Income tax
Order Instructions:
Part A
James Cookie is a ship’s officer employed by Sails International Inc, a company incorporated in Bermuda that owns cruise boats and operates passenger cruises in the Pacific Ocean.
James owns a house in Sydney which was formerly his family home but his estranged wife and children now live in Singapore. James rents the house to his cousin and family. The house is let fully furnished; the furniture belongs to James. Whenever he is in Sydney, James stays in the house and has his own room in which are stored his personal belongings. In the current income year James spent 80 days in the house. The remainder of the time was spent on a cruise ship except for 20 days spent visiting his children in Singapore.
The ship on which James serves visits a variety of ports, mainly in the South Pacific. James’s employment contract was negotiated and signed in Hong Kong.
Required 1: For Taxation purposes, is James a resident of Australia? What is the source of his salary from Sails International? Required 2: If James sold his house, would he be entitled to the main residence exemption in Subdiv 118-B?
Part B
On 1 July 2012 Lee commenced business as an architect. He operated as a sole proprietor from a converted garage at the rear of his residence. Much of his work consisted of preparing building designs and specifications for local council building permits but he quickly gained a reputation for quality drawings prepared within tight timeframes. By the end of 2012/13 he had a small client base of local builders and private referrals and billings (fees) of $75,000.
During the year Lee submitted a design as part of a national competition for the Citadel, the centrepiece of an urban redevelopment. His visionary design and revolutionary use of local materials left the judging panel speechless with admiration and, to national acclaim, he was awarded the prize and commissioned to build the structure. Immediately he borrowed $1 million, rented premises on Main Terrace, acquired state of the art equipment and employed six draughtsmen and two administrative staff. During 2013/14 his billings were $1.75 million.
Required Should Lee return on a cash or accrual basis in 2012/13 and 2013/14?
You must refer to appropriate case law. Your answer must include (but should not be limited to) a discussion of the following: • What factors affect the choice of a cash or accrual basis? • Does Lee have a choice of the basis he adopts? • Does the Commissioner of Taxation have a right to insist on a particular basis? • Should Lee’s basis be the same in both years?
SAMPLE ANSWER
Part A.
Introduction
- Income tax is generally payable annually by residents or non residents who are receiving income in Australia provided the income was derived, earned or accrued while living in Australia. The returns earned from a business operated partly in or out of the country i.e. Australia are considered to have accrued in totality from Australia. All the income earned from investments, sale of personal property or any other income is subject to taxation. (Renton, 2005)
The residents of Australia are basically taxed on their global income and from all sources but temporary residents mostly have their income from foreign exempted. Foreign residents are basically taxed on the income whose source is n Australia for example on the income they have earned while working in Australia. The residents of Australia pay lower rates of taxes than their foreign counterparts. (Centrelink website, 2013)
For tax purposes one is considered an Australian resident if one has lived in Australia entirely or has come to live in Australia permanently or if one is an Australian but travelling abroad temporarily and has not built or bought a permanent home in a different country or out of Australia. The other situations refer to students who have travelled to Australia to study for more than six months continuously or if a foreigner has been working in Australia continuously for more six months or even more and mostly living and working in the same place or one has been living in Australia for at least more than half of the financial year unless a person has an oversees home and does not intend or plan to live in Australia. The income tax assessment ruling IT 2650 of permanent place determination which is also related to case IT 2607 under the ATO ID 200/179 puts more emphasis on the place of resident.
It defines a resident as a person who is domiciled in Australia unless the commissioner is convinced and satisfied that the permanent place is not Australia as was illustrated in the case of Henderson v Henderson (1965) 1 All E.R.179.
James Cookie works for a foreign company that has been registered in Bermuda that owns and operates passenger cruises across the Pacific Ocean. He owns a house that he inherited from his parents in Sydney, Australia. By virtue of his inheritance and parentage he is an Australian citizen. But he has rented the family house to his relatives who live in the house but the furniture and one of the rooms belongs to him. In the current year he spent only eighty days in the house while most of the other days he was away. For tax purposes he will be considered as a resident as he has no other permanent home even though the company he works for is foreign based. All his income will be subjected to taxation in Australia together with the rent that he receives from his inherited house that he rents for his relatives. If the salary is taxed by the Bermuda tax authorities then he has to apply to be considered for tax reduction if there are tax treaties under the Australian Treaty Series agreements between the two countries. Australia has tax agreements with close to forty countries globally. If an Australian resident receives income or any kind of benefits from these countries, he can apply for a reduction in his withholding tax or alternatively to be exempted from the payment of tax in these other countries. These can be achieved by supplying the Australian tax office with a tax relief form and or a certificate of the status of residency.
The determination of the permanent place of abode is important. The taxpayer’s permanent, fixed and also habitual place of residence or abode is his home. James home is in Australia and he has no other permanent home. As in the case of F.C. of T v Jenkins (1982) ATC 4098, a permanent abode connotes an enduring relationship that develops as an attachment to a particular place of abode. The residency will determine his tax liability and not the length of stay in Australia for a particular year.
The tax liability is usually determined annually and a person must have a place of permanent residence. James will be taxed by the Australian authorities because his place of abode is in Australia not withstanding that his earnings are from a different country and he hardly lives in Australia. James intentions are to return to Australia eventually at the end of the transitory stay abroad qualifies him to be an Australian resident for tax purposes.
However, if James had been working and living in Bermuda, he would be considered a non resident for tax purposes but his income from the inherited properties that he has rented to his relatives would still be subjected to taxation in Australia as in the case of F.C of T V Applegate (1979) ATC 4307.
The source of his income is from Bermuda and its subject to taxation in that country if he resides their or has some residence in that country.
The circumstances are similar to the case of ATO ID 2005/249 where the taxpayer was present in Australia for less than 183 days. The decision under section 6-5 of the income Tax assessment Act of the year 1997 (ITAA 1997) was that he was not obliged to pay any taxes as he was a non resident.
- If James sold his house in Australia then he would be a non resident for tax purposes and he would not be entitled to the main residence exemption in Subdivision 118-B. (ATO, 2005) The case of ABB Australia Pty Ltd V FC of T (2007) ATC 4765 illustrates the withholding of tax by a non resident company which was also a shareholder of resident, the ABB of Australia who was also the applicant. The facts are also similar to the case of Federal Commissioner of Taxation v French (1957) 98 CLR 398. The case emphasized that the exertion of an employee must be at the place where the exertion took place and it’s the source of the earnings where the operations of a business take place. For this case it’s Bermuda.
Part B
- Lee should make his returns based on the cash basis for the year 2012/13 and 2013/14.
Taxes collected or even paid can either be reported as cash or accrual to the Australian Tax Office. The major difference between the two is determined or connected with the liability of recording the tax implications and payments.
When receipt of income is reported in cash basis then no taxes will be payable to ATO until all the amounts have been collected from the customers. One will also not be allowed to claim any tax benefits or claims that have been charged by the suppliers until one pays the suppliers. The reported amounts will actually represent 1/11th of the monies paid or even received during the financial or tax period.
Accrual based payments is when the tax liability is recognized when the invoice is received and one has legal obligation to pay all the suppliers and also to receive the payment after supplying goods to the customers.
For example, in cash basis, one is liable to pay the tax after receiving payments from the debtor. If one sells a TV set for ten thousand dollars on credit and the tax is 1000 dollars, the tax will be paid when the client pays for the TV set regardless whether it takes six months or one year. If he doesn’t pay for the TV set then the GST on the TV set will not be paid. The accounting system is based on the receipt system.
On accrual basis is the opposite, one is obliged to make the payments once the invoice has been raised regardless whether the client has paid for the TV set or not also one can claim the GST from the suppliers even if he has not paid them. The accounting system is based on the earnings method.
The factor that may determine is basically the nature of the trade or industry involved. The service industry bases most of their payments on the cash basis especially such fields as engineering and architecture whose payments are materially large and are paid in phases. It’s not practical to use the accrual basis of making the tax payments. Lee may have a choice on what basis to use but the accrual basis is basically not practical. If the money to support his operations have been borrowed it’s not possible for him to pay the tax when he has not received the payments.
The commissioner has a right to insist on the mode of tax payments if the systems as companies in the fast moving consumer goods industry have no reason to use the cash basis as most of their products are paid on delivery or on scheduled periods that can be synchronized to allow the accrual basis to operate effectively. Under sec 29-45 of the Australian GST Act, provides that a person can apply to the commissioner for authority to use the cash basis only after some requirements under the act have been met. The case of Lee is applicable as first, the nature and size of his business cannot allow him to use the accrual basis. He actually had to borrow some money from the bank to facilitate his operations as he is anticipating to be paid in future and as such there is no way he can make the tax payments before he has been paid his monies.. The tax is also on the higher side he cannot afford to make the payment before he has been paid for the work done. The nature of the accounting system applicable is also different.
Lee has little choice on the basis of accounting procedure to adopt unless he applies to the commissioner for approval while also outlining the appropriateness and the need for the change. The commissioner may also find it appropriate to allow him to use the cash basis. The case of ABB Australia Pty Ltd V FC of T (2007) ATC 4765 illustrates the withholding of tax by a non resident company which was also a shareholder of resident, the ABB of Australia who was also the applicant. The commissioner, submitted that for the purposes of identifying the right accounting basis, a company has to be classified as a trading company as in the case of Carapark Holdings Ltd v Commissioner of taxation (1966) 115 CLR 653 and Broken Hill Pty Co. Ltd v Federal Commissioner of Taxation (1999) 99 ATC 5193. A company such as the ABB Zurich that had over 1000 subsidiaries was actually a prima facie type accruals basis taxpayer as the nature of its trading activities are solely conducted for the major purpose of earning dividends which is the major objective of the company. The commissioner contended that the basis of making taxation returns must be the actual appropriateness of business operations and the mode of receiving the income.
The consistency of the accounting method adopted should be upheld until it’s no longer applicable or appropriate. These may occur when the tax payer’s business circumstances reflect that the cash method of accounting is more appropriate for determination of income tax. It may occur mostly because of business expansion or change in the operations or nature of the business.
In the case of FCT v Dunn, Davies J, mentioned that it was the appropriateness of the circumstances of the business operations and how the books and records are maintained that determines the relevant accounting practice to be adopted. The same case applied when Dixon J, in the case of Carden’s case, said that the considerations of each case are important as the nature of the profession or trade have to be considered as to the mode of accounting method to be adopted. The earnings method or the accruals basis largely applies where circumstances are not clear and also where there are conflicting indicators as to the method of accounting to be adopted subject to subsections 6-5(1) to (3) of the ITAA of the year 1997. The weight that should apply to the method of accounting largely depends on the course, appropriateness and the relevance of the specific case as illustrated by the case of Broken Hill Pty Co. Ltd v Federal Commissioner of Taxation (1999) 99 ATC 5193.
The commercial and also the general accounting principles, guidelines and practices that are maintained by companies require all companies to adopt the accrual or the earnings method of accounting or book keeping.
For example, Keith who is a plumber is normally contracted to perform repair broken pipes and drainages in personal homes while at times he has to purchase some materials. He accounts for his income from his business on receipt or cash basis. The material he purchases are not directly bought from his income and does not affect his work so much as his work is mostly from his services and not from the resale of materials. The method of cash basis suits his nature of work. For tax purposes, it’s substantially correct as it reflects the nature of Keith’s business income.
In ATO ID 2014/1 changing from cash basis to accrual basis accounting, the relevant sections of the case where the taxpayers business had grown and it was imperative for him to change the nature of the accounting method as in the case of Arthur Murray (1965) 14 ATD 98.
References
ATO (2005) Guide to Capital Gains Tax, Australian Taxation Office, publication NAT 4151-6.2005
Centrelink website (2013) Centrelink.gov.au. 2013-08-09. Retrieved 2013-11-15.
Renton, N.E. (2005) Income Tax and Investment, 2nd edition, 2005, ISBN 0-7314-0221-9
ABB Australia Pty Ltd V FC of T (2007) ATC 4765
Carapark Holdings Ltd v Commissioner of taxation (1966) 115 CLR 653
Broken Hill Pty Co. Ltd v Federal Commissioner of Taxation (1999) 99 ATC 5193
Carden’s case; Brent’s case, Dunn’s case; Arthur Murray (NSW) Pty Ltd v FC of T (1965) 114 CLR 314; (1965) 39 ALJR 262; (1965) 14 ATD 98 (Arthur Murray)
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