Topic 3 –Income from Business, Income from Property and

CompensationHobby or business, profit making scheme, Mutuality, Interest, Rent, Dividends and Intellectual property, Compensation for

loss of salary, pain and suffering

Chapters 6,7and 8

Income Tax Formula – s 4-10, s 4-15

Assessable Income (s 6-5 and s 6-10

Less: Allowable Deductions (s 8-1 & Div 25)

= Taxable Income x Tax rate + Medicare levy (1.5%) + (surcharge 1% if applicable)

= Tax payable - Less: tax offsets + rebates =

Tax refund or payment to ATO

Income from Property

• S 6(1) ITAA 36: income from property or income derived from property means all income not being income from personal exertion.

• definition circular – Income means ‘income from’

• Definition used when a scheduler system in Australia – up until 1953 and then again in 1974-75 – tax was higher than income from labour.

Principle of Mutuality

• Income has certain characteristics – provision of labour or services, regularity, sale of goods, interest or rent.

• If member of an association are payments to that association income? Payment to yourself? Bohemians Club v Acting FCT

• RACV v FCT – membership payments not income except other receipts – rent.

• It does not matter if the association is a company

Income v Capital

• Distinction very important prior to the introduction of CGT – 20 September 1985. Now important with discount method to reduce the amount of CGT – 22 Sept 1999

• Eisner v Macomber 252 US 189 (1920), Putney J – “capital likened to the tree or land and income likened to the fruit or the crop”

Business or Hobby

• Business activity denotes the derivation of assessable income whereas a hobby produces non-assessable income. ATO tends to regard income of less than $20,000 per annum as a hobby. (note Non-commercial loss provisions).

• These cases revolve around the deductibility of expenses but are relevant to determine if engaged in a business.

What constitutes a business?

• Leading case: Ferguson v FC of T:

• 4 tests made by the Court • A profit making motive is necessary, although the

amount of profit or even a loss does not mean that a business is not being carried on.

• Regularity or repetition of activities is important. However, a business has to begin and even isolated activities may be held to be the start of the business

Business (cont)

• There is a need to have organised activities in a business-like manner such as keeping books of account and records

• The amount of capital employed in the business and volume of operations may be significant.

• Mr Ferguson was in the Navy and leased 5 cows for breeding. The Full Bench of the Federal Court held that the activities were in the nature of a business.

FCT v Stone (2005)

• (page 655) Ms. Stone an Olympic athlete, received sponsorship money, prize money and worked as a police officer in Queensland.

• $93,429 winnings assessed as income. Needed to show that taxpayer engaged in a business and not a hobby. Sport or business, prize or gift.

• High Court – a business, therefore assessable income, but able to claim expenses as a deduction. The fact that she was not motivated to make money but represent her country did not change the fact that she carried on a business.

Gambling – Hobby or business

• Brajkovich v FC of T – (page 659) taxpayer wanted to claim as a tax deduction for his gambling losses. In order to do this he had to convince the Federal Court that the gambling was in the nature of a business.

• The Court held that the following six tests must be satisfied:– The betting is conducted in a systematic, organised and

business-like manner– The size and extent of betting wins and losses

Brajkovich v FC of T

– Whether betting activities related to other business-like activities, i.e. horse breeding

– taxpayer’s objective for activities for pleasure or profit

– Whether system rewards skill and judgement or just pure luck

– Whether activities considered a mere hobby or pastime

Evans v FC of T

• Between 1972 and 1979 the taxpayer operated a number of businesses declaring not more than $7,500 p.a. and in some years losses.

• Over the same period he bet between $400,000 and $1,000,000 p.a. winning $91,295 in 1978, $135,752 in 1979, $427,935 in 1980 and $351,948 in 1981.

• He clearly financed his lifestyle out of his gambling wins.• He did not extensively study form, nor use a computer to

store or analyse race-related information.• He did not utilise any betting system but used a mixture of

intuition and judgement for his bets.• He bet mostly on the TAB or on course and mainly on

"higher risk" exotic type of betting such as trifectas.

Evans v FC of T

• Taxpayer derived substantial income from gambling. ATO assessed the taxpayer on the income on the basis that it was a business.

• Federal Court said no, not assessable as the taxpayer did not have a betting system, kept no records and simply relied on luck. He did not satisfy the tests for a gambling business.

Income from Isolated Transactions

• The most recent case FC of T v Montgomery (1999) provides an up-to-date summary of the attitude of the High Court to one-off and isolated transactions

• High Court held that a lease incentive payment was assessable income and not a capital receipt, even though it was a one-off and isolated transaction

• The decision was based on previous cases such as Myer Emporium, Cooling and Westfield Ltd.

FCT v Montgomery

• High Court – 4-3 majority that the sum of $26.3 million was income and not capital. Federal Court held that it was a capital receipt, not income.

• Derived from wider business activities and would not have been paid except for the size and reputation of the law firm. The Law firm exploited its capital – its attractiveness as a tenant – a single and extraordinary transaction.

Profit-making Schemes

• Section 15-15(1) Your assessable income includes profit arising from the carrying on or carrying out of a profit-making undertaking or plan.

• Section 15-15(2) This section does not apply to a profit that:– (a) is assessable as ordinary income under section 6-5;

or

– (b) arises in respect of the sale of property acquired on or after 20 September 1985.

Section 15-15

• The section only applies to property acquired prior to the introduction of capital gains tax – 20 September 1985. After that date the taxpayer will pay CGT on any capital gain

• The original section, s 26(a) ITAA 36 was designed to tax profits on property that was acquired for the purpose of profit making or engaged in the carrying on of a profit making undertaking or scheme. Section 25A replaced s 26(a). Then in 1997, s 15-15 introduced.

Profit-making scheme (cont)

• Bernard Elsey Pty Ltd v FC of T, High Court The taxpayer had 4 blocks of land and built shops on the land and then sold them. He spent money on construction, interest expense, marketing, Council approval.

• The High Court held that the building of the shops was a profit making undertaking or scheme and therefore the profit was assessable income, s 25A , s 26(a), now s 15-15 and not a capital receipt.

• The sale was pre-CGT and a profit making scheme.

FC of T v Whitfords Beach Pty Ltd

• A further example of the application of s 25A / s 26(a) [ now s 15-15] although the High Court applied s 25(1) [now s 6-5] to make the profit assessable income.

• The basis for taxing the profit as assessable income was that the beach front land was developed, subdivided and sold off at a substantial profit. Originally the land was purchased merely for recreational purposes with no profit making motive in mind.

FCT v Myer Emporium

• Myer Emporium lent Myer Finance $80m at 12.5% interest. Myer Emporium assigned the receipt of the interest to Citicorp for $45.370m. The interest cash flow was discounted at 16% to give the above amount.

• Citicorp had accumulated tax losses, so no income tax on the interest and Myer Emporium argued that the $45m was a capital receipt.

FCT v Myer Emporium

• Myer Emporium would still receive the $80m principal from Myer Finance.

• High Court – amount of $45.370 was income and taxable s 6-5 and s15-15. Isolated transaction, Myer involved in retail operations, but still assessable. Myer would not have entered into the loan if Citicorp had not been prepared to take the interest income. The two transactions were part of a profit making scheme.

Westfield v FCT

• Sale of land, pre CGT originally purchased to build a shopping centre.

• Land subsequently sold at a profit of $267,906. Was it income or capital gain?

• Full Bench of Federal Court held capital gain and no income tax payable. Myer case distinguished.

• Taxpayer had no profit motive at time of purchase and not part of the normal business activity.

Stratham v FCT

• Land that was acquired in 1970 subsequently sold after it was subdivided.

• Full Federal Court held that not income as no business activity involved, no profit making scheme or undertaking.

• Could not sell the land as a single piece, no money borrowed, no business organisation to market the blocks and the council did most of the work.

Income from Property

• Property consists of money, real property, shares, capital equipment and Intellectual property.

• Passive or active investor – negative gearing and non-commercial loss provisions – Division 35 : four tests; real property $500,000, depreciating assets $100,000, assessable income more than $20,000 and profits test – 3 out of last 5 years.

• Does not apply to passive investments, primary production $40,000 or artist.

AGC case

• Debentures offered to the public, fixed interest, 20 years but could be redeemed at end of 5 years. AGC claimed a deduction for interest but interest not paid until after 5 years as a lump sum.

• Mismatch of income and deductions.• Federal Court held interest deductible even though

not paid.• Government introduced Division 16E, ITAA 36

taxes on an accruals basis even if no interest paid.

Taxation of Derivatives

• Either on revenue account or capital account. If on capital account then CGT provisions apply.

• If part of the business then on revenue account, similar to shares/equities/ debentures.

• Used to manage risk – interest rate risk, currency risk or a commodity risk.

Taxation of Financial Arrangements

• New law found in Division 230. Applies on or after 1 July 2009, or can elect to use after 1 July 2008.

• Does not apply to individuals, ADI’s with turnover less than $20m, entities with turnover less than $100m.

• Referred to as ‘TOFA’

Real Property – negative gearing

• Negative gearing, passive investment, not caught by Division 35.

• Designed to provide large tax deduction to be used to offset assessable income from salary.

• Need to obtain a capital gain to compensate for ‘loss’.

Taxation of Dividends

• Dividends assessable income – s 44(1), ITAA 36

• Ordinary and preference shares, convertible notes/hybrid shares

• Dividend imputation – franking credits, imputation credits – tax offsets.

• Dividend x t/1 – t = 30/70 (t = company tax rate)

Taxation of Leases

• Lease and Hire-purchase distinction – ownership of asset being leased.

• Division 40 – capital allowance /

depreciation deduction.

True operating lease – no option to purchase. Depreciation claimed by financier and total of lease payment income.

Intellectual property

• Does not include goodwill but goodwill a CGT asset

• Royalties ordinary income, s 6-5, but if a capital receipt then s 15-20 deems the amount to be statutory income.

• No overlap with s 6-5 and CGT by virtue of s 118-20 – no double taxation

Principles of Compensation

• Compensation takes the character of what it replaces – the ‘replacement principle’

• Compensation for loss of wages or salary – ordinary income, s 6-5, FCT v Dixon

• The payment may be periodic payments or a lump sum – still income.

• Compensation still assessable under s 15-30 if received by way of insurance or indemnity – if the amount ordinary income or not income under s 6-5

• Loss of a finger – lump sum ordinary income.

Loss of physical abilities

• Compensation for loss of an eye or limb a capital receipt and exempt from CGT under s 118-37(1) including post-judgment interest.

• Pain and suffering and medical expenses a capital receipt – exempt s 118-37(1)

• Anti-discrimination – either capital or income, depression, sexual harassment - capital, loss of promotion on the basis of sex or race income. Dismissal an ETP.

Division 54 Settlements

• The compensation for personal injury is structured as an annuity and or a lump sum – exempt from tax. Without this provision an annuity would be income.

• Designed to prevent a lump sum from being spent and not used to replace loss of income.

Compensation for business losses

• Compensation for breach of contract – income – Heavy Minerals v FCT

• If compensation is for loss of the structure of the business then capital – Californian Oil Products v FCT

• Loss of a depreciable asset – Division 40 – balancing adjustment

• Loss of a capital asset – if permanently destroyed then a capital receipt.

Business losses

• Compensation for loss of trading stock – income, s 6-5, by virtue of s 70-115.

• Insurance proceeds – s 15-30, statutory income, considers any amount paid by way of insurance or indemnity for loss of an amount that would have been income – loss of profit – is assessable income.

• Special arrangement for livestock and timber – s 385-130 – income spread over 5 years.

Business losses

• Composite claims – if for unliquidated damages and not capable of being dissected – capital – McLaurin v FCT

• Division 20 – assessable recoupments – where an amount has been claimed as a deduction and later an amount is paid as reimbursement, then income, s 20-30 – bad debts, larceny.

• Or insurance s 20-20, income.

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