Revenue Law

Lecture 6
Part 4
Taxation Accounting Chapter 16
Trading Stock Chapter 17

Tax Accounting
ITAA97 s6-5 the ordinary income section uses
the term derived a number of times.
ITAA97 s995 defines derive as derive has a
meaning affected by subsection 6-5(4)

Derived
Ss6-5(4) states
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.

Derivation of Income
In Brent v FCT Gibbs J held 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 taxpayers
true income.

Cash v Accruals Accounting

ITAA97 sections 6-5 and 6-10 leave it open to
taxpayers to calculate their assessable
income on a cash basis or accrual basis.

Derivation of income:
Cash vs accruals
For tax purposes, accruals or cash basis can be adopted.
accounting

Derivation of income
Recognition of when income is received:

Accruals basis

Cash basis

When invoice sent to

customer

When cash actually received

from customer

Which method?

Nothing in statute to compel use of a particular

method, however case law suggests cash basis for
professional practices and small businesses:
Henderson v FCT (1970).
PoTL 2015 paragraph [16.40]

Selecting the correct method

In Henderson v Commissioner of Taxation
(1968) 119 CLR 612 the High Court
established the legal principle that with large
professional firms the appropriate method to
calculate taxable income is the accruals
method. It is acceptable for small business to
use the cash method.

Switching from cash to

accrual
In Henderson v Commissioner of Taxation the
taxpayer was a partner in an accounting
practice employing 295 people.
The HC held that accruals basis appropriate
even though the change from cash basis
meant that $179,000 of outstanding fees
would not be subject to income tax.

Derivation of income:
Cash vs accruals
Illustration:
accounting
Invoice issued
Payment

$10,000

received

30 June 20X1

30 June 20X2

Under the accruals method, the $10,000 would be derived in

the year ended 30 June 20X1.

Under the cash method, the $10,000 would be derived in the

year ending 30 June 20X2.

PoTL 2015 paragraph [16.40]

Derivation of income:
SBE taxpayers & large
SBE taxpayers
firms
Businesses eligible to be a Small Business Entity (SBE) can

account on a cash or accruals basis

A SBE must have an average turnover of less than

$2 million.

Large firms and businesses

The accruals method is the appropriate method for large

professional firms: Henderson v FCT (1970).

PoTL 2015 paragraphs [16.50] [16.60]

Prepayments
In Arthur Murray (NSW) Pty Ltd v
FCT (1965) 114 CLR 314 the taxpayer provided dancing lessons and
students paid for tuition in advance. These fees
were put into an untaught lessons account and
transferred into earned income once the lesson
had been taken. The Commissioner assessed
the taxpayer on the total income received prior
to the end of the financial year.

Arthur Murray (NSW) Pty

Ltd v FCT
Barwick CJ, Kitto and Taylor JJ held
according to established accounting and
commercial principles, in the case of a business
either selling goods or supplying services,
amounts received in advance of goods being
delivered or the services being supplied are not
regarded as income.

Dividend Income when

derived
Under ITAA36 s44(1) the assessable income of
a shareholder includes dividends that are
paid to the shareholder by the company out
of profits

Brookton Co-Operative Society v

FCT (1997) 7 ATR 587
Helsham CJ of the Supreme Court of NSW
held that a dividend is treated as income in
the hands of the shareholder when actually
paid and not just declared by the directors.
This is because the directors can rescind the
decision to pay the dividend at any time up
until payment.

Delay because of legal

disputes
BHP Billiton Petroleum v FCT (2002) 51
ATR 520 The taxpayers entered into
contracts for the supply of gas, payable
monthly with an annual adjustment to
reflect the annual contract amount. After
the imposition of a petroleum resource
rent tax the buyers and sellers entered
into a dispute with the buyers refusing to
pay the tax.

BHP Billiton Petroleum v

FCT (cont)
The Commissioner assessed the taxpayers
as though they had derived the additional
income at the time gas was invoiced
monthly even though the amounts were in
dispute.

BHP Billiton Petroleum v

FCT (cont)
The Federal Court held the additional
amounts of income were only derived
when the dispute had been settled.

BHP Billiton Petroleum v

FCT (cont)
Reasons for the decision;
1. There is no Australian authority, where there
is a bona fide dispute, requiring a TP on an
accrual basis to account for trading income
that is the subject of the dispute in the year
when the goods are sold or the service
performed.

BHP Billiton Petroleum v

FCT (cont)
Reasons for the decision;
2.
The court should be slow to adopt a fiction (that
the successful litigant was going to be successful)
in preference for reality.
3.
It avoids the difficulty of reopening accounts where
a deduction for a possible bad debt may be the
subject of doubt.
4.
It avoids the unfairness to a taxpayer in being
required to pay tax immediately on amounts where
recoverability is out of control of the taxpayer.

Timing of Expenses deductibility

The meaning of the word incurred in ITAA97

s8-1 is defined in TR97/7 as;
you incur an outgoing at the time you owe a
present money debt that you cannot escape.

The meaning of Incurred

Further in TR97/7 it states that;
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.

Incurred (cont)
For a debt to be incurred, per TR97/7
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.

Expenses of an earlier
income year
In Placer Pacific Management Pty Ltd v FCT
the Federal Court held the expenses were
deductible because;
to preclude deductibility when those liabilities
come to fruition on the basis that the active
trading business which gave rise to them
ceased would be unjust.

Expenses incurred after

business ceased to operate
In FCT v Jones (2002) the taxpayer Mrs Jones
had an ongoing debt from a business owned
by her husband before his death. The
business had been sold but the proceeds
were insufficient to cover the debt. Mrs Jones
refinanced the debt and continued
repayments.

FCT v Jones (cont)

The federal Court held that 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
In Neville and Co v FCT (1937) the HC
held the expense was deductible even
though it was incurred to reduce future
deductions. The payment was not capital and
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
In Steele v DCT (1999) the taxpayer
borrowed to purchase land for a motel. The
motel did not proceed. The HC held that the
interest expense was deductible even though
the capital asset was not used as intended
and the volume of assessable income
produced was not as intended. The HC
dismissed the notion that the expense must
be contemporaneous to the gaining of
assessable income.

Prepaid expenses
Under ITAA36 s82KZL expenditure for loan
interest, rents, lease payments and
insurances are taken to be incurred during
the period to which the payment relates.

Provisions employee leave

In FCT v James Flood Ltd (1953) the taxpayer
claimed a deduction for a provision for annual
leave of 579. The leave was required to be
paid pursuant to an award.
The HC held that for an expense to be incurred
the amount does not have to be actually paid,
but the liability must be fixed and cannot be
changed.

Provisions employee leave

(cont)
ITAA97 s26-10 provides that;
(1) You cannot deduct under this Act a loss or
outgoing for long service leave, annual
leave, sick leave or other leave except;

An amount paid in the income year ;or

An accrued leave transfer payment that is

made in the income year.

Bad Debts
ITAA97 s25-35 provides that you can deduct an
amount written off for bad debts if;
a) It was included in your assessable income
for the income year or for an earlier income
year.
Recall the case of Point v FCT

Meaning of trading stock

Trading stock is defined in s 70-10 and includes:

(a)

(b)

Livestock

Anything can be trading stock: FCT v St Huberts Island Pty

Ltd (1978)

Anything produced, manufactured or acquired that is

held for purposes of manufacture, sale or exchange in
the ordinary course of a business; and

Necessary to determine the purpose for which it is

held.

An item can be trading stock of a taxpayer even if the taxpayer

is not its legal owner.
PoTL 2015 paragraph [17.20]

Land and Shares

Land (St Huberts Island and Barina
Corporation) and shares (Investment and
Merchant Finance Corporation Ltd and John)
can be trading stock if the business holding
the land or shares is in the business of
trading land or shares.

Goods for hire

Trading stock does not include goods acquired
for hire to customers (Cyclone Scaffolding
Pty Ltd)

Work in Progress
Work in Progress raw materials and partly
finished goods are considered trading stock.
However, products that represent the
provision of services are not considered
trading stock. That is, the work of lawyers
and accountants does not give rise to trading
stock even if their work results in a report, an
opinion or a set of accounts.

Tax treatment
Section 70-35 Bringing trading stock to
account for tax purposes compares the
value of trading stock at the end of a
financial year with the value of trading
stock at the beginning of a financial year.
Section 70-35(2) Where the value of trading
stock at the end of the year is greater than
trading stock at the beginning of the year,
the difference is included as assessable
income.

Tax treatment
Section 70-35(3) Where the value of trading
stock at the end of the year is less that the
value of the trading stock at the beginning
of the year, the difference is an allowable
deduction.
Section 70-40 The closing value of trading
stock in one financial year becomes the
opening value of trading stock in the next
year.

Accounting for trading

stock:
An adjustment is required to ensure the taxpayer only accounts
for a deduction when there is an actual economic decline.
Year-end
adjustments
Taxpayers are required under s 70-35 to compare the value of

trading stock on hand at the start and at the end of the year:
Value of
trading stock
at year-end

Value of
trading stock
at start of year

Difference is
included in
assessable
income

Value of
trading stock
at year-end

Value of
trading stock
at start of year

Difference is
included in
deductions

PoTL 2015 paragraph [17.120]

Value of trading stock

Section 70-45 Trading stock can be valued at
either of
a) Cost
b) market selling value and
c) replacement value

Accounting for trading

stock:
Cost: should be determined in accordance with accounting
Year-end
adjustments
principles: Phillip Morris Ltd v FCT (1979):

Manufacturers, retailers and wholesalers should use

the accounting absorption cost method.
The first-in-first-out method should be used where it
is not possible to track individual items: Australasian
Jam v FCT.

Market selling value: is the amount for which the taxpayer

could sell the stock in the ordinary course of business.
Replacement value: is the amount the taxpayer would have to
spend to replace the stock.
Note, for obsolete stock: taxpayer may value trading stock at
a value lower than the 3 methods if it is obsolete and the value
used by the taxpayer is reasonable: s 70-50.PoTL 2015 paragraphs [17.150] [17.190]

Trading Stock
Stock on Hand has been determined in case law.
FCT v Sutton Motors (Chullora) Wholesale Pty Ltd
(1985) 157 CLR 277

FCT v Sutton Motors

(Chullora) Wholesale Pty
The
Ltdtaxpayer held floor plan stock of motor

vehicles which were legally owned by GMAC, a

finance company. This stock of motor vehicles
was held to be the trading stock of the taxpayer
because the definition in ITAA97, s70-10 holds
that trading stock includes anything produced,
manufactured or acquired that is held for the
purposes of manufacture, sale or exchange in
the ordinary course of business.

FCT v Sutton Motors (Chullora)

Wholesale Pty Ltd
The High Court held that the definition is
expansive and though the vehicles were not
owned by the taxpayer they were plainly in
the possession and risk of the group and
were held for the only purpose of being
offered for sale.

Homework
Questions 16.2, 16.6, 17.1 and 17.4