Taxation Law: Factors for Income Recognition and Tax Deduction of Transactions

This article discusses the factors for income recognition and tax deduction of transactions in taxation law. It covers topics such as choice in basis, right possessed by Tax Commissioner, relevancy of cash/accrual distinction, and more.

TAXATION LAW
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Question 1
Factors taken into consideration
In the earnings method, income recognition considers only that income for which the seller or
service provider has fulfilled the contractual obligations and hence would derive payments.
The actual receipt of the payment is not crucial. In sharp contrast, receipts method requires
that the underlying cash must be received irrespective of whether the contractual obligations
towards the client have been discharged or not.
1) The primary factor is the nature of the income source. This is important since based on the
type of source of income, the appropriate method to be used for recognising income is
impacted. This has been highlighted in the Carden vs FCT case (i.e. Commissioner of Taxes
(South Australia) v. The Executor Trustee and Agency Company of South Australia
Limited (1938) 63 CLR 108) where Dixon J highlighted that in relation to non-trading
income, it is imperative that something of value ought to be realised for liability of tax to
arise, thereby indicating towards receipts method for such businesses (Barkcozy, 2015).
Further, the tax ruling TR98/1 also provides basic pointers with regards to appropriate
method for different income sources. In regards to income drawn as an employee and any
income which relates to the skill or knowledge that the taxpayer possesses, then in such cases
the receipts method is more suitable (Wollner, 2014). On the contrary, in case of businesses
carrying on trading or manufacturing activities, the earnings method would be given
preference over cash receipts.
2) It is noteworthy that the above advice regarding the application of a particular income
recognition method should not be considered rigidly as has been pointed to by Dixon J in
Carden’s case where he opines that the underlying business circumstances must be
necessarily considered before deciding the suitable for recognition and the same should not
be decided based on any rigid rule. Hence, it can be concluded that while the nature of the
business does provide a pointer to a suitable method but the same may be altered by specific
circumstances related to a given business and need to be considered.
3) Yet another factor to be taken into consideration is the business size. The importance of
this factor has been emphasized in the verdict of Henderson v. Federal Commissioner of
Taxation (1970) 119 CLR case. In this case, the taxpayer was derived income based on
underlying knowledge and thus was using the receipts method of income recognition for one

year (Wollner, 2014). However, by next time, the taxpayer made significant in the business
which resulted in explosive growth of the same As a result, the taxpayer Henderson altered
the appropriate income recognition method to earnings and this was acknowledged in the
court of law as well.
Choice in basis
With regards to income, at times circumstances arise when there is mismatch in the year of
cash receipt and the earning of income. In such cases, as highlighted in TR 98/1, the taxpayer
would exhibit choice in deciding between the two possible methods of recognising income
namely receipts method and earnings method. This choice is exhibited by taxpayer so that in
accordance with the factors highlighted in the previous section, the taxpayer can choose the
method which leads to faithful representation of the income earned. Therefore, Frank also has
this choice.
Right possessed by Tax Commissioner
No objection can be raised by the Tax Commissioner before the taxpayer files the returns.
Only after the returns have been filed and the Tax Commissioner considers it not suitable in
light of the underlying circumstances and income source, then only he/she may insist on
modifying the same according to the more preferred method in that circumstance. The
taxpayer can accept this or reject the same. In case of rejection of the opinion of the Tax
Commissioner, judicial intervention would take place to decide which of the two income
recognition methods would be more suited to the situation at hand (Gilders, Taylor, Walpole,
Burton, & Ciro, 2016).
Basis for Frank
In the given case, it is known that Frank is an architect by profession and hence it is
appropriate to consider that income for Frank would be derived on account of his knowledge
and skill. As a result, the correct method for income recognition to be used in 2016/2017
would be the receipts method as per the discussion highlighted in TR 98/1 along with the
Carden case (Gilders, Taylor, Walpole, Burton, & Ciro, 2016). It is also known that after
winning the prize for his work, there is significant business growth and hence sizable
business investments have been done by Frank besides appointing assistants for help and
related office work. Under this situation, the more suitable method of income recognition for

Frank would be earnings basis for 2017/2018. This is in line with the verdict in the
Henderson v FCT case where the scenarios were comparable to the given case.
Relevancy of Cash/Accrual Distinction
There are some who argue that in the age of advanced accounting software, the distinction
between cash and accrual method may be blurring. However, this is far from true considering
that the distinction is required so as to determine as to which receipts or earnings would be
realised as income in the given year. This takes into consideration a host of subjective factors
and is not concerned with the computation or timing which is what the software primarily
aids in. For instance, if there is a business selling manufactured goods and it receives an
advance payment for a particular consignment at the time of booking, then it needs to be
determined as to whether the income should take the advance received into consideration or
not.
Question 2
The tax deduction of various transactions enacted by Ruby Pty Ltd is discussed as follows.
(a) In the given case, repairs have been done to the kitchen fittings considering the fact that
the underlying character has not been altered and the damage was already incurred by the
fittings. The key aspects tend to comply with the features of repair as outlined in TR 97/23.
With regards to outgoings as repair, tax deduction is possible under one of the two sections
namely s.8-1 or s.25-10 (Wollner, 2014).
Deduction under s. 8-1 is permissible only when requisite nexus can be developed between
the expense incurred and the production of assessable income. An additional required of
general deduction under s. 8-1 is that the outgoing must not have a capital nature. Further, tax
deduction under s. 25-10(1) can be availed in case of depreciable assets provided these form
part of property used for generation of assessable income (Wollner, 2014). An addition
requirement according to s. 25-10(3) is that the underlying expenditure on repair must not be
capital (Deutsch, Freizer, Fullerton, Hanley, & Snape, 2016).
With regards to kitchen fittings, most of these exist in permanent fixture form particularly
sink, cupboard, stove, plumbing and hence are non-depreciable assets in accordance with IT
242. Further, tax ruling TR 97/23 states that the underlying expenditure that taxpayer incurs
for the permanent fixtures replacement will be capital in nature. Owing to this $ 8,500

expenditure being capital, it would not be deductible for tax purpose under s. 8-1 or s. 25-10
(CCH, 2013).
(b) Deduction under s. 8-1 is permissible only when requisite nexus can be developed
between the expense incurred and the production of assessable income. An additional
required of general deduction under s. 8-1 is that the outgoing must not have a capital nature
(Krever, 2016).
Thus, the crucial aspect which decides the deduction of the legal expenses for tax purpose
would be the underlying nature and essential character of this expense. A case law which
merits discussion under the given scenario is British Insulated and Helsby Cables Ltd v.
Atherton [1926] AC 205. In this case, the judge highlighted a way to segregate capital
expenditure from revenue expenditure. Any expense or outgoing would be termed as being
capital expenditure only if the underlying advantage gained from the outgoing would have ab
effect that would be enduring or long lasting. Further, any outgoing which is incurred during
the carrying of the business activity would be considered to be revenue in nature (Deutsch,
Freizer, Fullerton, Hanley, & Snape, 2016).
The underlying legal expense has been incurred during the business of rental property where
negligence claims often crop up for which legal expenses are incurred. Besides, whenever the
case is settled, there would be only one time advantage and no enduring benefit is expected to
be derived. Owing to the above, tax deduction for the legal expense would be available to the
company under the aegis of s. 8-1 ITAA 1997 (Barkcozy, 2015).
.
(c) Deduction under s. 8-1 is permissible only when requisite nexus can be developed
between the expense incurred and the production of assessable income. An additional
required of general deduction under s. 8-1 is that the outgoing must not have a capital nature.
Thus, the key question emerges as to whether this expense would be revenue or capital in
nature. In a bid to answer the same, consideration needs to be given to Sun Newspapers Ltd
and Associated Newspapers Ltd v. Federal Commissioner of Taxation (1938) 61 CLR 33 case
where Dixon J highlighted that the nature of a given outgoing can be deciphered by
considering the nature of advantage that the outgoing is providing (Deutsch, Freizer,
Fullerton, Hanley, & Snape, 2016). With regards to revenue expenditure, the advantage is

reflected in the present year financial statements but for capital expenditure, the influence is
seen in the future years as well and not limited to the present.
Making the requisite payment for the claim on faulty parts is essentially a part of the regular
business activity where the customers would make claims if faulty products are supplied to
them. Further, the money involved in the settling of these claims would not provide any long
term advantage to the business but it would be limited only to the current year when
settlement takes place. As a result, the underlying outgoing of $ 750,000 on the claim amount
would be deductible under s. 8-1 since sufficient nexus with the previous business exists and
also the expenditure is revenue (Gilders, Taylor, Walpole, Burton, & Ciro, 2016).
(d) In order for general deduction under s. 8-1, a necessary condition is that the outgoing
must have been incurred. It is noteworthy that incurred does not necessarily means paid but
only implies that the given circumstance provide significant assurance of the outgoing
occurring in the particular tax year besides providing an accurate estimation of the amount
expected (Deutsch, Freizer, Fullerton, Hanley, & Snape, 2016).
For the given facts, s. 8-1 would not lead to any tax deduction since with regards to the claim
for which provision is being made at that time neither could have the settlement year being
predicted and also a reasonable estimation of the claims could not have been made. This is
apparent from the vast difference in the provisions and the actual claim amount. Hence, no
outgoing has been incurred through provisioning to the extent of $ 100,000 and hence tax
deduction cannot be availed on the same under the aegis of s. 8-1 (Sdiq, 2016).
(e) Deduction under s. 8-1 is permissible only when requisite nexus can be developed
between the expense incurred and the production of assessable income. An additional
required of general deduction under s. 8-1 is that the outgoing must not have a capital nature.
The cost related to market research spent in this transaction would not be revenue expenditure
as per the test highlighted in the British Insulated and Helsby Cables Ltd v. Atherton [1926]
AC 205 (Gilders, Taylor, Walpole, Burton, & Ciro, 2016). The advantage accrued from the
market research would not be limited to the current year and hence s.8-1 cannot provide tax
deduction on the $ 220,000 paid to the consultant.
However, it is noteworthy that the given expenditure is a business expenditure related to start
up and hence deduction in a phased manner needs to be explored as per s. 40-880 ITAA 1997
(Barkcozy, 2015). Any capital expenditure such as market research, business structure

advisory which is related to future business can be tax deductible over a 5 year period in
accordance with s. 40-880(2A), The fact whether the future business actually is established
and yields assessable income is immaterial (Gilders, Taylor, Walpole, Burton, & Ciro, 2016).
Thus, for the given scenario, annual expenditure to the extent of $ 44,000 (i.e.$220,000/5)
can be availed by Ruby Pty Ltd for a 5 year period.

References
Barkcozy, 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.
Gilders, F., Taylor, J., Walpole, M., Burton, M. & Ciro, T. (2016) Understanding taxation
law 2016. 9th ed. Sydney: LexisNexis/Butterworths.
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