Taxation Law: Income Recognition and Tax Deductions

This study material discusses the critical factors that influence the choice of income recognition method and the legal requirements for tax deductions. It also provides insights into the difference between repair and maintenance expenses, legal expenses, and business-related capital expenditure. The material includes relevant case laws and tax rulings to support the discussion.

TAXATION LAW
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Question 1
Choice of income recognition
With regards to derivation of income, there does arise instances when the time period
between providing the promised products or services to the customer and the receipt of
payment from the client tend to be patterned in such a way that these two events take place in
different tax year. In such instances, a choice is provided to the taxpayer to choose whether to
report earnings on cash basis or accrual basis considering as to which method would allow a
more accurate description of the taxpayer’s income as has been indicated in TR 98/1 (ATO,
2018 a).
Critical Factors
The choice regarding the income recognition is influenced by certain factors that are as
outlined below.
1) Income source nature
There is a pivotal link between the method of income recognition chosen and the manner in
which the assessable income is derived by the taxpayer. In this regards, tax ruling TR 98/1
highlights the preference towards accrual method when the underlying earnings are derived
from business related to trading or manufacturing. Similarly, in case of income being derived
as a result of individual skill or implied knowledge, then it is preferred that the cash method
is chosen. A case law which endorses this approach is Carden v FCT (1938) 63 CLR 108 in
which it is hinted by Dixon J that income recognition in the context of non-trading income
should be carried out in way that ensures that tax payment to government is linked to
something valuable being obtained by the taxpayer (Sadiq, et.al., 2016).
2) Business & Taxpayer related circumstances
It is noteworthy that the income source potentially provides a preference towards a method
and does not make the decision conclusive which is in line with the commentary provided by
Dixon J in Carden v FCT case where he clearly outlines that the choice of appropriate
method must not be derived on account of any rigid rule but must consider the underlying
situation circumstances to arrive at a conclusion. This approach suggested by Dixon J is
reiterated by Javies J during the commentary in FCT v Dunn (1989) 85 ALR 244 case where

he highlights that choice need not be based on any legal principle but rather derived from
circumstances surrounding the business and taxpayer (Kreyer, 2016).
3) Investment in business and attained size
The method related to income derivation must factor in the size of the business and the
underlying capital investment. This aspect can be highlighted by the Henderson v. Federal
Commissioner of Taxation (1970) 119 CLR case. Initially, the taxpayer (i.e. Henderson) used
the cash method for income recognition as the income was derived on account of skill
possessed by Henderson. However, in the next year, his business was on a growth trajectory
fuelled by business investments and hired employees. Henderson decided to alter the income
recognition method to accrual method as the growth of business made this method more
suitable to capture income. This switch in method was upheld by the court (Kreyer, 2016).
Tax Commissioner- Right to Insist
It is apparent that the choice to select one of the two methods rests with the taxpayer and the
same cannot be dictated by the Tax Commissioner. However, it is imperative to note that the
choice available to the taxpayer must be used suitably and therefore if the Tax Commissioner
feels that the method used by taxpayer is not justified by the various factors identified above,
then an objection may be raised and the Tax Commissioner may insist on a particular method.
In such a circumstance, the taxpayer may concur with the Tax Commissioner or take the
matter to court for resolution (Barkoczy, 2015).
Frank – Income Recognition Basis
2016-2017 – The scenario given clearly highlights that Frank is working as an architect and
therefore his earnings are the result of his skill. Also, the business size is quite small since
most of the work is performed by Frank only. Besides, the use of hired employee is also
absent. Hence, as per the various case laws and tax rulings cited above, cash method seems
appropriate for Frank.
2017-2018 – After Frank has won the national award for design, he has taken an office on
rent, made investments of $ 1 million in the business along with hiring employees to assist
him in designing and also related administrative tasks. Considering the investments and
growth in business (receipts in excess of 2 million), Frank must switch to the accrual basis in

line with the decision highlighted in FCT vs Henderson case where there were comparable
circumstances.
Cash/Accrual Distinction
The real time monitoring of cash inflow and outflow has seen significant improvement with
the introduction of modern accounting software packages. Even though the use of these
software is on the rise but still the distinction between cash and accrual remains relevant. This
is because the need of these two methods is linked to instances when the time period between
providing the promised products or services to the customer and the receipt of payment from
the client tend to be patterned in such a way that these two events take place in different tax
year. In such a scenario, an obvious question which arises is that income needs to be
computed on cash or accrual basis and in answering this, accounting software is of limited
use only since it is more useful for cash flow management (CCH, 2013).
Question 2
The discussion with regards to availability of tax deduction on the various transactions that
have been outlined in context of Ruby Pty Ltd (“taxpayer”) is indicated below.
(a) The difference between repair and maintenance (including improvement) is highlighted in
accordance with TR 97/23 and includes the following (ATO, 2018 b)
 The objective of repair work is to restore the efficiency without altering the
underlying character. This differs from maintenance where the objective is to improve
efficiency by change of character.
 While maintenance is carried out to prevent damages when it has just commenced,
repair is usually carried out much later i.e. when significant damage has occurred.
In the scenario given, the expense related to kitchen fittings are repairs since they have
commenced only after significant damage has taken place. Also, these have been
implemented without altering the efficiency and also the layout has been largely kept the
same. Besides, it is known that the given property in question is used for assessable income
generation.

Possible tax deduction for the repairs can be availed under s. 25-10 ITAA 1997 or s. 8-1
ITAA 1997 (Austlli, 2018 a). As per s. 25-10, any repairs in relation to any depreciable asset
belonging to any assessable income generating property would have tax deductions provided
the repair expenditure does not assume a capital nature. As per s. 8-1, any particular loss or
outgoing in the production of assessable income can be deducted for tax purpose (Austlli,
2018 b). However, ss.8-1(2) prohibits the deduction of any expenditure that is not revenue
but capital.
In relation to kitchen fittings a crucial aspect that needs to be highlights is that most of the
components are permanent fixtures (eg. Cupboard, sink, pumbings) and therefore instead of
being considered as separate depreciable assets, they are considered as an integral part of the
overall property assets. This implies that expenses related to repair of kitchen fittings would
be considered as capital expenditure related to restoring the value of the property and hence
would reflect in the asset cost base as per s. 110-25 ITAA 1997. This stance is also supported
by the discussion indicated in TR 97/23. On account of the repair expenditure being capital,
the taxpayer would not be able to claim any tax deduction in relation to the repair expenses
(ATO, 2018 b).
(b) As per s. 8-1, any particular loss or outgoing in the production of assessable income can
be deducted for tax purpose. However, ss.8-1(2) prohibits the deduction of any expenditure
that is not revenue but capital (CCH, 2013).
In line with the above rule, it is essential to determine as to whether the legal expense would
be capital in nature or not. For shedding light in this regard, reference must be made to the
British Insulated and Helsby Cables Ltd v. Atherton [1926] AC 205 case. During the
proceedings of this case, a simple test was outlined whereby the capital expenditure can be
identified with the presence of an enduring advantage. On the other hand, revenue
expenditure would not lead to an advantage have is enduring (Austlli, 2018 c).
Considering the involvement of the taxpayer in real estate business and having rental
property under management, occurrence of negligence related claims is a common
phenomenon associated with the business. The advantage derived from the legal expenses is
limited in nature as it would help in saving payment of damages in a particular year. The
legal expenses do not provide any potential benefit once the case of settled and therefore tax
deduction under s. 8-1 can be availed by Ruby Pty Ltd (Sadiq, et.al., 2016).

(c) As per s. 8-1, any particular loss or outgoing in the production of assessable income can
be deducted for tax purpose (Austlli, 2018 b). However, ss.8-1(2) prohibits the deduction of
any expenditure that is not revenue but capital.
The key question on which the decision to provide tax deduction hinges is whether the
underlying outgoing would be termed as capital or revenue. A useful case which can be
referred in the given scenario is Sun Newspapers Ltd and Associated Newspapers Ltd v.
Federal Commissioner of Taxation (1938) 61 CLR 33. Reading the verdict of the case, Dixon
J highlighted that the nature of the expenditure incurred by the taxpayer can be identified by
analysis the attributes related to the advantage which arises from the outgoing. If the
underlying benefit or advantage continues for a sustained period of time, then the expenditure
would be capital. In contract, if the advantage has impact limited to the given tax year or time
period, then the expenditure is often categorised as revenue (Austlli, 2018 c).
Ruby Pty previously was engaged in business related to manufacturing of engines. In that
business, it would have been common occurrence whereby faulty parts were supplied to a
client which would have led to claims arising thus requiring settlement. This expense quite
closely is related to the act of producing income by manufacturing engines. Besides, the
advantage derived from paying the claims to the tune of $ 750,000 is not long term which
implies that expenditure on claims is revenue and hence tax deduction can be availed by
taxpayer (Sadiq, et.al., 2016).
(d) One of the requirements for general deduction of expense under s. 8-1 is for the expense
to be incurred. Incurred in the context of this section does not mean that payment for the
same should have been made. But TR 97/7 highlights that a key requirement for expense
incurring is that reasonable estimation of the cash outflow must be possible along with
reasonable assurance regarding the cashflow to occur (ATO, 2018 c).
Based on the given scenario, considering the potential of claims to be paid for faulty engine
parts supply , the company has made provisions to the extent of $ 100,000. It is evident from
the comparison of the actual amount and the provisional amount that the company at the time
of providing the provision was not in a situation to potentially estimate the extent of claims
that would arise. This implies that tax deduction to taxpayer will not be given in context of
the provisions made for the claim amount (Kreyer, 2016).

(e) As per s. 8-1, any particular loss or outgoing in the production of assessable income can
be deducted for tax purpose. However, ss.8-1(2) prohibits the deduction of any expenditure
that is not revenue but capital. The amount in this case has been paid to the consultant in
relation to market research the result of which would have an enduring advantage which
would not be limited to the current year. As a result, the payment made to the consultant is a
capital expenditure with no possible tax deduction under s. 8-1 (Austlli, 2018 b).
However, the amount paid to consultant does qualify as business expenses meant for future
business. Section 40-800 ITAA 1997 would be useful here for providing tax deduction for
business related capital expenditure. Unlike s. 8-1, the tax deduction under s. 40-800 would
be available over a five year period in equal amounts. Besides, as per ss.40-880(2A),
deductions are possible for future business related capital expenditure and the same is
independent of the eventual decision of the taxpayer to start the business or not (Austlli, 2018
d).
Therefore, tax deduction per year (for five years) = 220000/5 which amounts to $ 44,000

References
ATO (2018 a). TR 98/1, Income Tax: determination of income, receipts versus earnings.
Retrieved from:
https://www.ato.gov.au/law/view/document?DocID=TXR/TR981/NAT/ATO/00001
&PiT=99991231235958[Accessed 12 September 2018].
ATO (2018 b). Taxation Ruling, TR 97/23, Income tax: deductions for repairs. Retrieved
from: https://www.ato.gov.au/law/view/document?docid=TXR/TR9723/nat/ato/
00001[Accessed 12 September 2018].
ATO (2018 c). Taxation Ruling, TR 97/7, Income tax: section 8-1- meaning of ‘incurred’-
timing of deductions. Retrieved from: https://www.ato.gov.au/law/view/document?
Docid=TXR/TR977/NAT/ATO/00001 [Accessed 12 September 2018].
Austlli (2018 a) Income Tax Assessment Act 1997 –SECT 25.10. Retrieved from:
http://www5.austlii.edu.au/au/legis/cth/consol_act/itaa1997240/s25.10.html
[Accessed 12 September 2018].
Austlli (2018 b) Income tax Assessment Act 1997 –SECT 8.1 General Deductions. Retrieved
from: http://www8.austlii.edu.au/cgi-bin/viewdoc/au/legis/cth/consol_act/
itaa1997240/s8.1.html [Accessed 12 September 2018].
Austlli (2018 c) Income tax Assessment Act 1997. Retrieved from:
http://www8.austlii.edu.au/cgi-bin/viewdb/au/legis/cth/consol_act/itaa1997240/
[Accessed 12 September 2018].
Austlli (2018 d) Income Tax Assessment Act 1997 –SECT 40.880 General Deductions.
Retrieved from:
http://www5.austlii.edu.au/au/legis/cth/consol_act/itaa1997240/s40.880.html
[Accessed 12 September 2018].
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.

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