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28 FEBRUARY 2019

Tax 101 - Assessable Income

What we will cover

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• What is income?

• Ordinary income

• Statutory income

• Residence

• Income or capital?

• Isolated transactions

• Exempt income

• Non-assessable non-exempt income

• Non-assessable income

• Taxable income

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What is income?

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• Division 6 ITAA

• The legislation does not define what income is. Instead, the word is definedwith regard to general concepts and usage, assisted by ATO rulings and courtdecisions.

• Per section 6-1 (1) ITAA 1997, assessable income includes ordinary income(according to ordinary concepts) and statutory income.

Ordinary income

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• “Ordinary income” means income according to ordinary concepts (s 6-5(1)).

• It is included in a taxpayer’s assessable income unless it is exempt, or is made non-assessable.

• There is no specific guidance on what is meant by “ordinary concepts”.

• Typical examples of income include salaries, wages, proceeds of carrying on a business, rent, interest.

• Typical examples of items which are not generally income include lottery prizes, proceeds from a hobby, loans, and gifts.

• Whether an amount of ordinary income is included in a taxpayer's assessable income for an income year can be affected by the source of the income and whether the taxpayer is an Australian tax resident and whether the income has been derived.

• Profits from the sale of a capital asset are generally not income, although they may be assessable as statutory income (eg under the capital gains provisions).

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Ordinary income

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• Case law has identified various factors which may be relevant in working out whether an amount is income according to ordinary concepts. These include:

• whether the amount has the characteristics of periodicity, recurrence or regularity

• whether it is convertible into money or money’s worth

• whether it is associated with business activities or services rendered, as distinct from the mere sale of property, and

• whether it is solicited, as distinct from a windfall.

• The presence of these factors will help you work out if an amount is likely to be ordinary income. However, none of these factors is exhaustive or conclusive, and their relative importance varies depends on the circumstances and to the presence of any countervailing factors.

• Note that income from illegal activities can still be assessable as ordinary income eg income derived from illegal transactions conducted in a systematic, regular and organised way with a view to a profit can constitute business income.

Deriving ordinary income

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• Assessable income includes ordinary income “derived” by the taxpayer during the income year (s 6-5(2)).

• As a general rule, the income derived by a taxpayer is determined using a method of tax accounting which gives a “substantially correct reflex of the taxpayer’s income” (CT v Executor & Trustee Agency Co of South Australia (1938) 63 CLR 108 (Carden’s case).

• There are two basic methods of tax accounting:

• the “receipts” or “cash” basis

• income is not derived until it has been received by the taxpayer

• the “accruals” or “earnings” basis.

• under the accruals basis, actual receipt is not necessary for derivation; an amount is derived when it becomes “due” to the taxpayer, ie the taxpayer has a right to receive that amount presently (it has become a recoverable debt)

• The method to be used is reached based on looking at all all the circumstances relevant to the taxpayer and the income

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Deriving ordinary income

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• TR 98/1 sets out the Commissioner’s views on which tax accounting method should be used in a relevant year.

• The Commissioner considers that the receipts method is likely to be appropriate to determine:

• income derived by an employee

• non-business income derived from the provision of knowledge or the exercise of skill

• business income derived from the provision of knowledge or the exercise of skill in the provision of services

• income from investments (with the exception of interest derived from a business of money-lending), or

• rent or royalties (except where they are business income).

• On the other hand, the accruals method is, in most cases, appropriate to determine business income from a trading or manufacturing business (see further ¶27-040) and interest income from a business of money-lending.

Income or capital?

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• Not every receipt is ordinary income. Capital gains are not ordinary income and thus are not assessable under ITAA97 s 6-5 (although they may be assessable as statutory income under another provision). This fundamental distinction between ordinary income and capital gains remains important because, for instance, the amount of tax payable on income and capital profits may differ depending on whether it is taxed under the income tax regime or the CGT regime (eg a CGT discount may apply)

• The CGT provisions potentially apply to every disposal of an asset acquired or deemed to have been acquired on or after 20 September 1985. If the gain is also assessable as ordinary income, the amount of the capital gain is reduced accordingly.

• The traditional approach to distinguishing income from capital is to liken capital to a tree (example, an investment property or some shares) and income to the fruit of the tree (example, rent and dividends).

• Although some items are clearly income (eg wages) and others are clearly capital (eg a lump sum legacy), it is not always easy to determine whether a receipt is income or capital. Ultimately, it depends on the facts and circumstances of each particular case.

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Isolated transactions

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• The profit arising from an isolated business or commercial transaction will be ordinary income if the taxpayer’s purpose or intention in entering into the transaction was to make a profit, notwithstanding that the transaction was not part of the taxpayer’s daily business activities.

• This is called the Myer principle.

• For the Myer principle to apply, profit-making must be a significant (but not necessarily the sole or dominant) purpose or intention (TR 92/3).

Business v Hobby

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• Business income is assessable income

• Income from a hobby is not assessable income• Is activity being undertaken for commercial reasons?

• Is activity undertaken in order to make a profit?

• Is activity regularly and repeatedly undertaken?

• Is activity planned, organised and carried out in a businesslike manner?

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Business v Hobby

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• Joan bakes cakes at the weekend. She finds the activity satisfying and relaxing. Her cakes become very popular with her friends, who occasionally ask her to bake a cake for specific occasions such as birthdays. If Joan has time, she often agrees to these requests and charges her friends the cost of materials but doesn’t add on any profit.

• As Joan has no profit making motive and is not baking cakes in a business-like manner – she only accepts an order when she has time for instance – the ATO would accept that Joan has a hobby and wouldn’t expect her to declare the income from her cake-making on her tax return.

• Eventually, Joan realises that she can make a useful second income from baking cakes. Towards the end of the week, she sets aside several hours a night and bakes up to 30 cakes, which she takes to a local farmers market every Saturday morning and sells, at a mark-up of at least 50% on cost.

• Although Joan takes as much pleasure from baking cakes as before, she is now baking for profit and by setting aside set, regular times to make cakes, she is organising her activities in a business-like manner. She will now be expected to declare her baking income on her tax return.

Types of ordinary income

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• Employment income normally arises under a contract of service, an agreement between an employer and an employee and includes:

• Wages and salaries

• Allowances

• Lump sum payments

• Business income normally arises under a contract for service

• Disputes can arise where a contractor (in business) is in reality an employee. Hallmarks of self employment include:

• run your business for yourself and take responsibility for its success or failure

• have several customers at the same time

• can decide how, where and when you do your work

• can hire other people at your own expense to help you or to do the work for you

• provide the main items of equipment to do your work

• are responsible for finishing any unsatisfactory work in your own time

• charge an agreed fixed price for your work

• sell goods or services to make a profit

• Note that Personal Services Income rules can apply to attribute “business” income back to individuals

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Statutory income

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• An amount is “statutory income” if the amount is:

• not ordinary income; and

• included in assessable income by a specific provision of ITAA97 or ITAA36 (ITAA97 s 6-10(2)).

• An example of statutory income is a royalty which is not ordinary income under s 6-5 but which is included in assessable income under ITAA97 s 15-20

• Other items of statutory income include:

• Dividends

• Capital gains

• Employment allowances (e.g. car)

• Employment Termination Payments

• Leave (e.g. holiday) payments

• Partnership income

• Trust income

Poll:

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Q1. Which of the following statements most accurately describes assessable income under s. 6-5?

• a) Assessable income consists of ordinary income and statutory income.

• b) Assessable income includes all amounts over the tax-free threshold of $18,200.

• c) Assessable income is the difference between total income less allowable deductions.

• d) Assessable income does not include statutory income.

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Effects of residence on income

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• The accessibility of income is affected by the residence status of the person who derives it.

• The assessable income of an Australian resident will include the ordinary and statutory income derived directly or indirectly from all sources, whether in or out of Australia (s 6-5(2)).

• For a foreign resident, assessable income includes only the ordinary and statutory income derived directly or indirectly from Australian sources (s 6-5(3)(a)). Overseas income is excluded.

• “Source”, in this context, can mean both the geographic source of the income, as well as the transaction or means by which the income was generated. No statutory guidelines have been laid down in the tax Acts for determining the source of income and it has been left to the Courts to determine the approach to be applied and the factors to be taken into account.

Effects of GST

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• Generally, GST is disregarded when working out assessable income.

• The GST payable on “taxable supplies” is expressly excluded from assessable and exempt income and so is non-assessable non-exempt income.

• This applies to GST registered enterprises only.

• Example:• A Pty Ltd provides a service to Mr B at a price of $100 + GST

• Mr B pays $110 to A Pty Ltd

• $100 is assessable income of A Pty Ltd

• $10 is GST payable to the ATO

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Example: Income or capital; mere realisation or carrying on a business

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• In 1975, Joe Messina purchased five hectares of land 40 km from Sydney’s CBD. The land was used for agricultural pursuits, with produce sold through Sydney markets.

• In the year 2000 the government proposed construction of an airport adjacent to Joe’s land. Subsequently, in 2005 Joe sold the land for $700,000 and used this entire amount to acquire a large block of land closer to Sydney with the intention of keeping the land as a retirement nest-egg.

• In 2014, Joe was approached by a real estate developer to construct eight townhouses on the land. Joe accepted the proposal and employed architects, builders and obtained development approval from the local council. Joe oversaw the development and engaged real estate agents to market the townhouses for sale upon completion.

• During the course of the 2016/17 income year seven townhouses were sold for $650,000 each. Joe retired to the remaining townhouse.

• Advise Joe Messina on whether the proceeds from his land and building transactions constitute assessable income and the basis on which they may be assessed.

• (Taken from Australian Practical Tax Examples, Wolters Kluwer)

Example: Income or capital; mere realisation or carrying on a business

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• Sale of the five hectares; income or capital

• Assessable income consists of ordinary income and statutory income (ITAA97 s 6-1(1)). Ordinary income is assessable under ITAA97 s 6-5(1), whereas statutory income is assessable under specific provisions, such as those relating to capital gains, ie ITAA97 Pt 3-1 and 3-3. An amount may be assessable as both ordinary and statutory income, in which case the specific provisions will apply (ITAA97 s 6-25). An example may be the disposal of an asset, such as land. The amount received may be assessed as ordinary income where the taxpayer is carrying on the business of land development or statutory income, eg capital gain where the taxpayer is merely disposing of a parcel of land.

• Joe Messina’s original five hectares of land is a pre-CGT asset and can be disposed of free of CGT. However, a further issue must be considered, ie whether the sale of the land was a mere disposal of an asset or the proceeds from carrying on a business. Proceeds from the mere disposal of an investment are not assessable income, whereas the proceeds from carrying on a business are assessable as ordinary income. Even an isolated transaction or an extraordinary transaction may be assessable.

• In Joe’s case the purchase and sale of the land does not meet the indicia for carrying on a business. Joe did not enter into the transaction to sell the land with the intention to make a profit.

• Hence, the $700,000 proceeds from the sale of the land are not assessable income. They are exempt from CGT and do not result from carrying on a business or constitute an isolated or extraordinary transaction. The amount is not assessable on the principle that the proceeds from the mere realisation of a capital asset are not assessable as ordinary income.

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Example: Income or capital; mere realisation or carrying on a business

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• Sale of the townhouses

• The acquisition of the large block of land constitutes a post-CGT asset, with a cost base of $700,000. The sale of the seven townhouses constitutes the disposal of an asset and prima facie attracts CGT. However, it may be argued that the proceeds are normal proceeds from carrying on a business.

• The distinction between capital gains and carrying on a business is important because the amount of tax payable may differ. For example, capital gains may attract a 50% discount and some deductions against income from carrying on a business may not add to the cost base for CGT purposes.

• The tax-free proceeds from the mere disposal of a pre-CGT asset/investment do not apply in the case of post-CGT assets/investments.

• Had Joe Messina not been involved in the design, council approval, building and marketing of the completed townhouses it could not be said that he was carrying on a residential construction business — in which case the profit on the sale of the townhouses would be assessable as a capital gain and the gain, discounted by 50% would be added to Joe’s assessable income for the year or years in which the sales took place. The capital proceeds would be $4,550,000. The first element in the cost base, the $700,000 purchase price for the land would need to be apportioned because Joe is retaining one of the eight townhouses for his own use.

• However, on the facts, Joe Messina took an active role in the development and sale of the seven townhouses and this reflects a number of the factors applicable to carrying on a business, including profit motive, scope of the activity, personal effort and involvement, employing or sub-contracting staff and the commercial nature of the project. Consequently, it is likely that Joe will be held to be carrying on a business and the normal proceeds from carrying on a business are assessable income (Taxation Ruling TR 97/11).

Poll:

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Q2. You have been asked to prepare an analysis of which items would be included as assessable income for a client who is an individual resident taxpayer. From the list below, which items should be included as assessable income?

1 A trust distribution of $20,000 from the A Family Trust

2 Interest received from the United Kingdom: $2,400

3 Franking credit for dividend: $214

4 Legacy from the estate of the late A Smith: $50,000

• a) 1,2,3 and 4

• b) 1 and 3

• c) 1,2 and 3

• d) 1,2 and 4

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Exempt income

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• Exempt income is ordinary or statutory income that is made exempt from income tax by a provision of a Commonwealth law, including ITAA 1936 and 1997. In the case of ordinary income, this exemption may be express or implied.

• The consequences of an amount being exempt income are:• the amount is tax-free

• outgoings incurred in deriving the amount are not deductible

• capital gains and losses do not arise from the disposal of an asset which was used only to produce exempt income, or which was owned by a taxpayer whose income is totally exempt

• the amount may be taken into account to reduce the deduction allowable for a tax loss and

• the amount may be taken into account in determining the tax payable on income from certain overseas projects or employment.

Exempt income

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• Examples of exempt income:• Government superannuation co-contribution

• Exempt fringe benefits

• Family Tax Assistance, Child care benefit

• Some overseas employment income

• Payments to ADF personnel in war zones

• Payments to part-time ADF members

• Some social security payments (e.g. disability, carers)

• Welfare (e.g. rent assistance, maintenance payments)

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Non-assessable non exempt income

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• Non-assessable non-exempt income (NANE) is ordinary or statutory income that is expressly made neither assessable income nor exempt income by a provision of the tax legislation or any other Commonwealth law.

• The consequences of an amount being non-assessable non-exempt income are:• the amount is not assessable and is therefore tax free

• outgoings incurred in deriving the amount are not deductible

• capital gains and losses on assets used to produce some types of these amounts are disregarded, and

• tax losses are unaffected.

Non-assessable non exempt income

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• Examples of non-assessable non-exempt income (NANE):• GST

• Reportable Fringe Benefits

• Non-resident income (interest, dividends) subject to withholding tax

• Most foreign source income for temporary residents (foreign interest, dividends, pensions, rent, etc.)

• Superannuation benefits paid from a taxed fund to recipients who are 60 years or older at the time of receipt

• Government contribution to a First Home Saver Account

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Non assessable income

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• Income that is not assessable income, exempt income or non-assessable non-exempt income (NANE).

• Examples include:• Income from hobbies

• Bequests under a will

• Gambling wins

• Gifts unrelated to services rendered (e.g. birthday gifts)

• Lottery wins (unless from investment related lottery)

• Repayment of a loan

• Increases in the value of property, without any realisation through conversion into money or other property (excluding trading stock)

Taxable income

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• Taxable income is generally defined as assessable income minus all general and specific deductions (ITAA97 s 4-15).

• Such deductions will include all normal business expenses, ie expenses connected with the production of assessable income (excluding capital or private expenses), certain special deductions for expenditure of a capital nature and personal deductions.

• Taxable income is the amount to which the tax rates are applied.

• Tax offsets, eg credits for foreign taxes or rebates for medical expenses or dependants, are deducted not from the assessable or taxable income but from the computed tax to determine the final tax payable.

• The tax for the financial year is calculated as:

• (taxable income × rate) − tax offsets

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• You can type them in the “Questions” box now

• Or contact me via:

• Mark Chapman

• Director of Tax Communications, H&R Block

• mchapman@hrblock.com.au

• 0415 844 388

Questions?

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