You are on page 1of 5

Lecture Overview

 Income definition
 Capital vs. revenue
Topic 5 – why important to make the distinction
– principles derived from case law
(A) Capital and Revenue  Using income as the tax base
(B)Income Statement For Tax – economist’s view
Returns – accountant’s view
– capital gains tax debate
 Financial vs. tax accounting
– why the difference
1 – how different are they 2

INCOME DEFINITION CAPITAL V REVENUE

 Income is not defined in the Income Tax Act  Why do we need to identify the distinction?
2007 (or previous Acts)  New Zealand:
 CIR v Boyton (2001) – In terms of receipts
• Capital is generally non-taxable;
 How to decide what is income? • Income/revenue; liable for income tax;
– Implied in the Act • income generally excludes capital;
• some capital gains may be taxable -“circulating capital”
– Normal usage - e.g.dictionaries e.g. capital gains from the sale of land purchased with
– Judicial interpretation - ordinary concepts and intention for resale)
usages of mankind – In terms of expenditure
– Recap Topic 4 • deductions for capital outgoings are generally not
deductible

CAPITAL v REVENUE
Case Law: CAPITAL v REVENUE -
Pitney, J. Supreme Court, USA in: Summary
Eisner v Macomber (1919) 252 US 189

 Economists’ view  What is capital?


– capital: – An item of wealth or an asset capable of
• tree; producing wealth e.g. buildings, land,
• a reservoir supplied from springs. investments.. the “tree”
– Income is – Nature of “fixed capital”
• fruit/crop;  What is income?
• outlet stream to be measured by its flow over – The “fruits or crop”; rent, interest,
time;
dividends…derived from the above are income
• not a gain accruing to capital;
– Nature of “circulating capital”
• not a growth or increment of value;
Case Law
Case Law
CIR v McKenzies NZ Ltd (1988)
CIR v Inglis (1992)
 Taxpayer making a lump sum payment  Shares sold at a loss and claimed a
to lessor in consideration for surrender deduction for the loss
of lease  CIR claimed capital losses not deductible
 Court decision: share transactions were
capital in character BUT is taxed under the
 Court of Appeal held it is capital Act (s CB 4)- profit on sale of shares; shares
held on revenue account i.e. circulating
capital

Other Tax Cases INCOME AS A TAX BASE

 CIR v Fraser (1996) 17 NZTC 12,607  Most complex and controversial


-inducement payment
-character of receipt important
 Impact of economic, accounting and
 Union Steamship Co of NZ Ltd v CIR (1996)
legal principles
17 NZTC 12,629 (CA)
-surrender of option
-agreement not viewed in isolation but in context of
other agreements

INCOME: Economist’s View EXAMPLE


 At beginning of the year has cash
 Income = increase in economic power $1,500 but invested $1,000 in shares
 Earned salary $15,000
 Outside fees $2,000, expenses $400
 That is net accretion in wealth plus
consumption during the period in  Dividends received $900
question  Shares worth $9,800 at end of year
 $400 in bank a/c at end of year
 $17,600 cash spent on consumption
items
ECONOMIC INCOME INCOME: Accountant’s view
Value at Value at Increase or
begin end decrease
Cash $500 $400 ($100)  ‘inflows or other enhancements, or
savings in outflows, of service potential
Shares 1,000 9,800 8,800
or future economic benefits in the form
Increase in 8,700 of increases in assets or reductions in
net worth
liabilities of an entity...result in an
Consumption 17,600
exp. increase in equity’
Economic $26,300  GAAP - income measured on basis of
Income
completed transactions

ACCOUNTING INCOME DIFFERENCES


S a la ry $ 1 5 ,0 0 0  ECONOMIC  ACCOUNTING
 Needs valuation  realisation concept
F ees $ 2 ,0 0 0
 Subjectivity  historical cost
L ess: 400
 Unrealised  conservatism
ex p en ses
1 ,6 0 0 gains/losses  objectivity
 Includes gifts,  matching expenses
D iv id e n d s 900
inheritances, with revenue
A /C $ 1 7 ,5 0 0 bequests
In c o m e

Arguments Capital as a Tax Base


 New Zealand:
 Economist’s approach
– too impractical – No specific capital gains tax;
– difficult to apply – Tax Review 2001: current income tax base
– lack objectivity and accuracy includes a wide range of changes in value of
assets and liabilities;
– measurement of taxable income;
– Capital gains tax, as used overseas, is a
‘monetary’ v ‘real’ income
transactional tax on disposal of assets:
encourage tying up of assets unproductively
to avoid tax.
Capital as a Tax Base Capital as a Tax Base
 Arguments for:  Arguments against:
– Equity i.e. – Administration problems such as:
• the erratic nature of such gains;
• Profits in the form of income taxable so should profits of
• difficulty in assessing -rate of tax to be applied?
capital nature; difficulties with adjustment in changes in money values;
• Increase in taxable capacity (vertical equity); will the public accept a capital gains tax?
• It would prevent a common means of tax avoidance; – Political
• Avoids excessive concentrations of economic power in a • likely to incur bad feeling particularly as proportion of NZers
own their own homes, shares, etc.
few hands.
• Possible reduction in tax yield
– Economic – Economic; possibly interfere with society’s choice in the
• Absence – tendency to over invest in assets subject to patterns of production and consumption
capital gain and under invest in productive assets; – Grounds of equity; is the tax to be on real wealth or
• Stabilisation effective? In times of inflation and excess illusory increase?
demands the tax yield would increase. – Impact on farmers

Income Statement: Accounting v.


Financial v Tax Accounting
Tax
 Introduction:  Basic questions:
– Standard income year => “tax year” – Why are they different?
– How are they different?
– Tax year – 31 March
 Purpose of Financial Accounting:
– Alignment of corresponding income year to
– Accounting is the “the process of identifying,
a tax year measuring and communicating information to
– Non-standard income year (early or late) permit informed judgments and decisions by users
and accounting balance dates of that information” (Bazley & Hancock, 110.100)
– Profit v net / taxable income:
• Financial v tax accounting – Statements of Concepts for financial reporting
imposed for specific business/economic purposes
– Income returned in ‘prescribed forms’
– Concerned with ‘true and fair view’.

Financial v Tax Accounting Financial v Tax Accounting


 Tax accounting methods:
– When income is derived and expenditure
 Purposes of Taxation: incurred?
– To raise revenue for public goods and services;
– Cash method
– To encourage certain economic behaviours; • Based on income received
– Redistribute wealth. • Deemed to be derived if amount is credited in account,
etc. (s BD 3)

 Principles of taxation: – Accruals method


– Equity; • Based on income earned
– Certainty; • Adopt a method that best discloses taxpayer’s true
income
– Convenience/simplicity;
• Generally considered the appropriate method for
– Economy of collection. accounting for business
 Accurate assessment of tax liability
Financial v Tax Accounting Financial v Tax Accounting
 Permanent & timing differences for deferred  Timing/taxable temporary differences
tax purposes are:
– Difference between financial (profit) &
 Permanent differences result from: taxable incomes arising strictly from
• Items of income/gains realised for financial taxpayer’s method of accounting
accounting purposes but not recognized for tax; – Same item of income/gains or
and
expense/loss is taken into account in
• Items of expense/loss matched against
financial accounting revenue but not deductible
different year(s) for accounting v tax
against gross (tax) income. purposes

INCOME TAX LIABILITY


 Annual Gross Income
 Less: Annual Allowable Deductions
 Net Income
 Less: Available Losses (brought
forward)
 Taxable Income
 Multiply by tax rates
 TAX LIABILITY