HI6028 — Taxation Theory, Practice and LawInteractive Tutorial Questions – Week 3 Trimester1-2021Week 3Tutorial Question 1Discuss whether the below are categorized into Ordinary Income or not?• salary and a performance bonus received by an employee,• a tip received by a waiter,• Interest derived from a bank deposit,• rent received from an investment property,• a gift received under a will of a deceased relative,• Qantas frequent flyer points received by an accountant employed by a large charteredaccounting firm in relation to work related travel paid for by the firm,• a gift received from a close friend who was a former employer,• proceeds received from the sale of the goodwill of a restaurant business,• proceeds from the sale of trading stock (e.g., food sold by a supermarket),• a payment made by an employer to a former employee in consideration of theemployee agreeing not to sue the employer for wrongful dismissal,• a cash prize received by a competitor on a quiz show,• profit from the sale of shares by an insurance company.Suggested AnswerA taxpayer’s assessable income will include any ‘ordinary income’ as per s 6-5ITAA97. However, ordinary income is not defined within the legislation.Principles established through case law, help determine whether an amount isordinary income. The following will outline any principles or cases that wouldapply in determining whether each transaction is ordinary income as per s 6-5.Salary and a performance bonus received by an employee: The salary would be ordinaryincome as it is income from personal exertion, a reward for skills and regular or recurrent innature. The performance bonus would also be ordinary income for the same reasons.Additionally, s 15-2 ITAA97 would make the bonus statutory income as a bonus received inrespect of employment.A tip received by a waiter: The tip would be ordinary income as it is reward forskills and a ‘clearly recognised incident’ of the taxpayer’s employment, see Kellyv FC of T 85 ATC 4283. Additionally, s 15-2 ITAA97 would make the tip statutoryincome as a gratuity received in respect of employment.Interest derived from a bank deposit: Interest is generally considered to be theprice of money that is borrowed. Interest received is the return or compensationfor the use or retention by one person of a sum of money belonging to anotherperson. Interest derived from the bank would be considered to be a reward to thedepositor for foregoing the use of the money. The interest would be ordinaryincome as a regular or recurrent receipt from property, s 6-5 ITAA 97.Rent received from an investment property: Where property is leased to another,the price paid for the right to use the property is rent and is assessable income atcommon law. The rental income would be ordinary income as a periodic receiptin respect of property. See Adelaide Fruit and Produce Exchange Co Ltd v DFCof T (1932) 2 ATD 1.A gift received under a will of a deceased relative: A gift received under a willwould not be ordinary income as there is not a sufficient nexus with an earningactivity, so it would be a pure windfall gain. However, it should be noted that anyincome subsequently derived from the gift may be assessable income and thatspecial rules apply in relation to capital assets passed through a will.Qantas frequent flyer points received by an accountant employed by a largechartered accounting firm in relation to work-related travel paid for by the firm:The frequent flyer points would not be ordinary income as they are not periodicin nature and also are not money or money’s worth. Additionally, the pointswould not be income under s 15-2 ITAA97 in accordance with the case of Paynev FC of T 96 ATC 4407.A birthday gift received from a close friend who was a former employer: This giftis not likely to be ordinary income as it would be a one-off payment that did nothave the necessary connection to the person’s employment. This is inaccordance with the principle established in Scott v FC of T (1966) 117 CLR514, where the court held that ‘an unsolicited gift does not …. become part of theincome of the recipient merely because generosity was inspired by goodwill andthe goodwill can be traced to gratitude engendered by some service rendered.’So, it would need to be established that the gift did not have a connection to theservices performed by the recipient.Proceeds received from the sale of the goodwill of a restaurant business: Thiswould not be ordinary income as it would be taken to be the mere realisation of acapital asset of the business. The sale of goodwill would not be an ‘ordinaryincident’ of the business activities and would therefore be capital in nature.Proceeds from the sale of trading stock (e.g. food sold by a supermarket):Trading stock includes anything produced, manufactured or acquired that is heldfor the purpose of manufacture, sale or exchange in the ordinary course ofbusiness. The proceeds received from the sale of trading stock would beordinary income as it would be a regular or recurrent ‘ordinary incident’ of thebusiness activity. See FC of T v Wade (1951) 84 CLR 105.A payment made by an employer to a former employee in consideration of theemployee agreeing not to sue the employer for wrongful dismissal: This paymentis not likely to be ordinary income as it would be a one-off transaction without thenecessary nexus to assessable income because the employer is a formeremployer. Payments that restrict the rights of another party are generally foundto be capital in nature as they are a payment in consideration for giving up acapital asset, being a right (i.e. right to sue the employer).A reimbursement of an employee’s legal costs relating to an unfair dismissalcase paid by the employer: This would not be ordinary income under theprinciple established in FC of T v Rowe (1997) 187 CLR 266; 97 ATC 4317. Thecourt held that the payment was made in recognition of a wrong done to thetaxpayer and was not remuneration for any services performed.A cash prize received by a competitor on a quiz show: This would not beordinary income as it would not be periodic in nature and would be held to be amere windfall gain. There is no reward for services or exercise of skill. However,there may be circumstances where regular or recurrent appearances wouldconstitute assessable income. See Taxation Ruling IT167.Profit from the sale of shares by an insurance company: The profit on the sale ofthe shares by an insurance company is likely to be ordinary income as it wouldbe likely that the realisation of these types of investments would be an ordinaryincident of the taxpayer’s business activity. See Colonial Mutual Life AssuranceSociety Ltd v FC of T (1946) 73 CLR 604.Tutorial Question 2Why is it important to determine when income is derived? Explain the differencebetween the ‘cash’ and accruals basis of accounting.Assessable income must be attributed to a particular income year in order to calculate thetaxpayer’s taxable income for that period. For tax purposes, income is recognised in theperiod in which it is ‘derived’. By contrast, deductions are generally recognised in theperiod that they are ‘incurred’.In other words, it is important to determine when income is derived and when an outgoingis incurred as this enables the taxable income of a taxpayer to be determined for aparticular financial year.Taxpayers recognise income either on a cash basis or an accruals basis. These bases donot apply to deductions, which are recognised when ‘incurred’. Using the cash basis, ataxpayer derives income when cash or its equivalent is received. An amount is deemed tobe received by a taxpayer where it is applied or dealt with on the taxpayer’s behalf (e.g. anamount is paid directly to the taxpayer’s creditor) (s 6-5(4) ITAA97).By contrast, under the accruals method, income is derived when the right to receive theincome comes into being or, where a recoverable debt is created such that the person(creditor) is not obliged to take any further steps before becoming entitled to payment. Thisnormally occurs when the performance of the obligation which gives rise to the income iscomplete, e.g.:• when goods sold are delivered• when services have been performed, and• when rent or interest is due.(Henderson v FC of T 70 ATC 4016, Farnsworth v FC of T (1949) 78 CLR 504, FC of T vAustralian Gas Light Co & Anor 83 ATC 4800, Taxation Ruling TR 93/11, Taxation RulingTR 98/1)Which method is appropriate (based on case law) is dependent on the type of income thatis generated or the kind of income-earning activity that is involved. As a general rule, thecash basis method will be appropriate to determine income derived from employment andinvestments (by entities that are not financial institutions). The accruals basis method is, inmost cases, appropriate to determine business income derived from a trading ormanufacturing business. The correct method to determine the derivation of income byprofessionals such as lawyers, doctors or accountants may sometimes be contentious.Where these persons are paid for their personal services (in a manner similar toemployees), the cash method may be appropriate to account for their income, while forlarge professional practices it may be best to account on the accruals basis. Where therelevant amounts relate to income from advance payments derivation will depend onwhether the relevant services have been provided or whether a refund of the advancepayment may be required in the future. Where income is subject to genuine dispute, it maybe possible to defer derivation until the dispute is settled (BHP Billiton Petroleum (BassStrait) Pty Ltd & Anor v FC of T 2002 ATC 5169). For further guidance on this matter, youmay wish to refer to Taxation Ruling TR 98/1.
