1 INTRODUCTION TO INCOME TAX Learning Objectives After you have successfully completed the work in this unit you should be able to: + Explain the basic nature of income tax. © Understand the background to income tax law in Papua New Guinea by reference to the Income Tax Act 1959 as amended and other laws. + Define and explain basic terms used in income tax law. * Calculate taxable income by reference to the equation: Taxable income = Assessable income less allowable deductions. What is Income Tax? Income tax is a tax on the income of individuals, companies and other legal bodies which we shall cover in this course, Do not make the mistake of thinking that income tax refers only to the taxation ofa person’s salary or wage. Income tax differs from indirect tax which is, in most ‘cases, a tax on expenditure. ‘The main purpose of taxation is to raise revenue to finance government expenditure. There are other economic and social objectives. For example, the government may use fiscal policy, by lowering or raising taxes, in order to stimulate or reduce economic activity. The goverment may create tax incentives to encourage certain activity. For example, tax concessions (e.g., reduced tax or even no tax) may be offered to exporting firms, employment-creating firms or to foreign investors, Tax incentives may be offered to firms in remote rural areas to help develop such areas and to reduce rural-urban drift, as part of social policy. Taxes may also be levied on certain goods, such as drink and tobacco, with the declared aim of reducing their consumption. That such taxes rarely achieve a reduction in the consumption of such goods is seldom of great concern to governments which confirms the fact that the prime aim of levying taxes is to raise money. Income tax is a direct tax in that it is directly borne by the taxpayer who actually “bears the burden’ of the tax. This is in contrast to indirect taxes, such as goods and service tax (GST), ‘customs duties (import taxes) and excise taxes. In the case of these taxes, the taxpayer (eg. a store owner or importer) may pass on all or part of the tex to the consumer, for whom the tax is therefore an ‘indirect tax”, CPA Taxation: Introduction = page 1Income tax paid by individuals is normally ‘progressive’ in nature. This means that a person receiving a higher income pays not only a greater total amount of income tax, but more proportionally, or in percentage terms, as well. The reason for this is on the grounds of ‘equity or faimess. In taxation theory, the ‘marginal utility’ or extra satisfaction gained from obtaining more income decreases as one’s income rises. A person on a high income will not gain much additional ‘utility’ from further income increases. It follows that to lose some of that top income will not result in much hardship. For example, the loss of ‘utility’ or satisfaction in paying K250 tax per fortnight may be no worse than @ lower income eamer paying K50 per fortnight. You should bear this in mind when examining the vastly different amounts of tax payable by high and lower income earners in the fortnight tax tables for wages and salaries produced by the IRC. Income Tax Law Income tax law is a product of income tax legislation and case law (court decisions), The Papua New Guinea Income Tax Act was passed in 1959 when income tax was introduced to the country. The Act was based on Australian income tax. Since 1959, it has been amended many times. It may be referred to as the Income Tax Act 1959 as amended. In addition to the Income Tax Act, tax legislation also includes the following: ‘Income Tax Regulations, which prescribe how certain parts of the Income Tax Act, and other acts, are to be implemented. They are a form of delegated legislation, which allow certain amendments to be made conceming the implementation of income tax without requiring new Jaws to be passed. Income Tax Rates Acts of which there are currently eight separate Acts that specify the appropriate rates of tax to be paid by the various categories of taxpayers. © Stamp Duties Act and Regulation, which covers the imposition and collection of stamp duties and administration of the Act. ‘+ International Tax Agreements Act, which when read in conjunction with the Income Tax Act, covers the numerous bilateral taxation agreements made between Papua New Guinea and other countries for the collection of tax on transnational income. ‘© Goods and Services Tax (GST) which contains all provisions governing this tax. In addition the IRC publishes the schedule of depreciation rates for tax purposes. Papua New Guinea income tax legislation is issued in book form. The version of income tax law most widely used, by business firms and the IRC itself, is that issued by a commercial publisher, CCH Australia Ltd. The Goods and Services Act is produced in a separate binder booklet (which now also contains the Stamp Duty Act). CCH continually updates the law for subscribers to this service. (In this course, when reference is made to the ‘Act’ or ‘Income Tax Act’, or to certain sections of the Act, we are referring to the Income Tax Act 1959 as amended.) CPA Taxation: Introduction page 2Interpretation of tax legislation ‘The basic rule is that tax legislation should be precise and should state clearly the intention for imposing the tax so that the legislation can be strictly interpreted. The tax legislation is not, however always precise. Our tax system is not a simple one with few transactions. However, it is less complex than in more developed countries. The legislation is sometimes ambiguous and difficult to interpret. As already stated, in Papua New Guinea there are two sources of taxation law © Legislation (or statute law) © Case law (or common law) There are a number of steps than can assist in interpreting the legislation. First, we need to ‘examine the relevant statutory provisions of the legislation to determine the payments or transactions which will be assessable and those that will be exempt or deductible; secondly, to clarify situations where there is statutory ambiguity or uncertainty it is necessary to refer to ease Taw to interpret the legislative provisions. The courts have powers, under s155 of the Constitution to interpret legislation in a way which would promote its purpose. In units which follow we shall examine some case law in detail Language and terms used in Income Tax Law It is important to apply the correct meaning of words used in income tax law. The rules for applying the correct meaning of words are: the meaning of a word as applied in normal usage should be used except where it differs from a general or specific definition in the Act. Section 4 of the Income Tax Act contains general definitions of terms used throughout the Act. There are also specific definitions in other individual divisions of the Act. Section 4 definitions should apply unless there is a different specific definition. In other words: specific definitions override ‘general definitions and general definitions override the everyday usage of the word. It is important that you know at the outset the meaning of certain key terms in order to know how tax payable is calculated. In the following two units we shall consider in greater detail the meaning, in a tax context, of these and other terms. Assessable Income This is income that is taxable before any deductions are made; in other words, gross income, The following receipts, for example, are classified as assessable income: * Salary or wages © Interest * Dividends * Gross income from a business CPA Taxation: Introduction page 3Partnership income © Rent © Commissions © Bonuses Allowable Deductions (8.66-8.68) These are amounts which are allowed to be deducted from assessable income in order to arrive at a figure which represents taxable income. As a general rule, actual payment need not be made in order to claim a deduction, so long as a liability is “incurred”. Allowable deductions include most expenditure which would normally appear in the profit and loss accounts of a business (S.68). Allowable deductions would include: ‘© purchase of trading stock manufacturing, trading and administrative expenses ‘interest, rentals and royalties paid Interest includes interest on funds borrowed for the purpose of producing assessable income, this would include funds borrowed for the purpose of acquiring ineome producing. assets (including property plant and equipment and shares), or used in the conduct of business activities. The Income Tax Act contains provisions governing the allowance of tax deductions for general costs or outgoings incurred in deriving income or carrying on a business for that purpose (8.68). Excluded are expenses of a capital, private or domestic nature. These provisions will be considered in detail in later units Taxable Income This is actual income subject to tax after allowable deductions have been subtracted. It is calculated by subtracting allowable deductions from assessable income. Taxable income is quite often different to ‘accounting income” due to different treatment on certain items between the Income Tax Act and generally accepted accounting principles. Derived Income Income must normally be derived (or eamed) to be subject to tax. Income need not be actually received to be derived. It is derived even though it is not actually paid over, when itis reinvested, accumulated, or capitalised or otherwise dealt with on a tax payer's behalf or as he directs. For example, if a taxpayer has a fixed deposit in his bank for K20,000 on which interest of K2,000 is credited to his account annually, the K2,000 is income whether the taxpayer withdrew it or not (S.13). CPA Taxation: Introduction ~page 4In the accounting records of a trader, income is eamed when the transaction is complete, regardless of whether payment is received. The accrual method of accounting is generally the required basis for the disclosure of assessable income. Accrued income is income eared which has not yet been received. However, the earnings basis of assessment is not compulsory for professional people, such as medical practitioners or accountants who are sole practitioners. ‘Where money is received in advance, it is not actually assessable for tax until it has actually been earned. Exempt Income This is income which is not included in a taxpayer's assessable income. However, it must be disclosed in a tax return. Exempt income includes: education allowances, scholarships, etc. export sales of certain ‘qualifying goods’, i.e. which qualify for tax exemption certain government pensions income of religious institutions, hospitals and charitable bodies Payments made from exempt income may, however, be taxable (8.44). It should be noted that income from illegal sources is also included as income for tax purposes. Tax Rebates and Credits ‘A tax rebate is a tax allowance which is deducted from a person’s tax liability in order to arrive at his final (net) tax liability. It is an amount which is deducted from tax payable to arrive at the net ‘tax payable figure. A tax credit, like a rebate, is a deduction from tax payable. Tax eredits are given for taxes already paid or payable The amount of a rebate or credit can never exceed the tax otherwise payable. In some cases credits may give rise to a refund. Non Allowable Deductions: Capital expenditure: expenditure of a capital nature (eg. extension to premises, or purchase of machinery) even though incurred in the course of producing assessable income, is not deductible under the Income Tax Act. However, depreciation is allowable on assets used in the production of assessable income. Losses and outgoings ‘not incurred’: Certain expenditure, eg. provisions made in the company’s accounts for expected future liabilities, or bad debts, are not allowable as a deduction for tax purposes. When such future liabilities are discharged and payment is made or a bad debt written off in the case of a provision for bad debts, a tax deduction is allowed. CPA Taxation: Introduetion page 5Losses and outgoings of a private or domestic nature: Expenditure on the day to day necessities of life is not allowable for tax purposes. Thus items such as purchases of food, medical expenses, life insurance are not allowable deductions. This may also include expenditure to earn income; eg. expenditure incurred in travelling to work, or childminding to enable a mother to eam income is a private or domestic expense. It should be noted this restriction would not generally apply to companies as such expenditure would not be private or domestic from the ‘company’s perspective. However, the payment of private expenses of employees may give rise to a taxable benefit for the employee. Expenses incurred in changing jobs, clothing expenses, ‘wages paid to domestic servants, etc are also not allowable deductions. Similarly, expenses or losses incurred in deriving exempt income are not deductible. Allowable Deductions It is not necessary that the purpose of expenditure be the production of assessable income. But it should be necessarily incurred in carrying on a business. The Income Tax Act looks at the scope of the operations and activity and requires that the expenditure or loss in question was relevant or connected to the production of assessable income, Thus a deduction will be allowed for business takings lost through robbery on the way to the bank, or certain legal costs and advertising expenses incurred refuting allegations of dishonest business practices. The robbery example illustrates an ‘indirect’ expense but one that exists as a connected and relevant part of conducting a daily business undertaking. Expenditure is also allowed as a deduction in the particular year it was incurred, although it may not produce income until a future year. Evidence of Expenditure Before a deduction is allowable, a liability for the actual expenditure must have been incurred. That is, the amount must have been paid, or the taxpayer is under a legal obligation to pay the amount. There must be proof, and it is only allowable in the tax year in which it occurred. Therefore, proper records or proof are very important. There is a tendency for some accountants and taxpayers to expect the IRC to accept the amounts of deductible expenditures without proper documentation. However, a taxpayer must produce supporting documents if asked to do so. The ‘onus of proof” is on the shoulders of the taxpayer. The Income Tax Act ($.364) requires business records to be kept for seven years. It is permissible to keep such records electronically. Papua New Guinea Resident and Non Resident The distinction between a Papua New Guinea resident and a non resident is important for tax purposes because residents are taxed on their world wide income, whereas non residents are taxed only on their Papua New Guinea sourced income. In addition, non residents are taxed at different rates, Residence for income tax purposes has a particular meaning, different from residence for citizenship purposes. A non citizen can be a resident for tax purposes. Basically, an individual is resident for tax purposes if the person has lived (or intends to live) permanently, or who has lived for a considerable time (or intends to) in this country. CPA Taxation: Introduction page 6Normally, a person who has lived for at least 6 months (more than 183 days) can claim, for tax purposes, to be a resident, of the country (S.4(1)). A resident company is one that has been incorporated in Papua New Guinea, or one which, though not incorporated here, carries on business here and has either its central management and, control here or the majority of the shareholders who control the company are resident here. In the following unit we shall consider residence in greater detail. Taxation Clearance for Money Remitted Overseas Amounts of money exceeding K200,000 can be remitted overseas provided a tax clearance certificate has been obtained, certifying that no taxes are outstanding and all tax requirements to date have been met. This may be obtained from the IRC. Following the two rounds of liberalisation of exchange control in June 2005 and September 2007, there are fewer circumstances in which it is required for a persons or companies to obtain Bank of Papua New Guinea authority to remit funds outside the country. Capital and Income Ifa receipt is of a capital nature it will not, under normal circumstances be taxable, because itis, not a receipt of income, Receipts from capital, normally referred to as ‘capital gains’ are taxable in many countries, including Australia, and the introduction of capital gains tax in Papua New Guinea is always a possibility. The distinction between income and capital is obviously important because income receipts are taxable, but capital gains are not. Examples of capital gains are: «sale of private property (unless purchased with the intention of resale at a profit) ‘sale of a private car (unless purchased with the intention of resale at a profit) ‘© sale of shares(unless purchased with the intention of resale at a profit) Other gains, sometimes known as ‘windfall gains’ are similar to capital gains because they are not treated as income and therefore are not taxable, Examples include: * lottery win © betting win by punter # gifts from one person to another CPA Taxation: Introduction ~page7Receipts of income normally have an element of ‘periodicity, recurrence and regularity’, ie, normally recur on a regular basis, and are as a result of one’s work, business or investment. Capital gains are usually a once only receipt because of some entitlement. A worker's wage is clearly income and therefore assessable for income tax. Any surplus or profit the same person makes on the sale of a house is of a capital nature and therefore not assessable (taxable). But ‘hat if the person buys and sells a house every year? There are two guidelines for deciding whether a receipt is income or capital: 1. What was the intention of the taxpayer? 2. How often did he conduct the same transaction? If the capital, in this case a house, was bought for resale (.e. to make a profit), then the proceeds ‘would be assessable for income tax. A once and for all sale of capital would normally not be assessable, but if repeated might be assessable. A betting win by a punter would normally not be taxable, But if the punter was a professional punter, ie. was fully occupied in studying racehorses, and derived all his income from betting, then money from a betting win would be taxable. Similarly a gift is normally not taxable. But tips to waiters or taxi drivers are taxable because they are considered part of such persons’ income in return for service rendered. Waiters, for example, often receive very low wages in some countries, because it is expected they will receive much of their income as tips from customers, In the following unit we shall consider the distinction between capital and ineome, with the assistance of case law, in greater detail. Financial Year The financial year, or ‘year of income’ for tax purposes runs from | January to 31 December (S.4(1)). The Income Tax Act does allow the Commissioner General of Internal Revenue, at his discretion, to allow an alternative year in limited circumstances (S.12A). Permission may be given to a company whose overseas parent company has a different year end. For example, an Australian subsidiary company may be allowed to use the Australian financial year from July I to June 30. Reporting Currency (8.14) The currency used in tax returns should be kina, However, permission may be sought to use a ifferent reporting currency. For example, most tax returns submitted by petroleum production companies and some mining companies operating in Papua New Guinea are in US dollars. The accounts of these companies are in most cases in US dollars because most of the income earned and expenditure incurred by these companies is in US dollars. (CPA Taxation: Introduction page 8Internal Revenue Commission (IRC) The IRC is responsible for administering the income tax system, as well as indirect taxes — goods and services tax, and customs and excise taxes, The Commissioner General (Commissioner) heads the IRC. Previously the Papua New Guinea Taxation Office was responsible for income tax, and the Bureau of Customs and Excise was responsible for indirect tax. There are office branches of the IRC in all major towns. But, with the exception of Lae, they deal only with GST, and customs and excise tax. The main office is situated in Port Moresby in Champion Parade, and its address is: Intemal Revenue Commission P.O. Box 777 Port Moresby Telephone Number: 322 6600 Fax Number: 321 4249 ‘The Income Tax Act lays down that officers of the IRC must not reveal information submitted by taxpayers in their tax returns (S.9). Also, they must not assist tax payers to prepare their tax retum [S.10(2)]. How Taxable Income is Determined A Papua New Guinea resident's taxable income is calculated as follows: Gross income from all sources Less: exempt income (if any) = Assessable income Less allowable deductions = Taxable income Tax payable will depend on the tax rate applied, less tax rebates or credits, if any. Gross income includes all types of income, such as income from employment, from running a business and/or from other sources. Example Kina Gross income 20,000 Exempt income 2,000 Allowable deductions 10,000 ‘Tax rebate 50 Rate of tax (for companies) 30% CPA Taxation: Introduction page 9Calculation of taxable income and tax payable: Kina Gross income 20,000 Less: exempt income 2.000 Assessable income 18,000 Less: allowable deductions 10,000 Taxable income 8,000 Tax payable 8,000 x 30% 2,400 Less: tax rebate 50 Net tax payable: 2,350 CPA Taxation: Introduction =page 10