TOPIC 3: CHARACTERISTICS OF ORDINARY INCOME

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3 TOPIC 3: CHARACTERISTICS OF ORDINARY INCOME ORDINARY INCOME s 6-5 Ordinary income Generally most income which comes in to a taxpayer is ordinary income Judicial concept case law income according to ordinary concepts - The word income is not a term of art, 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 - Scott v CT (1935) 35 SR (NSW) 215 Compare: - Economic concept (Haig-Simons) Income = consumption + savings Y= C + W - Accounting concept P&L Account represented by revenue minus expenses OTHER TYPES OF INCOME ITAA97 What is assessable income? (Note: We will focus on this, assessable income is relevant for the tax formula) s 6-5 Ordinary income s 6-10 Statutory income What is not assessable income? (Note: this is NOT included in assessable income) s 6-20 Exempt income s 6-23 Non-assessable non-exempt income (NANE) s 6-25 Reconciliation Rules Where an amount may be included in the taxpayer s assessable income as either ordinary income or statutory income, use the statutory income provision (No double taxation) DOCTRINE OF CONSTRUCTIVE RECEIPT Rule: You constructively receive an amount if and when it is applied or dealt with on your behalf or as you direct. (Ordinary income: ITAA97 s 6-5(4) Statutory income (capital): 6-10(3)) Federal Coke (1977): Coal supplier arranged for release from contract payment to be paid to the supplier s subsidiary company. The receipt by subsidiary was assessable income for the supplier due to doctrine of constructive receipt. e.g. - Wife has her pay sent to her husband s account in husband s hand it is not assessable (ordinary) income, as it has no nexus to business/exertion/property. But doctrine of constructive receipt applies and as assessed in wife s hands clear nexus, is ordinary income. CHARACTERISATION PROCESS Is the amount ordinary income? Judicial concept applies Process of characterisation : - Look at the whole of the circumstances - No single element is necessarily determinative - The amount doesn t need to possess all of the characteristics We will now explore the characteristics of ordinary income, by reference to the 15 Parson s Propositions, developed by Professor R W Parsons, in Income Taxation in Australia, Principles of Income, Deductibility and Tax Accounting (available on UTSOnline). Note: This is simply another way of summarising the characteristics of ordinary income which are discussed in the Prescribed Textbook at [3-150]-[3-290]. PARSON S PROPOSITIONS Source: Parsons R W, Income Taxation in Australia, Principles of Income, Deductibility and Tax Accounting 6-5 Ordinary income # Effect Keyword Full proposition 1 Positive Must comein An item of income character is derived when it has come-home to the taxpayer. The presence of illegality, immorality or ultra vires does not preclude derivation.

4 2 - Realisable value An item of an income character that has been derived will be income in the amount of its realisable value. 3 Negative In hands The character of an item as income must be judged in the circumstances of its derivation by the taxpayer, and without regard to the character it would have had if it had been derived by another person. 4 Positive Gain To have the character of income an item must be a gain by the taxpayer who derived it. 5 - Beneficial entitlement There is no gain unless an item is derived by the taxpayer beneficially. 6 Negative Mutuality There is no gain if an item is derived by the taxpayer from himself: the principle of mutuality. 7 Negative Capital contribution There is no gain if an item is derived by the taxpayer as a contribution to capital. 8 Negative Mere gift A gain which is a mere gift does not have the character of income. 9 Negative Windfall gain A mere windfall gain does not have the character of income. 10 Negative Capital gain A capital gain does not have the character of income. 11 Positive Periodicity A gain which is one of a number derived periodically has the character of income. 12 Positive Property A gain derived from property has the character of income. 13 Positive PSI A gain which is a reward for services rendered or to be rendered has the character of income. 14 Positive Business A gain which arises from an act done in carrying on a business, or from the carrying out of an isolated business venture, has the character of income. 15 Positive A gain which is compensation for an item that would have had the character of income had it been derived, or for an item that has the character of a cost of deriving income, has itself the character of income. Each proposition is now discussed by reference to relevant examples from case law, however note that these references are not exhaustive, and a case may be relevant to more than one of the propositions PARSON S PROPOSITIONS 1 AND 2 1. An item of an income character is derived when it has come-home to the taxpayer. The presence of illegality, immorality or ultra vires does not preclude derivation. 2. An item of an income character that has been derived will be income in the amount of its realisable value. Must come in to the taxpayer Must be derived (accrual vs cash accounting basis) Tenant v Smith OVERTURNED by s 21A ITAA36 non cash business benefits may be treated as if they are convertible into cash. Taxpayer occupied house owned by bank; Court held as not assessable as house (the benefit of free accommodation prohibited from subletting) had no monetary value, and not controllable by the taxpayer as property. Parsons 2

5 Cooke & Sherden OVERTURNED by s 21A ITAA36 non cash business benefits may be treated as if they are convertible into cash. Soft drink manufacturer provided free holiday non-transferable and non-exchangeable for cash. Not assessable as not convertible to money, therefore not ordinary income. Parsons 2 Unrealised gains are NOT income Compare Economic concept But NOTE that a gain on discharge of liabilities may be income: Where a gain is made on the discharge of a borrowing and the purpose of the borrowing was to acquire an asset that is turned over in the ordinary course of business, as a trading company, that gain is assessable as ordinary income. - E.g. gain on revenue? FCT v Unilever Australia Securities Ltd 95 ATC Was the profit that arose as a result of the debt defeasance arrangement assessable under s 6-5? it was assessable under s 6-5 as income according to ordinary concepts on the basis that it was made in the ordinary course of the taxpayer s business as a finance company. International Nickel Australia Ltd v FCT (1977) 137 CLR Foreign currency gain was assessable income Illegality/immorality etc is irrelevant: Partridge v Mallandaine (1856) 2 TC 179 ( business of burglary) - Denman J: In my opinion if a man were to make a systematic business of receiving stolen goods and do nothing else, he thereby carried on a business and made profit per year. The income Tax Commissioners would be right in assessing him if it were his vocation. Lindsay v IRC (1993) 18 TC 43 (whisky smuggling when alcohol was banned) - Held assessable income No 275 v MNR (1955) 13 Can Tax ABC 279 (prostitution)

6 TOPIC 6: DEDUCTIONS PROBLEM Qs: start at s 8-1 then move down for reasoning apply case law and link to positive/negative limbs. CONTEXT ITAA97 S8-1 GENERAL DEDUCTIONS Two Positive Limbs (need to establish that at least ONE of these limbs apply): (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. Four Negative Limbs (need to establish that NONE of these limbs apply) ((b)-(d) has been criticised as being unnecessary (a) is most important): (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 nonassessable non-exempt income; or (d) a provision of this Act prevents you from deducting it. S8-10 NO DOUBLE DEDUCTIONS Where a loss/outgoing may be deductible under more than one provision, use the most appropriate provision No double deductions KEY REQUIREMENTS 1. Nexus test: is there a sufficient connection between the loss/outgoing and either one of the positive limbs? 2. If so, is the loss/outgoing NOT capital? S8-1 LOSS OR OUTGOING Loss taxpayer s financial resources have been diminished, e.g.: - taxpayer s money has been stolen (Charles Moore & Co (WA) Pty Ltd (1956) 95 CLR 344 old department store staff everyday at end of the day would take money from cash register then carry it across the road to bank where they deposited the money. One day, intercepted by thieves who stole the money. Court held that this was a loss within the meaning of s 8-1) - write off bad debts (AGC (Advances) Ltd v FCT (1975) 132 CLR 175) Outgoing- usually involves some form of payment, outlay or expenditure, or the taxpayer is committed to spend money e.g., has received invoice IN GAINING OR PRODUCING In = in the course of Incidental and Relevant test BINDING/PREVALENT TEST Ronpibon Tin NL v FCT (1949) 78 CLR 47: For expenditure to form an allowable deduction as an outgoing incurred in gaining or producing the assessable income it must be incidental and relevant to that end...in brief substance, to come within the initial part of the subsection 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 is produced, would be expected to produce assessable income.

7 Herald & Weekly Times - a newspaper publisher was allowed deductions for costs incurred in defending/settling an action brought against it for alleged defamatory articles that had been published in its newspaper. Court held it was incurred because of the very act of publishing the newspaper. Unavoidable incident of publishing a newspaper. W Nevill & Co - a company was allowed a deduction for amounts paid to one of its managing directors in consideration of him agreeing to resign, where the payment was made for the purpose of increasing the efficiency of the company