Income Recognition Basis and Implications of Transactions in Taxation Law

This article discusses the income recognition basis and implications of transactions in taxation law. It covers factors that decide the suitable basis, right to insist, distinction between cash/accrual, and implications of given transactions. The article also provides a suitable choice for Frank based on the provided facts. The implications of given transactions have been explained in detail.

TAXATION LAW
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Question 1
Income Recognition Basis
There are two basis for recognising income that are available to a taxpayer which are the cash
basis and accrual basis. In line with tax ruling TR 98/1, the taxpayer has the choice to select
one of these methods based on which method would present a more accurate picture of the
income of the taxpayer. In cash method, the income recognition takes place when the cash
payment is received without any consideration to product or service being provided to
customer or client. In earnings method, the income recognition takes place only when the
underlying product or service has been provided without any consideration to cash receipts
(CCH, 2013).
Factors that decide the suitable basis
In order to exhibit the choice provided, the following aspects need consideration.
1) The first pivotal factor is the income source type through which taxpayer earns assessable
income. Some basic indicators are presented by TR 98/1 which advises that for trading or
manufacturing based business, the preferred method would be accrual basis. However, the
cash basis would be preferred when the income is non-trading or linked to skill of the
taxpayer (Woellner, 2014). This assessment is provided support based on cases such as
Carden v FCT (1938) 63 CLR 108. It is advocated in the verdict of the given case law that for
tax to be levied on non-trading income, it Is imperative that the taxpayer should obtain
something of value on which tax becomes justified which could be cash only, therefore
indicating preference for cash basis in such scenario (Deutsch, Freizer, Fullerton, Hanley &
Snape, 2016).
2) The second key factor corresponds to the circumstances related to the business or income
production coupled with scenario of taxpayer. It has been indicated in the Carden v FCT case
that the decision to choose the appropriate bias should be a flexible decision not derived from
any rigid thumb rule or legal principle. Instead, the underlying circumstances should dictate
the choice. Support to this observation has been extended in FCT v Dunn (1989) 85 ALR 244
case when Javies J pointed that the requisite basis should be linked to the prevailing business
circumstances along with taxpayer rather than any legal rule (Barkoczy, 2015).

3) The third key factor relates to the extent of investment coupled with business size which is
also pivotal. The Henderson v. Federal Commissioner of Taxation (1970) 119 CLR provides
testimony in this regards. In this case, Henderson was the taxpayer who computed income on
cash basis in one year. However, the next year he chose the accrual basis owing to the
increase in business and the significant investment put owing to which he started using hired
labour for assisting him which previously was not done. The change in basis from receipt to
accrual was upheld by the honourable court (Sadiq et. al., 2016).
Right to Insist
The Tax Commissioner cannot insist that the taxpayer must report the earnings using a
particular basis only. However, once the returns filing is completed, the Tax Commissioner
can consider the various factors outlined above to highlight if the basis used presents the most
accurate description of income or not. If the Tax Commissioner considers otherwise, then an
objection may be raised and the taxpayer may need to revise the basis. However, if the
taxpayer considers that the basis originally used is suitable, then the same may be justified in
the court of law which would decide the appropriate basis (Krever, 2016).
Suitable Choice for Frank
Tax year 2016-2017 – On the basis of provided facts, it may be concluded that Frank is
deriving income based on his skill since he is working as an architect. The size of the
business is quite small and all the work is carried out by Frank. Taking into consideration the
various factors, cash method is the requisite choice for deriving income (CCH, 2013).
Tax year 2017-2018 – One of the crucial events in this year has been his national award.
Encouraged by the same, he has taken loan and invested the same into hiring a place and
setting business. The size of business has significantly enhanced considered client payments
in excess of $ 1 million. Also, hired labour is used to assist Frank is performing his job along
with rendering administrative support. Referring to the FCT vs Henderson case, Frank needs
to change in favour of accrual basis (Woellner, 2014).
Distinction between Cash/Accrual
Over the years, there has been introduction of accounting software packages which has
altered the way in which record keeping and transaction tracking is done. Since these systems
tend to monitor cash on a real time basis, hence the distinction between cash and accrual

basis is blurring. However, with regards to tax purposes, the distinction between cash and
accrual basis is necessary. This is because there does arise circumstances when the delivery
of products or service to the customers and receipt of payment do fall in different tax years.
As a result, there is a choice which the taxpayer needs to make with regards to whether derive
revenues on cash or accrual basis. In this regards, the accounting packages offer limited help
as without the distinction between the two methods, filing tax returns for businesses would be
quite difficult (Deutsch, Freizer, Fullerton, Hanley & Snape, 2016).
Question 2
The implications of the given transactions have been explained as follows.
(a) As per TR97/23 and the given facts, it may be concluded that the given expenses in
regards to replacement of kitchen fittings would be termed as repair. Evidence in this regards
can be offered by replacement being undertaken only after damage has been done. Further,
the objective is to restore the earlier efficiency and not to improve the same (Krever, 2016).
Also, another key aspect that the repair expense has been undertaken with regards to rental
property and hence potential tax deduction may be claimed under the following two sections.
1) Section 25-10 – Provides immediate tax deduction for repairs pertaining to depreciating
assets provided the assets are part of property engaged in assessable income generation.
Another key requirement is that the repair expenses must not be capital (Barkoczy, 2015).
2) Section 8-1 - Provides immediate tax deduction for repairs providing sufficient link of the
repairs to assessable income generation. However, the underlying expenditure must not
possess a capital nature or deduction cannot be availed under this section.
A crucial aspect related to kitchen fittings is that most of these exist as permanent fixtures.
Suitable examples could be plumbing, cupboard, sink etc. Owing to this nature, the kitchen
fittings are not considered a separate depreciable asset but essentially part of the overall rental
property which is a capital asset. Thus, any repairs expenses are essentially repairs on the
house and thereby are included in the property cost base as per s. 110-25 ITAA 1997 (Sadiq
et. al., 2016). Considering this, it is apparent that repair expenditure in the given context is
capital owing to which no tax deduction can be availed by Ruby Pty Ltd.
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(b) Section 8-1 provides immediate tax deduction for repairs providing sufficient link of the
repairs to assessable income generation. However, the underlying expenditure must not
possess a capital nature or deduction cannot be availed under this section (CCH, 2013).
Considering the above, the pivotal aspect is to highlight the nature of the legal expense
incurred. A relevant case which can provided assistance is British Insulated and Helsby
Cables Ltd v. Atherton [1926] AC 205 case. The presiding judge indicated that capital
expenditure can be differentiated from revenue expenditure since the former would lead to
obtaining an “enduring advantage”. Also, the expenses under revenue expenditure are
typically those who are usual business expenses (Deutsch, Freizer, Fullerton, Hanley &
Snape, 2016).
It would be appropriate to highlight that in the business of real estate, the owner have to often
face claims based on negligence and these are common business aspects. Further, through
incurring the legal expenses, Ruby Pty would not derive any enduring advantage expected to
provide benefit over multiple years (Woellner, 2014). Therefore, the legal expenses would be
revenue owing to which s. 8-1 ITAA 1997 can provide tax deduction to Ruby Pty Ltd.
(c) Section 8-1 provides immediate tax deduction for repairs providing sufficient link of the
repairs to assessable income generation. However, the underlying expenditure must not
possess a capital nature or deduction cannot be availed under this section (Barkoczy, 2015).
Again the key issue is to determine if the claims would constitute capital or revenue expense.
Assistance in this quest can be obtained by referring to Sun Newspapers Ltd and Associated
Newspapers Ltd v. Federal Commissioner of Taxation (1938) 61 CLR 33 case law. A useful
observation made by Dixon J in this case was that the expenditure type can be determined by
focusing on the type of advantage that the underlying expense aims to provide. If this
advantage stretches across multiple years, then the expenditure would be capital or less
revenue (CCH, 2013).
The taxpayer was earlier involved in engine and related parts manufacturing. In this business,
it is a common practice that defective parts are supplied to the customers resulting in legal
claims to be settled. The payment of claim amount does provide an advantage which
stretches over the years which is concerned with the reputation. As a result, the given
expenditure would be capital and non-deductible under s. 8-1. However, considering that it is

a business expenditure, phased deduction over a five year period is permissible under s. 40-
880 ITAA 1997.
(d) Only when the incurring of an expense has taken place can deduction under s.8-1 be
considered. Tax ruling TR 97/7 explains this aspect in detail. In accordance with this tax
ruling, the word ”incurred” does not represent occurring of actual cash flows to the expense
item. But there needs to be reasonable and credible assurance that the cash outflow would
occur along with the accurate estimate of the underlying amount (Krever, 2016). With
regards to the claims for the faulty components, it is known that the outflow would arise but
no reasonable estimation is possible in regards with the true magnitude of the claim along
with the time when the same would occur. The lack of reliability in estimating the claim
amount is apparent from the provision amount and the actual claims awarded by the court.
Hence, no tax deduction for claim related provisions is permissible under s. 8-1 ITAA 1997.
(e) Section 8-1 provides immediate tax deduction for repairs providing sufficient link of the
repairs to assessable income generation. However, the underlying expenditure must not
possess a capital nature or deduction cannot be availed under this section. The expense on
market research is clearly capital as the underlying advantage being derived would extend
into future years in the form of profits obtained from business or losses saved (Deutsch,
Freizer, Fullerton, Hanley & Snape, 2016). Hence, the given amount spent on consultant
would not be tax deductible for Ruby Pty Ltd as per s. 8-1.
An alternative to s. 8-1 can be provided in the form of s. 40-800 ITAA 1997 which provides
deduction for capital expenditure related to business. As per s. 40-800(2A), capital business
expenditure related to future business is also provided tax deduction over five equal annual
deductions. Further, despite the taxpayer not going ahead with the project, the expenditure
can still be claimed for tax deduction under this section (Woellner, 2014)
Thus, annual tax deduction for Ruby Pty Ltd arising on account of s. 40-880 would be
220000/5 or $ 44,000 and this tax deduction would be available for 5 year period so that
complete amount is deducted for tax purposes (CCH, 2013).

References
Barkoczy, S. (2015) Foundation of Taxation Law 2017. 9th ed. Sydney: Oxford University
Press.
CCH (2013), Australian Master Tax Guide 2013, 51st ed., Sydney: Wolters Kluwer.
Deutsch, R., Freizer, M., Fullerton, I., Hanley, P., & Snape, T. (2016) Australian tax
handbook. 8th ed. Pymont: Thomson Reuters.
Krever, R. (2016) Australian Taxation Law Cases 2017 2nd ed. Brisbane: THOMSON
LAWBOOK Company.
Sadiq, K, Coleman, C, Hanegbi, R, Jogarajan, S, Krever, R, Obst, W, & Ting, A
(2016) , Principles of Taxation Law 2016, 8th ed., Pymont: Thomson Reuters
Woellner, R (2014), Australian taxation law 2014 7th ed. North Ryde: CCH Australia