ACCG924 Taxation Law

Lecture Notes Week 3 2018

 Lecture Three
Readings from Australian Taxation Law 2018 OUP for this lecture

Income from property

Overview W5-000 to W5-010
Interest W5-200 to 5-215
Annuities W-300 to 5-320
Leases and rental income W5-400 to 5-420
Royalties W5-500 to 5-520

Income from business

Identifying a business W6-000 to 6-150
Commencement and termination W6-250 to 6-280
Taxation of income from business W6-400 to 6-455
Statutory expansion W6-480 to 6-495
Compensation payments W6-800 to 6-840; W6-910
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 Income from property
A taxpayer derives income from property if they own property (eg, an
apartment, money in the bank) and they receive income from the
property (eg, rent, interest) without active labour or business input.

Income comes from the ownership, not from personal exertion or

business activity.

Is often described as passive income (because it just “comes in” rather

than being “earned”).

Includes interest, rent and royalties. Also includes annuities (not

examined) and dividends (week 11).

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 Income from property
-- interest
No general definition of “interest” in the tax legislation.

Commonly interpreted as “the price of money borrowed”: see Riches v

Westminster Bank 1947

Is generally said that interest is ordinary income because it is a

periodic, recurrent and regular payment

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 Income from property
-- leases and rental income
Rent is an amount received by a taxpayer for allowing another person
to use their property, eg, a building or a vehicle. Rent is ordinary
income.
Whether a payment constitutes rent is determined by looking at the
substance of what the payment is for rather than how it is described:
Lathouras 1964 (amounts paid monthly in advance were called
“premiums” but were really rent)
A premium is generally a lump sum paid by a potential tenant to induce
the landlord to grant the lease of the premises – is typically treated
as a capital receipt.
But a premium may be ordinary income where the taxpayer receives
premiums as a regular part of its business or where the premium is
really disguised rent: Kosciusko Thredbo 1984.
The capital gains tax provisions may, since 20 September 1985, apply
to lease premiums that are considered capital in nature. 5
 Income from property
-- royalties
In general terms, a royalty is an amount paid for the right to use or
exploit another person’s property, eg:
–  payments for the right to use a person’s copyright or patent, or
–  payments for the right to remove trees from someone’s property.
Types of royalties for tax purposes
1.  Royalties within the ordinary meaning (most important type) --
assessable as ordinary income under sec 6-5.
McCauley 1944 -- High Court said an amount is an ordinary royalty
if: (i) it is an amount paid for the right to use someone’s property,
and (ii) the amount of the payment is directly connected to the
amount of use.
Contrast McCauley (amounts were taxed as royalties) and Stanton
(amounts escaped tax) – similar facts (in both cases, farmer was
paid when trees were taken from his property), but different results
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 Income from property
-- royalties
2.  Amounts that are not royalties under the ordinary meaning but fall
under the definition of royalty in sec 6(1) ITAA36 (eg, payment for
know-how) -- assessable as ordinary income.

3.  Royalties within the ordinary meaning of royalty but are not
ordinary income (no examples in the cases) -- assessable under
sec 15-20

4.  Amounts that are not royalties under the ordinary meaning but fall
under the definition of royalty in sec 6(1) and are not ordinary
income under sec 6-5. These royalties are not statutory income
under sec 15-20 (as sec 15-20 only applies to royalties within the
ordinary meaning) but may be included in the calculation of a
capital gain.
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 Income from business
Does a business exist?

Why it matters
-- income from the business is assessable
-- expenses relating to the business are deductible

The common law tests for determining whether a business exists:

•  System and organisation
•  Size and scale of activities
•  Sustained, regular and frequent transactions
•  Turning talent to account for profit
•  Profit motive

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 Income from business
System and Organisation

Ferguson 1979 – 5 cows

Walker 1985 – 1 goat

Were the business methods and procedures ordinarily used in that field
applied?
-- Case T58 1968: fishing business not carried on, just a hobby

If activities are primarily enjoyable or are more like a hobby than a

business, a higher level of system and organisation will be required to
prove that it constitutes a business, eg, artist painting pictures for sale
at local market
– Brajkovich 1989 (taxpayer’s gambling didn’t constitute a business so
no deduction for gambling losses)
Makes it more difficult to get a deduction for “business expenses”. 9
 Income from business
Size and scale of the activities
Is easier to show is a business if large size -- but business may be
small: Thomas 1972
Ferguson 1979
Walker 1985
Sustained, regular and frequent transactions
Most businesses engage in frequent and regular transactions – once
established, are intended to continue for years
Shields 1999 – contrast Smith 2010
Business may go through quiet periods, does not have to be busy all
the time -- but may suggest the business has ended
Isolated transactions can also constitute a business: Whitfords Beach
1982
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 Income from business

Turning talent to account for profit

A business can exist where a person turns their talent to account for
profit.
Stone 2005 – police woman earned large amounts from being a
champion athlete
Spriggs and Riddell 2009 – “business” expenses deductible even
though almost all their income came from employment
Profit motive
ATO view is that the “prospect of profit” is a very important indicator of
a business – must be a good chance of a profit, but immediate profit
not necessary (Taxation Ruling TR 97/11)
Brajkovich 1989: taxpayer had a strong profit motive – yet was found
not to be in business.
Daff 1998: the fact that a venture (14 years without a profit) fails
commercially does not prevent it from qualifying as a business.
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 Income from business
Other Issues
Is the person willing to trade on the open market? Important where a
taxpayer has lent money to a related party and claims it is in the
business of lending money: Bivona Pty Limited 1989

Inherent characteristics of the taxpayer -- a company structure, as

opposed to an individual, is more likely to indicate a business –
but most businesses in Australia are conducted by sole traders.

Means of carrying on a business – don’t need building, employees, etc.

-- trading activities conducted through an online selling site may
constitute a business
Illegal transactions can constitute a business: La Rosa 2003

In weighing up the various factors, the Court will look at the substance
of what is really going on: Deane & Croker 1982
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 Commencement of business

The time at which a particular business commences is significant -- no

business income is derived and no deductions are allowed for
expenses unless the business has started

Preparatory activities do not constitute the carrying on of a business.

See Softwood Pulp & Paper Ltd 1976

Preliminary or experimental activities, such as preparing land for

primary production, do not amount to engaging in a primary
production business. See Dalton 1998 and Thomas 1972

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 Termination of Business

The time at which a particular business ends is a question of fact and

degree.

Business hasn’t necessarily terminated just because it is inactive for a

period

Depends on the intention of the controllers, the nature of the business

and the reason for the cessation or the running-down of trading
activities
-- AGC (Advances) Ltd 1975: business operations almost ceased
but was a continuing business

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 Taxation of income from business
Normal proceeds of the business

Once it is determined that a business is carried on, the next step is to

determine which of the proceeds of the business are assessable.
Starting point: principle in Californian Copper 1904 – distinguish between:
(1) mere realisation of an asset or change of investment -- dispose of
something but not in the course of a business (receipt would be capital)
(2) act done in the carrying on of a business (ordinary income)
– Scottish Australian Mining 1950: High Court said mining company merely
took steps to sell the land at the best price – didn’t carry on business as a
property developer – amount received was capital
Normal proceeds of business operations are ordinary income.
What are the ‘normal’ proceeds of a business? -- need to determine the nature
and scope of the business .
GP International Pipecoaters Pty Ltd 1988 – wide interpretation
Merv Brown 1985 – narrow interpretation
Nature and scope of business activities may change. See Kosciusko Thredbo
Pty Ltd 1984 15
.
 Taxation of income from business
Expansion of the ‘business proceeds’ concept
Isolated or ‘one-off’ transactions

Before 1982, isolated transactions were unlikely to be held to constitute a

business.

Whitfords Beach 1982: company made profit when disposed of land (a one-off
transaction) that had been held for many years for private purposes
-- High Court held that the gain from the land development project was
assessable as ordinary income
-- no change in the owner of the land, but was a change in the majority
shareholding in the owner company

From the time majority ownership changed, the company became a land
development company and its activities were business activities -- the gain
from those activities was ordinary income.

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 Taxation of income from business
Expansion of the ‘business proceeds’ concept
‘Extraordinary’ transactions

Myer Emporium Limited 1987

– entered into an “extraordinary transaction” for the purpose of receiving
tax-free money for business purposes

•  Myer Emporium (a retailer and property developer) wanted to expand its

operations -- lent $80m to its subsidiary Myer Finance as part of a plan to
diversify its business operations

•  Myer Emporium was entitled to receive income stream over a 7 year period
at an interest rate of 12.5% on the loan – totalling $72 million

•  It assigned the right to receive the income stream to Citicorp (a finance

company with accrued tax losses), in return for a lump sum of $45.37m

Issue: Was the $45.37m received by Myer Emporium from the assignment of
the future interest payments assessable to Myer Emporium as ordinary
income?

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 Taxation of income from business
Expansion of the ‘business proceeds’ concept
‘Extraordinary’ transactions

Transaction entered into by Myer was both isolated and extraordinary

First strand of High Court decision:

A profit or a gain arising from an extraordinary transaction (ie, not part of the
taxpayer’s ordinary business activities) will be ordinary income if:
-- the circumstances show that the taxpayer’s intention in entering into the
transaction was to make a profit or gain, and
-- the property generating the profit or gain was acquired in a business
operation or commercial transaction for the purpose of profit-making by the
means giving rise to the profit.
Westfield Ltd 1991 -- imposed restrictions on the applicability of the Myer
principle – land was acquired for the purpose of building a shopping centre
but was sold at a profit when circumstances changed – the land was not
acquired for the purpose of resale at a profit, so profit on the sale was not
ordinary income.
-- shows that, if the profit from an extraordinary transaction is generated by
the purchase and sale of property, the profit is only ordinary income if the
profit-making purpose existed when the property was acquired.

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 Taxation of income from business
Expansion of the ‘business proceeds’ concept
‘Extraordinary’ transactions

Application of the first strand of Myer to lease incentive payments

Lease incentive payment arises if a landlord pays a tenant (eg firm of

accountants) a large sum to persuade them to enter into a lease of business
premises -- landlord is happy because gets a “big name” tenant
– are the partners in the firm assessable on their share of the payment?
Cooling 1990 – payment to firm of solicitors to persuade it to change premises
– ordinary income from profit-making scheme, applying first strand of Myer
Selleck 1996 -- landlord paid $1 million for tenant’s costs of fit-out -- not
assessable because the payment didn’t persuade the firm to change
premises, had already decided to do so
Montgomery 1999 -- most important -- $22 million to law firm assessable –
receipt of the lease incentive payment was ordinary income – applying first
strand of Myer
Lease incentive that is not cash and not convertible into cash, eg rent-free
period for the tenant
– not ordinary income (Cooke & Sherden), but
-- need to consider s 21A ITAA36; Taxation Ruling IT 2631
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 Taxation of income from business

Section 21A ITAA36: where a non-cash benefit is provided in respect of a

business transaction:
(1) it will be treated as if it is convertible into cash; and
(2) if the benefit is of an income nature (eg, because it derives from a business
relationship), the arm’s length value of the benefit is included in the
taxpayer’s income.
“Arm’s length value” is the amount that would be payable between parties that
aren’t related, eg from normal commercial transaction.
Enacted to overcome the effect of the decision in Cooke & Sherden 1980

Exceptions: s 21A does not apply:

1)  if the taxpayer would have been entitled to a once-only deduction if they had
incurred the cost of the benefit -- s 21A(3))
2)  if the expense is non-deductible entertainment expenditure to the provider
of the benefit: s 21A(4), or
3)  if the aggregate value of the non-cash business benefits received by the
taxpayer in the year is less than $300: s 23L(2) ITAA36.
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 Taxation of income from business
Expansion of the ‘business proceeds’ concept
‘Extraordinary’ transactions

Second strand of the Myer decision

Exchanging a lump sum for an income stream:

Ø  the lump sum is received in exchange for, and ordinarily as the
present value of, the future interest which the taxpayer would
have received, and
Ø  this is a revenue not a capital item – the taxpayer simply
converts future income into present income.

Accordingly the lump sum is assessable as ordinary income.

-- Henry Jones (IXL) 1991: company transferred right to royalties in
exchange for lump sum – lump sum took on the character of the
royalties, so was ordinary income.
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 Compensation payments
Compensation receipt (eg, payment from an insurance company for house
destroyed in bushfire or court award for unfair dismissal from employment)
generally takes the character of what it replaces (Meeks 1915).
Is ordinary income or capital according to what it replaces.
-- Sommer 2002: lump sum received in place of monthly benefits was income
-- Sydney Refractive Surgery Centre 2008: lump sum compensation for injury
to a company’s reputation was capital

Examples:
Compensation for the loss of income or profits
DP Smith 1981: insurance payment for loss of income
Compensation for lost trading stock has income character (Wade 1951)
assessable as ordinary income or statutory income under s 15-30 ITAA97

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 Compensation payments

Compensation for the cancellation of a business contract –

-- income if the cancelled contract is one of a number of ordinary business
contracts
-- capital if the contract was fundamental to the business structure
–  Allied Mills 1989
–  Van den Berghs 1935 cancellation of a “structural” agreement

Compensation received for the loss of a capital asset -- capital in nature if is a

fundamental or permanent loss
–  Glenboig Union Fireclay 1922 – permanent loss of a fixed asset

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 Compensation payments
Apportionment of lump sum compensation payments
Lump sum payments that represent compensation in part for assessable
(income) items and in part for non-assessable (capital) items are:
--- assessable as income to the extent a separate amount of income is
identifiable and quantifiable, and
--- wholly treated as capital where a lesser sum is accepted in compromise of
wholly unliquidated claims and the parties have not agreed on the income
and capital components
McLaurin 1961 – claim for £30,000 compensation for damage to both revenue
and capital assets when fire from train damaged property – lump sum of
£12,350 in full settlement of the claim was offered and accepted – High
Court said the full amount was capital because couldn’t be apportioned into
income and capital parts
Before 1985, capital amount was tax-free; since 19 September 1985,
compensation received as an undissected lump sum for the settlement of
rights of action may be liable to capital gains tax: CGT event C2 – sec
104-25 24