relatively concentrated. For instance, a
company cannot be a public company if, among other things, not more than
20 persons hold at least 75% of the value of the share or voting power in the
company: s 103A(3) of the ITAA 1936.
Deemed dividends [21.130]
If a private company pays salaries or fees for services provided by its
shareholder (or associate), and the amount exceeds a reasonable amount
determined by the Commissioner, the excess in general would be deemed as
a dividend paid by the company to a shareholder out of profits derived by
the company: s 109(1) of the ITAA 1936. The company cannot claim the
excess as a deduction.
Division 7A was introduced in 1998 to overcome limitations of the now
repealed s 108 of the ITAA 1936. For instance, s 108 required the
Commissioner to form an opinion that a loan represents a distribution of
profits. Division 7A, instead, would operate automatically provided the
conditions stipulated in the relevant sections are satisfied. The scope of the
Division is more comprehensive and applies to three kinds of amounts:

1. Payments to shareholders If a private company makes a payment to its

shareholder (or associate), the payment is in general deemed to be a
dividend: s 109C of the ITAA 1936. “Payment” is widely defined as a
payment or credit to, on behalf of, or for the benefit of, the shareholder, and
a transfer of property to the shareholder. The very wide scope of the section
is limited by certain exclusions. For example, a payment to discharge arm’s
length debt owed by the company to a shareholder is excluded from the
deeming provision: s 109J of the ITAA 1936. Payment made to a corporate
shareholder is also excluded, as the shareholder in this case would be
subject to the same tax rate as the private company: s 109K of the ITAA
1936.
2. Loans to shareholders If a private company makes a loan to its
shareholder (or associate) and the loan is not repaid by the “lodgement
date” of the income year, the amount of outstanding loan in general is
deemed to be a dividend: s 109D of the ITAA 1936. “Loan” is again widely
defined to include an advance, a provision of credit or a transaction which in
substance effects a loan. “Lodgement date” is defined to be the earlier of
the due date or actual lodgement date of the company’s income tax return.
Certain loans are excluded from the operation of s 109D. Examples include
loans made to a corporate shareholder: s 109K of the ITAA 1936; loans made
in the ordinary course of business of the private company on arm’s length
terms: s 109M of the ITAA 1936; and loans made under written agreements
which meet criteria for minimum interest rate and maximum term: s 109N of
the ITAA 1936.
3. Forgiven debts to shareholders If a private company forgives a debt owed
by a shareholder (or associate), the amount of forgiven debt is deemed as a
dividend: s 109F(1) of the ITAA 1936. Again, the section defines “forgiven
debts” widely. For instance, if a reasonable person concludes, based on all
the circumstances, that the private company will not insist on repayment of
the debt, the debt is taken to have been forgiven: s 109F(6) of the ITAA
1936. However, certain debts that are forgiven by a company are not taken
to be a dividend, for example, debt owed by another company, debt forgiven
due to the bankruptcy of a shareholder and debt forgiven for a shareholder
under financial hardship due to circumstances beyond its control: s 109G of
the ITAA 1936.
The total amount of deemed dividends under Div 7A is capped at a
maximum of the “distributable surplus” of the company: s 109Y of the ITAA
1936. The policy objective is to limit the amount of deemed dividends to the
amount of profits of the company. In broad terms, “distributable surplus” is
defined as the company’s net assets, reduced by the amounts of paid-up
capital and loans deemed as dividends under ss 108, 109D and 109E of the
ITAA 1936.
Amounts deemed as dividends under Div 7A are taken to be paid to the
taxpayer as a shareholder of the private company out of the profits of the
company: s 109Z of the ITAA 1936. The Division contains rules to avoid
double taxation on shareholders if subsequent dividends are used to set off
against amounts previously deemed as dividends under the Division: s
109ZC of the ITAA 1936.
Case study 21.3: Deemed dividends for private companies
Continuing with Case Study [21.2], if Div 7A applies and the company’s
distributable surplus is $180,000, the whole amount of the “loan to
shareholder” of $140,000 would be deemed to be assessable dividend and
Mr Solo would have to pay tax on it at his marginal tax rate.
Deemed dividends for distributions by liquidator [21.140]
For general law purposes, distributions made by a liquidator in the course of
the winding up of a company do not constitute distributions of the
company’s profits: Burrell’s Case [1924] 2 KB 52. The tax law overrides this
principle by deeming certain distributions by a liquidator to be dividends. In
particular, distributions to shareholders by a liquidator are in general
deemed to be dividends paid out of profits, to the extent that they represent
income derived by the company before or during liquidation: s 47(1) of the
ITAA 1936.
Similar to the definition of “dividend” in s 6(1) of the ITAA 1936, a
distribution by a liquidator that represents a return of capital is excluded
from being a deemed dividend under s 47. Provided a liquidator properly
keeps accounts for the company, it is possible for the liquidator to specify
the source of a distribution. In other words, the liquidator can determine that
a distribution is to be regarded as being out of particular profits or income,
or a return of capital: Archer Bros Pty Ltd v FCT (1953) 90 CLR 140. This
provides opportunities to reduce or defer income tax liability on the
distribution.
Liquidation distributions to shareholders would also be subject to CGT. When
a share is redeemed or cancelled, CGT event C2 in general would apply: s
104-25 of the ITAA 1997. If capital proceeds received by the shareholder
upon the cancellation are more than the cost base of the share, the
shareholder makes a capital gain. The amount of the capital gain would be
reduced by any amount that has already been captured as assessable
income pursuant to s 47 of the ITAA 1936: s 118-20 of the ITAA 1997. If a
liquidator makes an interim distribution that is not deemed a dividend and
the company is not dissolved within 18 months of the payment, CGT event
G1 may apply: s 104-135 of the ITAA 1997. In that case, the cost base and
reduced cost base of the shares are reduced by the amount of distribution.
Any excess of the distribution over the cost base in general would be a
capital gain of the shareholder.
Imputation system Introduction [21.150]
Income tax law in general treats a company as a separate taxpayer from its
shareholders. One important implication is the possible double taxation on
the same economic income flowing through the company to its shareholders.
If assessable income flows through a company to its shareholder, the income
would be subject to income tax first at the company level and then again at
the shareholder level upon the distribution of profits from the company.
Case study 21.4: Double taxation issue
Assume a company derives $100 assessable income and pays $30 income
tax on the income. When it distributes the $70 to the shareholder as
dividend, the shareholder would have to pay income tax on the dividend. If
the shareholder does not receive any credit for the tax paid at the company
level, and assuming the shareholder’s marginal tax rate is 47%, the tax
liability at the shareholder’s level would be $70 × 47%, or about $33. The
total income tax paid on the $100 income under this scenario would be $63.
However, if the income is received directly by the shareholder without
passing through the company, the income tax would have been only $100 ×
47%, or $47.
This outcome violates the efficiency principle, which requires that the
income tax system should not, as far as possible, affect the business
decisions of taxpayers. In other words, the income tax law ideally should
achieve the same net tax result regardless of whether a taxpayer decides to
carry on a business as a sole trader or through a company. However, the
income tax system depicted in Case Study [21.4] (known as the classical
system) is biased against using a company as an investment vehicle.
The imputation system is one of the possible regimes addressing the “double
taxation” issue. The fundamental feature of the system is to allow a
shareholder to claim a tax relief for the amount of income tax paid by the
company on the profits out of which the dividend is paid.
Case study 21.5: Imputation system: basic operation
Going back to Case Study [21.4], under an imputation system, upon
receiving the $70 dividend, the shareholder would be required to calculate
its income tax based on the gross amount of income received by the
company (i.e., $100). The income tax so calculated (i.e., $47) would then be
offset by the amount of income tax paid by the company (i.e., $30), leaving
a net income tax liability of $17 for the shareholder. The total income tax
paid on the $100 income under this system would be $47, the same amount
as if the income is received directly by the shareholder.
Australia adopted the classical system from 1941 to 1987. The imputation
system was introduced on 1 July 1987 with the primary objective to avoid
the “double taxation” issue of the classical system. The current imputation
system in Pt 3-6 of the ITAA 1997 is a result of the recommendations of the
Ralph Report, aimed at simplifying the system.
The imputation system in essence operates on a “gross up and offset”
mechanism. In general, a shareholder is required to “gross up” its assessable
income by the amount of franking credit attached to the dividend received
from a company. Franking credits basically represent income tax paid by the
company. The shareholder is then allowed to claim a tax offset equal to that
amount of franking credit: see [21.160]–[21.260] for more details of the
system.
Implications for companies Franking a distribution [21.160]
An entity can frank a distribution only if it satisfies the following conditions:
1. it is a resident “franking entity”; and 2. the distribution is a “frankable
distribution”: s 202-5 of the ITAA 1997. “Franking entity” is in general
defined as a “corporate tax entity”, excluding a company acting as a
corporate trustee at the time of distribution: s 202-15 of the ITAA 1997.
“Corporate tax entity” means a company or an entity that is taxed as a
company under the income tax law (ie, corporate limited partnership,
corporate unit trust or public trading trust): s 960-115 of the ITAA 1997.
A franking entity has to be an Australian resident before it can frank a
distribution: s 202-20 of the ITAA 1997. An exception to the residency
requirement is a “NZ franking company”: Div 220 of the ITAA 1997. The
Division is designed specifically to deal with the Trans-Tasman triangular tax
issue but illustrates a more general and fundamental problem of the
imputation system: bias against non-residents (see [21.260] for a discussion
of the implications of the imputation system on non-residents). Under the
Division, in broad terms, a New Zealand resident company can elect for the
application of the Australian imputation system. It would then keep a
franking account in respect of Australian income tax (including withholding
tax) and frank distributions to Australian shareholders. Correspondingly, in
general, New Zealand also allows Australian resident companies similar
treatment under the New Zealand imputation system.
For a company, “distribution” is defined as “a dividend, or something that is
taken to be a dividend” under the income tax law: s 960-120(1) of the ITAA
1997. Not all distributions are frankable. “Frankable distribution” is defined in
a negative sense as a “distribution ... to the extent that it is not
unfrankable ...”: s 202-40 of the ITAA 1997. “Unfrankable distributions” are
listed in s 202-45 of the ITAA 1997, including deemed dividends under Div
7A, Pt III of the ITAA 1936 and distribution in respect of a non-equity share.
Franking credit attached to dividends [21.170]
If a company is a franking entity and makes a frankable distribution, it can
attach a “franking credit” to the distribution: s 202-5 of the ITAA 1997.

The maximum amount of franking credit that can be attached to a

distribution is determined by the following formula under s 202-60(2) of the
ITAA 1997:
Frankable distribution × corporate tax rate
1 − corporate tax rate
The corporate tax rate in the formula in general is 30%, unless the company
is a small business entity. In that case, the applicable corporate tax rate is
the reduced corporate tax rate for small business companies.
Basically, the maximum franking credit amount represents the amount of
income tax that the company could have paid in respect of the distribution.
For example, if a company which is subject to the standard corporate tax
rate of 30% pays a distribution of $70, the maximum franking credit that can
be attached to it would be:
$70 × 30% = $30
1 – 30%
The $30 represents the maximum amount of income tax that the company
could have paid on its profits (i.e., $100), out of which it can distribute the
$70.
A company can decide whether or not to frank a distribution and, if so, how
much franking credit to attach to the distribution (up to the amount of
maximum franking credit). It must give its shareholder a distribution
statement which states, among other things, the franking percentage for the
distribution: ss 202-75 and 202-80 of the ITAA 1997.
The accounting profit of a company would most likely be different from its
taxable income. A company may also derive income that is not subject to
income tax, for example, certain foreign sourced income. Therefore, a
company may not always be able to fully frank its distributions.
Case study 21.6: Franking credit attached to a dividend
Assume a company decides to pay a cash dividend of $70 and frank it to
80%. The franking credit attached to the dividend is:
$70 × 30% × 80% = $24
1 − 30%

Franking account [21.180]

In theory, a franking credit should represent income tax already paid by a
company on profits from which a distribution is made. It is therefore
important for a company to keep track of the amount of available franking
credits to frank its distributions. Every corporate tax entity must keep a
franking account: s 205-10 of the ITAA 1997. Before 1 July 2002, the account
was kept on a taxed profits basis, which created problems whenever the
corporate tax rate changed. The account is now kept on a tax paid basis. The
current basis is not only simpler but also aligns better conceptually with the
objectives of an imputation system.
Credits in general arise in the franking account of a franking entity if the
entity (s 205-15 of the ITAA 1997):
1. pays income tax or Pay As You Go (PAYG) instalments;
2. receives a franked distribution directly or indirectly through a partnership
or trust; or
3. incurs a liability to pay franking deficit tax.
Debits in general arise in the franking account of a resident franking entity if
it (s 205-30 of the ITAA 1997): 1. franks a distribution; 2. receives an income
tax refund; or 3. violates the benchmark rule due to under-franking (see
[21.270] for details).
Franking deficit tax [21.190]
The tax law allows corporate tax entities to frank distributions based on
“anticipated” franking credits: s 205-45(1) of the ITAA 1997. If a company is
allowed to do so indefinitely, the legislation would compromise the
fundamental objective of the imputation system. In other words, the system
would not be passing on the amount of income tax already paid by a
company to its shareholders in the form of franking credit. What happens if a
company over-franks its distributions and has a net debit balance in its
franking account at the end of the income year?
If a franking account is in deficit at the end of an income year, the franking
entity is required to pay a franking deficit tax: s 205-45(2) of the ITAA 1997.
The tax is equal to the amount of deficit in the franking account. As a credit
arises in the franking account of the entity when it incurs the liability to pay
franking deficit tax pursuant to s205-15 of the ITAA 1997, the debit balance
in the franking account is effectively cancelled out.

The franking deficit tax is in general not a penalty, as the amount of the tax
is available to the franking entity as a tax offset against its income liability: s
205-70(1) of the ITAA 1997. However, a penalty is imposed if the deficit is
excessive. The deficit is regarded as excessive if it exceeds 10% of the total
amount of franking credits arising in the income year: s 205-70(2) of the
ITAA 1997. In that case, the amount of tax offset generated from the
franking deficit tax is generally reduced by 30%.
Implications for shareholders [21.200]
“Gross up and tax offset” is the basic mechanism of the imputation system
on shareholders. In general, if a shareholder receives a franked distribution,
it has to “gross up” its assessable income by the amount of franking credit
attached to the distribution: s 207-20 of the ITAA 1997. In addition, the
shareholder is entitled to a tax offset equal to the same amount of the
“gross up”.
Case study 21.7: Gross up and tax offset
Assume a shareholder receives a $70 fully franked dividend. Under the
imputation system, the shareholder’s assessable income includes not only
the $70 dividend pursuant to s 44 of the ITAA 1936 but also the “gross up” of
$30, which is the amount of franking credit attached to the dividend. In
addition, the shareholder is entitled to a tax offset of $30 which can be used
to offset against its income tax liability.
The following sections deal with the tax implications of four types of
shareholders under the imputation system: 1. Resident individuals: see
[21.210]; 2. Resident companies: see [21.220]; 3. Resident partnerships and
trusts: see [21.250]; and 4. Non-residents: see [21.260].
Resident individual shareholders [21.210]
If an individual shareholder’s income tax liability is less than the amount of
tax offset, should the excess tax offset be refunded to the shareholder?
Theoretically, it should be so; otherwise, the imputation system would not
achieve the tax policy objective of efficiency as discussed in [21.150].

Case study 21.8: Refund of excess tax offset

Assume that assessable income of $100 passes through a company
to an individual shareholder with a marginal tax rate of 0%. The
company pays $30 income tax on the income and distributes $70 as
dividend to the shareholder. The shareholder would not be liable to
any income tax. Therefore, the net income received by the
shareholder is $70. This would be the end result if excess tax offset
is not refundable to the shareholder. However, if the income is
received directly by the shareholder without passing through the
company, the net income received by the shareholder would have
been $100.
Pursuant to the policy objective of efficiency, the excess tax offset should be
refunded to the shareholder. In that case, the shareholder would receive $70
dividend tax free and $30 tax refund. The total net income received by the
shareholder would then be the same in both scenarios, namely $100.
The imputation system in Australia did not allow refund of excess tax offsets
to individual shareholders until 1 July 2000. Now, tax offsets available under
Div 207 of the ITAA 1997 are in general refundable, except for certain
entities including:
1. a corporate tax entity (except certain exempt institutions and life
insurance companies);
2. a trustee who is liable to tax on a share of net income of a trust under s
98 or 99A of the ITAA 1936; and
3. a trustee of non-complying superannuation fund: s 67-25 of the ITAA
1997.
Resident corporate shareholders [21.220]
Upon receiving a franked dividend, a corporate shareholder is subject to the
same “gross up and tax offset” mechanism as for an individual. In addition, a
credit arises in its franking account: s 205-15 of the ITAA 1997. However, as
explained in [21.210], it is not entitled to a refund of any excess tax offset.
That may lead to a problem of “wasting losses/deductions”. The following
example illustrates the problem.
Case study 21.9: Excess tax offset for corporate shareholders
Assume Company Z has a carried forward loss of $200 and receives
a fully franked dividend of $70 and other assessable income of
$100. Assessable income of Company Z is $200, which, in the
absence of any specific provision to deal with the issue, would have
been fully offset by the carried forward loss. Company Z would not
have any tax liability but have an excess tax offset of $30 that is not
refundable. This is not the proper tax outcome. A fully franked
dividend should be effectively tax free in the hands of a corporate
shareholder, as its tax rate of 30% is the same as that for the
dividend payer. In other words, a fully franked dividend should not
reduce the amount of tax loss that should be available to Company
Z to offset against its other assessable income.
Since 1 July 2002, the tax law has specific provisions designed to
deal with this issue. Different measures are adopted to deal with
situations involving carried forward losses and losses generated in
the current year, respectively.
Excess franking offset: carried forward losses [21.230]
A corporate tax entity with a carried forward loss in general can choose the
amount of the loss to be utilised in the current income year: s 36-17 of the
ITAA 1997. It may choose to utilise none of the loss or any amount up to a
maximum above which would generate excess franking offset.
Case study 21.10: Excess tax offset and carried forward losses
Referring back to Case Study [21.9], pursuant to s 36-17, the
company may choose not to use any of the carried forward loss. In
that case, the company would have a tax liability of $60. With the
tax offset of $30 generated by the franking credit attached to the
dividend, the net tax payable would be $30, representing the
income tax payable on the other assessable income of $100. In
other words, the fully franked dividend would flow through
Company Z effectively tax free. Alternatively, the company may
choose to use up to $100 of the carried forward loss this year. In
that case, assessable income of Company Z net of the carried
forward loss would be $100. Income tax thereon is $30, which would
be fully offset by the franking tax offset. The company cannot
choose to utilise more than $100 of the carried forward loss.
Otherwise, excess tax offset would result.
Excess franking offset: current year loss [21.240]
If a corporate tax entity has an excess franking offset due to deductions in
the current year, in general, the excess franking offset is converted into a
tax loss at the prevailing corporate tax rate: s 36-55 of the ITAA 1997.

Case study 21.11: Excess tax offset and current year loss
Assume a company receives a fully franked dividend of $70 and has
a deduction of $200. Its assessable income is $70 (dividend) and
$30 (gross up), or $100. After deducting the $200 expenses, it has a
tax loss of $100. The excess franking offset is $30, which is
converted into additional tax loss of $30/30%, or $100. The total tax
loss that can be carried forward to future income years is therefore
$200.
Resident partnerships and trusts as shareholders [21.250]
Specific rules in subdiv 207-B of the ITAA 1997 are designed to trace franked
distributions through partnerships or trusts that are not corporate tax
entities. The objective is to ensure that partners, beneficiaries or trustees
would receive their corresponding shares of the distributions and franking
credits.
In broad terms, when a partnership receives a franked distribution, it follows
the general rule to gross up its assessable income by the amount of the
franking credit attached to the distribution for the purpose of working out its
net income or partnership loss: s 207-35 of the ITAA 1997. Each partner
would share the net income or partnership loss according to the partnership
agreement. A partner in general would also be entitled to a tax offset equal
to the amount of its share of the franking credit: s 207-45 of the ITAA 1997.
This is so even if the partner does not receive the full amount of its share of
the distribution (e.g., due to deductions at the partnership level): s 207-55 of
the ITAA 1997.
Case study 21.12: Franked distribution flowing through a
partnership
Assume a partnership has two resident individual partners sharing profits
and losses equally, and the only assessable income it derives this income
year is a $70 fully franked dividend.
The net income of the partnership is $100, making up of $70 dividend and
$30 gross up. Each partner will share $50 assessable income and $15
franking credit from the partnership. The $50 will be included in the
computation of each partner’s taxable income, and the resulting tax liability
will be reduced by the $15 tax offset.
Distributions flowing through a trust would be subject to similar tax
treatment. However, as any loss at the trust level cannot be attributed to the
beneficiaries or the trustee, franking credit is lost if the trust is in a tax loss
position.

Non-resident shareholders [21.260]

When a franked distribution is made directly to a non-resident individual or
corporate tax entity, the general rule of “gross up and tax offset” does not
apply: s 207-70 of the ITAA 1997. In other words, a non-resident shareholder
will not include any franking credit attached to the distribution in its
assessable income and will not be entitled to a tax offset representing that
franking credit.
Furthermore, a dividend paid to a non-resident is generally non-assessable
non-exempt income: s 128D of the ITAA 1936 (note that the term “foreign
resident” is used in the ITAA 1997 instead of “non-resident”: see [4.160]).
Instead, the non-resident may be subject to withholding tax on the
unfranked part of the dividend. See Chapter 22 for discussion of the
withholding tax regime.
For franked dividends that flow indirectly through partnerships and trusts to
a non-resident, the recipient can deduct from its assessable income an
amount equal to its share of franking credit attributable to the distribution: s
207-95 of the ITAA 1997. Effectively, the provision cancels out the non-
resident’s share of the “gross up” amount included in its assessable income.

Case study 21.13: Franked dividend flowing indirectly to non-

resident shareholders
Going back to Case Study [21.12], assume that one of the partners
is a non-resident individual. In this case, out of the $50 share of net
income of the partnership, the dividend portion of $35 is non-
assessable non-exempt income pursuant to s 128D of the ITAA
1936. In addition, the non-resident partner is entitled to a specific
deduction of $15, thus removing the gross up portion of his share of
the partnership’s net income. The end result is that the non-
resident partner has no net assessable income from the fully
franked dividend. In addition, the fully franked dividend is exempt
from withholding tax.
In summary, a non-resident recipient of a franked distribution is effectively
outside the scope of the imputation system. Its tax position may be less
favourable than that of a resident shareholder. This is because the non-
resident shareholder would not be able to claim any tax offset for the
amount of income tax paid at the company level. In effect, the non-resident
shareholder is taxed under a classical system.

Case study 21.14: Imputation system and non-resident shareholders

Assume a resident company receives $100 income and pays $30 tax
on it. If it distributes $70 fully franked dividend to a non-resident
individual shareholder, the dividend would be non-assessable non-
exempt income to the shareholder under s 128D of the ITAA 1936.
Assume further that the shareholder is subject to income tax in its
home country, which has a tax system similar to Australia. In that
case, the $70 dividend would be taxable to the shareholder at its
marginal tax rate without any relief for the franking credit attached
to the distribution. For instance, if the marginal tax rate for the
shareholder is 47%, the home country tax payable on the dividend
would be about $33. The total tax paid on the $100 income would
therefore be $63, which is much higher than that for a resident
shareholder (namely, $47).
The structural bias of an imputation system against non-resident
shareholders is one of the driving forces in many countries to
search for alternative corporate/ shareholder taxation systems. In
fact, most countries have already replaced their imputation systems
with other forms of dividend taxation regimes.
Measures protecting the imputation system
The benchmark rule [21.270]
Not every shareholder can enjoy the benefit of a franking credit attached to
a dividend. As discussed in [21.260], franking credits in general are of little
value to non-resident shareholders. Companies may have the incentive to
stream franked dividends to resident shareholders and unfranked dividends
to non-resident shareholders.
The Government believes that dividend streaming is unacceptable. Elaborate
anti-streaming provisions have been introduced to tackle such
arrangements. For instance, the benchmark rule was introduced on 1 July
2002 with a policy objective to “ensure that one member of a corporate tax
entity is not preferred over another when the entity franks distributions”: s
203-15 of the ITAA 1997. The rule requires that a corporate tax entity should
frank all distributions in a “franking period” to the same franking percentage
known as the “benchmark franking percentage”: s 203-25 of the ITAA 1997.

“Benchmark franking percentage” is effectively the franking percentage of

the first frankable distribution made by the entity in the franking period: s
203-30 of the ITAA 1997. For a private company, “franking period” is the
income year: s 203-45 of the ITAA 1997. For a public company, in general, an
income year has two franking periods: the first six-month period and the
following six-month period in the year: s 203-40 of the ITAA 1997.

If an entity over-franks a distribution under the benchmark rule, it is liable to

pay over-franking tax: s 203-50(1)(a) of the ITAA 1997. The tax is a penalty
as it does not generate any credit in the entity’s franking account, or any tax
offset for the entity. If an entity under-franks a distribution under the
benchmark rule, a franking debit arises in its franking account: s 203-50(1)
(b) of the ITAA 1997. This is again a penalty, as the franking debit cancels
out otherwise available franking credits in the franking account. An entity
may deviate from the benchmark rule if the Commissioner permits, but such
permission may be given only in extraordinary circumstances: s 203-55 of
the ITAA 1997.
The benchmark rule requires the same franking percentage to be applied to
all distributions made in a franking period. There are opportunities for
entities to circumvent the rule by franking distributions to different franking
percentages over different franking periods. For instance, a company may
make a fully franked distribution to resident shareholders in one year and an
unfranked distribution to non-resident shareholders in the next year.
The income tax law has specific provisions to deal with this issue. In
particular, if the benchmark franking percentages between franking periods
differ significantly, the entity must notify the Commissioner in writing: s 204-
75 of the ITAA 1997. For two adjacent franking periods, benchmark franking
percentages differ significantly if they differ by more than 20%. In that case,
the Commissioner is empowered to request further information from the
entity to determine whether the entity is streaming distributions: s 204-80 of
the ITAA 1997.
Qualified person [21.280]
Subdivision 207-F of the ITAA 1997 in general denies an entity from the
“gross up and tax offset” rule if it manipulates the imputation system,
including: 1. the entity receiving the franked distribution is not a “qualified
person”; 2. streaming distribution under s 204-30 of the ITAA 1997; 3.
dividend stripping operations; and 4. arrangements that trigger the
operation of the general anti-avoidance provision on imputation benefits
under s 177EA of the ITAA 1936.
The concept of “qualified person” is briefly discussed in the next two
sections. Detailed discussions of the other anti-avoidance provisions are
outside the scope of this book.
45-day holding period rule [21.290]
If a franked distribution is made to an entity that is not a “qualified person”,
the franking credit attached to the distribution is not included in the
assessable income of the entity, and the entity is not entitled to a
corresponding tax offset: s 207-145(1)(a) of the ITAA 1997. The primary
objective of the provision is to ensure that only the entity that effectively
bears the risk of holding the shares and enjoys the benefit of the distribution
is allowed to apply the “gross up and tax offset” rule.

The definition of “qualified person” was stipulated in Div 1A, Pt IIIAA of the
ITAA 1936 and is still applicable through the operation of s 207-145. In broad
terms, a shareholder is a qualified person if, among other things, it holds the
shares for a continuous period of at least 45 days during the “primary
qualification period”: s 160APHO of the ITAA 1936. If the shares are
preference shares as defined under s 160APHD of the ITAA 1936, the holding
period is extended to 90 days. “Primary qualification period” is defined to be
the period beginning on the day after the acquisition day of the shares and
ending on the 45th day after the ex-dividend day: s 160APHD of the ITAA
1936. If the shares are preference shares, the period is extended to end on
the 90th day after the ex-dividend day.
In counting the number of days of the continuous holding period, days on
which the taxpayer has materially diminished risks of loss or opportunities
for gain in respect of the shares are excluded: s 160APHO(3) of the ITAA
1936. In other words, the taxpayer has to be “at risk” in relation to the
shares. If the taxpayer is not in effect bearing the economic risks of holding
the shares, those days would not be counted towards the holding period. A
taxpayer is taken to have “materially diminished” risks of loss or
opportunities for gain if its net position in relation to the shares has been
less than 30% of those risks and opportunities: s 160APHM of the ITAA 1936.
The “net position” is worked out based on a financial concept known as
“delta”: s 160APHJ of the ITAA 1936. For example, a put option with a delta
of −0.5 reduces the risks and opportunities in relation to the shares by 50%.
Individual shareholders with relatively small shareholdings are exempt from
the “qualified person” test. In particular, an individual shareholder is exempt
if the amount of tax offset in question is not more than $5,000, and there is
no related payment with respect to the dividends: s 160APHT of the ITAA
1936.
Related payment rule [21.300]
If the shareholder has made, or will make, a “related payment” with respect
to the dividend, the holding period test is tightened. In particular, in that
case, the shareholder would have to satisfy the 45-day (or 90-day for
preference shares) holding period test during the “secondary qualification
period”, which is defined to be the period beginning on the 45th day before,
and ending on the 45th day after, the ex-dividend day: s 160APHD of the
ITAA 1936.

A “related payment” in general refers to any arrangement under which the

taxpayer in effect passes the benefit of the dividend to other persons: s
160APHN of the ITAA 1936. Examples include a payment made to another
person, provision of services, transfer of properties and offset of debts.
Company losses Introduction [21.310]
If deductions exceed a taxpayer’s total assessable income and net exempt
income, the excess is the taxpayer’s tax loss for the income year: s 36-10 of
the ITAA 1997. In general, the tax loss can be carried forward indefinitely to
offset against future taxable income of the taxpayer. In the 2020–2021
Budget, the Government announced that it will introduce a temporary loss
carry-back regime to support companies suffering a temporary shock as a
result of the COVID-19 pandemic.

In particular, companies with an aggregated turnover of less than $5 billion

can carry back tax losses incurred in 2019–2020, 2020–2021 and/or 2021–
2022 to offset against taxable income made in or after 2018–2019, and may
elect to receive a tax refund in their 2020–2021 and 2021–2022 tax returns.
As this is a temporary measure, detailed discussion of this loss carry-back
regime is outside of the scope of this book.
The separate legal entity principle for companies creates a problem with
respect to the entitlement to enjoy the benefit of carried forward losses. For
example, in Year 1, a company incurred a tax loss. In Year 2, all its
shareholders changed and then it generated taxable income. Should the new
shareholders (through the company) be entitled to enjoy the benefit of the
tax loss from Year 1?
The separate legal entity principle would suggest that the company, being a
separate legal entity, is the taxpayer who incurred the tax loss and thus
should be the one to utilise the tax loss. This would be so even if the
company’s shareholders have changed after the loss year. This was the
policy in Australia before 1944, and it led to significant “loss trafficking”
activities. Companies with tax losses were actively traded. They were bought
by taxpayers who would then utilise the tax losses to offset against their
taxable income.
Anti-avoidance provisions were introduced in 1944 to tackle these
arrangements involving revenue losses. Over the years, the anti-loss
trafficking provisions have become stricter and additional provisions were
enacted to cover other categories of losses, for example, net capital losses
after the introduction of the CGT regime, and unrealised losses in response
to the recommendations of the Ralph Report.

Carried forward realised losses [21.320]

A company in general cannot deduct a carried forward revenue loss unless it
satisfies either the continuity of ownership test (COT) or the business
continuity test (BCT): s 165-10 of the ITAA 1997.
The tests also apply to a company that incurs a revenue loss in the current
year: subdiv 165-B of the ITAA 1997. In broad terms, the company would
have to divide the income year into two periods: one before the majority
change of ownership and one after that change. Notional taxable income or
net loss is calculated separately for each period. Any notional net loss in one
period cannot offset against notional taxable income in the other period.
Similar rules apply to prior year net capital losses, current year net capital
losses and bad debts: subdivs 165-CA, 165-CB and 165-C of the ITAA 1997.
Continuity of ownership test [21.330]
To satisfy the COT, a company has to maintain the same majority owners
during the “ownership test period”. The test period is defined to be the
period from the start of the loss year to the end of the current income year: s
165-12(1) of the ITAA 1997. A company is regarded as maintaining the same
majority owners if at all times during the ownership test period, the same
persons hold: 1. more than 50% of the voting power in the company; 2.
rights to more than 50% of the company’s dividends; and 3. rights to more
than 50% of the company’s capital distributions: s 165-12 of the ITAA 1997.

Subdivision 165-D of the ITAA 1997 stipulates detailed rules on the COT. For
instance, in counting the voting, dividend or capital rights, the focus is on
persons who beneficially own shares that carry those rights in the company.
If the company has one or more corporate shareholders, the counting
focuses on non-corporate persons who have, or are reasonably assumed to
have, control directly or indirectly over those rights in the company. In other
words, in general, it is necessary to trace the rights to the ultimate individual
owners of those rights.
Case study 21.15: Continuity of ownership test
A company is wholly owned by Mr Boxx and carries on a shoe retail
business at a loss for the past couple of years. On 1 July, this
income year, Mr Boxx transferred 80% of the shares in the company
to his son George, who managed to turn around the company to a
profitable position.
The company fails COT on 1 July this income year. It cannot utilise
the carried forward losses to offset against the current year’s
taxable income unless it satisfies the same business test.

The COT is protected by a number of anti-avoidance provisions, including:

1. “Same share same person” rule

The COT in general would take into account only shares that are “exactly the
same shares and are held by the same persons”: s 165-165 of the ITAA
1997. This rule prevents the situation under which there is a majority change
of share ownerships between existing shareholders, but the shareholders
taken together remain the same group of persons. However, a company is
deemed to have satisfied the same share same person rule if it can
substantiate that less than 50% of the tax loss has been duplicated: s 165-
12(7) of the ITAA 1997. This saving rule is particularly helpful in situations
when a loss company issues new shares.
2. Change of control over voting power
Even if a company satisfies the COT, it is deemed to have failed the test if,
during the ownership test period, a person began to control directly or
indirectly voting power in the company for the purpose of getting tax
benefits for itself or someone else: s 165-15 of the ITAA 1997. In practice, it
may be very difficult for listed companies to satisfy the COT, especially for
those that are heavily traded in the stock exchange. The tax law provides
certain concessional treatments for listed companies: Div 166 of the ITAA
1997. In broad terms, it is sufficient for these companies to satisfy the COT
at certain designated points of time during the ownership test period. The
designated points of time are (a) the start of the loss year, (b) the end of the
current income year, (c) the end of each intervening year and (d) the time of
each “corporate change”: s 166-5 of the ITAA 1997. “Corporate change” is
defined in s 166-175 of the ITAA 1997 to include: 1. a takeover bid for shares
in the company; 2. any arrangement involving acquisition of more than 50%
of the company’s shares; and
3. an issue of shares in the company that results in an increase of 20% or
more in the issued share capital of the company or the number of shares on
issue.
Furthermore, all shareholdings of less than 10% in a listed company are
treated as if they are held by a single shareholder: s 166-225 of the ITAA
1997. This reduces the compliance costs of listed companies with respect to
the COT, as they would not have to trace the rights to the ultimate owners of
these shares.

Business continuity test [21.335]

If a company fails to satisfy the COT, it must satisfy the BCT before it can
deduct a tax loss: s 165-13 of the ITAA 1997. The BCT is satisfied if the
company satisfies either the same business test (SaBT) or the similar
business test (SiBT): s 165-210 and 165-211 of the ITAA 1997. These two
tests are explained in the following paragraphs.
Same business test [21.340]
A company satisfies the SaBT if in the current income year:
1. it carries on the same business as it carried on immediately before the
test time; and
2. it does not derive any assessable income from a new kind of business or a
new kind of transaction that it did not carry on or enter into before the test
time: s 165-210 of the ITAA 1997.
“Test time” is defined in general to be the time that the company fails the
COT: s 165-13 of the ITAA 1997. However, if it is not practical to show that
there is a period under which the company would satisfy the COT, the test
time would in general be the start of the loss year.
An anti-avoidance provision would deem a company as failing the SaBT if the
company started a new kind of business or entered into a new kind of
transaction before the test time and did so for the purpose of satisfying the
SaBT: s 165-210(3) of the ITAA 1997.
The meaning of “same” business is critically important. In Avondale Motors
(Parts) Pty Ltd v FCT (1971) 124 CLR 97, it was held that the same business
meant an identical business, not merely a similar business. However, in AGC
(Advances) Ltd v FCT (1975) 132 CLR 175, the High Court adopted a more
liberal interpretation and held that a company could still carry on the same
business even if it had changed its name, address and clientele.
Case study 21.16: Same business test
Going back to Case Study [21.15], Mr Boxx’s company can utilise
the carried forward losses only if it satisfies the SaBT. If the
company continues to run the shoe retail business in the current
year and the only change was to expand its business with an online
shop having the same trade name, it would most likely satisfy the
SaBT. However, if the company opened a new retail shop selling
clothes, it would likely to have failed the SaBT.

Tax Ruling TR 1999/9 explains the Australian Taxation Office’s (ATO) position
on the interpretation and application of the SaBT. It contains some
interesting examples suggesting that the ATO adopts a restrictive view on
the meaning of “same business”.
Similar business test [21.345]
SiBT was enacted in 2019 and applies retrospectively to income years
starting on or after 1 July 2015: s 165-211 of the ITAA 1997. The policy
objective of the test is to encourage innovation, and is expected to be easier
to satisfy than SaBT.
In broad terms, a company satisfies the SiBT if the business it carries on in
the current income year is similar to the business it carried on immediately
before the test time, which is typically the time when the company fails the
COT. Whether the current business is similar to the former business is a
question of facts. The law stipulates that besides other matters that may be
taken into account in ascertaining whether the businesses are similar, the
following four factors must be considered: s 165-211(2) of the ITAA 1997:

1. the extent to which assets used in the current business were also used in
the former business;
2. the extent to which the activities and operations of the current business
were also those of the former business;
3. the identity of the current business and that of the former business; and 4.
the extent to which changes to its former business result from development
or commercialisation of assets, products, processes, services, etc of the
former business.
For the purpose of protecting the SiBT from abuse, a company does not
satisfy the test if before the test time, it started to carry on a new business
or entered into a new kind of transaction, and did so for the purpose of
meeting the “similar” business requirement: s 1675-211(3) of the ITAA 1997.
Unrealised losses [21.350]
Companies might circumvent the COT by transferring shares in a company
that had assets with unrealised losses. In that case, even though there was a
majority change of ownership in the company, the two tests would not apply
as there was no tax loss in the company at the time of the ownership
change. The unrealised loss may then be realised by the company by
disposing of the asset.
Since 11 November 1999, the scope of the COT tests is extended to cover
unrealised losses. The extension was implemented in response to the
recommendations of the Ralph Report. The highly complex regime in subdiv
165-CC of the ITAA 1997 will apply if, in broad terms, a company fails the
COT in an income year, and it has an “unrealised net loss” at that change-
over time: s 165-115A(1) of the ITAA 1997. “Unrealised net loss” is worked
out under either of the following methods:

1. “individual asset method”: under this method, unrealised net loss is

calculated by adding up unrealised gain or loss of each CGT asset of the
company; or
2. “global method”: this method was introduced as a compliance cost saving
measure. Unrealised net loss is calculated by comparing a global market
valuation of all the CGT assets of the company against the total cost bases of
those assets: s 165-115E of the ITAA 1997.
The general effect of the regime is to disallow, up to the amount of the
unrealised net loss, subsequent realisation of losses from those CGT assets
that the company held at the change-over time: s 165-115B of the ITAA
1997. The disallowance does not apply if the company were able to satisfy
the BCT.
The major source of complexity arises from the market valuation
requirements. The Government has introduced a number of measures to
reduce the compliance costs of taxpayers, including:

1. a company satisfying the maximum net asset value test under the small
business relief regime (i.e., net asset value not more than $6 million) is
exempt from the subdivision: s 165-115A of the ITAA 1997; and
2. a CGT asset with acquisition cost less than $10,000 is exempt from the
application of the regime (provided the company elects to use “individual
asset method” to calculate unrealised net loss): s 165-115A(1B) of the ITAA
1997.
Multiplication of losses [21.360]
A loss incurred by a company may affect the value of shares in the company.
If we assume that the value of shares would be reduced by the amount of
loss incurred at the company level, there would be duplication of the loss at
the shareholder’s level. The effect would multiply in a company chain. The
same multiplication effect, of course, may occur for gains derived by a
company.
The Ralph Report recommended that anti-avoidance provisions should be
introduced to tackle the issue of multiplication of losses (but not gains). The
resulting legislation is the highly complex subdiv 165-CD of the ITAA 1997.
The subdivision in general applies if:

1. an “alteration time” occurs in respect of a company: “alteration time”

basically refers to the time when the company fails the COT: ss 165-115L
and 165-115M of the ITAA 1997; and

2. the company is a “loss company” at that time: a company is a loss

company if, among other things, it has carried forward tax losses or current
year tax loss in the income year, or “adjusted unrealised loss” at the
alteration time: s 165-115R of the ITAA 1997. Similar to subdiv 165-CC,
“adjusted unrealised loss” may be calculated under either the individual
asset method or the global method: s 165-115U of the ITAA 1997. However,
there is one important difference. Under the individual asset method in
subdiv 165-CD, only unrealised losses (but not unrealised gains) are taken
into account. This contrasts with the global method which takes into account
both unrealised gains and losses.
The general effect of subdiv 165-CD is to adjust the reduced cost bases of
“relevant equity interest” in the company, except those held by individuals:
ss 165-115ZA and 165-115X(5) of the ITAA 1997. The adjustment effectively
reduces the corresponding reduced cost bases by the amount of total
realised and unrealised losses of the loss company: s 165-115ZB of the ITAA
1997.
Case study 21.17: Multiplication of losses
Company P owns all the shares in Company S1 which in turn owns
all the shares in S2. The cost bases and reduced cost bases of the
shares in S1 and S2 are both $10 million. S1 has no other asset than
the shares in S2, while the only asset of S2 is a piece of land (cost
$10 million; market value $8 million). S1 sells all the shares in S2 to
a third party for $8 million.
S2 is a “loss company” for the purposes of subdiv 165-CD. The sale
of S2 by S1 triggers the operation of the subdivision which adjusts
the reduced cost bases of the shares in both S1 and S2 from $10
million to $8 million. As a result, S1 does not have any capital loss
on the sale of S2. Furthermore, if P sells S1 in future for its market
value of $8 million, it will not result in any capital loss.
An entity has a “relevant equity interest” in a loss company if, among other
things, it:

1. together with its associates, directly or indirectly, controls more than 50%
voting power, or has more than 50% of dividend rights or capital distribution
rights in the company: s 165-115Z of the ITAA 1997; and
2. alone has an interest that directly or indirectly controls at least 50%
voting power, or has at least 10% dividend or capital distribution rights, in
the company: s 165-115X(1) of the ITAA 1997.
Similar adjustments apply to significant debt interest in the loss company: s
165-115Y of the ITAA 1997.

Similar to subdiv 165-CC, the market valuation requirement under subdiv

165-CD imposes substantial compliance costs on taxpayers. Measures to
reduce compliance costs are basically the same as those for subdiv 165-CC.
Consolidation
Introduction [21.370]
The tax consolidation regime was introduced in Australia on 1 July 2002. It
represents a fundamental change to corporate taxation and is one of the
most important tax reform items recommended by the Ralph Report. If a
group elects to consolidate, in general, the whole group will be treated as a
single entity under the income tax law. This is despite the fact that the
parent company and its subsidiary companies are separate legal entities for
general law purposes.
The consolidation regime is highly complex and consists of over 600 pages
of technically challenging legislation. The ATO has devoted substantial
resources to implement the regime. In particular, it has published and
continuously updates the Consolidation Reference Manual of over 1,300
pages.
Policy objectives [21.380]
In theory, a group of entities may be allowed to consolidate if they are
economically so integrated that they should be treated as a single entity for
income tax purposes. Many tax consolidation regimes require an ownership
level equal or close to 100% between group members.
The policy objectives of Australia’s consolidation regime are stipulated in s
700-10 of the ITAA 1997:
1. to prevent double taxation of the same economic gain realised by a
consolidated group;
2. to prevent duplication of the same economic loss realised by a
consolidated group; and
3. to reduce compliance costs and improve business efficiency by removing
complexities and promoting simplicity in the taxation of wholly owned
groups.
It is doubtful that, in view of the sheer volume of the legislation and related
materials on the consolidation regime, the last objective is achieved.

Membership requirements [21.390]

A resident company (known as the “head company”) with all its wholly
owned resident subsidiaries may elect to form a consolidated group:

s 703-10 of the ITAA 1997. Once the election is made, it is irrevocable: s 703-
50 of the ITAA 1997. Also, the “all in” rule applies, meaning that once an
election is made to consolidate, all eligible group members must join the
consolidation. The head company in general must be a resident company
subject to the normal corporate tax rate and cannot be a member of another
consolidated group: s 703-15(2) Item 1 of the ITAA 1997. Certain corporate
unit trusts and public trading trusts may also elect to be a head company: s
713-130 of the ITAA 1997.
Subsidiary members of a consolidated group can be a company, partnership
or trust and must be an Australian resident and a “wholly owned subsidiary”
of the head company: s 703-15(1) Item 2 of the ITAA 1997. An entity is a
“wholly owned subsidiary” of the head company if the head company
beneficially owns all the membership interests in the subsidiary: s 703-30 of
the ITAA 1997. “Membership interest” is defined based on the concept of
“members” of an entity. “Members” of entities are defined in s 960-130 of
the ITAA 1997 as follows:
Entity Member
Company A member of the company or a stockholder in
a company
Partnership A partner in the partnership
Trust (except corporate unit trust A beneficiary, unit holder or object of the
trust
or public unit trust)
Corporate unit trust or public unit A unit holder of the trust
trust
In other words, a member of a company is defined literally to be “a member
of a company”. Without further guidance from the tax legislation, the term is
taken to mean a “member” of a company under the Corporations Act 2001.
For companies limited by shares, in general, “member” refers to a
shareholder. This definition of “membership interests” that relies solely on
shareholding is uncommon in other countries’ consolidation regimes.
Arguably, it ignores more relevant factors in deciding whether a group
should be eligible for tax consolidation, for example, voting power. The
definition also lacks specific rules to deal with options or convertible
securities.
In determining whether a subsidiary is wholly owned by a head company,
shareholdings in a company issued under certain employee share schemes
are ignored, provided those shares account for not more than 1% of the
ordinary shares in the company: s 703-35 of the ITAA 1997.

Case study 21.18: Corporate groups eligible to consolidate

Consider the following corporate group:

All the six companies except S4 are resident of Australia. P owns all
the shares directly in S1 to S4 (except 1% shares in S3 being owned
by employees of the group under an employee share scheme) and
indirectly in S5. P can elect to form a consolidated group with S1,
S2, S3 and S5. S4 cannot join the consolidated group as it is a non-
resident company

Multiple entry consolidated groups [21.400]

In addition to the general consolidation rules catering for domestically
owned groups, Australia provides a more flexible consolidation regime for
groups owned by foreign parents, known as the Multiple Entry Consolidated
Group (MEC group) regime. In broad terms, if more than one company
(known as “tier-1 companies”) in Australia are direct wholly owned
subsidiaries of a foreign company, any two or more of the tier-1 companies
(and their wholly owned subsidiaries) may elect to form an MEC group: s
719-5 of the ITAA 1997. One of those tier-1 companies would be the “head
company” of the group.
Case study 21.19: Multiple entry consolidated group
Consider the same corporate group in Case Study [21.17], except
that P is a non-resident company. In this case, S1, S2 and S3 are
tier-1 companies. They can decide which companies to form an MEC
group. The possible combinations include:
1. all three companies (together with S5) form an MEC group;
2. S1 (together with S5) forms an MEC group with either S2 or S3;
and
3. S2 and S3 form an MEC group while S1 forms a separate
consolidated group with S5.

It is not clear why foreign-owned groups are allowed to cherry pick entities to
consolidate. This contrasts the strict “all in” rule for domestically owned
groups.
Implications of electing to consolidate
The single entity rule [21.410]
If a group elects to consolidate, in general, the whole group would be treated
as a single entity for income tax purposes. In particular, all subsidiary
members of the head company are taken to be “parts of the head company
of the group, rather than separate entities” for the purposes of computing
income tax liabilities and losses of the head company and the subsidiaries: s
701-1 of the ITAA 1997. This is known as the single entity rule (SER). In other
words, subsidiaries are treated as divisions within the head company under
the consolidation regime. An important implication is that assets of a
consolidated subsidiary are deemed to be held directly by the head
company, triggering a complex set of cost bases adjustment rules (see
[21.440] for more detail).
A consolidated group has to file only one single income tax return. Intra-
group transactions in general will be ignored under the income tax law.
Intuitively, the regime is quite attractive as, prima facie, it may imply lower
compliance costs. However, it is doubtful whether that is achieved in
practice. There is constant tension between the single entity concept under
consolidation and the separate legal entity principle that applies in general
in other parts of the income tax law (see, e.g., the difficulty of applying the
general anti-avoidance provisions to a consolidated group in Commissioner
of Taxation v Macquarie Bank Ltd [2013] FCAFC 13). This constant pressure
on the implementation of the consolidation regime often results in complex
provisions, and specific overrides of the SER are not uncommon. The position
of the ATO on the SER is stated in Ruling TR 2004/11.
The entry and exit history rules [21.420]
Upon consolidation, all subsidiary members become “parts” of the head
company. To ensure that the head company can inherit tax attributes of the
subsidiaries under the SER, the entry history rule applies. Under that rule,
“everything that happened in relation to [a subsidiary] before it became a
subsidiary member is taken to have happened in relation to the head
company”: s 701-5 of the ITAA 1997.
If a subsidiary member leaves a consolidated group, the exit history rule
applies to ensure that the subsidiary can inherit relevant tax attributes from
the head company: s 701-40 of the ITAA 1997. The rule applies to all assets
and liabilities that the subsidiary takes with it when it leaves the group.

Liability to tax [21.430]

Under the SER, a consolidated group is effectively treated as an “inflated”
version of the head company. It follows that the head company has the
primary obligation to pay the consolidated group’s tax liability.
If the head company fails to meet all its income tax liabilities by the due
date, the head company and each subsidiary of the group in general are
jointly and severally liable for the liabilities: s 721-15 of the ITAA 1997. This
is so even if the subsidiary has been a member of the group for just a part of
the period to which the liability relates: s 721-10(1) of the ITAA 1997.
Group members may avoid the joint and several liability if a valid tax sharing
agreement is in place to cover that liability. To be effective, a tax sharing
agreement has to satisfy requirements stipulated in s 721-25 of the ITAA
1997, including:

1. the amount of tax liability allocated to each subsidiary represents a

reasonable allocation of the total amount of the group liability; and
2. the tax sharing agreement is not entered into as part of an arrangement
with a purpose to prejudice the recovery of the group liability by the
Commissioner.
Pre-consolidation losses [21.440]
The major advantage of consolidation is intra-group loss offset among group
members during consolidation. A difficult policy issue arises in respect of
losses that a subsidiary has incurred before joining a consolidated group.
Should the pre-consolidation losses be allowed to transfer to the head
company and, if so, should there be any restrictions on the rate of utilisation
of the losses?
Intuitively, assuming the subsidiary would have satisfied the loss
recoupment tests (namely, the COT and BCT discussed at [21.330], [21.340])
if it has not joined the consolidated group, consistent application of the SER
and the entry history rule would imply that the pre-consolidation losses
should be deemed to have been incurred by the head company and should
be available to offset against the head company’s future taxable income.
In Australia, pre-consolidation losses of a subsidiary can be transferred to the
head company if it would have satisfied modified COT and BCT tests at the
joining time: s 707-120 of the ITAA 1997. However, in fear of substantial
revenue impact upon the introduction of the consolidation regime, the
government imposed additional restrictions on the rate at which a head
company may utilise pre-consolidation losses brought into the group by a
subsidiary member. The measure designed to achieve this purpose is known
as the “available fraction” rule. In broad terms, the maximum amount of pre-
consolidation losses of a subsidiary that can be utilised by a head company
in an income year is limited to the following amount (s 707-310 of the ITAA
1997):
Available fraction × head company’s taxable income for the year
The main principle underlying the design of “available fraction” is stipulated
in s 707-305(3) of the ITAA 1997:
[T] he amount of the loss that the [head company] can utilise is to reflect
the amount of the loss that the [subsidiary] could have utilised for the
income year if the [subsidiary] ... had not become a member of a
consolidated group.
However, “available fraction” for a subsidiary’s loss is basically defined in
terms of the ratio of the market value of the subsidiary at the time of the
loss transfer to the market value of the group at that time: s 707-320 of the
ITAA 1997. It is doubtful if such a ratio – which is not adjusted regularly to
reflect the prevailing market values of the subsidiary relative to the group –
can properly achieve the stated principle.
Case study 21.20: Available fraction for pre-consolidation losses
P owns all the shares in S and elects to consolidate on 1 July. S has
$10 million pre-consolidation losses and is transferred to P upon
consolidation. The available fraction of this loss determined on the
date of consolidation is 0.3. The taxable income of P and S for the
income year is $3 million and $9 million, respectively.
In this case, the consolidated taxable income of the group is $12
million. Though S generated $9 million taxable income, the amount
of pre-consolidation losses that can be used by P in the income year
is limited to $12 million × 0.3, or $3.6 million.
The formula to compute the “available fraction” may create anomalous
results; for example, the fraction may be more than one, zero or even
negative. The tax law contains several arbitrary rules to deal with these
situations: s 707-320 of the ITAA 1997.
Another feature of the consolidation regime with respect to pre-consolidation
losses is that if a subsidiary member leaves a group, it cannot take away the
remaining losses from the group: s 707-410 of the ITAA 1997. The amount
stays with the head company.

The tax cost setting rules [21.450]

During consolidation, intra-group transfers of assets are ignored as all
subsidiaries are treated as divisions of the head company. If a subsidiary
subsequently leaves the group, the tax law has to determine the tax cost
bases of both the membership interests in the subsidiary and the assets
taken away by the subsidiary. For this purpose, Australia adopts the asset-
based model, as recommended by the Ralph Report. The corresponding
rules, known as the tax cost setting rules (TCS rules), are highly complex.
When a subsidiary joins a consolidated group, the TCS rules apply with the
general effect of allocating the head company’s acquisition costs of the
membership interests in the subsidiary (adjusted for the accounting liabilities
of the company and other items) to the underlying assets held by the
subsidiary: s 701-10 of the ITAA 1997. Assets of the subsidiary (except
retained cost bases assets) are assigned reset cost bases which replaced the
original cost bases forever, even after the subsidiary subsequently leaves
the group. It is possible for an asset to receive a “step-up” cost base under
the TCS rules.
The TCS rules also apply when a subsidiary leaves a group. The objective of
the rules in this respect is to reconstitute the cost bases of the membership
interests in the subsidiary by basically adding together the cost bases
(including reset cost bases) of assets taken away by the subsidiary, reduced
by the amount of its liabilities: s 701-15 of the ITAA 1997. Under the exit
history rule, the subsidiary inherits the tax costs of assets from the head
company.
Case study 21.21: Tax cost setting rules
[This case study is based on the example at [C2-2-110] of the ATO’s
Consolidation Reference Manual, which detailed the complex
calculation involved in arriving at the reset cost bases.]
P acquired 40% shares in S in 2001 when S had a piece of land with
both cost base and market value equal to $100. P acquired all the
remaining shares in S in 2002 and elected to consolidate. At that
time, both the cost base and market value of the land remain $100.
Upon consolidation, the TCS calculation determines that the reset
cost base of the land is $74. If the group now sells the land to a
third party for its market value of $100, it will derive a capital gain
of $26. This is so despite the market value of the land remaining to
be the same as the original cost base.

Questions [21.460]
21.1 A resident company pays a fully franked dividend of $700 to a
resident shareholder. Advise the income tax implications of the
shareholder if it is:
(a) an individual subject to the top marginal tax rate;
(b) an individual with marginal tax rate of 19%;
(c) a company with other assessable income of $8,000 and a carried
forward loss of $12,000;
(d) a company with other assessable income of $9,000 and
deductions of $16,000; and
(e) a partnership with two resident individual partners sharing
equally partnership profits or losses.
21.2 A resident company pays a dividend of $1,400 (franked to 60%)
to a non-resident shareholder. Advise the Australian income tax
implications of the shareholder if it is:
(a) an individual living in the United States;
(b) a US company holding 20% shares in the resident company; and
(c) a US company holding all the shares in the resident company.
21.3 A resident company, owned by two resident individuals, has an
opening credit balance of $7,000 in its franking account in this
income year. It has the following transactions in the year:
• on 18 July, it paid a PAYG instalment of $30,000;
• on 29 August, it paid a $35,000 cash dividend franked to 80%;
• on 3 September, it received a $28,000 cash dividend franked to
90%;
• on 21 September, it paid a $7,000 cash dividend with franking
credits of $1,800 attached;
• on 5 October, salaries paid to one of its shareholders were
deemed to be dividends under Div 7A of the ITAA 1936. The amount
of deemed dividend was $21,000;
• on 2 February, it received an income tax refund of $18,000 from
the ATO;
• on 10 March, it paid a $20,000 cash dividend franked to 95%; • it
had a $90,000 PAYG instalment due on 21 April but did not pay it
until 3 July in the following income year. Prepare the company’s
franking account for this income year.

21.4 Yumyum Thai Pty Ltd is in the business of running a Thai

restaurant, serving traditional Thai food. It has two shareholders,
Gary and Matt. Gary held 75% of the shares in company while Matt
held 25%. After a decade of profitable operation, the company
incurred tax losses of $200,000 in each of the last two income
years. Gary sold two-thirds of his shares to Matt on 1 July in this
income year. Gary now holds 25% of the shares in the company and
Matt holds 75%. Gary incurred a capital loss of $300,000 in the
share disposal. Immediately after the share transfer, Matt
introduced a new menu in the restaurant. Instead of traditional Thai
dishes, the new menu features largely French dishes with hint of
Thai flavour. The name and decoration of the restaurant was also
changed to reflect the new menu. The company also published a
cookbook in October this income year featuring the signature
dishes of the restaurant. The book was a bestseller, contributing a
significant amount of revenue to the company. The company turned
around in the income year and became profitable again.
Advise whether the company can use the carry forward losses in
this income year.
21.5 Green Planet Pty Ltd was incorporated to research and develop
a new technology to produce biodegradable plastic from seaweed.
After making losses for several years, a venture capital company
purchased 60% of the shares in the company. The company then
discovered that the “seaweed to plastic” technology can also be
used to make an organic fertiliser. This new product contributed
40% of the turnover of the company, which turned around and made
a profit in the current income year.
Advise whether the company can use the carry forward losses in
this income year.
21.6 P has three wholly owned subsidiaries S1, S2 and S3. All the
four companies are incorporated in Australia. P holds directly all the
shares in S1 and S2. Shares in S3 are held through S4, another
wholly owned subsidiary of P incorporated in Bermuda. In this
income year, P has a taxable income of $2 million. S1 has a tax loss
of $10 million, in addition to its brought forward losses of $80
million. S2 has a taxable income of $60 million. S3 has a taxable
income of $10 million. S4 has no income or loss.
The group seeks your advice on its eligibility to consolidate for
income tax purposes and the tax implications of such an election.
Advise the group of the income tax implications with respect to
consolidation, including:
(a) Is this corporate group eligible to consolidate?
(b) If so, will you recommend the group to consolidate and why?
(c) If the election to consolidate is made, what are the tax
implications for the group, including the cost bases of assets in the
group and the accumulated losses in S1?
(d) What will be the tax consequences if P sells all shares in S1 a
year later for $20 million?
21.7 P, a company incorporated in Australia, is the head company of
a tax consolidated group with a wholly owned subsidiary S1. P
acquired all the shares in S2, a company incorporated in Australia,
on 1 July this income year. S2 had $20 million unused tax losses
which were transferred to P upon consolidation. The available
fraction for this bundle of losses is 0.3.
The following income and expenses were recorded for the
respective companies in this income year:
• P: dividend income of $2 million from S1.
• S1: sales income of $80 million on sales to S2, with production
costs of $65 million.
• S2: sales income of $100 million on sales to third party customers.
The company incurred purchase costs of $80 million for the goods
from S1. It also incurred marketing expenses of $8 million. S2 made
a capital gain of $15 million from a sale of a piece of land. The land
was acquired in 2006. The gain was calculated on a company stand-
alone basis, based on the original cost base of the land of $10
million. The reset cost base of the land was $12 million. Explain the
Australian income tax implications of the above transactions, and
calculate the income tax payable by P for this income year.
21.8 P is a non-resident company and owns all the shares in three
Australian resident companies, A, B and C. B owns all the shares in
D, another resident company. A owns 90% of the shares in E, a
resident company. The other 10% is held directly by P. How many
different consolidated groups may be formed under the Australian
consolidation regime?
How will your answer be different if P is a resident of Australia? Do
you think the different treatments between domestic and overseas
corporate groups are justified?
21.9 Gary, an Australian resident, is the sole shareholder of MC Pty
Ltd, a company incorporated in Australia. In this income year, MC
Pty Ltd made an interest-free loan of $80,000 to Gary. By the
income year end, the company waived 30% of the loan. The balance
of the loan remains outstanding by the company’s lodgement date.
The company’s distributable surplus for the income year is $60,000.
Advise the tax implications of the above transaction for Gary. How
will your answer be different if the shareholder of MC Pty Ltd is a
wholly owned subsidiary of another company incorporated in
Australia?

Chapter 23 - Tax avoidance

Key
points ............................................................................................
....... [23.00]
Introduction...................................................................................
............. [23.10]
Specific vs general anti-avoidance
provisions ........................................ [23.20]
Common tax avoidance
techniques ......................................................... [23.30]
Avoiding Australian-sourced income by non-residents ....................
[23.40]
Deferring income derivation or accelerating deductions ..................
[23.50]
Income splitting between family
members ....................................... [23.60]
Converting income to
capital.............................................................. [23.70]
Choice of
entity ...................................................................................
[23.80]
Use of tax
shelters...............................................................................
[23.90]
International tax
avoidance............................................................... [23.100]
Tax rate
arbitrage ..................................................................................
[23.102]
Hybrid
entities .......................................................................................
[23.104]
Hybrid
instruments ...............................................................................
[23.106]
Specific anti-avoidance
provisions......................................................... [23.110]
Non-arm’s length prices between associated parties .....................
[23.120]
Transfer of right to income from property .......................................
[23.130]
Deemed dividends for private companies .......................................
[23.140]
Non-commercial
losses .................................................................... [23.150]
Personal services
income ................................................................. [23.160]
What is personal services
income? ...................................................... [23.170]
Deductions with respect to personal services
income ....................... [23.180]
Personal services
business ..................................................................... [23.190]
Results
test ........................................................................................
[23.200]
Unrelated clients
test ........................................................................ [23.210]
Employment
test ............................................................................... [23.220]
Business premises
test ..................................................................... [23.230]
Personal services business
determination .......................................... [23.240]
Specific anti-avoidance regimes for international transactions ......
[23.250]
General anti-avoidance provision – Part
IVA ........................................ [23.260]

Introduction ...................................................................................
.... [23.260]
Key elements of Pt
IVA ..................................................................... [23.270]
Scheme .........................................................................................
......... [23.280]
Tax
benefit ..........................................................................................
... [23.290]
Dominant
purpose ................................................................................
[23.300]
High Court case on Pt
IVA ................................................................ [23.310]
Application of Part IVA to specific
transactions ................................... [23.320]
Leasing..........................................................................................
..... [23.320]
Agricultural
schemes ........................................................................ [23.330]
CGT losses through wash
sales ....................................................... [23.340]
Questions ......................................................................................
............ [23.350]
Key points [23.00]
• Tax evasion is illegal, involving fraud by telling lies to the ATO, deliberate
concealment of material facts or entering into sham transactions. In
contrast, tax avoidance is not illegal in the sense that a taxpayer attempts to
use lawful means to reduce tax liability.
• Legitimate tax planning consists of taking advantage of concessions and
loopholes in the tax law.
• The tax law has numerous specific anti-avoidance provisions which are
designed to deal with particular tax avoidance arrangements.
• Part IVA of the Income Tax Assessment Act 1936 (Cth) (ITAA 1936) contains
a general anti-avoidance regime designed to deal with tax avoidance
arrangements that are not addressed by specific anti-avoidance provisions. It
is not self-enforcing. The Commissioner must determine if a person has
entered into a scheme for the sole or dominant purpose of enabling a
taxpayer to obtain a tax benefit from the scheme. If so, the Commissioner is
empowered to cancel the tax benefit.
• There are eight criteria set out in s 177D(b) of the ITAA 1936 to ascertain
the objective purpose of a person entering into the scheme. The subjective
purpose is not relevant.
Introduction [23.10]
Tax minimisation arrangements represent a spectrum ranging from
legitimate tax planning through to blatant tax avoidance and, ultimately, tax
evasion. Tax evasion involves the reduction or elimination of tax liability by
illegal means, such as fraudulent concealment of transactions, supplying
false information to the Australian Taxation Office (ATO), entering into sham
transactions or the simple refusal to pay tax by companies operated through
dummy directors as occurred in the bottom-of-the-harbour schemes of the
1980s. In contrast, tax avoidance is not illegal. Nevertheless, the transaction
may be prohibited by specific anti-avoidance provisions or the general anti-
avoidance provision in Pt IVA of the Income Tax Assessment Act 1936 (Cth)
(ITAA 1936).
Leaving aside tax evasion, there is difficulty distinguishing between
acceptable tax planning and unacceptable tax avoidance that should be
subject to the general anti-avoidance provision. For example, a taxpayer has
a legitimate commercial transaction which can be achieved by two different
methods, one of which results in the paying of less tax. Should the taxpayer
be obliged to adopt a course of action resulting in a greater tax liability? The
High Court in Fletcher v FCT (1991) 173 CLR 1 stated that taxpayers were
not in general obliged to structure transactions in such a way as to attract
greater tax liability.
Case study 23.1: Entitlement to minimise tax liability
IRC v Duke of Westminster [1936] AC 1 is the general starting point
of discussions on tax avoidance. In that case, the Duke employed a
gardener for domestic purposes so that the salary was not
deductible. The employment contract was discharged and the
gardener was given an annuity which guaranteed the same
payments as the employment contract, but imposed no obligation to
work. The gardener continued to carry out the same work as when
he was employed. Under the UK law as it then stood, the Duke was
entitled to a deduction for this arrangement. The House of Lords
held that there was no basis for construing the annuity as
equivalent in substance to the earlier arrangement. Their Lordships
affirmed the principle that every person is entitled to order his (or
her) affairs so as to attract the least tax.
Figure 23.1 lays out the key issues discussed in this chapter.

Specific vs general anti-avoidance provisions [23.20]

The income tax law has numerous specific anti-avoidance provisions which
are designed to deal with particular tax avoidance arrangements. For
example, dividend made by a private company to its shareholder that is
disguised as a loan to the shareholder is one of the targets of the specific
anti-avoidance provisions in Div 7A of the ITAA 1936 (see [23.140]).
In contrast, the general anti-avoidance provision in Pt IVA of the ITAA 1936
has no specific target. Instead, it is designed to tackle any tax avoidance
scheme provided the Commissioner determines that the scheme should be
subject to Pt IVA (see [23.260]). In general, if a tax avoidance transaction is
subject to both a specific anti-avoidance provision and Pt IVA, the former has
priority.
Common tax avoidance techniques [23.30]
There are many techniques of tax avoidance. Nevertheless, certain themes
recur, some of which are briefly discussed in the following paragraphs.
Avoiding Australian-sourced income by non-residents [23.40] This occurs
frequently in the mining industry where a project between an Australian
resident and a non-resident is set up as a joint venture that does not
constitute a partnership and where agency is specifically excluded. The
Australian party will perform activities within Australia and be liable to tax.
The non-resident will perform activities outside Australia deriving foreign-
sourced income which is not subject to Australian income tax.
The government enacted s 6CA of the ITAA 1936 to ensure that in general it
has the taxing right over income derived from natural resources of Australia.
In particular, the section deems that in broad terms income derived by a
non-resident from natural resources produced or recovered in Australia to be
of an Australian source.
Deferring income derivation or accelerating deductions [23.50]
Following Arthur Murray (NSW) Pty Ltd v FCT (1965) 114 CLR 314,
prepayments of income for services are generally derived when the services
are provided in later years. In this regard, the tax law principle is consistent
with the accounting principles.

In contrast, the meaning of “incurred” does not depend on the actual

payment date. Many structures were designed to exploit this particular tax
accounting rule (eg, from FCT v Australian Guarantee Corporation Ltd (1984)
15 ATR 982 to FCT v Citilink Melbourne Ltd (2006) 62 ATR 648). Most of these
timing advantages are now eliminated under the Taxation of Financial
Arrangements (TOFA) rules (see [9.70]).
Specific anti-avoidance provisions were enacted to deal with prepayments
which are designed to accelerate deduction: subdiv H of Div 3 of Pt III of the
ITAA 1936 (see Chapter 16 for a discussion of the rules).
Income splitting between family members [23.60]
Income splitting between family members is a typical example of tax
arbitrage designed to take advantage of the different tax profiles of the
family members. For example, in a discretionary trust, income may be
distributed to children over 18 who are subject to low marginal tax rates,
capital gains may be distributed to beneficiaries who have capital losses,
and a corporate beneficiary may cap the overall tax rate to 30%.
As tax rates have been progressively flattened over the last 20 years, this
technique is less critical than it used to be. The top marginal tax rate at one
stage was 66% and in the early 1980s was 60%, which applied to an income
of $34,000 a year. The top marginal tax rate now is 46.5%, which still
provides incentive to this technique.
Converting income to capital [23.70]
Ever since the enactment of the Commonwealth income tax legislation in
1915, it has been conventional wisdom that it is better to have a capital
receipt than an income receipt. This was especially true before CGT was
introduced in 1985. Capital receipt may remain preferable for taxpayers with
pre-CGT assets, and individuals who are eligible for the 50% discount (see
Chapter 11 for a discussion of the CGT rules).
Choice of entity [23.80]
Partnerships and trusts have the advantage that in general the character of
income is preserved upon distribution to the partners and beneficiaries
respectively. Any CGT concession at the partnership or discretionary trust
level flows through to the individuals concerned. Furthermore, as
discretionary trusts are not subject to CGT event E4, they do not suffer from
the clawback of tax preferences. In contrast, regardless of the character of
income at the company level, distributions of profits to shareholders will in
most cases be dividends and thus taxable to the shareholders. See the
respective chapters on the taxation of entities for more discussion of the
rules.

Use of tax shelters [23.90]

Tax shelter is not a defined term in the tax law. In general, it refers to a legal
method of minimising a taxpayer’s tax liability and ranges from particular
forms of investment that provide favourable tax treatment to particular
activities or transactions that reduce taxable income.
Examples include superannuation and main residence exemptions. They are
specific concessions provided in the tax law and can be regarded as
legitimate tax planning. For instance, taxpayers may salary sacrifice future
income for which services have not already been provided into
superannuation giving an effective tax rate of 15% (see Chapter 18 for
discussion of the rules).

International tax avoidance [23.100]

Globalisation provides opportunities for multinational enterprises (MNEs) to
engage in international tax avoidance. They can achieve tax arbitrage not
only within the domestic tax provisions, but also between the differential tax
treatments offered by different countries. Detailed discussion of these issues
is beyond the scope of this book. The following paragraphs aim to provide
three examples illustrating some of the basic techniques of international tax
avoidance.
Tax rate arbitrage [23.102]
MNEs may take advantage of the different tax rates applicable to their
subsidiaries and shift profits to the low-tax countries. For example, if a
foreign subsidiary enjoys a flat 10% tax rate on its income, while the parent
company in Australia is subject to tax at 30%, the tax rate differential
creates incentive for the group to shift profits from Australia to the low-tax
subsidiary by say creating intra-group payments from the parent to the
subsidiary. This is achievable as the group operates as one single enterprise
in substance, while the international tax rules in general adopt the separate
entity doctrine under which each company is treated as a separate taxpayer.
Of course, in practice, the structure has to be carefully designed to avoid the
application of anti-avoidance provisions, including transfer pricing and thin
capitalisation regimes (see Chapter 22 for discussion of these regimes).

Hybrid entities [23.104]

International tax arbitrage can be achieved by exploiting the different
treatments of an entity in two countries. Hybrid entities in general refer to
entities that are treated as a company in one country and as a look-through
entity (e g, a branch or partnership) in another country. Double deduction
may be achieved through the use of hybrid entities. For example, an entity is
treated as a company in Australia and thus can deduct its expenses here. If
the entity is treated as a look-through entity in another country, the same
expenses would be regarded as incurred by the shareholders in that country
and thus deductible again in the shareholders’ tax returns. These “double
dip” structures are the targets of the deducting hybrid mismatch rules in
subdiv 832-G of the ITAA 1997.
Hybrid instruments [23.106]
Again, different tax treatments of a financial instrument in two countries
may give rise to tax arbitrage opportunities. For example, an Australian
company has a wholly owned subsidiary in a foreign country. It issued
financial instruments to the subsidiary, which are treated as shares for
Australian income tax purposes.
Therefore, dividends paid by the subsidiary are non-assessable non-exempt
income to the parent company (see [22.90]). However, the same financial
instrument may be treated as a debt in the foreign country. The subsidiary
can therefore claim deduction on the payments to the parent company. In
other words, the MNE can claim deductions from the intra-group payments in
the source country but does not have to pay tax on those payments in the
resident country.
Hybrid entities and instruments are the focus of Action 2 in the OECD’s Base
Erosion and Profit Shifting Project. For more detail of the project, see
[22.517]. In response to the OECD’s recommendations in Action 2, Australia
has introduced hybrid mismatch rules in Div 832 of the Income Tax
Assessment Act 1997 (Cth) (ITAA 1997), which in general applies to income
years starting on or after 1 January 2019.
Specific anti-avoidance provisions [23.110]
The tax law is peppered with numerous specific anti-avoidance provisions,
including rules dealing with:
• non-arm’s length prices between associated parties;
• deemed dividends for private companies;
• non-commercial losses; and
• personal services income.
These provisions are discussed in the following paragraphs.

Non-arm’s length prices between associated parties [23.120]

There are several specific anti-avoidance provisions in the tax law
addressing the issue. For instance, s 26-35 of the ITAA 1997 stipulates that
excessive payments to related entities shall be reduced to so much as the
Commissioner considers reasonable for the purposes of deductions.
Symmetric treatment is provided to the recipient who is not taxed on the
excess. Similarly, s 70-20 of the ITAA 1997 ensures that where trading stock
has been purchased in a non-arm’s length transaction at a price higher than
the market value, the amount of deduction is limited to the market value.
There are also market value substitution rules in the CGT regimes dealing
with non-arm’s length amounts with respect to cost base, reduced cost base
and capital proceeds: ss 112-20 and 116-30 of the ITAA 1997, respectively.
Case study 23.2: Trading stock purchased at overvalue from
associate
In Cecil Bros Pty Ltd v FCT (1964) 111 CLR 430, the taxpayer
purchased trading stock at above market value from an associated
company owned by family members. The effect of the transaction
was to direct income to family members. The High Court upheld this
transaction. Section 70-20 of the ITAA 1997 was enacted to override
the court decision.
Paradoxically, there is no specific provision dealing with the situation where
a taxpayer has sold trading stock below market value to an associate. Where
such a sale is substantially below market value, it may constitute a disposal
outside the ordinary course of business and be deemed to have disposed of
at market value under s 70-90: Pastoral & Development Pty Ltd v FCT (1971)
2 ATR 401.
For depreciating assets, there are similar specific anti-avoidance provisions
adjusting the cost and termination value, respectively, to market value: s 40-
180(2) Item 8 and s 40-300(2) Item 6 of the ITAA 1997.
International transfer pricing between related parties poses serious
challenges to tax authorities around the world. Australia’s transfer pricing
regime targeting cross-border transactions is stipulated in Div 815 of the
ITAA 1997. See [22.350] - [22.370] for a discussion of the issues.
Transfer of right to income from property [23.130]
Income splitting may be achieved by transferring the right to income from
property to an associate without transferring the property itself. For example,
a taxpayer with an investment property may transfer the right to the rental
income to a relative. In seeking to discourage this kind of arrangements, the
government introduced Div 6A of the ITAA 1936. In broad terms, if a
taxpayer transfers a right to receive income from property to an associate
for less than seven years and the consideration received by the transferor is
less than the arm’s-length amount, the transfer is ignored for income tax
purposes and the income in question remains as assessable income of the
transferor: s 102B of the ITAA 1936.
Where a transfer of right to receive income from property is not subject to s
102B, in general s 102CA applies and the amount of consideration in respect
of the transfer is included in the assessable income of the transferor.
Deemed dividends for private companies [23.140]
Division 7A of the ITAA 1936 is designed to deem certain payments and
loans by private companies to their shareholders as dividends paid out of
profits. The Division is a specific anti-avoidance regime to tackle
arrangements of disguising dividends as say salaries or loans to
shareholders. See [21.110]–[21.130] for a discussion of the regime.
Non-commercial losses [23.150]
High-income earners may reduce their tax liabilities by engaging in small
businesses (such as hobby farms) with the aim to claim deductions of the
losses incurred in the business against their assessable income. They may
even build up a capital asset which could be sold later and enjoy CGT
concessions such as the 50% discount.
Division 35 of the ITAA 1997 is the specific anti-avoidance regime to deal
with this kind of arrangements. In broad terms, if the Division applies, the
losses of a non-commercial business carried on by an individual are
quarantined and cannot be used to offset against other assessable income of
the taxpayer. Instead, they can be carried forward to offset against future
assessable income of the business.

Case study 23.3: Hobby farms regarded as a business

In Ferguson v FCT (1979) 9 ATR 873, the taxpayer was a naval
officer who leased five cows for the purposes of breeding. It was
held that he was carrying on a business and was able to write off
losses against his salary. In FCT v Walker (1985) 16 ATR 331, it was
held that the taxpayer carried on business through a manager 1,000
km away of breeding from a single female angora goat. He was able
to deduct losses against his public service income.
For a more detailed discussion of whether a taxpayer is carrying on
a business, see Case Studies [8.20] and [8.21].
Division 35 is designed to ensure that such losses are quarantined, unless
among other things the taxpayer satisfies one of the following exceptions:
1. the assessable income from the business for the income year is at least
$20,000;
2. the business made a profit for income tax purposes in at least three of the
past five income years, including the current year;
3. the total value of real property used in the business is at least $500,000;
or
4. the total value of other assets (excluding motor vehicles) used in the
business is at least $100,000.
These exceptions are not available to taxpayers with adjusted taxable
income of $250,000 or more: s 35-10(2E) of the ITAA 1997. This is an
integrity measure to ensure that high-income earners cannot escape from
the operation of Div 35 through these exceptions.
Division 35 does not apply to losses incurred in primary production or
professional arts businesses provided the taxpayer’s assessable income
(excluding net capital gain) from other sources in the income year is less
than $40,000: s 35-10(4) of the ITAA 1997.
Personal services income [23.160]
An individual taxpayer may seek to avoid paying tax on his salaries at his
marginal tax rate by deriving the income through a company, trust or
partnership. The specific anti-avoidance regime dealing with this kind of
arrangements is the personal services income regime in Divs 84–87 of the
ITAA 1997. If the regime applies, in general the income derived by the
company, partnership or trust is deemed to be assessable income of the
taxpayer, unless the amount is paid promptly to the individual as salaries: s
86-15 of the ITAA 1997. The ATO’s position on the issue of personal services
income regime is explained in TR 2001/7.
Even if a taxpayer is not subject to the personal services income regime, Pt
IVA may still apply: see note to s 86-10. For example, the taxpayers in FCT v
Gulland; Watson v FCT; Pincus v FCT (1985) 160 CLR 55 could satisfy the
separate premises test, but may still attract the operation of Pt IVA.

What is personal services income?[23.170]

Section 84-5 of the ITAA 1997 provides that income of a taxpayer is personal
services income if it is mainly derived as a reward for personal efforts or
skills. For example, a company providing computer programming services
where that company uses the equipment and software of the client would
fall within the definition. By way of contrast, where a company owns a
semitrailer used in its transportation business, the income will not be
personal services income because it is mainly produced by the use of the
semitrailer.

The critical factor is the amount of machinery and equipment and other
assets used by the taxpayer to produce income. Where these assets are
minimal, the proceeds will generally be personal services income: see
generally TR 2001/7.
Deductions with respect to personal services income [23.180]
In general, an individual who is not conducting a personal services business
cannot deduct expenses that would not have been deductible if the taxpayer
is an employee: s 85-10 of the ITAA 1997. For example, normally travelling
expenses to and from work are not deductible: Lunney v FCT; Hayley v FCT
(1958) 100 CLR 478. However, s 85-10 does not disallow expenses incurred
to:
• gain work through advertising, tendering or quoting for work;
• insuring against loss of income or income-earning capacity;
• engaging a non-associate to perform work; or
• contributing to superannuation fund.
Deductions for rent, mortgage, interest, rates and land tax for an individual
taxpayer’s residence are disallowed if the amounts are related to producing
personal services income: s 85-15 of the ITAA 1997. Monies paid to
associates in relation to the production of personal services income is also
not deductible, unless the payment is made for the associate to perform part
of the principle work that generates the personal services income: s 85-20 of
the ITAA 1997.
Personal services business [23.190]
The personal services income regime does not apply where an individual or
personal services entity (PSE) is carrying on a “personal services business”.
This will be the case where one of the four tests stipulated in Div 87 of the
ITAA 1997 is met:
1. results test;
2. unrelated clients test;
3. employment test; and
4. business premises test.

If the results test is satisfied, there is no need to proceed to any of the other
three tests. The personal services income is not included as assessable
income of the individual under Div 35. If an individual fails the results test,
he or she cannot rely on the other three tests if among other things, at least
80% of the personal services income (excluding amounts received as an
employee) is derived from the same entity (including its associates): s 87-
15(3). TR 2001/8 explains the ATO’s position on the issues with respect to a
personal services business.
A taxpayer may also be exempt from the personal services income regime if
the ATO has made a personal services business determination (PSBD).
The four tests for personal services business and the PSBD are discussed in
the following parts.

Results test [23.200]

The object of this test is to protect genuine independent contractors from
the application of Div 35 and allow them to carry on a personal services
business through an entity, such as a company, trust or partnership.
Pursuant to s 87-18 of the ITAA 1997, an individual or PSE in general satisfies
the results test in an income year if:
• at least 75% of the personal services income (excluding amounts received
as an employee) is for producing a result;
• the individual or PSE is required to supply the plant and equipment needed
to produce the result; and
• the individual or PSE is liable for the cost of correcting any defect in the
work performed.
Case study 23.4: Results test
In Re Scimitar Systems Pty Ltd and DCT (2004) 56 ATR 1162, the
taxpayer was a company controlled by an information technology
consultant. It had applied for a PSBD unsuccessfully and appealed
to the AAT unsuccessfully. Almost all of its income was derived from
a client called PIC and the contracts with that client did not provide
that the taxpayer or the consultant would be liable for the cost of
rectifying any defects. The consultant was required to attend the
place of work in the core hours of 9.30 am to 3.30 pm on business
days and was under no obligation to supply any tools or equipment.
Accordingly, the results test was not satisfied. The taxpayer in Re
Nguyen and FCT (2005) AATA 876 also failed the results test. In that
case, the taxpayer provided personal services to the ATO where he
supplied minimal equipment, was under supervision and was
subject to the ordinary annual performance evaluation of other
employees.
Unrelated clients test [23.210]
Pursuant to s87-20 of the ITAA 1997, an individual or PSE satisfies the
unrelated clients test if among other things:
• the individual or PSE derives income from providing services to two or
more entities that are not associates of each other and are not associates of
the individual or PSE. For this purpose, different government departments of
the Commonwealth or States count as different entities; and
• the services are provided as a result of having made offers or invitations
(e.g., advertising) to the public. It is not enough to meet this requirement by
being available to provide the services through an entity that conduct a
business of arranging for persons to provide services directly to its clients.
Case study 23.5: Unrelated clients test
In Cameron v Commissioner of Taxation [2012] FCAFC 76, the
taxpayer and his wife provided through their company drafting
services from business premises where they also carried on
business as provedores which involved supplying goods to ships. In
the relevant years, they had a number of clients contacted by
emails and telephone calls and were thus able to satisfy the first
limb of the unrelated clients’ test. The taxpayers, however, failed to
satisfy the requirement in the second limb of the test. The offers
had been made to specific individuals known to the taxpayer and
these offers did not extend to other members of the public. There
was no attempt to advertise generally to the public.

Employment test [23.220]

Pursuant to s 87-25 of the ITAA 1997, an individual in general satisfies the
employment test in an income year if he or she engages at least one entity
(other than associates of the individual) to perform work that represents at
least 20% by market value of the individual’s principal work for that year. It
is clear that this test will not be met where the person employed performs
only auxiliary activities such as typing, cleaning and filing.

If the taxpayer in question is a PSE, the same test applies except that work
performed by individuals whose personal services income is included in the
PSE’s assessable income are excluded from the 20% test.
The employment test is also met where an individual or PSE employs at least
one apprentice for at least half of the income year.
Business premises test [23.230]
Pursuant to s 87-30 of the ITAA 1997, an individual or PSE in general satisfies
the business premises test in an income year if at all times during the
income year, the individual or PSE uses business premises to conduct
activities that generate the personal services income. The individual or PSE
can satisfy this test even if it uses several different business premises during
the year. The individual or PSE must have exclusive use of these premises
which must be physically separate from the private premises of the
individual, PSE or their associates. The business premises must also be
physically separate from the premises of the entity (or its associates) that
acquires the services of the individual or PSE. These requirements are
designed to distinguish between disguised employment and genuine
personal services business.
Case study 23.6: Business premises test
In FCT v Dixon Consulting Pty Ltd (2006) 65 ATR 290, the PSE of Mr
Dixon operated its consulting business from an office above a
garage which was on the same block of land as Mr Dixon’s private
residence. The garage was physically separate from the private
residence and was used by Mr Dixon and his wife for private
purposes.

The AAT originally decided that the PSE satisfied the business
premises test on the basis that the office was physically separate
from the private residence. On appeal, the Federal Court held that
the AAT had erred and had to reconsider the issues of whether the
PSE satisfied the “exclusive use” and “physically separate”
requirements. The AAT decided in the rehearing that the PSE did
not have the exclusive use of the garage/office building due to the
private use of the garage, and thus failed the business premises
test.

The taxpayer in Cameron v Commissioner of Taxation [2012] FCAFC

76 discussed in Case Study [23.5] also failed the business premises
test because the office premise was used mainly for his provedore
business (which is not subject to the personal services income
regime) rather than the drafting business. In determining whether
the premise was used mainly for personal services business, both
time and floor area were relevant factors to consider.

Personal services business determination [23.240]

An individual or a PSE covered by a PSBD is deemed to be carrying on a
personal services business and thus not subject to the personal services
income regime. This is so even if the individual or the PSE would have failed
the four tests discussed at [23.200]–[23.230].
The detailed rules with respect to PSBD are stipulated in subdiv 87-B of the
ITAA 1997. In very broad terms, the Commissioner may issue a personal
services determination if he is satisfied that, among other things, unusual
circumstances have prevented the taxpayer from satisfying the tests: s 87-
60 of the ITAA 1997. Examples of “unusual circumstances” with respect to
the unrelated client test include (1) the taxpayer fails the test in an income
year because it has just started the business in this income year and can
reasonably be expected to meet the test in subsequent income year; and (2)
the taxpayer provides services to only one client this income year, but has
met the test in preceding income years and can reasonably be expected to
meet the test in subsequent income years: s 87-60(4) of the ITAA 1997.
Case study 23.7: Unusual circumstances
The ATO states in TR 2001/8 paras 96 and 97 that the term “unusual
circumstances” refers to “exceptional circumstances that are
temporary, with the likelihood that the usual circumstances will
resume in the short term ... Unusual circumstances that exist ... for
less than 12 months would not be regarded as having become usual
circumstances, except where that time period is significant having
regard to the nature of the activity”.
The ATO position must be contrasted with the decision in Creaton
Pty Ltd v FCT [2002] AATA 1121. In that case, the taxpayer provided
the personal services to just one entity (a not-for-profit special
purpose vehicle) from the 1995 to 2001 tax years. That client went
into voluntary liquidation in 2001 because its purpose had been
achieved. The taxpayer satisfied the unrelated clients test for
several tax years before 1995, and also for the 2002 tax year.
The Tribunal held that the taxpayer had experienced unusual
circumstances because it had met the unrelated clients test in one
or more preceding income years and could reasonably be expected
to meet the unrelated clients test in subsequent income years. In
particular, the Tribunal held that the reference to “preceding
income year” was not a reference to the immediately preceding
income year.

Specific anti-avoidance regimes for international transactions

[23.250]
The tax law contains a number of specific anti-avoidance regimes targeting
international tax arrangements, including the controlled foreign company
regime, thin capitalisation regime and transfer pricing provisions. See
Chapter 22 for a discussion of these regimes.
General anti-avoidance provision – Part IVA Introduction [23.260]
The presence of a general anti-avoidance provision in the tax law reflects the
serious challenge posed by the ingenuity of the army of tax advisors. It is
impossible in practice for the government to enact specific anti-avoidance
provisions to cover every tax avoidance scheme.
Originally, the general anti-avoidance provision was contained in s 260 of the
ITAA 1936. That section was so comprehensive that it could potentially apply
to almost any transaction and the judges accordingly read into the section a
number of limitations which eventually made it ineffective. As a result, a new
general anti-avoidance provision in Pt IVA of the ITAA 1936 was enacted in
1981.
Part IVA applies to schemes entered into after 27 May 1981 and was
designed to strike down arrangements that are “blatant, artificial or
contrived”, but it was not intended to have effect on arrangements of “a
normal business or family kind, including those of a tax planning nature”. As
discussed at [23.270], it may be relatively easy to state the key elements of
Pt IVA. However, it is often difficult to see why it applies in some cases but
not in others.
Specific provisions were inserted in Pt IVA in 2016 and 2017 to address
certain international tax avoidance structures of MNEs. See [22.517] for
more detail.
Key elements of Pt IVA [23.270]
There are three key elements in Pt IVA. First, there must be a “scheme” as
defined in s 177A. Second, a taxpayer must obtain from the scheme a “tax
benefit” as defined in s 177C. Finally, a person must have entered into the
scheme for the sole or dominant purpose of enabling the taxpayer to obtain
the tax benefit: s 177D. Where all the elements are satisfied, the
Commissioner is empowered to cancel the tax benefit by, for example,
including the amount in assessable income or denying the deduction of the
amount: s 177F.
In 2013, the government enacted amendments to Pt IVA as it believed that a
number of Full Federal Court cases had revealed weakness in the general
anti-avoidance provision, in particular the concept of tax benefit and its
interactions with the other elements of Pt IVA. The government was
concerned that some taxpayers had argued successfully that they did not
get a tax benefit because in the absence of the scheme, they would have
done nothing at all or would have entered into a different scheme that also
avoided tax.
The amendments apply retrospectively to schemes that are entered into on
or after 16 November 2012. In essence, they are designed to clarify that in
determining whether a taxpayer has obtained a tax benefit, what the
taxpayer would have reasonably expected to have done in lieu of the
scheme must be ascertained on a postulate that is a reasonable alternative
to the scheme, having particular regard to the substance of the scheme and
its effect for the taxpayer, but disregarding any potential tax costs: s
177CB(3) and (4) of the ITAA 1936. Furthermore, the amendments also
reflected the government’s belief that the application of Pt IVA would be
more effective if the dominant purpose element is considered first before the
other elements: s 177D(1) and (2) of the ITAA 1936.
The three key elements of Pt IVA are discussed in the following paragraphs.
Scheme [23.280]
“Scheme” is defined in s 177A(1) of the ITAA 1936 as:
(a) any agreement, arrangement, understanding, promise or undertaking,
whether express or implied and whether or not enforceable, or whether
intended to be enforceable, by legal proceedings; and
(b) any scheme, plan, proposal, action, course of action or course of conduct.
A scheme may be unilateral and does not require more than one person: s
177A(3).

The concept of a scheme is important to the operation of Pt IVA for two

reasons. First, Pt IVA applies only if a person has entered into a scheme with
the sole or dominant purpose of enabling a taxpayer to obtain a tax benefit.
It implies that in general a taxpayer may tend to argue for a “broad” scheme
which involves many steps with the aim of minimising the risk of being
regarded as having a “sole or dominant purpose” for the tax benefit. In
contrast, the ATO may tend to argue for a “narrow” scheme that involves
only a few steps, so that the dominant purpose for the tax benefit may be
easier to establish.
Second, before Pt IVA applies, the tax benefit must arise “in connection with
the scheme”: s 177D(a) of the ITAA 1936.

Tax benefit [23.290]

“Tax benefit” is defined in ss 177C and 177CA of the ITAA 1936. It includes
an amount not being included in the assessable income of a taxpayer, where
in the absence of the scheme it would reasonably be expected to have been
included. Similar definitions apply to an allowable deduction, a capital loss, a
foreign income tax offset, a discount capital gain and an amount subject to
withholding tax.
To determine if there is a tax benefit, the section requires a comparison
between what the taxpayer actually did and what the taxpayer “would have”
or “might reasonably be expected to have” done. The conduct that would
have occurred but for the scheme is sometimes referred to as the
“counterfactual” (Commissioner of Taxation v Lenzo (2008) 71 ATR 511 at
529) or the “alternative postulate” (FCT v Hart (2004) 217 CLR 216). In
Commissioner of Taxation v Peabody (1994) 181 CLR 359 at 385, the High
Court said: A reasonable expectation requires more than a possibility. It
involves a prediction as to events which would have taken place if the
relevant scheme had not been entered into or carried out and the prediction
must be sufficiently reliable for it to be regarded as reasonable.
Case study 23.8: Alternative postulate
The taxpayer in RCI Pty Ltd v Commissioner of Taxation 2011 ATC
20-275 successfully made the “would have done nothing”
argument. The case involved the relocation of the James Hardie
group to offshore headquarters. An offshore subsidiary paid a large
tax-exempt dividend to its Australian holding company in March
1988. In October of that year, the holding Company sold its shares
in the offshore subsidiary. The Commissioner alleged that the
scheme was to pay a dividend to reduce the value of the subsidiary
and thereby diminish the CGT liability on the sale of its shares
despite the fact that the payment of the dividend and disposal of
the shares were seven months apart. The Full Federal Court,
Edmonds, Gilmour and Logan JJ, ruled in favour of the taxpayer. It
was held that no tax benefit arose from the scheme, because if the
taxpayer had not entered into the scheme, it would be reasonable
to expect that the taxpayer would have done nothing or done
something else not involving the transfer of shares. Other cases in
which the taxpayers successfully argued for an alternative
postulate that negated the existence of a tax benefit include Futuris
Corporation Ltd v FCT [2012] FCAFC 32, FCT v AXA Asia Pacific
Holdings Ltd [2010] FCAFC 134 and Noza Holdings Pty Ltd & Ors v
FCT [2011] FCA 46.

As mentioned in [23.270], the government enacted amendments in 2013

attempting to strengthen Pt IVA by clarifying the definition of tax benefit. In
particular, the amended provision is intended to prevent taxpayers from
arguing that, among other things, there was no tax benefit as they would
have done nothing if they had not entered into the scheme. It also clarifies
that the “would have” and “might reasonably be expected to have” limbs in
s 177C(1) represent alternative bases upon which a tax benefit may be
ascertained. This reflects the government’s belief that for the purpose of
ascertaining whether a tax benefit exists, the reconstruction approach under
the “might reasonably be expected to have” limb should be regarded as an
alternative to, rather than as an exclusion of, the annihilation approach
under the “would have” limb.
Dominant purpose [23.300]
Part IVA applies if, among other things, a person has entered into a scheme
with the sole or dominant purpose to enable a taxpayer obtaining a tax
benefit. The subjective purpose of the person is irrelevant: Eastern Nitrogen
Ltd v FCT (2001) 46 ATR 474. Instead, the objective purpose must be
inferred from applying the eight factors listed in s 177D of the ITAA 1936:
• the manner in which the scheme was entered into or carried out;
• the form and substance of the scheme;
• the timing at which the scheme was entered into and the length of the
period during which the scheme was carried out;
• the result that would have been achieved by the scheme;
• the change in the financial position of the relevant taxpayer;
• the change in the financial position of any person connected to the
taxpayer;
• any other consequence for the relevant taxpayer and any person
connected to the taxpayer; and
• the nature of connection between the taxpayer and the person connected
to the taxpayer.
“Dominant” purpose means “the ruling, prevailing or most influential
purpose”: FCT v Spotless Services Ltd (1996) 34 ATR 183. The case also
established the principle that a person who enters into a scheme with a
genuine commercial reason can still have a dominant purpose of obtaining
the tax benefit. The dominant purpose may be inferred from someone else
(e.g., a professional advisor) other than the taxpayer: FCT v Consolidated
Press Holdings Ltd (2001) 47 ATR 229. These cases are discussed in the
following part.

High Court case on Pt IVA [23.310]

Part IVA of the ITAA 1936 was enacted in 1981. It took more than 13 years
before it received the first interpretation in the High Court in FCT v Peabody
(1994) 181 CLR 359. The key issues in the case are summarised in the
following case study.
Case study 23.9: Peabody case
Mrs Peabody and members of her family were beneficiaries of the
Peabody Family Trust. TEP Holdings Ltd, as trustee of the trust, held
62% shares in several companies with the common name of
Pozzolanic. The remaining 38% shares of those companies were
held by Kleinschmidt. The plan was to float 50% of the company
group on the stock exchange. However, Kleinschmidt did not want
to sell to the public, so Peabody had to acquire Kleinschmidt’s
shares. A shelf company Loftway Pty Ltd was formed and TEP
Holdings held the shares in the company as trustee for the family
trust. Loftway issued redeemable preference shares to Westpac
Bank and used the fund to purchase the Kleinschmidt shares for $8
million.

The price paid by Loftway for the Kleinschmidt shares was lower
than the intended listing price. Peabody claimed in evidence that,
due to the fear of the potential adverse effect on the listing if the
purchase price was disclosed in the prospectus, those shares were
made virtually worthless by converting those shares to “Z class
shares” with no voting rights but only limited rights to dividend and
surplus on winding up. In effect, the value of the 38% shares was
shifted to the 62% shares held by TEP Holding.
The Commissioner applied Pt IVA and assessed Mrs Peabody on the
basis that if not for the scheme of shifting value from the 38%
shares to the 62% shares, the trustee would have made a gain on
the share purchase from Kleinschmidt, which would have been
distributed to Mrs Peabody. While the Commissioner lost the case
due to other technical grounds, the High Court decision provided
important insight into the operation of Pt IVA. In particular, it held
that though there was an overall commercial object of raising
money from the public listing and only the value shifting step was
involved getting a tax benefit, the Commissioner could isolate and
identify that particular step as a scheme for the dominant purpose
test.
The second High Court case on Pt IVA was FCT v Spotless Services Ltd (1996)
186 CLR 404, which is summarised in the case study below.

Case study 23.10: Spotless case

The taxpayer was an Australian resident company that had $40
million surplus cash to invest after a public flotation. At that time s
23Q of the ITAA 1936 (since repealed) provided that if a resident
derived foreign-sourced income which had been subjected to
income tax at source, it would be exempt in Australia. The taxpayer
had a choice of investing in Australia or the Cook Islands. While the
interest rate was lower in the Cook Islands, the after-tax income
would be much higher from the Cook Islands investment. In this
sense, the decision to invest in the Cook Islands was commercially
justifiable. The High Court held that Pt IVA applied and the taxpayer
was assessable as if the investment had taken place in Australia.
The Court held that the dominant purpose means the most
influential and prevailing or ruling purpose and that a reasonable
person would conclude that the dominant purpose here was to get a
tax benefit. If not for the scheme, it would be reasonably expected
that the assessable income of the taxpayer would be higher.
The Court stressed that it was not striking down the scheme simply
because it represented a better investment, but a number of
deliberate steps, including financial services from an English bank,
had to be obtained to make the investment safe. No reasonable
person would have gone through all these complicated procedures
to secure a lower interest rate in the absence of the tax benefit.
This case showed that, although the taxpayer may have a genuine
commercial purpose, Pt IVA can still apply if the dominant purpose
is to get a tax benefit.
The third High Court case on Pt IVA was FCT v Consolidated Press Holdings
Ltd (2001) 47 ATR 229, as summarised below.
Case study 23.11: Consolidated Press Holdings case
The taxpayer wished to acquire a UK company called Bat Industries
Plc for a commercial purpose of publishing a magazine in that
country. It intended to hold the UK company through another UK
company, CPIL(UK). The taxpayer had to borrow $450 million to
finance the transaction. At the time s 79D of the ITAA 1936 provided
that certain offshore expenses (in this case, interest) could not be
deducted from Australian-sourced income.
Based on the advice of its professional advisor, the taxpayer
incorporated an Australian resident subsidiary called Murray
Leisure Group Pty Ltd (MLG) and used the borrowed funds to
acquire redeemable preference shares in that entity, which in turn
acquired shares in Bat Industries Plc. The interest expenses were
therefore incurred in respect of Australian-sourced income.
The High Court found that the dominant purpose of the scheme was
to obtain a tax benefit in the form of an interest deduction, which
would not be allowed pursuant to Pt IVA. The scheme was identified
as the insertion of MLG into the holding structure. Importantly, the
Court indicated that the purpose of a professional adviser could be
attributed to the taxpayer for the purpose of the dominant purpose
test. This is so even if the taxpayer did not understand the complex
tax legislations involved.

The next High Court case on Pt IVA was Hart v FCT (2004) 217 CLR 216
which is summarised below.

Case study 23.12: Hart case

The taxpayers were husband and wife who owned their main
residence under mortgage. In October 1996, they purchased
another property to reside in and leased out the first property. They
borrowed $298,000 to purchase the new property under a split-loan
arrangement. $202,888 was in a home loan account designated for
the purchase of the new property and $95,112 in an investment
loan account for the repayment of moneys owed on the investment
property which was producing rental income. The taxpayers
directed all their repayments to the home loan account and no
repayments were made to the investment loan account, where the
interest continued to compound which would be deductible under s
51(1) of the ITAA 1936. The split-loan arrangement was a mass-
marketed scheme.
The High Court was satisfied that there was a commercial purpose
of increasing wealth, but all the judges agreed that the dominant
purpose of the persons implementing the scheme, however defined,
was for the taxpayers to obtain a tax benefit, though the five judges
formed different opinions of what constituted the scheme in the
case. Some accepted the wider scheme which included all the steps
leading to, the entering into, and the implementation of the loan
arrangements between the lender and the taxpayers. Others
accepted the narrower scheme which referred in particular to the
provision in the loan splitting into the two portions.
A more recent High Court case on Pt IVA was Mills v FCT [2012] HCA 51. As
the case involved s 177EA which is a specific provision in Pt IVA dealing with
franking credit schemes and adopts a different purpose test instead of the
sole or dominant purpose test, detailed discussion of this case is beyond the
scope of this chapter.
Application of Part IVA to specific transactions Leasing [23.320]
A taxpayer who is carrying on a business may choose to borrow against the
security of its assets. In that case, only interest will be deductible as an
operating expense. Alternatively, the taxpayer may choose to lease plant
and equipment, in which case the entire rental payments will be fully
deductible as all leases are treated as operating leases for income tax
purposes: FCT v Citibank Ltd (1993) 26 ATR 423.
Under a standard operating lease, the lessor claims depreciation on the
asset and is fully assessable on the rental payments while the lessee is able
to fully deduct the rental payments.
The Commissioner has challenged lease financing and sought to characterise
it as a loan: FCT v Metals Manufactures Ltd (2001) 46 ATR 497; Eastern
Nitrogen Ltd v FCT (2001) 46 ATR 474.
Case study 23.13: Finance lease
In FCT v Metals Manufactures Ltd (2001) 46 ATR 497, the taxpayer
was a manufacturer of electrical cables and pipes who had a large
amount of short-term debt. It needed to refinance and the choice
was between sale and leaseback or borrowing on the security of
factory and land which were acquired pre-CGT. The taxpayer
decided to finance by means of sale and leaseback. The term of the
lease was five years with a possible extension of two further
periods of five years. At the end of the lease, the assets were to be
sold by the financier, but it is safe to say that the only possible
purchaser was the lessee, even though there was no such purchase
option in the agreement.
The Commissioner attacked the transaction on the threshold issue
that it was not legally possible to sell a fixture without selling the
land to which it was attached. In that case, the taxpayer was paying
rent in respect of an asset which it owned and therefore the
transaction represented a disguised loan where repayments had to
be split into principal and interest. The Commissioner also sought to
attack the arrangement by invoking Pt IVA.
At first instance, Emmett J held that there was sufficient equitable
interest in the financier with regard to the fixtures to justify the
rental payments and allow their deductibility. The Full Federal Court
upheld this decision.

With respect to Pt IVA, the Federal Court held that the tax benefit
was not the dominant purpose of the scheme. Instead, the dominant
purpose was commercial and unrelated to the taxation advantages
which were present. In this context, TR 2006/13 states that in
general the ATO will not apply Pt IVA to sale and leasebacks unless
among other things, particular steps are taken by the taxpayer
giving rise to inappropriate values of the sale price of the asset, the
lease payments or the residual value of the asset.
Agricultural schemes [23.330]
Agricultural schemes involving forestry, horticultural produce, breeding and
maintenance of animals may attract Pt IVA. A taxpayer may outlay one dollar
and borrow three from the promoter, giving rise to a four-dollar deduction,
and the promoter’s finance may be given by way of a round robin of cheques
and non-recourse or limited recourse loans. Under a non-recourse loan, the
debt need only be repaid out of the proceeds of the venture. The sums lent
by the promoter are often in the form of a cheque which is handed to the
investor who immediately hands it back to the promoter or to the manager
of the scheme. This is known as round-robin financing and provision will be
made for it in the contractual documents between the investor and the
promoter, which is often in the form of a deed.

If a court finds that the transaction is a sham, there would be no tax benefit
upon which Pt IVA of the ITAA 1936 could operate. Sometimes taxpayers fail
on the ground of threshold issues, such as the failure to establish that the
business has commenced or, where a business has commenced, the
taxpayer not being sufficiently involved to be carrying on a business or even
a profit-making scheme. As a result, there was no tax benefit and
accordingly no reason to apply Pt IVA: Howland-Rose v FCT (2002) 49 ATR
206. In Ruling TR 2007/8, the Commissioner ruled that the taxpayer’s lack of
real involvement in the running of the business meant that in general most
deductions would not be available.
Case study 23.14: Howland-Rose case
The taxpayer invested $24,000 in tea tree plantation scheme which
was entirely lent by the promoters in a round-robin arrangement.
The taxpayer agreed to pay back 25% of the loan within two years.
The money was spent in investigating whether there was a market
for the product in Europe and the USA and, although there was
research and development, no business had been commenced.
There had been no manufacture and sale of the product.

Conti J held that a business cannot commence, at least until the

taxpayers are definitively committed to it. As the deduction was not
allowed on general principles, Pt IVA was a non-issue.
Where a taxpayer satisfies the threshold test of carrying on a business, the
Commissioner may apply Pt IVA, especially to mass-marketed schemes
involving non-recourse loans that result in the taxpayer getting a refund
regardless of the commercial viability of the venture.
Case study 23.15: Sleight case
In FCT v Sleight (2004) 55 ATR 555, the Full Federal Court applied Pt
IVA of the ITAA 1936 to a scheme involving the planting, growing
and harvesting of tea trees for the purpose of producing tea tree
oil. The trial judge held that the dominant purpose was not the
gaining of a tax benefit because among other things, there was
expert evidence to the effect that the scheme was commercially
viable, that the taxpayers would increase their ownership of assets
and that the venture was carried out in a businesslike way.
The Full Federal Court reversed this finding. The initial outlay by the
taxpayers was $4,745 and a further $21,000 was invested through
round-robin finance, giving a total deduction of $25,445 on revenue
account. There was some capital investment involving the purchase
of seeds. On these figures, the taxpayer would receive tax refunds
even if the venture produced not a single dollar. Therefore, a
reasonable person would conclude that the dominant purpose was
to get the tax benefit.
CGT losses through wash sales [23.340]
Section 177C(1)(ba) of the ITAA 1936 includes as a tax benefit a capital loss
being incurred by a taxpayer where it might reasonably be expected not to
have been incurred if the scheme had not been entered into or carried out.
The following case illustrates the operation of this provision.

Case study 23.16: Wash sales attract operation of Pt IVA

In Cumins v FCT (2007) 61 ATR 625, the taxpayer was a trustee of a
family trust. The trust owned Cash Converters International Ltd. In
the relevant year, the trust made a capital gain of $790,000. One
day later, the trust sold some listed shares to another family trust
controlled by the same taxpayer and realised a capital loss of
$800,000. The taxpayer and his family were the beneficiaries of
both family trusts.
The Full Federal Court upheld the decision of the trial judge that Pt
IVA applied to this wash sale, as the dominant purpose of which was
to gain a tax benefit. TR 2008/1 explains the ATO position on wash
sales.

Questions [23.350]
23.1 John is a full-time teacher and also a keen cyclist. He spends
most of his spare time practicing and spends a lot of money on his
bike and gears. He regularly enters cycling competitions and
sometimes wins small amounts of prize money.
Advise what he can do to be in a position to argue for deductions of
his expenses incurred on cycling, and assuming he is regarded as a
professional cyclist, whether he can offset his losses from cycling
against his salaries.
23.2 P, a company incorporated in the US, is in the business of
providing online cloud services. It has a subsidiary in Australia, A,
which promotes and liaises with customers in the country. It also
negotiates the terms of contracts with customers in Australia. The
finalised contracts are entered into between the customers and
another subsidiary in Singapore, S. The two subsidiaries have
entered into a service agreement under which A provides the
marketing services as well as after-sale supporting services to S for
a service fee calculated on a cost plus basis. S has entered into
similar agreements with P’s subsidiaries in other Asian countries.
Discuss whether the structure may be subject to Pt IVA, including
the arguments that the group may put forward to support its
position.
23.3 Since 1960, X Co Ltd has owned and operated a factory which
manufactures ammonia for supply to the fertiliser industry. The
factory was built at a cost to the taxpayer of $3 million. Of that $3
million, $2 million was attributable to the cost of the building and
$1 million for the cost of plant. The factory and plant, which
consists of heavy machinery firmly attached to the base of the
factory, is now worth $15 million. X Co Ltd currently draws down
loans on the short-term money market at 8% interest.

In the previous income year, X Co Ltd was approached by a

financier, Y Co Ltd, which suggested that if X Co Ltd entered into a
sale and leaseback agreement in respect of the land, factory and
plant, finance could in effect be obtained at 5%, which would result
in considerable savings. X Co Ltd does not wish to sell the land
because it is a pre-CGT asset and is expected to increase in value in
years to come. Y Co Ltd then proposes that X Co Ltd retains the land
and, instead, sells the factory and plant to Y Co Ltd for $15 million
and leases back the factory and plant for 10 years at $2 million per
year. The lease agreement provides that (1) X Co Ltd acknowledges
that the factory and plant are personal property and they vest in Y
Co Ltd; and (2) after 10 years Y Co Ltd will sell the factory and plant
at a residual value of $2 million. The lease explicitly provides that X
Co Ltd has no option to purchase the factory and plant at the end of
the lease. On 1 July, this income year, the sale and leaseback
agreement on the above terms was executed by X Co Ltd and Y Co
Ltd. X Co Ltd claimed a deduction of $2 million in respect of the
lease payments and Y Co Ltd claimed depreciation of $2 million in
respect of the plant. Advise X Co Ltd and Y Co Ltd as to the tax
implications of the sale and leaseback agreement.
23.4 George is an accountant with an income of $300,000 per year
and he is looking for a tax-effective investment in agriculture. He
decides to invest in Hardwood Forests Pty Ltd, the promoter of a
scheme for growing trees in northern New South Wales. Forty-nine
other investors have already signed for the scheme. The promoter
has a private ruling from the Commissioner that the non-commercial
loss rules will not apply to the investment.
George was supplied with contractual documents that give him the
right to be informed of the progress of the venture and the right to
remove the promoter and substitute another by majority vote of the
investors. On 29 June, this income year, George writes out a cheque
for $50,000 and hands it to Smith, a director of the promoter, who
in turn hands him a cheque for $200,000 made out to George.
George endorses the cheque to Hardwood Forests Pty Ltd and
hands it back to Smith.
The promoter has 50 hectares of land in northern New South Wales
and one hectare is allocated to George, but it is not identified by
the end of the income year. The clearing and planting of the trees
commences on 29 June this income year. No returns are expected
from the venture until at least 10 years later.
Advise if George can claim a tax deduction of $250,000 in this
income year.

23.5 George is a fund manager with Bathurst Pty Ltd. His strategy is
to buy shares in companies that have a low price-earnings ratio,
and when the shares rise in price, he switches his investment to
different companies. In June 2004, George caused the fund to buy 1
million shares in the Ajax Mining Ltd at $4 per share. In June this
income year, Ajax Mining Ltd’s shares are listed at $12 each and
George decides it is time to sell. The fund also has a parcel of 2
million shares in Hill Ltd which were purchased in the year 2000 for
$10 each and are now worth $4 each. On 30 June this income year,
George causes the fund to sell the 1 million shares in Ajax Mining
Ltd, as well as all the shares in Hill Ltd at $4 each.
Two months later, George asks the analysts at the Bathurst Pty Ltd
to analyse all financial documents of Hill Ltd including the profit and
loss account, the balance sheet and a new prospectus just issued by
Hill Ltd. Based on a favourable report concerning the prospects of
Hill Ltd, George instructs Bathurst Pty Ltd to purchase 2.5 million
shares in Hill Ltd at $4.50 each.
Advise the tax implications of the disposal of the shares on 30 June
this income year.
23.6 Sara Lee entered into a contract in April 2014 to sell part of its
business to a Swiss company Roche Holdings Ltd for $60 million.
The sale is to be effected in November 2014.
In August 2014, the board of directors was advised by Sara Lee’s
lawyers that the company has made a CGT loss of $6 million in the
income year, and the sale of its business to Roche will result in a
CGT gain of $8 million.
Subsequently, Sara Lee and Roche entered into a deed of release in
October 2014, whereby the contract of April 2014 was discharged
for a consideration of $900,000 payable to Roach. Two hours later
after negotiation and change of some contractual terms, Sara Lee
entered into a new contract to sell the identical part of the business
to Roche holdings for $61 million. The minutes of the director’s
meeting said that the reason for discharging the earlier contract
was that the lawyers advised that the change in consideration
meant that the original contract could not be ratified, and that a
new contract had to be entered into. The minutes also declared that
changes in the redundancy entitlements also meant that discharge
and entry into another contract was the safest path to create a
binding contract. Advise the tax implications of these transactions
and whether Pt IVA will apply.

23.7 Jessica is a financial accountant working in the finance

department of an engineering consulting firm. The firm recently
reviewed their internal operations and decided that the finance
department should be outsourced to independent third-party
contractors, with existing staff being made redundant. The firm
was, however, keen to retain Jessica due to her intricate industry
knowledge. To achieve this, the following steps were undertaken:

(a) Jessica incorporated a company with the registered name of

Jessica’s Accountancy Services Pty Ltd (JAS). Jessica is the sole
director and shareholder of JAS.
(b) The firm and JAS entered into a “Services Contract” for the
provision of accountancy services for an annual sum of $130,000.
This annual sum is equivalent to what would have been Jessica’s
annual salary.
Jessica is required to attend the premises of the engineering firm
during normal business hours each working day. A bungalow located
at the rear of Jessica’s home, which is separate to her house, is
dedicated to Jessica to undertake any JAS business matters. JAS also
employs her son at
an annual salary of $30,000 to undertake administrative tasks.
Advise Jessica and JAS of the tax implications of the annual sum of
$130,000 and the salary of $30,000 paid to her son.

Chapter 24 - Tax administration

Key
points ............................................................................................
............. [24.00]
Introduction...................................................................................
.................... [24.10]
Taxpayer
lodgments .....................................................................................
..... [24.20]
Annual tax
returns ..........................................................................................
... [24.20]
Business Activity
Statements .............................................................................
[24.35]
Assessments ..................................................................................
.................... [24.40]
Self-assessment
……………....................................................................................
[24.40]
Definition of
assessment....................................................................................
[24.50]
Tentative
assessments...................................................................................
.... [24.80]
Default
assessments ..................................................................................
....... [24.90]
Assets betterment
statements.........................................................................
[24.100]
Serving a notice of
assessment.........................................................................
[24.110]
Effect of technical
shortcomings ......................................................................
[24.120]
Presumption of validity of
assessments ........................................................... [24.130]
Amendments of
assessments ...........................................................................
[24.140]
Collection of
tax................................................................................................
[24.150]
Methods of
collection ......................................................................................
[24.160]
Collection of tax from third parties owing money to a
taxpayer ........................ [24.170]
Collection of tax from person in control of foreign resident’s
money................. [24.175]
Mareva injunctions/freezing
orders .................................................................. [24.180]
Departure prohibition
orders ............................................................................ [24.190]
Penalties .......................................................................................
.................... [24.200]
Administrative
penalties ...................................................................................
[24.201]
Director penalty
notices ....................................................................................
[24.202]
Tax offences under the Taxation Administration
Act ......................................... [24.203]
Return prepared by a tax
practitioner ............................................................... [24.205]
Remission of administrative
penalties ............................................................... [24.206]
Promoter
penalties .......................................................................................
.... [24.207]
Objections, reviews and
appeals........................................................................ [24.210]
Onus of
proof .............................................................................................
....... [24.225]
Commissioner’s decision on taxation
objections ................................................ [24.230]
Application for appeal or
review ........................................................................ [24.240]
Choice between AAT and Federal
Court.............................................................. [24.260]
ATO Test Case Litigation
Program ...................................................................... [24.290]
The role of the
ATO ...........................................................................................
[24.300]
Commissioner’s statutory remedial
power ....................................................... [24.305]
Compliance
approach .......................................................................................
[24.310]
Third-party
reporting........................................................................................
[24.330]
Australian Business
Number .............................................................................
[24.340]
Taxpayers’
Charter ..........................................................................................
.. [24.350]
Compliance
model ............................................................................................
[24.360]
ATO support for
taxpayers ................................................................................
[24.370]
Common rules that apply to all
rulings .............................................................. [24.380]
Inconsistent
rulings ...........................................................................................
[24.390]
Public
rulings ...........................................................................................
.......... [24.410]
Law companion
rulings .....................................................................................
[24.415]
Product
rulings ...........................................................................................
...... [24.420]
Class
rulings ...........................................................................................
.......... [24.430]
Taxation
determinations ..............................................................................
.... [24.440]
Private
rulings............................................................................................
....... [24.450]
Oral
rulings ...........................................................................................
............ [24.490]
Non-ruling
guidance .......................................................................................
... [24.500]
Commissioner’s powers of access and
investigation........................................... [24.510]
Record-keeping
requirements ...........................................................................
[24.520]
Full and free
access............................................................................................
[24.530]
Commissioner’s power to obtain information and
evidence ............................. [24.540]
Legal professional privilege and the power to obtain
information...................... [24.560]
Elements of legal professional
privilege ............................................................. [24.570]
Access to lawyers’
premises ...............................................................................
[24.575]
Access to professional accounting advisers’
papers ............................................ [24.590]
Access to corporate board advice
papers ........................................................... [24.595]
Statutory
privilege ........................................................................................
.... [24.600]
Offshore information
notices ............................................................................. [24.610]

Secrecy .........................................................................................
..................... [24.620]
Taxpayers’ statutory rights to obtain
information .............................................. [24.630]
Freedom of Information Act
1982 ...................................................................... [24.640]
Administrative Decisions (Judicial Review) Act
1977 .......................................... [24.650]
Other taxation
authorities .................................................................................
[24.670]
Inspector General of
Taxation ............................................................................
[24.670]
Board of
Taxation ........................................................................................
...... [24.680]
Regulation of tax
practitioners ...........................................................................
[24.690]
Tax Practitioners
Board.......................................................................................
[24.690]
The Code of Professional
Conduct....................................................................... [24.695]
Complaints and
investigations ...........................................................................
[24.698]
Questions ......................................................................................
.................... [24.700]

Key points [24.00]

• The quality of a country’s tax administration affects all stakeholders:
taxpayers, tax professionals, the revenue authority and the broader
community. The ideal system is transparent and applies equally and fairly to
all taxpayers.
• The Australian Taxation Office (ATO) cannot sue a taxpayer for unpaid tax
until the taxpayer has been served with a valid assessment.
• “Assessment” is defined in s 995-1 of the Income Tax Assessment Act 1997
(Cth) (ITAA 1997) and, in the context of income tax assessments, by
reference to s 6(1) of the Income Tax Assessment Act 1936 (Cth) (ITAA
1936). An income tax assessment is ordinarily issued after a taxpayer has
lodged an annual return. If a taxpayer refuses to lodge, under s 167 of the
ITAA 1936, the Commissioner can issue a default assessment. For some
taxpayers, the income tax return serves as a deemed assessment.
• Tentative or provisional assessments are not valid assessments.
• Section 175 of the ITAA 1936 enables the Commissioner to rely on the
validity of an assessment, except where bad faith or conscious
maladministration is involved.
• The Commissioner is subject to time limits when amending assessments.
• The Commissioner can sue for unpaid tax when it is due and owing. The
General Interest Charge (GIC) or the Shortfall Interest Charge (SIC), as well
as administrative penalties, may be imposed for late lodgment or to
compensate the revenue for late payment.
• The ATO has the power to collect money from third parties who owe money
to a taxpayer.
• Taxpayers can object to their assessments. If they wish to appeal against
the Commissioner’s decision on their objection, they choose between the
Administrative Appeals Tribunal (AAT) (best for exercise of the
Commissioner’s discretion and questions of fact) and the Federal Court (best
for complicated questions of law).
• The ATO has many products to assist taxpayers: Rulings (Public, Private,
Product, Class, Oral), guidance materials, online tools and apps, and phone
help line.
• Methods of collection include withholding at source and payments of
instalments of tax in advance under the Pay As You Go (PAYG) system.
• Third-party reporting mechanisms bolster the integrity of the tax system.
• The Taxpayer’s Charter is an unlegislated “Bill of Rights” for taxpayers.
• The ATO uses a regulatory pyramid (the Compliance Model) to assist it in
managing taxpayer compliance and imposing penalties on taxpayers.
• The Commissioner’s powers of access and information collection are very
wide ranging. These powers are subject to the common law doctrine of legal
professional privilege (LPP). This doctrine only applies to lawyers, but the
ATO has granted an administrative privilege in relation to tax advice given
by accountants and advice to the board of directors on tax compliance risk.
• Taxpayers may be able to obtain information and assistance under the
Freedom of Information Act 1982 (Cth) (FOI Act), the Inspector-General of
Taxation Act 2003 (Cth) or the Administrative Decisions (Judicial Review) Act
1977 (Cth) (ADJR Act).
• The Inspector-General of Taxation (IGT) investigates taxpayer complaints
and undertakes reviews of systemic issues dealing with tax administration.
• The Board of Taxation oversees research into tax law issues and
commissions external advice in relation to new legislation.
• Tax professionals must be registered with the Tax Practitioners Board and
must comply with the Code of Professional Conduct.

Introduction [24.10]
This chapter deals with the importance of tax administration to all
stakeholders: taxpayers, tax professionals, the ATO and the broader
community. The way the ATO administers the law is as important as the
quality of the legislation. Tax administration involves two competing
principles: collection of the revenue due and owing to the State and fair and
efficient use of public resources. The focus of this chapter is the
administration of the income tax, but many of the principles, policies and
mechanisms apply equally to the other taxes that the ATO administers, such
as the Fringe Benefits Tax (FBT) and the Goods and Services Tax (GST).
Australia currently has a system of self-assessment. This puts the onus on
taxpayers to ensure all the details in their returns and other lodgments are
correct. To assist and encourage taxpayers, the ATO uses a mixture of
support and enforcement. The support consists of things such as the rulings
system, publications dealing with specific technical or compliance issues and
lodgment systems that are increasingly electronic to assist in speedy
refunds. The enforcement mechanisms include audits, court action, and
penalties and interest imposed on unpaid tax. The ATO publicises its
activities in order to encourage compliance and deter non-compliance.
Figure 24.1 details the taxation administration issues covered in this chapter.
Taxpayer lodgments Annual tax returns [24.20]
Section 161 of the Income Tax Assessment Act 1936 (Cth) (ITAA 1936)
provides that every person must, if required by the Commissioner, lodge an
annual return in relation to income tax. The Commissioner publishes an
annual notice specifying the persons required to lodge and the due dates for
lodgment. For many years, the date for most individual taxpayers has been
31 October. However, the due dates for returns prepared by tax agents are
spread across the year under the tax agent lodgment program. This usually
means that there is a later due date if the return is made by a tax agent.

Similarly, an annual return is required for FBT, due on 21 May each year: s
68 of the Fringe Benefits Tax Assessment Act 1986 (Cth) (FBTAA). In
response to the COVID-19 crisis, the FBT return due date was deferred until
25 June 2020. Non-lodgment of returns and the failure to provide other
information and documents as required are offences under taxation laws: s
8C of the Taxation Administration Act 1953 (Cth) (TAA). The Commissioner
has power, under Div 286, Sch 1 of the TAA, to impose penalties for late
lodgment of returns or other documents. A taxpayer who wishes to lodge
after the due date must make a request to the Commissioner before that
date, setting out in writing the reasons for the delay and a proposed
alternative lodgment date. The Commissioner has a broad discretion under s
388-55, Sch 1 of the TAA, to defer a lodgment date.
Sections 162 and 163 of the ITAA 1936 give the Commissioner the power to
require that a taxpayer lodge a return, a further or fuller return, or provide
any information about their financial affairs. When such a request is made,
the courts have consistently stated that the taxpayer must be given
reasonable time to comply with the request.
The tax return must be in the “approved form” (s 161A(1) of the ITAA 1936),
containing all relevant information, with a signed declaration by the taxpayer
and, where relevant, the taxpayer’s tax agent. This declaration confirms the
veracity of the information supplied in the return and that the taxpayer can
substantiate where relevant all deductions claimed. There are different forms
for different types of taxpayers and others required to lodge: individuals,
companies, partnerships and trusts.
The ATO offers assistance to taxpayers on phone help lines and web-based
materials. The ATO released its “Digital by Default” initiative in 2015 stating
its intention to deliver to taxpayers a simpler and more flexible method of
interaction. Although the ATO is committed to 100% digital interaction with
taxpayers, including electronic lodgment of annual returns, it still accepts a
very small number of paper returns.
Returns may be lodged by mail or electronically. The ATO encourages all
taxpayers to use its myTax online web-based lodgment system. Taxpayers
must have a myGov account linked to the ATO to access myTax. Expenses
incurred by taxpayers in relation to the preparation and lodgment of their
tax returns may be deducted as general business expenses or, for
individuals, under s 25-5 of the Income Tax Assessment Act 1997 (Cth) (ITAA
1997).

[24.30] Once a taxpayer has lodged an annual return, the Commissioner

processes the assessment and issues the taxpayer with a notice of
assessment. Under the self-assessment system, the onus is on taxpayers to
ensure all the details in their returns are correct. Usually returns are
accepted as lodged and a refund is issued or a notice of tax payable is sent
to the taxpayer.

In order to reduce compliance costs for individual taxpayers with

straightforward tax issues, Australia’s Future Tax System (the Henry Review)
Recommendation 11 proposed that taxpayers be offered the alternative of
accepting a standard deduction to cover work-related expenses and the cost
of managing their tax affairs. Taxpayers would have the choice of accepting
the standard deduction without the necessity of complying with the
substantiation requirements or claiming actual expenses subject to meeting
the substantiation requirements. This proposal was withdrawn, but the
concept is often raised when considering issues such as simplicity. As a
temporary measure in response to the COVID-19 crisis, the ATO is accepting
a shortcut method for calculating working from home expenses, based on a
flat amount per hour worked at home by employees. Recent research
conducted by the ATO on the “tax gap” for individuals (an estimate of the
difference between the tax the ATO collects and the amount that would be
collected with full compliance) reveals that most of the tax gap for
individuals not in business comes from incorrectly over-claiming work-related
expenses. As a result, this issue is a focus of the taxpayer education
program, and the ATO has launched a myDeductions tool to assist taxpayers
to claim the correct amount and keep the necessary records.
To assist taxpayers more generally, the ATO has a system of “pre filling”
items where it has been given information by a third party. Examples include
salary and wages and amounts withheld, dividends received including the
imputation credits and interest received from financial institutions. Taxpayers
still have the responsibility of ensuring that the information is correct.
Section 5-5(2) of the ITAA 1997 provides that tax is due and payable only if
the Commissioner has made an assessment of tax for the year. Section 5-
5(5) of the ITAA 1997 provides it is due and payable 21 days after the day on
which a taxpayer was required to lodge their return. If the taxpayer lodges
early, the tax is due and payable 21 days after the Commissioner gives the
notice of assessment: s 5-5(6) of the ITAA 1997. Full self-assessment
taxpayers pay tax instalments under the Pay As You Go (PAYG) instalment
system, and their final income tax is due and payable on the first day of the
sixth month after the end of the income year: s 5-5(4) of the ITAA 1997.
These dates are important for calculating any amount of General Interest
Charge (GIC) or Shortfall Interest Charge (SIC) that may be due. Any
additional tax due to an amended assessment is due and payable 21 days
after the notice of assessment.
The ATO uses risk-assessment measures to detect and prevent tax
avoidance and tax fraud. If a taxpayer appears to be claiming an unusually
large refund, the ATO might investigate further before paying it or check the
return in detail and refuse to pay it. If a taxpayer is not satisfied with the
assessment as issued, even if it is in accordance with the return as
submitted, the taxpayer can lodge an objection setting out in detail the
grounds relied on. The Commissioner then will allow the objection either
wholly or in part or disallow it. Avenues of appeal or objection are available
to the taxpayer: see [24.210].

Business Activity Statements [24.35]

Taxpayers may also be required to lodge a Business Activity Statement (BAS)
at least annually to report information in relation to a number of different
taxation laws that the Commissioner administers. The main element of the
BAS is the reporting of GST amounts but the BAS reporting system also
covers PAYG withholding and instalments (see [24.160]), FBT instalments,
wine equalisation tax, luxury car tax and fuel tax credits. The BAS form
allows a taxpayer to record both amounts payable to the Commissioner
(such as PAYG instalments) and amounts due from the Commissioner (such a
GST input tax credits) so that the net amount payable or refundable for the
period can be calculated. The Commissioner has created many alternative
approved forms of the BAS to suit the variety of reporting obligations that a
taxpayer may face. Depending on the taxpayer’s circumstances, a BAS may
be required on an annual, quarterly or monthly basis and taxpayers are
encouraged to lodge online. Further details on the administration of the GST
can be found at [25.300]–[25.315].
Assessments
Self-assessment [24.40]
The tax system in Australia is based on the requirement that taxpayers
complete and lodge an annual return. Before 1986, taxpayers lodged returns
which were checked by ATO officers in the assessing section. They would
either accept the return as lodged or make adjustments prior to posting a
Notice of Assessment to taxpayers.
Self-assessment was introduced in 1986. Self-assessment requires taxpayers
to ascertain their taxable income by considering their assessable income,
deductions and available tax offsets. For individual taxpayers, there is
effectively partial self-assessment. The ATO ordinarily accepts the return at
face value and calculates the taxable income, tax payable and any tax offset
refunds – checking its accuracy is accomplished by a system of random
audits. The ATO checks the information supplied by the taxpayer against
information provided by third parties, such as companies which paid
dividends and financial organisations which paid interest to taxpayers.
Penalties and interest are imposed when errors are discovered.
For companies, public trading trusts, superannuation funds and approved
deposit funds (both complying and non-complying), and pooled
superannuation trusts, there is “full self-assessment”. Under s 166A of the
ITAA 1936, the Commissioner is deemed to have made an assessment of the
taxable income and the tax payable on that income in accordance with the
amounts specified
in the return as required by s 161AA of the ITAA 1936. The assessment is
deemed to be made on the day the return is lodged, and the return is taken
to be the notice of assessment, deemed to have been served on the same
day.
Definition of assessment [24.50]
Section 166 of the ITAA 1936 provides that from the returns and any other
information in his or her possession, the Commissioner must make an
assessment of the amount of taxable income (or that there is no taxable
income) of any taxpayer, the tax payable thereon (or that there is no tax
payable) and the total tax offset refunds (or that no such refund is due).
For these purposes, “assessment” is defined in s 6(1) of the ITAA 1936 as the
ascertainment of these three amounts. The elements in parentheses stating
that a taxpayer may have no taxable income or no liability to pay tax were
inserted in 2005 to overcome the decision in FCT v Ryan (2000) 43 ATR 694.
What constitutes an “assessment” was discussed by Isaacs J in R v DCT; Ex
parte Hooper (1926) 37 CLR 368 at 373. An “assessment” is not a piece of
paper: it is an official act or operation; it is the Commissioner’s
ascertainment, on consideration, of all relevant circumstances, including
sometimes his own opinion, of the amount of tax chargeable to a given
taxpayer. When he has completed his assessment of the amount, he sends
by post a notification thereof, called a “notice of assessment”. But neither
the paper nor the notification it gives is the “assessment”. That is and
remains the act or operation of the Commissioner.
[24.60] The courts consistently interpreted the pre-2005 definition of
“assessment” as meaning that a positive amount of tax was due and owing:
Batagol v FCT (1963) 109 CLR 243; FCT v Ryan (2000) 43 ATR 694. This
caused commercial problems. If no tax was due, and there was no
assessment, the Commissioner was free to issue an original assessment at
any time, as happened in Batagol, where the taxpayer had received a refund
notice stating that no tax was payable. Because there was no original
assessment, time limits under s 170 of the ITAA 1936 in relation to the
Commissioner’s power to issue amended assessments never commenced to
run. The High Court majority (Kirby J dissenting) in Ryan followed Batagol,
although they were aware of the problems this interpretation caused. If a
taxpayer did not owe tax because there was no assessment, the taxpayer
could not object to the disallowance of a deduction, nor did the taxpayer
ever have finality in relation to that tax year. The amended definition of
“assessment” has solved these problems.
The current position is that if taxpayers have no taxable income and do not
owe tax because their deductions exceed their assessable income or they
have a taxable income but no tax is payable because their income is below
the tax-free threshold or their tax offsets reduce the tax payable to nil, this
determination constitutes an assessment. However, this degree of finality is
not available in relation to tax losses, where a taxpayer has a negative, not a
nil, assessment. Whether a tax loss is deductible is only decided in the later
tax year in which the taxpayer has positive income and the loss may apply
to reduce it.
Tentative assessments [24.80]
Where an assessment is tentative or provisional, the courts have
consistently held that there is not at that stage a valid assessment: FCT v
Hoffnung & Co Ltd (1928) 42 CLR 39. If the notice of assessment contains a
note that it is subject to review, this does not mean it is tentative. However,
when a taxpayer received three notices of assessment, each fixing a
different sum of tax payable, and all three dealing with the same year of
income, the Federal Court held that there was no single valid assessment
that the ATO could enforce: FCT v Stokes (1996) 34 ATR 478.

Where the ATO issues alternative assessments to two taxpayers in relation to

the same income and the same year of income, providing they are not made
in bad faith and fix a definite tax liability, they remain valid assessments.
The ATO can only collect tax on one assessment but may issue the
alternatives in order to ensure that the taxpayer does not escape their
liability, for example, by issuing an assessment to a trustee and also to a
beneficiary of a trust: DCT v Richard Walter Pty Ltd (1995) 29 ATR 644.
Default assessments [24.90]
Where a taxpayer has not lodged a return (this may be deliberate) or the
Commissioner is not satisfied with the return (e.g., where taxpayers in a
service industry or small business deliberately do not declare cash receipts),
the Commissioner has power under s 167 of the ITAA 1936 to issue a default
assessment. The High Court in George v FCT (1952) 86 CLR 183 stated that
the power under s 167 is not an independent power but is an additional
supportive power to enable the Commissioner to exercise the power under s
166.
The two most important cases on default assessments involve a taxpayer,
Mr Peter Briggs.
Case study 24.1: Default assessments
In Re DCT (WA); Ex parte Briggs (1986) 17 ATR 1031, the taxpayer
had been totally uncooperative and refused to engage with the ATO.
In frustration, the Commissioner issued notices of assessment and
amended assessments with respect to a number of tax years under
167 of the ITAA 1936. The taxpayer applied to the Federal Court
seeking orders to quash the assessments and for writs of
mandamus (to compel a public official to do their duty) and
prohibition (to prevent a public official from exceeding their
jurisdiction), alleging that the ATO had acted in bad faith. Before
further considering the case, the Federal Court referred to the Full
Federal Court the issue of whether s 177 of the ITAA 1936 (now s
350-10, Sch 1 of the TAA) operated in relation to the assessments to
therefore strike out the taxpayer’s claims in relation to judicial
review. Section 177 provided that the production of a notice of
assessment was conclusive evidence of the due making of the
assessment. As part of the agreed facts for the purpose of the
proceedings in the Full Federal Court on this particular issue (but
not more generally), the ATO conceded that there had been no
genuine attempt to ascertain the taxpayer’s taxable income. The
Full Court found that in these circumstances, there were no
“assessments” and therefore the protection of s 177 did not
operate. The Full Court’s alternative view was that even if the
notices were to have effect as an “ambit” claim to be followed by
further and more definitive assessments, they were merely
provisional and therefore did not attract s 177. So the judicial
review application could go ahead.

As the protection of s 177 was not available, the Federal Court

resumed its consideration and, in the subsequent proceedings,
considered the judicial review application. The Court held, after
considering the submissions of the taxpayer and the Commissioner,
that the taxpayer had received valid notices of assessment and
dismissed the taxpayer’s application. The Court made some very
important statements about the ambit of s 167: Re DCT (WA); Ex
parte Briggs (No 2) (1987) 18 ATR 570. Sheppard J said (at 587): It
may be true ... that Section 167 is not the gateway to fantasy and
that it is not open to the Commissioner either to pluck a figure out
of the air or to make an uninformed guess. But that process may go
close to guesswork, and yet be lawful, ... [T] he legislature did not
intend to confer upon a potential taxpayer the valuable privilege of
disqualifying himself in that capacity by the simple and relatively
unskilled method of losing either his memory or his books; or, I
would add, by ... his failure to lodge returns of income.
Law Administration Practice Statement (PS LA) 2007/24 sets out the issues
which the ATO takes into account when issuing s 167 assessments. The
Practice Statement says that tax officers should make a genuine attempt to
determine the taxpayer’s taxable income, but it is not necessary to estimate
assessable income and then consider every potential deduction. In
Marijancevic v Mann (2008) 73 ATR 709, the Full Federal Court confirmed
that when making an assessment under s 167, the Commissioner is entitled
to exercise his judgment when ascertaining the amount of taxable income.
From a practical point of view it is important to recognise that, once a default
assessment is made (which will necessarily be based to some degree on
guesswork), the burden of proof rests on the taxpayer on objection to prove
that the default assessment is incorrect and what the correct assessment
should be.
In Rigoli v FCT [2014] FCAFC 29, the Full Federal Court confirmed that under
s 167 the taxpayer has the burden of proving on the balance of probabilities
the actual taxable income such that therefore the assessment is excessive:
see also Gashi v FCT [2013] FCAFC 30. Merely proving that the
Commissioner has made a mistake by not considering all individual items of
assessable income or allowable deductions is insufficient. When this case
was remitted to the AAT for the second time, the taxpayer submitted his
accountant’s report as evidence of his taxable income. The AAT found again
that the taxpayer had not discharged the onus of proof that on the balance
of probabilities the taxpayer’s taxable income was less than the amount on
which the Commissioner had assessed him: Re Rigoli v FCT [2015] AATA 169.
This decision was upheld by both the Federal Court (Rigoli v FCT [2015] FCA
803) and the Full Federal Court (Rigoli v FCT [2016] FCAFC 38).
In FCT v Donoghue [2015] FCAFC 183, the Full Federal Court held that the
ATO was able to use privileged documents that had been received from a
third party in making the default assessments. This was not a case of
conscious maladministration, as required by the High Court decision in FCT v
Futuris (2008) 69 ATR 41: see Case Study [24.4].

Assets betterment statements [24.100]

When issuing a default assessment under s 167 of the ITAA 1936, the
Commissioner may rely on an asset betterment statement. This involves
comparing a taxpayer’s assets at the end of the year with those at the
beginning.
If a taxpayer declares a fairly low income but during the year has purchased
and paid for luxury items, accumulated assets or otherwise led an
extravagant lifestyle, then the Commissioner may assume that these items
have been paid for with undeclared income: L’Estrange v FCT (1978) 9 ATR
410. In Gashi v FCT [2013] FCAFC 30, the taxpayers failed to demonstrate
that the unexplained accumulated wealth was derived from non-income
sources.
Taxpayers commonly argue that the source of the money that the
Commissioner attempts to tax as income was a family gift or gambling
winnings. As Re DCT (WA); Ex parte Briggs (1986) 17 ATR 1031
demonstrated (see Case Study [24.1]), the Commissioner has to make a
genuine attempt to ascertain the true source of the funds, but then the
burden shifts to the taxpayer to show that this is incorrect and what the
correct amount should be.
Serving a notice of assessment [24.110]
Under s 174 of the ITAA 1936, after making an assessment, the
Commissioner is required to serve notice of it on the person liable to pay the
tax. In Batagol v FCT (1963) 109 CLR 243, the High Court emphasised that
this was the last step after a valid assessment has been made.
The normal method of service is to post or deliver it, either by hand or
electronically, to the taxpayer’s preferred address for service. If a taxpayer
employs a tax agent, often the preferred address for service is the office of
that agent. Many electronic communications are now made through the
myGov platform.
Section 29 of the Acts Interpretation Act 1901 (Cth) provides that where a
document such as a notice of assessment has been properly addressed,
prepaid and posted, it will be deemed to be delivered in the ordinary course
of post, unless the taxpayer can prove the contrary. Electronic delivery
occurs when an electronic communication is capable of being retrieved by
the addressee at an electronic address: s 14A of the Electronic Transactions
Act 1999 (Cth).
Effect of technical shortcomings [24.120]
Section 175 of the ITAA 1936 provides that the validity of any assessment is
not affected merely because any of the provisions of the Act have not been
complied with. This section covers technical irregularities, such as where the
Commissioner might describe what is in fact an original assessment as an
amended assessment: Cadbury-Fry-Pascall Pty Ltd v FCT (1944) 70 CLR 362.
Case study 24.2: Validity of assessment
In FCT v Prestige Motors Pty Ltd (1994) 28 ATR 336, the Full High
Court unanimously held that notices of assessment which were
correct in all details except the name of the taxpayer were valid
assessments. The taxpayer was a trustee, and the notices of
assessment were addressed to the trust, and not the trustee. They
were served at the trustee’s address for service and contained the
trustee’s correct tax file number. The Court held that s 174 of the
ITAA 1936, which provides for the notice of assessment to be served
on the person liable to pay the tax, does not also require that the
notice include the name of the taxpayer.

Presumption of validity of assessments [24.130]

As noted in [24.120], s 175 of the ITAA 1936 provides that the validity of any
assessment is presumed. Section 350-10(1) (Table Item 2) Sch 1 of the TAA
(formerly s 177 of the ITAA 1936) provides that the production of a notice of
assessment is conclusive evidence of the proper making of the assessment
and, except for proceedings on review or appeal against the assessment,
that the amount and all the particulars of the assessment are correct. Cases
such as Re DCT (WA); Ex parte Briggs (1986) 17 ATR 1031 (see Case Study
[24.1]) have established that the Commissioner cannot rely on the section
unless a valid assessment has been made. However, pursuant to the
decision of the High Court in FCT v Futuris (2008) 69 ATR 41, and as applied
in many decisions of the Federal Court since, a claim of invalidity will only
succeed if the taxpayer can show that the assessment was made in bad faith
or was the result of conscious maladministration: Chhua v FCT [2018] FCAFC
86. This is a very difficult standard to meet.
Case study 24.3: Validity of assessment
In FJ Bloemen Pty Ltd v FCT (1981) 147 CLR 360, the High Court held
that the Commissioner is entitled to rely on s 177 of the ITAA 1936
when a taxpayer objects to an assessment and that the ITAA 1936
sets out clear procedures to be followed by taxpayers when there is
a dispute. The taxpayer had argued that the Commissioner had not
exercised his powers bona fide when making the original
assessments. The Court rejected this claim.
Case study 24.4: Validity of assessment
In FCT v Futuris (2008) 69 ATR 41, the Commissioner issued a
second amended assessment which contained overlapping amounts
with the first amended assessment. The second amended
assessment relied on Pt IVA of the ITAA 1936, and when it was
issued, the taxpayer’s appeal to the Federal Court in relation to the
first amended assessment had not yet been finalised. The taxpayer
applied for judicial review of the second amended assessment
under s 39B of the Judiciary Act 1903 (Cth), seeking to have that
assessment quashed. The High Court held that there was no
jurisdictional error (as required under s 39B) and any errors in
relation to the second assessment would be covered by s 175. The
substantive issues were being dealt with under the proceedings
under Pt IVC of the TAA, available by virtue of s 175A of the ITAA
1936. The Court found there was no conscious maladministration or
bad faith by the Commissioner, where such could be the basis for
finding jurisdictional error. The Commissioner was entitled to use s
177F(3) at a later time to make an adjustment in relation to the
double counting of the same item of income in both amended
assessments. In Hii v FCT [2015] FCA 375, the taxpayer was audited
and amended assessments were issued. Subsequently, several more
amended assessments were issued. The Federal Court held that
because the assessments were neither tentative nor provisional and
there was no evidence of bad faith, the Commissioner could rely on
ss 175 and 177 of the ITAA 1936 and the taxpayer could not show
that the assessments were invalid under s 39B of the Judiciary Act
1903. In Chhua v FCT [2018] FCAFC 86, the taxpayer alleged that
there was jurisdictional error by the Commissioner in the formation
of an opinion of fraud or evasion, which is necessary for the
unlimited amendment period under s 170 of the ITAA 1936: see
[24.140]. In dismissing the appeal, the Full Federal Court confirmed
that the grounds available to taxpayers under s 39B in relation to
an assessment are limited to bad faith or conscious
maladministration on the part of the Commissioner.
The Full Federal Court in Denlay v FCT (2011) 83 ATR 625 held that when
considering the validity of an amended assessment, the Court considers the
accuracy of the information and the competence and honesty of the ATO
officers who make the assessment. Providing the assessment is not made in
bad faith and there is no evidence of maladministration, it is not an issue
that the information on which the assessment was based may have been
obtained illegally by the party supplying it to the ATO. This was recently
reconfirmed in DCT v Advanced Holdings Pty Ltd [2019] FCA 1917.
Amendments of assessments [24.140]
Section 170 of the ITAA 1936 deals with amendments of assessments.
Legislative changes in 2005 reduced the time available to the Commissioner
to amend assessments. The policy behind this was to provide more certainty
and finality to taxpayers.
The general rule now is that, in relation to taxpayers with simple affairs
(many individuals and small business entities), the Commissioner has two
years from the date on which the notice of assessment is given to amend it:
s 170(1) (Table Items 1–3) of the ITAA 1936. Most other taxpayers are subject
to a four-year amendment period. These other taxpayers include entities
that are not small business entities and taxpayers whose affairs might be
subject to the application of “scheme benefit” anti-avoidance provisions,
including Pt IVA of the ITAA 1936.

Where the Commissioner forms the opinion that a taxpayer has been
involved in fraud or evasion, the Commissioner has an unlimited time to
amend: s 170(1) (Table Item 5) of the ITAA 1936. In 2018, the ATO updated
its practice statement regarding reliance on this unlimited amendment
period: PS LA 2008/6. The concept of “fraud” is common law fraud where a
taxpayer makes a statement either knowing it is false or not believing it is
true or with reckless indifference as to its truth or falsity. “Evasion” involves
a blameworthy act or omission on the part of the taxpayer. An obvious
example of evasion is undeclared cash economy income. A taxpayer’s return
may also be amended at any time if the fraud or evasion is committed by his
or her agent, even if the taxpayer is unaware of the agent’s conduct:
Kajewski v FCT (2003) 52 ATR 455. Challenging the Commissioner’s access
to this unlimited amendment period has been proven to be quite difficult:
Chhua v FCT [2018] FCAFC 86.
Before the time limit expires, a taxpayer can apply for an amendment. This
can happen, for example, where a taxpayer has lodged promptly and is later
informed that they are entitled to a distribution of trust income in their
capacity as a beneficiary of a discretionary trust. The Commissioner will also
amend assessments to give effect to a decision on review or appeal or to
give effect to a private ruling. When there is an amended assessment, the
period for amendment may be refreshed in relation to that particular: s
170(3) of the ITAA 1936.
Where an amended assessment increases taxpayers’ taxable income or
reduces the amount of an offset which has been claimed, the SIC is payable
from the date the original liability was payable until the date of notice of
amendment: Div 280, Sch 1 of the TAA. The underlying policy is to
compensate the revenue for the income forgone during that period. This is in
addition to any administrative penalties which may be imposed, such as a
late lodgment fee. The Commissioner has the power to remit the SIC: s 280-
160, Sch 1 of the TAA. The GIC applies to unpaid tax liabilities and is at a
higher rate: s 8AAG of the TAA. It applies from the time that the tax is due
and is also subject to remission by the ATO: s 8AAB of the TAA. Both interest
charges are deductible under s 25-5(1)(c) of the ITAA 1997.
Collection of tax [24.150]
An amount of a tax-related liability, including an amount of income tax due
and payable, is a debt due to the Commonwealth and payable to the
Commissioner: s 255-5, Sch 1 of the TAA. The time when income tax
becomes due and payable is dealt with in s 5-5 of the ITAA 1997. For
taxpayers who do not fully self-assess, tax is due and payable only after the
Commissioner has issued an assessment. Under s 5-5(5) of the ITAA 1997,
tax is due and payable 21 days after the date the taxpayer is required to
lodge their annual return. When taxpayers lodge their returns either on or
before the due date for lodgment and the Commissioner has issued an
assessment, income tax is due and payable 21 days after the taxpayer
receives the notice of assessment. Full self-assessment taxpayers for whom
lodgment constitutes a deemed assessment and who have been subject to
the PAYG instalment system are required to pay their tax on the first day of
the sixth month after the end of the income year: s 5-5(4) of the ITAA 1997.
When a taxpayer does not lodge a return, then tax is due and payable 21
days after the scheduled lodgment date.
The GIC is levied on late payment of income tax as well as other unpaid tax-
related amounts: s 8AAB of the TAA. The rate is calculated under s 8AAC of
the TAA on a daily compounding basis. The policy behind the GIC is to
compensate the revenue for the loss caused by the late payment. Section
8AAG of the TAA gives the Commissioner power to remit the GIC in specified
circumstances, for example, if the delay in making a timely payment was not
caused by the taxpayer.
Under s 340-5, Sch 1 of the TAA, individual taxpayers and trustees of
deceased estates may apply to the Commissioner for the release of specified
tax liabilities, including income tax, in a case of serious hardship. Otherwise,
tax debts can only be extinguished by the Finance Minister. However, the
ATO may grant any taxpayers an extension of time to pay or other payment
arrangements when they have difficulty in meeting the full amount by the
due date: ss 255-10 and 255-15, Sch 1 of the TAA.
When a tax liability is due and payable, the Commissioner may sue and
recover in any court of competent jurisdiction: s 255-5(1), Sch 1 of the TAA.
In debt recovery proceedings, the notice of assessment is conclusive
evidence that the assessment was properly made and that the amounts are
correct: s 350-10(1) Table Item 2, Sch 1 of the TAA, formerly s 177 of the
ITAA 1936. This is to ensure that any challenge to the substantive tax liability
is resolved by way of the Pt IVC processes and cannot be challenged again in
the debt recovery proceedings.
The Commissioner can pursue recovery even when there is a current and
pending Pt IVC review or appeal of the assessment which gave rise to the
liability: ss 14ZZM and 14ZZR of the TAA; DCT v Broadbeach Properties
(2008) 69 ATR 357. Nor can a taxpayer rely on provisions of another Act,
such as in the Broadbeach case the Corporations Act, to side-step the
Commissioner’s recovery action. In Rawson Finances Pty Ltd v DCT [2011]
FCA 1231, the Federal Court held that the Commissioner was entitled to
pursue recovery and was not required to exercise its discretion to delay
recovery under s 255-10 the TAA despite the fact the taxpayers had lodged
objections to their assessments. The ATO has published its policies in
relation to collection and recovery of tax due in a series of PS LAs setting out
the circumstances when it will sue to recover tax or, alternatively, come to
an arrangement with the taxpayer.

Methods of collection [24.160]

In Australia, much of the income tax revenue is collected under the PAYG
system. This system has two separate strands: 1. PAYG withholding – The
payer deducts amounts from payments to others and remits these to the
ATO. This is the system imposed on employers when paying employees.
2. PAYG instalments – Taxpayers who have business or investment income
report and make regular payments to the Commissioner towards their
anticipated annual tax liability.
The PAYG system means that the Commissioner progressively receives
money from and in relation to taxpayers throughout the tax year. There is
less risk to the revenue, and it is harder for taxpayers to escape the system.
A taxpayer is required to pay PAYG instalments only once they have been
given notice of an instalment rate from the Commissioner: s 45-15, Sch 1 of
the TAA. PAYG instalments must be reported by way of an instalment activity
statement or a BAS and paid at various intervals as required by Pt 2-10, Sch
1 of the TAA. Large taxpayers, those with base instalment income of $20
million or more, must report and pay their instalments electronically on a
monthly basis.
The PAYG withholding system applies to the various payments listed in s 10-
5, Sch 1 of the TAA. As noted above, the main category of payments includes
various remuneration payments such as salary and wages to employees.
Where a taxpayer has not quoted their tax file number (TFN) to a company
that pays the taxpayer a dividend or a financial institution that pays the
taxpayer interest, then the no-TFN withholding mechanism within the PAYG
withholding system will be triggered and the payer must withhold and remit
to the Commissioner tax at the maximum personal income tax rate.
When the taxpayer subsequently lodges their return, the taxpayer receives
credit against the amount of tax payable for any amounts withheld under the
PAYG withholding system: s 18-15, Sch 1 of the TAA. The taxpayer also
receives a credit for the total PAYG instalments payable: s 45-30, Sch 1 of
the TAA. The intention of the system is that most of the tax will be collected
by way of PAYG during the course of the year, and only relatively minor
additional amounts are payable or refundable as a result of the final return.
The PAYG system also incorporates the withholding tax system with respect
to certain payments of unfranked dividends, interest and royalties to foreign
residents. These withholding taxes are at flat rates and act as final taxes (ie,
the taxpayer is not required to lodge a return in relation to this income).
One of the big risks to the PAYG withhold system is when an employer’s
business is failing and the employer retains the money collected from
employees as working cash for the business, instead of remitting it to the
ATO. A new initiative of the ATO, Single Touch Payroll, commenced on 1 July
2018 for employers with 20 or more employees and provides a mechanism
whereby PAYG withholding and superannuation information are automatically
reported in real time to the ATO by the employer’s payroll software. This
system was extended to all employers from 1 July 2019. The ATO is working
on integrating this information into the reporting processes, and employers
are no longer required to provide payment summaries for payments reported
through Single Touch Payroll. The Director Penalty Notice (DPN) regime is
also designed to protect against risk of non-remittance of PAYG withheld
amounts (see [24.202]).
Collection of tax from third parties owing money to a taxpayer
[24.170]
Where a taxpayer owes a debt to the Commonwealth that is being collected
by the ATO and a third party owes money to the taxpayer, the Commissioner
can issue a notice in writing under s 260-5, Sch 1 of the TAA, directing the
third party to pay the money directly to the ATO to meet the taxpayer’s
outstanding tax liability. The Commissioner’s policy in relation to these
notices is set out in Practice Statement PS LA 2011/18. This type of notice is
called a “garnishee” notice and is also used in non-tax proceedings. It is very
hard for a taxpayer to establish that such a notice has been issued in bad
faith: see Saitta Pty Ltd v FCT (2002) 50 ATR 565. The third party needs to
assure itself that the notice is valid, because if it pays the client’s money
directly to the ATO, it may be in breach of its contract with its client and
therefore may be liable to be sued. When complying with a valid notice, the
third party is indemnified for the payment by s 260-15, Sch 1 of the TAA.
In Brown v Brown (2007) 69 ATR 533, the Federal Court held that s 260-5(3)
(b) (which states that money is deemed to be owed to a debtor, whether or
not it is actually due and payable to the debtor, if it is held for or on account
of the debtor) applied to a notice issued by the Commissioner to a firm of
solicitors who were holding money in their trust account on behalf of the
taxpayer. In Marijancevic v Mann (2008) 73 ATR 709, the Commissioner
accidentally issued the garnishee notice before he issued the default
assessments. The Full Federal Court upheld the validity of the default
assessments, stating that they had not only been made to support the
garnishee notices, and found that there was no improper purpose or
conscious maladministration in relation to the assessments. Section 260-5
creates an obligation on the third party which is enforceable by an action in
debt or alternatively by civil process: FCT v Barnes Development Pty Ltd
(2009) 76 ATR 570. Where the notice contained conflicting statements as to
when the payment was due, it was held to be invalid: FCT v De Martin (2011)
82 ATR 906. Failure to comply with a valid notice is also an offence: s 260-20,
Sch 1 of the TAA.
PS LA 2011/13 deals with the application of the section where the taxpayer
lives overseas. In DCT v Conley (1998) 40 ATR 227, the Full Federal Court
held that “money” for the purposes of s 218 of the ITAA 1936 (the
predecessor to s 260-5) is limited to Australian currency.
Collection of tax from person in control of foreign resident’s money
[24.175]
Under s 255 of the ITAA 1936, the Commissioner can serve a notice on a
person who has receipt, control or the disposal of money belonging to a
foreign resident who is liable to pay Australian income tax, requiring that
person to pay the tax which is due and payable under an Australian
assessment. The recipient of the notice is:
• authorised to retain sufficient amounts from the money they receive:
s255(1)(b);
• made personally liable to the extent that they should have retained the
money: s 255(1)(c); and
• entitled to be indemnified for any amounts paid under the ITAA 1936: s
255(1)(d).
The Commissioner may serve a notice prior to the person having receipt,
control or the ability to dispose of the money, but the notice will only be
effective if the foreign resident is liable to pay tax in Australia by virtue of an
assessment at the time of service: DCT v Bluebottle UK Ltd (2007) 67 ATR 1.
The Full Federal Court in FCT v Resource Capital Fund IV LP [2013] FCAFC
118 held that “money” is not confined to Australian currency, and the fact
that the notice directed the taxpayer to pay the debt in Canadian currency
did not render the notice invalid.
Mareva injunctions/freezing orders [24.180]
In accordance with r 7.32 of the Federal Court Rules, on application of the
Commissioner the Federal Court may issue an asset freezing order (also
referred to as a Mareva injunction after the case Mareva Compania Naviera
SA v International Bulkcarriers SA, The Mareva [1980] 1 All ER 213). The
purpose of a freezing order is to prevent the frustration or inhibition of the
Court’s processes, which in the tax context ordinarily would involve recovery
proceedings for a tax debt. The order may prevent a party (in this case a
taxpayer) either from moving assets out of the jurisdiction or from disposing
of them to a third party. The intention to frustrate the judgement does not
need to be shown, and these orders cannot prevent a person from dealing
with assets in the ordinary course of business: FCT v Regent Pacific Group
Ltd [2013] FCA 36. The Commissioner must present evidence that there is a
danger that the debt will be unsatisfied because the assets are removed and
the Court will consider the impact of the requested order on the taxpayer as
well as third parties: DCT v Hua Wang Bank Berhad [2010] FCA 1014.

Departure prohibition orders [24.190]

When the Commissioner believes a taxpayer intends to leave Australia
without discharging their tax liability or without making arrangements to
discharge it, the Commissioner can issue a departure prohibition order (DPO)
under s 14S of the TAA. Practice Statement PS LA 2011/18 discusses the
issues that will be considered by the Commissioner when deciding whether
or not to issue the order. If the Commissioner is satisfied that the tax liability
will be discharged or, alternatively, will never be recovered, the DPO can be
varied or revoked: s 14T; Skase v FCT (1991) 22 ATR 889.
It is possible for a tax debtor to be granted permission to leave Australia
temporarily when there is a DPO in place. Under s 14U of the TAA, the
Commissioner will issue a departure authorisation certificate where he or she
is satisfied that the taxpayer will return to Australia after a short absence
and will then make satisfactory arrangements to discharge the debt. The
onus is on the taxpayer to establish that it should be granted. Section 14U(1)
(b) of the TAA provides that a departure authorisation certificate may also be
granted where a person has provided security to the satisfaction of the
Commissioner or, if the person is unable to give security, the Commissioner
is satisfied that a departure authorisation certificate should be issued on
“humanitarian grounds”: Lui v FCT (2009) 76 ATR 633.
It is an offence for a taxpayer to leave Australia if they know that a DPO is in
force: s 14R of the TAA. A person aggrieved by the issue of a DPO may
appeal to the Federal Court or a State Supreme Court: s 14V of the TAA. If
the Commissioner refuses to revoke or review a DPO or refuses to issue a
departure authorisation certificate, the taxpayer can apply to the AAT for a
review of that decision: s 14Y of the TAA.
Penalties [24.200]
The underlying rationale for any penalty regime is to deter non-compliance.
Penalties in a tax regime can also compensate the government for the
opportunity cost of not having the use of the tax revenue. Effective penalties
are:
• understandable and fair;
• flexible; and
• administered consistently.
The Australian tax system contains a variety of administrative, civil and
criminal penalties including:
• Administrative penalties – Pt 4-25, Sch 1 of the TAA;
• Tax Offences – Div 2, Pt III of the TAA;
• Promoter Penalties – Div 290, Sch 1 of the TAA.
Financial Penalties are imposed using penalty units. The Commonwealth
penalty unit is currently the amount of $222: s 4AA of the Crimes Act 1914
(Cth).
There are also interest regimes described at [24.140] and [24.150].
Administrative penalties [24.201]
The uniform administrative penalties regime in Pt 4-25, Sch 1 of the TAA
consists of three categories of penalty and applies in relation to income tax
as well as the other taxes that the Commissioner administers, such as GST
and FBT. Division 284 deals with statement penalties. Division 286 deals with
failure to lodge documents on time. Division 288 deals with a range of other
issues, including failure to keep or retain a record and failure to provide
reasonable facilities to an authorised ATO officer who is exercising access
and inspection powers under s 353-15 or s 353-10, Sch 1 of the TAA,
discussed at [24.510]. Some of the penalties can overlap.
The main administrative penalties are:
• a taxpayer makes a false or misleading statement to the Commissioner,
such as in a tax return, either because of things included or omitted from it
(s 284-75(1));
• a taxpayer makes a statement that treats an income tax law as applying to
a matter or identical matters in a way that was not reasonably arguable (s
284-75(2));
• penalties in relation to tax avoidance schemes (s 284-145);
• a taxpayer fails to give a return, notice or other document to the
Commissioner by the day it is required to be given (s 286-75); and
• a taxpayer fails to keep or retain records (s 288-25).
The amount of the false or misleading statement penalties in Div 284
depends upon culpability, where the base penalty amount can range from
25% to 75% of the tax shortfall amount or from 20 to 60 penalty units if
there is no shortfall: s 284-90. The base penalty for taking a position that is
not reasonably arguable is limited to 25% of the shortfall: s 284-90 Item 4.
The scheme penalty is 25% or 50% of the scheme shortfall amount: s 284-
160. All of these penalties may be doubled in relation to significant global
entities (defined in s 960-555 of the ITAA 1997). The Commissioner must
make a formal assessment of these penalties (s 298-30) and can increase or
reduce the base penalty amount depending on the behaviour of the
taxpayer: ss 284-220 and 284-224, Sch 1 of the TAA. The taxpayer may
object to such an assessment as set out in Pt IVC of the TAA: s 298-30(2);
see [24.210].
The other administrative penalties arise by operation of law, but the
Commissioner must give notice of the penalty (s 298-10) and has the power
to remit the administrative penalties: s 298-20, Sch 1 of the TAA. One
example of such a penalty is the penalty for failure to lodge documents on
time: s 286-75. A taxpayer who is dissatisfied with the Commissioner’s
decision not to remit can object to this decision under Pt IVC of the TAA: s
298-20(3).
PS LA 2012/5 states that if a statement is unclear or creates a false
impression, it may be “misleading” even if it is literally accurate. In the same
way, a statement that is erroneous will be “false” and it is not necessary to
show dishonesty. Section 284-75(4) extends this penalty to taxpayers who
give statements to someone other than the ATO which are required under a
tax law.
The false or misleading statement penalty does not operate if the taxpayer
can demonstrate that reasonable care was taken when making the
statement: s 284-75(5), Sch 1 of the TAA. What constitutes reasonable care
depends on the individual circumstances of the taxpayer: Ruling MT 2008/1.
It is an objective test and considers the circumstances of the individual
taxpayer, for example, education, health, age, experience: see also PS LA
2012/5. Tax professionals, lawyers and accountants are subject to higher
standards than individual taxpayers. Using a professional does not excuse
taxpayers from checking their individual returns: Re Necovski and FCT
(2009) 75 ATR 152. However, there is a safe harbour for the false and
misleading penalty if the taxpayer uses a tax agent and has provided the tax
agent with all relevant information: s 284-75(6). A similar exception is
available in relation to the late lodgment penalty: s 286-75(1A).
Taxpayers are expected to rely on a reasonably arguable position in relation
to income tax, and if they fail to do so they are liable to pay an
administrative penalty: s 284-75(2). The meaning of “reasonably arguable
position” is given in s 284-15 and requires that the taxpayer take into
account all relevant authorities. Taxpayers may demonstrate that they have
a reasonably arguable position because they have followed public rulings,
applied for a private ruling or consulted specialists. This is considered to be
an objective test: Walstern v FCT (2003) 54 ATR 423. The false or misleading
statement penalty and the penalty for failing to take a reasonably arguable
position are separate and distinct but the Commissioner in practice will only
collect one: Sanctuary Lakes v FCT [2013] FCAFC 50.
Case study 24.5: Division 284 – Re Andriopoulos and FCT (2009–
2010) 78 ATR 654
The taxpayer, a sole trader, owed money to the ATO. Her husband
colluded with an ATO officer to bypass ATO procedures and lodged
two BASs, which had the effect of extinguishing the debt. When the
taxpayer was notified that she would be audited, she consulted a
lawyer and disclosed the “mistake”. The AAT held that including
figures in the BAS constituted a statement under s 284-75(1) and
that the penalty was correctly imposed at the 75% base amount.
The Commissioner reduced the penalty by 20% because of the
voluntary disclosure.

Director penalty notices [24.202]

In order to encourage companies to comply with their tax obligations, Div
269, Sch 1 of the TAA, empowers the Commissioner to issue the directors of
the company with a DPN. The DPN system is designed to encourage the
company either to promptly pay the amounts owing to the Commissioner or
to go into voluntary administration or liquidation by imposing the liability to
pay the amounts on the directors. This system applies to PAYG and
superannuation guarantee charge obligations and was extended to GST
obligations from 1 April 2020. The penalty is imposed automatically by law,
but the Commissioner must issue a notice to the directors and wait 21 days
before commencing recovery: s 269-20, Sch 1 of the TAA. The penalty is
automatically remitted if the company pays the amount or goes into
administration within the 21 days: s 269-30, Sch 1 of the TAA. However, if
the required payment is neither reported nor paid for three months, the
penalty will only be remitted if the company pays the amount: s 269-30(2).
This is referred to as the “lock down rule”.
Tax offences under the Taxation Administration Act [24.203]
The TAA also establishes offences in relation to tax matters: ss 8A–13C of the
TAA. In some cases, these offences overlap with the administrative penalty
provisions in Sch 1, but the two sets of rules are alternatives: one cannot be
both prosecuted for a tax offence and subject to an administration penalty in
relation to the same act: s 8ZE of the TAA. For example, making a false or
misleading statement to a tax officer is an offence under s 8K but could also
give rise to an administrative penalty under s 284-75(1).
The potential penalties vary in relation to the offences but can be quite
serious, including imprisonment. The Commonwealth Department of Public
Prosecutions (CDPP) is responsible for all prosecutions, but the ATO is
granted the power to prosecute the less serious cases (summary offences).
The offences contained in s 8C (failure to lodge a return, produce
information, etc) are absolute liability offences, meaning that there are no
fault elements and the defence of mistake of fact is not available. The
offences contained in s 8D (failure to answer questions or produce
documents when attending before a taxation officer) are strict liability such
that there are no fault elements, but the defence of mistake of fact is
available. However, in both cases, a person will only be liable if they were
capable of complying. The offence under s 8K (false and misleading
statements) is also an absolute liability offence, but the TAA provides a
number of defences. The other main tax offences are s 8L (incorrectly
keeping records) (absolute liability); ss 8N and 8Q (recklessly making false or
misleading statements or recklessly and incorrectly keeping records) (strict
liability); and ss 8T and 8U (acts done with the intention to deceive or
mislead).
Serious cases of tax evasion and other tax-related crimes may be prosecuted
under the Criminal Code Act 1995 (Cth) or the Crimes (Taxation Offences)
Act 1980 (Cth). For example, prosecutions in the tax context can take the
form of the offences of dishonestly obtaining a gain or financial advantage
from the Commonwealth and conspiracy to defraud the Commonwealth:
Criminal Code Act 1995 (Sch 1, ss 135.1, 135.2 and 135.4 respectively). In a
case of tax evasion or tax fraud, both the taxpayer and others involved in
the offence, such as tax advisors, may be prosecuted: R v Issakidis [2018]
NSWSC 378 and Dickson v R [2017] NSWCCA 78. The most serious tax
crimes are managed by the Serious Financial Crime Taskforce, a cross-
agency group that includes the ATO, the Australian Federal Police, Australian
Securities and Investments Commission (ASIC), Border Force and the CDPP.
Return prepared by a tax practitioner [24.205]
Section 284-75(5) provides a taxpayer is not liable to pay false or misleading
statement penalties where they or their agent took reasonable care in
making the statement. This test is objective and where a taxpayer uses the
services of a lawyer, accountant or tax/BAS agent, there is a higher standard
of care than if they were a self-preparer: Re Necovski and FCT (2009) 75 ATR
152.
However, a taxpayer is not liable to pay the penalty if they gave a registered
tax agent or BAS agent all relevant tax information and the agent made the
statement without recklessness or intentional disregard of a taxation law: s
284-75(6), Sch 1 of the TAA. This is called a “safe harbour” for taxpayers
who use the services of registered agents (see [24.690]). The penalty for late
lodgment is also relieved on a similar basis if one uses a registered tax
agent: s 286-75(1A), Sch 1 of the TAA.
Remission of administrative penalties [24.206]
The administrative statement penalties in Div 284 are imposed at a base
rate, but the Commissioner has the discretion in assessing such a penalty
whether to reduce it or increase it because of the taxpayer’s behaviour. In
relation to Div 284 as well as the administrative penalties that operate
automatically, the Commissioner also has the discretion to remit the penalty:
s 298-20, Sch 1 of the TAA. A taxpayer has objection rights to the
assessment of the statement penalties (s 298-30(2)) and the non-remittance
of penalties (s 298-20(3)), subject to time limits: s 14ZW(1)(c) and (1BB) of
the TAA. The onus is on the taxpayer to prove that the penalty is excessive.
The ATO policy on remission of penalties is set out in several Practice
Statements that are continually reviewed.

Promoter penalties [24.207]

Division 290, Sch 1 of the TAA, deals with promoters of tax exploitation
schemes and persons who implement arrangements not in accordance with
a relevant product ruling (PR). On application by the Commissioner to the
Federal Court, the Court may impose civil penalties (s 290-50(3)) or issue
injunctions: s 290-125. The Commissioner also has the power to enter into
voluntary undertakings with an entity: s 290-200, Sch 1 of the TAA.
The division deals with promoters who market or encourage the growth of a
tax exploitation scheme. The term “tax exploitation scheme” is defined to
include cases where it is reasonable to conclude that an entity that entered
into or carried out the scheme did so with the sole or dominant purpose of
obtaining a scheme benefit and it is not reasonably arguable that the
scheme benefit is available at law: s 290-65. This language is similar to that
used on Pt IVA of the ITAA 1936 but is broader as it is designed to include
avoidance of income tax as well other tax obligations and it can apply to
schemes that have not yet been implemented. There have only been a few
applications by the Commissioner for this penalty since the introduction of
these measures in 2006 but all have been successful: FCT v Ludekens [2013]
FCAFC 100. In FCT v Arnold (No 2) [2015] FCA 34, Edmonds J in the Federal
Court found all elements of the division applied and imposed very large fines
as a deterrent. There was “deliberate wrongdoing, sustained denials of
contraventions and lack of remorse”.
In FCT v Ludekens (No 2) [2016] FCA 755, the Court considered those factors
relevant when deciding what penalties should be imposed on promoters. The
penalty imposed should achieve a just and fair result but must not be
oppressive or punish for the same behaviour twice. The Court stressed that
the appropriate penalties must serve as both general and specific
deterrence. The recent cases, FCT v International Indigenous Football
Foundation Australia Pty Ltd [2018] FCA 528 and FCT v Bogiatto [2020] FCA
1139, involved research and development (R&D) tax offset incentives
schemes.
Tax agents, lawyers, accountants, financial planners and other entities who
merely give tax planning advice about a scheme are not caught under the
legislation: s 290-60(2), Sch 1 of the TAA. On the other hand, tax agents who
give aggressive tax advice or false and misleading information to clients may
be prosecuted and also referred to the Tax Practitioners Board (see
[24.690]).

Objections, reviews and appeals [24.210]

The procedure for an objection, review or appeal relating to any reviewable
tax decision of the Commissioner is set out in Pt IVC of the TAA.

This is a merits review system that tests whether the decision is accurate
and goes to the substantive liability. This operates alongside the right of an
aggrieved person to apply for judicial review of an administrative action,
such as a decision of the Commissioner, under s 39B of the Judiciary Act,
which tests whether the administrative power was validly exercised. Some
decisions of the Commissioner can also be the subject of statutory judicial
review under the Administrative Decisions (Judicial Review) Act 1977 (Cth)
(ADJR Act). In some limited instances, it may be possible to pursue both a Pt
IVC appeal and an ADJR Act judicial review application in the same
proceedings: The Buddhist Society of WA Inc v FCT [2020] FCA 1126.
The tax legislation must contain a provision that specifically states that the
decision is reviewable in order to access the Pt IVC process and not all
actions of the Commissioner are reviewable. The main reviewable decisions
are assessments and private rulings. For the purposes of this process, an
objection is called a taxation objection. Figure 24.2 sets out the appeal
process in relation to an assessment.
The general rule is that the time limit for lodging an objection to an
assessment is the same as the time limit the Commissioner has to amend an
assessment, so two or four years: s 14ZW(1)(aa). Where the taxpayer has
been served with an amended assessment, the right of objection in relation
to the amended assessment relates to the particulars of the amendment: s
14ZV. The objection period for amended assessments is the later of the
objection period for the original assessment and 60 days after the notice of
amended assessment was served on the taxpayer: s 14ZW(1B) and (1BA) of
the TAA. A taxpayer can apply to the Commissioner for an extension of time
to lodge an objection: s 14ZX. When deciding whether to grant the request,
relevant issues include the following: the reason for the delay (e.g., taxpayer
overseas and unaware of the issue, ill health of the taxpayer, or negligence
of tax agent); the merits of the objection; whether the Commissioner will be
prejudiced; and fairness to the taxpayer compared to other taxpayers in a
similar position: Hunter Valley Developments Pty Ltd v Cohen (1984) 3 FCR
344 and FCT v Brown (1999) 43 ATR 1. The Commissioner’s views can be
found in PS LA 2003/7.
An objection must be in an approved form in writing, stating fully and in
detail the taxpayer’s grounds of objection: s 14ZU. Unless the court or AAT
hearing the matter exercises its discretion, a taxpayer cannot amend the
grounds stated in the original objection: ss 14ZZK and 14ZZO; Lighthouse
Philatelics Pty Ltd v FCT (1991) 22 ATR 707.
[24.220] A taxpayer can object to an assessment even if it is made in
accordance with the original tax return. This may be a desirable strategy to
test an issue as it minimises potential penalties. It is also possible to object
even when the result is to increase the taxpayer’s liability: Gulland v FCT
(1984) 15 ATR 892. A taxpayer can also withdraw an objection at any time
after it has been lodged.
A taxpayer is entitled to request the Commissioner to supply details of the
material on which the assessment is based: Bailey v FCT (1977) 136 CLR
214.
Under s 25-5 of the ITAA 1997, taxpayers can claim a deduction for costs
paid to a tax agent to prepare a taxation objection as an expense in
managing their tax affairs.
Onus of proof [24.225]
The onus (burden) of proof when challenging an assessment, amended
assessment or default assessment rests with the taxpayer. The taxpayer has
to prove that the assessment is excessive and what the correct assessment
should be: ss 14ZZK(b) and 14ZZO(b) of the TAA.

Case study 24.6: Discharge of onus of proof

In FCT v Dalco (1990) 20 ATR 1370, the Commissioner had issued
amended default assessments under s 167 of the ITAA 1936 alleging
that the amount of income disclosed in the taxpayer’s returns was
insufficient to maintain his lavish lifestyle. The issue in the case
involved what was required of the taxpayer to discharge his burden
of proof.
The High Court held that, in discharging the burden of proof, a
taxpayer needs to show that their actual taxable income is less than
the amount assessed. That burden is not discharged if the taxpayer
only demonstrates that the Commissioner’s assessment is wrong.
The taxpayer needs to establish on the balance of probabilities
what amendments need to be made to the assessment to correct it.
Commissioner’s decision on taxation objections [24.230]
When a taxation objection is lodged within the prescribed time limit, the
Commissioner must decide whether to allow it wholly or in part or disallow it:
s 14ZY of the TAA. The Commissioner must inform the taxpayer of their
further rights of review, including any fees relating to the review and
relevant time limits.
The Commissioner makes the objection decision and serves the taxpayer
with written notice of the decision. There is no prescribed time limit within
which the Commissioner must make an objection decision. However, Pt IVC
contains a mechanism under s 14ZYA for a taxpayer to take action and
ensure an objection is not ignored for a long period by the ATO. If an
objection decision has not been made within 60 days of receipt of the
objection, or within 60 days after the taxpayer has responded to the ATO’s
request for further information, the taxpayer can send a written notice
requesting it to be made. If the decision is not made within 60 days of
receipt of the notice, the objection is deemed to be disallowed. This then
gives taxpayers the option of seeking a review of the decision by the AAT or
appealing the decision to the Federal Court: see [24.240]. In FCT v
McGrouther [2015] FCAFC 34, the Full Federal Court had held that taxpayers
could withdraw a s 14ZYA notice which they had given the Commissioner
before the 60-day period had expired and thereby waive their right to the
deemed objection decision. They would also be able to issue a new s 14ZYA
notice within the relevant time period if they wished.
It may not always be in the best interests of taxpayers to rush to use the s
14ZYA procedure. The Commissioner may require longer than 120 days to
deal with a very complex matter. If the objection is deemed to be disallowed
under s 14ZYA, it is still possible for the Commissioner subsequently to
consider the matter.

Application for appeal or review [24.240]

Section 14ZZ of the TAA provides that if a taxpayer is dissatisfied with the
Commissioner’s objection decision, the person may either: 1. apply to the
AAT for a review of the decision; or 2. appeal to the Federal Court against the
decision.
The application must be in writing, using the prescribed form, stating the
reasons for the application and lodged within 60 days after the objection
decision has been served: ss 14ZZC and 14ZZN of the TAA.
If the taxpayer is delayed in lodging the application for review, and the
circumstances causing delay are reasonable (e.g., a taxpayer’s agent failed
to follow instructions to lodge an application to the AAT), a taxpayer may be
granted an extension of time to lodge an application for review to the AAT: s
29(7) of the Administrative Appeals Tribunal Act 1975 (Cth) (AAT Act). The
Federal Court does not have the power to extend the time for lodging an
appeal later than the 60-day period.
[24.250] Part IVC of the TAA contains two categories of decision: appealable
objection decision and reviewable objection decision (s 14ZQ). The type of
decision dictates whether a taxpayer applies to the AAT or the Federal Court.
Most objection decisions are both appealable and reviewable, and a taxpayer
has to choose between commencing proceedings in the AAT or the Federal
Court. If the taxpayer is not satisfied with the decision of the AAT, they can
appeal on a question of law to the Federal Court: s 44 of the AAT Act. In all
proceedings, the onus of proof remains with the taxpayer to prove that the
assessment is excessive.
Choice between AAT and Federal Court [24.260]
There are several factors for taxpayers to consider when deciding whether to
elect to start proceedings in the AAT or the Federal Court: s 14ZZ of the TAA.
Time, cost, availability of further avenues of appeal and the powers
exercised by the AAT and the Court will all be important.
The powers of the tribunal are set out in the AAT Act. The AAT has all the
powers and discretions of the original decision-maker and it may confirm,
vary or set aside a decision. In March 2019, a Small Business Taxation
Division was established within the AAT to provide a more accessible and
cost-effective option for the resolution of small business tax disputes.
Factors to consider when choosing the AAT include the following:
• It can exercise all the powers of the Commissioner, including the exercise
of a discretion.
• It can use evidence not before the Commissioner in making its decision.
• Parties bear their own costs. These are a lot less than in court proceedings
because taxpayers may act for themselves. They do not need representation
by either a lawyer or an accountant, although they may have it if they wish.
• There are no formal rules of evidence, unlike in a court: s 33(1)(c) of the
AAT Act.
• It must follow the rules of procedural fairness/natural justice (hear both
sides of the issue and neither party is allowed to be a judge in relation to
their own matter).
• It follows previous court decisions but, where there are conflicting
decisions, it makes a choice which one to follow.
• It can consider and make the final decision on questions of fact.
• Applicants can request that hearings be held in private (s 14ZZE of the
TAA) or, alternatively, request that the identity of the taxpayer or some of
the evidence not be made public: s 35 of the AAT Act. Factors to consider
when choosing the Federal Court include the following:
• It limits itself to the evidence available before the Commissioner.
• Court costs are higher as the taxpayer requires legal representation.
• The Court has the power to award costs, that is, the losing party may be
required to pay some or all of the costs of the winning party. At times when a
test case is involved, the Commissioner undertakes to pay agreed costs
regardless of the outcome.
• It is bound to comply with the formal rules of evidence.
• Hearings are conducted in public. There is no right to privacy.
• Courts are bound by the doctrine of precedent.
• Taxpayers have the normal procedural rights available for obtaining
information.
[24.270] Under s 43(1) of the AAT Act, the AAT may exercise all the powers
and discretions which any relevant Act confers on the person who made the
decision, such as the Commissioner, and shall make a decision in writing: 1.
affirming the decision under review; 2. varying the decision under review; or
3. setting aside the decision under review and making a decision in
substitution for the decision set aside or remitting the matter for
reconsideration in accordance with any direction or recommendations.

The AAT is the better choice for taxpayers where the exercise of the
Commissioner’s discretion is an issue or a simple question of fact is involved.
Where there are complicated legal issues, the Federal Court is preferable.
The AAT gives the reasons for its decision either orally or in writing but
where the decision is given orally, a party may within 28 days after receiving
the decision request the AAT to supply written reasons for its decision: s
43(2A) of the AAT Act. The AAT cannot amend an assessment, but the
Commissioner is given 60 days to amend the assessment to implement the
decision of the tribunal: s 14ZZL of the TAA.
The Commissioner and the taxpayer have 28 days after the AAT’s decision
has been handed down to appeal to the Federal Court, providing there is a
point of law involved: s 44 of the AAT Act. A point of law, as distinct from a
question of fact, usually involves the interpretation of a section of an Act or
the meaning of a precedential case and a question of law can include a
mixed question of fact and law: Haritos v FCT [2015] FCAFC 92. The facts as
found by the AAT stand for all further appeals from its decision: FCT v Brixius
(1988) 19 ATR 506. An appeal from the decision of a single judge of the
Federal Court is available to the Full Federal Court (usually three judges): ss
24 and 25 of the Federal Court of Australia Act 1976 (Cth). A further appeal
to the High Court is only available when special leave has been granted: s
33(3) of the Federal Court of Australia Act 1976 (Cth) and s 35A of the
Judiciary Act 1903 (Cth).
ATO Test Case Litigation Program [24.290]
The ATO has a Test Case Litigation Program, whereby it agrees to fund some
or all of a taxpayer’s costs in relation to a case (up to the High Court if
necessary) to assist in clarifying the law. These cases involve issues where
there is uncertainty or contention about how the law operates and it is in the
public interest that the matter be litigated, so ordinarily the issue will be one
that is significant to a substantial section of the public or an industry sector.
The program is not available for cases that only involve factual issues.

In most cases, taxpayers must apply for funding and the applications are
considered by a Panel, made up of internal senior ATO members and external
members, which makes recommendations with respect to funding. The ATO
maintains an online register that shows a brief description of the matters
accepted and declined for funding and also tracks the progress of funded
cases.
The role of the ATO [24.300]
In a self-assessment environment, it is impossible for the ATO to check every
return it receives. Instead, it relies on “risk-assessment” techniques in order
to target which returns or taxpayers should be the subject of closer
examination or an audit. The ATO’s overall strategy consists of a mixture of
assistance and enforcement.
Revenue authorities rely on voluntary compliance, that is, that taxpayers are
honest, declare all their income and only claim the deductions to which they
are entitled and for which they have the required substantiation documents.
However, there will always be taxpayers who do not comply, for example,
criminals such as drug dealers or cash economy participants. The integrity of
the tax system depends on an administration which encourages or, where
necessary, forces these taxpayers into the system.
The Commissioner’s speeches since 2015 have continued with the theme of
“re-inventing” the ATO. The ATO should be known for its contemporary
service, expertise and integrity. It has concentrated on efficiency and
improving a taxpayer’s interaction with the ATO with the use of streamlined
processes. It wants to make the legislation understandable and fair and its
administration consistent and flexible. The ATO wishes to build trust, respect
and confidence at both an individual and organisational level. Core values
include the following: fairness and professionalism; openness and
transparency; and consultation, collaboration and co-design. The ATO strives
to understand the individual problems faced by all types of taxpayer, engage
with them in a useful supportive manner, assist them to be compliant and do
this while upholding the rule of law. Tax administration is no longer a single
country issue but instead it has become borderless particularly in the area of
organised crime. The ATO has engaged with international co-operative
networks of tax administrations.
In 2020, the ATO released its Corporate Plan for 2020–2021 that highlights
the important role played by the ATO in administering the government
stimulus measures in response to the COVID-19 crisis (such as JobKeeper
and the early release of superannuation measures) and also includes a
longer term set of strategic objectives for the period to 2024. The intention is
to build on the gains realised through the re-invention program to date and
focus on two aspirations: “building trust and confidence” and “being
streamlined, integrated and data-driven”. This plan is further detailed in
eight strategic objectives related to government, client (taxpayers and tax
professionals), workforce, operational and financial perspectives.
The Corporate Plan highlights a number of strategic initiatives that will
support the “future goal” of having a system where dealings between the
ATO and clients are seamless and easy, where many interactions occur
automatically. More specifically, the ATO has identified the following strategic
initiatives in relation to clients (taxpayers): optimise taxpayer experience
through self-service channels; improve small business tax performance by
integrating tax reporting; and make verifiable data easier for business
taxpayers to provide, access and use.
Commissioner’s statutory remedial power [24.305]
Division 370, Sch 1 of the TAA, provides the Commissioner with the power to
make disallowable legislative instruments that modify taxation laws to
ensure that they can be administered in such a way that their intended
purpose or effect is achieved. This will reduce disproportionate compliance
costs and benefit the community. It will also give greater flexibility where
legislative problems cannot be solved by administration or interpretation and
recognises that the process of legislative amendment is often slow. The
power may only be exercised where there will be a negligible revenue impact
and gives affected taxpayers a beneficial outcome. It cannot be exercised in
a way inconsistent with the purpose or object of the provision or where there
is a negative impact on taxpayers.
Before exercising this power to issue a legislative instrument, the
Commissioner will consult publicly. As is the case with all legislative
instruments, Parliament has 15 sitting days during which the modifications
can be disallowed. To date this power has only been used three times.
Compliance approach [24.310]
The ATO divides taxpayers into main client groups which can be identified by
the structure of the ATO’s Client Engagement Group structure and the
consultative Stewardship Groups:
• Individuals;
• Small Business;
• Privately Owned and Wealthy Groups (Private Wealth) (resident individuals
who, with associates, have net wealth exceeding $5 million and privately
owned companies which, with associated entities, have a turnover in excess
of $10 million);
• Public and Multinational Businesses;
• Not-for-profits;
• Superannuation funds; and
• Tax professionals and other intermediaries.

There is a separate business line which deals with serious non-compliance

and prosecutions. The ATO works with other law enforcement agencies, such
as the Australian Federal Police, when dealing with these taxpayers.
[24.320] As part of its commitment to transparent tax administration, the
ATO publishes online material dealing with various topics, for example,
capital gains tax (CGT) and record keeping, to assist taxpayers to comply. On
a more macro level, the work of the ATO can be divided into early and
ongoing engagement (such as through the Justified Trusts program for larger
taxpayers), active compliance (audit), and active prevention (such as
Taxpayer Alerts, Practical Compliance Guidelines and Product Rulings).
Third-party reporting [24.330]
The ATO uses computerised data-matching systems to check the accuracy of
the information in tax returns and to pre-fill certain elements of individuals’
tax returns. Much of this is done using TFNs, which are issued to all
taxpayers, including companies, or ABNs. Data are also used to identify
taxpayers for investigation and audit.
Investment bodies, including financial institutions (such as banks) which pay
interest on deposits and companies that pay dividends on shares, must
annually report the amounts paid to taxpayers to the ATO: Div 393, Sch 1 of
the TAA. When an investor fails to give a TFN to a financial institution, that
institution must withhold tax at the maximum individual rate plus Medicare
levy before paying the money or dividend to the taxpayer: s 12-140, Sch 1 of
the TAA. From 1 July 2016, a variety of other government and private entities
must report tax-related information about transactions to the Commissioner:
subdiv 396-B, Sch 1 of the TAA. For example, government revenue collection
departments, such as the Land Titles Office, must report on transfers of real
property. The Taxable Payments Annual Reporting required under subdiv 396-
B, Sch 1 of the TAA, also applies to payments to contractors and
subcontractors and in recent years has been expanded to include categories
considered to be of higher risk, including cleaning, courier, security and
information technology services. There are also rules in Div 405, Sch 1 of the
TAA, that impose special reporting obligations on the building and
construction industry: see also s 70 of the Taxation Administration
Regulations 2017 (Cth). These formal reporting obligations are
complemented by data matching programs that operate under the
Commissioner’s general access to information power (see [24.510]) and are
notified by way of Gazette Notices.
Through the development of international information exchange agreements
and processes, the ATO now has access to large volumes of information
provided by foreign revenue authorities. Financial institutions must report
financial account information to the ATO in a specified format under the
Common Reporting Standard, where the ATO then exchanges information
with other jurisdictions based on the identification of relevant taxpayers.
With respect to company information, the Country-by-Country (CbC)
reporting system has recently commenced where countries will exchange
CbC statements that include details of revenues, profits, taxes paid, cross-
border transactions and other specific information at different levels of a
multinational. The CbC reporting obligations only apply to significant global
entities.
Australian Business Number [24.340]
The Australian Business Number (ABN) is a single number issued to business
taxpayers for use in their dealings with government and other businesses.
Taxpayers who register for GST have the same number for their ABN and
GST registration. The ABN was introduced as an integrity measure when the
GST was introduced and taxpayers must have an ABN to register for GST.
Any person who makes a payment of over $75 to a taxpayer who is
conducting a business for profit is required to withhold and remit to the
Commissioner the maximum personal rate plus Medicare levy if the supplier
of the goods or services fails to quote an ABN: s 12-190, Sch 1 of the TAA.
Taxpayers’ Charter [24.350]
The Taxpayers’ Charter was first issued on 1 July 1997 and sets out the
treatment taxpayers can expect to receive in their dealings with the ATO. It
is not a legislated “Bill of Taxpayer Rights”, unlike the position in the United
States. Although it lacks the force of law, it sets out taxpayers’ rights and
obligations and the ATO’s client service commitments. The ATO views the
Charter as part of its professional approach to tax administration.

The rights of taxpayers include the following:

• Taxpayers can expect the ATO to treat them fairly and reasonably, taking
individual differences into account.
• There is a presumption that taxpayers are honest unless their conduct
demonstrates otherwise.
• The ATO accepts accountability for its actions and assists taxpayers to
meet their tax obligations.
• The ATO is also committed to minimising compliance costs for taxpayers,
provided the revenue is not compromised. The Taxpayers’ Charter also
contains obligations which taxpayers are expected to meet. These include:
• Honesty – taxpayers are expected to be honest in their dealings with the
ATO.
• Record keeping – taxpayers are expected to accurately prepare and keep
required tax records.
• Taxpayers are expected to take reasonable care, meet lodgment deadlines
and pay their tax on time.

Compliance model [24.360]

The Compliance Model was developed for the ATO as part of its
acknowledgment that taxpayers are individuals and there is no “one-size-fit-
all” approach. It is a responsive regulatory pyramid that has been adapted to
specifically relate to tax matters. A pictorial representation of the pyramid is
provided on the ATO website.
The ideal taxpayer is at the base of the pyramid: the taxpayer is willing to do
the right thing; the compliance strategy is to make it easy to comply; and
the level of compliance costs is low. The left side describes the attitude of
taxpayers towards compliance, and the right side describes the strategies to
be used by the ATO to encourage taxpayers back to the base. In relation to
those taxpayers who have decided not to comply, the ATO will use the full
force of the law.
The Compliance Model is accompanied by a client behaviour model that
accepts that many different factors influence taxpayers’ behaviour. The ATO
identifies the following factors: business, industry, sociological, economic,
psychological, and technology and data.
The ATO also uses risk differentiation or assessment frameworks to assess
tax risk and determine an appropriate choice of response. These frameworks
are sometimes provided to taxpayers in ATO guidance materials, such as the
Practical Compliance Guidelines, so that taxpayers can self-assess risk and
adjust behaviours to qualify for a lower risk rating (see, e.g., PCG 2017/1 on
transfer pricing issues and offshore marketing hubs).
ATO support for taxpayers [24.370]
Tax legislation is becoming more complex every year. This makes it very
hard for taxpayers to comply with their obligations because self-assessment
requires them to ascertain their taxable income and, if they make a mistake,
they may be subject to penalties and interest. In addition, in a review or
appeal, the burden of proof rests with them, not the ATO.
The ATO offers a range of products to assist taxpayers and reduce their
uncertainty and risk of error. Some of these products, such as rulings, are
provided for in the tax administration legislation while others have been
developed by the ATO to further assist taxpayers. These products include: •
public rulings (including product rulings (PRs), class rulings (CRs) and
taxation determinations (TDs)): see [24.410]–[24.440];
• private rulings: see [24.450];
• oral rulings: see [24.490];
• interpretative decisions and edited private advice: see [24.500];
• practice statements;
• practical compliance guidelines;
• policy statements;
• decision impact statements;
• online self-help tools, calculators and apps;
• Taxpayer Alerts;
• telephone guidance;
• written guidance;
• press releases;
• booklets and public information videos;
• fact sheets; and
• a comprehensive website: http://www.ato.gov.au. This website contains, in
addition to ATO Policy papers, a schedule of documents containing ATO
precedential views and technical discussion papers.

A distinction is drawn between binding advice (which protects taxpayers

from additional tax, penalties and interest if the advice applies to them) and
guidance (which only protects taxpayers from penalties and interest if it is
reasonable for them to rely on the guidance). Schedule 1 of the TAA sets out
the legislative regime for ATO advice: Div 357 (common rules), Div 358
(public rulings), Div 359 (private rulings), Div 360 (oral rulings) and Div 361
(non-ruling advice and administrative practices).
Common rules that apply to all rulings [24.380]
Division 357, Sch 1 of the TAA, permits the ATO to make a ruling on issues
relating to any provision in an Act or regulation of which the Commissioner
has the general administration and specifically dealing with income tax,
Medicare levy, FBT, franking tax, withholding tax, mining withholding tax,
petroleum rent resources tax, indirect tax including GST, excise duty, the
major banks levy and the administration and collection of those taxes, as
well as other matters: s 357-55, Sch 1 of the TAA.
Rulings bind the Commissioner when a taxpayer acts or fails to act, either
deliberately or through ignorance, in accordance with the ruling: s 357-60,
Sch 1 of the TAA. It is critical that the taxpayer’s affairs fall within the scope
of the ruling if the taxpayer wishes to rely on it: Bellinz Pty Ltd v FCT (1998)
39 ATR 198. Taxpayers can cease to rely on a ruling by deliberately or
unknowingly acting in a manner contrary to its ambit, but, if their behaviour
later changes, they can opt back in and receive the benefit of the system.
There is no penalty if a taxpayer chooses not to follow a ruling, but naturally
the ATO will apply the law in accordance with the position stated in the
ruling.
In Mount Pritchard & District Community Club Ltd v FCT [2011] FCAFC 129,
the taxpayer argued that the Commissioner had raised assessments which
were contrary to an earlier private ruling, in contravention of the former s
170BB of the ITAA 1936 and s 357-60, Sch 1 of the TAA. The taxpayers
sought judicial review of the assessment decisions under s 39B of the
Judiciary Act 1903 and a declaration that the assessments were invalid. The
Full Federal Court unanimously held that there were no provisions in the
private ruling regime which limited the ability of the Commissioner to issue
an assessment and noted that the substantive issues (ie, whether the
private ruling applies such that the assessments were excessive) would be
resolved through the Pt IVC proceedings also on foot in the AAT.
Inconsistent rulings [24.390]
Section 357-75, Sch 1 of the TAA, deals with inconsistent rulings. Where
there is a conflict between a public ruling and any later ruling, the taxpayer
can choose which one to rely on.
When a taxpayer has a private or oral ruling and then applies for a
subsequent private ruling, the taxpayer must follow the earlier ruling unless
the Commissioner has been informed of its existence when the later ruling is
applied for: s 357-75(1), Table Item 2, Sch 1 of the TAA.
When a taxpayer has a private or oral ruling and a public ruling is
subsequently published, the taxpayer can rely on either ruling unless, when
the public ruling is published, either the scheme or the period of time to
which the private ruling relates has not commenced: s 357-75(1), Table Item
3, Sch 1 of the TAA.
When the Commissioner has issued a ruling and the law is subsequently re-
enacted or modified, the ruling will still apply provided the new section
expresses the same ideas as the repealed one: s 357-85.
The validity of a ruling is not affected merely because a provision in Div 357,
Div 358, Div 359 or Div 360 has not been complied with: s 357-90.
[24.400] When a taxpayer has applied for a private or an oral ruling or has
lodged an objection against a private ruling they have received, a taxpayer
is still required to lodge a return, and the Commissioner can still make or
amend an assessment: s 357-125, Sch 1 of the TAA.
Where a taxpayer has applied for a private or an oral ruling, the
Commissioner has the power to request further information before making
the ruling. If the taxpayer does not supply the information in a reasonable
time, the Commissioner may decline to make the ruling: s 357-105(2), Sch 1
of the TAA. If it is a private ruling, written reasons for declining to make it
must be given: s 359-35(4).
Where necessary, the Commissioner may make assumptions about a future
event when issuing a private or oral ruling, but the applicant must be
informed of the assumptions made and be given time to respond to them: s
357-110(2). The Commissioner can also take into account information from
third parties, provided the applicant is fully informed and given the
opportunity to respond: s 357-120.
Public rulings [24.410]
Public rulings (Div 358, Sch 1 of the TAA) may apply to all entities or a class
of entities either generally or in relation to a particular scheme or class of
scheme. They are named as follows: Taxation Ruling TR, the year of issue
and the particular number in sequence of the ruling issued. For example,
Ruling TR 2006/10 is a public ruling issued in 2006. The number 10 merely
means it is the tenth ruling issued that year and has no other significance.
Ruling TR 2006/10 explains the current public rulings system. A ruling must
state that it is a public ruling. Other public rulings include CRs, PRs, law
companion rulings (LCR), TDs and other ruling specific to the other taxes and
regimes of which the Commissioner has general administration, such as GST
rulings (GSTR) and superannuation guarantee rulings (SGRs). Prior to 1992,
the Commissioner issued formal rulings in the Income Tax series. These
rulings are not public binding rulings, but the Commissioner considers that
they are administratively binding on the ATO: see TR 2006/10 at [23].
The ATO’s Project Refresh commenced in 2017 with the objective to review
all public rulings which are over five years old, and if necessary or
appropriate withdraw, update, amalgamate or rewrite them. Through this
process, some of the old ITs have been withdrawn and replaced by binding
TRs. This project has now been integrated into the ATO’s business as usual
program of activities.
The Commissioner issues public rulings when the area of the ruling affects a
sufficiently wide group of taxpayers, the application of the law or its
administration would benefit from clarification and there is a need to give
taxpayers further guidance. A public ruling applies from its date of issue or a
later or earlier date if specified in the ruling. It applies until it is withdrawn
either wholly or in part (s 358-20, Sch 1 of the TAA) when the Commissioner
publishes a notice in the Gazette.
A taxpayer has no right of objection against a public ruling. If taxpayers wish
to challenge a public ruling, they can lodge their return, following the ruling
and then object to the assessment. Alternatively, they can apply for a
private ruling in relation to the same issue, knowing the ATO will follow its
own public ruling and then object to that private ruling.
Law companion rulings [24.415]
LCRs are a relatively new initiative of the ATO, and the first LCR was issued
in 2015. The LCRs are public rulings that state the ATO’s view of how
recently enacted law applies. They are developed when the new legislation is
at draft Bill stage and are finalised when the Bill has received royal assent
and becomes law. They supplement the Explanatory Memorandum that
accompanies the Bill. This process provides early certainty about the
application of the new law for taxpayers.
Product rulings [24.420]
PRs are a type of public ruling that deal with the availability of tax benefits,
usually tax deductibility of expenses, in relation to “product” which is
generally a tax-effective investment: see PR 2007/71 for an outline of the
system. These investments are often classified as “Managed Investment
Schemes” (s 9 of the Corporations Act 2001 (Cth)), and they usually involve
financial products or rural investments, such as in timber, olive growing, or
macadamia nuts. Before PRs were developed in 1998, it was necessary for
every investor in these schemes to apply individually for a private ruling.

A promoter of a product applies to the ATO for a PR. If the ATO issues it, then
all investors in the scheme are entitled to the protection of the ruling, such
as being able to claim a deduction for their expenses, provided the promoter
carries out the scheme in accordance with the documentation given to the
ATO. The promoter penalty rules protect the integrity of the PR system by
penalising promoters who do not implement the scheme in accordance with
the Ruling. The ATO audits these schemes and will withdraw a ruling if the
facts differ from the documents it had ruled on: Carey v Field (2002) 51 ATR
40. The ATO does not investigate the commercial viability of the scheme.
Usually a PR in relation to a financial product is given for a maximum period
of three years, but rulings in relation to forestry investment schemes, for
example, are often longer. PRs have been a very successful part of advice
given by the ATO. Investors would now be reluctant to invest in a product
which does not have a PR because of the uncertainty of their own tax
position, unless they applied for a private ruling. The Federal Court has held
that the decision of the Commissioner not to issue a product ruling was
reviewable under the ADJR Act on application by the product developer:
Agriwealth Capital Ltd v C of T [2019] FCA 56.
Class rulings [24.430]
Ruling CR 2001/1 contains an outline of the CR system. CRs enable the
Commissioner to give a public binding ruling to an entity that needs advice
about the application of the tax legislation to a specific class of person in
relation to a particular taxpayer. Examples include the tax effect for
shareholders of a share buy-back and the tax effect for employees in relation
to an employment termination scheme.
As with PRs, this saves each individual taxpayer who is affected by the
arrangement from having to apply for a private ruling. Where the
arrangement is carried out in accordance with the information supplied to
the Commissioner, the ruling is legally binding on the Commissioner and all
taxpayers in the class can rely on it.
Taxation determinations [24.440]
TDs were introduced as part of the public rulings system. The ATO issues
them when it wishes to clarify its approach to a single issue. Taxation rulings
usually involve multiple issues, they are written in conjunction with external
input and can take months to be finalised. TDs do not usually contain
detailed analysis or alternative viewpoint but are confined to a single issue
without extensive reference to the ATO’s legal analysis of how it reached its
position. Some of the TDs are issue to provide notice of relevant thresholds
for the given income tax year, such as the reasonable travel and overtime
meal allowances.
TDs are binding on the Commissioner in the same way as other public
rulings and apply either from the date specified in the determination or from
the date of issue.
Private rulings [24.450]
Private rulings are dealt with in Div 359, Sch 1 of the TAA, and the system is
explained in Ruling TR 2006/11. Private rulings are statements of the
Commissioner’s view of how a relevant provision applies or would apply to a
taxpayer (the rulee) in relation to a particular set of facts.
Taxpayers may apply for a private ruling in relation to an administrative
matter or a question of fact. Examples of questions of fact are: Is the
taxpayer carrying on a business? Is there a partnership? Is the taxpayer a
resident?
[24.460] A private ruling only applies to the rulee, except for a trust
situation, where the rulee is a trustee and the ruling relates to trust matters
and therefore applies to a replacement trustee and the beneficiaries of the
trust: s 359-30, Sch 1 of the TAA. A private ruling provides no protection to
other taxpayers.
The Commissioner has the power to request further information, and the
taxpayer must supply it within a reasonable time or the Commissioner may
decline to rule: s 357-105(2), Sch 1 of the TAA. The Commissioner can also
decline to make a private ruling on the basis that to do so would require
assumptions to be made about future events: FCT v Hacon Pty Ltd & Ors
[2017] FCAFC 181.
Under s 359-35, the Commissioner can also decline to make a ruling on
various grounds, such as when the application is frivolous, vexatious, or the
scheme is not seriously contemplated, or if the matter is already being
considered by the Commissioner in relation to the applicant. If the
Commissioner decides not to make a ruling, the rulee must be notified in
writing with reasons: s 359-35(4).
[24.470] If the Commissioner has not issued a private ruling within 60 days
after receipt of the application and the rulee has not been informed of the
reasons for the delay under s 359-50(1), Sch 1 of the TAA, the applicant can
issue a notice requiring the Commissioner to rule. If the ruling is not then
issued or formally declined within 30 days, the applicant has the right to
object as set out in Pt IVC: s 359-50(3).
[24.480] As part of its commitment to transparent administration, the ATO
publishes edited versions of private rulings as “edited private advice” on the
ATO legal database. It is important for privacy purposes that individual
taxpayers cannot be identified, so many of the details of the scheme in
question may need to be removed. These edited versions are provided to
taxpayers as information but cannot be relied upon, provide no protection
and are not binding: PS LA 2008/4. Taxpayers receive a copy of the edited
version for comment before it is published. The published documents are not
updated, but in some cases may be annotated if, for example, the edited
version is determined to be misleading.

Oral rulings [24.490]

Under Div 360, Sch 1 of the TAA, an individual taxpayer may apply for an
oral ruling in relation to a simple tax matter. The Commissioner can decline
to rule where the matter is too complex, a business taxpayer is involved or
the issue is already or has been considered by the Commissioner: s 360-5(3).
If the Commissioner requests further information and the taxpayer does not
supply it, the Commissioner can refuse to rule.
Oral rulings are made orally, and the taxpayer is not entitled to request a
written version but is given a registration identifier. The Commissioner is
bound by an oral ruling provided the facts supplied by the taxpayer do not
change. At times, taxpayers prefer to ask for non-binding oral guidance, for
example, by using the ATO phone help line.
Non-ruling guidance [24.500]
The ATO also provides taxpayers with non-ruling guidance and although it is
not legally bound by it, it has usually considered itself administratively
bound. Various descriptions of administrative practice are set out in the PS
LAs. These inform taxpayers of the ATO’s approach when administering the
law. They are followed by the ATO officers.
Other helpful material includes approved policy documents published by the
ATO, for example, speeches by ATO officers. The ATO’s Interpretative
Decisions (ATO IDs) are summaries of decisions on technical issues. Often
they are produced based on a private ruling, but they merely state the ATO’s
interpretation of a particular issue. These are never updated but are rather
withdrawn and are neither legally nor administratively binding on the
Commissioner. No new ATO IDs have been added to the database since
2016, but since that time edited private advice (based on private rulings)
has been included in the searchable ATO legal database and serves a similar
purpose.
Decision Impact Statements are sometimes released by the ATO after a court
has handed down a decision. They inform taxpayers of the ATO’s position
after the decision and how it will administer and apply the law in future to
take it into account. Taxpayers are also informed whether the ATO intends to
appeal.

Taxpayer Alerts are published when the ATO becomes aware of a new,
specific, high risk tax-planning arrangement. They describe the ATO’s
concerns and what they intend to do, such as issue advice or guidance in the
future.
Commissioner’s powers of access and investigation [24.510]
Under s 8 of the ITAA 1936 and s 3A of the TAA, the Commissioner is charged
with the general administration of the tax system under the tax legislation.
When self-assessment was introduced, the focus of the ATO changed from
assessing taxpayers by scrutinising their returns to accepting returns at face
value and subsequently conducting audits or reviews. It is impossible to do
this for every taxpayer, so the ATO chooses taxpayers, either individuals,
small businesses, large companies or the clients of certain tax agents on the
basis of various risk-assessment techniques. Most taxpayers are surprised
when they learn that the Commissioner of Taxation in Australia has greater
powers than the police.

For example, ATO officers may access premises without notice at all
reasonable times for the purposes of a taxation law and copy documents by
virtue of s 353-15, Sch 1 of the TAA, while the police must obtain a search
warrant in order to access private premises, though the police may seize
documents rather than merely copy them: ss 3E and 3F of the Crimes Act
1914 (Cth).
Record-keeping requirements [24.520]
Section 262A of the ITAA 1936 requires every taxpayer carrying on a
business to keep sufficient written records in English (or readily convertible
to English) of income, expenditure and other relevant transactions and retain
them for a period of at least five years after the completion of the
transactions. Recipients of payment summaries must also keep them for five
years, from the end of the financial year: s 18-100, Sch 1 of the TAA. This is
one year longer than the time the Commissioner usually has to make an
amended assessment under s 170 of the ITAA 1936: see [24.140].
Information stored or recorded by means of a computer is recognised as a
document for the purposes of Commonwealth law, and therefore such
storage will satisfy tax record keeping requirements. The ATO’s views
regarding electronic records can be found in TR 2018/2.
Failure to keep or retain records can give rise to an administrative penalty
under s 288-25, Sch 1 of the TAA. It is an offence to keep any required
records in a way that does not correctly reflect the matter or transaction: s
8L of the TAA.

Full and free access [24.530]

Section 353-15, Sch 1 of the TAA (formerly s 263(1) of the ITAA 1936), states
that, for the purposes of a taxation law, the Commissioner or any individual
authorised by the Commissioner:
(a) may at all reasonable times enter and remain on any land, premises or
place; and
(b) is entitled to full and free access at all reasonable times to any
documents, goods or other property; and
(c) may inspect, examine, make copies of or take extracts from, any
documents; and
(d) may inspect, examine, count, measure, weigh, gauge, test or analyse any
goods or other property and, to that end, take samples. One difference
between the former s 263 of the ITAA 1936 and the current s 353-15(1)(b),
Sch 1 of the TAA, is the limitation that access is to be available at all
“reasonable” times. This could prove a practical problem if the ATO sought
access without notice at an early time where they are worried that
documents may be destroyed.
In relation to its previous version as s 263 of the ITAA 1936, the High Court
has always given a very wide interpretation to the section: South Western
Indemnities Ltd v Bank of New South Wales (1973) 129 CLR 512, involving
access to records of an Australian taxpayer held in a bank on Norfolk Island.
Section 353-15(2) provides that any individual authorised by the
Commissioner for the purposes of the section is not entitled to remain on
any land, premises, or place if, after having been requested by the occupier
to produce proof of her or his authority, the individual does not produce an
authority signed by the Commissioner stating that the individual is
authorised to exercise powers under this section. A so-called “wallet
authorisation” is sufficient for these purposes: FCT v Citibank (1989) 20 ATR
292.
Section 353-15(3) states that you commit an offence if:
(a) you are an occupier of land, premises or a place; and
(b) an individual enters, or proposes to enter, the land, premises or place
under this section; and
(c) the individual is the Commissioner or authorised by the Commissioner for
the purposes of the section; and
(d) you do not provide the individual with all reasonable facilities and
assistance for the effective exercise of powers under this section.

Case study 24.7: Accessibility of records

In Industrial Equity Ltd v DCT (1990) 170 CLR 649, the High Court
held that the Commissioner was entitled to obtain records relating
to Industrial Equity which were held by Bankers Trust, where the
purpose of obtaining those records was in the conduct of a random
tax audit. Although the powers must be exercised for the purposes
of the Act, such as ascertaining taxable income or general
administration, a “fishing expedition” was not an improper use of
the power.
Commissioner’s power to obtain information and evidence [24.540]
Section 353-10, Sch 1 of the TAA (formerly s 264 of the ITAA 1936), gives the
Commissioner the power to issue a notice in writing requiring a person to do
all or any of the following for the purpose of the administration or operation
of a taxation law:
1. to give the Commissioner any required information; and
2. to attend and give evidence before the Commissioner, or an individual
authorised by the Commissioner; and
3. to produce to the Commissioner any documents in your custody or under
your control.
Case study 24.8: Commissioner’s power to require information
In Smorgon v Australia and New Zealand Banking Group Ltd,
Smorgon v FCT (1976) 134 CLR 475, the High Court held that the
Commissioner’s power under s 264 of the ITAA 1936, requiring a
bank to produce documents held in a safety deposit box, overrode
the bank’s contractual duty to its client, the taxpayer.

Further, in FCT v ANZ; Smorgon v FCT (1979) 143 CLR 499 (Smorgon
(No 2)), the expression “custody or control” was satisfied by the
fact that the bank had physical custody over the safe deposit box
within which the documents were kept. The Court further held that
s 264 was a wide power, and it enabled the Commissioner to make a
roving inquiry and “fish” for information without needing to specify
with total precision which documents he wished to see.
[24.550] For a notice to be valid, it must specify the relevant taxpayer if the
person on whom the notice is served is not that taxpayer. It should not be
too wide, or the court will strike it down: Australia and New Zealand Banking
Group Limited v Konza [2012] FCAFC 127. Section 264 of the ITAA 1936,
when read in conjunction with s 8C of the TAA, abrogates the common law
privilege against self-incrimination: Stergis v Boucher (1989) 20 ATR 591;
DCT v De Vonk (1995) 31 ATR 481; Binetter v DCT (No 2) [2012] FCAFC 126.
In Australian Crime Commission v Stoddart [2011] HCA 47, the Full High
Court by majority held that the privilege against spousal incrimination did
not exist at common law at the date of the case or at any time.
In Australia and New Zealand Banking Group Limited v Konza [2012] FCAFC
2012, the Full Federal Court unanimously held that s 264 notices requesting
information from an affiliate of the bank about customers using the Vanuatu
branch were valid. The information was stored in a database maintained in
Australia.
It was often easier for the Commissioner to use s 263 rather than s 264
because there are more technicalities involved in ascertaining that a notice
under s 264 is valid.
Case study 24.9: Commissioner uses s 263 to gain access to safety
deposit box
In JJ Kerrison & Banich Management Pty Ltd v FCT (1986) 17 ATR
338, the Commissioner used s 263 of the ITAA 1936 to gain access
to safety deposit boxes kept with a bank. Unlike the facts in
(Smorgon (No 2)) (see Case Study [24.8]), the bank did not have
duplicate keys to the boxes. The Court held that a box was a
“place” under s 263, and the Commissioner’s authorised officer was
entitled to have full and free access to it and, if necessary, to use
reasonable force to open the boxes (such by employing locksmiths
or, if necessary, breaking them open).
In relation to both ss 263 and 264, the occupier of premises is entitled to
request time to obtain legal advice before granting access to the
Commissioner, and if the delay is temporary and not unreasonable, it will not
constitute obstruction and a breach of the sections: Swan v Scanlan (DCT
Qld) (1982) 13 ATR 420.
In Darling, it was held that the ATO could have access to documents which
had been disclosed in a family court dispute on the basis that the taxpayer
had not disclosed everything to the ATO: FCT v Darling (2014) 285 FLR 428.
More recently, the Full Federal Court held that a liquidator was required to
provide to the ATO documents that it had obtained pursuant to a Court order
issued under the Corporations Act, and they could not rely on the so-called
“Harman obligation” that imposes on a party to litigation not to use or
disclose information obtained for any other purpose outside of the
proceedings: DCT v Rennie Produce (Aust) Pty Ltd (in liq) [2018] FCAFC 38.
Legal professional privilege and the power to obtain information
[24.560]
The only restraint on the Commissioner’s access powers under ss 353-10
and 353-15, Sch 1 of the TAA (former ss 263 and 264 of the ITAA 1936), is
the doctrine of legal professional privilege (LPP). This is a common law rule
that promotes the public interest because it assists and enhances the
administration of justice by facilitating the representation of clients by legal
advisers. By keeping communications secret, the client is encouraged to
engage a lawyer and make full and frank disclosure of all relevant
circumstances.
The Commissioner is obliged to give taxpayers the opportunity to claim the
privilege.
Case study 24.10: Legal professional privilege overrides s 353-10
(former s 263)
In FCT v Citibank Ltd (1989) 20 ATR 292, 37 ATO officers conducted
an unannounced raid on the taxpayer’s premises because the
taxpayer had been stalling for several months in complying with s
264 notices. The Full Federal Court held that in exercising the
access power under s 263, ATO officers must give the person with
custody of the documents (in this case Citibank) a practical and
realistic opportunity to claim LPP.

Elements of legal professional privilege [24.570]

LPP cannot always be claimed with respect to confidential communications
with advisers. LPP protects from disclosure communications between a
lawyer and a client made for the dominant purpose of giving or obtaining
legal advice, including advice regarding litigation: Daniels Corp v ACCC
[2002] HCA 49 and Esso Australia Resources Ltd v FCT (2000) 43 ATR 506. To
substantiate a claim, all the elements of privilege need to be made out:
1. there are communications between a lawyer and a client which have been
produced in the context of a lawyer–client relationship;
2. the communications are made in circumstances of confidentiality; and
3. the communication must have been produced or created for the dominant
purpose of providing legal advice to the client.

The High Court has recently confirmed that the nature of LPP is an immunity
from a requirement to disclose: Glencore International AG v C of T [2019]
HCA 26. That case confirmed the ATO’s ability to use documents that had
been released as part of the “Paradise Papers”, which might otherwise be
privileged. Documents or communications which would otherwise enjoy
privileged status will lose that status if disclosed to a third party because
confidentiality has been lost. Documents provided by a third party to the
ATO will not be protected by privilege, and rather, the Commissioner has a
duty to use all information available to him in determining an assessment:
FCT v Donoghue [2015] FCAFC 183.
The privilege belongs to the client taxpayer and not the legal advisor or tax
agent. Taxpayers can choose to waive privilege and give the Commissioner
the documents being sought.
The purpose of the communication must be established at the time the
document is created. If subsequently a copy is made for the dominant
purpose of providing legal advice, the copy may attract the privilege even
though the original did not: Commr of Australian Federal Police v Propend
Finance Pty Ltd (1997) 188 CLR 501; Barnes v FCT (2007) 67 ATR 284.
In Australian Crime Commission v Stewart [2012] FCA 29, the taxpayers
claimed LPP for documents obtained by the Australian Crime Commission on
the grounds that many of the documents were prepared in California and
were governed by the law of that state. The Federal Court held that there
was not an issue in relation to choice of law and that the claim of LPP was to
be decided under Australian law.
On public policy grounds, a communication which would otherwise be
privileged will lose that status if the communication is made in furtherance
of fraud or crime, but is not limited to these objects: Attorney-General (NT) v
Kearney (1985) 158 CLR 500.
The problem with disclosure to a third party is the fact that all tactical
advantage is lost once the other side (usually the ATO) has seen the
privileged document. However, in order to assess a claim for LPP, it is
necessary to inspect the document. One development addressed in case law
and also reflected in the ATO-published materials on the topic is the concept
called a “quick peek”. If the ATO does look at the document as part of the
assessment process, the privilege is not waived and the ATO will work with
taxpayers to develop a process to resolve LPP claims. An LPP working group
was established by the ATO in 2019 to improve the processes for claiming
LPP.

Case study 24.11: LPP – quick peek

In JMA Accounting Pty Ltd v Carmody (2004) 57 ATR 365, the ATO
sought unannounced access to two separate premises of alleged
promoters of tax schemes. The ATO scanned relevant documents
onto discs – one copy for the applicants and one for the ATO to be
held by the Australian Government Solicitor for a fortnight in case
the applicant’s clients wished to claim LPP.
The applicant was excluded from one of its offices for two days. The
Full Federal Court suggested that the ATO was fortunate not to be
sued for trespass. However, the Court was only concerned with the
ATO’s copying and taking of the records in question. The Court
upheld the s 263 access and said that the ATO had made reasonable
provision for LPP to be claimed.
In relation to the specific facts, the Court stated that copying a
privileged document without reading it was not a breach of the
privilege. It was necessary to glance at, but not closely read, the
documents to determine their relevance, and it was also “lawful”
for the ATO officers to read the privileged material for the limited
purpose of deciding whether it might be privileged.
LPP does not extend to third parties but may apply to third-party
communications to a taxpayer.
Case study 24.12: LPP – third-party communications to taxpayer
In Pratt Holdings Pty Ltd v FCT (2004) 56 ATR 128, the taxpayer had
sought advice from its lawyers, and in conjunction with that advice,
documents were created by the taxpayer’s accountants. When the
Commissioner sought access to those documents (valuation
details), the Full Federal Court confirmed that LPP extends to
communications by third-party experts to the taxpayer or to the
legal advisor provided that the communications are made for the
dominant purpose of obtaining legal advice. It is not necessary that
the third party is an agent of the client.
LPP can be waived explicitly or impliedly. In Krok v FCT [2015] FCA 51, it was
held that the taxpayer had impliedly waived his right to claim LPP on the
grounds that he had sworn affidavits about legal advice he had been given
to assist his appeal against his assessments. The Court held that this was
not consistent with the intention of maintaining confidentiality.

In LHRC v FCT [2015] FCAFC 184, the Full Federal Court held that the ATO
was entitled to use evidence which the taxpayer had given to the Australian
Crime Commission (ACC) in a Project Wickenby matter when considering
whether to issue a notice under s 264. The taxpayer acknowledged he had
no privilege against self-incrimination in the ACC but argued he was entitled
to protection under the Australian Crime Commission Act 2002 (Cth). The
Court rejected this argument on the grounds that the protection only applied
to disclosing the information in later criminal proceedings. In addition,
although the ATO officer had already drafted a decision which disallowed the
objections, this did not preclude him from subsequently examining the
taxpayer.
Access to lawyers’ premises [24.575]
The ATO and the Law Council of Australia have developed guidelines for
access to lawyers’ premises. These guidelines specifically retain the sole
purpose test for LPP, which seems to be contradictory to the decision in Esso
Australia Resources Ltd v FCT (2000) 43 ATR 506, but these guidelines were
drafted before this case was decided.
An example of when LPP will generally be recognised is when a client is
seeking legal advice in advance of litigation or for a transaction which is
actual or contemplated. The privilege will not be available if the client is
merely using the lawyer to obtain immunity from production of the
documents. It is also not available in relation to physical objects such as
cash. It belongs to the client not the lawyer, and the client can choose to
waive the claim. Items subject to the claim include:
• advice and opinions of a solicitor or legal counsel;
• drafts or copies of documents created for the purpose of submitting a
report or seeking the advice of a solicitor;
• briefs and copies of solicitors’ briefs to counsel;
• written communication, formal or informal by the client to the solicitor/
barrister or vice versa; and
• solicitors’ draft notes, including counsel’s advice.
[24.580] To assist taxpayers, the ATO provides a guidance document
entitled Our Approach to Information Gathering. This document is available
online, is written in plain English and is comprehensive. It details the various
procedures that the ATO takes in exercising the Commissioner’s access
powers and includes many examples, such as when it might seek access
without notice. The ATO provides approved forms that can be used for
claiming LPP.
Access to professional accounting advisers’ papers [24.590]
After the decision in FCT v Citibank Ltd (1989) 20 ATR 292 (see Case Study
[24.10]), the ATO issued guidelines setting out the procedures it would follow
when seeking access to papers prepared by professional accounting
advisers. The Commissioner acknowledged that in the tax area many
accountants do very similar work to that done by lawyers, so the ATO
granted an administrative privilege to documents prepared by accountants.
The material is contained in the ATO’s Our Approach to Information
Gathering.
The guide categorises documents held by accountants and lists the
Commissioner’s approach to access:
1. Source documents – These are prepared, usually by accountants,
setting out the planning, implementation and recording of a transaction or
agreement. Included in this category are accounting records, such as
ledgers, journals, profit and loss statements and balance sheets. Working
papers of accountants in preparing trial balances and all formal documents,
such as the memorandum and articles of association and transaction
documents, are also source documents. The ATO states that it expects
unrestricted access to these documents.
2. Non-source documents – These include advice papers prepared after
the transaction is complete (including tax return opinions), advice papers on
arrangements that have not been and are not intended to be put into effect,
and advice that does not materially contribute to a tax strategy as well as
papers prepared during a statutory or prudential audit or due diligence.
However, this classification only applies to documents prepared by external
advisers. Despite the fact that LPP could in many cases not be claimed in
relation to non-source documents, the ATO states that the Commissioner will
only seek access to them in exceptional circumstances, such as cases
involving fraud or evasion, or where other avenues of access have been
exhausted.

3. Restricted-source documents – These include tax advice prepared by

accountants on how to structure or present a transaction prepared solely to
advise a client on a tax-related matter. The ATO states that the
Commissioner will only seek access to these documents in extraordinary
circumstances, the same way as access is sought to non-source documents.
The Commissioner will first request further information from taxpayers
before proceeding to enforce access. The guidelines are an administrative
concession by the ATO and apply only to documents prepared by external
professional accounting advisers who are independent of the taxpayer. The
guidelines apply when the request for access is made in the course of an
audit.
Case study 24.13: ATO’s Access guidelines
In Deloitte Touche Tohmatsu v DCT (1998) 40 ATR 435, the Federal
Court held that the Commissioner is required to take the guidelines
into account before issuing a notice under s 264 of the ITAA 1936.
Although they do not constitute a set of rights, ATO officers must
have regard to them and there is a legitimate expectation by
taxpayers and their professional accounting advisers that the ATO
will comply with the guidelines. This was the first case decided
under the original guidelines. Subsequent cases moved away from
the concept of “legitimate expectation” and adopted the standard
of “procedural fairness”, a fundamental tenant in Australian
administrative law.
As a related issue to a claim for LPP relating to documents prepared
by both lawyers and accountants, the taxpayer in Hogan v
Australian Crime Commission (No 4) (2008) 72 ATR 107 and Hogan v
Australian Crime Commission (2010) 75 ATR 794 failed in his claim
for confidentiality on the grounds that disclosure would prejudice
the administration of justice.

Access to corporate board advice papers [24.595]

The Commissioner has also granted an administrative concession in relation
to access to advice prepared for corporate boards regarding tax compliance
risk. This advice may be prepared by either in-house or external advisers and
relates to tax compliance risk management relating to a major transaction or
arrangement or a corporate process. Like restricted source and non-source
documents, the ATO will only seek access to these papers in exceptional
circumstances. Further details are provided in PS LA 2004/14.
Statutory privilege [24.600]
The Evidence Act 1995 (Cth) contains sections granting statutory privilege in
court proceedings, such as for the recovery of tax. Section 118 of that Act
permits the client to claim “client privilege” in relation to confidential
communications prepared with the dominant purpose of providing legal
advice to the client. Section 119 provides a “litigation privilege” when the
advice relates to anticipated or pending litigation. Section 120 gives
litigation privilege to parties lacking representation, but only when the
litigation has commenced.
In New Zealand, s 20B of the Taxation Administration Act 1994 (NZ) provides
that any tax adviser who belongs to an approved professional body can
refuse to disclose a “tax advice document” as defined. This right cannot be
claimed for information in the advice which is factual (so called “tax
contextual information”). The operation of these rules was considered by the
High Court of New Zealand in Blakeley v CIR (2008) 23 NZTC 21,865.

Offshore information notices [24.610]

Section 353-25, Sch 1 of the TAA (former s 264A of the ITAA 1936), gives the
Commissioner the power to obtain information and documents that are
located offshore. He does this by serving a notice on the taxpayer. Before
issuing a notice, the Commissioner must have an objective basis for
believing that the taxpayer has knowledge of the information or the
documents requested, it is offshore, and it is relevant to the taxpayer’s
assessment: FCT v Pilnara Pty Ltd (2000) 43 ATR 581.
The taxpayer must be given at least 90 days to respond to the notice. There
is no penalty if the taxpayer fails to respond, but the taxpayer is precluded
from later using any of the information which is the subject of the notice if
there is a dispute about the taxpayer’s assessment, except with the consent
of the Commissioner: s 353-30, Sch 1 of the TAA.
Operation Wickenby was a major project undertaken by the ATO involving
tracking the offshore income of high net wealth individuals. Section 264A
notices were used as well as the provisions of Taxation Information Exchange
Agreements. These are bilateral tax information exchange agreements,
which deal with the sharing of tax information between developed countries
and low tax jurisdictions where Australia has no comprehensive tax treaty in
place.
Secrecy [24.620]
Division 355, Sch 1 of the TAA, prohibits taxation officers from divulging
“protected information”. This covers information disclosed or obtained for
the purposes of a taxation law that relates to the affairs of an entity and may
identify the entity: s 355-30, Sch 1 of the TAA. This applies to ATO officers,
both during their employment and after it has ceased. It applies to
information dealing with a person’s business matters, professional conduct
or personal affairs.
Often the ATO uses the services of external professional advisers (e.g., on
their public rulings panels, to review the quality of its work in its various
business lines or to advise on developing policy) for various technical issues
and may outsource some functions such as debt collection. Section 355-15
deems these consultants to be “taxation officers” for the purposes of Div
355, and therefore they are bound by the secrecy provisions.
Case study 24.14: Secrecy
In Consolidated Press Holdings v FCT (1995) 30 ATR 390, the Federal
Court upheld the right of the ATO to employ external advisers to
assist in understanding material given to it by the taxpayer, but
stated that the taxpayer had a reasonable and legitimate
expectation that the information they provided would not be given
to third parties without first consulting them. The rules of natural
justice had not been followed.

There are additional statutory exceptions in Div 355 permitting information

to be disclosed to other bodies, such as Ministers, courts of law, Royal
Commissions, the Australian Federal Police and the Australian Security
Intelligence Organisation. Recent amendments to Div 355 allow the ATO to
disclose certain information about tax debts to credit reporting agencies
from 29 October 2019: s 355-72, Sch 1 of the TAA.
ATO operations are also subject to the requirements of the Privacy Act 1988
(Cth) in relation to personal information. There are also specific tax offences
in relation to TFNs and unauthorised access to tax records: ss 8WB and 8XA
of the TAA.
Taxpayers’ statutory rights to obtain information [24.630]
Taxpayers have no general right at common law to have the Commissioner’s
decisions reviewed on their merits or to be given information about a
government department’s reasoning process when dealing with them. The
main Acts relating to taxpayers’ rights to information are the Freedom of
Information Act 1982 (Cth) (FOI Act) (see [24.640]), the ADJR Act (see
[24.650]) and the Inspector-General of Taxation Act 2003 (Cth) (see
[24.670]).
Freedom of Information Act 1982 [24.640]
The philosophy behind the FOI Act is to give members of the public the right
of access to official documents of the Commonwealth Government and its
agencies, including the ATO. The FOI Act also requires government agencies
to publish certain information concerning their functions. Information may be
requested by a taxpayer with respect to documents that contain information
about themselves or in relation to ATO functions more generally. There are
costs associated with FOI requests, specified in the legislation.
The FOI Act gives members of the public a legally enforceable right of access
to a government document other than an exempt document: s 11 of the FOI
Act. The information acquired under this Act can be useful to taxpayers if
they are negotiating a settlement after a tax audit. The information
requested may be provided by way of a right to inspect, or by provision of a
copy, or a recording or transcript for recorded materials, with the person
making the request being able to specify the means by which the material
should be supplied, providing it is reasonable.
If a document is classified as an “exempt document”, the agency is not
required to give it. If a document is “conditionally exempt”, the agency is not
required to give it if to do so would be contrary to the public interest.
Categories of documents that are “exempt” include documents affecting
national security (s 33), Cabinet documents (s 34) and documents subject to
LPP (s 42). Those documents that are “conditionally exempt” include
documents that would reveal the deliberative processes of an agency (s 47C)
and those that would unreasonably reveal personal information (s 47F) or
information concerning business or commercial affairs of a person or
organisation (s 47G) (documents containing trade secrets or commercial in
confidence information are exempt: s 47). There is a specific conditional
exemption for documents that could prejudice the effectiveness of audits (s
47E).
In order to comply with its obligations under s 11A of the FOI Act, the ATO
published an online FOI disclosure log that lists documents that have been
provided under FOI requests and which are available to others for inspection.
Such documents do not include personal information or commercial or
business information of persons.
Administrative Decisions (Judicial Review) Act 1977 [24.650]
The ADJR Act provides a statutory right of judicial review in relation to
administrative decisions. This is in addition to the right to seek judicial
review of a decision or act of the Commissioner under s 39B of the Judiciary
Act. The ADJR Act also provides a statutory right to reasons for decisions
covered by the Act: s 13 of the ADJR Act. For the decision to be reviewable, it
must be “under an enactment” and this has been held to require that the
specific decision-making power is provided under the act (such as the TAA)
and does not, therefore, include decisions made by the Commissioner under
the power of general administration: Hutchins v DCT (1996) ATR 620.
Importantly, many classes of administrative decisions are excluded from the
operation of the ADJR Act: Sch 1 of the ADJR Act. This list includes many
decisions of the Commissioner, listed at paras (e)–(gab), including those
forming part of the process of making an assessment of tax, decisions
disallowing objections to assessments and decisions regarding amending
assessments.
A person aggrieved by a decision may apply to the Federal Court for judicial
review of that decision. Section 5(1) of the ADJR Act sets out the grounds for
review of administrative decisions (these generally reflect the common law
grounds for judicial review):
• where breaches of the rules of natural justice have occurred;
• where procedures required by the law to be observed were not followed;
• where the person did not have jurisdiction to make the decision;
• where the decision was not authorised by the enactment;
• where the making of the decision was an improper exercise of power
(which is expanded on in s 5(2));
• where the decision involved an error of law;
• where the decision was affected by fraud;
• where there was no evidence to justify it; or
• where it was otherwise contrary to law.
Under s 5(2), an improper exercise of power is expressed to cover many
traditional bases for judicial review such as taking irrelevant matters or
failing to take relevant matters into account, acting in bad faith or at the
direction of another, acting contrary to the merits of the matter and acting
unreasonably or in a manner which could produce an uncertain result. FCT v
Citibank Ltd (1989) 20 ATR 292 is an example of the use of the ADJR Act in
relation to the Commissioner’s access power: see Case Study [24.10]. The
Federal Court may set aside the decision, refer the matter for
reconsideration subject to directions, make a declaration regarding the
parties’ rights or make an order directing a party to do or restraining a party
from doing an act or thing: s 16 of the ADJR Act.
Other taxation authorities
Inspector General of Taxation [24.670]
The office of the Inspector-General of Taxation (IGT) was established as an
independent statutory agency following a recommendation of the Ralph
Review of Business Tax: Inspector General of Taxation Act 2003 (Cth).
The IGT undertakes broad reviews into tax administration matters and makes
recommendations to the ATO and to the Government. Recent reviews of the
IGT have been completed on deceased estates (2020), the future of the tax
profession (2019) and the ATO’s use of garnishee notices (2019).
From 2015, the IGT also assumed the role of the Taxation Ombudsman
investigating specific taxpayer complaints with regard to the administration
of the tax system by the ATO, taking over the role previously undertaken by
the Commonwealth Ombudsman. The IGT is not empowered to investigate
issues going to substantive tax liability. The IGT is also responsible for
complaints made against the Tax Practitioners Board.
Board of Taxation [24.680]
The Board of Taxation was established in 2000 following a recommendation
of the Ralph Review of Business Tax. It is an independent non-statutory body,
which advises the Government on the formulation and development of tax
policy. Part of its role is to commission research into areas of difficulty as
requested by the Treasurer and arrange for community consultation,
including input from relevant practitioners. Some reviews are self-initiated by
the Board. For example, in 2017, the Board undertook a self-initiated review
into the tax issues arising from the sharing economy.
In 2018, the Minister for Revenue and Financial Services requested the Board
of Tax to conduct a review of the compliance costs associated with the FBT
regime and to compare that to the experience in overseas jurisdictions with
similar regimes. In order to gather relevant information, the Board ran focus
groups, conducted on-line surveys and conducted case study interviews with
employers. In 2019, the Board of Taxation undertook two reviews into the
residency rules for tax purposes, in relation to individuals as well as
corporates.
Regulation of tax practitioners Tax Practitioners Board [24.690]
Tax agents are professionals employed by taxpayers to assist them in
managing their tax affairs. The Tax Agents Services Act 2009 (Cth) (TASA)
established a national Tax Practitioners Board (TPB), which replaced the
previous State-based system. The underlying rationale of the system is
consumer protection. The TPB was established as an independent statutory
body within the Treasury portfolio but administrative support is provided by
the ATO. The TPB deals with the registration and, where relevant, the
deregistration of tax agents, BAS agents (BAS service providers) and tax
(financial) advisers (since 2014). Civil penalties can apply if one provides
these services for a fee or advertises to do so without the necessary
registration.
The Government announced a review in early 2019 into the regulatory
framework established by the TASA and the TPB and Treasury issued a
Discussion Paper in August 2019. According to the Discussion Paper, there
are currently more than 78,000 active tax practitioners. There are “safe-
harbour” provisions for taxpayers who have consulted a registered tax
agent, such as the false or misleading statement penalty safe harbour at s
284-75(6), Sch 1 of the TAA. One proposal canvassed in the Discussion Paper
is the introduction of an administrative penalty regime that would apply to
tax practitioners where a taxpayer has a tax shortfall owing to the tax
practitioner’s fault. The final report was due to be provided to the
Government by 31 October 2019 but is not yet available.
An individual will be eligible for registration as a tax agent, BAS agent or tax
(financial) advisor if the individual is a fit and proper person who has met the
requirements in relation to qualifications and experience, maintains
professional indemnity insurance and has completed any necessary
continuing professional education requirements: s 20-5 of the TASA. The
criteria for determining if someone is a fit and proper person are prescribed
in s 20-15 of the TASA. The qualifications and experience requirements for
each category of tax professional are given in Sch 2 of the Tax Agent
Services Regulations 2009 (Cth).
Applications for registration and renewals are made to the TPB, which will
evaluate the applicant against the relevant eligibility criteria: s 20-20 of the
TASA. The TPB can grant registration, deny registration or grant registration
with conditions: s 20-25 of the TASA. An applicant can apply to the AAT for
review of a decision to deny the application or specify conditions: s 70-10 of
the TASA.
The Code of Professional Conduct [24.695]
All registered tax agents, BAS agents and tax (financial) advisers must
comply with the Code of Professional Conduct: s 30-5 of the TASA. Non-
compliance with the Code can lead to a written caution, an order to take
specific action, suspension of registration or, in the most extreme cases,
termination of registration: s 30-15 of the TASA. Section 30-10 of the TASA
provides the 14 elements of the Code, which are grouped together under the
following main headings:
• Honesty and integrity: this includes a requirement to comply with the
taxation laws in the conduct of the tax professional’s own affairs and to keep
proper trust accounts in relation to clients’ funds.
• Independence, which requires adequate management of conflicts of
interest.
• Confidentiality.
• Competence: this includes both maintaining one’s knowledge and skills,
taking reasonable care in determining a client’s state of affairs, and taking
reasonable care to ensure that taxation laws are applied correctly.
• Other responsibilities, including the requirement that one not knowingly
obstruct the proper administration of the taxation laws and maintaining
professional indemnity insurance.
The TPB has published a number of information sheets to assist tax
professionals in complying with the Code.
Complaints and investigations [24.698]
Section 60-95 grants formal investigation powers to the TPB in relation to
matters including breaches of the Code of Professional Conduct or other
breaches of the TASA. Such investigations may commence as a result of a
complaint lodged with the TPB in relation to a registered tax professional or
someone providing tax services without the proper registration. For the
purposes of an investigation, the TPB has the power to request that
information or documents be provided and to require witnesses to appear
and give evidence, and failure to comply is an offence under the TAA: ss 60-
100 and 60-105 of the TASA. Complaints regarding the conduct of the TPB
can be made to the IGT.
As a result of an investigation, the TPB may determine that the appropriate
action is to suspend or terminate the registration of the tax professional. The
professional may apply to the AAT seeking a review of such decisions: s 70-
10 of the TASA. By way of example, the AAT confirmed the TPB’s decision to
terminate the registration of a tax agent on the basis that he was not a “fit
and proper” person: Shmuel and Tax Practitioners Board [2019] AATA 2168.
The grounds asserted by the TPB included that the agent had been issued
with a DPN and the tax related liability had not been paid, that he had been
issued with a default judgment in relation to this tax liability and had been
declared a bankrupt but had not disclosed this as required, and that he had
pled guilty to a criminal charge involving dishonesty against the
Commonwealth. In contrast, a decision of the AAT confirming the TPB’s
termination of a tax agent’s registration was set aside on appeal to the
Federal Court on the basis that the tax agent had been denied procedural
fairness in the AAT proceedings: Beckett v Tax Practitioners Board [2019]
FCA 353. More recently, a tax agent’s claim that he had been denied
procedural fairness was dismissed by the Full Federal Court: Frugtniet v TPB
[2019] FCAFC 193.
While a review by the AAT is underway, the applicant can apply to have the
operation and implementation of the deregistration decision stayed pending
resolution of the review: s 41 of the AAT Act. An example of such an
application can be found in Hill and Tax Practitioners Board [2019] AATA 756.
In that case, the TPB had decided to cancel the tax agent’s registration on
the basis that he had failed to comply with the Code of Professional Conduct
specifically that he had failed to act honestly and to comply with taxation
laws in the conduct of his own affairs. The practitioner’s application to stay
the termination decision was unsuccessful.
Questions [24.700]
24.1 Nicole has just received an amended assessment that shows a
significant increase in her taxable income and tax payable. She
thinks the ATO is being very heavy handed in their approach to her
and is treating her unfairly. What options does Nicole have to
challenge this amended assessment – she wants to claim that it is
invalid and excessive. In relation to each avenue of challenge, at a
basic level, what does Nicole need to show?
24.2 Phil is an Australian resident taxpayer who is intending to live
and work in Dubai for three years. Phil wants to know how he will
be treated for tax purposes when he is overseas. He does a few
internet searches and finds a couple of documents in the “edited
private advice” section of the ATO’s legal database that involve
very similar circumstances to what Phil is planning. To what extent
can he rely on this information when completing his tax returns?
What alternative does Phil have to get more tailored advice from
the ATO and what level of protection would that provide?
24.3 Ten officers from the ATO arrive unannounced at the premises
of BDE Ltd, a firm of chartered accountants which specialises in
promoting agricultural tax investments. The ATO copies the entirety
of the hard disk of the chief accountant and as a result copies and
removes advice prepared by BDE on proposed tax investment
arrangements, documents prepared for a prudential audit for a
client and documents prepared by legal advisors on how to avoid
being caught under the promoters’ penalties legislation. Discuss.
24.4 Robert Jones consults a local lawyer in relation to his tax
affairs. He has invested in an olive-growing scheme which did not
have a product ruling. Robert gave details of his tax affairs,
including expenditure in the scheme, to the lawyer in August. The
lawyer did not lodge Robert’s return until the following June. The
lawyer also omitted to include in the return the rental income
Robert derived from a property in New York. Robert was fined for
late lodgment and subsequently audited, resulting in an amended
assessment, a false or misleading statement penalty and the SIC.
Discuss. What difference would it make if Robert consulted a
registered tax agent?
24.5 Elizabeth Wilson prepared and lodged her income tax return on
1 October. On 10 October, she received notice that she was entitled
to a $120,000 distribution from a family discretionary trust in
relation to the prior year. She assumed the trustee would have paid
the tax on her behalf, but in case this was wrong she notified the
ATO of the distribution. Her notice of assessment was issued on 25
October, stating no tax was payable. She was unaware that the ATO
did not take the trust distribution into account when making the
assessment. Elizabeth later realised that she had failed to claim
deductions she had incurred in relation to her home office. Three
years later, she was contacted by the ATO seeking further
information regarding the trust entitlement. Discuss whether the
Commissioner can issue an amended assessment to Elizabeth and
what new issues can now be taken into account.
24.6 ABC Lumber Pty Ltd mills Australian grown timber and sells it
wholesale to other businesses as well as on a retail basis to
individual customers. Bill is in the business of making custom
designed timber furniture and has taken delivery of some recycled
timber from ABC, with payment due in 90 days. The ATO has been
seeking to recover an outstanding tax liability from ABC and
decides that, due to ABC’s reluctance to enter into a payment
arrangement, more aggressive debt recovery actions are required.
The ATO issues a s 260-5 notice to Bill requiring that Bill pay the
amount owing to ABC instead to the ATO. What is the nature of Bill’s
obligation as a result of this notice and what if he ignores it and
pays the money to ABC?
24.7 Mary Jones is an accountant and registered tax agent who
specialises in small business clients, especially those running
restaurants and cafes. As part of the investigations of the Black
Economy Taskforce, Mary has been identified as a potential
facilitator of tax evasion. In particular, evidence suggests that Mary
makes arrangements to allow non-declared cash income to be
funnelled overseas and then back into legitimate accounts in
Australia. The ATO issues a s 353-10 notice to Mary requiring that
she provide any and all information she has regarding the business
accounts of clients running cafes (including balance sheets and
profit and loss accounts) and any employees of those businesses. Is
Mary required to comply with this notice? Can she object to
supplying this information on the basis that to do so would violate
her duty of confidentiality to her clients?
24.8 Over the last income tax year, Kate sold her investment
property and made a capital gain of $50,000. When preparing her
income tax return, Kate inadvertently omitted the gain. A Notice of
Assessment was issued and one year later, Kate received a letter in
the mail from the Commissioner of Taxation asking her to explain
her undeclared income and to take necessary steps to amend her
income tax return. Explain to Kate how the Commissioner may have
discovered the undeclared income and of the potential penalties
and interest she might face.
24.9 Sam works on a full-time basis for WonderWorks, which pays
him a salary on a monthly basis. Sam also derives significant
investment income from shares he inherited from his grandmother.
Sam has just received a notice of a PAYG instalment rate from the
ATO. Explain how the PAYG system will apply in relation to these
income amounts. How are advance payments of tax under this
system taken into account when Sam later lodges his tax return for
the year?
24.10 Simon Wilson is a registered tax agent. Most of his clients are
individual taxpayers. After he has lodged their returns, he advises
the clients what he calculates their refund will be. Then he contacts
the ATO and amends the returns which results in a larger refund.
When he receives the refund, Simon forwards to the client the
amount he had informed them they would receive and keeps the
difference. A complaint is made to the TPB about Simon. What
options are available to the TPB?

Part 7 Indirect and State Taxes

Part 7 of this book focuses on indirect and state taxes. An indirect tax is one
generally embedded in the price of goods or services and is collected by an
intermediary from the entity that bears the ultimate responsibility for the
tax. The Income Tax Assessment Act 1997 (Cth) (ITAA 1997) defines “indirect
tax” to mean GST, wine and luxury car taxes. The most important of these
indirect taxes is GST and, as such, Chapter 25 outlines the GST regime
contained in the A New Tax System (Goods and Services Tax) Act 1999 (Cth).
Chapter 25 explains that GST is a consumption tax for which the ultimate
economic burden falls on the private consumer. This tax was introduced in
Australia on 1 July 2000 and is currently at the rate of 10%. The chapter goes
on to outline the registration process for GST and the rules which give rise to
a GST liability along with the various concepts contained in the GST regime,
such as taxable supply, GST-free supply, input taxed supply, creditable
acquisition and importations. Finally, Chapter 25 outlines the administrative
procedures for GST and its interaction with other taxes.
Separate to Commonwealth taxes, each of the states and territories of
Australia may impose their own taxes. Where this occurs, each jurisdiction
implements its own tax regimes based on its specific legislation and
regulations. Chapter 26 deals with the three major state taxes that students
should be aware of. First, there is stamp duty which is a tax on various
transactions such as property, motor vehicles, mortgages and insurance
policies. Second, there is land tax which is a tax imposed annually on the
holder of land where certain criteria are met. Third, employers may be liable
for payroll tax based on wages paid to employees.

Chapter 25 - Goods and services tax

Key
points ............................................................................................
....... [25.00]
Introduction...................................................................................
............. [25.10]
Registration ...................................................................................
............. [25.50]
Enterprise ......................................................................................
............. [25.60]
Registration turnover
threshold.................................................................. [25.70]
Choosing to
register.....................................................................................
[25.80]
Taxable
supply ...........................................................................................
.. [25.90]
Supply............................................................................................
............. [25.100]
Consideration ................................................................................
............ [25.110]
In the course or furtherance of an
enterprise ........................................... [25.115]
Connection to the indirect tax
zone .......................................................... [25.120]
Consequences of making a taxable
supply ................................................ [25.130]
GST-free
supply .........................................................................................
[25.140]
Food ..............................................................................................
............ [25.142]
Health............................................................................................
............ [25.144]
Education ......................................................................................
............ [25.146]
Other GST-free
supplies ............................................................................
[25.148]
Consequences of making a GST-free
supply.............................................. [25.150]
Input taxed
supply ....................................................................................
[25.160]
Financial supplies: subdiv 40-
A.................................................................. [25.163]
Residential rent: subdiv 40-
B..................................................................... [25.165]
Residential premises: subdiv 40-
C ............................................................ [25.167]
Consequences of making an input taxed
supply....................................... [25.170]
Mixed or composite
supply ...................................................................... [25.175]
Supply
summary ......................................................................................
[25.180]
Creditable
acquisition ...............................................................................
[25.190]
Acquisition.....................................................................................
............ [25.200]
Creditable
purpose....................................................................................
[25.210]
Acquisitions related to input taxed
supplies ............................................ [25.214]
Solely or
partly .........................................................................................
[25.220]
Supply to the entity was a taxable
supply ................................................ [25.225]
Consequences of making a creditable
acquisition ................................... [25.230]
Special
rules .............................................................................................
[25.235]
Non-deductible
expenses ........................................................................ [25.240]
Importation ...................................................................................
........... [25.250]
Taxable
importation .................................................................................
[25.260]
Consequences of making a taxable
importation ...................................... [25.270]
Creditable
importation .............................................................................
[25.280]
Consequences of making a creditable
importation ................................. [25.290]
Offshore
supplies .....................................................................................
[25.295]
Intangible
supplies ...................................................................................
[25.297]
Low value
goods ......................................................................................
[25.299]
Administration ...............................................................................
.......... [25.300]
Timing ...........................................................................................
........... [25.304]
Tax
invoice ..........................................................................................
..... [25.306]
Adjustments ..................................................................................
.......... [25.310]
Non-
residents .......................................................................................
... [25.313]
GST
groups ...........................................................................................
... [25.315]
Interaction with other
taxes .................................................................... [25.320]
Income
tax ...............................................................................................
[25.320]
Fringe benefits
tax.................................................................................... [25.330]

Questions ......................................................................................
.......... [25.340]
Key points [25.00]
• Goods and services tax (GST) is imposed on the consumption of goods and
services in Australia.
• The current rate of GST is 10% on the value of the goods or services.
• Registration for GST purposes is central to the imposition of GST, and
entities may be required to register for GST or may choose to register for
GST depending on their circumstances.
• Liability to pay GST is imposed on the supplier of goods or services.
• A limited number of supplies, categorised as GST-free supplies and input
taxed supplies, do not attract GST.
• Entities may be entitled to a refund of GST paid on the acquisition of goods
or services where the acquisition is for a business purpose.
• Importers of goods into Australia will be liable for GST in most cases
regardless of whether the entity is carrying on a business or whether the
goods are imported for business or private purposes. However, importers
may be entitled to a refund of GST paid on the importation where the goods
are acquired for a business purpose.
• GST is administered by the Australian Taxation Office (ATO), and entities
are required to report their GST obligations on a quarterly or monthly basis,
depending on their circumstances.
• Entities may make an adjustment where there is a change in their
circumstances which alters their GST obligations.
Introduction [25.10]
GST came into effect in Australia on 1 July 2000. GST is a different type of
tax in that it is a tax on consumption and not, for example, on income. In
fact, one reason for its introduction was to reduce Australia’s reliance on
income tax as a source of government funding. Although GST is
administered federally through the ATO, all GST revenue is distributed to the
State Governments under an agreement between the Federal and State
Governments. In return, various State-based taxes, such as the financial
institutions duty and the debits tax, were abolished.
The current GST rate is 10%, which is imposed upon the consumption of
goods and services, including imports, in Australia. GST is a broad-based tax
as it is imposed on the consumption of most goods and services with few
exceptions. Although all consumers (whether private individuals, businesses
or companies) pay GST upon consumption, GST is effectively borne by the
final private consumer due to the ability of certain entities to obtain a refund
of GST paid on acquisitions (known as “input tax credits”).
As discussed in Chapter 3, under the Federal Constitution, taxation laws
must deal with one subject of taxation only. As such, the provisions regarding
GST are contained in separate legislation: A New Tax System (Goods and
Services Tax) Act 1999 (Cth) (GST Act) and A New Tax System (Goods and
Services Tax Administration) Act 1999 (Cth).
Further, the imposition of tax must be dealt with in separate legislation. In
the case of GST, this is through the A New Tax System (Goods and Services
Tax Imposition – General) Act 1999 (Cth); the A New Tax System (Goods and
Services Tax Imposition – Customs) Act 1999 (Cth); and the A New Tax
System (Goods and Services Tax Imposition – Excise) Act 1999 (Cth).
[25.20] Example 25.1 provides an overview as to the application of GST in
practice.
Example 25.1: GST overview
A furniture wholesaler purchases a table for $110 (including GST) from a
furniture manufacturer. The furniture wholesaler sells the table to a furniture
retailer for $220 (including GST). The furniture retailer sells the table to a
private consumer for $330 (including GST). The GST consequences of the
transaction are as outlined in the following table:
[25.30] In the rest of this chapter, the rules which give rise to the outcomes
in Example 25.1 are outlined. We will learn why the manufacturer,
wholesaler and retailer charged GST on the sale of the table (because it is a
“taxable supply”), why the wholesaler and the retailer were entitled to input
tax credits (i.e., a refund of GST paid) on the acquisition of the table
(because it is a “creditable acquisition”) and why the private consumer was
not entitled to input tax credits on the acquisition of the table (because it is
not a “creditable acquisition”).
This chapter also briefly discusses the provisions regarding importations,
administration and adjustments. Although the fundamentals of the GST are
reasonably straightforward, there are a large number of special rules which
complicate the operation of the GST in practice. Some of these special rules
are highlighted in the chapter, but an extensive discussion of them is beyond
the scope of this book.
[25.40] Figure 25.1 provides a guide to dealing with GST.
Registration [25.50]
Registration is a key aspect of GST and is central to both the imposition of
GST and the entitlement to a refund of GST paid. One exception to the
general rule is that registration may not be relevant to the imposition of GST
on importations: see [25.250]. Note that registration refers to registration for
GST purposes and not to obtaining a Tax File Number (TFN) for income tax
purposes or obtaining an Australian Business Number (ABN), although a
corollary of registering for GST is that entities will obtain an ABN.
A wide range of entities, including individuals, companies, trusts and
partnerships, can register for GST. However, an entity must be carrying on
an enterprise in order to register: s 23-10 of the GST Act; see [25.60].
Registration for GST purposes is prima facie optional, but entities will be
required to register in certain circumstances: see [25.70].
Enterprise [25.60]
“Enterprise” is defined in s 9-20 of the GST Act and includes an activity or
series of activities conducted:
• in the form of a business;
• in the form of an adventure or concern in the nature of trade; or
• in the form of leasing, licensing or other grant of an interest in property on
a regular or continuous basis.
Therefore, the income tax topics on whether a taxpayer is carrying on a
business for tax purposes (see Chapter 8) or an isolated commercial
transaction that constitutes a business (such as in FCT v Whitfords Beach Pty
Ltd (1983) 14 ATR 247: see Case Study [8.7]) are relevant in determining an
entity’s entitlement to register for GST.
Example 25.2: Carrying on an “enterprise”
Jesse cleans shoes for his friends and family. He is so good at it that
many people ask him to clean their shoes. He enjoys cleaning shoes,
and so he readily agrees to clean the shoes. He charges for the cost
of his products and his time, and he has found it to be a very
profitable activity. He has decided to become a full-time shoe
cleaner.
The fact that Jesse performs his shoe-cleaning activities repetitively
and on a regular basis and the fact that he intends to and does
make a profit from the activity indicate that Jesse is carrying on a
business for income tax purposes: see Chapter 8.
As Jesse is carrying on a business for income tax purposes, his
activities constitute an enterprise for GST purposes. He is entitled
to register for GST if he so chooses but may be required to do so
depending on his circumstances.
Certain activities, such as the provision of labour as an employee, a private
recreational pursuit or hobby, or activities done without a reasonable
expectation of profit or gain, are specifically excluded from the meaning of
“enterprise” (s 9-20(2)), while the activities of certain entities, such as
charitable and religious institutions, are specifically included as constituting
an enterprise: s 9-20(1)(d)–(h). There is some uncertainty as to the operation
of the exception for employees following Spriggs v FCT; Riddell v FCT (2009)
72 ATR 148 (see Case Study [8.9]), where the High Court found that
employment activities can form part of a business.
Unless there is a taxable importation (see [25.260]), GST is not relevant if
the entity is not carrying on an enterprise.

Registration turnover threshold [25.70]

Entities that are carrying on an enterprise must register for GST where their
annual turnover exceeds the registration turnover threshold: s 23-5 of the
GST Act. From 1 July 2007, the registration turnover threshold is $150,000
for non-profit organisations and $75,000 for all other entities: s 23-15; regs
23-15.01 and 23-15.02 of the A New Tax System (Goods and Services Tax)
Regulations 1999 (Cth) (GST Regulations). Prior to that date, the registration
turnover thresholds were $100,000 and $50,000, respectively.
There is one exception to the general rule which is that suppliers of “taxi
travel” are required to register for GST regardless of their annual turnover: s
144-5. “Taxi travel” is defined in s 195-1 as “travel that involves transporting
passengers, by taxi or limousine, for fares”. In Uber BV v Commissioner of
Taxation [2017] FCA 110, the Federal Court held that the provision of UberX
services constituted the supply of “taxi travel”. As such, entities that carry
on an enterprise and provide ride-sourcing services must register for GST,
regardless of turnover. “Ride-sourcing” refers to an ongoing arrangement
where a taxpayer makes a car available for public hire; a passenger uses a
website or smart phone application provided by a third party to request a
ride; and the taxpayer uses the car to transport the passenger for payment
with a view to profit.
The meaning of “annual turnover” is outlined in Div 188. An entity’s annual
turnover is the value of all of its supplies during the relevant 12-month
period related to its enterprise, excluding any input taxed supplies (see
[25.160]) and supplies not made for consideration: s 188-15. The relevant
12-month period includes the current-year annual turnover (i.e., annual
turnover for the current month and the preceding 11 months) and the
projected annual turnover (i.e., annual turnover for the current month and
the following 11 months). Broadly, an entity’s annual turnover is its GST-
exclusive sales revenue arising from its enterprise. See GST Ruling GSTR
2001/7 for further guidance on the meaning of “annual turnover”.

Choosing to register [25.80]

Entities with an annual turnover below the registration turnover threshold
may still choose to register for GST provided that they are carrying on an
enterprise. Entities generally choose to register for GST in order to obtain a
refund of GST paid on acquisitions: see [25.190]. However, the
consequences of registration are that the entity may incur additional
compliance costs in satisfying its administrative responsibilities (see
[25.300]) and that the entity may be required to impose GST on its supplies,
potentially increasing the cost of its supplies to the customer: see [25.130].
Example 25.3: GST registration
Jesse owns a mobile shoe-cleaning business. He used to work on his
own and earned sales revenue of approximately $30,000 each year.
He has now hired two more employees as business is booming. He
expects that, with the additional employees, his sales revenue for
the year will increase to approximately $90,000. Initially, Jesse is
not required to register for GST purposes as his current and
projected annual turnover ($30,000) is below the registration
turnover threshold ($75,000). However, Jesse may choose to
register for GST purposes depending on his circumstances. Once
Jesse hires the two additional employees, he is required to register
for GST as his projected annual turnover ($90,000) exceeds the
registration turnover threshold.
Taxable supply [25.90]
Taxable supplies are central to the operation of GST as they create the
obligation to pay (and therefore charge) GST. An entity makes a taxable
supply under s 9-5 of the GST Act if:
• it makes a supply: see [25.100];
• the supply is for consideration: see [25.110];
• the supply is made in the course or furtherance of the entity’s enterprise:
see [25.60] and [25.115];
• the supply is connected with the indirect tax zone: see [25.120]; and
• the entity is registered or required to be registered for GST: see [25.50].

However, a supply is not a taxable supply to the extent that it is a GST-free

supply (see [25.140]) or an input taxed supply: see [25.160].

Supply [25.100]
Section 9-10 of the GST Act defines “supply” as “any form of supply
whatsoever” and specifically includes (but is not limited to) the following:
• a supply of goods;
• a supply of services;
• a provision of advice or information;
• a grant, assignment or surrender of real property;
• a creation, grant, transfer, assignment or surrender of any right;
• a financial supply: see [25.163]; and
• an entry into, or release from, an obligation to do anything, to refrain from
an act or to tolerate an act or situation.
Example 25.4: Making a supply
Jesse has his own shoe-cleaning business.
The cleaning of shoes is a supply as it is the provision of services.
This definition of “supply” is very broad, and many activities of an entity may
constitute the making of a supply. In FCT v Reliance Carpet Co Pty Ltd (2008)
68 ATR 158, the High Court considered the meaning of “supply” in the
context of the GST legislation. The Court’s decision supports a wide
interpretation of “supply”.
Case study 25.1: Meaning of supply
In FCT v Reliance Carpet Co Pty Ltd (2008) 68 ATR 158, the taxpayer
granted a purchaser an option to buy commercial property in
Victoria. The purchaser exercised the option and the parties
entered into a contract for the sale of the property for a price of
A$2.975 million plus GST. The purchaser paid a deposit of
A$297,500. The purchaser subsequently defaulted and, under the
terms of the agreement, the deposit was forfeited to the taxpayer.
The Commissioner assessed the taxpayer for GST on the forfeited
deposit under s 99-10 of the GST Act, which establishes the time of
recognition for a forfeited deposit. The taxpayer argued that GST
was not applicable on the forfeited deposit as there was no supply,
a requirement for the application of s 99-10.
The High Court found that the deposit was consideration for a
supply, being the obligations undertaken by the vendor on entry
into the contract. The High Court noted that “there was upon
exchange of contracts the grant by the taxpayer to the purchaser of
contractual rights exercisable over or in relation to land, in
particular of the right to require in due course conveyance of the
land to it upon completion of the sale”.

The wide interpretation of “supply” was affirmed by the High Court in FCT v
Qantas Airways Ltd [2012] HCA 41.
Case study 25.2: Existence of a supply
In FCT v Qantas Airways Ltd [2012] HCA 41, the taxpayer was the
supplier of domestic and international air travel. GST is imposed on
domestic travel and the question arose as to whether GST was
payable where a passenger books and pays for a domestic flight but
subsequently cancels the booking or does not turn up for the flight
and does not receive a refund.
The taxpayer argued that GST was not payable as there was no
“supply” (ie, the provision of a flight). The Commissioner argued
that the relevant supply when the passenger made a booking and
paid for it was the booking itself. The AAT had found that there was
a “supply” when the booking was made being the fact that the
taxpayer was “holding itself ready” to carry the passenger at a
future time.
The Full Federal Court held that the relevant supply was the
provision of travel, and it was inappropriate to artificially split the
transaction into two separate components (ie, the booking and the
travel). Here, the conditions of carriage were specifically linked with
a particular flight, rather than the booking, which further supported
the conclusion that the relevant supply was the provision of travel.
The High Court, by 4-1 majority, found that the taxpayer was liable
for GST in respect of bookings made by customers where the
customer did not travel on the booked flights. The relevant supply
by Qantas was “the promise to use best endeavours to carry the
passenger and baggage, having regard to the circumstances of the
business operations of the airline” (para 33).
The High Court’s decision in FCT v Qantas Airways Ltd suggests that it will
generally be the case that there is a “supply” for GST purposes as most
transactions involve the formation of a contract and the granting of rights
under the contract will constitute a “supply”. A broad view of “supply” was
also adopted by the High Court in FCT v MBI Properties Pty Ltd [2014] HCA
49. The Commissioner discusses the meaning of “supply” in Ruling GSTR
2006/9.

The only exclusion to the definition of “supply” is the supply of money or

digital currency, unless the money or digital currency is provided as
consideration for a supply that is a supply of money or digital currency: s 9-
10(4). For example, the provision of money on the acquisition of a table will
not constitute a “supply”. However, the provision of money in a foreign
exchange transaction will constitute a “supply”.
Consideration [25.110]
“Consideration” is defined in s 9-15 of the GST Act as including any payment
or any act or forbearance in connection with the supply. As such,
consideration is not limited to the provision of money, but includes anything
of value, such as the provision of services or goods.
Note that the consideration does not have to be voluntary or even provided
by the recipient of the supply: s 9-15(2).
Example 25.5: Consideration
Adam is an accountant. He recently assisted Jesse in completing his
tax return for his shoe-cleaning business. Adam would normally
charge $110 for his services, but in this case, he decided to accept
Jesse’s offer of one year of free shoe-cleaning services, which would
normally be worth at least $300.
The free shoe-cleaning services would constitute consideration for
Adam’s supply of accounting services. Further, the accounting
services would constitute consideration for Jesse’s supply of shoe-
cleaning services.
In the course or furtherance of an enterprise [25.115]
The meaning of “enterprise” is discussed at [25.60]. The expression “in the
course or furtherance of” is not defined in the legislation. FCT v Reliance
Carpet Co Pty Ltd (2008) 68 ATR 158 (see Case Study [25.1]) suggests that a
wide approach is to be adopted and any supply that is connected to the
enterprise will be made “in the course or furtherance of” that enterprise.
Connection to the indirect tax zone [25.120]
Section 9-25 of the GST Act details when a supply would be connected with
the indirect tax zone. The “indirect tax zone” is defined in s 195-1 of the GST
Act and in essence refers to Australia. The term “Australia” was replaced in
the GST Act with “indirect tax zone” from 1 July 2015 to ensure consistency
of terminology across the tax legislation. There was no change in policy with
the change in terminology, and the term “Australia” is used here for
readability. Examples of supplies connected to Australia include where:
• the goods are delivered or made available to the recipient in Australia;
• the supply involves goods being removed from Australia;
• the supply is of Australian land;
• the supply is done in Australia;
• the supply is made through an enterprise carried on in Australia; or
• the recipient of the supply is an Australian consumer (see [25.297]).
The Commissioner has published Ruling GSTR 2018/1 on when supplies of
real property will be connected with Australia, Ruling GSTR 2018/2 on when
supplies of goods will be connected with Australia and Ruling GSTR 2019/1
on when supplies of anything other than goods or real property (i.e.,
intangibles) will be connected with Australia.

Consequences of making a taxable supply [25.130]

An entity that makes a taxable supply is liable to pay GST on the taxable
supply: s 9-40 of the GST Act. It is therefore important to note that, although
in practice it is often the recipient of a taxable supply who pays GST, the
imposition of the liability to pay GST under the law is actually on the
supplier.
The amount of GST payable on the taxable supply is 10% of the value of the
taxable supply: s 9-70. The value of a taxable supply is equal to ten-
elevenths of the price of the supply: s 9-75. Generally, the price of a supply
is equal to the consideration for the supply. Remember that consideration
can be monetary or non-monetary in nature (see [25.110]), and the price is
the sum of any monetary consideration and the GST-inclusive value of any
non-monetary consideration: s 9-75(1).
Example 25.6: Consequences of making a taxable supply
Jesse has his own shoe-cleaning business, which is registered for
GST purposes. Jesse charges his customers $22 per cleaning. The
cleaning of shoes is a taxable supply as it meets all of the
requirements of a taxable supply in s 9-5. As a consequence of
providing a taxable supply, Jesse must pay GST of 10% on the value
of the taxable supply. The value of the taxable supply is ten-
elevenths of the price of the supply.
The price of the supply is equal to the consideration received, which
in this case is $22.
Therefore, GST payable by Jesse on the provision of shoe-cleaning
services
= 10% × (10/11 × $22) = $2.
GST-free supply [25.140]
Certain goods and services are exempt from being a taxable supply if they
are listed in Div 38 of the GST Act as “GST-free supplies”.
The list of items which are GST-free supplies is limited and generally relates
to goods or services which are considered essential living expenses,
necessary to maintain the international competitiveness of Australian
businesses or charitable activities.
The following items are listed in Div 38 as GST-free supplies:
• food – subdiv 38-A: see [25.142];
• health – subdiv 38-B: see [25.144];
• education – subdiv 38-C: see [25.146];
• child care – subdiv 38-D: see [25.148];
• exports – subdiv 38-E: see [25.148];
• religious services – subdiv 38-F;
• non-commercial activities of charitable institutions, etc – subdiv 38-G;
• raffles and bingo conducted by charitable institutions, etc – subdiv 38-H;
• water, sewerage and drainage – subdiv 38-I;
• supplies of going concerns – subdiv 38-J: see [25.148];
• transport and related matters – subdiv 38-K;
• precious metals – subdiv 38-L;
• supplies through inward duty free shops – subdiv 38-M;
• grants of land by governments – subdiv 38-N;
• farm land – subdiv 38-O;
• cars for use by disabled people – subdiv 38-P;
• international mail – subdiv 38-Q: see [25.148];
• mobile global roaming services provided in Australia – subdiv 38-R;
• eligible emissions units – subdiv 38-S; and
• inbound intangible consumer supplies – subdiv 38-T: see [25.297].
Some of the more common categories of GST-free supplies are discussed in
further detail below.

Food [25.142]
Section 38-2 of the GST Act stipulates that a supply of food is GST-free. Food
is defined in s 38-4 as:
• food and beverages for human consumption;
• ingredients for food and beverages for human consumption;
• goods to be mixed with or added to food for human consumption (including
condiments, spices, seasonings, sweetening agents or flavourings); and
• fats and oils marketed for culinary purposes.
Under s 38-4, “food” does not include live animals (other than crustaceans or
molluscs); unprocessed cow’s milk; grain, cereal or sugar cane that has not
been subject to any process or treatment; or plants under cultivation that
can be consumed as food for human consumption without being subject to
further process or treatment.
The broad exemption from GST for food is narrowed by s 38-3, which
specifies when food is not GST-free. Food is not GST-free where it is:
• for consumption on the premises from which it is supplied (e.g., restaurant
food);
• hot food for consumption away from those premises; and
• food specified in Sch 1 of the GST Act as not being GST-free. A wide range
of food is listed in the Schedule as not being GST-free. Food that is not GST-
free includes:
• prepared food (e.g., quiches, sandwiches, pizzas, prepared meals but not
including soup, burgers);
• confectionary (e.g., muesli bars, popcorn);
• savoury snacks (e.g., potato crisps, processed seeds or nuts);
• bakery products (e.g., cakes, pies, scones, bread with a sweet filling or
coating); and
• ice-cream food and biscuit goods.
Despite the detailed list in Sch 1, the question as to whether a particular
item of food is GST-free or not continues to arise in practice. In Lansell House
Pty Ltd v FCT (2011) 79 ATR 22, the Full Federal Court considered whether
“mini ciabatte” (Italian flat bread) is “bread”, which is GST-free, or a
“cracker”, which is not GST-free. Based on the evidence presented (the
appearance of the mini ciabatte, the ingredients and manufacturing process,
as well as the treatment by stockists who sold it as a cracker or in the
company of crackers), the Court concluded that “mini ciabatte” is a cracker
and therefore not a GST-free supply. The High Court refused the taxpayer’s
application for special leave to appeal.
Beverages that are GST-free are listed in Sch 2 and include milk products;
soy milk and rice milk; tea and coffee (but not in ready-to-drink form); fruit
and vegetable juices; beverages for infants and invalids and natural, non-
carbonated water without any additives.
A broad rule of thumb is that only fresh, unprocessed food will be GST-free.
Note that, under s 38-6, the packaging in which food is supplied is also GST-
free if the supply of the food is GST-free.
Health [25.144]
Under s 38-7 of the GST Act, the supply of a medical service is GST-free.
“Medical service” is defined in s 195-1 as a service for which a Medicare
benefit is payable or any other service supplied by or on behalf of a medical
practitioner or approved pathology practitioner that is generally accepted in
the medical profession as being necessary for the appropriate treatment of
the recipient of the supply. Under s 38-7(2), certain medical services, such as
those provided for cosmetic reasons for which a Medicare benefit is not
payable, are not GST-free. Any goods supplied in the course of supplying
medical services are GST-free if the medical services are GST-free: s 38-7(3).
Section 38-10 extends GST-free treatment to the supply of other health
services, such as acupuncture, chiropractic, dental, nursing, podiatry and so
forth, where the requirements of the section are satisfied. Broadly, the
service must be supplied by a person who is a recognised professional in
services of that kind, and the service provided would be accepted in the
profession as appropriate treatment for the patient.
Under s 38-45, medical aids and appliances which are listed in Sch 3 of the
GST Act are GST-free if the thing supplied is specifically designed for people
with an illness or disability and is not widely used by people without an
illness or disability. Examples of medical aids and appliances listed in Sch 3
include heart monitors, pacemakers, orthotics, nebulisers and prescription
contact lenses. Section 38-50 specifies that drugs and medicines are GST-
free if the supply is on prescription, and certain other conditions are
specified.
In addition, subdiv 38-B also lists other government-funded health services
(s 38-15), hospital treatment (s 38-20), residential care (s 38-25), community
care (s 38-30), flexible care (s 38-35), specialist disability services (s 38-40)
and private health insurance (s 38-55) as being GST-free supplies where the
necessary conditions are satisfied. Determination GSTD 2012/4 sets out the
Commissioner’s views as to when the supply of hospital treatment will be
GST-free under s 38-20.

Education [25.146]
The supply of an education course and any administrative services directly
related to the supply of such a course which are provided by the supplier of
the course are GST-free supplies under s 38-85 of the GST Act. “Education
course” is defined in s 195-1 as being:
• a pre-school course;
• a primary course;
• a secondary course;
• a tertiary course;
• a Masters or Doctoral course;
• a special education course;
• an adult and community education course;
• an English language course for overseas students;
• a first aid or life saving course; and
• a professional or trade course or a tertiary residential college course. Each
of these courses is separately defined in s 195-1.
In addition, excursions or field trips (s 38-90), course materials (s 38-95) and
leases of curriculum-related goods (s 38-97) are also GST-free where they
relate to an education course and satisfy the conditions specified in those
sections. Accommodation at boarding schools may be GST-free under s 38-
105, while certain services provided in recognising prior learning may be
GST-free under s 38-110.
Aside from course materials (s 38-95) and those items covered by s 38-97, a
supply of any other goods related to an education course (eg, textbooks) and
membership in a student organisation are not GST-free under s 38-100.
Other GST-free supplies [25.148]
Other GST-free supplies that are worth noting are childcare, exports, going
concerns and international mail.
Broadly, childcare is GST-free when provided by a registered carer, an
approved childcare service or a carer eligible for Commonwealth funding for
prescribed care: subdiv 38-D.
Exports are generally GST-free under subdiv 38-E. A supply of goods will be
GST-free if exported from Australia within 60 days after the earlier of the day
the consideration is received or the day a tax invoice is provided by the
supplier: s 38-185(1); Ruling GSTR 2002/6. The GST-free status will be lost if
the goods are reimported into Australia: s 38-185(2). The supply of things,
other than goods or real property, will be GST-free where the supply is
connected with property outside Australia, made to a non-resident outside
Australia or used or enjoyed outside Australia: s 38-190(1), Items 1-3. Where
the supply is made in relation to rights, the supply will be GST-free where the
rights are for use outside Australia or the supply is made to a non-resident of
Australia who is outside Australia when the supply is made: s 38-190(1),
Item 4. Repairs of goods from outside Australia will be GST-free if the final
destination of the goods at the time the repairs are done is outside Australia:
s 38-190(1), Item 5.

The supply of a going concern is GST-free under subdiv 38-J. The supply
must satisfy the requirements in s 38-325(1) to be GST-free. The
requirements are that the supply must be for consideration; the recipient of
the supply must be registered or required to be registered for GST; and the
supplier and the recipient must have agreed in writing that the supply is of a
going concern. In Midford v DFCT (2005) 60 ATR 1009, the Administrative
Appeals Tribunal (AAT) stated that the last requirement meant that the
agreement “when reasonably read, must identify the relevant supply and
express a mutual understanding that it is a supply of a going concern”. A
supply will be a supply of a going concern where the supplier supplies to the
recipient all of the things that are necessary for the continued operation of
an enterprise and the supplier carries on, or will carry on, the enterprise until
the day of the supply: s 38-325(2). The question of when the supplier has
provided “all things necessary” for the business to continue is a difficult
issue in practice and will depend on the particular circumstances of the
supply: see Ruling GSTR 2002/5.
The supply of international mail (i.e., mail posted overseas) is GST-free under
s 38-540. It is therefore important when purchasing stamps to ensure that
the correct stamps are purchased. Stamps for domestic mail include GST in
their price, while stamps for international mail (marked “international”) do
not include GST.
Consequences of making a GST-free supply [25.150]
An entity that supplies GST-free supplies is not required to pay GST on the
making of the supply: s 38-1 of the GST Act. This is because GST-free
supplies are excluded from the definition of “taxable supply” in s 9-5.
Note that the making of a GST-free supply does not impact upon the entity’s
entitlement to a refund of GST paid on any creditable acquisitions related to
the making of the GST-free supply: see [25.190].

Example 25.7: GST-free supplies

Rob runs a fruit and vegetable stall in the local market. He is
registered for GST purposes. Rob sells packs of five apples for $5
per pack. He pays $66 (including GST) per week for rental of his
stall. The supply of the apples for $5 per pack is a GST-free supply
as it meets the requirements for the exemption on food in subdiv
38-A. As a result, Rob does not have to pay GST on the supply of the
fruit. Rob may be entitled to a refund of GST paid on the stall rental
if it is a “creditable acquisition”: see [25.190].

Input taxed supply [25.160]

Another category of goods and services which are exempt from being
taxable supplies are input taxed supplies. There are only a limited number of
goods and services which are input taxed supplies, and these are listed in
Div 40 of the GST Act as:
• financial supplies: subdiv 40-A;
• residential rent: subdiv 40-B;
• residential premises: subdiv 40-C;
• precious metals: subdiv 40-D;
• school tuckshops and canteens: subdiv 40-E;
• fund-raising events conducted by charitable institutions: subdiv 40-F; and
• inbound intangible consumer supplies: subdiv 40-G (see [25.297]). Where
a supply is both an input taxed supply and a GST-free supply (e.g., financial
supplies to an overseas customer), the GST-free characterisation prevails: s
9-30(3).
Financial supplies: subdiv 40-A [25.163]
The term “financial supplies” is defined in s 40-5 of the GST Act by reference
to the GST Regulations. Regulation 40.5.09 of the GST Regulations specifies
those supplies that are “financial supplies”. The broad categories of financial
supplies include the provision, disposal or acquisition of an interest in or
under a bank account; a loan arrangement; a superannuation fund; an
insurance agreement; and shares or derivatives.
Regulation 40.5.11, by reference to Sch 7 of the GST Regulations, provides a
non-exhaustive list of examples of each of the categories of financial
supplies in reg 40.5.09. These include opening, keeping, operating,
maintaining and closing of cheque, debit card, deposit and savings accounts
for account holders; cashing cheques and payment orders; electronic funds
transfer; supply of credit cards; a mortgage over land, premises or chattel;
various types of contracts of insurance; foreign currency, and so forth.
Regulation 40.5.12 of the GST Regulations specifies the broad categories of
supplies that are not financial supplies such as professional services in
relation to a financial supply; a payment system; certain store value cards;
broking services, and so forth. Regulation 40.5.13, by reference to Sch 8 of
the GST Regulations, provides a non-exhaustive list of examples of supplies
that are not financial supplies. These include advice by a legal practitioner or
accountant in the course of professional practice; taxation or actuarial
advice; health insurance, and so forth.
Where an item is listed as both a financial supply and not a financial supply,
it will not be a financial supply: Note 1 to reg 40.5.12. The Commissioner’s
guidance on financial supplies is in Ruling GSTR 2002/2.
Residential rent: subdiv 40-B [25.165]
The supply of premises by way of lease, hire or licence (including renewals
and extensions) is an input taxed supply where the premises are:
• residential premises that are not commercial residential premises; or
• commercial accommodation that would be subject to Div 87 of the GST Act
but for a choice made by the supplier under s 87-25.

“Residential premises” is defined in s 195-1 as land or a building that is

occupied or intended to be occupied or capable of being occupied as a
residence or for residential accommodation (including a floating home). The
period of occupation or intended occupation is irrelevant. In Vidler v FCT
(2009) 74 ATR 520, the Federal Court held that vacant land is not “residential
premises” (affirmed by the Full Federal Court in Vidler v FCT (2010) 75 ATR
825). The taxpayer argued that the land is “capable of being occupied as a
residence or for residential accommodation”. In South Steyne Hotel Pty Ltd v
FCT (2009) 71 ATR 228, Stone J held that this meant that the premises must
be capable of being occupied as such at the time and not merely have the
potential to be developed to have that capacity. Residential premises must
have the “element of shelter and basic living facilities such as provided by a
bedroom and bathroom”. This view was affirmed by the Full Federal Court in
South Steyne Hotel Pty Ltd v FCT (2009) 74 ATR 41. It is clear from Ruling
GSTR 2012/5 that the Commissioner will focus on the physical characteristics
of the premises to determine whether it is “residential premises”.
Accommodation provided in an office building, private hospital, residential
care facility or a shop will generally not be considered the supply of
residential premises.
“Commercial residential premises” is defined in s 195-1 as:
• a hotel, motel, inn, hostel or boarding house;
• premises used to provide accommodation in connection with a school;
• a ship that is mainly let out on hire in the ordinary course of a business of
letting ships out on hire;
• a ship that is mainly used for entertainment or transport in the ordinary
course of such a business;
• a marina at which one or more of the berths are occupied or are to be
occupied by ships used as a residence; or
• a caravan park or camping ground.
Premises that are similar to these will also be “commercial residential
premises”, except for premises used to provide accommodation to students
in connection with an education institution that is not a school. The
Commissioner’s views on when premises will be considered “commercial
residential premises” for GST purposes are set out in Ruling GSTR 2012/6.
“Commercial accommodation” is defined in s 87-15 as the right to occupy in
whole or in part “commercial residential premises”, including the supply of
cleaning and maintenance; electricity, gas, air-conditioning or heating; or
telephone, television, radio or similar if provided. Division 87 applies to the
supply of long-term (more than 28 days continuously) accommodation in
commercial residential premises. Suppliers of long-term accommodation in
commercial residential premises have the choice of treating the supply as a
taxable supply subject to concessional GST rates in Div 87 (GST is charged
but the supplier is entitled to input tax credits on acquisitions) or as an input
taxed supply under Div 40 (no GST is charged but the supplier is not entitled
to input tax credits on acquisitions). The Commissioner’s views on when
“long-term accommodation” is provided in commercial residential premises
are set out in Ruling GSTR 2012/7.
The distinction between “residential” and “commercial residential premises”
has been considered in several cases, including Sunchen Pty Ltd v FCT
(2010) 78 ATR 197; South Steyne Hotel Pty Ltd v FCT (2009) 74 ATR 41;
Meridien Marinas Horizon Shores Pty Ltd v FCT (2009) 74 ATR 787; and
Toyama Pty Ltd v Landmark Building Developments Pty Ltd (2006) 62 ATR
73.
Residential premises: subdiv 40-C [25.167]
The sale (s 40-65(1) of the GST Act) and long-term lease (s 40-70(1)) of
“residential premises” ([25.165]) is input taxed where it is to be used
predominantly for residential accommodation (regardless of the term of
occupation). However, the sale or long-term lease is not treated as input
taxed if the premises are “commercial residential premises” (see [25.165])
or “new residential premises”: ss 40-65(2) and 40-70(2).
“Long-term lease” is defined in s 195-1 as a lease, hire or licence for a period
of at least 50 years.
“New residential premises” is defined in s 40-75 as residential premises:
• which have not previously been sold as residential premises and have not
previously been the subject of a long-term lease;
• have been created through substantial renovations of a building; or
• have been built or contain a building that has been built to replace
demolished premises on the same land.
Premises will not be treated as “new residential premises” if:
• they were used for residential accommodation before 2 December 1998,
regardless of the term of occupation (s 40-65(2)); or
• if they have only been used as residential rental premises for a period of at
least five years since they first became residential premises; were last
substantially renovated or were last built: s 40-75(2). The determination as
to what constitutes “substantial renovations” can be difficult in practice, and
the Commissioner provides some guidance on this issue in Ruling GSTR
2003/3.
Consequences of making an input taxed supply [25.170]
An entity that makes input taxed supplies is not required to pay GST on the
making of the supply: s 40-1 of the GST Act. This is because input taxed
supplies are excluded from the definition of “taxable supply” in s 9-5.
A further consequence of making input taxed supplies is that the entity is not
entitled to a refund of GST paid on any acquisitions related to the making of
that supply as the acquisition would not satisfy the requirements of
“creditable acquisition”: see [25.190] and [25.210]–[25.217].
Example 25.8: Input taxed supplies
Guido owns eight houses which he rents out to students at the
nearby university. He charges rental of $110 per week for each
house. Guido recently paid $66 (including GST) to a plumber for
repairs in one of the houses. Guido is registered for GST purposes.
The rental of the houses would constitute input taxed supplies as it
is residential rent. Guido does not have to pay GST on the $110.
Guido is not entitled to a refund of the GST paid to the plumber as
the acquisition relates to the provision of an input taxed supply and
would therefore not satisfy the requirements of creditable
acquisition: see [25.190] and [25.210]–[25.217].

Mixed or composite supply [25.175]

An entity may also make a supply that is partly a taxable supply and partly
GST-free or input taxed. Such supplies fall into two categories – mixed
supplies and composite supplies. A mixed supply is a supply that can be
unbundled into separately identifiable parts, and each part is treated
separately for GST purposes. A composite supply is one that is made up of a
dominant part and something that is integral, ancillary or incidental to that
part. A number of examples of mixed and composite supplies are discussed
in Ruling GSTR 2001/8.
In the case of a mixed supply, the value of the supply is to be apportioned
between the taxable supply and the GST-free or input taxed supply: s 9-80.
The Commissioner considers a number of different direct and indirect
apportionment methods in Ruling GSTR 2001/8.
Example 25.9: Consequences of making a mixed supply
Jill sells a property that consists of commercial and residential
premises on a single title. Commercial premises are taxable
supplies while residential premises are input taxed supplies.
Therefore, the sale of the property is a mixed supply. Jill is
registered for GST purposes. The property was sold for $200,000.
Jill estimates that the commercial premises comprise 70% of the
property area, while the residential premises comprise 30% of the
property area. As a consequence of making a taxable supply, Jill
must pay GST of 10% on the value of the taxable supply. The value
of the taxable supply is apportioned to take into account the fact
that the value also relates to an input taxed supply. Jill may
calculate the value of the commercial premises as 70% × $200,000
= $140,000.
Therefore, GST payable by Jill on the sale of the commercial
premises = 10% × (10/11 × $140,0000) = $12,727.
Note that property area is only one example of a method Jill could
use to determine the proportionate value of the commercial
premises. She could also determine the value using other bases,
such as the rentals received on each premises or a professional
valuation.
In FCT v Luxottica Retail Australia Pty Ltd [2011] FCAFC 20, the Full Federal
Court held that taxpayers can choose to only discount the taxable
component of a mixed supply and not the GST-free or input taxed
component (i.e., a discount does not have to be apportioned across both
supplies). In FCT v Luxottica, the taxpayer had offered its customers a
discount on spectacle frames (which are taxable supplies) if they purchased
full-price lenses (which are GST-free supplies). The Court rejected the ATO’s
argument that the discount had to be applied to the whole package and
accepted the taxpayer’s treatment of the transaction.
Composite supplies are treated as a single supply, and it is necessary to
ascertain which is the dominant part of the supply to determine the GST
consequences of the supply. It is not always easy to distinguish the dominant
part of a supply from that part of a supply that is integral, ancillary or
incidental to the dominant part. The Commissioner discusses a number of
ways in which this determination can be made in Ruling GSTR 2001/8.

Supply summary [25.180]

Table 25.1 provides a summary of the GST consequences for an entity of the
three different categories of supplies: Table 25.1 GST consequences of
making a supply

Where the supply comprises a combination of taxable and GST-free or input

taxed supplies, it is necessary to determine whether the supply is a mixed or
composite supply. The GST consequences are determined accordingly.
As mentioned earlier, the basic rules regarding taxable supplies, GST-free
supplies and input taxed supplies are generally quite straightforward.
However,
it should be noted that there are a large number of special rules that may
alter the treatment of a supply. These special rules include:
• supplies to associates: Div 72;
• margin scheme for sale of real property: Div 75;
• insurance claims or settlements: Div 78;
• offshore supplies other than goods or real property: Div 84;
• vouchers: Div 100;
• supplies in satisfaction of debts: Div 105; and
• agents: Div 153.
Discussion of these special rules is beyond the scope of this book.
Creditable acquisition [25.190]
So far in this chapter we have looked at the consequences, for an entity that
is registered for GST, of making a supply. The second key concept in GST is
“creditable acquisition”, which governs an entity’s entitlement to “input tax
credits” (refund of GST paid on acquisitions).
Under s 11-5 of the GST Act, an entity makes a creditable acquisition if:
• the entity makes an acquisition: see [25.200];
• the acquisition was solely or partly for a creditable purpose: see [25.210]–
[25.220];
• the supply to the entity was a taxable supply: see [25.225];
• the entity provided or was liable to provide consideration for the supply:
see [25.110]; and
• the entity is registered or required to be registered for GST purposes: see
[25.50].

Acquisition [25.200]
Similar to the definition of “supply” (see [25.100]), “acquisition” is defined
very broadly in s 11-10 of the GST Act as “any form of acquisition
whatsoever” and includes:
• an acquisition of goods;
• an acquisition of services;
• a receipt of advice or information;
• an acceptance of a grant, assignment or surrender of real property;
• an acceptance of a grant, transfer, assignment or surrender of any right;
• an acquisition of something the supply of which is a financial supply; and
• an acquisition of a right to require another person to do anything or to
refrain from an act or to tolerate an act or situation.
Example 25.10: Meaning of “acquisition” Jesse bought shoe polish
from the local supermarket for his shoe-cleaning business. Jesse
paid his accountant $110 for preparing his tax return for the year.
The purchase of the shoe polish is an acquisition as Jesse has
acquired goods. The payment for the preparation of the tax return
is an acquisition as Jesse has acquired services.
Creditable purpose [25.210]
Establishing that an acquisition is for a creditable purpose is generally the
key issue in satisfying the requirements of “creditable acquisition”.
Creditable purpose is defined in s 11-15 of the GST Act; see also the
Commissioner’s guidance in Ruling GSTR 2008/1. An acquisition would be for
a creditable purpose where the acquisition relates to the carrying on of the
entity’s enterprise. Generally, an acquisition would be for a creditable
purpose where it is made for a business purpose. Section 11-15(2)(b)
expressly states that an acquisition will not be for a creditable purpose if it is
private or domestic in nature. However, acquisitions which relate to the
provision of fringe benefits that are for an employee’s private use are taken
to be for a creditable purpose: see Ruling GSTR 2001/3.
Example 25.11: Acquisition for a creditable purpose Jesse has his
own shoe-cleaning business. He recently purchased shoe polish for
the business. While he was at the store, he also purchased various
cleaning products for use in his home and a digital camera to
provide as a gift to his employee. The provision of the digital
camera constitutes the provision of a fringe benefit. The acquisition
of the shoe polish is for a creditable purpose as Jesse purchased the
shoe polish for use in his business. The acquisition of the cleaning
products is not for a creditable purpose as they were purchased for
use in his home and were therefore not related
to the carrying on of his enterprise. Further, they are specifically
excluded under s 11-15(2)(b) of the GST Act as they are private or
domestic in nature.
The acquisition of the digital camera is for a creditable purpose as it
relates to the provision of a fringe benefit. It does not matter that
the employee may use the digital camera for private purposes.

Acquisitions related to input taxed supplies [25.214]

As mentioned at [25.170], acquisitions related to the making of input taxed
supplies are not creditable acquisitions. This is because of s 11-15(2)(a) of
the GST Act, which states that an acquisition is not for a creditable purpose
where it relates to the making of input taxed supplies. In Rio Tinto Services
Pty Ltd v FCT [2015] FCAFC 117, the Full Federal Court held that acquisitions
were not for a creditable purpose because they are related to the provision
of input taxed supplies (residential accommodation), notwithstanding that
the input taxed supplies were provided as part of a broader enterprise which
made taxable supplies.
Example 25.12: Acquisition for a creditable purpose and input taxed
supplies
Guido owns various investment properties which he rents out to
students at a nearby university. Guido recently paid $66 (including
GST) to a plumber for repairs in one of the houses. Guido is
registered for GST purposes.
The acquisition of plumbing services is not for a creditable purpose
as it relates to the provision of residential rental premises, which is
an input taxed supply.
[25.217] Financial supplies. Where the input taxed supplies are financial
supplies, the supplier may nonetheless be entitled to input tax credits on
acquisitions related to the making of those supplies in certain circumstances.
Under s 70-5 of the GST Act, suppliers may be entitled to a partial input tax
credit (75%: reg 70-5.03) for certain acquisitions listed in regs 70-5.02 and
70-5.02A. Examples include acquisitions related to cheque clearing services,
loan services, debt collection services and transaction processing services.
The reduced input tax credit was introduced to address the bias between
financial suppliers performing certain functions in-house or outsourcing
those services.
The operation of the reduced input tax credit (including examples) is
discussed in Ruling GSTR 2004/1.
Under s 11-15(4), any acquisitions related to the making of financial supplies
are treated as being for a creditable purpose where the entity does not
exceed the “financial acquisitions threshold”. Generally, an entity will not
exceed the financial acquisitions threshold where the amount of its input tax
credits on acquisitions related to the making of financial supplies does not
exceed $150,000 (since 1 July 2012; $50,000 prior to that date), and its
input tax credits on acquisitions related to the making of financial supplies is
less than 10% of its input tax credits on all acquisitions: ss 189-5 and 189-
10. The test requires a determination of current and future acquisitions –
that is the preceding and following 11 months. The Commissioner’s guidance
on the financial acquisitions threshold is contained in Ruling GSTR 2003/9.

Example 25.13: Acquisition for a creditable purpose and the

financial acquisitions threshold
J Pty Ltd runs a furniture manufacturing business. During the year,
it provided customers with various loan arrangements to finance
the purchase of furniture. Its expenses relating to the loan
arrangements totalled $33,000 (including GST), while its total
expenses were $2 million (including GST). J Pty Ltd is registered for
GST purposes. Although some of J Pty Ltd’s acquisitions relate to
the provision of input taxed supplies (loans are financial supplies),
the acquisitions are for a creditable purpose because the input
taxed supplies are financial supplies, and the amount of J Pty Ltd’s
input tax credits on these acquisitions for the year would be $3,000,
which is below the financial acquisitions threshold of $150,000.
Further, its input tax credits on those acquisitions are less than 10%
of its input tax credits on all acquisitions.
Solely or partly [25.220]
The expression “solely or partly” for a creditable purpose in s 11-5 of the
GST Act ensures that an acquisition will still be treated as being for a
creditable purpose even though the entity may have had a non-business
purpose as well as a business purpose in making the acquisition. The
Commissioner’s guidance on determining the extent of creditable purpose is
in Rulings GSTR 2006/3 (for providers of financial supplies) and GSTR 2006/4
(for providers of supplies other than financial supplies). Example 25.14:
Partial creditable purpose
Jesse has his own shoe-cleaning business. He purchased shoe polish which
he uses for the business as well as to clean his own shoes at home. The
acquisition of the shoe polish is for a creditable purpose even though Jesse
also had a non-business purpose (home use) for the shoe polish at the time
of acquisition.
Although the acquisition is still a creditable acquisition, the consequences
will differ where it is partly for a creditable purpose: see [25.230].
Supply to the entity was a taxable supply [25.225]
This element ensures that input tax credits are only available where GST was
in fact paid on the acquisition. Where the information provided states that
the amount paid for an acquisition includes GST, this is clearly the
acquisition of a taxable supply by the entity. However, where it is not clear
that the amount paid includes GST, it will be necessary to go through the
analysis at [25.90] from the supplier’s perspective to determine whether the
supplier has or should have charged GST on the supply. This includes
deliberation as to whether the supplier is or should be registered for GST
purposes and whether the supply is a GST-free or input taxed supply.
Example 25.15: Acquisition was a taxable supply Jesse runs his own
shoe-cleaning business. He recently purchased shoe polish for $22
(including GST). He also purchased a shoe polishing machine for
$5,500 from the manufacturer, Big Machines Pty Ltd, which is
located in Perth. Big Machines Pty Ltd is one of the largest
manufacturers of shoe polishing machines in the world and has an
annual turnover of $2 million.
The acquisition of the shoe polish is clearly the acquisition of a
taxable supply as the information states that the price paid includes
GST. The acquisition of the shoe polish will be a creditable
acquisition if all of the other elements are satisfied.

To determine whether Jesse’s acquisition of the machine is the

acquisition of a taxable supply, it is necessary to consider whether
the supply of the machine is a taxable supply from Big Machines’
perspective. Big Machines is clearly carrying on an enterprise and,
with an annual turnover of $2 million, is required to be registered
for GST. Big Machines is located in Perth, and therefore the supply
is connected to Australia. The supply is made for consideration. The
machine is not a GST-free or input taxed supply. Therefore, the
supply of the machine to Jesse is a taxable supply, and the $5,500
includes GST. The acquisition of the machine by Jesse will be a
creditable acquisition if all of the other elements are satisfied.
Consequences of making a creditable acquisition [25.230]
An entity that makes a creditable acquisition is entitled to input tax credits
on the acquisition: s 11-20 of the GST Act.
The amount of input tax credits on a creditable acquisition is the amount
equal to the GST payable on the supply of the thing acquired: s 11-25. As
discussed at [25.130], the amount of GST payable on a taxable supply is
10% of the value of the taxable supply: s 9-70. The value of a taxable supply
is equal to ten-elevenths of the price of the supply: s 9-75. Generally, the
price of a supply is equal to the consideration for the supply.
Example 25.16: Consequences of making a creditable acquisition
Jesse has his own shoe-cleaning business, which is registered for
GST purposes. Jesse purchased a bottle of shoe polish for $22 for
use in the business.
The acquisition of the shoe polish is a creditable acquisition as it
satisfies all of the requirements in s 11-5 of the GST Act.
As a consequence of having a creditable acquisition, Jesse is
entitled to input tax credits in relation to the acquisition. The
amount of the input tax credits is equal to the GST payable on the
taxable supply. The GST payable on the supply is calculated as
follows:
• The value of the taxable supply is ten-elevenths of the price of the
supply.
• The price of the supply is equal to the consideration received,
which in this case is $22.
• The GST payable on the supply is 10% × (10/11 × $22) = $2.
Therefore, Jesse is entitled to input tax credits of $2 on the
acquisition of the shoe polish.
Where the acquisition was only partly for a creditable purpose, the amount
of input tax credits on the acquisition is limited to the extent that the
acquisition was for a creditable purpose: s 11-30.
Example 25.17: Consequences of making an acquisition partly for a
creditable purpose
Following on from Example 25.16, assume that Jesse expects to use
the shoe polish 80% for business purposes and 20% for private use
on cleaning his own shoes.
We established that Jesse is entitled to input tax credits of $2 on
the acquisition of the shoe polish. The amount of input tax credits
on the acquisition where Jesse only has a partly creditable purpose
is calculated by multiplying the amount of the input tax credits on
the acquisition by the creditable purpose percentage (i.e., the
extent to which the acquisition is for a creditable purpose). In this
case, the amount of Jesse’s input tax credits on the acquisition
would be $2 × 80% = $1.60.
Special rules [25.235]
As with taxable supplies, the entitlement to input tax credits for creditable
acquisitions may be varied under the operation of various special rules in the
GST Act. These rules include:
• Div 60 in relation to pre-establishment costs;
• Div 137 relating to stock on hand when an entity becomes registered; and
• Div 153 in relation to agents.
A particularly important override to the general creditable acquisition rules is
Div 69, relating to non-deductible expenses.
Non-deductible expenses [25.240]
Even where all of the elements of “creditable acquisition” are satisfied, an
acquisition will not be a creditable acquisition if it is a non-deductible
expense: s 69-5 of the GST Act. A “non-deductible expense” refers to an
expense which is not deductible for income tax purposes. However, for GST
purposes, only the following non-deductible expenses are treated as not
being creditable acquisitions under s 69-5:
• penalties: s 26-5 of the Income Tax Assessment Act 1997 (Cth) (ITAA
1997);
• relative’s travel expenses: s 26-30 of the ITAA 1997;
• family maintenance expenses: s 26-40 of the ITAA 1997;
• recreational club expenses: s 26-45 of the ITAA 1997;
• expenses for a leisure facility or boat: s 26-50 of the ITAA 1997;
• entertainment expenses: Div 32 of the ITAA 1997;
• non-compulsory uniforms: Div 34 of the ITAA 1997; and
• agreements for the provision of non-deductible non-cash business benefits:
s 51AK of the Income Tax Assessment Act 1936 (Cth) (ITAA 1936).
Note that some of these expenses (e.g., entertainment expenses) may be
deductible for income tax purposes where they relate to the provision of a
fringe benefit: see [12.220]–[12.230]. Where a non-deductible expense is
deductible for income tax purposes because it relates to the provision of a
fringe benefit, the restriction in s 69-5 of the GST Act does not apply, and the
acquisition will be treated as a “creditable acquisition” if all the elements of
“creditable acquisition” are satisfied.

Example 25.18: Input tax credits on entertainment expenses

Jesse took his two employees out to dinner to celebrate the end of a
successful year. The dinner cost $110 (including GST). Assume that
Jesse chooses to treat the meal as a meal entertainment fringe
benefit and uses the 50/50 split method to calculate the taxable
value (see [7.230]–[7.240]). Also assume that all of the elements of
“creditable acquisition” are satisfied.
By choosing the 50/50 split method, Jesse only pays fringe benefits
tax on half of the cost of the fringe benefit. As such, Jesse is
entitled to a deduction for income tax purposes for that half of the
meal expense ($55): s 32-20 of the ITAA 1997 and s 51AEA of the
ITAA 1936. The other half of the meal entertainment expense is a
“non-deductible expense” and does not give rise to a creditable
acquisition: s 69-5(3A) of the GST Act. Therefore, Jesse is only
entitled to input tax credits of $5 for the half of the expense that is
deductible. Note that Jesse’s deduction will be reduced from $55 to
$50 because of the $5 of input tax credits: s 27-5 of the ITAA 1997
(see [25.320]).
Further, as mentioned at [14.125], the amount of input tax credits in relation
to a car is generally limited to 1/11 of the “car limit”: s 69-10. The “car limit”
is $59,136 for the 2020–2021 income year: “Car cost limit for depreciation”
on ATO website.
Importation [25.250]
The rules regarding importations are covered in Div 13 of the GST Act and
are different to the general rules regarding GST as they:
• apply regardless of whether an entity is registered for GST purposes;
• only apply to the importation of goods and not other types of importations;
and
• impose the liability to pay GST on the importer of goods, not the supplier.
These special rules are necessary because, in the case of an importation, the
supplier is located outside Australia, and it would be administratively difficult
to collect GST from an entity located outside Australia. The rules also ensure
that goods consumed in Australia are subject to GST regardless of whether
they are acquired in or out of Australia, thereby maintaining the
competitiveness of Australian businesses.
The general rules regarding importations in Div 13 is supplemented by the
special rules in Div 84 which imposes GST on certain offshore supplies not
covered by Div 13: see [25.295].
Taxable importation [25.260]
Liability for GST is imposed on an entity which makes a taxable importation.
Under s 13-5 of the GST Act, an entity makes a taxable importation where:
• goods (excluding the importation of money: s 13-5(4)) are imported; and
• the goods are entered for home consumption.
“Entered for home consumption” is an expression used in customs law and
essentially means that goods are brought into Australia for consumption or
use in Australia (i.e., the goods are not in Australia in transit). An entity does
not have to be carrying on an enterprise or be registered for GST purposes to
make a taxable importation. Similarly, a taxable importation will exist
regardless of whether the goods are being imported for business or private
purposes.

However, an importation is not a taxable importation to the extent that it is a

non-taxable importation. The following are non-taxable importations:
• goods that would have been GST-free or input taxed supplies if they were
supplies (i.e., supplied in Australia) (s 13-10(b));
• goods exported from Australia and returned to Australia unchanged (s 42-
10); and
• goods that qualify for certain customs duty concessions (s 42-5).
A wide range of goods qualify for customs duty concessions and would
therefore be non-taxable importations. The most relevant category in this
range is low value goods, which are goods that have a customs value of less
than $1,000. However, from 1 July 2018, importations of low value goods are
subject to GST under different provisions: see [25.299]. Example 25.19: Non-
taxable importations
Paul moved to Australia from New Zealand. He purchases fresh kiwifruit and
New Zealand chocolates online directly from a New Zealand supplier. The
chocolates and kiwifruit are delivered to him in Australia by the seller’s
representative. He purchases the items for himself as he misses the taste of
New Zealand and cannot get the same quality items in Australian shops. The
customs value of the chocolates is $1,200, and the customs value of the
kiwifruit is $3,000.
The purchase of the chocolates from New Zealand and brought into Australia
will be a taxable importation (as confectionary, chocolates are not GST-free
food: Sch 1 of the GST Act). The chocolates are not low value goods as they
have a customs value in excess of $1,000. The purchase of the fresh kiwifruit
will not be a taxable importation as it would have been a GST-free supply
had it been a supply (i.e., purchased in Australia).
Consequences of making a taxable importation [25.270]
GST is payable on the making of a taxable importation by the person making
the taxable importation: ss 13-1 and 13-15 of the GST Act.
The amount of GST payable on the making of a taxable importation is 10% of
the value of the taxable importation: s 13-20(1). The value of a taxable
importation is the customs value of the goods plus any costs incurred in
transporting and insuring the goods to bring them into Australia: s 13-20(2).
Generally, the customs value of goods is the cost of the goods in Australian
dollars.
Example 25.20: Consequences of making a taxable importation
Jimmy purchased a new mobile phone from the United States as he
could not wait for it to be sold in Australia. The phone cost him
approximately A$1,500 plus A$100 in postage and insurance costs.
The purchase of the mobile phone is a taxable importation as goods
are being imported into Australia for home consumption. The mobile
phone would not fall into any of the categories of non-taxable
importations. The value of the taxable importation is the customs
value of the mobile phone ($1,500) plus the freight and insurance
costs ($100), which is $1,600.
Therefore, GST payable by Jimmy on the importation of the mobile
phone is 10% × $1,600 = $160. If Jimmy brings the phone into
Australia personally after travelling to the United States, he is
required to declare the taxable importation and pay tax at the
airport when he enters into Australia. If the phone is shipped to him
by post or courier, the post office or courier company will collect the
GST from Jimmy and remit it to the ATO on his behalf.
Creditable importation [25.280]
The making of a taxable importation gives rise to a liability to pay GST,
whereas the making of a creditable importation gives rise to an entitlement
to input tax credits. Under s 15-5 of the GST Act, a creditable importation
exists where:
• an entity imports goods solely or partly for a creditable purpose: see
[25.210]–[25.220];
• the importation is a taxable importation: see [25.260]; and
• the entity is registered or required to be registered for GST purposes: see
[25.50].
These elements of “creditable importation” preserve the general rule that
GST is imposed on final, private consumers. Entities will be entitled to input
tax credits on importations that are for a business purpose, provided that the
entity is registered for GST purposes.
Even where all of the elements of “creditable importation” are satisfied, an
importation will not be a creditable importation if it is a non-deductible
expense: s 69-5. See [25.240] for a list of non-deductible expenses.
Consequences of making a creditable importation [25.290]
An entity that makes a creditable importation is entitled to input tax credits
on the importation: ss 15-1 and 15-15 of the GST Act.
The amount of input tax credits on a creditable importation is the amount
equal to the GST payable on the importation: s 15-20. As discussed at
[25.270], the amount of GST payable on a taxable importation is 10% of the
value of the taxable importation. Example 25.21: Consequences of making a
creditable importation
Following on from Example 25.20, assume that Jimmy purchased the new
mobile phone from the United States for business purposes only. Jimmy is
registered for GST purposes. As established in Example 25.20, the purchase
of the mobile phone is a taxable importation, and Jimmy is liable to pay GST
of $160 on the importation.
As the mobile phone was purchased for a creditable purpose (for Jimmy’s
business) and Jimmy is registered for GST purposes, the importation of the
phone is also a creditable importation and Jimmy is entitled to input tax
credits of $160 on the importation. In practice, the two amounts would
generally arise in the same GST period (see below) and Jimmy would be able
to net off the two amounts, so that there is no amount payable or receivable
in relation to the importation.
Offshore supplies [25.295]
The general importation rules in Div 13 are supplemented by the special
rules in Div 84 which extend the imposition of GST on importations to the
importation of intangible supplies and to the importation of low value goods.
A detailed examination of the special rules is beyond the scope of this book,
and only a brief outline is provided here. The consequence of the different
sets of rules is that the liability for GST on the importation of non-low value
goods (taxable importations) is imposed on the importer of such goods,
while the liability for GST on importations of intangible supplies and low
value goods is generally imposed on the overseas supplier. Further, the rules
regarding offshore inbound intangible supplies and the importation of low
value goods refer to supplies made to Australian consumers. As such,
supplies made to Australian businesses (B2B transactions) generally fall
outside the scope of these measures. Under subdiv 84-A, where the offshore
supply of intangibles or low value goods is made to a recipient carrying on
an enterprise in Australia but the acquisition was not solely for a “creditable
purpose” (see [25.210]), or the supplier reasonably believed that the
recipient was not a consumer, the supplies are treated as taxable supplies
and a “reverse charge” applies (GST on the supply is payable by the
recipient of the supply, not the supplier). A “reverse charge” can also apply
to taxable supplies made by non-residents where the recipient agrees to
such an arrangement: Div 83.
Intangible supplies [25.297] From 1 July 2017, offshore inbound intangible
supplies, such as the provision of services (e.g., consultancy or professional
services) or digital products (e.g., movie streaming or downloading services,
music, apps, games, ebooks), are treated as being connected to Australia for
GST purposes if the recipient of the supply is an Australian consumer: s 9-
25(5)(d). An “Australian consumer” is an Australian-resident entity (refer to
the residency tests in Chapter 4) that is not registered for GST in Australia
or, if GST-registered, the supply is acquired for a non-business purpose: s 9-
25(7). Under s 84-100, an entity may treat a supply as not being made to an
Australian consumer (and not subject to GST) if the entity took reasonable
steps to obtain information as to whether the recipient of the supply was an
Australian consumer, or, had business systems and processes which provide
a reasonable basis for identifying if the recipient in an Australian consumer,
and, having taken such steps or had such processes, reasonably believed
that the recipient was not an Australian consumer. Where this is later found
not to be the case, a “reverse charge” may apply, as discussed at [25.295],
and the Australian consumer may be subject to administrative penalties if
they have made false or misleading statements. Ruling GSTR 2017/1
provides guidance on how overseas suppliers can determine whether a
recipient of a supply is an “Australian consumer”. Where the supplies are to
be used or enjoyed outside Australia, the supplies will continue to be GST-
free supplies under s 38-190.
Unlike the general rules regarding importations, which impose the liability for
GST on the importer (see [25.260]), the liability for GST on the importation of
intangible supplies is placed on the offshore supplier of such supplies.
Broadly, a non-resident supplier is required to register for GST (and pay GST
on the supply) if it is carrying on an enterprise and the “registration turnover
threshold” (see [25.70]) is met. However, in determining whether the
“registration turnover threshold” is satisfied, any supplies that are not
connected with Australia are disregarded: ss 188-15(3) and 188-20(3).
Where an inbound intangible consumer supply is made through an
“electronic distribution platform” (EDP) (e.g., an app store), the operator of
the EDP is treated as the supplier and required to comply with the GST
obligations (register for GST if it meets the “registration turnover threshold”
and pay GST on the supply): s 84-55.
Low value goods [25.299]
As mentioned at [25.260], GST also applies to offshore supplies of low value
goods from 1 July 2018. Low value goods are goods with a customs value of
$1,000 or less and the goods are not tobacco, tobacco products or alcoholic
beverages: s 84-79(3). An offshore supply of low value goods is treated as
being connected to Australia if the recipient of the supply is a
consumer of the supply and the goods are brought into Australia: ss 84-75
and 84-77. Broadly, a non-resident supplier is required to register for GST
(and pay GST on the supply) if it is carrying on an enterprise and the
“registration turnover threshold” (see [25.70]) is met. However, in
determining whether the “registration turnover threshold” is satisfied, any
supplies that are not connected with Australia are disregarded: ss 188-15(3)
and 188-20(3).
Where low value goods are supplied through an EDP or a redeliverer, the
operator of the EDP or the redeliverer may be treated as the supplier and
required to comply with the GST obligations (register for GST if it meets the
“registration turnover threshold” and pay GST on the supply): s 84-81.
Administration [25.300]
GST is administered by the ATO. Entities that are registered or required to be
registered for GST are required to complete and lodge a GST return (known
as a “Business Activity Statement” or BAS) on a quarterly basis: ss 27-5, 31-
5 and 31-8 of the GST Act. However, entities with an annual turnover in
excess of $20 million, entities that will be carrying on business in Australia
for less than three months or entities that have a bad history of compliance
must complete the BAS on a monthly basis: ss 27-15, 31-5 and 31-10. Other
entities have the option of choosing to report on a monthly basis (s 27-10)
and may return to quarterly reporting whenever they wish as long as they do
not have to report on a monthly basis: s 27-10.
Entities must report the amount of any GST payable (i.e., GST on taxable
supplies or taxable importations) and GST refundable (i.e., input tax credits
on creditable acquisitions or creditable importations) for the period on the
BAS. The two amounts are netted off, and the entity is either in a net GST
payable or refundable position (known as the “net amount”) for the period: s
17-5(1).
Taxpayers who have made an error in working out their net GST amount in a
particular period may correct that error in a later period where the
circumstances set out in GST Errors Determination 2013 are satisfied. Anti-
avoidance provisions similar to Pt IVA of the ITAA 1936 (see [23.180]–
[23.260]) are contained in Div 165.
Timing [25.304]
Entities are generally required to report their GST obligations on an accruals
basis unless they choose to account for GST on a cash basis. Section 29-40
specifies that entities may choose to account for GST on a cash basis in
certain specified circumstances (e.g., the entity is a “small business entity”):
see also Ruling GSTR 2000/13. In this context, a “small business entity” is a
sole trader, partnership, company or trust that operates a business for all or
part
of the income year and has an aggregated turnover of less than $10 million.
Broadly, “aggregated turnover” is the entity’s turnover plus the annual
turnover of any business that is connected or affiliated to the entity.
For entities that account for GST on an accruals basis, GST payable is
attributed to the tax period when any consideration is received or an invoice
is issued in relation to the supply: s 29-5. Entities that account for GST on a
cash basis account for GST payable in proportion to the cash received. For
example, if an entity invoices a customer for a supply on 20 June but only
receives payment on 5 July, the entity will be required to include the GST
amount in its GST payable for the period ending 30 June if it accounts for
GST on an accruals basis. However, if it accounts for GST on a cash basis, it
will only include the GST amount in its GST payable for the next period, once
the amount is actually received.
Where the GST payable relates to a taxable importation, GST is payable
when the customs duty is payable, regardless of whether the entity accounts
for GST on a cash or accruals basis: s 33-15(1)(a).
In relation to acquisitions, s 29-10 provides that, for accruals basis entities,
input tax credits are attributable to the period when the entity provides any
consideration or an invoice is issued in relation to the acquisition. Entities
that account for GST on a cash basis are entitled to input tax credits in
proportion to the consideration provided: s 29-10(2). The Commissioner’s
guidance on the attribution rules for GST payable, input tax credits and
adjustments is contained in Ruling GSTR 2000/29.
Input tax credits due to creditable importations are attributable to the tax
period when the entity actually pays GST on the importation, regardless of
whether the entity accounts for GST on a cash or accruals basis: s 29-15(1).
In response to a recommendation by the Board of Taxation in its report into
the Review of the Legal Framework for the Administration of GST, the
government has introduced a four-year limitation period, subject to certain
exceptions, to claim input tax credits: s 93-5. The four-year period
commences from the day on which a taxpayer is required to give the
Commissioner a return for the tax period to which a credit would be
attributable under the basic attribution rules in s 29-10.
Tax invoice [25.306]
For both cash and accruals taxpayers, the entity must have a tax invoice to
be entitled to input tax credits: s 29-10(3) and (4). Where the entity does not
possess a tax invoice, the input tax credits are attributable to the period in
which the entity holds a tax invoice.
Section 29-70 sets out the requirements that must be satisfied for a
document to be a “tax invoice”. These requirements were amended with
effect from 1 July 2010 by replacing the existing requirements with
equivalent but flexible principles. A document will be a tax invoice if it:
• is issued by a supplier or a recipient in the case of a recipient created tax
invoice;
• is in the approved form;
• contains the required information;
• was intended to be a tax invoice, which must be clearly ascertained from
the document; and
• contains any other matters specified by the GST Regulations.

The required information that must be contained in the document includes

the supplier’s identity and ABN, the recipient’s identity or ABN if the
consideration for the supply is $1,000 or more, the thing supplied including
the quantity and price of the thing, the extent to which the supply is taxable,
and the date the document is issued. Under these requirements, a collection
of documents can constitute a tax invoice. The Commissioner has published
Ruling GSTR 2013/1 which sets out the minimum information requirements
for a tax invoice under s 29-70(1).
Under s 29-80(1), tax invoices are not required for low value transactions
(currently transactions with a value of less than $75 (excluding GST): reg 29-
80.01).

Adjustments [25.310]
The net amount calculated under s 17-5 of the GST Act is increased or
decreased for any adjustments: s 17-5(2). An entity can make an adjustment
to its GST obligations on supplies or acquisitions under Div 19: see also
Ruling GSTR 2000/19. An adjustment may arise because the supply or
acquisition is cancelled, there is a change to the consideration for a supply
or acquisition, or the supply or acquisition becomes or stops being a taxable
supply or creditable acquisition: s 19-10. Adjustments relating to a change in
the extent of creditable purpose are dealt with in Div 129, while adjustments
relating to goods applied solely to private or domestic use are dealt with in
Div 130. Adjustments for bad debts are dealt with in Divs 21 and 136: see
also Ruling GSTR 2000/2.
Where an adjustment is necessary, the entity must compare its obligations
following the adjustment with its previously reported GST obligations and
include an adjustment to increase or decrease its GST liability on its BAS.
The adjustment is attributable to the tax period when the entity becomes
aware of the adjustment: s 29-20(1). However, adjustments for entities
which account for GST on a cash basis are attributable in accordance with
consideration paid or received: s 29-20(2).

Similar to the requirement that entities must possess a tax invoice to be

entitled to input tax credits, entities making a decreasing adjustment must
have an adjustment note when making the adjustment, otherwise the
adjustment is attributable to the first period when the entity has an
adjustment note: s 29-20(3). The requirements of an adjustment note
(essentially an amended tax invoice) are set out in s 29-75. The
Commissioner has published Ruling GSTR 2013/2 which sets out the
requirements for adjustment notes under Div 29. An adjustment note is not
required for decreasing adjustments of $75 or less: s 29-80(2), reg 29.80.02.
Example 25.22: Adjustments
Dino purchased a table for his office on 1 June for $330 (including
GST). Dino accounts for GST on an accruals basis. The acquisition of
the table was a creditable acquisition, and Dino included his
entitlement to $30 input tax credits in his June quarter BAS as he
possessed a valid tax invoice at the time. The table was delivered to
Dino on 16 July, but it was not in the colour he had ordered. The
supplier offered Dino a 20% discount on the price if Dino would
accept the delivered table. Dino accepted the discount as the colour
of the table did not make any difference to him.
Dino must make an adjustment as there has been a change in the
consideration of a creditable acquisition. He has received a 20%
discount on the price, which means that the new consideration is
$264 (including GST). Dino originally claimed input tax credits of
$30, but he is now only entitled to input tax credits of $24 and
therefore he has an increasing adjustment of $6. The adjustment is
attributable to the September quarter as that is when Dino became
aware of the adjustment.

Non-residents [25.313]
Non-residents which are required to register for GST can choose to be a
limited registration entity under Div 146. In the absence of such an election,
a non-resident will be a standard registration entity. Table 25.2 outlines the
differences between the two systems:

GST groups [25.315]

Generally, transactions between companies which are part of the same
corporate group will be subject to GST in accordance with the rules
discussed in this chapter. In other words, a company making a “taxable
supply” is required to pay GST on that supply, and a company making a
“creditable acquisition” is entitled to input tax credits on that acquisition.
This is the case even where the companies may have formed a tax
consolidated group for income tax purposes: see [21.650].
To reduce GST compliance costs, companies are permitted to form a GST
group under Div 48 of the GST Act if they satisfy the membership
requirements. Broadly, the effect of forming a GST group is that the group is
treated as a single entity for GST purposes, and most transactions between
group members are disregarded for GST purposes. One member of the group
is nominated as the responsible member and deals with the group’s GST
obligations on transactions with non-group members and lodging the group’s
GST return.
Interaction with other taxes Income tax [25.320]
Entities include the GST-exclusive amount of their supplies in their
assessable income: s 17-5 of the ITAA 1997. The amount to be included as a
deduction will depend on the entity’s entitlement to input tax credits on the
acquisition. Where the entity is entitled to input tax credits, the deduction
amount will be the GST-exclusive amount: s 27-5 of the ITAA 1997. On the
other hand, if the entity is not entitled to input tax credits, the deduction
amount will be the GST-inclusive amount.
Example 25.23: GST and income tax Jesse has a shoe-cleaning business. Last
year he earned $220,000 (including GST) from providing shoe-cleaning
services and spent $110,000 (including GST) on shoe polish and special
cloths for the business. Jesse is registered for GST purposes.
Jesse will include $200,000 in his assessable income for the year as it is
income from business. The GST component of Jesse’s sales revenue is 10%
× 10/11 × $220,000 = $20,000.
Jesse will include $100,000 in his deductions for the year as they are
ordinary business expenses. The GST component of Jesse’s expenses is 10%
× 10/11 × $110,000 = $10,000.
Fringe benefits tax [25.330]
Where an entity’s acquisition relates to the provision of a fringe benefit, the
entity’s fringe benefits tax (FBT) liability in relation to the provision of the
fringe benefit will depend on the entity’s entitlement to input tax credits.
This is because the gross-up factor to be used in calculating the fringe
benefits taxable amount depends on whether the entity is entitled to input
tax credits on the acquisition: see [7.400].
Note that reimbursements of an employee’s expenses (i.e., an expense
payment fringe benefit) are taken to have been made by the employer for
GST purposes under s 111-5 of the GST Act. This ensures that the employer
is entitled to any input tax credits in relation to the acquisition as long as the
elements of “creditable acquisition” are satisfied: see Ruling GSTR 2001/3.
Questions [25.340]
25.1 Advise whether the following would be considered “taxable
supplies”, “GST-free supplies” or “input tax supplies” (you may
assume that the supplies are made by an entity located in Australia
and registered for
GST purposes and that the supplies are made for consideration in
the furtherance of an enterprise):
(a) Sale of t-shirts by a retailer.
(b) Sale of a new residential house by a property developer.
(c) Loan set-up fees charged by a bank.
(d) Sale of fresh fruit by a grocer.
(e) Airline ticket from Adelaide to Perth.
(f) Painting a house.
(g) Sale of herbal tea by a café.
(h) Home-delivered pizza with separate charges for the pizza and
the delivery.
(i) Airline ticket from Melbourne to London (return).
(j) Sale of an existing residential house owned as an investment
property.
(k) Interest on a loan to buy shares.
(l) Sale of shares in an ASX listed company.
(m) Sale of Australian souvenirs to purchasers located overseas.
25.2 Audrey is a talented artist. Her paintings of Australian scenery
sell for $50,000 to $100,000 each. She sells at least one painting a
month to buyers in Australia and overseas. Her paintings are highly
sought after and she uses only premium paints and canvasses for
her paintings. She purchases these items at a large local retailer.
Advise Audrey as to her GST consequences arising out of the above
information.

25.3 Big Boats Pty Ltd is a large company incorporated in Australia.

Big Boats is registered for GST purposes. The company sells boats
for $330,000 each (including GST) to customers in Australia. The
boats are purchased from a company in France at a cost of
approximately $200,000 each. However, Big Boats pays an
additional $20,000 per boat for shipping and insurance. Big Boats is
the exclusive supplier of these boats for the Asia Pacific region. The
company also sold two boats to customers in Indonesia and five
boats to customers in Singapore. These boats are sold for $300,000
and are shipped directly from France to the customers in Indonesia
and Singapore. The customers pay for the shipping and insurance
costs.
Advise Big Boats as to its GST consequences arising from the above
information.
25.4 Big Bank Ltd operates nationally with more than 50 branches,
a 10-storey head office and numerous call centres. It is registered
for GST purposes. Big Bank has for many years provided loans and
deposit
facilities to customers in Australia. Last year it launched a new
product, Big Bank home and contents insurance policies. It was a
significant step for Big Bank and required it to change some of its
computerised accounting systems due to the fact that GST needed
to be charged on the new product.
Big Bank budgeted to spend $1,650,000 (including GST) on
advertising campaigns last year. Of that sum, $550,000 was
allocated to a television advertising campaign specifically
promoting Big Bank home and contents insurance policies. The
other $1,100,000 was allocated to a general advertising campaign,
including television, radio and print media advertisements
promoting Big Bank to the public as the bank that is “Here for You”.
When Big Bank Ltd launched Big Bank home and contents insurance
policies, it forecast that its home and contents insurance business
would constitute 2% of its entire enterprise. Big Bank has been
proved correct in its forecasts. The other 98% of its enterprise is
made up of its traditional loans and deposit facilities businesses.
Last month, the advertising consultants issued their tax invoice for
$1,650,000.
Discuss Big Bank’s ability to claim input tax credits with respect to
its advertising expenditure of $1,650,000.
25.5 New Developments Pty Ltd (New Developments) is a property
investment and development company. Recently, New
Developments purchased an old warehouse which it is converting
into apartments for sale. New Developments also owns an
established apartment building, which it rents out to tenants. In the
course of its activities, New Developments negotiates many
contracts. It engages a busy independent lawyer, Rumpole
Richardson, to assist in drafting and negotiating these contracts.
Rumpole Richardson has a number of clients and turns over
$250,000 per year in his legal advisory business. New
Developments offered to allow Rumpole Richardson to live in one of
its apartments rent-free in exchange for his legal work. Rumpole
Richardson agreed to this arrangement. Normally, the rent payable
on the apartment would be $22,000 per annum.
Advise New Developments and Rumpole Richardson of their GST
obligations and any input tax credit entitlements they may have.
Assume that New Developments is registered for GST purposes.
25.6 Following on from Question 25.5, New Developments sold one
of the apartments in the newly converted warehouse for $550,000.
It also sold one of the apartments in the established apartment
building for $500,000.
Advise New Developments of its GST obligations arising from the
sale of the apartments. 7 Windows R Us is a large window
manufacturing company in Australia. The company accounts for GST
on an accruals basis and submits its BASs monthly. The company
supplies windows for office buildings across Australia. On 15 March,
the company sold windows valued at $44,000 (including GST) to be
used in an office building in Sydney. A tax invoice was issued on
that day. The windows were manufactured in Adelaide and shipped
to the customer in Sydney on 10 April. When the customer received
the windows, it was discovered that the windows had been made in
white whereas the customer had ordered black windows. After some
negotiation, the customer agreed to accept the white windows for a
20% discount. Windows R Us issued a refund of $8,800 to the
customer on 15 April. Unfortunately, April was not a good month for
the company, and it received a penalty of $11,000 (including GST)
from the Environmental Protection Agency for breaching Australia’s
environmental protection laws. Advise Windows R Us as to its GST
consequences arising out of the above information.
25.8 Gemma is a university student. She recently purchased a new
computer from a retailer in Singapore as the computer was not yet
available in Australia. The computer is for her personal use. The
computer cost A$3,000 and was shipped directly to Gemma’s home.
Gemma also purchased a book from Amazon US for $50.
What are the GST consequences arising from the above
information?