Principles of Income Tax and Negative Gearing

This study material from Desklib covers the principles of income tax, including ordinary and statutory income, and small business concessions. It also discusses negative gearing and its implications for property investors and the government.

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PRINCIPLES OF INCOME TAX
PART – 1
ANSWER – 1A
Since both taxation Acts, the 1936 and the 1997, are referred as ‘Income Tax
Assessment Acts’, it is essential to not only understand Income but to critically assess it
for arriving at a suitable result of the question posed in this case study of Kristie. In
ITAA, 1997, two type of income are discussed under Sections 6-1, 6-5 and 6-101.
1. Ordinary Income
Ordinary Income has not been defined in any of the Acts, but can be best understood by
the Court Rulings in the following Law Cases2.
Scott v Commissioner of Taxation (NSW) (1935) SR (NSW) 215
Tennant v Smith (1892) AC 150
FCT v Cooke & Sherden 80 ATC 4140
FCT v Dixon 86 CLR 450
FCT v Blake 84 ATC 4661
Income derived by providing personal services is also Ordinary Income.
2. Statutory Income
Incomes other than ordinary incomes which are included in the Assessable Income of
the taxpayers are termed as Statutory Incomes. This is the applicable definition in the
case of Kristie. But before making an assessment, it should be clearly understood
whether income derived by Kristie was a Business Income or an income from an
Isolated Transaction. Both these factors are briefly discussed for arriving at a
justification3.
Business Income
1 ATO homepage: Taxable Income of Individuals. <http://www.ato.gov.au/>, accessed 8 September,
2018.
2 Barkoczy, S., Foundations of Taxation Law, 3rd ed. (Sydney: CCH Australia Limited, 2011).
3 Taxpayers Australia. <http://www.taxpayer.com.au/>, accessed 8 September, 2018.

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Here two basic issues arise. First, whether the receipt is from a business which is being
carried on regularly or the activity is either a hobby or a one-off receipt as was
distinguished in the following Case Laws4.
FC of T v Walker 85 ATC 4179
Ferguson v FCT
FCT v Stone (2005) 22 CLR 289
Isolated Transactions
An isolated transaction5 will be considered as income producing if it is –
(i) Of Commercial nature.
and
(ii) Conducted with the intention of profit making at the time it was conceived.
These issues were clarified in Case Laws of Whitfords Beach Pty Ltd v FC of T
(Whitford’s Beach) and FC of T v Myer Emporium Ltd (Myer Emporium) where the
courts successfully determined the profit making intention of the taxpayers.
Conclusion
The circumstances of the above discussed case laws (Whitford’s Beach and Myer
Emporium) involved deals concerning capital assets, but the transactions were of
business in nature. This was also established in the case of Scottish Australian Mining
Co Ltd v FCT by the court. On the basis of all these factors, it is safe to assume that
although Kristie made an isolated financial dealing, it was done with an intention of
making profit. Hence, the earned amount will be treated as Ordinary Income and
assessed accordingly6.
ANSWER – 1B
Being an individual tax payer and also being a sole trader, Dave can use any one of the
two methods available to him for evaluating his Capital Gains Tax (CGT). The methods
are ‘The Indexation Method’ and ‘The Discount Method’. All investments made by
Dave in his factory for manufacturing doors will be treated as Capital Assets as per
4 Tax Institute of Australia. <http://www.taxinstitute.com.au/>, accessed 8 September, 2018.
5 Barkoczy, S., Rider, C., Baring, J. and Bellamy, N., Australian tax casebook, 10th ed. (Sydney: CCH
Australia Limited, 2010).
6 Nethercott, L., Devos, K. and Richardson, G., Australian taxation study manual: questions and
suggested solutions, 20th ed. (Sydney: CCH Australia Limited, 2010).

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Section 104 of ITAA, 19977. CGT was introduced on September 20, 1985 by the ATO
and became applicable to all capital assets owned by a taxpayer and which were
acquired by a taxpayer after this date. For assets acquired till 20-09-1999, the taxpayer
can use only the Indexation Method. The Capital Gains Tax (CGT) is calculated on
assets and the Capital Gains Incentive (CGI), using the Indexation Method is allowed
provided the asset is held by the taxpayer for a minimum period of 12 months. The Cost
Price of the asset is calculated by indexing it with Consumer Price Index8 (CPI) by
using the following formula –
Indexation Factor = CPI for Quarter 01-07-1999 to 30-09-1999 /
CPI for Quarter in which the asset is acquired
The system of CGI was changed with effect from September 20, 1999, when the
Indexation Method using CPI Indexing was replaced by a new method of discounting
the asset by 50%. This was termed as the Discount Method. Using this method, all
capital gains are reduced by 50% for calculating the Capital Gain and finally the CGT is
calculated on the reduced amount. Assets brought after September 20, 1999 have the
option, provided they have been held by the taxpayer for more than 12 months, to use
either the Indexation Method or the Discount Method. Hence, Dave can use both the
methods for evaluating his CGT liability and chose the method which gives the least
liability for paying the CGT amount9.
INDEXATION METHOD
Dave acquired the factory on 1 February 2013, so for calculating the Indexation Factor
use of the CPI for quarter ending March 2013 will be made and as per the CPI Chart this
factor is 102.4. Using the formula
Indexation Factor = CPI for Quarter 01-07-1999 to 30-09-1999 /
CPI for Quarter in which asset is acquired
The indexation factor would be = 123.4/102.4 = 1.205
Small Business Concessions
Dave can avail the benefits provided under the Small Business Concessions. He can
make a selection from the following four concessions which comprise the four main
7 Barkoczy, S., Foundations of Taxation Law, 3rd ed. (Sydney: CCH Australia Limited, 2011).
8 CPI can be accessed using URL http://www.ato.gov.au/content/1566.htm
9 Barkoczy, S., Foundations of Taxation Law, 3rd ed. (Sydney: CCH Australia Limited, 2011).

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‘benefits’. Dave will have to see which concession is most effective for him and for
which he can fulfil all the required criteria and can be highly beneficial. However, Dave
must understand that the below discussed concessions can be availed by him only when
the basic threshold test explained in Subdiv 152–A is satisfactorily implied. An entity is
a small business entity if it is a Sole Trader, a partnership, a company or a trust and
provided that it has:
 carried on a business during all or part of an income year, and
 aggregated turnover of less than $2 million.
Aggregated Turnover
To make an assessment of aggregated turnover10, one must take into account the annual
business turnover of the entity for an income year and combine it with the annual
turnover of any other business entity which is connected with the main entity as an
affiliate. It is essential to follow the aggregation rules for working out and including the
other business' annual turnover into the aggregated turnover of the main entity. The
purpose of this rule is to stop large business entities from splitting their business
turnover in an inappropriate manner and make use of the small business concessions.
Assessing if it is a Small Business
Dave can apply any one of the following three methods to make an assessment whether
he can become a small business entity and avail the concessions discussed below11.
Method 1 - Using Previous Year's Aggregated Turnover
Dave can used the aggregate turnover of previous income years and in case he proves
that the aggregated turnover was less than $2 million in the previous income years, he
can declare his business entity to be a small business entity for the current income year.
Method 2 - Estimating Current Year Aggregated Turnover
In case the estimated aggregated turnover of current year is less than $2 million, then
also Dave can declare his business as a small business entity for the current income
year. But Dave can only use this method if the aggregated turnover of his entity is less
than $2 million in any one of the last two income years.
Method 3 – Using the Current Year Turnover
In case Dave has the actual aggregated turnover available for the current income year
and this is less than $2 million, his entity can be treated as a small business entity for the
current income year.
10 Tax Institute of Australia. <http://www.taxinstitute.com.au/>, accessed 8 September, 2018.
11 Taxpayers Australia. <http://www.taxpayer.com.au/>, accessed 8 September, 2018

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However, to apply any one of these three method, Dave must:
 use the same method for any of his connected or affiliated business entities
 keep a record of the method used for working out the aggregated turnover.
The four principal CGT concessions12 in relation to small business are the:
Subdiv 152–B: Small Business ‘15-year Exemption’
If the owner/promoter is aged above 55 years or is older and is retiring, and his business
owned an asset at least for last 15 years continuously, he is not required to pay CGT on
selling the asset.
Subdiv 152–C: Small Business ‘50% Active Asset Reduction’
If the owner/promoter has owned an asset and used it for conducting his business
(known as an 'active asset'), he will pay tax only on 50% of the capital gain amount
when the asset is sold.
Subdiv 152–D: Small Business Retirement Concession
There is a CGT exemption on the sale of a business asset, up to a lifetime limit of
$500,000. If the owner/promoter is under 55 years of age, amount received from sale of
the asset must be deposited into a complying superannuation fund or into a retirement
savings account.
Subdiv 152–E: Small Business Rollover
In case the owner/promoter sells a small business asset and subsequently buys another
asset as a replacement, he can rollover the CGT liability, into the value of the new
replacement asset. In this way, the owner/promoter will not have to pay any CGT
amount until the replacement asset is sold.
As Dave is not able to prove that his business entity is a small business entity in any of
the income years, he can still access the:
 Capital gains tax concessions provided his total asset value passes the $6 million
maximum net asset value test.
 Fringe benefits tax concession if his combined ordinary and statutory income
proves to be less than $10 million.
12 Nethercott, L., Devos, K. and Richardson, G., Australian taxation study manual: questions and
suggested solutions, 20th ed. (Sydney: CCH Australia Limited, 2010).

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PART – 2
Negative Gearing
The subject matter is society oriented, complex, as well as politically motivated. If the
issue is considered for its social values, then in all fairness it can be termed as a
“Necessary Evil” which needs to be monitored closely and always kept on a tight leash.
If complexity is to be considered, it simpler than most laws and should be commended
for the administrative efficiency with which it has been regulated over the years. As far
as political motivation is concerned, it would not be out of context to mention that it not
helps the governments in earning safe revenues, it also contributed to the government
coffers through direct and indirect taxes. In support of my above arguments, I would
like to place the following elements of understanding Negative Gearing and it
functioning.
Understanding Negative Gearing
In simple language, when the net rental income of an investment property is LESS
than the total interest paid by the owner on the borrowed funds, the investment is
termed as negatively geared13. Economists will term it as regression but it is in fact a
loss which the administration turns into a profit for itself. Look at it this way. The LOSS
of revenue is borne by the owner/investor of the property. This loss is deductible from
his assessable income and can be termed as revenue loss to the administration in terms
of less income tax collection. But how is the loss incurred by the owner/investor? It is in
terms of the expenses and the two major expenses incurred by the owner/investor are
interest on the borrowed funds and the Council Taxes paid to Local Governments.
The lending institutions pay higher taxes (being companies) than the individual
taxpayers, hence the Federal Government is in fact earning more revenue and the Local
Governments are also earning revenues through Council Taxes. Although it is widely
used, at least in Australia, by property investors, negative gearing is also finding use in
other financial instruments, including market shares and government bonds14.
13 Hamson, D. & Ziegler, P. (1986), “The Implications of Negative Gearing Restrictions and Capital
Gains Taxation on Investment”, 3 Australian Tax Forum 369.
14 Hayes, J., “How Negative Gearing Gives Positive Results”, Australian Financial Review, 20 June 2001.

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Working of Negative Gearing
As I pointed in the above paragraph, the real effect of negative gearing is to turn a
negative into a positive. To take forward my point of view in favour of negative
gearing, let me elaborate “investment”. Every investor’s main aim of making an
investment is for making profits, although it happen in all cases. Let us keep our focus
on real estate investments. It can be unexpectedly hit by a downtrend in the rental
market and can be subjected to the unforeseen expenses, which were beyond the
conception of the investor when he planned of purchasing the investment property.
These can include those numerous reasons which accelerated the cost of the investment
and hence outweighed the income which was expected from the investment15. The
outcome is a negative outcome. But negative gearing gives the investor a chance of
using this to his advantage through a low tax burden. All investors, including the wage
earners, can turn around this loss from their investments by offsetting the income they
receive from salary or wages. This makes the taxpayer happy and encourages him to
invest more in real estate to take more advantage of negative gearing. Thus, in the short
term the investor saves on tax and in the long term makes a capital gain on his
investment. Negative Gearing is a win-win situation for both – the investor as well as
the government16.
Pros and Cons of Interest-only Loans
I have a mixed outlook on this factor and is what I referred to, in my opening paragraph,
as a “Necessary Evil”. Interest-only loan on a rental property can help the taxpayer to
deduct all the mortgage payments (including depreciation deduction in case of a
company) as an expenses. Even in cases where the house appreciates every year and is
giving a positive cash flow to the investor, it is shown to be losing money as far as
taxation matters are concerned as the taxpayer will pay less tax on his salary and other
incomes17.
This is the pros of “negative gearing” in Australia, although the expression is quite
similar to “negative cash flow” but for an Australian Taxpayer, a negative gearing refers
15 Hanegbi, R. (2002), “Negative Gearing: Future Directions”[2002] DeakinLawRw 17; 7 Deakin Law
Review 349.
16 Mellish, M. & Hepworth, A. “RBA Targets Negative Gearing” Australian Financial Review, 15
November 2003.
17 Walkley, P. (2003), “Negative Thinking” 121 The Bulletin 62 (Issue No.6383).

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to the tax advantage he gets when his investment property shows a negative cash flow.
On the positive side, more investors turn to real estate investments because of these tax
advantages as they pay for the negatively geared homes18. As both these factors increase
the property prices, the investors get more interested in buying rental properties. The
factor encouraging them is the monthly payment and with interest-only loans, investors
can borrow more money and hence invest more in rental properties. Although investors
are increasing their debt, they are also increasing their gains as the houses appreciate in
value over time. The only con that I found in the interest-only loans was that when
property values fall, the homeowners will not be in a position to earn capital
appreciation and their equity will reduce substantially. In my opinion, a high percentage
of interest-only loans may soon turn into a speculative bubble and hence should be kept
on a leash19.
Negative Gearing is good for Australia
Actually, negative gearing topic in Australia is a highly debated one in the business,
social and political circles. In fact its popularity as a classic argument is because of it
being between the ‘have nots’ and the ‘haves’, of affordable housing. In case a
dispassionate view of the debate is taken, it becomes hard to judge which side has more
merit20. Politically, the debate keeps shifting between the two sides, depending on which
side the debater is – in the ruling party or the opposition. The opposition is clear that it
cannot be considered as a productive policy and has clear negative effects, some of
which are being highlighted below21.
 The incentives allows the investors to value the property at a higher price
 The prices would be lower without the tax incentives.
 This high level of pricing puts the homes out of reach for the genuine buyer.
 A bigger portion of population has to wait and this in the longer term increases the
demand for welfare sponsored homes as more people rely on social security after
their retirement.
18 Negative gearing is not unique to Australia. Several OECD countries including New Zealand, Canada
and Japan provide a full negative gearing concession to offset taxes from other income sources. Other
countries such as the U.S., Germany, France, Switzerland and Sweden allow partial offsetting against the
loss from housing investment
19 Duffy-Jones, Dr. R. and Rogers, Dr D. (ed). Housing in 21st-Century Australia: People, Practices and
Policies. (Farnham: Ashgate Publishing, Ltd., 2015).
20 Lomas, M. How to Create an Income for Life. (Milton, QLD: John Wiley & Sons, 2012).
21 Braithwaite, J. Markets in Vice, Markets in Virtue. (Annandale, NSW: Federation Press, 2005).

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 The incentives being given to investment properties is leading more money out of
the productive investments to be used as capital for infrastructure development
thereby creating more jobs.
 It can be the cause of increasing the risk of speculative market behavior and may
result in creating a price bubble which on bursting will have long-lasting negative
effects22.
Now, the ruling party offers the counter argument with their view as was put by Scott
John Morrison, Australia’s current Prime Minister, recently and I quote –“You’ve got a
quarter of the investment property – the rental property in this country – is owned by
mum & dad investors. Now, you need people to own rental stock otherwise people’s
rents go up.” Unquote. What the honorable PM is suggesting is that if the government
does not incentivize the investors for investing in investment properties and then rent it
out, there is bound to be a shortage in supply of rental properties forcing the rents to rise
steeply thereby making it difficult for the tenants to pay rent23.
On similar lines as the PM, Ben Kingsley, the founder & CEO of Empower Wealth
Advisory, does not consider negative gearing to be used as a strategy at all. According
to him it should be treated as a means of allowing the investors in buying the best
investment property they can afford and earn a good return on their investments. His
argument is that negative gearing is like setting up a start-up. He says and I quote –
"Negative gearing is like forecasting losses in the first few years of starting a business.
The data shows that the best properties are usually in better locations with good
amenities. Those properties come at a premium and you will have to fund the earlier
stages of the investment," Unquote.
In my opinion, it would be good for Australia to draw emergency plans as to how the
administration, at State as well as Federal level, would handle a worst case scenario.
Government should not wait for the worst – prices are already going down – and should
formulate plans for reducing the damage in case the country has to face the worst case
22 Brammall, B., Tyson, E. and Griswold, R.S. Getting Started in Property Investment For Dummies –
Australia. (Milton, QLD: John Wiley & Sons, 2013).
23 Tomlinson, R. and Spiller, M. (ed). Australia's Metropolitan Imperative: An Agenda for Governance
Reform. (Clayton South, VIC: Csiro Publishing, 2018).

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scenario24. The worst case scenario could emerge fast if the government does not look
closely at the following two factors –
1. The governments start pulling out one property from the available stock of
properties for the additional property which an investor buys. This will reduce the
available stock of properties from the stock of properties available in the market to
a genuine buyer.
2. Statistics of the Australian Bureau of Statistics (ABS) show that over 90% of
commitments for financial investment by investors is for the
already existing properties in the market. Less than 10% of commitments for
financial investment goes for new properties to be built-up.
FOOTNOTES
ATO homepage: Taxable Income of Individuals. <http://www.ato.gov.au/>, accessed 8
September, 2018.
Austlii. <http://www.austlii.edu.au/>, accessed 8 September, 2018.
Barkoczy, S., Foundations of Taxation Law, 3rd ed. (Sydney: CCH Australia Limited,
2011).
Barkoczy, S., Rider, C., Baring, J. and Bellamy, N., Australian tax casebook, 10th ed.
(Sydney: CCH Australia Limited, 2010).
Braithwaite, J. Markets in Vice, Markets in Virtue. (Annandale, NSW: Federation Press,
2005).
Brammall, B., Tyson, E. and Griswold, R.S. Getting Started in Property Investment For
Dummies – Australia. (Milton, QLD: John Wiley & Sons, 2013).
Chapter Twelve: Current Liabilities and Employer Obligations.
<http://www.principlesofaccounting.com/chapter12/chapter12.html>, accessed 8
September, 2018.
Duffy-Jones, Dr. R. and Rogers, Dr D. (ed). Housing in 21st-Century Australia: People,
Practices and Policies. (Farnham: Ashgate Publishing, Ltd., 2015).
24 Park, C. Housing Australia. (Melbourne, VIC: Macmillan International Higher Education, 2017).

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Hayes, J., “How Negative Gearing Gives Positive Results”, Australian Financial
Review, 20 June 2001.
Hamson, D. & Ziegler, P. (1986), “The Implications of Negative Gearing Restrictions
and Capital Gains Taxation on Investment”, 3 Australian Tax Forum 369.
Hanegbi, R. (2002), “Negative Gearing: Future Directions”[2002] DeakinLawRw 17;
7 Deakin Law Review 349.
Lomas, M. How to Create an Income for Life. (Milton, QLD: John Wiley & Sons,
2012).
Mellish, M. & Hepworth, A. “RBA Targets Negative Gearing” Australian Financial
Review, 15 November 2003.
Negative gearing is not unique to Australia. Several OECD countries including New
Zealand, Canada and Japan provide a full negative gearing concession to offset taxes
from other income sources. Other countries such as the U.S., Germany, France,
Switzerland and Sweden allow partial offsetting against the loss from housing
investment
Nethercott, L., Devos, K. and Richardson, G., Australian taxation study manual:
questions and suggested solutions, 20th ed. (Sydney: CCH Australia Limited, 2010).
Park, C. Housing Australia. (Melbourne, VIC: Macmillan International Higher
Education, 2017).
Taxpayers Australia. <http://www.taxpayer.com.au/>, accessed 8 September, 2018.
Tax Institute of Australia. <http://www.taxinstitute.com.au/>, accessed 8 September,
2018.
Tomlinson, R. and Spiller, M. (ed). Australia's Metropolitan Imperative: An Agenda for
Governance Reform. (Clayton South, VIC: Csiro Publishing, 2018).
Walkley, P. (2003), “Negative Thinking” 121 The Bulletin 62 (Issue No.6383).
BIBLIOGRAPHY
Barkoczy, S. 2011, Foundations of Taxation Law, 3rd ed. CCH Australia Limited,
Sydney.

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Barkoczy, S., Rider, C., Baring, J. and Bellamy, N. 2010, Australian tax casebook, 10th
ed. CCH Australia Limited, Sydney.
Brammall, B., Tyson, E. and Griswold, R.S. 2013, Getting Started in Property
Investment For Dummies – Australia. John Wiley & Sons, Milton, QLD.
Braithwaite, J. 2005, Markets in Vice, Markets in Virtue. Federation Press, Annandale,
NSW.
Duffy-Jones, Dr. R. and Rogers, Dr D. (ed). 2015, Housing in 21st-Century Australia:
People, Practices and Policies. Ashgate Publishing, Ltd., Farnham.
Lomas, M. 2012, How to Create an Income for Life. John Wiley & Sons, Milton, QLD.
Nethercott, L., Devos, K. and Richardson, G. 2010, Australian taxation study manual:
questions and suggested solutions, 20th ed. CCH Australia Limited, Sydney.
Park, C. 2017, Housing Australia. Macmillan International Higher Education,
Melbourne, VIC.
Tomlinson, R. and Spiller, M. (ed). 2018, Australia's Metropolitan Imperative: An
Agenda for Governance Reform. Csiro Publishing, Clayton South, VIC.