CPA PROGRAM
AUSTRALIA TAXATION
FIFTH EDITION
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Published 2022 by John Wiley & Sons Australia, Ltd,
42 McDougall Street, Milton Qld 4064,
on behalf of CPA Australia Ltd,
ABN 64 008 392 452
Previously published as Introductory Taxation by BPP Learning Media Ltd
First edition published January 2019
Second edition published June 2019
Third edition published June 2020
Fourth edition published June 2021
Fourth edition revisions published November 2021
Fifth edition published April 2022
© 2010–2022 CPA Australia Ltd (ABN 64 008 392 452). All rights reserved. This material is owned or licensed by CPA
Australia and is protected under Australian and international law. Except for personal and educational use in the CPA
Program, this material may not be reproduced or used in any other manner whatsoever without the express written
permission of CPA Australia. All reproduction requests should be made in writing and addressed to: Legal, CPA Australia,
Level 20, 28 Freshwater Place, Southbank, VIC 3006, or legal@cpaaustralia.com.au.
Edited and designed by John Wiley & Sons Australia, Ltd.
Printed carbon neutral by Finsbury Green
ISBN 978 0 64 875148 9
Technical Editor
Nick Jinoh Park
Partner, Business Advisory for Crowe Australasia (Findex Group)
Authors
Dr Ken Devos
Rami Hanegbi
Stephen Marsden
Wes Obst
Associate Professor, Faculty of Business and Law, Swinburne University of Technology
Senior Lecturer, Faculty of Business and Law, Deakin University
Lecturer, School of Accountancy, Queensland University of Technology, Brisbane
Consultant
CPA Australia acknowledges the contribution of Suzannah Andrews, Tony Greco, Robert Gregory, Dianne Harvey,
Dean Matchett, Roger Timms, Denis Vinen and Robin Woellner to previous editions of this study guide.
Advisory panel
Joanna Roach
Ken Devos
Wes Obst
Anna Ronald
Matthew Wealands
Venkat Narayanan, CPA Australia
Seng Thiam Teh, CPA Australia
CPA Program team
Kathleen Anderson
David Baird
Shubala Barclay
Amelia Colman
Jeannette Dyet
Kate Glenister
Yani Gouw
Kristy Grady
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Mandy Herbet
Alex Huang
Elise Literski
Christel O’Connor
Alana Park
Rohit Singh
Shari Serjeant
Seng Thiam Teh
Tiffany Tan
Helen Willoughby
Joyce Wong
Emily Wu
Belinda Zohrab-McConnell
Luke Xu
ACKNOWLEDGEMENTS
MODULE 1
Figure 1.3: © Parliament of Australia; Figure 1.6: © Commonwealth of Australia; Figure 1.10 and
table 1.4: © Reproduced with the permission of the copyright owner, Accounting Professional & Ethical
Standards Board Limited APESB, Australia; Tables 1.1, 1.2, 1.3 and 1.5: © Tax Practitioners Board –
www.tpb.gov.au; Tables 1.6, 1.10, 1.11, 1.12 and 13, and example 1.14: © Australian Taxation Office
for the Commonwealth of Australia; Extract: © Parliament of Australia; Extracts: © Tax Practitioners
Board – www.tpb.gov.au; Extracts: © Reproduced with the permission of the copyright owner, Accounting
Professional & Ethical Standards Board Limited APESB, Australia; Extracts: © Sourced from the
Federal Register of Legislation. For the latest information on Australian Government law please go to
www.legislation.gov.au.
MODULE 2
Table 2.6, examples 2.1, 2.2, 2.3 and 2.4, and question 2.25: © Australian Taxation Office for the
Commonwealth of Australia; Example 2.13: Source: Adapted from ASIC MoneySmart, ‘Negative and
positive gearing’; Extracts: © Sourced from the Federal Register of Legislation. For the latest information
on Australian Government law please go to www.legislation.gov.au; Extracts: © Australian Taxation
Office for the Commonwealth of Australia.
MODULE 3
Tables 3.2, 3.3, 3.4, 3.6, 3.7 and 3.8, and example 3.20: © Sourced from the Federal Register of Legislation.
For the latest information on Australian Government law please go to www.legislation.gov.au; Table 3.5
and examples 3.18, 3.19 and 3.25: © Australian Taxation Office for the Commonwealth of Australia;
Extracts: © Sourced from the Federal Register of Legislation. For the latest information on Australian
Government law please go to www.legislation.gov.au.
MODULE 4
Figure 4.5 and tables 4.11, 4.12, 4.15, 4.16, 4.17 and 4.18: © Sourced from the Federal Register of
Legislation. For the latest information on Australian Government law please go to www.legislation.gov.au;
Figure 4.7: © Commonwealth of Australia, The Treasury; Tables 4.2, 4.5, 4.7, 4.8, 4.9, 4.13, 4.14a, 4.19,
4.20 and 4.21, and example 4.20: © Australian Taxation Office for the Commonwealth of Australia;
Table 4.14b: © Commonwealth of Australia; Extracts: © Australian Taxation Office for the Commonwealth of Australia; Extracts: © Sourced from the Federal Register of Legislation. For the latest
information on Australian Government law please go to www.legislation.gov.au.
MODULE 5
Figures 5.5 and 5.6: © Based on content from the Federal Register of Legislation. For the latest information
on Australian Government law please go to www.legislation.gov.au; Figure 5.7, tables 5.5 and 5.10,
and examples 5.8, 5.9, 5.10, 5.11, 5.12, 5.13, 5.14, 5.22 and 5.27: © Australian Taxation Office for the
Commonwealth of Australia; Extracts: © Based on content from the Federal Register of Legislation. For
the latest information on Australian Government law please go to www.legislation.gov.au; Extracts: ©
Australian Taxation Office for the Commonwealth of Australia.
MODULE 6
Figure 6.10 and table 6.8: © Australian Taxation Office for the Commonwealth of Australia;
Examples 6.14 and 6.15: © Sourced from the Federal Register of Legislation. For the latest information
on Australian Government law please go to www.legislation.gov.au; Extracts: © Sourced from the
Federal Register of Legislation. For the latest information on Australian Government law please go
to www.legislation.gov.au; Extracts: © Australian Taxation Office for the Commonwealth of Australia.
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ACKNOWLEDGEMENTS iii
These materials have been designed and prepared for the purpose of individual study and should not be
used as a substitute for professional advice. The materials are not, and are not intended to be, professional
advice. The materials may be updated and amended from time to time. Care has been taken in compiling
these materials, but they may not reflect the most recent developments and have been compiled to give
a general overview only. CPA Australia Ltd and John Wiley and Sons Australia Ltd and the author(s) of
the material expressly exclude themselves from any contractual, tortious or any other form of liability on
whatever basis to any person, whether a participant in this subject or not, for any loss or damage sustained
or for any consequence that may be thought to arise either directly or indirectly from reliance on statements
made in these materials.
Any opinions expressed in the study materials for this subject are those of the author(s) and
not necessarily those of their affiliated organisations, CPA Australia Ltd or its members.
As the supplier of third-party study guide materials to the publisher, CPA Australia is responsible for
the use of any materials for which the intellectual property is owned or controlled by a third party.
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iv ACKNOWLEDGEMENTS
BRIEF CONTENTS
Subject Outline xi
Module 1: The Legal, Ethical and Regulatory Fundamentals and Administration of the Tax System
Module 2: Principles of Taxable Income 73
Module 3: CGT Fundamentals 173
Module 4: Taxation of Individuals 223
Module 5: Taxation of Various Types of Entities other than Individuals 285
Module 6: GST and FBT Fundamentals 355
Glossary 423
Suggested Answers 431
Index 479
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1
CONTENTS
Subject Outline xi
MODULE 1
The Legal, Ethical and
Regulatory Fundamentals
and Administration of the
Tax System 1
Preview 2
Part A: Fundamentals of Australian tax
law and practitioner responsibilities 3
Introduction 3
1.1 Tax law environment 3
Overview of the Australian legal system 4
Power to raise taxes in Australia 4
Progress of taxation bills through
parliament 5
How the courts interpret taxation law 7
Taxation and administrative law 10
Accessing the law 11
1.2 Tax Practitioner Board and tax
practitioners 13
What is the TPB? 13
Tax agent 13
Business activity statement agent 15
Tax (financial) adviser 17
1.3 Ethical principles and behaviour 20
Standards of the APESB 20
What are ethics? 21
Ethical principles 22
APES 110 Code of Ethics for Professional
Accountants (including Independence
Standards) 22
APES 220 Taxation Services 24
Applying the conceptual framework to
identify ethical dilemmas 25
Facing ethical conflicts 25
Resolving ethical dilemmas 27
Steps for making a good decision 27
Ethical dilemma checklist 27
1.4 TPB Code of Professional
Conduct 28
Principles of the TPB Code of Professional
Conduct 28
Overlap between TPB Code and other
requirements 29
Summary 31
Part B: Administration of the tax system 33
Introduction 33
1.5 Income tax self-assessment 33
Income tax self-assessment 33
Requirements to lodge tax returns 34
Tax return lodgment requirements 35
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Assessments 35
Amended assessments 36
1.6 ATO guidance documents and rulings 37
The rulings system 37
Public rulings 38
Private rulings 39
ATO guidance documents other
than rulings 40
1.7 Tax audits 40
Why tax audits are needed 40
The audit process 40
ATO information gathering powers 41
1.8 Objections, reviews and appeals
(Part IVC TAA) 42
Objections (Division 3 of Part IVC TAA) 42
Reviews (Division 4 of Part IVC TAA) 46
Appeals (Division 5 of Part IVC TAA) 47
1.9 Tax reporting and payment obligations 49
Payment dates 49
PAYG withholding system 49
JobMaker hiring credit 50
Other key administrative changes resulting
from COVID-19 51
PAYG instalment system 51
Business activity statement 53
Instalment activity statement 53
Running balance account 53
1.10 Penalties and interest charges 53
Administrative civil penalties 54
Criminal penalties 60
General interest charge and shortfall
interest charge 60
1.11 Tax planning, avoidance and evasion 62
Distinguishing between terms 62
1.12 General anti-avoidance provisions 64
Part IVA of the Income Tax Assessment Act
1936 64
Purpose of the adviser 66
Discharge of duty to the client 66
What is the promoter penalty regime? 68
Operation of the scheme 68
Penalties 69
Exclusions and exceptions 69
Summary 70
Review 71
References 72
MODULE 2
Principles of Taxable
Income 73
Preview 73
Part A: Principles of Assessable Income
Introduction 75
75
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2.1
Residency and source 75
Test of residency for individuals 75
2.2 Test of residency for companies 79
Source of income 80
Assessable income 81
Ordinary income 81
Statutory income 93
Non-assessable income 95
Exempt income 95
Non-assessable non-exempt (NANE)
income 97
2.3 Derivation 97
Cash or accruals basis 97
Summary 100
Part B: Principles of General and Specific
Deductions 101
Introduction 101
2.4 Income tax deductions 101
General deductions 101
Specific deductions 107
Repairs 107
Bad debts 110
Tax losses of current and
previous years 111
Borrowing expenses 114
Other specifically deductible
expenses 115
2.5 Limitations to deductions 115
Four negative limbs of s. 8-1
of ITAA97 115
Entertainment expenses 120
Payments to related entities 121
Prepaid expenditure 121
Non-commercial loss rules 123
Thin capitalisation 125
2.6 Substantiation requirements for
individuals 126
Work expenses 126
Car expenses 126
Travel expenses 127
Evidence required 128
Retention of documents 129
Penalty tax 129
Summary 131
Part C: Capital Allowances 132
Introduction 132
2.7 Capital allowances 132
Capital allowances core concepts 132
Determining the capital allowance
amount 133
Capital allowances for non–small business
entities 135
Non-business depreciating asset of $300 or
less (ITAA97, s. 40-80(2)) 136
Low-value pool (ITAA97,
Subdivision 40-E) 136
Computer software 137
General rules and determining
effective life 138
Balancing adjustment
(Subdivision 40-D) 141
Temporary 100 per cent asset write-off for
business use 142
Blackhole expenditure 144
Project pool expenditure 145
Capital allowance rules and small
business entities 146
What is a small business entity? 146
Carrying on a business 147
Aggregated turnover test 148
Capital allowance rules for small
business entities 148
Small business asset pool 149
Blackhole expenditure and start-up
expenditure 150
Capital works 151
2.8 Trading stock core concepts 154
Definition of trading stock and whether
on hand 155
Accounting for trading stock 155
Valuation of trading stock 156
Disposal of trading stock 158
Trading stock concessions for small
business entities 159
2.9 International taxation core concepts 160
Treatment of foreign income, deductions
and offsets 160
Double taxation agreements and allocation
of taxing rights 162
Withholding tax regime 163
Transfer pricing regime 164
Conversion of foreign currency rules 165
Summary 168
Review 170
References 171
MODULE 3
CGT Fundamentals
173
Preview 174
3.1 CGT core concepts 175
What is capital gains tax? 175
CGT interaction with other taxes 176
Six-step process for determining CGT 177
CGT equation 177
Record keeping 177
3.2 CGT events 179
Overview of CGT events 179
Defined CGT events 179
Determining the CGT event 183
Specific CGT events 183
3.3 CGT assets 188
What is a CGT asset? 188
Collectables 189
Personal use assets 189
CONTENTS vii
Separate CGT assets 190
CGT treatment 191
3.4 Determining gain/loss from CGT event 192
How to calculate the gain/loss 192
Capital proceeds 193
Cost base 195
Indexed cost base 198
Reduced cost base 199
Determining exception or exemption 200
Main residence exemption 201
Amount of main residence exemption
available 202
Foreign residents and the main residence
exemption 205
CGT – exemption on granny flats 205
Rollover provisions and other reliefs 206
3.5 Calculating net capital gain/loss 212
Determining net capital loss 212
Determining net capital gain 212
Applying the CGT discount 213
CGT small business concessions 214
Review 220
References 220
MODULE 4
Taxation of Individuals
223
Preview 224
4.1 Individual taxation core concepts 224
Steps for calculating individual
taxation 224
The tax equation 225
4.2 Defining types of assessable income 225
Employee-related income 225
Tax treatment of minors 225
Remuneration for overseas services 229
Income derived from the sharing
economy 229
Income derived from dividends 229
Income derived from property 230
Income derived from trust investments 231
Income derived from trusts 231
Income derived from royalties 231
4.3 Employment termination payments,
personal services income and
employee share schemes 231
Employment termination payments 231
Personal services income 241
Division 83A employee share schemes 247
Capital gains tax relief for individuals 250
Taxing superannuation for individuals 253
4.4 Calculating allowable
deductions 259
Employee versus contractor test for
deductions 260
Employment-related expenditure 262
Negative gearing 263
Income protection/replacement 263
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viii CONTENTS
Tax-deductible superannuation
contributions 263
4.5 Applying tax offsets 264
Non-refundable tax offsets 264
Refundable tax offsets and tax credits 270
4.6 Calculating tax payable/
refundable 272
Tax on taxable income 272
Medicare levy 274
Medicare levy surcharge 275
Accumulated study and training
support loans 277
Review 282
References 283
MODULE 5
Taxation of Various Types of
Entities other than
Individuals 285
Preview 285
Part A: Taxation of various types of entities
other than individuals 287
Introduction 287
5.1 SBE concessions core concepts 288
Refresher on the definitions of SBE 288
Company tax rates 289
Refresher on trading stock and capital
allowance rules for SBEs 289
Refresher on CGT concessions
for SBEs 290
5.2 Calculating the small business income
tax offset 293
What is the small business income
tax offset? 293
Calculating net small business income for
the SBITO 293
Eligible income and deductions 293
5.3 Small business restructure rollover 294
What is the small business restructure
rollover? 294
Who can access the rollover? 295
Eligible assets 295
When is the rollover available? 295
Taxation implications of the rollover 296
5.4 Determining the net partnership
income/loss 297
Partnership taxation core concepts 297
Determining net partnership income
or loss 299
Partnership elections and tax
administration 300
5.5 Calculating a partner’s share of
tax payable 300
Non-commercial loss rules
(Division 35) 300
Impact of salaries paid to a
partnership 304
Impact of interest paid to partners 307
Impact of drawings made by partners 308
5.6 Alteration of a partner’s interest 308
Real and effective control of partnership
income 308
Alteration of a partner’s entitlement
to profit 309
General work in progress rule and general
CGT rule 310
Dissolution or reconstitution of a
partnership 310
Summary 313
Part B: Taxation of Trusts, Companies
and Superannuation Funds 315
Introduction 315
5.7 Taxation of trusts core concepts 315
Overview of trusts 315
Rules governing taxation of trust
income 316
5.8 About Division 6 and trust
administration requirements 317
Introducing Division 6 317
Taxation of trust income 318
Overview of deceased estates 319
Administration and reporting for trusts 321
5.9 Determining the net income of a trust 322
Seven-step process for determining net
income, how it is assessed and workflow
for determining net income 322
Trust loss provisions 325
5.10 Discrepancies and capital gains – trusts 325
Discrepancies in income and net
income 325
Capital gains included in trust income 327
5.11 About trust distributions 328
Overview of streaming 328
5.12 Family trusts 330
The test individual 330
Family group 330
Tax concessions for family trusts 330
Family trust distribution tax 330
Seeking expert advice 330
5.13 Company taxation 333
General company concepts 333
Company for taxation purposes 334
Public or private companies 334
Residency status of a company 335
Company tax rate 335
Calculating a company’s taxable
income 336
Gross-up and franking credit
tax offset 336
Tax administration 340
5.14 Dividend imputation system 340
Introducing the dividend imputation
system 340
Franking credit qualified person
requirements 341
Maximum franking credit 342
The benchmark rule 343
Anti-streaming rules 344
Franking account 345
5.15 Superannuation fund taxation 346
Entry: Contributions 347
Earnings 349
Exit: Retirement phase 350
Summary 351
Review 354
References 354
MODULE 6
GST and FBT
Fundamentals
355
Preview 355
Part A: GST Fundamentals 356
Introduction 356
6.1 GST core concepts 356
GST key terms 358
Indirect tax zone 359
Registration 359
Cancellation of GST registration 360
Tax invoices 361
6.2 GST supplies and taxable importations 362
Taxable supply 362
Special cases relating to supply 368
GST-free supply 371
Input-taxed supply 373
Taxable importations 376
6.3 Input tax credits 377
Creditable acquisition 377
Creditable importations 378
Special input tax credit rules 378
6.4 Attributing GST 380
GST attribution rules 380
GST reporting and payment period 380
Accounting for GST 380
Special attribution rules 383
6.5 Administration 384
Withholding GST on purchase of new
residential property 384
GST grouping provisions 385
Branches 385
Amalgamations 385
Anti-avoidance provisions 386
Summary 387
Part B: FBT Fundamentals 390
Introduction 390
6.6 FBT core concepts 390
Essential features of FBT 390
Definition of a fringe benefit 391
Allowances versus reimbursements 392
Types of fringe benefits 392
FBT: Administration 393
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CONTENTS ix
6.7
Calculating FBT 394
The gross-up formula 395
FBT-rebatable employers 399
6.8 Specific fringe benefits 400
Summary table of specific fringe benefits
and examples 400
6.9 FBT exemptions 410
Exempt fringe benefits 410
FBT-exempt employers 413
6.10 Salary packaging 414
What is salary sacrificing? 414
Does FBT apply to salary sacrificing? 416
Salary sacrificing superannuation 417
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6.11 Reportable fringe benefits 418
Exempt and excluded fringe benefits
Summary 420
Review 422
References 422
Glossary 423
Suggested Answers 431
Index 479
419
SUBJECT OUTLINE
INTRODUCTION
The purpose of this subject outline is to:
• provide important information to assist you in your studies
• define the aims, content and structure of the subject
• outline the learning materials and resources provided to support learning
• provide information about the exam and its structure.
The CPA Program is designed around five overarching learning objectives to produce future CPAs
who will be:
• technically skilled and solution driven
• strategic leaders and business partners in a global environment
• aware of the social impacts of accounting and business
• adaptable to change
• able to communicate and collaborate effectively.
BEFORE YOU BEGIN
Important Information
Please refer to the CPA Australia website for dates, fees, rules and regulations, and additional learning
support: www.cpaaustralia.com.au/cpaprogram.
SUBJECT DESCRIPTION
Australia Taxation
Australia Taxation is designed to provide you with an awareness of the key provisions of the relevant
taxation legislation and enable you to apply the relevant legislative concepts to determine taxation
consequences. It is important to consider the taxation impact on individuals, partnerships, companies,
trusts and superannuation funds.
SUBJECT OVERVIEW
General Objectives
On completion of this subject, you should be able to:
• understand the key administrative components of the Australian taxation system and the basic principles
of Australian income tax, fringe benefit tax and goods and services taxation legislation
• analyse, discuss and resolve issues relating to the determination of assessable income and allowable
deductions
• explain key taxation laws that relate to the taxation of individuals, companies, partnerships, trusts and
superannuation funds
• analyse transactions and circumstances and apply relevant taxation laws to determine tax liability.
The Australian Taxation subject reflects legislation in place as at 1 January 2022. Exam questions
will be based upon the 2021–22 tax year and the FBT year ending 31 March 2022.
STUDY GUIDE
Module Descriptions
The subject is divided into six modules. A brief outline of each module is provided below.
Module 1: The Legal, Ethical and Regulatory Fundamentals and Administration of the Tax System
This module provides an overview of many of the important fundamentals of the Australian tax system
and principles that apply to those working in the Australian tax field. The legal framework that the
Australian tax system operates in is described, including the relevant parts of the Australian Constitution,
the legislative process of creating tax laws and the judicial process for interpreting them. The ethical
environment relevant to those involved in the tax advice industry, including the more important principles
in the FASEA code of ethics for financial advisors and requirements under the Corporations Act are
explained. The roles and responsibilities of the Tax Practitioners Board (TPB) and a description of the
services offered by those registered by the TPB (tax agents, BAS agents and tax (financial) advisers) is
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SUBJECT OUTLINE xi
provided. In addition, the code of conduct which those registered by the TPB need to abide by is explained.
This module concludes with a description of the concepts of tax planning, avoidance and evasion. These
concepts are very important for tax professionals as they must act in their clients’ best interests and ensure
there is compliance with the relevant laws and obligations.The module also focuses on the administration
of the tax system and the interaction between taxpayers and the tax authority. The module covers the
process by which taxpayers are to operate under the self-assessment system that applies in Australia.
The ATO guidance documents and rulings available to assist taxpayers under the self-assessment system
are outlined, including public and private rulings, law companion guidelines, practice statements and
interpretative decisions. The module also focuses on the audit process that may follow the issue of an
assessment, the tax reporting and payment obligations of the taxpayers and penalties and interest charges
imposed on taxpayers who fail to comply with the law and meet their tax obligations.
Module 2: Principles of Taxable Income
This module introduces the key concepts of taxable income, including the principles of assessable income,
general and specific deductions and capital allowances. Assessable income of a taxpayer comprises both
ordinary income and statutory income except when these components are exempt income or otherwise
excluded from assessable income. This module discusses the concepts of residence, source and derivation,
which underpin the Australian income tax system. As ordinary income also includes income derived
from carrying on a business, the module also examines the criteria for determining whether a business
exists. This module then discusses s. 8-1 of ITAA97, which enables a deduction under one of the two
positive limbs, provided none of the four negative limbs apply. Specific deductions available under one
of the specific provisions outlined in ITAA97 for repairs, bad debts, tax losses and borrowing expenses
are explained. Next, circumstances where limitations of deductibility apply, specific exclusions and
record keeping requirements are reviewed. This module finally introduces the capital allowance regime
for taxpayers. These capital allowance rules, under Division 40 of ITAA97, allow taxpayers to claim a
deduction for the decline in value of depreciating assets based on the business use percentage of the asset
spread over its effective life using either the prime cost or diminishing value method. Also explained are the
capital allowance provisions, in which an SBE or another eligible entity can benefit from the temporary
full expensing measure or an immediate write-off of depreciating assets costing less than the relevant
thresholds. The module also explains how capital works deductions are calculated under Division 43
of ITAA97.
Module 3: CGT Fundamentals
This module introduces and reviews the capital gains tax (CGT) law provisions in the income tax
legislation. The module discusses the core CGT concepts, including an overview of what capital gains,
capital losses and CGT events entail. It then goes on to discuss CGT events in more detail. As many
of these CGT events involve a CGT asset of the taxpayer, the next part of this module explains what is
considered a CGT asset. This includes an examination of collectables and personal use assets, which are
subject to specific rules. This module explains how to calculate the capital gain or loss resulting from a CGT
event being triggered. Many of the CGT events utilise the concepts of capital proceeds, cost base, indexed
cost base and reduced cost base in determining the capital gain or loss, so these concepts are explained in
some detail. Next, when capital gains and losses are disregarded for CGT purposes is discussed. Lastly,
the module explains how to calculate the net capital gain/loss of the taxpayer and apply the CGT discount
and small business CGT concessions if applicable.
Module 4: Taxation of Individuals
This module begins with a brief outline of the steps used for calculating individual taxation and highlights
the importance of the tax equation. Next, particular types of assessable income are defined, including,
but not limited to, income relating to employees, minors, dividends, interest, property and royalties. This
module then discusses three particular income regimes: (1) the tax treatment of employment termination
payments, (2) personal services income (PSI) including the rules for determining whether a taxpayer is
conducting a personal service business (PSB) and (3) employee-share schemes (ESS) provisions. The
taxation of superannuation for individuals is illustrated, including the taxation of concessional and nonconcessional contributions, and the tax treatment of superannuation benefits. The module makes reference
to individual allowable deductions and various employment-related expenditure, negative gearing and
income protection. This module then examines the most common tax offsets and rebates available to
individuals. Finally, in calculating the tax payable for an individual, the tax rates for both residents and
non-residents are indicated along with the application of the tax-free threshold formula, the Medicare levy
and the Medicare levy surcharge.
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xii SUBJECT OUTLINE
Module 5: Taxation of Various Types of Entities other than Individuals
This module examines the core concepts of SBEs, partnerships, trusts, companies and superannuation
funds. The module revisits the definition of an SBE and the core income tax concessions that apply to
SBEs, such as the trading stock rules, capital allowances provisions and CGT small business concessions.
The small business income tax offset is also discussed, which reduces the tax paid by eligible sole traders
and SBEs. This module examines taxation of partnerships. As a partnership is not a separate legal entity,
it does not pay income tax in its own right. Instead, the net income of the partnership is distributed to the
partners in accordance with the profit sharing arrangements in the partnership agreement. This module also
discusses the taxation implications when a partnership derives a loss, pays salaries and interest to partners
and when partners take drawings. This module covers the taxation of trusts, including the different types
of trusts, and the parties involved in a trust structure. Next, the relevant provisions of Division 6 of ITAA36
are discussed, including its application to deceased estates. This is followed by an overview of the trust
streaming rules and a description of the rules and advantages of family trusts. An overview of the core
concepts relating to the taxation of companies is provided. This is followed with a description regarding
how companies are taxed. The dividend imputation system is discussed in detail. Some of the specifics of
the imputation system covered in this part include the circumstances in which shareholders are entitled to
franking credits, the maximum number of franking credits that companies can distribute, the benchmark
rule and some of the other aspects of the franking system. The final section of this module examines the
taxation laws relating to superannuation funds. This includes a discussion of the types of superannuation
contributions and their taxation treatment and the important principle that, in most instances, withdrawals
made by superannuation members of at least 60 years of age will be tax-free.
Module 6: GST and FBT Fundamentals
This module examines the principles of GST and FBT. This module covers the fundamentals of GST,
starting with a summary of the core concepts including the registration and tax invoice requirements. Also
discussed are the methods of accounting for GST (cash or accruals) that determine which period the liability
and input tax credit are attributed to. To simplify the reporting process, group entities can be treated as one
entity if they meet the requirements of the grouping provisions. Anti-avoidance provisions included in the
legislation to penalise taxpayers that undertake a scheme with a dominant purpose of artificially reducing
their GST liability or increasing input tax credits are discussed. The module then explains the core FBT
rules and how FBT liability is calculated. As an essential feature of the Australian FBT regime, FBT is
a tax that is payable by employers on certain non-salary/non-wages benefits that they provide to their
employees or their employees’ associates in respect of employment. For income tax purposes, the amount
of the FBT payable is generally tax deductible to the employer, as is the value of the benefit provided. The
module explains the specific fringe benefits, exempt fringe benefits and salary packaging. This module
also discusses employee’s reportable fringe benefits and specific fringe benefits which are not reported.
Module Weightings and Study Time Requirements
Total hours of study for this subject will vary depending on your prior knowledge and experience of the
course content, your individual learning pace and style, and the degree to which your work commitments
will allow you to work intensively or intermittently on the materials. You will need to work systematically
through the study guide, attempt all the questions, and revise the learning materials for the exam. The
workload for this subject is the equivalent of that for a one-semester postgraduate unit.
An estimated 15 hours of study per week through the semester will be required for an average candidate.
Additional time may be required for revision. The ‘Weighting’ column in the following table provides an
indication of the emphasis placed on each module in the exam, while the ‘Recommended proportion of
study time’ column is a guide for you to allocate your study time for each module.
Do not underestimate the amount of time it will take to complete the subject.
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SUBJECT OUTLINE xiii
TABLE 1
Module weightings and study time
Recommended
proportion of study time
(%)
Weighting
(%)
1. The legal, ethical and regulatory fundamentals and
administration of the tax system
15
15
2. Principles of taxable income
25
25
3. CGT fundamentals
15
15
4. Taxation of individuals
15
15
5. Taxation of various types of entities other than
individuals
15
15
6. GST and FBT fundamentals
15
15
Module
LEARNING MATERIALS
Module Structure
The study guide is your primary examinable resource and contains all the knowledge you need to learn and
apply to pass the exam. The Australia Taxation study guide includes a number of features to help support
your learning. These include the following.
Learning Objectives
A set of learning objectives is included for each module in the study guide. These objectives provide
a framework for the learning materials and identify the main focus of the module. The objectives also
describe what candidates should be able to do after completing the module.
Examples
Examples are included throughout the study materials to demonstrate how concepts are applied to realworld scenarios.
Questions (and Suggested Answers)
Questions provide you with an opportunity to assess your understanding of the key learning points. These
questions are an integral part of your study and should be fully utilised to support your learning of the
module content.
Key Points
The key points feature relates the content covered in the section to the module’s learning objectives.
Review
The review section places the module in context with other modules studied and summarises the main
points of the module.
References
The reference list details all sources cited in the study guide. You are not expected to follow up this
source material.
My Online Learning and your eBook
My Online Learning is CPA Australia’s online learning platform, which provides you with access to a
variety of resources to help you with your study.
You can access My Online Learning from the CPA Australia website: www.cpaaustralia.com.au/
myonlinelearning.
eBook
An interactive eBook version of the study guide will be available through My Online Learning. The eBook
contains the full study guide and features instructional media and interactive questions embedded at the
point of learning. The media content includes animations of key diagrams from the study guide and video
interviews with leading business practitioners.
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xiv SUBJECT OUTLINE
GENERAL EXAM INFORMATION
All information regarding the Australia Taxation exam can be found on My Online Learning.
The study guide is your central examinable resource. Where advised, relevant sections of the CPA
Australia Members’ Handbook and legislation are also examinable.
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SUBJECT OUTLINE xv
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MODULE 1
THE LEGAL, ETHICAL
AND REGULATORY
FUNDAMENTALS AND
ADMINISTRATION OF
THE TAX SYSTEM
LEARNING OBJECTIVES
After completing this module, you should be able to:
1.1 describe the Australian tax system and its regulatory framework
1.2 identify the potential ethical conflicts or dilemmas in a tax advisory context
1.3 apply the income tax and tax administration laws and the Australian Taxation Office guidance documents
associated with the Australian income tax assessment system
1.4 explain the difference between tax planning, tax avoidance and tax evasion
1.5 analyse situations where tax penalties and/or interest charges may apply
1.6 explain how the general anti-avoidance provisions of Part IVA operate.
LEGISLATION AND CODES
• A New Tax System (Goods and Services Tax) Act 1999 (Cwlth) (GST Act)
• Administrative Appeals Tribunal Act 1975 (Cwlth)
• APES 110 Code of Ethics for Professional Accountants (including Independence Standards)
• APES 220 Taxation Services
• Crimes Act 1914 (Cwlth)
• Criminal Code Act 1995 (Cwlth)
• Fringe Benefits Tax Assessment Act 1986 (Cwlth) (FBTAA)
• Higher Education Support Act 2003 (Cwlth)
• Income Tax Assessment Act 1936 (Cwlth) (ITAA36)
• Income Tax Assessment Act 1997 (Cwlth) (ITAA97)
• Superannuation Industry Supervision Act 1993 (Cwlth)
• Tax Administration (Payroll Tax) COVID-19 Exemption Scheme Determination (2020) (Cwlth)
• Taxation Administration Act 1953 (Cwlth) (TAA)
• Tax Practitioners Board (TPB) Code of Professional Conduct
• Trade Support Loans Act 2014 (Cwlth)
• Treasury Laws Amendment (A Tax Plan for the COVID-19 Economic Recovery) Act 2020 (Cwlth)
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PREVIEW
It is important for tax professionals to understand the tax law environment they operate in. Part A of this
module discusses the fundamentals of the Australian taxation law system, including an overview of the
relevant parliamentary and judicial powers and processes. It then examines the important legal and ethical
responsibilities of tax professionals.
The focus in Part B turns to some of the details of how the federal government administers the tax system
through the Australian Taxation Office. Part B also examines the difference between tax planning, tax
avoidance and tax evasion, and the operation of the general anti-avoidance provision in the tax legislation.
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2 Australia Taxation
PART A: FUNDAMENTALS OF AUSTRALIAN
TAX LAW AND PRACTITIONER
RESPONSIBILITIES
INTRODUCTION
Part A of this module discusses the legal, ethical and regulatory fundamentals of the Australian tax system.
The power to raise taxes is defined in the Australian Constitution. Generally, the federal government
has the power to raise taxes including income tax, fringe benefits tax (FBT) and goods and services tax
(GST). Taxation law is administrated by the Australian Taxation Office (ATO), and decisions regarding
disputes are made by the ATO or through the court system.
The Tax Practitioners Board (TPB) is responsible for the registration and regulation of tax agents,
business activity statement (BAS) agents and tax (financial) advisers across Australia. However, as of
1 January 2022, tax (financial) advisers who provide tax (financial) advice services for a fee will no
longer need to be registered under TPB as a tax (financial) advisor. Instead, the Financial Services and
Credit Panel within the Australian Securities and Investments Commission (ASIC) will be the sole body
overseeing such practitioners. Practitioners already registered with the TPB will be deemed to be registered
with ASIC until their TPB registration expires.
Persons offering tax services will often be members of one of the major professional accounting bodies
and thus subject to the ethical codes prescribed by the Accounting Professional and Ethical Standards
Board (APESB). These codes contain professional obligations and steps to make good ethical decisions in a
professional context. Tax professionals registered with the TPB are also subject to the TPB Code of Professional Conduct (TPB Code), which has standards that have a strong degree of overlap with those prescribed
by APESB.
1.1 TAX LAW ENVIRONMENT
It is essential to have a good knowledge of the legal obligations and rights of taxpayers in respect of the
imposition and collection of taxes under Australian law.
Understanding the source of taxation law in Australia (made by the federal government) and any major
legal principles is very important. These legal principles will also be used by the Administrative Appeals
Tribunal (AAT) and/or the federal court system when resolving disputes or questions of law in the area
of taxation.
Figure 1.1 gives an overview of the taxation law environment in Australia.
FIGURE 1.1
The taxation law environment
Taxation law
Federal law
ITAA36
ITAA97
Australian Constitution
Australian
Taxation Office (ATO)
Administrative Appeals
Tribunal (AAT)
Court system
Federal Court
High Court
Source: CPA Australia 2022.
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MODULE 1 The Legal, Ethical and Regulatory Fundamentals 3
OVERVIEW OF THE AUSTRALIAN LEGAL SYSTEM
Australia operates under a federal system of government. Power is shared between the federal government
and the various state governments under the division of powers. Of primary importance is the Australian
Constitution, which outlines the division of powers between the federal and the state governments. The
Australian Constitution gives the federal government the power to make laws regarding the collection
of income tax. The next section, ‘Power to raise taxes in Australia’, explains the power to raise taxes in
more detail.
The doctrine of the separation of powers is also important because it ensures that no one arm of
government holds all the power. Power is shared between the three separate arms of government: the
legislature (parliament), the judiciary and the executive. Under the separation of powers, the legislature
makes the law by passing legislation. The judiciary (the courts) applies the law to individual cases.
The executive, made up of government departments and executive authorities (of which the ATO is one),
is responsible for implementing the laws passed by the legislature.
There are federal statutes enacted by the parliament of Australia that apply to the whole of Australia, and
laws enacted by the self-governing parliaments of the Australian states and territories. Federal statutes and
subordinate legislation govern Australian taxation law, and the federal court system applies and interprets
this statute law.
Australian Constitution
The federal government has the power to make laws under the Australian Constitution. The chief items
included in the Australian Constitution are summarised as follows:
• the structure and operation of federal parliament
• the powers held by the federal government to create law
• the existence of the six Australian colonies at federation in 1901 and their recognition as states; it also
recognises the state constitutions and state laws as at 1901, and that they will remain in place unless
changed by later state or federal legislation
• the division of powers, which states how the federal and state parliaments share powers to create law
under the federal system, and the regulation of the power-sharing relationship
• the role of the executive arm of government, including the creation of federal executive authorities, such
as the ATO, and their powers
• the existence of representative democracy and an independent federal judiciary
• the creation and powers of the High Court of Australia
• the rules for amending the Constitution: it can only be amended if the change has the support of both
houses of federal parliament and then passes a referendum where it has been agreed to by a majority of
people in a majority of states.
The Australian Constitution can be easily accessed online at, for example, www.aph.gov.au/About_
Parliament/Senate/Powers_practice_n_procedures/Constitution.aspx.
POWER TO RAISE TAXES IN AUSTRALIA
As discussed in the section ‘Overview of the Australian legal system’ section, it is the Australian
Constitution that contains the power of the federal government to raise taxes. The relevant sections of
the constitution are presented and discussed here.
Section 51(ii)
Section 51(ii) of the Constitution is a general power to make laws in respect of taxation. This is a
concurrent power (i.e. shared between the federal and state governments) because the states or territories
may also make laws with respect to taxation, except for those powers reserved exclusively for the
Commonwealth (e.g. imposition of duties and customs and excise under s. 90). Where a state or territory
law conflicts with a law enacted by the Commonwealth, the Commonwealth law will prevail.
Although both the state and federal governments can in theory impose income taxes, for many decades
the arrangement has been that only the federal government does so.
Further, the federal government has coupled taxation with the power to ‘enact grants’ to the states or
territories under s. 96 of the Constitution (revenue power). This means the federal government collects the
tax, and then makes ‘grants’ to the state and territory governments of funds from income tax and GST, to
deliver services such as health and education.
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4 Australia Taxation
Section 114
Section 114 of the Constitution says of state powers:
A State shall not, without the consent of the Parliament of the Commonwealth, raise or maintain any naval
or military force, or impose any tax on property of any kind belonging to the Commonwealth, nor shall the
Commonwealth impose any tax on property of any kind belonging to a State.
The states or territories also (through their residual powers) raise taxes in their jurisdiction, such as
stamp duty, land tax and payroll tax. They also provide for municipal authorities (e.g. city councils) to
impose rates and levies for local services provided (e.g. a garbage collection service). These local councils
could be regarded as a third level of government, with their own very limited power to raise taxes.
Section 53
A taxation Bill imposes a tax and, under s. 53 of the Constitution, these particular Bills cannot originate
in, or be amended by, the Senate. They must originate in the House of Representatives. However, the
Senate may ask the House of Representatives to amend these Bills. This progress of taxation Bills through
parliament is discussed in more detail later in the module.
Sections 54 and 55
Under s. 54 of the Constitution, laws that appropriate revenues or monies for the ordinary, annual services
of the government can only deal with that appropriation.
Under s. 55 of the Constitution, laws imposing tax can only deal with the actual imposition of taxation.
Because of this, a form of assessment Act deals with assessment and collection of tax while a ratings
Act imposes that tax and determines the rate.
Figure 1.2 summarises the discussed Constitutional provisions that are relevant to the imposition
of taxation.
FIGURE 1.2
Constitutional provisions relating to the imposition of taxation
Section 51(ii) of the Constitution gives the
Commonwealth Government power to impose
taxation.
Subject to
s. 53, which
prevents tax
Bills from
originating in the
upper house
(Senate).
Subject to
s. 55, which
only allows
a law imposing
tax to deal with
imposing tax
and nothing
else.
States have residual taxation powers under the
Constitution.
Subject to
s. 114, which
prevents the
Commonwealth
from taxing the
property of the
States (and vice
versa).
States cannot
impose customs
duties and
excise, due to
s. 90 of the
Constitution.
Subject to
s. 114, which
disallows
the States
to tax the
property of the
Commonwealth.
Source: CPA Australia 2022.
Assessment Acts
There are two chief assessment Acts that govern the assessment and collection of income tax in Australia:
ITAA36 and ITAA97.
PROGRESS OF TAXATION BILLS THROUGH PARLIAMENT
A Bill is a proposed piece of legislation in draft form. It must go through a formal procedure for it to
become enacted as law. The seven steps are as follows.
1. Preparation of Bill. Proposals for tax legislation are considered by the prime minister and cabinet,
who initiate most proposed laws for debate in parliament. The Treasurer is the minister responsible
for arranging the preparation of Bills relating to raising revenue. The Office of Parliamentary Counsel
drafts the Bill in accordance with instructions from Treasury.
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MODULE 1 The Legal, Ethical and Regulatory Fundamentals 5
2. First reading. The Bill is introduced to the House of Representatives with a first reading, where the long
title is read out. Copies of the Bill and any explanatory memoranda are given to members of parliament and made publicly available. The Treasurer will then move that the Bill be read a second time.
3. Second reading. The second reading speech explains the purpose and principles of the Bill. The second
reading debate gives an opportunity for the opposition and other non-government members to speak
before voting on whether to agree to the Bill in principle. The Bill is then examined in detail, with the
opportunity for members to suggest amendments.
4. Third reading. The third reading is the final stage. If the Bill is likely to pass the House of
Representatives, then this is a mere formality. The second reading speech, any explanatory memoranda
and a record of any debate may provide assistance to the courts in determining the meaning or intention
of the Act (Acts Interpretation Act 1901 (Cwlth), s. 15AB).
5. Three readings in Senate. The Bill is then presented to the Senate, where it again has three readings.
However, the Senate has no power to amend the Bill, although it may request that the House of
Representatives make an amendment. If agreement cannot be reached with the House of
Representatives, the Bill is laid aside.
6. Royal Assent. If the Bill passes both houses, it is then presented to the Governor-General for Royal
Assent, at which time it becomes an Act of Parliament.
7. Commencement. An Act may specify the date of commencement but, if not, the default commencement
is the 28th day after receiving Assent.
Figure 1.3 illustrates the passage of Bills through parliament.
FIGURE 1.3
The legislative process
Draft Bill
House of
Representatives
Bill presented
Federation
Chamber
(Second debating
Chamber)
Second reading
(in principle debate)
Consideration
in detail
(amendments may
be made)
First reading
Possible reference to
Or
Second reading
(in principle debate)
House of
Representatives
Standing
Committee
Consideration in detail
(amendments may
be made)
Third reading
(amendments must be
agreed to by both Houses)
Senate
Similar process to
the House of
Representatives
Senate committee
may consider Bill
Governor-General
Assent
Law
Source: Parliament of Australia, ‘Infosheet 7 – Making laws’, accessed December 2021, www.aph.gov.au/about_parliament/
house_of_representatives/powers_practice_and_procedure/00_-_infosheets/infosheet_7_-_making_laws.
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6 Australia Taxation
Retrospective Taxation Law
It is not uncommon for taxation law to have retrospective operation. If a law doesn’t commence from the
date of the announcement, but from a stated date in the Act, which applies before the law receives Assent,
then it is said to apply retrospectively.
The Federal Budget is a good example of retrospective operation. The Federal Budget is delivered
on a specific date in May every year (although in 2020, due to the coronavirus (COVID-19) pandemic,
the Budget was not actually delivered until October 2020), and will include announcements that may be
‘effective from the date of the Budget’ but that have not yet been enacted in law.
The prospect of a taxpayer being subject to laws that were not in force at the time of a particular
transaction can be challenging. A common retrospective situation is legislation by public announcement,
whereby the federal government publishes a statement of intention to change a tax law with an effective
date of that notice. Such a situation can result in uncertainty about potential legislative change, for which
there is little guidance and that may not ever be passed by parliament when it is eventually drafted as a Bill.
For example, in the May 2017–18 Federal Budget it was announced that, for tax purposes, foreign
residents would no longer be able to claim the capital gains tax (CGT) Main Residence Exemption
(discussed in module 3). However, it was also announced that those non-residents who had held property
prior to 9 May 2017 would be able to utilise the exemption as long as they sold their property prior to
30 June 2019. The legislation that brought this into effect was not enacted until 12 December 2019. The
law enacted was broadly in line with the budget announcement, but had some modifications. One important
difference between the enacted law and budget announcement was that property purchased prior to
9 May 2017 could be exempt if sold by foreign residents prior to 30 June 2020 (rather than the originally
announced date for sales prior to 30 June 2019).
The government announced during the 2020–21 budget on 6 October 2020, in response to the economic
impact of the COVID-19 pandemic, that eligible assets can be fully expensed immediately as opposed
to being depreciated over time (see module 2). Although the relevant legislation that enacted these
changes did not receive Royal Assent until 14 October 2020, this final enacted legislation stated that the
measures were to retrospectively apply from the date of the announcement of the package, 6 October 2020,
notwithstanding that the legislation came into force eight days after this.
How to Amend Taxation Law
Governments may invite public discussion on taxation policy through bodies such as the Board of Taxation.
This provides opportunities for stakeholders, including professional associations such as CPA Australia,
to make submissions about policy. In later stages, Treasury — which is responsible for tax policy for the
federal government — may invite public submissions in response to draft legislation dealing with issues
that are complex and may have unintended consequences. This process ensures that the potential impact
of proposed legislation can be considered long before the legislation is enacted.
Practically, this is the model by which Australia operates where most law is now made by parliament
through legislation, or the executive through subordinate legislation. This is the case in relation to the
creation and interpretation of taxation law.
HOW THE COURTS INTERPRET TAXATION LAW
Legislation is now the primary source of new law in Australia, but it does not automatically override
common law (though it will in circumstances where it shows a clear intention to do so).
Generally, taxation case law falls under one of two categories. The first category of cases involves
determining common law tax concepts, such as what constitutes ordinary income (see module 2), The
second category involves issues of interpreting the relevant statutes so that affected groups, including tax
advisers and tax officials, can apply the law efficiently and correctly.
Common Law Tax Concepts
There are some established common law concepts in tax law that continue to evolve through case law. The
most important of these is case law that determines what constitutes ordinary income. As will be discussed
in module 2, ordinary income is a type of assessable income, and is determined by which gains case law
regards as ordinary income. Another example concerns which individuals are regarded by common law as
being Australian residents for tax purposes (see module 2).
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MODULE 1 The Legal, Ethical and Regulatory Fundamentals 7
Statutory Interpretation
The second category of tax law cases relates to judges who are faced with the task of applying legislation
to the particular case heard before them. To apply the legislation, they must first interpret and understand
it. Problems occur when the judge has difficulty interpreting the statute.
There are a number of situations that might lead to a need for statutory interpretation.
• Ambiguity might be caused by an error in drafting, or words may have a dual meaning.
• Uncertainty may arise where the words of a statute are intended to apply to a range of factual situations
and the courts must decide whether the case before them falls into any of these situations.
• There may be unforeseeable developments.
• The legislation may use a broad term.
The courts can be reluctant to make significant changes to the interpretation of legislation since this
encroaches on the responsibility of parliament, which is better able to investigate new laws and their
potential effect on the community. This is a particular consideration in relation to taxation law. Parliament
is regarded as the body that (as long as it is acting within its Constitutional power) has the ultimate power
to make law, and also has the power to overrule case law.
Parliament Overriding Case Law
In Federal Commissioner of Taxation (FCT) v Payne (2001) HCA 3, the High Court held that a taxpayer’s
travel costs between two unrelated income earning activities were not deductible. However, the government
wished to allow such costs to be deductible in most circumstances. Subsequently, the Commonwealth
passed a law that enacted a new section,s. 25-100, into the legislation, which allowed such travel costs
to be generally deductible so long as the travel resulted in the taxpayer engaging in income-producing or
business activities, and the taxpayer did not reside at any one of the two workplaces. Although the High
Court is the most powerful court in Australia, the Commonwealth Government can make laws to overrule
High Court decisions as long as such laws are within the powers of the Australian Constitution.
Interpreting Legislation
An example of it being necessary for the courts to interpret legislation can be seen in FCT v Applegate
(1979) ATC 4307.
A ‘resident of Australia’ is defined in s. 6(1) of ITAA36 as including a person whose domicile is
Australia unless they have a ‘permanent place of abode’ in another country. This means that individuals
who retain their Australian domicile will remain tax residents while staying overseas unless they can satisfy
the Commissioner of Taxation (the Commissioner) that they have a permanent place of abode in that other
country for the tax year in question.
The Full Federal Court in FCT v Applegate was required to decide the meaning of the word ‘permanent’
in this context. A literal interpretation using the dictionary would mean a taxpayer would have to
abandon Australia forever. This would produce an absurd outcome because the individual would lose
their Australian domicile and the ‘domicile test’ in s. 6(1) would not be necessary in the first place. The
court looked to the purpose of the legislation and held that ‘permanent’ does not mean everlasting in this
context, but requires an enduring association with the place of abode that is more than temporary for the
year in question.
Federal Court System
The High Court of Australia has the sole judicial authority to interpret the provisions of the Australian
Constitution, including the operation of the various powers of the federal government to create law.
It is the ultimate court of appeal, meaning that its judgment is final and conclusive. Appeal to the High
Court from lower courts is by special leave. The granting of special leave depends on the seriousness of the
issue being considered, and whether it has national significance. Special leave is not commonly granted.
Appeals concerning taxation would stem from decisions at the Federal Court. The Federal Court is created
under a parliamentary power and can only hear matters dictated by parliament.
Questions of law concerning taxation usually originate before a single judge of the Federal Court. They
may also arise on appeal from a federal tribunal such as the AAT. There is also a right of appeal to the Full
Federal Court where a majority decision will prevail. Where the case is heard before a single judge of the
High Court there may, under certain circumstances, be an appeal to the full bench of the High Court.
Figure 1.4 illustrates the Australian federal court system.
As will be referred to later, in the section ‘Reading a taxation law case’, a court’s reason for its decision is
known as the ‘ratio decidendi’ of the case (commonly referred to as ‘ratio’). The principle of the ‘doctrine
of precedent’ means that courts are bound by the ratio of courts higher in the court hierarchy (illustrated
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8 Australia Taxation
in figure 1.4). For instance, if the High Court previously decided that a taxpayer in a certain situation was
allowed a certain deduction under the legislation, and a case with very similar relevant facts (involving a
different taxpayer) comes before the Full Federal Court, the latter court is obliged to arrive at a similar
decision. Although courts are not bound by the ratio of earlier decisions of courts that are not higher in
the court hierarchy, they are still persuaded by such decisions. The degree of persuasiveness is stronger
where a previous decision has been made by a court of the same level as compared to a decision by a lower
level court.
FIGURE 1.4
Australian federal court system
High Court of Australia
Appeal by special leave
Full Court of Federal Court
Full bench
majority decision
Federal Court
Appeals
from AAT
on questions
of law only
Direct appeal
of certain
Commonwealth
administrative
decisions
Non-judicial
administration
Source: CPA Australia 2022.
Sometimes courts might make statements in their decision that are not essential to the decision but
are made in passing. These statements are known as ‘obiter dictum’. An example of this would be a
taxpayer claiming a deduction, the court stating the expense is deductible and stating why (ratio), but then
commenting that the expense would not be deductible had the facts been different in certain ways (obiter).
Statements that constitute obiter are persuasive rather than binding on later court decisions. Figure 1.5
illustrates when a prior decision is binding and when it is persuasive.
Example 1.1 provides a brief summary of a legal case to illustrate the difference between ratio and obiter.
EXAMPLE 1.1
Ratio and Obiter
When the case of Stone v Federal Commissioner of Taxation (2002) FCA 1492 appeared before the
Federal Court, one of the issues that Justice Hill had to decide was whether certain grants received by a
professional sportsperson were assessable income. Justice Hill found that the taxpayer was, due to their
sporting and related activities, carrying on a business, and so the grants were assessable. Justice Hill
then went on to consider if the taxpayer had not been found to be carrying on a business, whether such
grants would still have been assessable. Justice Hill stated that one of the types of grants received by
the taxpayer would still have been assessable under such an assumption, whereas the other two types of
grants received would not have been assessable had the taxpayer not been carrying on a business. Think
about what parts of the above would be regarded as ratio, and what would be regarded as obiter.
The ratio in this decision could be considered the finding that such a taxpayer is carrying on a business
and that the grants are assessable, since this applied the law to the actual facts of the case. The comments
regarding the assessability of grant income had the taxpayer not been carrying on a business are an
example of obiter, since they are ‘by the way’ comments not based on the actual findings of the case.
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MODULE 1 The Legal, Ethical and Regulatory Fundamentals 9
FIGURE 1.5
When prior decisions are binding
Prior decision will be persuasive rather than binding.
Prior
decision
from
higher
courts?
No
How persuasive it is will depend on factors including whether:
• the prior decision was from a court of the same level in the court
hierarchy (in which case it is relatively more persuasive), or from a court
lower in the hierarchy (the lower the court of the earlier decision, the less
relatively persuasion its prior decision will have)
• the prior decision was ratio (relatively more persuasive) or obiter
(relatively less persuasive).
Yes
Prior
decision
is ratio
rather
than
obiter?
No
The prior decision will be persuasive rather than binding.
Yes
Prior decision is binding
Source: CPA Australia 2022.
TAXATION AND ADMINISTRATIVE LAW
The ATO is responsible for collecting revenue for the federal government and is part of the federal
Treasurer’s portfolio.
The ATO administers legislation for taxes, superannuation and excise under supervision of the
Commissioner, who in turn is appointed by the Governor-General.
The Commissioner is granted general powers of administration under s. 8 of ITAA36 and may delegate
authority to tax officers (e.g. for the purpose of conducting audits and investigations — see section ‘Tax
audits’ in Part B of this module).
A particularly relevant area for tax agents and advisers concerns disputes about the assessment
process — this is discussed in more detail in Part B of this module under ‘Objections, reviews and appeals’.
Taxation decisions (known as ‘objection decisions’) are reviewable or appealable or both under
Part IVC of the Taxation Administration Act 1953 (TAA). The taxpayer can seek a review or appeal (as
appropriate) by either applying to the AAT or appealing to the Federal Court.
The Commissioner has quasi-judicial powers such as the ability to impose administrative penalties.
Guidance on the Commissioner’s views as set out in ATO-issued tax rulings may be regarded as de facto
law where taxpayers choose not to object or litigate but rather arrange their affairs in accordance with this
view. Tax rulings are discussed in Part B of this module under ‘ATO guidance documents and rulings’.
Similarly, the AAT has quasi-judicial powers by hearing disputes that become binding on those parties,
although it is not a court and is not bound by its own precedent. However, the AAT is a tribunal so it has
no powers of judicial review. The taxpayer has a right to appeal to the Federal Court on a question of law
(see later discussion in ‘Objections, reviews and appeals’ in Part B of this module).
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10 Australia Taxation
Commonwealth Ombudsman
The Commonwealth Ombudsman is appointed by the Governor-General as an independent person with
wide powers to investigate complaints about certain government departments and agencies (including the
ATO). A report may be made concerning the relevant agency if an informal view or recommendation is
not acted on. However, the ombudsman is usually a last resort because they cannot overturn or remake a
taxation review or decision; they can merely make a written decision about a complaint about the agency.
As far as tax matters are concerned, the ombudsman will only deal with matters that involve public officials
alleging wrongdoings in the public sector (such as corruption and abuse of power). For most administrative
tax matters, the relevant body to contact is the Inspector-General of Taxation.
Further details about the Commonwealth Ombudsman can be accessed at www.ombudsman.gov.au.
Inspector-General of Taxation
The Inspector-General of Taxation (IGT) is a statutory body, formed under the Inspector-General of
Taxation Act 2003 (Cwlth). It is independent from both the ATO and the TPB. Its roles are as follows.
• To investigate complaints about the administrative actions of the ATO and TPB. Such administrative
complaints involve matters concerning the fairness and reasonableness of the ATO or TPB in their dealings with people (which would include the fairness and reasonableness of their policies and procedures).
Examples of administrative complaints include complaints about the timeliness of responses from
either of these bodies, the conduct of the officers of these bodies, or whether the ATO has considered
all the relevant information in an audit. Administrative complaints do not include ones concerning a
disagreement about the presence of a tax liability or the amount of tax payable.
• To improve the administration of the tax system for all taxpayers by carrying out broad reviews, leading
to recommendations made to the ATO, TPB and the government. This is, at times, linked to the first
role, in that the IGT, using an analysis of complaints data, can undertake a review on an issue relating
to tax administration, which can contribute to improvements in the tax system.
Further details about the IGT can be accessed at www.igt.gov.au.
ACCESSING THE LAW
In Australia, all federal and state legislation, subordinate legislation in the form of regulations, and all
reserved judgments are available freely and publicly through a variety of law databases, both online and
in physical libraries.
The most comprehensive Australian database is the Australasian Legal Information Institute
(AustLII), a free online legal database, which can be accessed at www.austlii.edu.au. AustLII is published
by the law faculties of two major Australian universities and is the primary source of both Australian law
and links to the world’s legal resources. All Australian taxation legislation is available on the AustLII
database. All taxation decisions of the AAT and the Federal Court are also available on the AustLII
database. Using their web page you can search for any Australian federal government or state government
legislation or case, or browse through the various listed databases.
ATO Website
The ATO website is a very important and authoritative source of correct information on taxation law
in Australia.
Access the ATO website at www.ato.gov.au. The search function is excellent, and the best way to find
information is to search the area or term you are looking for, and then use the results to access relevant
fact pages and information sheets.
The ATO Legal Database is published by the ATO and available at www.ato.gov.au/law. This database
provides access to much of the material the ATO uses when making decisions. This includes tax legislation
and related material, public rulings, tax-related case law, ATO interpretative decisions and taxpayer alerts.
To use the database, select from the document links or use the search function.
Reading a Taxation Law Case
Each case heard by a judge contains a judgment and a decision. These are delivered orally by the judge
in a closed or open court. All judgments follow the same format. This is the same for all civil law cases,
including taxation cases heard in the AAT or the Federal Court.
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MODULE 1 The Legal, Ethical and Regulatory Fundamentals 11
We can use the example of a well-known AAT decision, Robyn Frances Murtagh and Commissioner
of Taxation (1984) AATA 249, to demonstrate how to read an AAT judgment. This judgment contains
the following.
• Case citation. The case has a title and citation in the form of Robyn Frances Murtagh and Commissioner
of Taxation (1984) AATA 249. This denotes the claimant (Robyn Frances Murtagh) versus the
defendant (Commissioner of Taxation), the year the decision was made (1984), the tribunal hearing
the case (Administrative Appeals Tribunal of Australia) and the page where it appears (249).
• Court. The court states whether this is the first time the case has been heard (original jurisdiction) or if
it is an appeal, and if so, from which court or tribunal (e.g. from the AAT in a Federal Court judgment).
• Catchwords and the precedents used to inform the decision.
• Actual judgment (the order and the decision). The actual judgment appears about halfway into the report.
The judgment contains two important elements, which we have already referred to in the section ‘Federal
court system’.
(a) Ratio decidendi. This is Latin for ‘the reason for the decision’, and it is the ratio decidendi that
may create a precedent for the future. This key element of the judgment can sometimes be difficult
to determine when reading a decision. Helpful tips are to separate the important facts from the
unimportant ones, determining what precedents were applied in the decision, cross-checking against
the points made in the catchwords and precedent listing, and reading the judgment with later
decisions that cite that judgment.
(b) Obiter dictum. This is Latin for ‘sayings by the way’. These are additional observations on the
case itself that, although made by the judge, are not directly relevant to the judge’s decision. They,
therefore, carry less weight than the ratio decidendi and are not binding as precedents.
Figure 1.6 shows the beginning of the AAT judgment of Robyn Frances Murtagh and Commissioner.
FIGURE 1.6
First page of case of Robyn Frances Murtagh and Commissioner of Taxation
Re Robyn Frances Murtagh and Commissioner of Taxation [1984]
AATA 249 (5 July 1984)
Case Citation
ADMINISTRATIVE APPEALS TRIBUNAL
Re:
And:
ROBYN FRANCES MURTAGH
Parties which the
Case involves
COMMISSIONER OF TAXATION
No.V.83/236
Freedom of Information
COURT
ADMINISTRATIVE APPEALS TRIBUNAL
Court
GENERAL ADMINISTRATIVE DIVISION
Mr Justice J.D. Davies (President)
Sir Ernest Coates (Member)
Names of those
deciding the Case
Mr R.A. Sinclair (Member)
CATCHWORDS
Freedom of Information - refusal of access to documents relating to taxation
return - documents claimed to be exempt - partnership loss claimed as
deduction - appeal to Taxation Board of Review Jurisdiction - whether Tribunal
can consider documents born after request for access
Beginning of the
Catchwords
Source: © Commonwealth of Australia, Administrative Appeals Tribunal. Robyn Frances Murtagh and Commissioner of Taxation
[1984] AATA 249 (5 July 1984). Screenshot taken from the AustLII website (www.austlii.edu.au).
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12 Australia Taxation
1.2 TAX PRACTITIONER BOARD AND
TAX PRACTITIONERS
WHAT IS THE TPB?
The TPB is responsible for the registration and regulation of tax agents, BAS agents and tax (financial)
advisers across Australia; however, from 1 January 2022 tax (financial) advisers will no longer be
registered and overseen by the TPB. These three types of registered entities are collectively referred to
as ‘tax practitioners’.
The TPB is responsible for ensuring compliance with the Tax Agent Services Act 2009 (TASA), which is
the legislation that governs tax practitioner registration. The TPB is also responsible for compliance with
the TPB Code. The TPB Code is discussed in the section ‘TPB Code of Professional Conduct’.
The TPB has the following responsibilities:
• administering a system to register tax practitioners, ensuring they have the necessary competence and
personal attributes
• providing guidelines and information on relevant matters
• investigating conduct that may breach the TASA, including non-compliance with the [TPB] Code, and
breaches of the civil penalty provisions
• imposing administrative sanctions for non-compliance with the Code
• applying to the Federal Court in relation to contraventions of the civil penalty provisions in the TASA
(TPB 2022a).
Figure 1.7 summarises the environment in which the TPB operates.
FIGURE 1.7
TPB
Tax Practitioners Board (TPB)
Code of
Professional Conduct
Types of
tax practitioner
Link to
Corporations Act
Tax agent
Tax (financial)
adviser (prior to
1 January 2022)
BAS agent
Source: CPA Australia 2022.
TAX AGENT
Any individual (or partnership) who provides tax agent services for a fee or other reward must be registered
with the TPB.
Under TAA, taxpayers using a registered tax agent may not be liable to some administrative
penalties imposed by the ATO.
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MODULE 1 The Legal, Ethical and Regulatory Fundamentals 13
Tax agent services relate to:
• ascertaining or advising about liabilities, obligations or entitlements of entities under a taxation law
• representing entities in their dealings with the Commissioner of Taxation (Commissioner) in relation to
a taxation law
• where it is reasonable to expect the entity will rely on the service to satisfy liabilities or obligations, or
to claim entitlements, under a taxation law (TPB 2019a).
Table 1.1 provides a non-exhaustive list of the types of services that may or may not constitute a tax agent
service under the TASA, if provided for a fee or reward.
TABLE 1.1
Examples of tax agent services
Service
Tax agent
service
Preparing returns, notices, statements, applications or other documents
about your client’s liabilities, obligations or entitlements under a taxation law.
X
Lodging returns, notices, statements, applications or other documents about
your client’s liabilities, obligations or entitlements under a taxation law.
X
Assisting clients with tax concessions for expenditure incurred on research
and development activities where the service involves the application of
taxation laws.
X
Preparing depreciation schedules on the deductibility of capital expenditure.
X
Preparing or lodging objections on behalf of a taxpayer under Part IVC of the
Taxation Administration Act 1953 (TAA) against an assessment, determination,
notice or decision under a taxation law.
X
Giving clients advice about a taxation law that they can reasonably be
expected to rely on to satisfy their taxation obligations.
X
Dealing with the Commissioner on behalf of clients.
X
Applying to the Commissioner or the Administrative Appeals Tribunal (AAT) for
a review of, or instituting an appeal against, a decision on an objection under
Part IVC of the TAA.
X
Reconciling BAS provision data entry to ascertain the figures to be included
on a client’s activity statement.
X
Filling in an activity statement on behalf of a client or instructing them which
figures to include.
X
Ascertaining the withholding obligations for employees of your clients,
including preparing payment summaries.
X
Installing computer accounting software and determining default goods and
services tax (GST) and other codes tailored to clients.
X
Installing computer accounting software without determining default GST and
other codes tailored to clients.
Coding transactions, particularly in circumstances where it requires the
interpretation or application of a taxation law.
Not a tax
agent service
X
X
Coding tax invoices and transferring data onto a computer program for clients
under the instruction and supervision of a registered tax or BAS agent.
X
Contracting the services of a specialist to provide advice about an area of
taxation law that you have no expertise and cannot review for accuracy.
X
Providing services as an auditor of a self-managed superannuation fund
under the Superannuation Industry (Supervision) Act 1993.
X
Providing general taxation advice to clients that does not involve the
application or interpretation of a taxation law to the client’s personal
circumstances.
X
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14 Australia Taxation
General training (such as in a classroom) in relation to the use of
computerised accounting software not related to particular fact situations.
X
Preparing bank reconciliations.
X
Entering data.
X
Providing a payroll service which involves interpreting and applying a taxation
law, including reporting of employee payroll information through the use of
single touch payroll (STP) enabled software.
X
Undertaking a payroll compliance review, providing an assessment or opinion
as to whether the client is compliant with their taxation obligations under one
or more taxation laws.
X
Providing tax related advice specific to client’s circumstances regarding:
PAYG withholding liability, Superannuation Guarantee obligations, fringe
benefits tax laws, and termination and redundancy payments.
X
Transmission of data to the Commissioner through STP enabled software,
where the data transmission does not require the interpretation or application
of a taxation law.
X
Source: TPB 2019a, ‘Tax agent services’, accessed December 2021, www.tpb.gov.au/tax-agent-services.
QUESTION 1.1
Consider whether the following would be considered tax agent services.
(a) Informing the client as to the general circumstances in which the CGT provisions in the income
tax legislation will allow concessional treatment.
(b) Giving taxation advice to a client regarding whether the sale of their investment property can
benefit from a concession that will reduce their CGT liability.
(c) Lodging a tax return for a self-managed superannuation fund.
(d) Auditing a self-managed superannuation fund.
BUSINESS ACTIVITY STATEMENT AGENT
With the introduction of the self-assessment regime, pay-as-you-go (PAYG) and GST, compliance tasks
(e.g. lodging activity statements such as the BAS) have significantly increased. The registered BAS agent
category was introduced with a scope that is limited to the preparation and lodgement of BAS activity
statements, which may allow suitably qualified entities (e.g. bookkeepers) to perform these tasks.
Any individual (or partnership) who provides BAS agent services for a fee or other reward must be
registered with the TPB.
BAS services include any service that relates to:
• ascertaining liabilities, obligations or entitlements of an entity that arise, or could arise, under a BAS
provision
• advising an entity about liabilities, obligations or entitlements of an entity or another entity that arise,
or could arise, under a BAS provision
• representing an entity in their dealings with the Commissioner of Taxation, and
is provided in circumstances where the entity can reasonably be expected to rely on the service for either
or both of the following purposes:
• to satisfy liabilities or obligations that arise, or could arise, under a BAS provision, or
• claim entitlements that arise, or could arise, under a BAS provision.
A BAS service also includes a service that the Tax Practitioners Board has declared, by way of a legislative
instrument to be a BAS service (TPB 2022c; see also TASA, s. 90-10).
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MODULE 1 The Legal, Ethical and Regulatory Fundamentals 15
A BAS provision includes:
•
•
•
•
•
•
•
GST law
wine equalisation tax law
luxury car tax law
fuel tax law
FBT law (relating to collection and recovery only)
pay as you go (PAYG) withholding
PAYG instalments (TPB 2022c; see also ITAA97, s. 995-1(1)).
Table 1.2 includes a non-exhaustive list of the types of services that may and may not constitute a
BAS service under the TASA.
TABLE 1.2
Examples of BAS agent services
Service
Applying to the Registrar for an ABN on behalf of a client.
BAS
service
X
Installing computer accounting software without determining default GST and
other codes tailored to the client.
Coding transactions, tax invoices and transferring data onto a computer
program for clients through processes that require the interpretation or
application of a BAS provision.
Not a BAS
service
X
X
Coding transactions, tax invoices and transferring data onto a computer
program for clients through processes that do not require the interpretation or
application of a BAS provision.
X
Confirming figures to be included on a client’s activity statement.
X
Completing activity statements on behalf of an entity or instructing the entity
which figures to include.
X
General training in relation to the use of computerised accounting software not
related to client’s particular circumstances.
X
Preparing bank reconciliations.
X
Entering data without involvement in or calculation of figures to be included on a
client’s activity statement.
X
Providing advice about or confirming the withholding tax obligations for the
employees of a client.
X
Services declared to be a BAS service by way of a legislative instrument issued
by the TPB.
X
Preparing and providing an income statement that may include reportable fringe
benefits amounts and the reportable employer superannuation contributions.
X
Registering or providing advice on registration for GST or PAYG withholding.
X
Services under the Superannuation Guarantee (Administration) Act 1992 to the
extent that they relate to a payroll function or payments to contractors.
X
Advising about an SGC liability, including calculating the liability and preparing
the SGC statement.
X
Advising about the offsetting of late payments of superannuation contributions
against the SGC.
X
Completing the late payment offset election section of an SGC statement.
X
Representing a client in their dealings with the ATO relating to the SGC —
lodging SGC statements, being an authorised contact relating to SG and SGC,
and accessing these accounts in the ATO’s online services for BAS agents.
X
Being an authorised contact with the ATO for payment arrangements relating to
SGC account.
X
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16 Australia Taxation
Being an authorised contact with the ATO for requesting penalty remissions
relating to SGC.
X
Being an authorised contact for any audit or review activity undertaken by the
ATO relating to SGC.
X
Advising about claiming of an allowable tax deduction for superannuation
contributions.
X
Advising about superannuation contribution caps and the effect of exceeding
those caps.
X
Advising on salary sacrificing arrangements and salary packaging.
X
Advising about FBT laws.
X
Advising about preparing and/or lodging income tax returns.
X
Determining and reporting the superannuation guarantee shortfall and
associated administrative fees.
X
Dealing with superannuation payments made through a clearing house.
X
Completing and lodging the taxable payments annual report to the ATO on
behalf of a client.
X
Sending a TFN declaration to the Commissioner on behalf of a client.
X
Transmitting data to the Commissioner through STP enabled software, where
the data transmission does not require the interpretation or application of a
BAS provision.
X
Providing a payroll service which involves interpreting and applying a BAS
provision, including reporting of employee payroll information through the use
of STP enabled software.
X
Undertaking a payroll compliance review, providing an assessment and/or
opinion whether the client is compliant with one or more BAS provisions.
X
Determining eligibility, providing advice and assisting eligible clients to elect to
participate in the JobKeeper Payments scheme.
X
Determining eligibility, providing advice and assisting eligible clients in relation to
their Cashflow boost entitlements.
X
Determining eligibility, providing advice and assisting eligible clients to claim the
JobMaker Hiring Credit.
X
Source: TPB 2020, ‘BAS services’, accessed January 2022, www.tpb.gov.au/bas-services.
TAX (FINANCIAL) ADVISER
Until 1 January 2022, all Australian financial services (AFS) licensees and their representatives (we will
refer to them as a ‘financial adviser’ to differentiate terms) who provide tax (financial) advice services for
a fee or other reward must have been registered with the TPB. Since 1 January 2022, a new registration
process is in place for such persons, which will be overseen and administered by ASIC rather than the TPB.
What is the Australian Financial Services Licensing Regime?
Given the registration requirements for AFS licensees (and their representatives) who provide taxation
advice, it is important to understand the background of the AFS licensing regime. The AFS licensing
regime for financial planners and advisers is governed through the Corporations Act 2001 and compliance
is through ASIC.
Under the AFS licensing regime, all entities or individuals providing a defined financial service to a retail
client — for example, providing advice on investing surplus monies into a managed investment fund to an
individual or couple — must be registered as either an AFS licensee or as an authorised representative
of an AFS licensee. An authorised representative can be an individual, a body corporate, a partnership, a
group of body corporates or individuals who are trustees of a trust, or an employee or director or an AFS
licensee or related body corporate.
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MODULE 1 The Legal, Ethical and Regulatory Fundamentals 17
Section 761A of the Corporations Act states that an ‘authorised representative of a financial services
licensee means a person authorised in accordance with section 916A or 916B to provide a financial service
or financial services on behalf of the licensee’.
Section 766A(1) of the Corporations Act defines a ‘financial service’ as:
For the purposes of this Chapter, subject to paragraph (2)(b), a person provides a financial service if they:
(a)
(b)
(c)
(d)
(e)
(ea)
(eb)
(ec)
provide financial product advice (see section 766B); or
deal in a financial product (see section 766C); or
make a market for a financial product (see section 766D); or
operate a registered scheme; or
provide a custodial or depository service (see section 766E); or
provide a crowd‐funding service (see section 766F); or
provide a claims handling and settling service (see section 766G); or
provide a superannuation trustee service (see section 766H); or(f) engage in conduct of a kind
prescribed by regulations made for the purposes of this paragraph.
TPB provides the following definition.
A tax (financial) advice service consists of five key elements:
1.
2.
3.
4.
a tax agent service (excluding representations to the Commissioner of Taxation)
provided by an Australian financial services (AFS) licensee or representative of an AFS licensee
provided in the course of advice usually given by an AFS licensee or representative
relates to ascertaining or advising on liabilities, obligations or entitlements that arise, or could arise,
under a taxation law
5. reasonably expected to be relied upon by the client for tax purposes (TPB 2022b).
Table 1.3 includes a non-exhaustive list of the types of services commonly provided by a financial
adviser and whether they constitute a tax (financial) advice service.
TABLE 1.3
Examples of tax (financial) advice services
Tax (financial)
advice service
Tax agent
service
Any service specified by the TPB by legislative instrument to be a tax
(financial) advice service.
Yes
Yes
Personal advice (as defined in the Corporations Act 2001), including scaled
advice and intra-fund advice, which involves the application or interpretation
of the taxation laws to a client’s personal circumstances and it is reasonable
for the client to expect to rely on the advice for tax purposes.
Yes
Yes
Any advice (other than a financial product advice as defined in the
Corporations Act 2001) that is provided in the course of giving advice of a
kind usually given by a financial services licensee or a representative of a
financial services licensee that involves application or interpretation of the
taxation laws to the client’s personal circumstances, and it is reasonable for
the client to expect to rely on the advice for tax purposes.
Yes
Yes
Factual tax information that does not involve the application or interpretation
of the taxation laws to the client’s personal circumstances. Such information
could be included in, but is not limited to:
• regulated disclosures such as product disclosure statements and financial
services guides
• other products such as general marketing and promotional materials.
No
No
Client tax-related factual information. Such information includes, but is not
limited to:
• payment summaries
• other documents such as annual summary of interest paid and account
statements.
No
No
Service
Pdf_Folio:18
18 Australia Taxation
General advice (as defined in the Corporations Act 2001).
No
No
Any service that does not take into account an entity’s relevant circumstances
so that it is not reasonable for the entity to expect to rely on it for tax
purposes. This includes simple online calculators as defined in the ASIC’s
Class Order (CO 05/1122).
No
No
Factual information provided by call centres and front line staff and specialists
that would not be expected to be relied upon for tax related purposes.
No
No
Preparing a return or a statement in the nature of a return (to provide this
service would require registration as a tax agent).
No
Yes
Preparing an objection under Part IVC of the Taxation Administration Act
1953 against an assessment, determination, notice or decision under a
taxation law.
No
Yes
A service specified not to be a tax agent service in section 26 of the Tax
Agent Services Regulations 2022.
No
No
Dealing with the Commissioner of Taxation on behalf of a client. This may
include, for example, applying for a private binding ruling on behalf of a client.
No
Yes
Source: TPB 2022b, ‘Tax (financial) advice services’, accessed April 2022, www.tpb.gov.au/tax-financial-advice-services.
Registering as a Tax Agent
The requirements for registration as a tax agent are as follows:
• a primary qualification in one of certain stated fields or, in the alternative, be a voting member of a
recognised tax agent association. Note that in some cases, extensive work experience will mean that this
requirement is unnecessary
• completion of board-approved course/s in certain areas (this will depend on the qualifications and work
experience of the applicants). If the first requirement was fulfilled due to having voting membership of
a recognised tax agent association, then this requirement is unnecessary
• sufficient work experience (the amount required is dependent on the primary qualifications of
the applicant).
Tax agents are also required to meet continuing professional education requirements (TPB 2021a).
Registering as a BAS Agent
The requirements for registration as a BAS agent are:
• primary qualifications in bookkeeping or accounting
• completion of a board-approved GST/BAS course
• sufficient relevant work experience (less hours of work experience are required where the person is a
voting member of a recognised BAS or tax agent association).
BAS agents are also required to meet continuing professional education requirements (TPB 2021b).
Registering as a Tax (Financial) Adviser
The requirements for registration as a tax (financial) adviser with the TPB are:
• be, or have been within the preceding 90 days, an Australian financial services (AFS) licensee or a
representative of an AFS licensee
• meet certain qualifications and experience requirements.
Tax (financial) advisers are also required to meet continuing professional education requirements
(TPB 2022d).
As discussed, as of 1 January 2022, registration of tax (financial) advisers is no longer the responsibility
of the TPB. Rather, practitioners who are not registered tax agents and wish to provide tax advice for
reward will in general need to be registered with ASIC as a qualified tax relevant provider (QTRP).
As a transitional measure, those registered as individual tax (financial) advisers with the TPB prior to
1 January 2022 will normally be deemed to have registration with ASIC from that date (ASIC 2021). The
details of the registration process with ASIC as of 1 January 2022 are beyond the scope of this course.
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MODULE 1 The Legal, Ethical and Regulatory Fundamentals 19
Figure 1.8 illustrates the tax agent services provided by different types of advisors.
FIGURE 1.8
Tax agent services
Tax agent services
Registered tax agent can
undertake any tax agent
services.
BAS agent
services
Tax
(financial)
advice
services
Registered BAS agent can
undertake BAS agent
services, which are a
subset of tax agent
services.
Registered tax (financial)
adviser can undertake tax
(financial) advice services,
which are a subset of tax
agent services.
Source: CPA Australia 2022.
Example 1.2 provides three scenarios that require assessment as to whether the services provided are
considered part of their specific role.
EXAMPLE 1.2
Providing Tax Advice
Bill is a tax agent. You seek his advice on a complex tax matter. He feels it is outside his area of expertise,
contracts a leading law firm to write a report on the issue and, without reviewing it, passes the report on
to you.
Sally is a BAS agent who undertakes a bank reconciliation for you, and also advises you if you’ve
underpaid the compulsory superannuation payments for your employees.
Cath is a tax (financial) adviser who applies to the ATO for a private ruling on your behalf (prior to
1 January 2022).
Now consider whether the three professionals provided services that are considered to be parts of
their role.
Bill contracting an expert for a report on an area outside his area of expertise which he does not review
would not be considered a tax agent service.
Sally undertaking a bank reconciliation would not be a BAS agent service. However, her determining
superannuation guarantee shortfalls would be considered a BAS agent service.
Cath applying for a professional ruling would not be considered a tax (financial) advice service.
1.3 ETHICAL PRINCIPLES AND BEHAVIOUR
STANDARDS OF THE APESB
The APESB is an organisation formed by the main accounting bodies in Australia. Established in 2006,
the board is made up of three members: CPA Australia, Chartered Accountants Australia & New Zealand
(CA ANZ) and the Institute of Public Accountants (IPA).
All members of these organisations are bound by the standards published by the APESB. Specifically,
the relevant APESB standards affecting members of the relevant accounting bodies providing tax services
are APES 110 Code of Ethics for Professional Accountants (including Independence Standards) (aimed
at professional accountants) and APES 220 Taxation Services (aimed at taxation services). Although the
relevant APESB standards do not explicitly state that they cover tax professionals registered with the TPB,
Pdf_Folio:20
20 Australia Taxation
the services of such tax professionals, where they are registered with one of the main three accounting
bodies, would be covered by the APESB pronouncements.
WHAT ARE ETHICS?
Ethics and morals are concerned with right and wrong and how conduct should be judged to be good or
bad. It is about how we should live our lives and, in particular, how we should behave towards other people.
It is therefore relevant to all forms of human activity.
Morals differ from ethics in the sense that they derive from a person’s individual beliefs and are often
linked to religious views. They are not derived from professional ethics, which are the views and rules of
the professional organisation that an individual is a member of. Therefore, it is perfectly possible for an
individual to find an action to be justified ethically (in terms of professional ethics) but be immoral (to
their personal views).
Where an individual’s morals clash with their professional ethics, they can protest or resign — but this
will have consequences for them professionally and therefore is the hardest choice that a professional
may face. The law will provide the individual some protection if they make an ethical protest. Where an
individual follows their professional ethics, they may not be taking (for themselves) the correct course of
action from their own perspective, but they will be afforded the protection of their profession.
When developing professional ethical standards, such as the ones studied in this module, professional
bodies attempt to develop strong fundamental ethical behaviour in their members. By doing this it is
hoped that members will practice ethical decision making and therefore have a strong sense of what is
ethically right and wrong. Figure 1.9 summarises the relationship between ethical behaviour, ethics codes
and positive decision making.
FIGURE 1.9
Ethical behaviour
Ethical behaviour
Codes of ethics
Making good
decisions
APES 110
Determine
ethical conflicts
TPB Code of
Professional Conduct
Steps for making
a decision
APES 220
Applying the
conceptual framework
Ethical tensions
between values
Source: CPA Australia 2022.
QUESTION 1.2
Consider the following situations. Do you think the person is acting morally and in accordance with
professional ethics?
(a) A registered tax agent uses legitimate tax planning to allow a high-income earning business
owner to only pay as much tax as a salary earner who receives a much lower income.
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MODULE 1 The Legal, Ethical and Regulatory Fundamentals 21
(b) A registered tax agent prepares the accounts and tax returns of a client. Unknown to the client,
the tax agent’s sister runs a competing business, but the tax agent feels that due to his own and
his sister’s honesty, they can keep the client’s affairs confidential.
(c) An airline pilot decides to risk an emergency landing in severe bad weather for a passenger who
is gravely ill and will die if not treated very soon.
ETHICAL PRINCIPLES
All codes and standards in this module — APES 110, APES 220 and the TPB Code (discussed in
the section ‘TPB Code of Professional Conduct’) — set out very similar principles. They specify the
fundamental principles all members should follow in their professional lives. These principles are
regarded as fundamental because they form the bedrock of professional judgements, decisions, reasoning
and practice.
All members who subscribe to these standards must not only know the fundamental principles, but also
apply them in their everyday work. Both APES 110 and APES 220 are framework or ethics based. There
are serious consequences for failing to follow them. Whenever a complaint is made against a member
who must comply with the APESB standards, failure to follow the contents of the fundamental principles
will be taken into account when a decision is made as to whether a prima facie case exists of professional
misconduct.
APES 110 CODE OF ETHICS FOR PROFESSIONAL
ACCOUNTANTS (INCLUDING INDEPENDENCE STANDARDS)
APESB publishes APES 110, which sets out a code of ethics for professional accountants. APES 110
is based on the international code issued by the International Ethics Standards Board for Accountants
(IESBA), which is commonly used by accounting bodies internationally. An updated version of APES 110
was released in November 2018 and became operative from 1 January 2020. Amendments to APES 110
were issued in September 2020 and are effective from 1 July 2021. Amendments issued in March 2021
are effective from July 2022.
Fundamental Ethical Principles of APES 110
First, the member as a professional accountant should be guided by the one overarching principle of
APES 110: to act in the public interest (para. 100.1 A1). It states:
A distinguishing mark of the accountancy profession is its acceptance of the responsibility to act in the
public interest. A Member’s responsibility is not exclusively to satisfy the needs of an individual client
or employing organisation. Therefore, the [APESB] Code contains requirements and application material
to enable Members to meet their responsibility to act in the public interest (APES 110 Code of Ethics for
Professional Accountants (including Independence Standards). Issued: November 2018. Para. 100.1 A1,
page 25).
The member should follow the five fundamental principles of APES 110 at all times. The five
fundamental principles of ethics for members are:
(a) Integrity — to be straightforward and honest in all professional and business relationships.
(b) Objectivity — not to compromise professional or business judgements because of bias, conflict of
interest or undue influence of others.
(c) Professional competence and due care — to:
– attain and maintain professional knowledge and skill at the level required to ensure that a client or
employing organisation receives competent Professional Activities, based on current technical and
professional standards and relevant legislation; and
– act diligently and in accordance with applicable technical and professional standards.
(d) Confidentiality — to respect the confidentiality of information acquired as a result of professional and
business relationships.
(e) Professional behaviour — to comply with relevant laws and regulations and avoid any conduct
that the Member knows or should know might discredit the profession (APES 110 Code of
Ethics for Professional Accountants (including Independence Standards). Issued: November 2018.
Para. 110.1 A1, page 26).
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22 Australia Taxation
Example 1.3 illustrates how to identify which fundamental principle is being violated in a range
of circumstances.
EXAMPLE 1.3
Examples of Acting Unethically
A professional has a responsibility to make ethical decisions based on honesty, integrity, objectivity and
confidentiality. As part of this, they need to manage their emotions in order to maintain professionalism, so
they should not allow personal feelings to interfere with their professional judgements. They must also be
aware of situations where they should request assistance if there is work that they are not qualified to do. In
addition, they should always check that information gathered for analysis is accurate and comprehensive.
The following list provides examples of unethical behaviour:
(a) handing over work that you know contains errors to a colleague
(b) allowing personal feelings about something to cloud your judgement
(c) taking on work you are not qualified to do
(d) leaving sensitive or confidential information where anyone can look at it
(e) cheating in professional exams.
For each of these examples of unethical behaviour, consider which fundamental principle is being
violated:
(a) integrity
(b) objectivity
(c) professional competence and due care
(d) confidentiality
(e) professional behaviour.
Consider how each of the listed examples of unethical behaviour, would affect the employability of that
person. It would certainly harm their career prospects.
Source: Adapted from BPP Learning Media 2015, ‘CIMA Study Text’, p. 425.
Fundamental Threats
As well as identifying fundamental principles, APES 110’s ethical guidelines identify five types of threat
to those principles. These threats are self-interest threats, self-review threats, advocacy threats, familiarity
threats and intimidation threats. The fundamental threats are described in table 1.4.
TABLE 1.4
Fundamental threats
Type of threat
Description of threat
Self-interest
The threat that a financial or other interest will inappropriately influence a Member’s
judgement or behaviour.
Self-review
The threat that a Member will not appropriately evaluate the results of a previous judgment
made, or an activity performed by the Member, or by another individual within the Member’s
Firm or employing organisation, on which the Member will rely when forming a judgement as
part of performing a current activity.
Advocacy
The threat that a Member will promote a client’s or employing organisation’s position to the
point that the Member’s objectivity is compromised.
Familiarity
The threat that, due to a long or close relationship with a client, or employing organisation, a
Member will be too sympathetic to their interests or too accepting of their work.
Intimidation
The threat that a Member will be deterred from acting objectively because of actual or
perceived pressures, including attempts to exercise undue influence over the Member.
Source: APES 110 Code of Ethics for Professional Accountants (including Independence Standards). Issued: November 2018.
Para. 120.6 A3, page 33.
The ethical guidelines take an identify, evaluate and address threats approach to dealing with ethical
issues. They state that, where a threat is identified, the member should assess whether or not it is significant
and then take action to remove or mitigate it. Further advice for dealing with ethical issues is covered in
‘Tax practitioner obligations’ and ‘Identifying ethical dilemmas’.
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MODULE 1 The Legal, Ethical and Regulatory Fundamentals 23
NOCLAR Standard
The NOCLAR standard, incorporated as a new section of APES 110 in 2017, provides guidance on
responding to non-compliance with laws and regulations (NOCLAR), which a professional accountant
may encounter in their professional activities. An example of where NOCLAR may potentially apply is in
the area of tax evasion.
Under NOCLAR, accountants are able to report non-compliance with laws and regulations when it is
in the public interest and where the conditions for reporting NOCLAR are met. First, the non-compliance
must have a direct and material effect on the financial statements of the client or employer. Second, if the
non-compliance is not quantitative, then the non-compliance must be fundamental to the business and its
operations. There needs to be credible evidence of serious negative consequences for employees, creditors,
investors or the general public in financial or non-financial terms.
When these conditions are met, the standard not only enables, but places a responsibility upon,
all professional accountants to consider disclosing NOCLAR to public authorities subject to laws and
regulations. The NOCLAR standard came into effect in Australia on 1 January 2018.
APES 220 TAXATION SERVICES
APESB has issued professional standard APES 220, which sets out a code of ethics concerning the
provision of taxation services and related activities (current version revised in July 2019). Revisions to
APES 220 have incorporated the NOCLAR standard just discussed.
Paragraph 1.1 of APES 220 states:
The objectives of APES 220 Taxation Services are to specify a Member’s professional and ethical
obligations in respect of:
• fundamental responsibilities when the Member performs a Taxation Service for a Client or Employer;
• preparation and lodgement of returns to Revenue Authorities [such as the ATO];
• association with tax schemes and arrangements;
• the use of estimates;
• false and misleading information;
• professional Engagement matters;
• Client Monies;
• professional fees; and
• documentation (APES 220 Taxation Services. Revised: July 2019. Para. 1.1, page 3).
One of the topics covered in the standard is ‘false and misleading information’. Paragraphs 7.1 and
7.2 of APES 220 require members to refuse to provide taxation services to a client or employer if the
member is aware that the information on which the taxation service is to be based contains false or
misleading information, or omits material information and the client or employer is not prepared to amend
the information (APES 220 Taxation Services. Revised: July 2019. Paras. 7.1 and 7.2, page 9). Under
paragraph 7.3:
Where a Member forms the view that a Taxation Service is based on false or misleading information or
the omission of material information, the Member shall discuss the matter with the Client or Employer and
advise them of the consequences if no action is taken (APES 220 Taxation Services. Revised: July 2019.
Para. 7.3, page 9-10).
APES 220 has been updated to reflect the NOCLAR standard, and this has changed the reporting of
false and misleading information when it meets the NOCLAR conditions.
All members must follow the mandatory requirements of APES 220 when providing taxation services.
The fundamental responsibilities of APES 220 that members must follow when providing taxation
services mirror the fundamental principles that must be followed in APES 110. Some of the APES 220
fundamental responsibilities are:
•
•
•
•
•
•
public interest [the overarching principle in APES 110]
integrity and professional behaviour
objectivity
independence obligations
confidentiality
professional competence and due care.
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24 Australia Taxation
A Member providing Taxation Services shall at all times safeguard the interests of their Client or Employer
provided that such services are delivered in accordance with Part 1 Complying with the Code, Fundamental
Principles and Conceptual Framework of the Code and relevant law, including applicable Taxation Law
(APES 220 Taxation Services. Revised: July 2019. Section 3, page 5).
QUESTION 1.3
Access the latest version of APES 220 at www.apesb.org.au/standards-guidance/taxationservices or by searching for it using your search engine. Make sure you have found the most upto-date edition (July 2019).
(a) What is the chief requirement for a member when preparing and lodging a tax return to the ATO
on behalf of a client?
(b) What is the obligation of the member if they find the information provided by the client is false
and misleading?
APPLYING THE CONCEPTUAL FRAMEWORK TO IDENTIFY
ETHICAL DILEMMAS
APES 110 provides a conceptual ethical framework to guide decision making for tax advisers needing to
make an ethical decision.
The conceptual framework specifies an approach for a Member to:
(a) Identify threats to compliance with the fundamental principles;
(b) Evaluate the threats identified; and
(c) Address the threats by eliminating or reducing them to an Acceptable Level (APES 110 Code of
Ethics for Professional Accountants (including Independence Standards). Issued: November 2018.
Para. 120.2, page 31).
Figure 1.10 demonstrates the application of the conceptual framework in APES 110.
FACING ETHICAL CONFLICTS
The previous discussion stated the need for taxation professionals, including tax advisers, to be ethical,
and the consequences of being unethical. The conceptual framework presented in figure 1.10 shows tax
advisers the steps to follow to make a good ethical decision.
It is therefore important that tax advisers can recognise an ethical problem and be able to deal with it
effectively and appropriately.
Many taxation services dilemmas challenge both personal integrity and business skills, and therefore a
strong ethical understanding is important. We now consider potential situations where tax advisers have to
make ethical decisions, and how they should resolve them.
Ethical Conflicts and Conflicts of Interest
Ethical conflicts are situations where two ethical values or requirements seem to be incompatible. They
can also arise where conflicting demands or obligations are placed on an individual tax adviser.
A conflict of interest arises where a situation creates a threat to the objectivity of the adviser. This might
be due to the member undertaking a professional activity for two parties where their interests are in conflict
or, alternatively, where the member’s interests are in conflict with a party (APES 110, para. 210.2).
While working, information or other matters may arise that mean the adviser cannot continue to work for
one party without harming another. Conflicts of interest are not wrong in themselves, but they will become
a problem if a professional continues with a course of action while being aware of and not declaring them.
Example 1.4 considers whether a conflict of interest exists when giving advice to a client under specific
circumstances. Read the scenario presented and think about your response.
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MODULE 1 The Legal, Ethical and Regulatory Fundamentals 25
EXAMPLE 1.4
Conflict of Interest
An employee accountant is giving advice to a high net worth client regarding their investment decisions.
If the advice involves the client potentially investing in assets that would result in the accountant, or
their family, financially benefiting due to them holding a current stake in such assets, would there be a
conflict of interest?
The accountant has an interest in the client investing in such assets, in that they or their family would
potentially benefit from the client doing so. On the other hand, the client’s interests are to invest in a
manner that will benefit themselves by achieving the best return possible that is commensurate to their
risk tolerance and other requirements. As a result, there is a clear conflict of interest.
FIGURE 1.10
The conceptual framework
Are there any facts or circumstances that create any
threats? Keep in mind the rules and policies of the
profession, laws and the employing organisation that are
aimed at enhancing ethical behaviour.
(APES 110, paras. R120.6, 120.6 A1)
No
Proceed/continue with the
professional service,
engagement or with the
employing organisation.
Yes
Are these threats at an acceptable level?
(APES 110, para. R120.7)?†
Yes
No
Could the threat/s be reduced to an acceptable level by
eliminating the circumstances creating the threat/s
or through the use of safeguards?
(APES 110, para. R120.10)
Yes
Eliminate the circumstances or apply
safeguards, so that threats are reduced to
an acceptable level.
No
Decline or discontinue the professional service or resign
from the engagement or the employing organisation.
(APES 110, para. R120.10)
†
‘Acceptable level’ in the Code is defined by using the reasonable and informed third party test. It means a level at which a reasonable
and informed third party would be likely to conclude — weighing all the relevant facts and circumstances that were known, or
could be reasonably expected to be known, by the Member at that time — that there is compliance with the fundamental principles
(APES 110, paras 120.5 A4 and 120.7 A1).
Source: APES 110 Code of Ethics for Professional Accountants (including Independence Standards). Issued: November 2018.
Situations Where Ethical Conflicts May Arise
Ethical conflicts occur as a result of tensions between four sets of values.
1. Societal values — the laws that govern our behaviour and culture, which reflect the attitudes and values
of the community.
2. Personal values — values and principles held by the individual.
3. Corporate values — the values and principles of the organisation where the individual works, often
laid down in ethical codes.
4. Professional values — the values and principles of the professional body that the individual is a member
of, often laid down in standards as discussed previously.
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26 Australia Taxation
Where society believes that businesses are not conducting themselves correctly, laws may be introduced
to ensure a minimum level of behaviour is followed. Examples of this are laws created to deal with tax
evasion, fraud and tax avoidance.
Ethical conflicts involve unclear choices of what is right and wrong. In fact, the choice could be to
determine what is the least wrong course of action to take. In such circumstances, there is little an individual
can do but to seek advice and trust their own instincts to make the correct choice.
Remember that laws do not necessarily help an individual to resolve an ethical issue — indeed many
members of society feel torn when their personal ethics lead them to feel that following a particular law
is immoral.
Where a professional duty conflicts with statute, the advice of all the relevant professional standards is
clear — the law overrides every time.
RESOLVING ETHICAL DILEMMAS
Tax advisers will encounter situations throughout their professional life that present them with an ‘ethical
dilemma’ or ‘conflict of interest’.
Ethical conflicts may arise from:
• members asked to act contrary to taxation laws or technical and/or professional standards
• divided loyalties between colleagues and the taxation law and/or professional standards
• tax advisers having to do work beyond the degree of expertise or experience they possess
• personal relationships with other employees or clients
• gifts and hospitality being offered.
QUESTION 1.4
Lucy is a junior accountant in her second year of full-time employment. During Lucy’s lunch break,
her company’s People and Culture manager has asked Lucy for some help. The manager has
recently inherited a considerable portfolio of investment properties, shares and cash. She would like
Lucy to advise her on potential income tax and CGT liabilities. What are the key ethical issues here?
STEPS FOR MAKING A GOOD DECISION
We have seen there are many situations that could cause ethical conflicts, ranging from the trivial to the
very serious (such as taxation fraud).
Generally, individuals should consider the following.
• Transparency. Do I feel comfortable with others knowing about my decision? Is my decision
defensible?
• Effect. Have I considered all parties who may be affected by the decision? Have all factors been taken
into account, such as mitigating circumstances?
• Fairness. Would a reasonable third party, such as a taxation authority, view the decision as fair?
QUESTION 1.5
Which of the following would not be a suitable question to ask yourself when resolving an ethical
dilemma in your role as a tax adviser? Explain your choice.
(a) Does my solution benefit my career?
(b) Have I thought about all the possible consequences of my solution?
(c) Would my colleagues or my clients think my solution is reasonable?
(d) Could I defend my solution under public scrutiny, including to the relevant taxation authorities?
ETHICAL DILEMMA CHECKLIST
The following steps suggest an approach for conflict resolution.
1. Gather and record relevant facts.
2. Assess the ethical issues involved.
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MODULE 1 The Legal, Ethical and Regulatory Fundamentals 27
3.
4.
5.
6.
7.
8.
Decide if the issue is legal in nature.
Identify any fundamental principles that may be affected.
Identify any affected parties.
Consider possible courses of action.
If necessary, seek professional or legal advice.
Refuse to be associated with the conflict.
Always document all meetings, conversations and actions in relation to a particular ethical problem as
you may be required at a later date to show how you dealt with the matter. It is equally important to remain
alert and appropriately deal with conflict of interest which may arise at a later period.
Paragraph R210.5 of APES 110 states that ‘a Member shall take reasonable steps to identify circumstances that might create a conflict of interest, and therefore a threat to compliance with one or more of
the fundamental principles’. Additionally, paragraph R210.6 states that ‘a Member shall remain alert to
changes over time in the nature of the activities, interests and relationships that might create a conflict of
interest while performing a Professional Activity’ (APES 110 Code of Ethics for Professional Accountants
(including Independence Standards). Issued: November 2018. Paras. R210.5–R210.6 page 43.
1.4 TPB CODE OF PROFESSIONAL CONDUCT
PRINCIPLES OF THE TPB CODE OF PROFESSIONAL CONDUCT
All three types of TPB registered tax practitioners (tax agents, BAS agents and tax (financial) advisers)
are subject to the TPB Code, which sets out 14 principles under five specialist categories. These principles
are essentially the same for each of the three types of tax practitioners.
The TPB Code principles are set out under five separate categories: honesty and integrity, independence,
confidentiality, competence and other responsibilities. All five categories are based on the law in s. 30-10
of TASA:
Honesty and integrity
1. You must act honestly and with integrity.
2. You must comply with the taxation laws in the conduct of your personal affairs.
3. If:
(a) you receive money or other property from or on behalf of a client; and
(b) you hold the money or other property on trust;
you must account to your client for the money or other property.
Independence
4. You must act lawfully in the best interests of your client.
5. You must have in place adequate arrangements for the management of conflicts of interest that may
arise in relation to the activities that you undertake in the capacity of a registered tax agent or BAS
agent.
Confidentiality
6. Unless you have a legal duty to do so, you must not disclose any information relating to a client’s affairs
to a third party without your client’s permission.
Competence
7. You must ensure that a tax agent service that you provide, or that is provided on your behalf, is provided
competently.
8. You must maintain knowledge and skills relevant to the tax agent services that you provide.
9. You must take reasonable care in ascertaining a client’s state of affairs, to the extent that ascertaining
the state of those affairs is relevant to a statement you are making or a thing you are doing on behalf
of the client.
10. You must take reasonable care to ensure that taxation laws are applied correctly to the circumstances
in relation to which you are providing advice to a client.
Other responsibilities
Pdf_Folio:28
11. You must not knowingly obstruct the proper administration of the taxation laws.
12. You must advise your client of the client’s rights and obligations under the taxation laws that are
materially related to the tax agent services you provide.
28 Australia Taxation
13. You must maintain the professional indemnity insurance that the Board requires you to maintain.
14. You must respond to requests and directions from the Board in a timely, responsible and reasonable
manner.
OVERLAP BETWEEN TPB CODE AND OTHER REQUIREMENTS
Although not identical, there is broad overlap between the principles in the five categories of the TPB Code
and the five principles in APES 110 discussed earlier in this module.
Further, tax (financial) advisers are required to comply with the obligations contained in s. 30-10 of
TASA. This is a requirement of their registration and, if it were not for the rules around recognising
other obligations, the requirements would be onerous, as tax (financial) advisers are already subject to
the provisions of another licensing regime.
A lot of the fundamental principles of the TPB Code are similar to the obligations of AFS licensees and
their representatives under the Corporations Act (TPB 2019b).
Also, since 1 January 2020, all financial advisers are required to comply with the Code of Ethics
set by the Financial Adviser Standards and Ethics Authority (FASEA) (TPB 2019b). The FASEA Code
of Ethics is available at www.afa.asn.au/wp-content/uploads/Financial-Planners-and-Advisers-Code-ofEthics-2020-Guide.pdf. It is worth noting that as of 1 January 2022, FASEA ceased to exist and
the Minister for Superannuation, Financial Services and the Digital Economy (under Treasury) is
responsible for setting the relevant code of ethics. However, as a transitional measure, till such time that
Treasury enacts a different code, the FASEA Code of Ethics will continue to apply despite FASEA no
longer being in existence (Corporations Act, s. 1684P).
Further, as discussed earlier in this module, from 1 January 2022 the TPB is no longer the governing
operating body for tax (financial) advisers and registration and oversight is now the responsibility of
ASIC. As a result, from 1 January 2022, the TPB Code no longer applies to such persons. However, they will still be subject to the code of ethics originally set by FASEA (until a new code
is set by Treasury) and the Corporations Act rules.
Table 1.5 provides a brief summary comparison of the TPB Code’s principles with relevant obligations
under the Corporations Act and FASEA Standards.
TABLE 1.5
TPB Code and Corporations Act requirements
TPB Code of Professional Conduct principles
FASEA Code of Ethics
Corporations Act
Code Item 1
You must act honestly and with integrity.
Code item 2
You must comply with the taxation laws in the conduct
of your personal affairs.
Standard 1
Standard 2
Sections 912A, 913B,
915C, 991A, 1041E,
1041G and 1041H have
similar obligations.
Code item 3
If you:
• receive money or other property from or on behalf of
a client, and
• hold the money or other property on trust you
must account to your client for the money or other
property.
No similar obligations.
No similar obligations.
Code item 4
You must act in the best interests of your client.
Standard 2
Standard 3
Standard 4
Standard 5
Standard 7
Sections 912A, 961B,
961G, 961J and 961H.
(continued)
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MODULE 1 The Legal, Ethical and Regulatory Fundamentals 29
TABLE 1.5
(continued)
TPB Code of Professional Conduct principles
FASEA Code of Ethics
Corporations Act
Code item 5
You must have in place adequate arrangements to
manage conflicts of interest that may arise in relation
to the activities that you undertake in the capacity of a
registered tax practitioner.
Standard 2
Standard 3
Standard 4
Standard 5
Standard 7
Sections 912A, 961B,
961G, 961J and 961H.
Code item 6
Unless you have a legal duty to do so, you must not
disclose any information relating to a client’s affairs to a
third party without your client’s permission.
Standard 1
Standard 8
No similar obligation
exists in the
Corporations Act.
Code item 7
You must ensure that a tax agent service you provide or
that is provided on your behalf is provided competently.
Standard 5
Standard 6
Standard 9
Standard 10
Sections 912A, 961B
and 961H.
Code item 8
You must maintain knowledge and skills relevant to the
tax agent services that you provide.
Standard 5
Standard 6
Standard 9
Standard 10
Sections 912A, 961B
and 961H.
Code item 9
You must take reasonable care in ascertaining a client’s
state of affairs, to the extent that ascertaining the
state of those affairs is relevant to a statement you are
making or a thing you are doing on behalf of the client.
Standard 2
Standard 3
Standard 4
Standard 5
Standard 6
Standard 7
Standard 9
Standard 10
Sections 912A, 961B,
961G, 961J and 961H.
Code item 10
You must take reasonable care to ensure that taxation
laws are applied correctly to the circumstances in
relation to which you are providing advice to a client.
Standard 1
Standard 2
Standard 9
Sections 912A, 913B,
915C, 961B, 961G,
991A, 1041E, 1041G
and 1041H have similar
obligations.
Code item 11
You must not knowingly obstruct the proper administration of the taxation laws.
Standard 11
Sections 912A, 912B,
912C, 961B, 961G,
961H and 1310.
Code item 12
You must advise your client of the client’s rights and
obligations under the taxation laws that are materially
related to the tax agent services you provide.
Standard 5
Standard 6
No similar obligations
exist in the Corporations Act. However,
Sections 912A, 961B
and 961H deal with
duties relating to giving
accurate advice.
Code item 13
You must maintain the professional indemnity insurance
that the Board requires you to maintain.
Standard 11
Sections 912A, 912B,
912C, 961B, 961G,
961H and 1310.
Code item 14
You must respond to requests and directions from the
Board in a timely, responsible and reasonable manner.
Standard 11
Sections 912A, 912B,
912C, 961B, 961G,
961H and 1310.
Note: This table does not aim to comprehensively cover all the relevant obligations under the Corporations Act and FASEA’s
Standards.
Source: Adapted from TPB 2019b, ‘Code comparison with the Corporations Act and FASEA Standards’, accessed January 2022,
www.tpb.gov.au/code-comparison-corporations-act-fasea-standards.
Figure 1.11 describes the overlap between the TPB Code and other requirements that are relevant to
registered tax professionals.
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30 Australia Taxation
FIGURE 1.11
Overlap between the TPB Code and other requirements.
Though not identical, the TPB
Code broadly aligns with the
five principles in APES 110.
TPB Code of Professional
Conduct is nearly identical to
section 30-10 of Tax Agent
Services Act 2009 (Cwlth).
For tax (financial) advisers,
compliance with the TPB Code
will often lead to compliance with
the relevant requirements under
the Corporations Act and FASEA
standards.
Source: CPA Australia 2022.
Act in the Best Interests of the Client
Code item 4 of the TPB Code is to ‘act lawfully in the best interests of your client’. This directly
corresponds to one of the core tenets of the AFS licensing regime, which is the duty to act in the best
interests of the client.
One of the main duties of an AFS licensee representative under the Corporations Act is the duty —
enshrined in law — to act in the best interests of the client, to give priority to the interests of the client in
relation to any conflict of interest, and to ensure that the advice given to the client is appropriate.
Example 1.5 provides information relating to a tax agent’s professional conduct and requires evaluation
of this behaviour against the TPB Code.
EXAMPLE 1.5
Professional Conduct
Lara is a tax agent and has a client who runs a successful business. It turns out that Lara’s friend Nick
lives in the house opposite to the client. Lara mentions to Nick what a coincidence that her client lives so
close to him and hints to him that her client is very wealthy.
Lara also has another client who wishes to know whether they can claim a certain tax deduction. Lara
informs her client that a deduction is not possible. However, Lara has not kept up with the latest tax events
which, due to recent legislation changes, now allow such a deduction.
Consider which of the five categories of the TPB Code Lara is likely to have breached.
The action regarding telling Nick the details of her client breaches the duty relating to confidentiality.
The actions regarding telling the client the incorrect information potentially breaches the duties relating
to competence.
QUESTION 1.6
Don is a tax agent and has a client wanting to legally reduce their tax liability. Don recommends to
his client to buy an off the plan apartment from a leading developer and explains to the client the
tax advantages of doing so. Unknown to the client, Don receives a commission for each apartment
that a client purchases. However, if the client is not interested, Don does not pressure the client
into purchasing such an apartment.
Which of the five categories of the TPB Code is Don likely to have breached?
SUMMARY
Part A outlined the Australian tax law environment, including the respective roles of the parliament and
courts in creating and interpreting taxation laws. Part A then described the tax practitioner registration
system and discussed the legal and ethical responsibilities of tax practitioners.
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MODULE 1 The Legal, Ethical and Regulatory Fundamentals 31
The key points covered in this part, and the learning objectives they align to, are as follows.
KEY POINTS
1.1 Describe the Australian tax system and its regulatory framework.
• Section 51(ii) of the Constitution gives the power to legislate taxation law to the Commonwealth
Government. Other relevant provisions of the Constitution are:
– Section 96, which allows the Commonwealth to grant money to the states/territories
– Section 114, which prohibits the Commonwealth from taxing the property of the state governments (and vice versa)
– Section 53, which states that a taxation Bill can only originate in the lower house of parliament
(House of Representatives)
– Section 55, which states that legislation dealing with taxation law can only deal with taxation and
not with other matters.
• For Commonwealth legislation, such as income tax laws, to be valid they need to be passed
by both houses of parliament (the House of Representatives and the Senate) and receive
Royal Assent.
• The ATO is a government body that falls under the Federal Government Treasury portfolio, and is
responsible for collecting government revenue and administrating the Commonwealth tax regimes.
• The ATO is run under the supervision of the Commissioner, who can delegate authority to other tax
officers in the ATO.
• The court system that applies income tax law is hierarchical, with the courts, listed in order of
ascending power being: the Federal Court (single judge), the Full Federal Court and the High Court.
Courts are only bound by prior decisions of higher courts.
• Figure 1.1 provides an overview of the Australian taxation law environment.
• Figure 1.2 illustrates the Constitutional provisions relating to the imposition of taxation, figure 1.3
provides an overview of how tax legislation is formed and figure 1.4 illustrates the hierarchy of the
Australian court system that applies income tax law.
• Example 1.1 illustrates the difference between the ratio and obiter of a case.
1.2 Identify the potential ethical conflicts or dilemmas in a tax advisory context.
• Tables 1.1, 1.2 and 1.3, respectively, give detailed instances of what are regarded as services for
tax agents, BAS agents and of tax (financial) advisers.
• APES 110 contains the conceptual framework for dealing with potential ethical dilemmas. This
involves identifying threats to the fundamental principles not being complied with. The fundamental
principles are:
1. integrity
2. objectivity
3. professional competence and due care
4. confidentiality
5. professional behaviour.
• Figure 1.10 demonstrates how APES 110 applies the conceptual framework for dealing with
ethical dilemmas.
• The TPB is the body responsible for registering and regulating tax agents, BAS agents and, prior to
1 January 2022, tax (financial) advisers across Australia. It is also responsible for compliance with
the TPB Code.
• The TPB Code consists of 14 principles that fall under five categories. They apply to tax agents,
BAS agents and tax (financial) advisers. Section 30-10 of TASA sets out the basis for the TPB Code.
• Table 1.5 provides a brief comparison of the TPB Code and relevant obligations under the FASEA’s
Standards and the Corporations Act or tax (financial) advisers.
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32 Australia Taxation
PART B: ADMINISTRATION OF THE
TAX SYSTEM
INTRODUCTION
Part A of this module examined the legal fundamentals of the tax system, as well as the regulatory
environment in which tax practitioners operate in. Part B discusses the administration of the tax system.
The body in charge of this is the federal government’s delegated agency, the ATO. The ATO is headed
by the Commissioner of Taxation (the Commissioner) and decisions are made by the ATO acting in
the authority of the appointed Commissioner. The ATO is in charge of administering the income tax selfassessment system with which all taxpayers must comply.
In order to assist taxpayers under the self-assessment system, the ATO publishes taxation guidance
through a variety of publications including public and private rulings, law companion rulings, practice
statements and interpretative decisions. After the lodgment of a tax return by a taxpayer, the ATO issues
an assessment. Subsequently, a taxpayer may be subject to an audit under the self-assessment system. The
audit may result in penalties and/or interest charges being imposed. If the taxpayer does not agree with the
Commissioner’s treatment of a certain tax issue, they may request a review, lodge a formal objection or
further appeal the decision.
Taxpayers and tax professionals must be familiar with their various tax reporting and payment
obligations under the law. Failure to comply with the relevant tax laws can lead to a range of penalty
and interest charges. Taxpayers and professionals should especially be aware of the distinction between
tax planning, tax avoidance and tax evasion. The distinction between tax planning and tax avoidance is
especially important in light of the fact that the latter can be potentially targeted by the Part IVA antiavoidance laws of the tax legislation. Consequently, it is important that taxpayers and tax professions are
familiar with their operation, as well as being aware of the operation of the promoter penalty regime. All
of these issues will be examined in Part B.
Figure 1.12 summarises the relevant tax administration issues covered in Part B of this module.
Summary of taxation administration
FIGURE 1.12
Taxation
administration
Penalties and
interest charges
Part IVA
obligations
Promoter
penalty regime
Tax payment
and reporting
obligations
Self-assessment
system
ATO Guidance
and Rulings
ATO conducts
audits
Objections
Lodge returns
Issue
assessments
Reviews
Appeals
Source: CPA Australia 2022.
1.5 INCOME TAX SELF-ASSESSMENT
INCOME TAX SELF-ASSESSMENT
A taxpayer’s tax liability is calculated by first determining their taxable income. As discussed in module 2,
the taxable income is equal to the taxpayer’s assessable income less their allowable deductions. The
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MODULE 1 The Legal, Ethical and Regulatory Fundamentals 33
relevant tax rates are then applied to a taxpayer’s taxable income, which determines the basic tax liability
amount. This is then reduced by any tax offsets that the taxpayer is entitled to in order to determine their
final tax liability.
Importantly, the actual legal liability to pay income tax arises upon the assessment of a taxpayer.
Assessment is defined in s. 6(1) of ITAA36 as the ‘ascertainment of the amount of taxable income and
of the tax payable upon that taxable income’. The process of assessment is completed by the serving of a
notice on the taxpayer.
Australian income tax operates on a system of self-assessment. This means that the onus is on
the taxpayer to complete the tax return and to report all assessable income and allowable deductions. According to the Taxpayers’ Charter (www.ato.gov.au/About-ATO/Commitments-and-reporting/
Taxpayers--Charter/Taxpayers--Charter---essentials), the taxpayer, even if represented, is responsible for
ensuring information is correct and is expected to lodge all information on time. There is a large emphasis
on post-assessment checking for compliance. Compliance is reviewed through taxation audits, discussed
in ‘Tax audits’.
Under the ‘partial self-assessment system’, which applies to most taxpayers, the ATO generally accepts
the statements made in a tax return at face value and issues a tax assessment based on the taxpayer’s
return. The return is not generally subject to close technical scrutiny by the ATO prior to the assessment
being issued.
For a ‘full self-assessment’, the relevant taxpayer (companies and superannuation funds come under
the full self-assessment guidelines) by lodging a tax return triggers an ATO automatic deemed assessment
based on the information in the tax return. Assessments are discussed in more detail in ‘Assessments’.
Example 1.6 describes how the self-assessment regime operates in a given situation.
EXAMPLE 1.6
Self-Assessment Regime
Tim Robertson is a salaried employee working for IMF bank and an Australian resident for income tax
purposes. Tim received his annual wage of $44 000, dividend income of $6000 from an Australian company
and rental income of $10 000 from his Melbourne investment property for the year ended 30 June 2022.
During the tax year Tim was also the recipient of $2000 interest income from an overseas bank account
which he thought he would not have to declare as it originated from outside Australia. Tim declared a
total of $60 000 as his assessable income for the 2021–22 tax year and an assessment was issued on
this basis. An audit later discovered that Tim had omitted the $2000 interest income from his tax return.
Consider the tax implications for Tim.
The onus is on the taxpayer to complete the tax return and to report all assessable income and allowable
deductions. Tim is responsible for ensuring information is correct. As a resident taxpayer, he is assessable
on his worldwide income and it is his responsibility to know that his overseas interest income should
have been declared in his tax return or alternatively, he should have sought professional advice. This
demonstrates that there was a lack of reasonable care shown by Tim, that an ordinary person would
have exercised in the circumstances to fulfil the taxpayer’s tax obligations. As a result, Tim would receive
an amended assessment from the ATO and is potentially liable for additional tax and penalties in these
circumstances.
REQUIREMENTS TO LODGE TAX RETURNS
Each income tax year, a legislative instrument is made that sets out which entities are required to lodge
returns under ITAA36, ITAA97, TAA, the Superannuation Industry Supervision Act 1993 Act, the Higher
Education Support Act 2003 and the Trade Support Loans Act 2014. It is published on the Federal Register
of Legislation, www.legislation.gov.au.
Most individuals, sole traders, partnerships, trusts, superannuation funds and companies are required to
lodge annual income tax returns (ATO 2021a). All these taxpayers have the option of using a registered
tax agent to lodge their return. As discussed earlier in this module, the tax agent must be registered with
the TPB. The separate requirements are as follows.
• Individuals (excluding sole traders). Resident taxpayers (full or part year) earning over the tax-free
threshold (as discussed in module 4, this is $18 200 in the 2021–22 tax year, or threshold apportioned
for part-year residents) are generally required to lodge an income tax return. There are exceptions for
those resident taxpayers with special circumstances, which means they may not have to complete a
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34 Australia Taxation
return. These exceptions include those receiving a type of Australian Government taxable allowance or
payment with income under a certain amount (and where other conditions are met), and special rules
also apply for minors and beneficiaries of a trust (among others).
There is an online tool available via the ATO website aimed at individuals, which determines if the
taxpayer needs to lodge a tax return. Available at www.ato.gov.au/Calculators-and-tools/Do-I-need-tolodge-a-tax-return.
• Sole traders. They are required to lodge tax returns even if the income derived is below the tax-free
threshold or they are in a tax-loss situation.
• Partnerships. The partnership is required to lodge a partnership tax return and is required to report the
partnership’s net income (as discussed in module 5). Each individual partner must also report their share
of the partnership’s net income or loss, as well as any other individual assessable income (such as salary,
interest, rent and dividends).
• Trusts. Trustees are required to lodge a trust tax return. Each beneficiary of the trust is also generally
required to lodge an individual tax return, where they must declare any income they receive from the
trust, as well as any other individual assessable income (such as salary, interest, rent and dividends).
• Superannuation funds. All superannuation funds, including self-managed superannuation funds
(SMSFs), are required to lodge a separate superannuation fund trust return.
• Companies. Companies are required to lodge a company income tax return. ‘The company reports its
taxable income, tax offsets and credits, PAYG instalments and the amount of tax it is liable to pay on
that income or the amount that is refundable’ (ATO 2021a). Certain large companies are also required
to complete a ‘Reportable tax position schedule’, which identifies contentious or disputable positions
they have taken on significant tax arrangements. Company income is separate to individual income.
TAX RETURN LODGMENT REQUIREMENTS
There are separate requirements for individuals and entities regarding the lodgment of tax returns.
A registered tax agent has the authority to lodge income tax returns on behalf of individuals and entities
based on the tax agent’s lodgment program (see later in this section). They also have the authority to
undertake communications on the taxpayer’s behalf in relation to income tax returns.
A registered BAS agent has the authority to lodge BAS and instalment activity statements (IASs) —
see later in the module for a description of those documents. They have the authority to undertake
communications on the taxpayer’s behalf in relation to the BAS and the IAS.
A tax return must be in the approved form and contain the prescribed information. The return must be
signed by the taxpayer (and the registered tax agent, where they have prepared it) and contain a declaration
that the return is true and correct.
Tax returns are due to be lodged by specified lodgment dates. For most individual taxpayers, who selfprepare, the due date for lodgment is usually 31 October following the end of the tax year.
However, the ATO has the power to extend the time for lodgment of a return, under s. 161 of ITAA36
and may grant an arrangement to lodge or an extension to lodge. The Commissioner can also use this
power to create ‘lodgment programs’ for tax agents. Where a taxpayer’s return is prepared and lodged
by a registered tax agent, an extension of time to lodge is usually available in accordance with the tax
agent’s lodgment program. The ‘Tax reporting and payment obligations’ section examines lodgment dates
in more detail.
Further and Special Tax Returns
In addition to normal annual tax returns, the Commissioner also has power under s. 162 of ITAA36 to
require a further return — for example, where the Commissioner is not satisfied with the original return
lodged by the taxpayer, or the taxpayer has not lodged a return.
The Commissioner may also, under s. 163, require a special return where the normal lodgment time
would not be appropriate or effective — for example, because the taxpayer proposes to leave Australia
before the normal lodgment date.
ASSESSMENTS
For taxpayers not subject to the full self-assessment system, the ATO provides a notice of assessment of
the tax payable after the income tax return has been lodged.
A tax assessment issued by the ATO is deemed prima facie to be correct when challenged under the
statutory objections, reviews and appeals process as contained in Part IVC of TAA.
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MODULE 1 The Legal, Ethical and Regulatory Fundamentals 35
Accordingly, it is the responsibility of the taxpayer to challenge the tax assessment. Taxpayers can
undergo a statutory review and appeal process through Part IVC of TAA. When relying on the statutory
right to a review or appeal under Part IVC, the taxpayer must not only show that the assessment is excessive
but also demonstrate the correct amount. This process is discussed further in the section ‘Objections,
reviews and appeals’.
Where some taxpayers might be tempted to avoid assessment simply by not lodging a tax return, the
Commissioner has the power under s. 167 of ITAA36 to issue a default assessment (it may be issued as an
original or amended assessment), based on the amount of tax the Commissioner believes is payable.
AMENDED ASSESSMENTS
The ATO recognises that not every assessment issued by them will be correct, so there needs to be a method
of correcting, or amending, an issued assessment. Similarly, a taxpayer is also able to request the ATO to
amend their return — known as ‘self-amendment’ — in the same time frames as for amended assessments
in general.
The time frames for amending an assessment, which apply to both the ATO and the taxpayer, are
as follows.
• Two-year time limit — applies to most individuals, small business entities (SBEs) (those with an
aggregate turnover of less than $10 million) and medium business entities (those with an aggregate
turnover of less than $50 million). Specifically, this limit is two years from the day the ATO served
(or is deemed to have served) the original notice of assessment on the taxpayer (ITAA36, s. 170(1),
Items 1–3).
• Four-year time limit — applies to other taxpayers, namely larger entities, individuals with complex
affairs or higher-risk taxpayers, and is four years from the day the ATO served (or is deemed to have
served) the original notice of assessment on the taxpayer (ITAA36, s. 170(1), Item 4).
In very limited circumstances, the ATO has unlimited time to amend an assessment. This applies if they
suspect there has been tax avoidance or evasion. The amendment gives effect to a decision on review or
appeal, or if the amendment relates to a specific provision that allows for an unlimited time frame.
Section 170(3) of ITAA36 permits the Commissioner to re-amend an assessment for a second or
subsequent time in prescribed circumstances. The ATO may repeat this process — but only for some
items — within two or four years of the later assessment.
The Commissioner can amend an assessment after the expiry of the normal time limit where, before the
expiry of the time limit:
• the taxpayer requested an amendment (s. 170(5)), or
• the taxpayer had applied for a Private Ruling (s. 170(6)). Rulings are discussed later in this module.
The Commissioner can also, under s. 170(7), obtain an extension to amend an assessment, where the
ATO has begun but not completed an examination of the taxpayer’s affairs before expiry of the time limit,
and either:
1. the Federal Court in its discretion grants an extension
2. the taxpayer consents in writing to an extension.
Example 1.7 illustrates the time limits available to the ATO to amend an assessment for a taxpayer with
simple tax affairs.
EXAMPLE 1.7
Amendment of Assessment — Time Limits
The ATO served a notice of income tax assessment for the 2017–18 tax year on Reece Morris on
20 November 2018. Reece is an individual taxpayer who works as an employee in a retail store and has
very simple tax affairs. In his tax returns there is only a salary, a small amount of interest income from a
bank account and a few deductions.
The ATO has been conducting a tax audit of Reece for some time but has not yet completed it. The ATO
intends to issue an amended assessment for the 2017–18 tax year to Reece.
Consider the tax implications for Reece.
As Reece is an individual with simple tax affairs, the time limit for amendment under s. 170(1), Table
item 1 is two years from the day the Commissioner gives notice of the assessment to the taxpayer. As it
is now the 2021–22 tax year, more than two years have passed since the 20 November 2018 assessment,
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36 Australia Taxation
the ATO could use the s. 170(7) extension procedure to apply to the Federal Court or ask Reece to consent
to an extension. If an extension cannot be obtained under s. 170(7), the ATO can only issue an amended
assessment against Reece if it can establish, for example, that Reece entered into a scheme for the
dominant purpose of obtaining a tax benefit (s. 170(1), Table item 1(e)) or there has been fraud or evasion
(s. 170(1), Table item 5).
QUESTION 1.7
Adnet Pty Ltd is a distributor of computer parts. For the year ended 30 June 2021, Adnet valued
its trading stock at $1.45 million and returned a taxable income of $5.68 million. On 1 April 2022,
Adnet realised that it had made an error in their manual stocktake and that trading stock should
have been valued at $1.54 million. As discussed in module 2, comparatively larger stock on hand at
the end of a tax year typically results in lower deductions or higher assessable income than would
otherwise be the case.
Under the self-assessment regime, what are the implications for Adnet and what specific action
should it take with regards to the error?
QUESTION 1.8
Rick Downer is a taxpayer who has had constant disagreements with the ATO with regards to his
tax affairs. During the 2021–22 tax year he had been totally uncooperative and refused to engage
with the ATO. Rick has been diverting $100 000 of income offshore into foreign bank accounts and
has not lodged a tax return for over five years.
What action can the ATO take under the tax law in these circumstances to make Rick
accountable?
1.6 ATO GUIDANCE DOCUMENTS AND RULINGS
Tax law can raise very difficult issues, but under self-assessment a taxpayer may be liable for substantial
penalties if they do not report their income and deductions correctly. To help taxpayers navigate through
the tax legislation and practice, the ATO publishes a range of advice in the form of guidance documents
setting out the ATO’s views on key issues.
This guidance is set out in a variety of publications, including public and private rulings, law
administration practice statements and interpretative decisions.
THE RULINGS SYSTEM
There are several different categories of rulings issued by the Commissioner to provide taxpayers with
guidance regarding how the ATO interprets the tax legislation.
The Commissioner can issue rulings about the application of tax legislation to a specified situation,
and accordingly the ATO can rule on actual tax liability and matters such as collection and payment of
tax, administrative or procedural matters, and ultimate conclusions of fact such as whether an activity is a
hobby or a business (TAA, Schedule 1, s. 357-55).
A ruling is a statement of the ATO’s opinion on how the law applies to a particular situation. Although it
is not legislated law, a ruling will bind the Commissioner in specified circumstances. Acting in accordance
with a ruling will protect the taxpayer against liability for tax, interest and penalties.
A ruling only binds the Commissioner. The taxpayer is not required to follow a ruling though, if they
do not and the ruling is found to be correct, the taxpayer may be liable to penalties (TAA, Schedule 1,
s. 357-60, which includes examples and s. 357-65).
Crucially, a ruling will only apply and bind the Commissioner where the taxpayer’s facts fall within the
scope of the ruling. If the taxpayer’s arrangement is materially different to the situation covered by the
ruling, the ruling (and its protection) will not apply to the taxpayer’s arrangement.
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MODULE 1 The Legal, Ethical and Regulatory Fundamentals 37
PUBLIC RULINGS
A public ruling is issued by the ATO to provide guidance on issues of general importance and sets out
the ATO’s opinion on how a particular provision of an Act applies to taxpayers or a class of taxpayers in
relation to an arrangement outlined in the ruling.
To be a binding public ruling, the ruling must state that it (or a specified part of the document) is a public
ruling and be published by the Commissioner (TAA, Schedule 1, s. 358-5).
A public ruling will apply automatically to anyone who is acting in accordance with its terms. Unlike a
private ruling, the taxpayer does not have to apply for the protection of a public ruling. Taxpayers cannot
object or appeal against a public ruling but can apply for a private ruling on the issue in question and are
then able to object to the private ruling.
Public rulings include, among others, the following.
• Taxation Rulings. These generally cover a comparatively broad area of income tax law, therefore, often
deal with various issues relating to the relevant area covered. For example, TR 2020/1 discusses when
a work-related expense is regarded as a general deduction.
• GST Rulings. As the name suggests, these deal with various elements of the GST law. For example,
GST Ruling GSTR 2012/5 discusses the impact of GST law on the sale of residential property.
• Tax Determinations. These are a type of public ruling that covers a very specific point of tax law. They
have exactly the same status as taxation rulings, but only deal with a single issue, rather than a number
of tax issues that are evident in an arrangement or transaction. For example TD 2017/11 discusses which
taxpayer is assessable on interest earned from a bank account in certain scenarios, such as where there
is a joint account.
• Product Rulings. These apply to all taxpayers who participate in a particular product. Specifically,
a ‘product’ is an arrangement under which individual taxpayers enter into substantially the same
transaction, with either a common entity or a group of entities. Product Rulings are generally aimed at
taxpayers that borrow or invest money in such arrangements. For example, PR 2020/8 discusses the tax
consequences of a borrower being charged a discounted interest rate by a particular home loan facility
that is offered by a specific financial institution.
• Class Rulings. These apply to all members of a particular class (such as employees or shareholders)
in relation to a particular arrangement. A class ruling is potentially wider than a product ruling as it
does not need to apply to a particular ‘product’. A class ruling can apply to groups such as employees
of a certain organisation, certain employers or shareholders of certain companies. Class rulings often
deal in transactions such as share buybacks schemes offered to shareholders of specific companies, or
redundancies offered to groups of employees of specific employers. For example, CR 2020/2 deals with
the tax consequences for shareholders of a previous Qantas share buyback scheme,
• Product Grants and Benefits Rulings. These deal with some types of government grants and benefits
(e.g. grants for agriculture, mining and forestry operations). For example, PGBR 2012/1 discusses
the circumstances that businesses can benefit under a certain government scheme that encourages the
recycling of oil.
A public ruling applies from the time it is published — or such earlier or later time as is specified in the
ruling — and ceases to apply when it is withdrawn, or at the time specified in the ruling. A public ruling is
withdrawn from the time specified by the Commissioner in a notice published in the Government Notices
Gazette (TAA, s. 358-20) (see ATO 2018).
Example 1.8 illustrates the operation and application of public rulings.
EXAMPLE 1.8
Public Rulings
The Commissioner issued Public Ruling Number 4000, which expressly applied to a class of entities in
relation to a particular land cultivation scheme. Charles Duckworth is a member of that class of entities and
he is one of a number of taxpayers who entered into that land cultivation scheme. Consequently, the ruling
applies to Charles and he relies on the ruling by lodging an income tax return that is in accordance with
the ruling. Under the ruling, Charles’ deductions in relation to the scheme are worked out to be $10 000.
Consider the tax implications for Charles.
As Charles has relied on the ruling, the Commissioner must allow that $10 000 deduction in making
Charles’ assessment (unless Charles stops relying on the ruling or the law is more favourable to him, see
TAA, ss. 357-65 and 357-70).
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38 Australia Taxation
Law Companion Rulings
A law companion ruling is a form of public ruling. Its purpose is to provide the view of the ATO on how
recently enacted law applies. It is usually developed at the same time as the drafting of the legislation Bill.
For example, when the company carried forward loss provisions were expanded to include the instance
whereby companies are allowed to carry forward losses when they fulfil a ‘similar business test’ (see
module 2), Law Companion Ruling LCR 2019/1 was introduced to provide guidance for when there is a
‘similar business’ under this test.
The ATO normally releases a law companion ruling in draft form for comment when the Bill is
introduced into parliament. It is finalised after the Bill receives Royal Assent. It provides early certainty
in the application of the new law, before it can be tested through the rulings system.
A law companion ruling is usually finalised as a public ruling when the law is enacted. As they are
prepared so early in the existence of the law, a law companion ruling is not informed by experience of the
new law operating in practice. While they offer the same protection in relation to underpaid tax, penalties
or interest as a normal public ruling, this protection only applies if the taxpayer relies on it in good faith
(see LCR 2015/1).
PRIVATE RULINGS
A taxpayer may be contemplating a transaction not covered by a public ruling or may wish to challenge
the interpretation applied in a public ruling. In such cases, the taxpayer can apply for a private ruling.
A private ruling is personal to the person whose tax affairs are ruled on (the ‘rulee’) and no-one other
than the rulee can rely on it, even if their facts are very similar or even identical. However, a private income
tax ruling given to the trustee of a trust also applies to the beneficiaries of the trust and any replacement
trustee (TAA, Schedule 1, s. 359-30).
In addition, a private ruling only applies to the particular scheme (set of facts) described in the ruling.
Thus, if the taxpayer changes the arrangement in any significant way, the ruling will not apply to the
changed arrangement (CTC Resources NL v FCT (1994) ATC 4072). A new private ruling will have to be
requested (TAA, Schedule 1, ss. 359-5, 359-10, 359-20, 359-25) (see ATO 2017a).
For the guidance of other taxpayers, summaries of each private ruling issued are posted on the ATO
website, but all names and other identifying features are removed. It is important to note that these rulings
are not updated when legislation changes and so the advice they contain can be out of date. Taxpayers can
object or appeal against a private ruling under Part IVC of TAA.
See private ruling requirements at www.ato.gov.au/general/ato-advice-and-guidance/in-detail/
private-rulings/reference-guide-for-private-rulings.
QUESTION 1.9
Mains Manufacturing Ltd (M&M Ltd) is a large conglomerate that, among other activities, supplies
parts for domestic heating and cooling. It has an aggregate turnover of $6 billion. As a result of
a breakdown in its manufacturing plant in October 2021, it incurred expenditure of $350 000 in
repairing and replacing machinery. M&M Ltd is unsure whether the expenditure is capital or revenue
in nature. As discussed in module 2, if it is revenue, then an immediate deduction will typically
be allowed. M&M Ltd’s accountant is also unsure how the expenditure should be treated and is
considering applying for a private ruling on this matter.
Advise M&M Ltd as to whether it should apply for a private ruling and briefly outline what is
required from both M&M Ltd and the Commissioner.
Oral Rulings
Unlike traditional private rulings, which are in writing, individual taxpayers can, in some instances, rely
on oral rulings by the Commissioner, which are given to individuals over the telephone. An oral ruling is
an expression of the ATO’s opinion of how a provision of the law applies to an individual in relation to
their specific circumstances (TAA, Schedule 1, s. 360-5).
The ruling is given orally and the taxpayer is provided with a registration identifier only. There is no
written record of the ruling. As with other rulings, an oral ruling will be binding on the Commissioner
where it applies to the rulee and the rulee acts in accordance with it (s. 357-60). Taxpayers cannot object
to or appeal against an oral ruling but can apply for a written private ruling on the issue in question and
are then able to object to the private ruling. (TAA, Schedule 1, s. 359-60).
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MODULE 1 The Legal, Ethical and Regulatory Fundamentals 39
ATO GUIDANCE DOCUMENTS OTHER THAN RULINGS
The ATO produces a number of guidance documents that technically speaking do not constitute rulings
and so are not legally binding on the ATO.
Practical Compliance Guidelines
Practical Compliance Guidelines (PCGs) provide broad compliance guidance in regards to any significant
legal administration issues. For example, a PCG may outline administrative safe harbour approaches for
taxpayers. Although PCGs are generally not regarded as public rulings and are not legally binding, they
do provide general guidance on how the ATO will manage its compliance resources according to risk
assessments (see PCG 2016/1).
Law Administration Practice Statements
The ATO produces law administration practice statements, to provide direction and assistance to ATO staff
on approaches to take when performing duties involving the laws they administer. Practice statements are
published on the ATO’s legal database.
Practice statements are not law and are not public rulings. They are not intended to provide interpretative
advice, but technical issues may be discussed in the practice statements in the course of providing directions
to ATO staff.
ATO Interpretative Decisions
According to the ATO:
An ATO interpretative decision (ATO ID) is an edited version of a decision we have made on an
interpretative matter and gives an indication of how we might apply a provision of the law (ATO 2017b).
The ATO produces IDs to help them apply the law consistently and accurately. Those IDs set out the
precedential ATO view that the ATO must apply in resolving interpretative issues. ATO IDs don’t provide
advice to taxpayers and they are not rulings (ATO 2017b) —see PS LA 2001/8; PS LA 2003/3.
Taxpayer Alerts
Taxpayer alerts are warnings given to taxpayers regarding any significant new tax planning issues or
arrangements that the ATO considers to be of a risky nature (PS LA 2008/15).
1.7 TAX AUDITS
WHY TAX AUDITS ARE NEEDED
Most taxpayers in Australia endeavour to comply with their tax obligations (voluntary compliance) and,
over recent years, the ATO has introduced a number of initiatives to help taxpayers do the right thing —
for example, education programs, simplified tax returns and pre-filling of returns by the ATO.
Nevertheless, there are some taxpayers who attempt to avoid paying the correct amount of tax — for
example, by failing to declare all income they derive or incorrectly claiming deductions or tax offsets.
To prevent this, the Commissioner needs some method of checking a taxpayer’s affairs, to confirm that
they are paying the correct amount of tax. One of the chief ways of doing this is to conduct taxation audits.
The ATO does not have the resources — or the political will of the people and governments — to audit
every Australian taxpayer to ensure they are correctly adhering to the self-assessment taxation regime.
THE AUDIT PROCESS
Consequently, the ATO needs to be able to obtain timely and accurate information about taxpayers and
their transactions in order to identify who to target.
To do this, the ATO uses data-matching technology. This means it compares items that taxpayers
have declared or claimed in their returns with information from other sources such as banks (interest
income), companies (dividends), land title offices (land purchases), the Family Assistance Office (spouse
rebates and other tax concessions), AUSTRAC (fund transfers), and other government and non-government
organisations. Data matching also identifies persons who should have lodged a return but have failed to
do so. The use of data matching is improving rapidly, and each year more taxpayers are being detected
where their assessable income does not match the sources of their income.
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40 Australia Taxation
See www.ato.gov.au/About-ATO/Commitments-and-reporting/Information-and-privacy/Data-match
ing.
Enhanced third-party reporting, pre-filling and data matching have improved audit activity. For example
in 2017, the ATO investigated taxpayers in the sharing economy, such as those working as Uber drivers,
letting rooms on Airbnb and offering services through Airtasker. Because the transactions in the sharing
economy are made electronically, they are easy to trace.
The ATO can also mine social media sites, such as Instagram, for disparities between assessable income
declared and images of a more expensive lifestyle. For example, a person may be identified as having
$25 000 assessable income in the last tax year, but their Instagram shows images of extended European
holidays or the purchase of expensive sports cars.
Where the ATO suspects that a taxpayer has not declared all assessable income in their tax return for
a particular tax year, or is not entitled to all the deductions they have claimed, the ATO may initiate a
‘risk review’. This is important because voluntary disclosures at this stage can often give rise to significant
penalty reductions. This is when the ATO will serve the taxpayer with an initial please-explain letter.
If matters cannot be resolved on review, the ATO may decide to conduct an audit. This may be either an
internal audit, or an audit in the field, with tax officers attending the taxpayer’s premises to seek information
and examine documents. Where an audit reveals inaccuracies in the taxpayer’s return (or the fact that
they should have lodged a return), the ATO will issue an amended assessment (or a default assessment)
reflecting the true situation.
To improve compliance activities, the ATO have established Annual Compliance Arrangements between
the ATO and key/large taxpayers and piloted an external compliance assurance process which allows
selected companies to use a registered company auditor to clarify factual matters identified by the ATO.
ATO INFORMATION GATHERING POWERS
Often when the ATO is undertaking an audit, it will ask the taxpayer for information informally in the first
instance. The taxpayer generally has a reasonable time to respond to the initial please-explain notice.
Failure to respond can result in the ATO using its formal powers to gather information. Under s. 353-10
of Schedule 1 of TAA, a person (whether the taxpayer or not) is required to:
• provide specified information
• attend before one or more taxation officers to give evidence on relevant matters
• produce specified books, documents and other papers in their custody or control.
Section 353-15 of Schedule 1 of TAA allows the ATO to make access visits in order to gather
information. These are the access powers and they will generally only be used if the ATO cannot obtain the
documents or information required from the taxpayer. Under these access powers, the ATO can enter and
remain on any land, premises or place; and they can have full and free access to books, documents, goods
or other property. Access rights can only be exercised for the purposes of the taxation laws administrated
by the ATO.
The ATO publishes detailed guidance on its information gathering and access powers, which can
be found at www.ato.gov.au/about-ato/commitments-and-reporting/in-detail/privacy-and-informationgathering/information-management/access,-accountability-and-reporting.
Limitations in ATO Power
While the ATO’s powers are very wide, they do have important limitations. The two main limitations are
the legislated legal professional privilege (LPP) and the administrative-only accountants’ concession.
The ATO cannot obtain access to documents or communications that are protected by legal professional
privilege. This privilege applies to protect from disclosure confidential communications (or a relevant part
of a communication) between a taxpayer and their legal adviser, which were created for the dominant
purpose of giving or receiving legal advice or for use in current or anticipated litigation. (See FCT v
Citibank Ltd (1989) ATC 4268; Esso Australia Resources Ltd v FCT (2000) ATC 4042; JMA Accounting
Pty Ltd & Entrepreneur Services Pty Ltd v Carmody (2004) ATC 4736; AWB Ltd v Cole (2006) 152 FCR
382; Glencore International AG v FCT (2019) HCA 26.)
While legal professional privilege only applies to communications with a lawyer, most tax advice is
given by accountants, and there is a strong argument for extending similar protection to such advice.
Accordingly, the ATO has for some years provided an accountants’ concession, under which the ATO
will seek access to source documents such as contracts and other documents that record a transaction but
will only seek access to restricted source and non-source documents in exceptional circumstances.
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MODULE 1 The Legal, Ethical and Regulatory Fundamentals 41
Restricted source documents are those prepared by an external accountant at the time of planning or
implementing a transaction for the sole purpose of advising on that transaction — for example, how to
structure a transaction. Non-source documents cover advice provided after the completion of a transaction,
or papers prepared as part of an audit or due diligence report.
It should also be noted that the Commissioner has an obligation to keep taxpayer information
confidential (TAA, s. 355-10). In this regard, the disclosure of information regarding the tax affairs of
a taxpayer are prohibited and is an offence (s. 355-25) except in certain specific circumstances where the
public benefit of the information outweighs the taxpayer’s right to privacy. For details about disclosures
for other government purposes, see s. 355-65 of TAA, Table 1 and Table 7.
Example 1.9 illustrates the ATO’s information gathering powers and the possible application of LPP.
EXAMPLE 1.9
ATO Information Gathering Powers
Mark Evans, an ATO tax auditor, was not able to find all the information and documents he wanted during
his access visit to BTC Enterprises (BTC). Accordingly, the ATO decided to issue a notice to BTC under
s. 353-10 of TAA, requiring BTC to:
• provide specified information about the tax planning scheme that they have been promoting
• produce all documents relating to the scheme for the period 1 July 2018 to 1 July 2021
• attend before the ATO and others to be examined on oath about aspects of the scheme.
Subsequently, BTC refused to provide the information, arguing that it will require time and trouble to
assemble it; refused to produce the documents requested on the basis that they are all protected by legal
professional privilege; and attended examination, but refused to answer any questions on the basis that
the answers might be incriminating.
The fact that compliance with the notice may require some effort is not a valid reason for refusing to
comply. While legal professional privilege is a valid defence to a notice, a vexatious claim for privilege
where it is clearly not available amounts to obstruction, so BTC would need to be sure that the privilege
was arguably available. That is, that the documents relating to the scheme were in fact confidential
communications between BTC and their legal adviser, which were created for the dominant purpose of
giving or receiving legal advice or for use in current or anticipated litigation.
QUESTION 1.10
Karen Davies is an accountant and financial adviser and has a number of clients who run small
businesses. During the 2021–22 tax year, one of Karen’s clients who made a claim for deducting
building costs of $33 400 associated with their business restructure was subject to an audit. The
ATO issued a Notice under s. 353-10 of Schedule 1 of TAA and was seeking access to all types of
documents and records held by the taxpayer on their business premises in order to investigate the
claim.
Applying the Commissioner’s access powers under s. 353-10 of Schedule 1 of TAA and other
relevant guidelines, how will the ATO’s request be met by Karen?
1.8 OBJECTIONS, REVIEWS AND APPEALS
(PART IVC TAA)
OBJECTIONS (DIVISION 3 OF PART IVC TAA)
Some tax assessments issued by the ATO will contain errors or apply interpretations of the law or facts with
which the taxpayer disagrees. Procedural fairness, therefore, requires that the taxpayer must have some way
to challenge or dispute an assessment. A taxpayer may object to a tax assessment, determination, notice
or decision.
A taxpayer who is unhappy or dissatisfied with an income tax assessment can lodge a written objection
against that assessment within prescribed time limits and on the approved form, stating fully and in detail
the grounds on which the taxpayer relies. The taxpayer may lodge their objection within two years (or
within four years for more complex matters). This time limit begins from the date the notice of assessment
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42 Australia Taxation
is served, unless there is an agreed extension. (See ss. 14ZU and 14ZW of TAA regarding how and when
taxation objections are to be made.)
An unusual feature of self-assessment is that a taxpayer may choose to prepare their return on the basis
of an ATO ruling or interpretation (even though they disagree with that interpretation) in order to avoid
the risk of imposition of penalties. However, the taxpayer may then object against an assessment based on
their own return, in effect arguing that the ATO interpretation is wrong and their interpretation — even
though not reflected in their return — is right.
Where a taxpayer wishes to object against an amended assessment, the objection must be lodged by the
later of:
• the normal two- or four-year limit applying to the original assessment
• 60 days after the notice of amended assessment has been served.
Any objection to an amended assessment is limited to the particular issues that were amended by
the later assessment (s. 14ZV). The taxpayer has the right to withdraw their objection up to the time
the Commissioner decides to accept or reject the objection. Once the objection is withdrawn, the
Commissioner can no longer make an objection decision in relation to it.
Unless the objection is withdrawn, the Commissioner must make an ‘objection decision’ on whether
to allow or disallow the objection. Where the Commissioner has not made a decision on their objection
within the prescribed time (most often 60 days after the objection was lodged with the Commissioner),
the taxpayer can give the Commissioner a notice requiring the Commissioner to make a decision on
the objection.
If the Commissioner fails to make a decision within a further 60 days, the Commissioner is deemed to
have disallowed the objection, and the taxpayer can then seek review of this decision. Reviews and appeals
will be discussed shortly.
Table 1.6 shows the type of decisions and time limits for each area of tax law to lodge an objection. This
table is adapted from the ATO.
TABLE 1.6
Types of decisions and time limits for lodging an objection
FBT
You can object to
How long you have
Assessments
Four years from the date the assessment was given to you.
Amended assessments
Until the later of:
• 60 days from the date the amended assessment was given to you
• four years from the date the original assessment (that was
amended) was given to you.
Private rulings
Until the later of:
• 60 days from the date the ruling was given to you
• four years from the last day for lodging the relevant return.
You cannot object to a private ruling if you have an assessment for
the period concerned — object to the assessment instead.
GST
You can object to
How long you have
Assessments
Four years and one day from the date the assessment was given
to you. For assessments relating to tax periods that started before
01.07.12, you have until the later of:
• 60 days from the date the assessment was given to you
• four years from either the:
– end of the relevant tax period
– date of importation (for imported goods).
(continued)
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MODULE 1 The Legal, Ethical and Regulatory Fundamentals 43
TABLE 1.6
(continued)
GST
You can object to
How long you have
Amended assessments
For amended assessments relating to tax periods that started on or
after 01.07.12, you have until the later of:
• 60 days from the date the amended assessment was given to you
• four years after the assessment that has been amended was
given to you.
For amended assessments relating to tax periods that started
before 01.07.12 you have until the later of:
• 60 days from the date the amended assessment was given to you
• four years from either the
– end of the relevant tax period
– date of importation (for imported goods).
Private rulings
You have until the time you lodge a BAS that takes into account the
matter to which the ruling relates. For private rulings relating to tax
periods that started before 01.07.12, you have until the later of:
• 60 days from the date the ruling was given to you
• four years from either the
– end of the relevant tax period
– date of importation (for imported goods).
You cannot object to a private ruling if you have an assessment for
the period concerned — object to the assessment instead.
Reviewable GST decisions
60 days from the date the decision was given to you.
Failures to make an assessment
60 days — starting 30 days after the date you gave notice
requesting an assessment.
Decisions to retain refunds
Your objection period starts 75 days (plus any time you take to
provide additional information the ATO asks for) after you lodge
your activity statement. It ends when you receive an amended
assessment (or equivalent for refunds relating to tax periods that
started before 01.07.12).
Income tax
You can object to
How long you have
Assessments
Two or four years from the date the assessment was given to you:
• two years for most individuals, small businesses and medium
businesses
• four years for all other taxpayers.†
Amended assessments
Until the later of:
• 60 days from the date the amended assessment, was given to
you
• two or four years from the date the assessment that has been
amended was given to you
– two years for most individuals, small businesses and medium
businesses
– four years for all other taxpayers.†
Private rulings
Until the later of:
• 60 days from the date the private ruling was given to you
• two or four years from the last day for lodging the relevant return
– two years for most individuals, small businesses and medium
businesses
– four years for all other taxpayers.†
You cannot object to a private ruling if you have an assessment for
the period concerned — object to the assessment instead.
Decisions to retain refunds
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44 Australia Taxation
Your objection period starts 90 days after you lodge your activity
statement. Any time you take to provide additional information we
ask for will extend the objection period. It ends when you receive an
amended assessment.
Penalties and interest
You can object to
How long you have
Shortfall penalty
Until the later of:
• 60 days from the date the penalty assessment notice was given to
you
• the last day for lodging an objection to the assessment to which
the penalty relates.
Penalty for failing to provide a document
Until the later of:
• 60 days from the date the penalty assessment notice was given to
you
• the last day for lodging an objection to the assessment to which
the penalty relates.
Decisions not to remit shortfall interest
charge (SIC), but you cannot object to our
decision not to remit SIC if the interest is
20% or less of the shortfall amount. For
example, if your shortfall is $2000, 20%
is $400. If the SIC you were left to pay
after the ATO had made a decision on
remission was $400 or less, you could not
object to it. Other administrative penalties,
but you cannot object to a decision not to
remit (waive) a penalty if the amount you
are faced with paying is less than $444
(two penalty units).
60 days from the date the decision was given to you.
Superannuation
You can object to
How long you have
Excess contributions tax assessments
Four years from the date the assessment was given to you.
Excess transfer balance cap tax
assessment
Four years from the date the assessment was given to you.
Excess transfer balance determination
60 days from the date the determination was given to you.
Termination payments surcharge
assessments
60 days from the date the assessment was given to you.
Superannuation guarantee charge
60 days from the date the assessment was given to you (note —
an employee does not have a right to object to a superannuation
guarantee assessment).
Administrative penalties
60 days from the date you were notified of the decision.
Superannuation: Reviewable decisions
You can ask for a review of
How long you have
A notice about a complying fund status
21 days from the date that you first received notice of the decision.
A notice of disqualification of an individual
from being a trustee
21 days from the date that you first received notice of the decision.
All other reviewable decisions made by
the Commissioner as regulator under the
Superannuation Industry (Supervision) Act
1993 (Cwlth)
21 days from the date that you first received notice of the decision.
JobKeeper payments
You can object to
How long you have
Decisions that you are not entitled to a
JobKeeper payment for a period.
60 days from the date the decision was made.
(continued)
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MODULE 1 The Legal, Ethical and Regulatory Fundamentals 45
TABLE 1.6
(continued)
JobKeeper payments
You can object to
How long you have
Decisions about the particular amount of a
JobKeeper payment for a period
60 days from the date the decision was made.
Decisions that you are not given relief from
repaying an overdue amount
60 days from the date the decision was made.
Decisions on whether you are exempt
from record-keeping requirement
60 days from the date the decision was made.
Decisions that you are jointly and severally
liable to repay an overpaid amount
60 days from the date the decision was made.
Cash flow boost
You can object to
How long you have
Decisions that you are not entitled to the
cash flow boost
60 days from the date the decision was made.
Decisions about the amount of cash flow
boost you are entitled to for a period
60 days from the date the decision was made.
†
‘All other taxpayers’ refers to companies, superannuation funds and individuals that are not eligible for the two-year period. Income
tax assessments include tax offsets and rebates.
Source: Adapted from ATO 2021b, ‘Decisions you can object to and time limits’, accessed January 2022, www.ato.gov.au/
General/Dispute-or-object-to-an-ATO-decision/Object-to-an-ATO-decision/Decisions-you-can-object-to-and-time-limits.
Example 1.10 illustrates the implications for a taxpayer in relation to lodging an objection to an amended
assessment issued by the Commissioner.
EXAMPLE 1.10
Objection to Amended Assessment
A notice of assessment for the 2020–21 tax year is received by Joe Canon (who carries on a business but is
not an SBE or a medium business taxpayer) on 11 October 2021. As a result of an audit, the Commissioner
served a notice of an amended assessment on 8 September 2022. Consider the implications for Joe.
Joe would need to lodge an objection to the amended assessment by the later of 7 November 2022
(60 days after the service of the notice of the amended assessment) or 11 October 2025 (four years after
the service of the original assessment).
REVIEWS (DIVISION 4 OF PART IVC TAA)
Where a taxpayer is dissatisfied with the Commissioner’s objection decision, they can choose in almost all
cases to seek review of that decision by either applying to the Administrative Appeals Tribunal (AAT) or
appealing to the Federal Court (TAA, s. 14ZZ) (see also the definition of ‘reviewable objection decision’ in
TAA, s. 14ZQ). Additionally, individuals, small businesses or not-for-profits with a tax or superannuation
dispute can use the ATO’s in-house facilitation service. This form of alternative dispute resolution (ADR)
is commonly used for less complex disputes and can be used at any stage from the audit up to and including
the litigation stage. Where the taxpayer has reached a settlement of issues with the ATO it cannot recontest
those issues (EE&C Pty Ltd as Trustee for the Tarcisio Cremasco Family Trust (2018)).
The majority of reviews and appeals are settled by the parties through ADR through the in-house
facilitation service and the AAT, or ADR via the Federal Court. A Small Business Taxation Division
(SBTD) was established in the AAT in early 2019.
Process of Review
Taxpayers can seek a review of an objection decision through the AAT and then with litigation through the
Federal Court of Australia. In most cases, the taxpayer must lodge an objection and be dissatisfied with
the outcome before an external review can be applied for.
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46 Australia Taxation
The taxpayer may be able to access a test case litigation program where the ATO will reimburse some
or all of the legal costs if they decide the case has important implications for the administration of the
revenue system.
Procedure of Review
Both the AAT and Federal Court use ADR processes to help resolve tax disputes that come before them.
Such ADR processes can occur at any time, including after a position paper has been issued following an
audit, to even the early stages of litigation.
Where the dispute cannot be settled, it will proceed to the AAT or Federal Court for a court-based hearing
and adjudication. When a taxpayer takes a review to the AAT or the Federal Court for litigation, they will
need to supply evidence. The onus is on the taxpayer to prove that the decision should not have been made
or should have been made differently. They should also show what the correct assessment should be. The
onus is on the taxpayer of proving the case on the civil law balance of probabilities (TAA, ss. 14ZZK(b)(i),
14ZZO(b)(i); Brookdale Investments Pty Ltd v FCT (2013) ATC 10-310). Basically, this means that the
Commissioner does not have to prove that the assessment is correct or not excessive. If the arguments of
the Commissioner and taxpayer are evenly balanced, the taxpayer will lose (FCT v Dalco (1990) 168 CLR
614; Healey v FCT (No. 2) (2012) ATC 20-365; Gashi v FCT (2013) ATC 20-377).
APPEALS (DIVISION 5 OF PART IVC TAA)
A taxpayer can appeal a ‘review decision’ of the AAT to the Federal Court, but only on a question of
law (Administrative Appeals Tribunal Act 1975, s. 44(1)). This means that the Federal Court is limited to
determining whether or not the AAT decided the disputed question of law correctly — it does not re-hear
the entire case (Bell v FCT (2013) FCAFC 32; FCT v Trail Bros Steel & Plastics Pty Ltd (2010) ATC
20-196, 11, 213–4; Politis v FCT (1988) ATC 5029, 5032).
If the taxpayer is dissatisfied with the Federal Court judge’s decision, they can appeal to the Full Federal
Court. If still dissatisfied, they can seek special leave to appeal to the High Court — however, special leave
is not often granted.
When deciding to appeal to the AAT or Federal court the taxpayer will need to take into consideration
the following factors:
• type of case — simple or more complex
• nature of proceedings — the AAT is not bound by the rules of evidence and is less formal
• publicity — AAT matters can be held in private while a court hearing is public
• costs — in the AAT, the taxpayer and the Commissioner generally bear their own costs, whereas the
Federal Court may award costs against the unsuccessful party.
The appeals process is summarised in figure 1.13.
Example 1.11 demonstrates what is involved in the review and appeals process.
EXAMPLE 1.11
Analysis of the Review and Appeals Process
Peter Smith has been involved in a dispute with the ATO, involving substantial amounts of what Peter
believes are non-assessable amounts, but which the ATO regards as the proceeds of a tax avoidance
scheme.
The ATO has rejected Peter’s objection against its assessment, and Peter is trying to decide whether to
take the case to the AAT or Federal Court. The issue in dispute raises some interesting and difficult legal
issues and has not previously been taken to court. There is a considerable amount of potential tax and
penalties at risk. Consider Peter’s options.
If the result of the case depends on how a discretion should be exercised by the Commissioner, the
AAT will be able to re-exercise the discretion, whereas the Federal Court can only override the exercise of
a discretion by the Commissioner where it involves an error of law.
AAT members are very experienced in tax matters, but so are members of the Tax Division of the
Federal Court.
It will usually be much more expensive to go to the Federal Court than the AAT, so unless there are
substantial amounts at issue, the AAT may be preferable.
In Peter’s circumstances, if there are complex legal issues involved and Peter can afford it, many
advisers would suggest going to the Federal Court, with the availability of appeal to the Full Federal
Court and the possibility that on a complex and important legal question arising for the first time, the High
Court might grant special leave if it were necessary to appeal beyond the Federal Court.
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MODULE 1 The Legal, Ethical and Regulatory Fundamentals 47
FIGURE 1.13
Appeals process
High Court
(if special leave granted)
Full Federal Court
Administrative Appeals
Tribunal
Federal Court
Commissioner’s decision
on objection
Objections
Assessment
Source: CPA Australia 2022.
QUESTION 1.11
As the result of an audit, IMF Productions Ltd received an amended assessment on 1 June 2023
for the year ended 30 June 2022. The ATO amended an earlier assessment, which was dated
11 December 2022, by disallowing a $110 000 deduction for work-related travel expenses. The
travel expenses were incurred in establishing an office in China. IMF Productions Ltd already has
a number of offshore offices in the Asia-Pacific region.
(a) Advise IMF Productions Ltd about objecting to the amended assessment.
(b) Assuming that, on 1 October 2023, IMF Productions Ltd received notice that their objection had
been disallowed, what further options are available to them? What are some of the factors that
should be considered?
QUESTION 1.12
Susan Johnson has always had simple tax compliance obligations. On 18 October 2021, Susan
received her income tax notice of assessment for the 2020–21 income tax year. Susan objected
to her notice of assessment. She objected to the refusal of a deduction of expenses for ongoing
maintenance on her investment property, which she rents out through the sharing economy vehicle,
Airbnb, for nine months of the year. The ATO rejected her claim of $8450 worth of expenses.
The Commissioner also indicated that Susan failed to take reasonable care when making her
deductions as they were clearly for capital works and consequently the Commissioner applied a
base penalty (penalties are discussed later in this module).
Susan lodges a written objection to her original notice of assessment on 24 January 2022, which
includes an objection to the application of the penalty.
The Commissioner makes their decision and upholds their refusal of Susan’s claim for the
deductions and the application of the penalty. Susan is determined to seek a review of the
objection decision.
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48 Australia Taxation
(a) What is the final date that Susan can lodge her objection against the notice of assessment?
Susan is not successful in the review decision, and the decision for the disallowing of her
deductions still stands.
(b) How long does the Commissioner have to make an objection decision about Susan’s case?
(c) Describe the review process as it relates to Susan’s case.
(d) Is Susan able to appeal the review decision?
1.9 TAX REPORTING AND PAYMENT OBLIGATIONS
PAYMENT DATES
The annual dates for when taxation is due vary depending on the entity.
• Individuals who lodge income tax returns on or before the lodgment date: the payment of any outstanding
tax is due 21 days after the notice of assessment. If a tax return is late or not lodged at all, the default
payment date is 21 days after the due date for lodgment of the return.
• Self-assessment entities (such as companies and superannuation funds): the payment of any outstanding
amounts is due on the first day of the sixth month after the end of the tax year. As most of these taxpayers
apply the standard tax year ending on 30 June, the payment date is generally 1 December.
These dates represent the final date for any outstanding tax amounts. Generally, taxpayers will have
already made some payments of tax (directly or indirectly) during the tax year by way of the PAYG
withholding and/or instalment systems.
PAYG WITHHOLDING SYSTEM
The PAYG withholding system is the process of deducting tax from payments made to others (such as
employees) and remitting that tax directly to the ATO. For example, an employer is an entity who has a
responsibility to withhold tax on behalf of the employee and remit that tax to the ATO.
The rules governing when a withheld amount should be paid to the Commissioner largely depend upon
the status of the withholder as being large, medium or small. The timing of withholding payments and
method of payment available for each size withholder are listed in table 1.7.
TABLE 1.7
Timing of withholding payments (TAA, Schedule 1, ss. 16-75, 16-85, 16-95, 16-100, 16-105)
Withholder status
Due date of payments
Method of payment
Large amount > $1 million
Depending on the day of the week, large
withholders will remit the tax within a week
Electronic
Medium amount $25 000
and </= $1 million
Payment due by the 21st or 28th day after
the end of the month in which the amount
was withheld
Electronic or other means
approved by the Commissioner
Small amount </= $25 000
Payment due by the 21st or 28th day after
the end of the quarter in which the amount
was withheld
Electronic or other means
approved by the Commissioner
Source: CPA Australia 2022.
Where an entity fails to comply with the PAYG requirements when paying employees and contractors,
a deduction for the payment will be denied (ITAA97, s. 26-105). All employers need to report to the
Commissioner using Single Touch Payroll (STP). STP is a reporting framework which allows employers
to provide payroll information to the Commissioner in line with their payroll cycle (see TAA, Schedule 1,
Division 389).
From 1 July 2020, particular deductions from salary and wages, such as child support payments paid to
the Child Support Registrar, can be voluntarily reported using STP.
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MODULE 1 The Legal, Ethical and Regulatory Fundamentals 49
Common types of payments from which entities are required to withhold tax and the amount that should
be withheld are set out in table 1.8 (ATO 2020).
TABLE 1.8
Withholding rates for 2021–22*
Type of payment
Withheld amount
Payments of salary or wages to an
employee or remuneration to a director
(as above)
Amount calculated via the withholding schedules (based on
progressive rates). Where no TFN supplied, 47%† for residents or
45% for non-residents
Payments to a resident arising from an
investment where no tax file number
(TFN) or Australian Business Number
(ABN) has been provided
47%† (for dividends, withholding only applies to unfranked portion
unless streamed through certain trusts)
Dividends paid to non-residents
To the extent that non-resident receive dividends that are unfranked,
30% withholding tax applies, but may be reduced under a double
tax agreement. Note that franked dividends are not subject to
withholding tax when paid to non-residents (ITAA36, s. 128B(3)(ga))
(see module 2). However, non-residents cannot utilise franking
credits to reduce their tax liability on other Australian income or to
obtain a tax refund (ITAA97, s. 207-65) (see module 4).
Interest paid to non-residents
10%
Royalty paid to non-residents
30%, but may be reduced under a double taxation agreement
Business transaction payments where
recipient does not quote an ABN
47%†
† The rate of 47% represents the top marginal tax rate of 45% plus the 2% Medicare levy.
* PAYG Withholding Schedules for 2021–22 are in legislative instrument F2021L00779.
Source: Based on Taxation Administration Act Withholding Schedules 2021, Federal Register of Legislation, www.
legislation.gov.au/Details/F2021L00779; Income Tax Assessment Act 1997 (Cwlth), s. 207-65, Federal Register of Legislation, www.
legislation.gov.au/Details/C2022C00029; Income Tax Assessment Act 1936 (Cwlth), s. 128B, Federal Register of Legislation, https://www.legislation.gov.au/Details/C2021C00582; ATO 2020, ‘Withholding rate’, www.ato.gov.au/Business/PAYGwithholding/In-detail/Investment-income-and-royalties-paid-to-foreign-residents/?page=5.
Payees (such as employees) who have had amounts withheld under the PAYG withholding rules are
entitled to tax credits for the amounts withheld, which are claimed through their annual tax returns.
Payees are advised of the total amount withheld (with some exceptions) during the tax year via an income
statement. However, non-residents in receipt of interest, dividend or royalty income subject to Australian
withholding tax (or not subject to withholding tax due to it being franked dividends) will not be liable to
tax on their income receipts (ITAA36, s. 128D).
JOBMAKER HIRING CREDIT
With regards to tax credits, as part of the 2020–21 Federal Budget, the government introduced the
JobMaker Hiring Credit (JMHC) as an incentive to employ young job seekers. Eligible employers will
have access to hiring credits of $200 per week for each eligible employee aged 16 to 29 years and $100
per week for those aged 30 to 35 years (ATO 2021c).
Employers will have access to the JMHC for each job they create for a period of 12 months (for jobs
created from 7 October 2020 to 6 October 2021), for a maximum claim period of 12 months from the
employment start date. Eligible employers are required to meet a number of conditions including: holding
an ABN, being up to date with their tax obligations, being registered for PAYG withholding, reporting
through STP and have not claimed JobKeeper (ATO 2021c).
In addition, employers must hire eligible additional employees who must have also worked an average
of at least 20 hours per week over the quarter for the employer to qualify for the payment. Employers must
register for the JMHC before making the first claim, and satisfy the headcount increase condition and the
payroll increase condition (ATO 2021c).
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50 Australia Taxation
OTHER KEY ADMINISTRATIVE CHANGES RESULTING
FROM COVID-19
Further to the JMHC, other consequential changes in tax administration brought about by the government’s
response to COVID-19 can be found in the Treasury Laws Amendment (A Tax Plan for the COVID-19
Economic Recovery) Act 2020. The following are some other key tax administration changes:
• reporting of information about the research and development tax offset that applies from 1 July 2021
(TAA, s. 3H)
• increasing the threshold for some of the concessions previously only available to SBEs (ITAA 1997,
Subdivision 328-C, s. 328-110). As a result, some of the small business concessions are now also
available to medium business entities that have a turnover of less than $50 million (s. 328-285(2)) (see
module 2)
• time limits for amendments by the Commissioner in relation to assessments for income years starting
on or after 1 July 2021 are reduced from four years to two years for medium-sized businesses with a
turnover of less than $50 million (ITAA 1936, s. 170). This aligns them with the two-year time limit
applicable to small businesses
• amendments that allow a wider range of entities to calculate their PAYG instalments based on GDPadjusted notional tax amendments made in relation to income years starting on or after 1 July 2021
(TAA, Schedule 1, s. 45-130).
PAYG INSTALMENT SYSTEM
The PAYG instalment system is the paying of instalments on expected tax liabilities for business and/or
investment income.
The aim of the PAYG instalment system is to spread larger tax obligations over time through the
progressive collection of income tax in a financial year. The system applies to entities such as companies,
superannuation funds and individuals that have business and/or investment income.
A taxpayer is only liable to make PAYG instalments if they have been issued an instalment rate by the
Commissioner.
Despite some exceptions, instalments are generally paid quarterly, or monthly for large taxpayers.
Taxpayers (all entities, including individuals, trusts, companies and superannuation funds) with ordinary
income of over $20 million must pay their PAYG instalments monthly.
Some taxpayers may be eligible to pay their PAYG instalment through one annual payment. Taxpayers
will be eligible for annual payments if:
• their most recent notional tax assessment was less than $8000
• they are registered for GST and report and pay GST annually
• they are a partner in a partnership that is registered for GST, and reports and pays GST annually
• in the case of a company, the company is not part of an instalment group, head company of a consolidated
group, or a participant in a GST joint venture.
The instalments paid by the taxpayer result in a credit against their actual tax liability at the time of
annual assessment.
Calculating the PAYG Instalments
There are two main ways of calculating PAYG instalments: the GDP-adjusted notional tax method (TAA,
Schedule 1, s. 45-112) and the instalment rate method (TAA, Schedule 1, s. 45-110).
For the GDP-adjusted notional tax method, the Commissioner provides a taxpayer with their GDPadjusted notional tax, which is based on the tax liability from the previous lodged tax return, and multiplied
by a GDP adjustment factor that is based on the gross domestic product (GDP) activity of the previous
two calendar years, which is supposed to reflect expected changes in the Australian economy (TAA,
Schedule 1, s. 45-405). (The GDP adjustment factor for 2021–22 is 0 per cent.) Those who may be eligible
for this method include individuals, small companies and superannuation funds.
Since 1 July 2021, entities with an aggregated turnover of up to $50 million are eligible to pay PAYG
instalments using this method (TAA, Schedule 1, s. 45-130).
The taxpayer may vary their GDP-adjusted notional tax instalment by calculating an estimate of their
benchmark tax. Taxpayers must advise why a variation is being sought — for instance, changes in trading
conditions. If the PAYG instalment amount is varied down and the taxpayer pays less than 85 per cent of
their actual tax liability, then the general interest charge (GIC) might be levied.
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MODULE 1 The Legal, Ethical and Regulatory Fundamentals 51
However, it should be noted that to assist businesses that have been affected by COVID-19, the ATO
will not apply penalties and interest on excessive PAYG instalment variations for the 2021–22 income tax
year, if a ‘best attempt’ is made to estimate the end of year tax. However, it is possible that GIC may still
apply to any outstanding PAYG instalment balances.
Both the taxpayer and Commissioner contribute to the instalment rate method. The Commissioner issues
the taxpayer with an instalment rate. The taxpayer can vary this rate if they consider it is not appropriate
(TAA, Schedule 1, s. 45-205). The taxpayer calculates their instalment income, which is ordinary income
derived over the quarter (or month for monthly payers). Instalment income generally excludes statutory
income such as capital gains.
The instalment income is then multiplied by the instalment rate (TAA, Schedule 1, ss. 45-110, 45-114).
The taxpayer is obliged to inform the Commissioner of their instalment income in the approved form —
even if it is nil (TAA, Schedule 1, s. 45-20). As with the GDP-adjusted notional tax method, a taxpayer can
vary the instalment rate bearing in mind that, if the varied rate is less than 85 per cent of the benchmark
instalment rate, GIC may be payable, albeit possibly waived in the 2021–22 income tax year due to
COVID-19. The benchmark instalment rate is the rate calculated in reference to benchmark tax. Benchmark
tax is tax payable on taxable income less net capital gains (TAA, Schedule 1, ss. 45-355, 45-360, 45-365).
Example 1.12 illustrates the calculation of a PAYG instalment after the taxpayer’s annual GDPadjusted notional tax is changed by the Commissioner. Calculate the amount of the payment for the second
quarter before checking your answer against the solution.
EXAMPLE 1.12
Calculating PAYG Instalments
Grace Jones is eligible to pay her PAYG instalments on the basis of the GDP-adjusted notional tax method.
Before the first quarterly payment was due, she was notified by the Commissioner that her annual GDPadjusted notional tax was $100 000, so for the first quarter of the income tax year she paid 25 per cent of
that amount ($25 000).
By the next quarter, Grace had lodged a further tax return, and the Commissioner notified her that her
annual GDP-adjusted notional tax was now $120 000.
Consider Grace’s payment for the second quarter.
The second quarter payment due was then calculated under s. 45-400 of Schedule 1 of TAA to be
(50% × $120 000) – $25 000 (already paid) = $35 000.
QUESTION 1.13
Vivienne Choo is eligible to pay her PAYG instalments on the basis of the instalment amount method.
When the first quarterly payment became due, she was notified by the Commissioner that her
annual instalment amount was $200 000, and so for the first quarter of the income tax year she
paid 25 per cent of that amount ($50 000).
By the next quarter, Vivienne had lodged a further tax return, and the Commissioner notified that
her annual ‘GDP-adjusted notional tax’ was now $220 000.
What is Vivienne’s second quarter payment?
Table 1.9 compares the main features of the PAYG withholding and PAYG instalment
systems.
TABLE 1.9
PAYG withholding versus PAYG instalment system
PAYG withholding system
PAYG instalment system
Deduction of tax from payments made to others and
remitting that tax to the Commissioner of Taxation
Paying instalments on expected tax liabilities for
investment and business income
Applies to individual taxpayers, both residents and
non-residents
Applies to companies, superannuation funds and
individuals with business or investment income
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52 Australia Taxation
Withheld from payments made to the taxpayer
Generally paid quarterly, or monthly for large taxpayers
with ordinary income of over $20 million. Some
taxpayers, with a notional tax assessment of less than
$8000 and who are registered for GST and pay GST on
an annual basis, may be able to make annual payments
Amount to be withheld from payments: TAA
(Schedule 1,s. 15-10) contains a summary of
withholding payments, and the relevant sections
of TAA indicate how much to withhold.
Two methods of calculation:
1. Instalment amount method (Tax liability of last return
× GDP adjustment factor)
2. Instalment rate method (taxpayer given an
instalment rate that they can then vary based on
ordinary income over the quarter)
Example — interest paid to non-residents: 10% is
withheld
Source: CPA Australia 2022.
BUSINESS ACTIVITY STATEMENT
Entities registered for GST must complete a BAS for each reportable tax period. Types of tax reported on
the BAS are:
• GST
• PAYG withholding
• PAYG instalments
• FBT instalments
• wine equalisation tax
• luxury car tax
• deferred company instalments.
INSTALMENT ACTIVITY STATEMENT
An entity that is not registered for GST will be issued an IAS instead of a BAS. Individuals and trustees
with investment income are also issued with an IAS. Types of tax covered in the IAS are:
• PAYG instalments
• PAYG withholding
• FBT
• deferred company instalments.
The effect of both a BAS and IAS is that taxpayer credits and obligations are offset, and the taxpayer
pays one lump sum for all types of tax listed.
RUNNING BALANCE ACCOUNT
The running balance account (RBA) consolidates the reporting of a taxpayer’s liabilities and payments.
Debit entries arise when assessments are raised or interest charges imposed, while credits occur when
instalments are paid.
Difficulties can arise due to the fact that this is a consolidated account and the Commissioner has a
discretion to apply a refund from one activity statement amount (e.g. GST) against a different tax debt
before the latter is due and payable. The taxpayer may apply to the ATO for a refund and/or request that
future refundable amounts are only applied against debts due and payable.
1.10 PENALTIES AND INTEREST CHARGES
The ATO will accept most taxpayers returns at face value, subject to some basic cross-checking. This is
the basis of the self-assessment system.
Consequently, there needs to be a system of penalties in place for taxpayers who fail to correctly report
an amount of income or over-claim tax deductions and benefits, whether through mistake, carelessness or
intentional evasion. The penalty system is split into two — actual administrative and criminal penalties —
and a system of interest charges on unpaid or late tax payments.
Accordingly, Part 4-25 of Schedule 1 of TAA imposes administrative and criminal penalties, and
penalty interest on taxpayers who fail to meet their tax obligations. Other penalties are imposed by the
Crimes Act 1914 (Cwlth) and related legislation.
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MODULE 1 The Legal, Ethical and Regulatory Fundamentals 53
ADMINISTRATIVE CIVIL PENALTIES
Administrative penalties relating to statements (such as tax returns) are specified as a ‘base penalty amount’
that can be varied according to the behaviour of the taxpayer during the process of sorting out the issue
with the ATO. Taxpayer behaviour can be classified according to the following categories.
1. Failing to have a Reasonably Arguable Position with a
Significant Shortfall
A taxpayer will be liable to a penalty if they applied the tax legislation in a manner that is not reasonably
arguable and there is a significant tax shortfall (ss. 284-75(2), 284-90(1); see items 4–6 of the ‘Base penalty
amount’ table in s. 284-90(1)). The reasonably arguable threshold amount is the greater of $10 000 and
1 per cent of the tax liability based on the tax return for an individual, or $20 000 and 2 per cent for the
tax return of a partnership or trust s. 284-90(3).
In simple terms, a position will be reasonably arguable if, when the relevant authorities are applied
to the facts, it would be concluded that the taxpayer’s argument is about as likely to be correct as
incorrect — that is, the arguments for and against the taxpayer’s interpretation are finely balanced (see
ATO 2021d) (s. 284-15; Walstern Pty Ltd v FCT (2003) ATC 5076).
Example 1.13 demonstrates a situation where the taxpayer failed to have a reasonably arguable position
in the presence of a significant tax shortfall.
EXAMPLE 1.13
Failing to Have a Reasonably Arguable Position with a
Significant Shortfall
A taxpayer has made a substantial claim of a $14 000 deduction in his tax return for conventional clothing
worn as result of his office occupation. The claim is clearly incorrect at law, denied under s. 8-1 as being of
a private and domestic nature. There is scarce case law to support the taxpayers claim. In this situation it
is highly likely that the taxpayer has applied the tax legislation in a manner that is not reasonably arguable
and there is a significant tax shortfall.
2. Failing to Exercise Reasonable Care
Taking ‘reasonable care’ in the context of making a statement to the Commissioner or to an entity means
giving appropriately serious attention to complying with the obligations imposed under a taxation law.
The reasonable care test requires an entity to take the same care in fulfilling their tax obligations that
could be expected of a reasonable ordinary person in their position. Consequently, in ascertaining whether
reasonable care was exercised, it is important to consider all the taxpayer’s circumstances, including the
taxpayer’s knowledge, education, experience and skill (see ATO 2015, para. 28). A lack of reasonable care
can potentially arise from a variety of circumstances, including negligently omitting material information
in a tax return (such as forgetting to add interest income to one’s tax return), not taking sufficient care
in interpreting the law (such as undertaking inadequate research and thus not including proceeds from a
certain transaction in one’s tax return) and poor record keeping (such as incorrectly recording figures on
an activity statement due to poor records).
Judging whether there has been a failure to take reasonable care depends on an evaluation of all
the circumstances surrounding the making of the false or misleading statement to determine whether
a reasonable person of ordinary prudence in the same circumstances would have exercised greater care
(ATO 2015, para. 29).
Example 1.14 demonstrates a situation where the taxpayer failed to exercise reasonable care.
EXAMPLE 1.14
Failing to Exercise Reasonable Care
Richard is a professional musician. Because of his touring commitments he has spent roughly one week
in every four away from home. When not on tour, he has had a full schedule of rehearsals and has also
been making arrangements for his wedding. He has not had time to organise his tax records and has
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54 Australia Taxation
overlooked interest earned on one of his investment accounts. He explains that he forgot to include the
interest because he had been too busy to devote time to organising his tax records and had misplaced
the particular statement from the financial institution.
Although Richard has a busy professional and personal life, these are not special circumstances that
warrant the application of a lower standard of care in meeting his tax obligations. These circumstances do
not impair or compromise his capacity to comply with his taxation obligations. A reasonable person in the
taxpayer’s circumstances would be expected to devote sufficient time to record keeping so assessable
income is accurately returned.
Source: ATO 2015, MT 2008/1 ‘Penalty relating to statements: meaning of reasonable care, recklessness and intentional disregard’, paras 50–51, accessed January 2022, www.ato.gov.au/law/view/view.htm?PiT=99991231235958&docid=
MXR%2FMT20081%2FNAT%2FATO%2F00001.
3. Recklessness
Behaviour will indicate of care expected of a reasonable person in the same circumstances as the entity.
Recklessness assumes that the behaviour in question shows disregard of or indifference to a risk that is
foreseeable by a reasonable person. In Shawinigan Ltd v Vokins & Co Ltd [1961] 2 Lloyd’s Rep 153 at
162; Justice Megaw interpreted recklessness as:
gross carelessness — the doing of something which in fact involves a risk, whether the doer realises it or
not; and the risk being such having regard to all the circumstances, that the taking of that risk would be
described as ‘reckless’. The likelihood or otherwise that damage will follow is one element to be considered,
not whether the doer of the act actually realised the likelihood. The extent of the damage which is likely to
follow is another element ... (ATO 2015, paras 101–103).
Example 1.15 demonstrates a situation where the taxpayer’s actions would be considered reckless.
EXAMPLE 1.15
Recklessness
A tax agent claims a deduction for a taxpayer for operational expenses from activities that did not
constitute the carrying on of a business (as discussed in module 2, costs relating to activities that
constitute a hobby rather than a business are not typically deductible). In addition, there was evidence of
a long history of low income being generated by the taxpayer in comparison to large outgoings where the
amount of the expenses claimed as deductions was significant. In these circumstances ‘any reasonably
well-informed tax agent’ would have addressed the possibility that no business was being carried on and
would have foreseen the significant risk that the claim for the deduction was highly likely to involve an
incorrect application of the law. In the circumstances, disregarding this risk equalled recklessness.
Source: Based on ATO 2015, MT 2008/1 ‘Penalty relating to statements: meaning of reasonable care, recklessness and
intentional disregard’, paras 105–107, accessed January 2022, www.ato.gov.au/law/view/view.htm?PiT=99991231235958
&docid=MXR%2FMT20081%2FNAT%2FATO%2F00001.
4. Intentional Disregard
Intentional disregard means that there must be actual knowledge that the statement made is false. To
establish intentional disregard, the entity must understand the effect of the relevant legislation and how
it operates in respect of the entity’s affairs and make a deliberate choice to ignore the law. Dishonesty is a
requisite feature of behaviour that shows an intentional disregard for the operation of the law.
Example 1.16 demonstrates a situation where the taxpayer’s actions show an intentional disregard for
the operation of the law.
EXAMPLE 1.16
Intentional Disregard
A tax agent prepared clients’ tax returns that failed to disclose trust distributions as assessable income,
but instead disguised the amounts as loans that he knew did not have to be repaid and with no
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MODULE 1 The Legal, Ethical and Regulatory Fundamentals 55
interest payable. The surrounding facts supported the inference that the tax agent must have intentionally
disregarded the requirement to disclose the income.
Source: Based on ATO 2015, MT 2008/1 ‘Penalty relating to statements: meaning of reasonable care, recklessness and
intentional disregard’, paras 112–113, accessed January 2022, www.ato.gov.au/law/view/view.htm?PiT=99991231235958
&docid=MXR%2FMT20081%2FNAT%2FATO%2F00001.
5. Failing to Make a Statement
A taxpayer will be regarded as failing to make a statement where both of the following conditions
are fulfilled.
• They fail to lodge a document necessary to establish their tax-related liability.
• In the absence of this document, the Commissioner establishes their tax-related liability.
For instance, if the taxpayer fails to lodge their tax return and the Commissioner determines their tax
liability through other means, then they will be regarded as failing to make a statement. Although the
default position is that the 75 per cent base penalty applies in such a scenario, this amount can be remitted
by the Commissioner where it is fair and reasonable to do so (ATO 2021d).
Tables 1.10 and 1.11 present a summary of the penalties relating to the behaviour of the taxpayer.
TABLE 1.10
Summary of penalties relating to statements — related to taxpayer behaviour
Base penalty if no shortfall
(penalty units — see table 1.11)
Base penalty as a
percentage of shortfall
No reasonable care
20
25%
Recklessness
40
50%
Intentional disregard
60
75%
Behaviour of taxpayer
No reasonably arguable position
with a significant shortfall
25%
Failure to make a statement
75%
Source: Based on ATO 2021d, ‘Statements and positions that are not reasonably-arguable’, accessed January 2022, www.ato.
gov.au/General/Interest-and-penalties/Penalties/Statements-and-positions-that-are-not-reasonably-arguable.
TABLE 1.11
Summary of penalties relating to statements — infringement date and penalty amount
When infringement occurred
Penalty unit amount
Up to 27.12.12
$110
28.12.12 – 30.07.15
$170
31.07.15 – 30.06.17
$180
1.07.17 – 30.06.20
$210
On or after 1.07.20
$222
Source: ATO 2021e ‘Penalties’ accessed December 2021, www.ato.gov.au/general/interest-and-penalties/penalties.
The reference to a shortfall in table 1.10 generally applies to a situation where there is a difference
between the correct tax liability or credit entitlement, and the incorrect liability or entitlement worked
out using the inaccurate information as provided by the taxpayer (s. 284-80). In contrast, a situation
where there is no shortfall generally applies where the incorrect information has not led to a lower tax
liability in the relevant tax year, but can still give the taxpayer an advantage (typically a future one). For
instance, assume that had the taxpayer provided the correct information in the particular tax year they
would be in a tax loss position, but due to providing incorrect information (such as overstated deductions)
they are in an even greater loss position. In such a scenario, although there is no shortfall (as with or
without the overstated deductions there would be no tax payable in the relevant tax year). However, had the
taxpayer been successful, they would still be potentially advantaged in the longer term by their misleading
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56 Australia Taxation
information (as they would have greater losses to carry forward for future tax years). Note that where two
or more items in the table apply to a taxpayer, the greater penalty is used (s. 284-90(2)).
As seen in table 1.10, failure to take reasonable care results in a penalty of 25 per cent of the amount
owed. Recklessness incurs a penalty of 50 per cent of the amount owed and intentional disregard attracts
a penalty of 75 per cent. Where the taxpayer has aggravated the situation (e.g. by trying to obstruct the
Commissioner’s investigation), the base penalty is increased by 20 per cent on top of the original 25 per cent
(e.g. 25% + (20% × 25% = 5%) = 30%) (TAA, s. 284-220(1), Schedule 1, Division 284). Conversely, if the
taxpayer takes steps to assist the Commissioner by voluntarily disclosing a tax shortfall, the base penalty
will be reduced by 20 per cent or 80 per cent. Specifically, if the disclosure is made after the Commissioner
has informed the taxpayer that their tax affairs are to be examined, and the voluntary disclosure has resulted
in saving the Commissioner significant time or resources, then the reduction will be 20 per cent (s. 284225(1)). If the disclosure is made before the day the Commissioner has informed the taxpayer that their tax
affairs are to be examined, then the reduction will be 80 per cent (s. 284-225(2)–(5)) and will be reduced
to nil where the shortfall amount is below $1000 (s. 284-225(3)(b)).
As of 1 July 2021, one penalty unit is $222. There is a sliding scale dependent on when the infringement
to which the penalty being applied to, actually occurred.
A taxpayer will not be liable for a statement penalty where they (or their agent):
• took ‘reasonable care’ in making the statement (TAA, s. 284-75(5), Schedule 1, Division 284).
Reasonable care basically requires that the taxpayer and agent take the care that ‘a reasonably prudent
person with the taxpayer’s knowledge, education, experience and skill would take’ (JG & JA Williamson
Holdings Pty Ltd v FCT (2007) ATC 2206; Practice Statement PS LA 2012/4; Aurora Developments
Pty Ltd v FCT (No. 2) (2011) ATC 20-280)
• created a ‘safe harbour’ by providing their registered tax or BAS agent with all relevant taxation
information, and the false or misleading nature of the statement by the agent did not result from either
intentional disregard or recklessness as to the operation of a taxation law (TAA, s. 284-75(6))
• followed advice received from the ATO or a general ATO administrative practice in making the statement
(PS LA 2012/4).
On or after 1 July 2018, eligible individuals and entities with a turnover of less than $10 million receive
penalty relief after an audit for inadvertent errors in tax returns and activity statements that have resulted
from a failure to take reasonable care or taking a position that is not reasonably arguable. Penalty relief is
available once every three years, provided there has not been any infringement during a three-year period.
Examples 1.17 to 1.20 further illustrate the operation of the penalty provisions.
EXAMPLE 1.17
No Failure to Exercise Reasonable Care
Cassie was recently diagnosed with cancer and had to undergo emergency surgery and have extensive
chemotherapy treatment. During the period of the chemotherapy treatment, she lost a statement from a
financial institution from which she earned interest income, and subsequently did not disclose this income
in her tax return.
Consider whether Cassie would be liable to pay a penalty for her tax shortfall due to her omission.
In the circumstances, a reasonable person experiencing such an illness and treatment would not
be expected to have the same level of organisation in keeping records as someone not experiencing
such health problems. As a result, in Cassie’s situation, it could be argued that she has taken sufficient
reasonable care. As a result, she would not be subject to a base penalty amount due to her shortfall.
Source: Based on ATO 2015, MT 2008/1 ‘Penalty relating to statements: meaning of reasonable care, recklessness and
intentional disregard’, paras 48–49, accessed January 2022, www.ato.gov.au/law/view/view.htm?PiT=99991231235958&
docid=MXR%2FMT20081%2FNAT%2FATO%2F00001.
EXAMPLE 1.18
Failing to Exercise Reasonable Care and Have a Reasonably
Arguable Position
Jenny lodged her tax return but excluded a $500 000 profit from a certain sale of property during the year,
on the basis of a casual conversation with her butcher. The butcher suggested that the profit was not
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assessable because his brother did something similar a while ago and he didn’t declare it. Jenny made
no other enquiries and did no research into the issue.
As it turns out, the case law, some ATO rulings and other materials (of which Jenny was completely
unaware) suggests that there is an argument, though not a strong one, that in some circumstances the
sale might not be assessable.
Consider whether Jenny is likely to be subject to a base penalty due to a shortfall amount.
Jenny probably has not taken ‘reasonable care’ in completing the return (it would not seem reasonable
to rely on a casual conversation with someone who is not a tax expert, although Jenny is inexperienced
in tax matters, which will mean that the standard of required behaviour will not be as high as if Jenny was
more experienced). Jenny could be liable for a penalty of 25 per cent of the tax shortfall under table 1.10
because she has not taken the care that a reasonably prudent person with her knowledge, education,
experience and skills would take.
Further, because the tax shortfall on the $500 000 profit will presumably be over $10 000, Jenny must
establish that she had a ‘reasonably arguable position’ (RAP) for omitting the profit from her return in order
to avoid a 25 per cent penalty under table 1.10.
The RAP test is objective — that is, whether or not the taxpayer’s position is ‘about as likely as not’ to
be correct, based on the relevant authorities. It does not seem to matter whether the taxpayer was aware
of the authorities.
Whether Jenny has taken a RAP will depend on the authorities; if the position Jenny has taken is only
‘arguable’ but not strong, it may not be ‘about as likely’ to be correct (though some cases have applied a
lower standard of whether the position is ‘arguable’).
In summary, Jenny is likely to be subject to a penalty of 25 per cent of the tax shortfall under table 1.10
under both the RAP and lack of reasonable care categories. Note that only one penalty will be applied.
This is because s. 284-90(2) requires that where two or more items in the table apply, the greater penalty
should be used. However, in Jenny’s case, the two applicable penalties are the same.
Jenny could, however, have the penalty waived if the conditions for relief are fulfilled, including her
turnover being under $10 million and her not being subject to such relief in the previous three years.
Source: Based on Sanctuary Lakes Pty Ltd v FCT 2013 ATC 20-395.
EXAMPLE 1.19
Penalty from Acting with Intentional Disregard
Dorothy works part time, but supplements her income by selling items on eBay. Although her eBay
operation started off small, in recent years it has become increasingly large. In the most recent tax year,
Dorothy spent 40 hours per week on her eBay activities and has incurred $20 000 in expenses and earned
revenue of over $100 000 from them. She is aware that her activities no longer could be regarded as a
hobby, but rather as a business, and so should be subject to tax (module 2 discusses the differences
between a business and hobby). Despite this, she did not declare the income from her eBay activities on
her tax return.
Consider the penalty implications regarding Dorothy’s non-disclosure of her business income.
It could be argued that Dorothy acted with intentional disregard, as she appears to show a total disregard
concerning her tax obligations regarding her eBay operations. Given that her activities would constitute a
business (see module 2), she will not only be liable to pay the tax shortfall (how much extra tax she should
have paid had she disclosed her business income and expenses) but also a base penalty of 75% of this
shortfall (assuming there was no adjustment for helping or hindering the ATO with their investigation).
Dorothy’s behaviour is likely to be regarded as falling in the ‘intentional disregard category’ because she
knew that her income from her eBay operations were assessable and intentionally did not declare them.
EXAMPLE 1.20
Voluntary Disclosure
Due to being busy with work, Neil forgot to include royalty income of $2000 that he earned from one of
his many books while filling out his tax return. Upon realising this, Neil made a full voluntary disclosure of
his omission to the ATO.
Consider whether Neil will be subject to a base penalty due to his original omission.
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58 Australia Taxation
Neil would likely be considered to have shown a lack of reasonable care. However, his shortfall
(underpayment of tax) will be under $1000, because even if he is on the top tax rate (see module 4),
the tax payable on $2000 would be under $1000. As Neil has made a voluntary disclosure before the ATO
notified him of any investigation and he had a shortfall of under $1000, he will not be subject to a tax
penalty (s. 284-225(3)(b)).
Penalties Relating to Schemes
Under Division 284 of TAA, penalties will apply where a taxpayer would have obtained a tax benefit from
a taxation scheme but for the application of Part IVA of ITAA36 (see the next section of this module) or
other anti-avoidance provisions. These penalties also cover situations where a transfer pricing adjustment
has arisen.
Example 1.21 demonstrates the application of the administrative penalties when an individual taxpayer
fails to declare profits from complex international share-trading arrangements and fails to respond to
ATO queries.
EXAMPLE 1.21
Applying Administrative Penalties
Susie Brown was involved in complex international share-trading arrangements over the period 2015–17,
which yielded substantial profits. Susie did not declare these profits in her tax return for any of those years.
The ATO discovered these transactions in December 2021 and requested details from Susie on certain
aspects of these transactions, including the amount of the profits. Susie did not answer these queries
or provide any information, despite several reminders. The ATO subsequently assessed Susie on these
profits. It imposed a base penalty of 75 per cent of the total tax-related liability under s. 284-75(3) due
to failure to provide a document necessary for the Commissioner to work out that tax liability. The ATO
increased this base penalty by 20 per cent (to a total of 90 per cent, i.e. (75% + (20% × 75% =15%)) of
the tax-related liability).
Consider the tax implications for Susie.
Susie would be liable for the 90 per cent penalty, as the failure to respond to the ATO requests for
information ‘was a step taken to prevent or obstruct the Commissioner of Taxation from finding out about
the shortfall amount’ (Leighton (As Trustee of the Leighton Family Trust) v FCT (2010) ATC 20-215). The
taxpayer may also be liable for failing to lodge a return or other documents on time under s. 286-80(2) of
TAA, Schedule 1 (discussed in the next section of this module).
The ATO has the ability to increase or decrease the base penalty by 20 per cent for aggravating or
mitigating behaviour. Here, the fact that Susie did not answer the queries despite several reminders
means the increase by 20 per cent is warranted and justified. If the taxpayer is dissatisfied with a TAA
Division 284 penalty imposed on them, they can lodge an objection.
Penalties for Failing to Lodge Documents on Time
There are administrative penalties for failing to lodge documents on time or in the approved form (TAA,
s. 286-80).
For small entities, the penalty is imposed at the rate of one penalty unit ($222) for each 28-day period
or part of a period of 28 days that a statement (e.g. a BAS) remains not lodged, with a maximum penalty
of five penalty units.
The penalty increases according to the size of the taxpayer.
The basic penalty is doubled (i.e. $444 per 28-day period) for medium-sized PAYG with holders, entities
with an assessable income between $1 million and $20 million in the current year, or entities with a current
annual turnover for GST purposes of between $1 million and $20 million (s. 286-80(3)).
The basic penalty is multiplied by five (i.e. $1110 per 28-day period) for large PAYG with holders and
entities with current annual assessable income or current annual turnover for GST purposes of $20 million
or more s. 286-80(4).
The safe harbour defence may be applied by entities for failure to lodge documents (s. 286-75(1A)).
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MODULE 1 The Legal, Ethical and Regulatory Fundamentals 59
Penalties for Failing to Withhold or Remit PAYG Withholding Amounts
Failure to withhold an amount under the PAYG withholding system or to pay it to the Commissioner as
required carries a penalty of 10 penalty units ($2220). In addition, the taxpayer may be required to pay the
Commissioner the amount that should have been withheld.
Alternatively, the taxpayer (other than an exempt Australian Government agency) may be required to
pay a penalty equal to the amount that should have been withheld (TAA, s. 16-30).
There are also new laws that make company directors personally liable where there is a failure to meet
company tax obligations. For instance, where the company has failed to remit the tax amounts withheld,
the directors of a company will each be personally liable to pay to the Commissioner by way of penalty,
an amount equal to the unpaid amount of the company’s liability under its obligation (TAA, s. 269-20).
Miscellaneous Administrative Penalties
Penalties for failing to meet other tax obligations are imposed in multiples of $222 penalty units. Relevant
penalties include, among others:
• not keeping or retaining records as required: 20 penalty units (s. 288-25), $4440
• preventing a tax officer from gaining access to premises or records when permitted: 20 penalty units
(s. 288-35), $4440
• failing to issue a tax invoice as required: 20 penalty units (s. 288-45), $4440.
CRIMINAL PENALTIES
Taxpayers and their agents may also face criminal prosecution for tax offences, either under the TAA or
the Crimes Act and related legislation (e.g. the Criminal Code Act 1995).
Natural persons (individuals, sole traders, partners, trust beneficiaries and individual trustees) may be
punishable by penalty units and/or imprisonment for certain offences, while maximum penalties for a
company are five times higher. In each case, a taxpayer is only liable to the extent they are capable of
complying with the requirement (Ganke v FCT (No. 1) (1975) ATC 4097; Griffin & Elliott v Marsh (1994)
ATC 4354; Ambrose v Edmunds-Wilson (1988) ATC 4173).
In recent years, a number of taxpayers and advisers have been found guilty of offences under the general
criminal law provisions and sentenced to jail for significant periods.
GENERAL INTEREST CHARGE AND SHORTFALL
INTEREST CHARGE
As discussed earlier, there are interest charges levied on outstanding tax payments and late payments for
taxation. These are the general interest charge (GIC) and the shortfall interest charge (SIC).
Why are the GIC and SIC Levied?
Interest is charged to taxpayers to compensate the ATO for the time value of money, to address inequities
between taxpayers who pay their taxes on time and those who do not, and to punish taxpayers who may
be careless about the conduct of their tax affairs.
GIC and SIC interest is calculated on a daily compounding basis. However, a deduction may be claimed
for GIC or SIC in the year in which the notice of assessment (which includes the GIC/SIC) is issued
(ITAA97, s. 25-5(1)).
Operation of the GIC
The GIC is a uniform interest charge with the rate being updated quarterly, and interest compounding daily
(TAA, Part IIA, s. 8AAA–8AAH). The GIC applies where:
• an amount of tax, charge, levy or penalty remains unpaid (such as a PAYG instalment)
• there is an underpayment of tax (which might occur if an amended assessment is ignored)
• an instalment of tax is underestimated (this generally occurs when an instalment rate is varied down)
• returns are lodged late (such as a BAS)
• there is a failure to remit certain amounts (e.g. PAYG withholding).
The GIC compounding rate covers most taxes including income tax, FBT, GST and PAYG.
As shown in table 1.12, the GIC is updated quarterly, with rates for the next quarter generally announced
two weeks before the start of that quarter.
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60 Australia Taxation
TABLE 1.12
General interest charge rates
2020–21 Income year
Quarter
GIC annual rate
GIC daily rate
April – June 2021
7.01%
0.01920548%
January – March 2021
7.02%
0.01923288%
October – December 2020
7.10%
0.01939891%
July – September 2020
7.10%
0.01939891%
GIC annual rate
GIC daily rate
January – March 2022
7.04%
0.01928767%
October – December 2021
7.01%
0.01920548%
July – September 2021
7.04%
0.01928767%
2021–22 Income year
Quarter
Source: ATO 2022a, ‘General interest charge (GIC) rates’, accessed January 2022 , http://www.ato.gov.au/rates/general-interestcharge-(gic)-rates/?=top_10_rates.
QUESTION 1.14
Joseph Jensen’s October to December 2021 quarterly BAS was lodged late with $15 000 owing. It
was due to be lodged on 28 February 2022 (day that tax is due). It was not lodged and the tax was
not paid until 17 March 2022. GIC was due for 17 days (28 February to 17 March 2022) at the daily
GIC compounding rate of 0.01928767 per cent.
Added to the GIC is a penalty for failing to lodge on time, which is imposed for each 28-day
period (or part thereof) that a statement is overdue. Assume that Joseph is an SBE. How much is
his penalty, and what is the GIC charge?
Operation of the SIC
The SIC rate is 4 per cent lower than the GIC rate. It is applied in the case of amended assessments where
the amount of tax payable is increased compared with the original assessment. The SIC replaces the GIC
for the period between the due date for payment of the original (understated) assessment and the day before
the amended assessment is issued.
As shown in table 1.13, the SIC rate is updated quarterly with rates for the next quarter generally
announced two weeks before the start of that quarter. The applicable SIC rate is based on the relevant
quarter/s between the due date of the original assessment and the day prior to the amended assessment
(TAA, Schedule 1, s. 280-105). The SIC is calculated for the period between the due date for payment of
the original (understated) assessment and the day before the amended assessment is issued. According to
the ATO, ‘if a calculation period spans more than one quarter, make a separate calculation for each quarter
there has been a change in the shortfall interest charge rate’ (ATO 2007). The legislation states that ‘the
SIC for a day is calculated by using the rate for that day’ (TAA, Schedule 1, s. 280-105 (1)). Therefore,
there will be multiple rates in instances like question 1.15 as there are multiple quarters involved.
TABLE 1.13
SIC rates
2020–21 Income year
Quarter
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SIC annual rate
SIC daily rate
April – June 2021
3.01%
0.00824657%
January – March 2021
3.02%
0.00827397%
October – December 2020
3.10%
0.00846994%
July – September 2020
3.10%
0.00846994%
(continued)
MODULE 1 The Legal, Ethical and Regulatory Fundamentals 61
TABLE 1.13
(continued)
2021–22 Income year
Quarter
SIC annual rate
SIC daily rate
January – March 2022
3.04%
0.00832877%
October – December 2021
3.01%
0.00824657%
July – September 2021
3.04%
0.00832877%
Source: ATO 2022b, ‘Shortfall interest charge (SIC) rates’, accessed January 2022, www.ato.gov.au/rates/shortfall-interest-charge(sic)-rates.
QUESTION 1.15
Ava Brown incorrectly claimed $700 for clothing related to her office job in her 2019–20 tax return.
The due date for the payment of her assessment was 21 January 2021. Following an ATO audit
carried out in 2021, Ava’s claim of $700 for clothing was disallowed. Ava’s top marginal rate is 32.5
per cent (plus the Medicare levy of 2 per cent). An amended assessment was issued, increasing her
tax liability by $241.50 (34.5% × $700) and the amendment is notified to Ava on 20 July 2021.
Determine for which period and at what rate SIC will apply.
1.11 TAX PLANNING, AVOIDANCE AND EVASION
DISTINGUISHING BETWEEN TERMS
Tax Planning, Tax Avoidance and Tax Evasion
It is important that tax professionals understand the difference between tax planning, tax avoidance and
tax evasion. Tax professionals will often advise clients on legal tax planning matters so as to minimise
their tax burdens. However, legitimate tax planning needs to be distinguished from tax avoidance and
tax evasions
Specifically, the law regarding what is or is not acceptable tax planning behaviour may vary over
time with community attitudes. Advisers who create legal tax planning strategies are working within the
constraints of taxation law to legally and ethically minimise taxation paid by their clients. Advisers also
act within their remit to legally minimise taxation for their client using the rules allowed for in the taxation
system. This is tax planning and it operates within the law. This is acceptable behaviour.
But the lines between good tax planning and unacceptable tax avoidance easily become blurred. It can
be difficult to distinguish between tax planning and tax avoidance because determining the intention or
spirit of the law is to some degree a subjective judgement.
‘Tax planning’ is defined as organising a taxpayer’s affairs to minimise the incidence of tax using legal
means and in a way that is not artificial or contrived. The taxpayer’s financial affairs are optimised in such
a way that a reduction in tax payable is merely incidental to, or a consequence of, genuine investment
decisions.
Example 1.22 provides a scenario that requires assessment as to whether it constitutes tax planning or
tax avoidance.
EXAMPLE 1.22
Allowable Tax Planning
A taxpayer brings forward a capital loss on disposal of a CGT asset that the taxpayer had already intended
to sell, so as to offset it against a capital gain in that same tax year. The CGT provisions allow a capital
loss to be offset against a capital gain in the year in determining assessable income. Consider whether
this constitutes tax planning or tax avoidance.
This would be an example of legitimate tax planning. The purpose of the legislation is to provide relief
for realised capital gains. A tax adviser has a duty to ensure their client accesses these CGT provisions
as provided for under the taxation legislation.
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62 Australia Taxation
Tax laws sometimes provide different outcomes for the same economic activity conducted in different
ways, which encourages the development of aggressive schemes to exploit what may be unintended legal
features. This has been described as tax avoidance and is based on exploiting tax laws in a manner
that is not necessarily illegal (though the anti-avoidance provisions in the legislation often make tax
avoidance illegal).
Example 1.23 provides another scenario that requires assessment as to whether it constitutes tax planning
or tax avoidance. After completing both of these examples compare the two situations and identify how
they differ.
EXAMPLE 1.23
Tax Avoidance
A taxpayer has a capital gain, and an unrealised capital loss on another asset that they wish to
keep. However, the sale and immediate repurchase of this asset would realise the capital loss and
reduce the taxpayer’s assessable income for the year. Consider whether this constitutes tax planning
or tax avoidance.
This would cross over into tax avoidance. The actions of the taxpayer are not consistent with the
intention of the legislation, since the immediate repurchase means that the taxpayer has enjoyed a
reduction in assessable income while still holding the other asset. There has been no economic loss
to the taxpayer and the sale and repurchase does not make commercial sense except for the tax
benefit obtained.
Tax evasion has been described as a ‘blameworthy act or omission’ generally requiring intent and
knowledge that it will affect the person’s tax position (Denver Chemical Manufacturing Co v FCT (1949)
HCA 25). An example would be deliberate non-disclosure of assessable income.
Figure 1.14 shows how the line can be blurred between tax planning and tax avoidance.
FIGURE 1.14
The line between tax planning and tax avoidance
Tax evasion
(Deliberate non-compliance)
Behaviour outside the law
Legal compliance boundary
Tax avoidance
(Use of means that, but for
the anti-avoidance provisions,
legally reduce tax in a manner
unintended by the legislation)
Unacceptable behaviour
Indistinct behaviour boundary
Tax planning
(Use of legal means in a way
intended by legislation)
Acceptable behaviour
Source: CPA Australia 2022.
QUESTION 1.16
Consider whether the following situations constitute tax evasion, tax avoidance or tax planning.
(a) A business owner has a personal holiday but claims the amount on their tax return as a
deductible work-related trip.
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MODULE 1 The Legal, Ethical and Regulatory Fundamentals 63
(b) A salary earner buys a property with borrowed money and utilises negative gearing — a strategy
where the excess of interest costs (on the borrowed money) and other property expenses over
rental income is a deduction that reduces the tax payable on their assessable income. The
taxpayer’s long-term intention is that, as rents rise in the future, the rental income will exceed the
property related expenses (including interest expense). The salary earner only repays interest
on the interest-only loan so as to maximise the negative gearing deduction in the future.
(c) A business owner (who is on a high tax rate) hires her husband (who is on a low tax rate)
to undertake administrative tasks for the business and pays her husband $200 an hour for
performing these tasks. The comparable hourly rate for these tasks in a similar business is
$40 per hour. The business owner claims this expense as a tax deduction. The monies earned
by the husband are transferred from the funds of the business to the husband’s bank account.
1.12 GENERAL ANTI-AVOIDANCE PROVISIONS
The previous discussion outlined the distinction between tax planning, avoidance and evasion. To ensure
that transactions constitute tax planning rather than avoidance, it is important that tax professionals are
aware of the potential impact of the specific and general anti-avoidance provisions in the tax legislation.
Good tax planning will ensure that the risks of such provisions applying have been suitably minimised.
While the impact of specific anti-avoidance provisions (some of which are discussed throughout this
subject) is usually predictable, the general anti-avoidance provisions, by their nature, can potentially apply
to a wide variety of transactions.
General anti-avoidance provisions are found in the following taxation legislation:
• income tax — Part IVA of ITAA36
• GST — Division 165 of the GST Act
• FBT — s. 67 of FBTAA.
PART IVA OF THE INCOME TAX ASSESSMENT ACT 1936
The anti-avoidance provisions of Part IVA of ITAA36 will apply where it appears that a taxpayer has
entered into a scheme with the dominant purpose of obtaining a tax benefit. In establishing the dominant
purpose, regard must be given to the eight matters listed in s. 177D(2) of ITAA36 discussed below. All
eight matters require an objective finding of fact that should be considered, although not all need to be
met. The taxpayer’s subjective intentions are not considered decisive or relevant.
Penalties apply for those found to have entered into a scheme proven to fall under the anti-avoidance
provisions of ITAA36 (TAA, Schedule 1, ss. 284-140–284-160).
The requirements for the application of Part IVA are as follows.
• There is a scheme (s. 177A).
• There is a tax benefit in connection with the scheme (s. 177C, see below).
• It would be concluded, having regard to the eight matters listed in s. 177D(2) of the Act, and reproduced
as the purpose test below, that one or more persons who entered into or carried out the scheme, or any
part thereof, did so for a dominant purpose of enabling the taxpayer to obtain a tax benefit.
• The Commissioner makes a determination that the whole or part of the tax benefit is cancelled (s. 177F).
‘Scheme’ is defined in s. 177A of ITAA36 and is expressed in very broad terms. The term is used in a
neutral and not a moral sense, and refers to:
(a) any agreement, arrangement, understanding, promise or undertaking, whether express or implied and
whether or not enforceable, or intended to be enforceable, by legal proceedings; and
(b) any scheme, plan, proposal, action, course of action or course of conduct (ITAA36, s. 177A).
Section 177C(1) provides that a tax benefit is obtained in a number of different ways. As discussed
earlier in this module (and in more detail in module 2), the tax liability of a taxpayer is based on their
taxable income, which is their assessable income less deductions. The relevant tax rates are applied to
this taxable income, and the tax liability calculated from this is reduced by any offsets that the taxpayer is
entitled to.
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64 Australia Taxation
A tax benefit according to s. 177C(1) includes:
(a) an amount not being included in the assessable income of the taxpayer in a year of income where that
amount would have been included, or might reasonably be expected to have been included … if the
scheme had not been entered into or carried out; or
(b) a deduction being allowable to the taxpayer in … a year of income where the whole or a part of
that deduction would not have been allowable, or might reasonably be expected not to have been
allowable … if the scheme had not been entered into or carried out; or
(ba) a capital loss being incurred by the taxpayer ...; or
(bb) a foreign income tax offset being allowable to the taxpayer ...; or
(bbaa) an innovation tax offset being allowable to the taxpayer ...; or
(bba) an exploration credit being issued to the taxpayer ...; or
(bc) the taxpayer not being liable to pay withholding tax on an amount.
Most commonly, a tax benefit for Part IVA purposes involves reducing taxable income by a scheme that
leads to lower assessable income or increased deductions (see s. 177C(1) (a) and (b)). However, there are
some other more limited types of tax benefits. Specifically, s. 177C(1) (ba) refers to the scheme leading
to a capital loss, where without the scheme there would be either no capital loss or a lower one. Such an
entitlement to a capital loss would lead to a taxpayer paying less tax in the future, as this capital loss could
be carried forward and used to offset a capital gain in a future year, which could reduce a future tax liability
(see module 3). Some of the other types of tax benefits involve the taxpayer having their tax reduced due
to an increased entitlement to an offset.
To determine whether a tax benefit has arisen under s. 177C, the actual tax position must be compared
with what would have arisen, or might reasonably be expected to have arisen, if the scheme had not
been entered into. This involves a comparison with an alternative postulate (i.e. a theoretical alternative
situation or counterfactual).
In FCT v Futuris Corporation Ltd (2012) FCFCA 32, the Full Federal Court dismissed the Commissioner’s appeal, accepting the view that the taxpayer might have pursued transactions different from the
counterfactual offered by the Commissioner had it not used the beneficial transactions that it did.
The purpose test is an objective one based on the facts of the case. In this respect, s. 177D(2) provides
that regard should be given to eight factors:
1. the manner in which the scheme was entered into or carried out
2. the form and substance of the scheme
3. the time and duration of the scheme
4. the result that would be achieved by the scheme
5. the change in the financial position of the relevant taxpayer that resulted, or may reasonably be expected
to result from the scheme
6. the change in the financial position of any person connected with the taxpayer
7. any other consequences for the taxpayer or other person connected with the taxpayer
8. the nature of any connection between the relevant taxpayer and other person connected with
the taxpayer.
Consideration of the dominant purpose of the scheme is critical. In FCT v Spotless Services & Anor
(1996) 186 CLR 104, the High Court upheld the Commissioner’s assessment on the basis of Part IVA. A
rational commercial purpose for the arrangement entered into was to increase the after-tax returns for the
taxpayer by investing in the Cook Islands rather than in Australia. However, the commercial purpose was
consistent with a ‘dominant purpose’ of obtaining a tax benefit. The investment at a much lower interest
rate was only sensible if Australian tax could be avoided and this suggested that the dominant purpose of
the arrangement was to obtain a tax benefit.
See FCT v. Spotless Services & Anor (1996) 186 CLR 104: www.austlii.edu.au/cgi-bin/viewdoc/
au/cases/cth/HCA/1996/34.html?context=1;query=Spotless%20services%20and%20iva%20and%201
996;mask_path=.
When Part IVA is Contravened
If a scheme is found to be in breach of Part IVA, the Commissioner can cancel the tax benefit arising under
the scheme by including the amount as assessable income or denying a deduction (ITAA36, s. 177F).
The taxpayer may be subject to scheme penalties of 50 per cent of the tax avoided. This may be reduced
to 25 per cent of the tax avoided if the taxpayer has a contrary position that is able to be reasonably argued
(see TAA, Schedule 1, s. 284-160).
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MODULE 1 The Legal, Ethical and Regulatory Fundamentals 65
Other Key Cases on Part IVA
Some other key cases on Part IVA include FCT v Peabody (1994) 181 CLR 359; FCT v Consolidated
Press Holdings Ltd (No. 1) (2001) ATC 4343; Eastern Nitrogen Ltd v FCT (2001) ATC 4164; FCT v
Metal Manufactures Ltd (2001) ATC 4152; FCT v Hart (2004) 50 ATC 4599; FCT v Mochkin (2003) ATC
4272; FCT v BHP Billiton Finance Ltd (2010) 182 FCR 256; FCT v News Australia Holdings Pty Ltd
(2010) FCFCA 78; British American Tobacco Australian Services Ltd v FCT (2010) 189 FCR 151 and
Howland‐Rose v FCT (2002) ATC 4200.
These issues are discussed in more detail in the subject Australia Taxation – Advanced.
PURPOSE OF THE ADVISER
The case FCT v Consolidated Press Holdings Ltd (No. 1) (2001) ATC 4343, deals with a financing structure
put into place by Australian Consolidated Press (ACP) to affect a takeover of an overseas company. The
High Court found that, regardless of the overall commercial purpose of a wider scheme, it is permissible
to identify within the wider scheme a narrower tax avoidance scheme in respect of s. 177D (the ‘purpose’).
In this case, except for a step in the wider scheme of interposing an entity, interest deductions would not
have been available.
The ACP taxpayer group retained the services of a firm of accountants as a tax adviser. ACP argued that
it was unaware of the implications of a complex transaction and merely relied upon their adviser. The High
Court was prepared to accept attribution of the purpose of a professional adviser to a person who entered
into the scheme.
DISCHARGE OF DUTY TO THE CLIENT
The taxpayer is not only subject to penalties for entering into the scheme (TAA, ss. 284-140–284-160), but
may also suffer costs and reputation damage. The tax adviser is also at risk of becoming personally liable
under contract law and tort of negligence. There may be sanctions imposed through the tax practitioner’s
regime (discussed in Part A of this module) for registered tax agents negligently causing a taxpayer to be
liable to pay a fine, penalty or a GIC.
Under laws of negligence, a duty of care arises from the relationship of professional and client, where
the latter may be expected to rely on advice. This is a positive duty to give advice regardless of whether it
is specifically requested. Given the uncertainty associated with application of Part IVA, a mere disclaimer
is inadequate within any advice and the client should be assisted in making a decision regarding the risk
of a prospective scheme.
Frequently, a client is unaware that Part IVA could apply to a scheme having a commercial purpose, so
it is important to stress that the purpose test is an objective one that does not usually try to uncover any
subjective intention. This reassurance will make it easier to raise the issue of further investigation of the
facts, perhaps involving consultation with other specialists. The possibility of applying for a private ruling
to achieve certainty should be considered, being careful to specifically ask whether the Commissioner may
apply Part IVA to the arrangement.
Example 1.24 provides a detailed explanation of how the anti-avoidance provisions apply to a
given scenario.
EXAMPLE 1.24
Applying Part IVA
Paul Armstrong is an independent agent who earns commissions by referring clients to stockbroking
houses. Paul has no employees or professional associates. Subsequently, he maintained his existing
contracts and established a private company, of which he was a director and significant shareholder,
to act as a trustee of a family trust. The trustee now contracts to provide similar services as Paul carried
out previously himself.
Paul was paid a salary by the trustee for his services to the business. However, the amount paid by the
trustee was significantly lower than the commissions derived by Paul in previous years. Paul also provided
personal guarantees to business lenders occasionally in order for the trustee to access finance. The trust
income was generally distributed to his family members, consisting of his spouse and adult children who
received little other income and so were on a lower tax rate than Paul had previously been subject to (prior
to entering into this arrangement).
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66 Australia Taxation
Consider how the anti-avoidance provisions apply to this scenario.
In these circumstances, the Commissioner could perceive there to be a scheme under s. 177A, being
the steps of interposing the trust between Paul and the stockbroking houses, and the distribution of the
net trust income to family members sourced from the business income.
It could also be argued that Paul received a tax benefit under s. 177C (1)(a), being income that was not
included in his assessable income that might reasonably have been assessed to him had the scheme not
been entered into and carried out. That is, Paul would have derived the entire business income in his own
name instead of a lower salary. If the Commissioner could establish that Paul would not have engaged in
more-risky transactions, the Commissioner could argue that Paul would have at least otherwise derived
a fair reward for his professional skill and exertion.
In determining whether this was a scheme or part of a scheme entered into with the dominant purpose
of obtaining a tax benefit, the Commissioner would consider the relevant matters as stated in s. 177D (2)
as follows.
• Section 177D(2)(a) — the manner in which the scheme was entered into does not appear to be for
commercial purposes, given the use of personal guarantees and the non-commercial remuneration
arrangement. In addition, the manner in which the scheme was carried out ensured the net income was
distributed in a tax effective manner.
• Section 177D(2)(b) — the form and substance of the scheme does not achieve the commercial objective
of limiting personal liability to the extent that personal guarantees are used.
• Section 177D(2)(d) — the result of the scheme apart from Part IVA, is that business income is distributed
to beneficiaries of the trust.
• Section 177D(2)(e) — regarding the change in the financial position of the taxpayer, it is noted that
Paul has not eliminated any business risk but has received less remuneration by way of salary and
distributions compared with his skill and exertion contributed to the business.
• Section 177D(2)(h) — the nature of the connection between the taxpayer and any connected persons
given his family are trust beneficiaries where trustee discretions could be exercised in their favour.
Based on the above, the Commissioner could form an opinion that a reasonable person would regard
the dominant purpose of the taxpayer as tax driven. Consequently, the Commissioner may include the
whole or part of the trust income in Paul’s assessable income and make an amendment to cancel the tax
benefit under s. 177F.
QUESTION 1.17
Claire Smith entered into a contract in March 2021 to sell part of her business, Lanes Manufacturing
(LM), to a US company, XYZ Holdings Ltd (XYZ), for $30 million. The sale was to be affected in
December 2021. Under the relevant CGT law, the tax year in which the gain would be accounted
for would be the 2020–21 tax year, being the tax year in which the contract was entered into (see
module 3).
In September 2021, the board of directors of LM was advised by Claire Smith’s accountant that
the company had made a CGT loss of $5 million in the 2021–22 tax year, and the sale of its business
to XYZ will result in a CGT gain of $7 million.
Subsequently, Claire Smith and XYZ entered into a deed of release in November 2021, whereby
the contract of March 2021 was discharged for a consideration of $800 000 payable to XYZ. A few
hours later, after negotiations and change of some contractual terms, Claire Smith entered into a
new contract to sell the identical part of the business to XYZ for $31 million. If the anti-avoidance
provision would not apply, this new arrangement would be advantageous from a tax point of view.
This is because the sale of part of the business would instead be considered as occurring in the
2021–22 tax year (when the new contract was entered into), meaning any resulting capital gain from
the sale could be offset against the $5 million capital loss in the 2021–22 tax year. On the other hand,
if the gain had remained in the 2020–21 tax year, the loss in the 2021–22 tax year could not offset
it. The minutes of the director’s meeting of LM said that the reason for discharging the earlier
contract was that the lawyers advised that the change in consideration meant that the original
contract could not be ratified, and that a new contract had to be entered into. The minutes of the
meeting also indicated that changes in the redundancy entitlements also meant that discharge of
the old contract and creation of a new binding contract was to eliminate any risks.
Briefly discuss as to whether Part IVA would apply to these transactions.
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MODULE 1 The Legal, Ethical and Regulatory Fundamentals 67
WHAT IS THE PROMOTER PENALTY REGIME?
The promoter penalty regime is in place in order to deter the promotion of tax avoidance and tax evasion
schemes (TAA, Schedule 1, Division 290).
Before the introduction of the promoter penalty regime, there were no civil or administrative penalties
available for the promotion of these schemes. This meant that promoters could obtain substantial profits
from the sales of these schemes, while investors could be subject to penalties under the existing Part
IVA and other specific anti-avoidance provisions. By introducing this law, the government addressed the
imbalance of the taxpayer bearing the risk while the scheme promoters avoided any penalty.
The ATO has provided clarity, stating that these laws are not intended to obstruct advisers or tax
practitioners and intermediaries from giving typical advice to their clients.
OPERATION OF THE SCHEME
Section 290-50 of Schedule 1 of TAA states:
Promoter of tax exploitation scheme
(1) An entity must not engage in conduct that results in that or another entity being a promoter of a tax
exploitation scheme.
Implementing scheme otherwise than in accordance with ruling
(2) An entity must not engage in conduct that results in a scheme that has been promoted on the basis
of conformity with a product ruling being implemented in a way that is materially different from that
described in the product ruling.
Note: A scheme will not have been implemented in a way that is materially different from that described in
a product ruling if the tax outcome for participants in the scheme is the same as that described in the ruling
(TAA, Schedule 1, s. 290-50).
Section 290-60 of Schedule 1 of TAA defines a ‘promoter’ as follows.
(1) An entity is a promoter of a tax exploitation scheme if:
(a) the entity markets the scheme or otherwise encourages the growth of the scheme or interest in it;
and
(b) the entity or an associate of the entity receives (directly or indirectly) consideration in respect of
that marketing or encouragement; and
(c) having regard to all relevant matters, it is reasonable to conclude that the entity has had a substantial
role in respect of that marketing or encouragement.
(2) However, an entity is not a promoter of a tax exploitation scheme merely because the entity provides
advice about the scheme.
(3) An employee is not to be taken to have had a substantial role in respect of that marketing or
encouragement merely because the employee distributes information or material prepared by another
entity (TAA, Schedule 1, s. 290-60).
Section 290-65 of Schedule 1 of TAA defines a ‘tax exploitation scheme’ as follows.
(1) A scheme is a tax exploitation scheme if, at the time of the conduct mentioned in subsection 290-50(1):
(a) one of these conditions is satisfied:
(i) if the scheme has been implemented — it is reasonable to conclude that an entity that (alone
or with others) entered into or carried out the scheme did so with the sole or dominant purpose
of that entity or another entity getting a scheme benefit from the scheme;
(ii) if the scheme has not been implemented — it is reasonable to conclude that, if an entity (alone
or with others) had entered into or carried out the scheme, it would have done so with the sole
or dominant purpose of that entity or another entity getting a scheme benefit from the scheme;
and
(b) one of these conditions is satisfied:
(i) if the scheme has been implemented — it is not reasonably arguable that the scheme benefit
is available at law;
(ii) if the scheme has not been implemented — it is not reasonably arguable that the scheme benefit
would be available at law if the scheme were implemented.
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68 Australia Taxation
Note: The condition in para. (b) would not be satisfied if the implementation of the scheme for all
participants were in accordance with binding advice given by or on behalf of the Commissioner (for
example, if that implementation were in accordance with a public ruling under this Act, or all participants
had private rulings under this Act and that implementation were in accordance with those rulings).
(2) In deciding whether it is reasonably arguable that a scheme benefit would be available at law, take into
account anything that the Commissioner can do under a taxation law.
Example: The Commissioner may cancel a tax benefit obtained by a taxpayer in connection with a scheme
under s. 177F of ITAA36 (TAA, Schedule 1, s. 290-65).
PENALTIES
If an entity is found to be a promoter of a tax exploitation scheme, the Federal Court can impose civil
penalties. This penalty will be the greater of:
• 5000 penalty units ($1.11 million) for an individual
• 25 000 penalty units ($5.55 million) for a body corporate
• twice the consideration received or receivable, directly or indirectly, by the entity or its associates in
respect of the scheme (s. 290-50(4)) (ATO 2021f).
Depending on the type or seriousness of the conduct, the ATO could also consider:
• voluntary self-correction for less significant non-compliance with these laws
• applicants for rulings (including product rulings) providing additional promises or guarantees to mitigate
taxation risks (including material differences in implementation of the relevant arrangement)
• offers of voluntary undertakings
• issuing of warnings to lower risk entities or ‘cease and desist’ letters to higher-risk entities (ATO 2021f).
See FCT v Ludekens & Anor (2016) FCA 755; FCT v Bogiatto & Ors (2020) FCA 1139 and FCT v
Rowntree & Ors (2020) FCA 1322, where civil penalties applied to promoters of tax avoidance schemes.
EXCLUSIONS AND EXCEPTIONS
People who advise on tax planning arrangements, even those who advise favourably on a scheme later
found to be a tax exploitation scheme, are not at risk of civil penalty to the extent that they have merely
provided independent, objective advice to clients (ATO 2012).
However, this ‘advice exclusion’ is limited to balanced and impartial advice. When a tax agent has
marketed or encouraged an arrangement, even by presenting an overly positive view, the ATO may regard
this as a more ‘entrepreneurial activity’. Promoter penalties may apply if it is reasonable to expect that a
client may use this advice to promote a scheme themselves. In this respect, the tax agent should be alert to
the possibility of unwittingly assisting the promotion of a scheme.
Employees or other entities that have only minor involvement in a tax avoidance scheme are excluded
(s. 290-60(3)).
If the conduct is found to have occurred by mistake or accident, the adviser is exempted. Similarly, an
event that occurs outside an entity’s control is excluded. A four-year time limit for prosecution under the
penalty regime may apply unless there is tax evasion (ss. 290-55(1)(4)).
Example 1.25 demonstrates the evaluation of advice provided by two tax agents to assess whether the
promoter penalty regime applies in either situation.
EXAMPLE 1.25
Promoter Penalty Regime
Peter Mack, a retiree, was seeking tax advice with regards to some of his investments. Tax Agent A
provided Peter with some general advice about various schemes that could legally reduce his tax and
were well known in the market. Dissatisfied with this, Peter sought advice from Tax Agent B who indicated
that Peter should invest in an unknown incentive schemes that would deliver a tax benefit by way of R&D
credits. This scheme was dubious, involved a high level of risk and was aggressively marketed by the
tax agent.
Consider the implications for the tax agents in this case.
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MODULE 1 The Legal, Ethical and Regulatory Fundamentals 69
The advice provided by Tax Agent A appears to be general tax planning advice that would not be caught
by the tax promoter provisions s. 290-60(2) of Schedule 1 TAA. On the other hand, the aggressive advice
provided by Tax Agent B on potentially false and misleading information would come within the scope of
s. 290-60(1) and could also lead to prosecution and referral to the TPB.
SUMMARY
Part B has discussed the administration of the Australian taxation system. It began with a discussion of
the assessment regime and then discussed ATO guidance documents, including the various types of public
rulings. The tax audit system, as well as the objection, review and appeal system were also covered. This
was followed by a discussion of the tax reporting and payment systems and the penalties imposed for
non-compliance with taxation obligations. Lastly, Part B explained the distinction between tax planning,
avoidance and evasion, as well as the operation of the general anti-avoidance provision and the promoter
penalty regime.
The key points covered in this part, and the learning objectives they align to, are as follows.
KEY POINTS
1.3 Apply the income tax and tax administration laws and the Australian Taxation Office guidance
documents associated with the Australian income tax assessment system.
• Tax return requirements and what is needed to lodge a tax return are outlines, as are the issuing of
assessments and amended assessments in the self-assessment environment.
• Example 1.6 describes how the self-assessment regime operates in a given situation while
example 1.7 illustrates the time limits for an amended assessment.
• Questions 1.7 and 1.8 provide the opportunity to to review the concept of amending a return, the
raising of an assessment, amended assessments and default assessments.
• A detailed explanation is given of the rulings system, including public and private rulings and
guidance documents including; law companion rulings and practical compliance guidelines,
practice statements, interpretive decisions and taxpayer alerts.
• Example 1.8 illustrates the operation and application of public rulings.
• Question 1.9 provide the opportunity to review the operation and application of a private ruling.
• An outline is given of why audits are needed, the audit process and the ATO’s information gathering
powers.
• Example 1.9 illustrates the ATO’s information gathering powers and the possible application of LPP.
• Question 1.10 provides the opportunity to review the Commissioner’s access powers, LPP and the
‘accountants concession’.
• Figure 1.13 illustrates the objections, review and appeals process.
• Table 1.6 indicates the specific types of objectionable items and the time limits for lodging the
objections.
• Examples 1.10 and 1.11 illustrate an objection to an amended assessment and what is involved in
the appeals and review process.
• Questions 1.11 and 1.12 provides the opportunity to assess lodging an objection and avenues for
appeal.
• Table 1.7 shows the timing of withholding payments, table 1.8 the withholding rates for various
types of payments and table 1.9 illustrates the difference between the PAYG withholding and
instalment systems.
• Example 1.12 illustrates the calculation of a PAYG instalment.
• Question 1.13 tests calculating a PAYG payment.
1.4 Explain the difference between tax planning, tax avoidance and tax evasion.
• Tax planning is the legitimate, legal application of tax law to minimise the tax payable.
• Tax avoidance involves utilising the tax law in a manner that is against the intent of the law and is
disallowed by specific or general anti-avoidance provisions in the legislation.
• Tax evasion involves misrepresenting or omitting essential information so as to underpay the
amount of required tax.
• Figure 1.14 illustrates the connection between the three tax concepts.
• Examples 1.22 and 1.23 demonstrate the distinction between tax planning and tax avoidance.
• Question 1.16 tests the distinction between tax planning, tax avoidance and tax evasion.
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70 Australia Taxation
1.5 Analyse situations where tax penalties and/or interest charges may apply.
• Various administrative civil penalties and criminal penalties are outlined.
• Table 1.10 indicates the various penalties that can be imposed based on the taxpayer’s statements
and behaviour and table 1.11 indicates the actual penalty amounts.
• Tables 1.12 and 1.13 indicated both the general interest charge and SICs respectively.
• Examples 1.13 to 1.21 demonstrate the application of administrative penalties in various scenarios.
• Questions 1.14 and 1.15 test the concept of calculating the penalty and the GIC and SIC.
1.6 Explain how the general anti-avoidance provisions of Part IVA operate.
• The operation and application of Part IVA of the Income Tax Assessment Act 1936, the purpose of
the advisor and the discharge of duty to the client are discussed.
• Example 1.24 provides a detailed explanation of how the anti-avoidance provisions apply to a given
scenario, while example 1.25 illustrates the operation of the promoter penalty regime.
• Question 1.17 provides the opportunity to review and describe how Part IVA and the promoter
penalty regime might apply to a given scenario.
REVIEW
This module gave an overview of many of the important fundamentals of the Australian tax system,
the principles that apply to those working in the Australian tax field, and details of the tax system’s
administration. It started off by describing the legal framework that the Australian tax system operates
in. This included an overview of the relevant parts of the Australian Constitution, as well as a description
of the legislative process of creating tax laws, and the judicial process for interpreting them. This part also
included an introduction to accessing tax laws online, and how to read tax cases.
The module then discussed the roles and responsibilities of the TPB and provided a description of
the services offered by TPB registered tax practitioners (tax agents, BAS agents and tax (financial)
advisers). This was then followed by a discussion regarding the relevant APESB ethical pronouncements
that members of any of the three major accounting bodies are subject to. The principles in these
pronouncements were then discussed using scenarios where ethical conflicts and conflicts of interest
potentially arise, as well as how to deal with such conflicts. This was followed by further discussion of
the relevant code of conduct, which those registered with the TPB are required to abide by. It was noted
that this code of conduct has a strong overlap with the APESB ethical pronouncements, the FASEA code
of ethics and the relevant requirements of the Corporations Act.
The module then went on to discuss the details of the administration of the Australian tax system. This
began with an overview of the self-assessment environment and the requirement of taxpayers to lodge a
tax return, in most cases regardless of the type of entity. Upon lodging a tax return, an individual taxpayer
is issued with a notice of assessment, whereas a deemed assessment arises in the case of other taxpayers
(e.g. companies). An assessment can be amended by the ATO or requested to be amended by the taxpayer,
which is known as ‘self-amendment’. These amendments must be done within particular time frames.
The module then discussed ATO guidance documents that assist taxpayer compliance. Specifically, these
documents include taxation rulings, taxation determinations, law companion rulings, practice statements,
ATO interpretative decisions and taxpayer alerts.
As a method of ascertaining the correctness of these assessments, the Commissioner conducts audits
after employing data-matching technology and exercising various information gathering powers. This
module described how a taxpayer that is dissatisfied with an assessment can challenge or dispute it
by lodging an objection. There are specific time limits that apply when lodging objections to various
decisions concerning income tax, GST, FBT, superannuation, penalties and interest. Where a taxpayer is
still dissatisfied with an objection decision, they can generally seek a review by either applying to the AAT
or the Federal Court.
The next section of the module then discussed the tax reporting and payment obligations of taxpayers.
This includes the operation of the PAYG withholding and instalment systems, the lodgment of BASs and
IASs and maintaining a running balance account.
The module then considered the consequences for taxpayers who fail to comply with the law and meet
their tax obligations, in which instance the tax system imposes penalty and interest charges. These can
take the form of administrative civil penalties for failure to lodge and failure to withhold, or criminal
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MODULE 1 The Legal, Ethical and Regulatory Fundamentals 71
prosecution and penalties for more serious offences. Along with the tax owing, there is also the GIC and
the SIC that may apply.
The module then went on to explain the concepts of tax planning, avoidance and evasion. These concepts
are very important for tax professionals because, while it is important to act in the client’s best interests,
tax professionals must also ensure there is compliance with the relevant laws and obligations.
The final section of the module went into more detail concerning the distinction between tax planning
and avoidance by describing the general anti-avoidance rule found in Part IVA of ITAA36. In particular,
the concept of scheme, tax benefit and having a dominant purpose of obtaining a tax benefit are all critical
elements. The operation of the promoter penalty regime and the penalties that potentially apply were
discussed along with the relevant exclusions and exceptions.
REFERENCES
ASIC 2021, ‘FAQs: Regulation and registration of relevant providers who provide tax (financial) advice services’, accessed
January 2022, www.asic.gov.au/regulatory-resources/financial-services/financial-advice/your-obligations-when-giving-finan
cial-advice/faqs-regulation-and-registration-of-relevant-providers-who-provide-tax-financial-advice-service.
ATO 2007, ‘ROSA in brief — Shortfall interest charge’, accessed January 2022, www.ato.gov.au/assets/0/104/2474/2574/1d120e6
0-bdb7-43ef-a966-908c0942021e.pdf.
ATO 2012, ‘Good governance and promoter penalty laws’, accessed February 2022, www.ato.gov.au/assets/0/104/146/151/aa146c
3f-feb2-499d-8d89-63821e4925ab.pdf.
ATO 2015, MT 2008/1, ‘Penalty relating to statements: meaning of reasonable care, recklessness and intentional disregard,’
accessed January 2022, www.ato.gov.au/law/view/view.htm?PiT=99991231235958&docid=MXR%2FMT20081%2FNAT%
2FATO%2F00001.
ATO 2017a, TR 2006/11, ‘Private Rulings’, accessed January 2022, www.ato.gov.au/law/view/document?locid=%27TXR/TR2006
11/NAT/ATO/fp9%27&PiT=20080613000001.
ATO 2017b, ‘ATO interpretative decisions’, accessed January 2022, www.ato.gov.au/General/ATO-advice-and-guidance/ATO-gui
dance-products/ATO-interpretative-decisions.
ATO 2018, TR 2006/10, ‘Public Rulings’, accessed January 2022, www.ato.gov.au/law/view/document?locid=%27TXR/TR20061
0/NAT/ATO%27&PiT=20081031000001.
ATO 2020, ‘Withholding rate’, accessed January 2022, www.ato.gov.au/Business/PAYG-withholding/In-detail/Investment-income
-and-royalties-paid-to-foreign-residents/?page=5.
ATO 2021a, ‘Income tax return’, accessed January 2022, www.ato.gov.au/Business/Reports-and-returns/Income-tax-return.
ATO 2021b, ‘Decisions you can object to and time limits’, accessed January 2022, www.ato.gov.au/General/Dispute-or-object-to-a
n-ATO-decision/Object-to-an-ATO-decision/Decisions-you-can-object-to-and-time-limits.
ATO 2021c, ‘Eligible employers’, accessed January 2022, www.ato.gov.au/general/JobMaker-Hiring-Credit/Employers/Eligibleemployers.
ATO 2021d, ‘Statements and positions that are not reasonably arguable’, accessed January 2022, www.ato.gov.au/general/interes
t-and-penalties/penalties/statements-and-positions-that-are-not-reasonably-arguable/#:~:text=You%20may%20be%20liable%
20to,that%20is%20not%20reasonably%20arguable.
ATO 2021e, ‘Penalties’, accessed January 2022, www.ato.gov.au/general/interest-and-penalties/penalties.
ATO 2021f, ‘Promoter penalty laws’, accessed January 2022, www.ato.gov.au/General/Tax-planning/Promoter-penalty-laws/#:~:
text=If%20an%20entity%20is%20found,units%20for%20a%20body%20corporate.
ATO 2022a, ‘General interest charge (GIC) rates’, accessed January 2022, www.ato.gov.au/rates/general-interest-charge-(gic)rates/?=top_10_rates.
ATO 2022b, ‘Shortfall interest charge (SIC) rates’, accessed January 2022, www.ato.gov.au/rates/shortfall-interest-charge-(sic)rates.
BPP Learning Media 2015, ‘CIMA Study Text’, BPP Learning Media, London, UK.
TPB 2019a, ‘Tax agent services’, accessed December 2020, www.tpb.gov.au/tax-agent-services.
TPB 2019b, ‘Code comparison with the Corporations Act and FASEA Standards’, accessed January 2022, www.tpb.gov.au/codecomparison-corporations-act-2001.
TPB 2020, ‘BAS Services’, accessed January 2022, www.tpb.gov.au/bas-services.
TPB 2021a, ‘Qualifications and experience for tax agents’, accessed January 2022, www.tpb.gov.au/qualifications-and-experience
-tax-agents.
TPB 2021b, ‘Qualifications and experience for BAS agents’, accessed January 2022, www.tpb.gov.au/qualifications-and-experien
ce-bas-agents.
TPB 2022a, ‘About the Tax Practitioners Board’, accessed January 2022, www.tpb.gov.au/about-tpb.
TPB 2022b, ‘Tax (financial) advice services’, accessed April 2022, www.tpb.gov.au/tax-financial-advice-services.
TPB 2022c, ‘Terms explained’, accessed January 2022, www.tpb.gov.au/terms-explained.
TPB 2022d, ‘Qualifications and experience for tax (financial) advisers’, accessed January 2022, www.tpb.gov.au/qualificationsand-experience-tax-financial-advisers.
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72 Australia Taxation
MODULE 2
PRINCIPLES OF
TAXABLE INCOME
LEARNING OBJECTIVES
After completing this module, you should be able to:
2.1 identify the different types of income in a given situation and the tax implications relating to income source
and residence
2.2 determine whether a loss or outgoing is tax deductible in a given situation
2.3 evaluate the tax implications of the capital allowance and capital works rules available to different types
of entities
2.4 determine the taxable income for different types of taxpayers in a given situation.
LEGISLATION AND CODES
• Corporations Act 2001 (Cwlth)
• Income Tax Assessment Act 1936 (Cwlth) (ITAA36)
• Income Tax Assessment Act 1997 (Cwlth) (ITAA97)
• International Tax Agreements Act 1953 (Cwlth)
• Superannuation Act 1990 (Cwlth)
• A New Tax System (Goods and Services Tax) Act 1999 (Cwlth) (GST Act)
• Higher Education Support Act 2003 (Cwlth)
• Income Tax (Transitional Provisions) Act 1997 (Cwlth)
• Taxation Administration Act 1953 (Cwlth) (TAA)
PREVIEW
Part A of the module builds an understanding of how taxable income is determined and Part B covers
the tax rates that are applied to the taxable income and any offsets that are applied to reduce the final
amount of tax payable. Figure 2.1 shows that the first step in determining taxable income is to decide
whether a taxpayer is a resident of Australia for tax purposes and, if not, whether the taxpayer has any
Australian-sourced income that is taxable in Australia.
Figure 2.1 goes on to develop the process of how the income tax legislation defines taxable income
as assessable income less allowable deductions. In Part A each of these components of taxable income
are discussed in detail. Figure 2.1 also provides the structure on how this module is presented. Finally,
this module deals with the treatment of trading stock and international transactions in the calculation of
taxable income for the relevant taxpayers.
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74 Australia Taxation
FIGURE 2.1
s. 6-20 & s. 6-23
(Exempt income and
NANE)
s. 6-10
(Made assessable via
specific legislation)
s. 6-5
(Characteristics of
ordinary income)
Derivation
Non-assessable
income (excluded)
Statutory income
Ordinary income
Assessable income
Components of taxable income
Source: CPA Australia 2022.
Pdf_Folio:74
Trading stock
(Assessable income and
deductions)
Taxation of
international transactions
Taxable income = Assessable income – Deductions
Tax equation
Income tax = (Taxable income x Rate) – Offsets
What income is taxed in Australia?
(residency and income source)
Principles of
taxable income
Capital allowances
Substantiation
Limitations to
deductions
Specific deductions
General deductions
Deductions
Division 40 and 43
(capital allowances
and capital works)
Division 900
(Recordkeeping and
other obligations)
s. 8-1(2)
(Limited or denied
deductibility)
s. 8-5
(Made deductible by
specific legislation)
s. 8-1(1)
(Requirements)
PART A: PRINCIPLES OF
ASSESSABLE INCOME
INTRODUCTION
The final income tax liability of a taxpayer is determined by applying a tax rate to taxable income, and
then deducting tax offsets (ITAA97, s. 4-10), as shown in the following equation.
Income tax = (Taxable income × Tax rate) − Offsets
Income tax is levied on taxable income. The concept of taxable income is an essential feature of the
Australian taxation system. The concept of assessable income is contained in Part 1.3, Division 4 of
ITAA97, particularly ss. 4-10 and 4-15. There are a number of considerations in relation to residency
and source of income that affect an individual or company’s assessable income. In Part A of this module,
these concepts will be discussed in relation to the relevant legislation.
2.1 RESIDENCY AND SOURCE
Determining a taxpayer’s residency for tax purposes is the first step in calculating taxable income (see
figure 2.1). This is because residency for tax purposes (not related to residency for immigration and
citizenship) is important in assessing what income forms part of taxable income in Australia. A resident
of Australia for taxation purposes is assessed on their worldwide income (ITAA97, s. 6-5(2)), while a
non-resident is assessed only on income derived from Australian sources (ITAA97, s. 6-5(3)).
Unfortunately, there is no specific rule that will, in all situations, determine residency for tax purposes
so it is necessary to rely on both the legislation and the decisions of the courts.
TEST OF RESIDENCY FOR INDIVIDUALS
There are four tests to determine whether an individual is a resident for taxation purposes, which must be
applied in the following order:
1. resides test (the common law test)
2. domicile test (the first statutory test)
3. 183-day test (the second statutory test)
4. superannuation fund test (the third statutory test).
Note: It was announced in the 2021–22 Federal Budget that the current individual tax residency rules
will be replaced with a new, modernised framework, which consists of a primary test and secondary tests.
Under the primary test, a person who is physically present in Australia for 183 days in any income year will
be an Australian tax resident. Individuals who do not meet the primary test will be subject to secondary
tests that depend on a combination of physical presence and measurable, objective criteria. As at March
2022 this new framework has not been legislated.
The first test is the common law test (based on court decisions). The last three tests are referred to as
the statutory tests (based on specific legislation). A person need only satisfy one of these four tests to be
classified as a resident for taxation purposes. Therefore, for a person to be regarded as a non-resident of
Australia for tax purposes, they must fail all four tests.
Test 1: Resides Test
According to s. 6(1) of ITAA36, a resident of Australia means ‘a person, other than a company, who resides
in Australia’.
Under the first residency test a person’s residency is determined according to ordinary concepts of the
meaning of ‘resides in Australia’. However, the term ‘resides’ is not defined in either ITAA36 or ITAA97.
Although the question of whether a person resides in a particular country is a question of fact, over
the years, the courts have considered a number of important factors which help determine whether an
individual taxpayer resides in a particular country (e.g. Levene v CIR (1928) AC 217 and FCT v Miller
(1946) 73 CLR 93).
In November 1998, the Commissioner of Taxation (the Commissioner) issued Taxation Ruling
TR 98/17 dealing with the Commissioner’s interpretation of the word ‘resides’ for the purposes of the
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resides test. This taxation ruling applies to individuals entering Australia, including migrants, academics
teaching or studying in Australia, students studying in Australia, visitors on holidays and workers with
pre-arranged employment contracts.
While all facts and circumstances relating to an individual’s behaviour in Australia are relevant, the
Commissioner places a strong emphasis on the following four factors in determining whether a person is
considered to be a resident of Australia for tax purposes:
1. intention or purpose of presence
2. family and business/employment ties
3. maintenance and location of assets
4. social and living arrangements.
The critical question from the Commissioner’s perspective is whether the individual’s day-to-day
behaviour (i.e. mode of life) during the time spent in Australia reflects a degree of continuity, routine
or habit that is consistent with residing in Australia.
Based on an analysis of these factors, if the facts are inconclusive and there is no clear indicator to
determine whether a person is a resident, the Commissioner takes the view in Taxation Ruling TR 98/17
that a person will be regarded as a resident if the individual has been physically present in Australia for at
least six months during the income year and their behaviour is consistent with being a resident of Australia.
Examples 2.1, 2.2 and 2.3 consider the application of the first residency test and the principles
contained in Taxation Ruling TR 98/17.
EXAMPLE 2.1
Resident or Non-Resident?
Bjorn Olsson, who is from Sweden, is offered an 18-month contract to play soccer for the Brisbane
Roar, the Brisbane-based club competing in the national A-League competition. The club provides rental
accommodation for Bjorn and his family. Bjorn rents out his house in Sweden, sells his Swedish car and
redirects his mail from Sweden to Australia. His children attend an Australian school and his wife and
children become involved in sporting activities.
However, Bjorn is having trouble acclimatising to Australian conditions. Bjorn’s form begins to slide to
the point that management seek to terminate his contract on the ground of non-performance. Bjorn’s
contract is paid out for an agreed sum. Four months after arriving in Australia, Bjorn and his family return
to Sweden.
Consider if Bjorn is a resident or non-resident under the resides test.
As Bjorn established that he intended to live in Australia for eighteen months with his family and his
behaviour over the four months is consistent with the intention, Bjorn resided in Australia for tax purposes.
Source: Adapted from ATO 1998, Taxation Ruling TR 98/17 ‘Income tax: residency status of individuals entering Australia’,
accessed January 2022, www.ato.gov.au/law/view/pdf/pbr/tr1998-017.pdf.
EXAMPLE 2.2
Resident or Non-Resident?
Michelle Dubois is a doctor who comes to Australia from France to conduct medical research for five
months. She actually stays for seven months to complete the Australian phase of her research project.
Michelle’s husband and children do not accompany her to Australia. They stay in their home in Paris.
From Australia, Michelle assists her husband in running the family business.
While in Australia, Michelle stays in a hotel. She uses credit cards to meet day-to-day expenses which
are reimbursed by her employer.
Consider if Michelle is a resident or non-resident under the resides test.
Michelle was in Australia for a considerable time. However, all of the factors relating to her presence
in Australia suggest that the quality and character of her stay reflect that of a visitor who is temporarily
in Australia rather than establishing behaviour consistent with residing here. Therefore, Michelle does not
reside in Australia for tax purposes under the common law rule but may still be a resident under the
statutory rules discussed next.
Source: Adapted from ATO 1998, Taxation Ruling TR 98/17 ‘Income tax: residency status of individuals entering Australia’,
accessed January 2022, www.ato.gov.au/law/view/pdf/pbr/tr1998-017.pdf.
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76 Australia Taxation
EXAMPLE 2.3
Resident or Non-Resident?
Dipak Agarwal is a student from India who comes to Australia to study a four-year bachelor’s degree in
civil engineering. Dipak lives in rental accommodation near the university with fellow students and works
part-time at the university social club as a barman. He also joins the local cricket club.
Soon after arriving, Dipak receives a call from his mother informing him that his father is seriously ill.
After five months, Dipak withdraws from his studies and permanently returns home to India.
Consider if Dipak is a resident or non-resident under the resides test.
Dipak’s routine of study and continuing accommodation on campus establishes a pattern of habitual
behaviour over the six months. His employment adds support to the conclusion he is residing here and
would thus be regarded as a resident for tax purposes.
Source: Adapted from ATO 1998, Taxation Ruling TR 98/17 ‘Income tax: residency status of individuals entering Australia’,
accessed January 2022, www.ato.gov.au/law/view/pdf/pbr/tr1998-017.pdf.
The Three Statutory Tests
Even if a person does not reside in Australia under ordinary concepts (common law test), they may still
be deemed to be a resident of Australia for tax purposes if they meet one of three additional statutory tests
contained in the extended definition of resident in s. 6(1) of ITAA36.
According to s. 6(1), a resident of Australia means:
(a) a person, other than a company, who resides in Australia and includes a person:
(i) whose domicile is in Australia, unless the Commissioner is satisfied that the person’s permanent
place of abode is outside Australia;
(ii) who has actually been in Australia, continuously or intermittently, during more than one-half of
the year of income, unless the Commissioner is satisfied that the person’s usual place of abode is
outside Australia and that the person does not intend to take up residence in Australia; or
(iii) who is:
(A) a member of the superannuation scheme established by deed under the Superannuation Act
1990; or
(B) an eligible employee for the purposes of the Superannuation Act (1976); or
(C) the spouse, or a child under 16, of a person covered by sub-subparagraph (A) or (B).
These are referred to as the three statutory tests. Each of these tests is explained in further detail below.
Test 1: Domicile Test
The domicile test applies unless the Commissioner is satisfied that the person has a permanent place of
abode outside Australia. Domicile is a legal concept legislated in the Domicile Act 1982. Domicile is
defined in s. 10 of the Domicile Act as:
The intention that a person has to make his home indefinitely in that country.
Domicile refers to a person’s choice about the country in which they intend to make their home
indefinitely. If a person’s domicile is Australian they will still not be a resident for tax purposes if they can
prove to the Commissioner that they have established a permanent place of abode outside of Australia.
A permanent place of abode outside Australia means a person establishing a permanent residence or
home outside Australia. From a practical point of view, it means having a fixed address outside Australia.
Permanent in this sense does not mean forever but can be contrasted with temporary or transitory (see
FCT v Applegate 79 ATC 4307 and FCT v Jenkins (1982) 82 ATC 4098).
Taxation Ruling IT 2650 outlines some of the factors that the Commissioner takes into account in
determining whether a taxpayer has established a permanent place of abode outside Australia.
These factors include:
• intended and actual length of time overseas
• any intention to return to Australia at some definite point
• establishment of a home overseas
• abandonment of any residence in Australia
• duration and continuity of presence overseas.
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MODULE 2 Principles of Taxable Income 77
The Commissioner takes the general view that where a taxpayer leaves Australia for two years or more
and establishes a home in another country, the overseas home will generally represent a permanent place
of abode outside Australia.
Conversely, a taxpayer who has an Australian domicile but leaves Australia with the definite intention
of returning within two years will normally remain a resident of Australia for tax purposes, unless the
taxpayer can clearly demonstrate that they have established a permanent place of abode outside Australia.
Example 2.4 considers the issue of the permanent place of abode principle in light of the domicile test
and the principles contained in Taxation Ruling IT 2650.
EXAMPLE 2.4
Resident or Non-Resident?
Damien Brown, an Australian chartered accountant was seconded to his employer’s London office for a
period of two years, or such longer period as mutually agreed upon. Damien closed his Australian credit
card accounts and sold most of his Australian assets. He rented out his Australian home and redirected
his mail to London.
Soon after arriving in London, Damien and his wife bought an apartment and lived there for two years.
Damien’s wife became pregnant and they decided to permanently return to Australia so that the child is
born and raised in Australia.
Consider if Damien is a resident or non-resident under the domicile test.
Damien’s domicile is still Australia but he would be considered to be a non-resident of Australia for tax
purposes. This is because he has established a permanent place of abode outside of Australia. He has left
Australia and has established a fixed address outside of Australia for a period of two years or more with
no definite plans to return. He has also closed his Australian credit card accounts and sold most of his
Australian assets. He rented out his Australian home and redirected his mail to London (FCT v Applegate
(1979) 79 ATC 4307 and FCT v Jenkins (1982) 82 ATC 4098).
Source: Adapted from ATO 1991, Taxation Ruling IT 2650 ‘Income Tax: Residency — Permanent Place of Abode Outside
Australia’, accessed January 2021, www.ato.gov.au/law/view/document?Docid=ITR/IT2650/NAT/ATO/00001.
Test 2: 183-Day Test
Under the second statutory test contained in s. 6(1) of ITAA36, a person is deemed to be a resident of
Australia if they are physically present in Australia for more than 183 days (184 days in the case of a leap
year). However, the 183-day test only applies where the taxpayer:
(a) does not have a usual place of abode outside Australia, and
(b) has the intention to take up residence in Australia.
If both conditions are not met, then the person is not considered a resident under the 183-day test.
According to Taxation Ruling IT 2681, a person’s physical presence in Australia does not need to be
continuous for this test (i.e. all the days the person is present in Australia during the income year will be
counted).
Note that the 183-day test generally only applies to people coming to Australia, rather than people
leaving Australia.
Test 3: Commonwealth Superannuation Test
The final statutory test only relates to Commonwealth Government employees and their immediate families
who are located in an overseas country (e.g. employees of the Australian embassy or consulate-general in
a foreign country).
A person is considered to be a resident of Australia for tax purposes under the third statutory test
if they are an active contributing member of a Commonwealth Government superannuation scheme
established by deed under the Superannuation Act 1990 or are an eligible employee for the purposes of
the Superannuation Act 1976.
QUESTION 2.1
Consider each of the following scenarios.
(a) On 1 December 2021, Martina Andersson, a single 19-year-old Swedish student, arrives at the
University of Wollongong to commence a three-year Bachelor of Commerce degree. Martina
obtains a three-year student visa. She works part-time in a local pizza restaurant to help pay her
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78 Australia Taxation
way. She signs a lease on a one-bedroom apartment near the university. Unfortunately, Martina
does not spend enough time studying and fails all of her subjects which then causes her to
return home to Sweden on 1 July 2022.
(b) James Bligh, a single 23-year-old motor mechanic from Sydney, left Australia on 1 March 2021
for the purpose of going to Saudi Arabia to work for a fixed period of nine months as a motor
mechanic. James is single and lived with his parents in Sydney. He left most of his belongings
in Australia and hopes to start a full-time course at the University of Sydney in February 2022.
(c) John Kelly, a US executive, is sent to Australia to set up a new branch of a US company. He
obtains a 12-month visa and his wife and two young children accompany him. John’s children
are enrolled in a local private school and they rent a house in Melbourne and remain living there
for 12 months in the current income year. At the end of their 12-month stay, they return to the
US to live in their house in New York which they had rented out whilst they were in Australia.
For each scenario, determine whether the taxpayer is a resident or non-resident for Australian
tax purposes.
2.2 TEST OF RESIDENCY FOR COMPANIES
According to s. 6(1) (b) of ITAA36, a company is considered to be a resident of Australia if it is:
(a) incorporated in Australia, or
(b) not incorporated in Australia, but carries on business in Australia and has its central management and
control in Australia, or
(c) not incorporated in Australia, but carries on business in Australia and has its voting power controlled
by shareholders who are residents of Australia.
Although a company cannot in the normal sense reside anywhere, an often-cited test to determine the
residence of a company is contained in De Beers Consolidated Mines Ltd v Howe (1906) AC 455, where
the following was observed.
We ought … to proceed as nearly as we can upon the analogy of an individual. A company cannot eat or
sleep, but it can keep house and do business. We ought, therefore, to see where it really keeps house and does
business … I regard that as the true rule … the real business is carried on where the central management
and control actually abides (p. 438).
This view was supported in the decision in Koitaki Para Rubber Estates Ltd v FCT (1941) 2 AITR 167
where there was a claim by the company that it was a dual resident. It was observed that one factor to be
examined in determining the residence of the taxpayer is where the affairs of the company are controlled.
The mere trading in Australia by a company not incorporated in Australia will not, by itself, be sufficient
to render the company a resident. In determining where the central management and control is located, the
Courts have looked not only at where the directors meet, but also at where the day-to-day running of the
business occurs (see Malayan Shipping Co v FCT (1946) 71 CLR 156).
The issue of determining where the central management and control and the issue of which shareholders
had control of the company has proved difficult to determine in practice.
On 21 June 2018, the ATO released its Taxation Ruling on the central management and control (CM&C)
test of residency. Taxation Ruling TR 2018/5 covers the circumstances in which a foreign-incorporated
entity may be an Australian tax resident, together with Practical Compliance Guideline (PCG 2018/9).
TR 2018/5 addresses four key matters related to residency.
1. Does the company carry on business in Australia? If a company carries on business and has its central
management and control in Australia, it will carry on business in Australia within the meaning of the
CM&C test of residency. It is not necessary for any part of the actual trading or investment operations
of the business of the company to take place in Australia because the central management and control
of a business is factually part of carrying on that business.
2. What does central management and control mean? CM&C refers to the control and direction of a
company’s operations in making high-level decisions that set the company’s general policies, and
determine the direction of its operations and the type of transactions it will enter. This is different
from the day-to-day conduct and management of its activities and operations.
3. Who exercises central management and control? This is a question of fact and, in reality, it is the
company’s directors who exercise a company’s CM&C. However, a person who has the legal power
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or authority to control and direct a company but does not use it, does not exercise CM&C. For
example, in Bywater Investments Limited & Ors v Commissioner of Taxation; Hua Wang Bank Berhad
v Commissioner of Taxation (2016) HCA 45, the court disregarded the role of those directors who were
formally appointed, but did not play any real role in the affairs of the company.
4. Where is central management and control exercised? A company will be controlled and directed where
those making its high-level decisions do so as a matter of fact and substance, not where the decisions are
merely recorded and formalised. Thus, the CM&C of a company is not necessarily exercised where the
trading or investment activities of the company are carried on or the place where those who control and
direct a company live. What matters is where directors or other persons actually perform the activities
to control and direct the company.
In the 2020–21 Federal Budget, the Federal government announced technical amendments to
the legislation to clarify the income tax residency tests for corporate entities (not legislated as at
February 2022).
Confusion has existed following the Bywater Investments Ltd v FCT court decision and the subsequent
withdrawal by the ATO of Taxation Ruling 2004/15. There have been concerns that foreign incorporated
companies that have Australian resident directors may be regarded as Australian resident companies
despite the fact that the company does not operate a business in Australia.
The 2020–21 Federal Budget proposes to implement a two-prong corporate residency test. The proposal
is that a company incorporated offshore will only be regarded as an Australian resident company for tax
purposes if they have a significant economic connection to Australia. This test will be satisfied where
both the company’s core commercial activities are undertaken in Australia and its central management
and control is in Australia. The budget announcement replaces the ‘carrying on business test’ with a novel
‘core commercial activities test’.
This is proposed to take effect from the first income year after the date of Royal Assent, but early
adoption is available from 15 March 2017 (being the pivotal date the ATO withdrew their prior ruling on
this matter).
SOURCE OF INCOME
Under s. 6-5(2) of ITAA97, a taxpayer who is a resident of Australia for tax purposes is required to include
in their assessable income all ordinary and statutory income derived from all sources whether in or out of
Australia.
Conversely, s. 6-5(3) states that a taxpayer who is not a resident of Australia is only required to include
in their assessable income all ordinary and statutory income derived from Australian sources.
The concept of source deals with the issue of from where the income has been derived. Source of income
refers to the geographical location at which the act, transaction or event that produces the income occurs.
The guiding principle applied by the courts in determining source was stated by Justice Isaacs in the
High Court decision in Nathan v FCT (1918) 25 CLR 183 at 189:
. . . the word ‘source’ meant, not a legal concept, but something which a practical man would regard as a
real source of income.
Therefore, the courts identify the source of income based on the type of income derived, not the situation
of the taxpayer. Table 2.1 sets out the sources of common types of income.
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80 Australia Taxation
TABLE 2.1
Sources of common types of income
Type of income
Source
Income from
personal services
The source of wages and salaries is usually where the services or duties are performed (FCT
v French (1957) 98 CLR 398).
The general rule is that if the taxpayer is being paid to undertake work under a normal
contract of employment or contract for services, the source is generally the place where
the work is undertaken.
However, where the services are particularly specialised or can be performed anywhere,
then the place where the service contract was entered into may be considered the source of
the income (see FCT v Mitchum (1965) 113 CLR 401).
This is to say that, if creative powers or special knowledge is involved to such a high degree
that the physical location as to where the work is undertaken is relatively unimportant (e.g.
an author writing a book), then the dominant source may be the place where the contract
was made.
Business (trading)
income
The source of trading income (i.e. income from carrying on a business) is generally where
the profits of the business have been made.
For example, the profits of a manufacturer come from the manufacture and sale of goods,
while the profits of a share trader come from the buying and selling of shares. Hence, where
the purchase and sale of goods occurs is the major factor, and the place where the contract
is made is relatively unimportant. The source will generally be where the goods are sold (see
Tariff Reinsurance Ltd v C of T (1938) 59 CLR 194).
Conversely, where business profits are derived predominantly from the making of contracts
and performance is relatively unimportant, the place where the contract is made is usually
the major factor in determining source.
Interest income
The source of interest income is generally the location of the bank account where the
monies are deposited.
For example, in the case of FCT v Spotless Services Ltd (1996) 186 CLR 404, the taxpayer
company entered into a loan arrangement in the Cook Islands. Money was subsequently
deposited into a Cook Islands bank account. The court held that, despite the fact that all
negotiations took place in Australia, the interest in relation to the deposit was sourced in the
Cook Islands (i.e. where the loan was made and the place where the money was advanced).
Dividend income
The source of dividends is determined by reference to the place where the company paying
the dividends made its profits. This was confirmed in the case of Esquire Nominees Ltd v
FCT 72 ATC 4076.
Rental income
The source of rental income is the country in which the property itself is located.
Royalty income
Royalties arising out of the right to use property — such as copyright, patents, trademarks,
designs, mines or oil fields. from which the royalty flows — will generally be sourced in the
country in which the intellectual property is located and registered.
However, where an Australian business pays a royalty to a non-resident, the royalty is
deemed to have an Australian source under s. 6C(1) of ITAA36.
Source: CPA Australia 2022.
ASSESSABLE INCOME
Assessable income comprises three components, all of which must be considered to arrive at the final
determination of the amount of assessable income. These three components can be summarised in the
following equation:
Assessable income = (Ordinary income + Statutory income) excluding non-assessable income
ORDINARY INCOME
Section 6-5(1) of ITAA97 (previously s. 25(1) of ITAA36) defines assessable income as including
‘income according to ordinary concepts’, which is called ordinary income. Unfortunately, there is no
further clarification on the meaning of ordinary income in the legislation and therefore we must turn to the
decision of the courts to define ordinary income. In examining whether an amount is ordinary income, the
courts have tended to weigh up a number of factors that characterise income in ordinary concepts. These
characteristics are summarised in table 2.2.
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MODULE 2 Principles of Taxable Income 81
TABLE 2.2
Characteristics of ordinary income
Income characteristic
Explanation
Authority
It comes to the recipient
beneficially
Ordinary income is often described as ‘what comes
into the pocket’. An unrealised gain is not ordinary
income. If an amount does not come to the taxpayer,
it will not be ordinary income. Even if the amount
saves a taxpayer from incurring expenditure, the
saving is not ordinary income because income
is what comes in, it is not what is saved from
going out.
Tennant v Smith (1892)
AC 150
Squatting Investment
Co. v FCT (1953) 86
CLR 570
It is not necessary that money actually be paid over to
the taxpayer. Instead, the income may be dealt with
at the taxpayer’s direction on the taxpayer’s behalf.
This principle is recognised in s. 6-5(4) of ITAA97 which
states:
You are taken to have received the amount as
soon as it is applied or dealt with in any way on
your behalf as you direct.
This is referred to as the doctrine of constructive
receipt.
It is money or money’s
worth
A benefit is not considered ordinary income unless it
consists of money or is capable of being converted into
money. Hence, if a taxpayer sells goods or provides
services to another person and receives monetary
compensation, this is clearly assessable.
FCT v Cooke & Sherden
80 ATC 4140
Income Tax Ruling IT
2668
Similarly, if a taxpayer sells goods or provides services
to another person and, instead of receiving money,
receives goods or services equivalent to the value of
the goods or services provided, this is still assessable
because it is money’s worth and can be converted into
money. This is referred to as a barter transaction (see
Income Tax Ruling IT 2668).
It will often exhibit
periodicity, recurrence
and regularity
A frequent characteristic of ordinary income is an
element of periodicity, recurrence or regularity, even
if receipts are not directly attributable to employment
or services rendered. Conversely, an unsolicited lump
sum is generally not ordinary income.
FCT v Harris 80 ATC
4238
Myer Emporium Ltd v
FCT 87 ATC 4363
However, periodicity, recurrence or regularity is not
always essential, for an amount to be ordinary income.
For example, in the case of Myer Emporium Ltd v
FCT 87 ATC 4363, the High Court of Australia held
that a lump sum payment received from an isolated
transaction was ordinary income as the transaction was
entered into in the ordinary course of business and was
done so with a profit-making intention.
Conversely, instalments of a capital sum, even though
received regularly from one source, may still be
deemed to be capital rather than ordinary income.
The normal proceeds
of personal exertion,
property or business are
income
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82 Australia Taxation
Income from personal exertion (e.g. wages, salaries,
allowances, bonuses, tips), whether as an employee
or otherwise, are clearly ordinary income even if the
services are performed and the rewards received
irregularly.
Kelly v FCT (1985)
80 FLR 155
Receipts in the nature of a return on capital invested,
such as interest, dividends and rent (termed income
from property) are considered ordinary income.
Amounts received as a result of carrying on a business,
but not a pastime or hobby, are also ordinary income.
Scott v FCT (1966) 117
CLR 514
Commissioner of
Taxation v Stone (2005)
HCA 21
Even if the receipt is
illegal or immoral it may
still be income
The tests for determining whether an amount is
ordinary income are the same whether it is received
from legal or illegal activities. Hence, the proceeds of
illegal activities can be assessable (see Taxation Ruling
TR 93/25).
Partridge v Mallandaine
(1886) 2 TC 179
(business of burglary)
Lindsay v IR Commrs
(1932) 18 TC 43 (whisky
smuggler)
No. 275 v MNR (1955)
55 DTC 439 (prostitution)
Compensation receipts
may be income if it
replaces a loss of
revenue
A compensation payment (e.g. insurance receipt)
will generally take the same character as the item
or amount it replaces. Consequently, compensation
for the loss of wages or earnings will generally be
characterised as ordinary income, even if received in
a lump sum.
Higgs v Olivier (1951)
TC 899
Liftronic Pty Ltd v FCT
(1996) 96 ATC 4425
On the other hand, compensation for the loss,
surrender or substantial impairment of a capital asset
(e.g. loss of a limb, eye or finger) will generally be
characterised as capital and not ordinary income. This
is so whether the compensation is received by way of a
single lump sum payment or in several instalments.
Capital receipts/(gains)
are not ordinary income
Capital gains resulting from the sale of a capital asset
are not considered ordinary income. The Act does not
define either income or capital. Instead, over the years,
the courts have come up with guidelines in order to
distinguish ordinary income from capital.
John Smith and Son v
Moore (1921) 2 AC 13
The traditional approach to distinguishing income
from capital is to liken capital to the tree and income
to the fruit of the tree. Hence, if a person purchases
a property, such as a building and leases it to a third
party, the property is capital and the rent received is
ordinary income.
In a business context, the distinction between capital
and income has also been equated to the distinction
between fixed and circulating capital. Fixed capital is
one which ‘the owner turns to profit by keeping it in his
own possession’, whilst a circulating asset is one which
the ‘owner makes a profit by parting with it and letting it
change masters’ (per Lord Haldane in John Smith and
Son v Moore (1921) 2 AC 13).
For example, the machinery used by a manufacturer to
produce goods will be a fixed (or non-current) asset,
whilst the goods produced and sold to customers are
circulating assets (trading stock).
The distinction between ordinary income and capital
is still relevant even with the introduction of capital
gains tax which applies to the disposal of capital assets
acquired on or after 20.09.85 (see module 3).
Income does not include
windfall gains
Windfall gains (e.g. lottery winnings, betting and
gambling wins) are generally not ordinary income
unless the taxpayer is carrying on a business of betting
or gambling. This is because lottery and gambling
winnings are usually lump sum payments, isolated,
unexpected and have an element of chance attached
to them (see Moore v Griffiths (1972) 3 All ER 399).
Moore v Griffiths (1972)
3 All ER 399
Hayes v FCT (1956) 96
CLR 47
Martin v FCT (1954) 90
CLR 470
These receipts usually lack sufficient connection
with any income producing activity nor display any
of the usual characteristics of ordinary income. This
would also cover gratuitous payments not related
to services provided (see Hayes v FCT (1956) 96
CLR 47).
(continued)
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MODULE 2 Principles of Taxable Income 83
TABLE 2.2
(continued)
Income characteristic
Explanation
Authority
An example of the non-assessable nature of windfall
gains is illustrated in Martin v FCT (1954) 90
CLR 470, where it was held that the taxpayer was not
assessable on prizes won by racing his own horses and
betting on them. It was held the gains were made from
undertaking an activity that gave pleasure.
It must be characterised
as income in the hands
of the person who has
derived it
The character of ordinary income must be determined
by reference to the person who derives the income and
not by reference to any other person (e.g. the person
making the payment). In other words, to characterise
a payment as ordinary income, it must be examined in
the hands of the recipient not the payer.
FCT v Dixon (1952) 86
CLR 540
Federal Coke Co Pty Ltd
v FCT, 77 ATC 4255
Note: These tests are indicators/guidelines and not determinative in themselves.
Source: CPA Australia 2022.
Figure 2.2 illustrates that the first step in determining assessable income is to understand the meaning
of ordinary income.
FIGURE 2.2
Determining assessable income
Taxable income = Assessable income – Deductions
Assessable income
Ordinary income
Statutory income
Non-assessable
income (excluded)
Derivation
s. 6-5
(Characteristics of
ordinary income)
s. 6-10
(Made assessable via
specific legislation)
s. 6-20 & s. 6-23
(Exempt and
NANE income)
Source: CPA Australia 2022.
Example 2.5 illustrates how these principles apply to ordinary income.
EXAMPLE 2.5
Income According to Ordinary Concepts
Consider the following transactions and whether they are ordinary income or not under s. 6-5(1) of ITAA97.
(a) Paul Johnson receives a payment of $8 per pizza from his employer, Beagle Boys Pizza when he
delivers a pizza. He also occasionally receives tips from customers when the pizzas are delivered.
All income from personal services received in the capacity as an employee constitutes ordinary income
in accordance with s. 6-5(1). In terms of any tips Paul receives, a voluntary payment or gift in the hands
of the recipient, as a product or incident of employment or a reward for services, is assessable as
ordinary income, even though it is paid or given by a third party. Hence, Paul should include the $8 per
pizza he receives from his employer for delivering pizzas plus any tips he receives from customers as
assessable ordinary income.
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(b) A $1000 cash prize won by a journalist for coming first in a writing competition.
A $1000 cash prize won by a journalist in a writing competition is directly related to the journalist’s
income producing activities (i.e. related to their job). As such, the prize could not be said to be a
gratuitous payment in the hands of the journalist. The prize is, therefore, assessable as ordinary income
under s. 6-5 (see Kelly v FCT 85 ATC 4283).
Distinguishing Between Income and Capital
Historically, the courts have made a key distinction between income and capital, and the introduction of
capital gains tax (CGT) in September 1985 did not alter the importance of this distinction. The distinction
between the two is significant because capital and income are potentially subjected to different taxation
treatment. If an item is considered income, the full amount is included in the taxpayer’s assessable income
and taxed at their marginal tax rate. On the other hand, if an item is considered capital in nature, the
CGT provisions may apply and the gain is taxed differently to ordinary and other statutory income (see
module 3).
Originally, the Australian courts relied on English law to make the distinction between capital and
income. Generally, the courts distinguished between fixed and circulating assets. Fixed assets refer to
the profit yielding structure of the business such as the machinery used to produce goods and are capital
in nature. Circulating assets refer to assets that the business sells to create profits such as the trading stock
of a retail business (e.g. John Smith and Son v Moore (1921) 12 TC 266). Generally speaking, an item
is capital if it is a once-off or non-recurring transaction. However, there are exceptions and isolated or
once-off transactions can still be income in nature rather than capital.
Is Income Generated From Isolated Sale Transactions Ordinary Income?
Income from an isolated transaction may still be assessable as ordinary income as shown by the decision in
Californian Copper Syndicate v Harris (1904) 5 TC 159, where it was held that receipts will be assessable
as ordinary income where:
what is done is not merely a realisation or change of investment, but an act done in what is truly the carrying
on, or carrying out of a business (pp. 165–6).
A transaction that represents the realisation of an asset is usually considered capital in nature (Scottish
Australian Mining Company Ltd v FCT (1950) 81 CLR 188). However, courts can take a broad view of
what constitutes the business activities of the taxpayer and, in the case of a leasing business, the courts can
sometimes find that not only will the taxpayer business be assessed on the rent received from leasing but
sometimes also on the profits derived from the sales of the leased equipment. This was the outcome in the
cases of FCT v GKN Kwikform Services Pty Ltd 91 ATC 4336 and also in Memorex Pty Ltd v FCT 87 ATC
5034. Where courts have held that the leased equipment was not acquired for the purpose of resale, any
gains arising from the sale of this leased equipment have been held to be capital. This was the outcome
in the cases of FC of T v Hyteco Hiring Pty Ltd 92 ATC 4694 and FC of T v Cyclone Scaffolding Pty Ltd
87 ATC 5083. Whether a transaction is merely the realisation of a capital asset or income according to
ordinary concepts is a difficult question and one of fact and degree. This concept is discussed in further
detail later in this section (see ‘Mere realisation of a capital assets and profits from isolated transactions
of a business’).
Lump Sum Proceeds
The proceeds received as a lump sum are usually considered capital in nature, although if the proceeds are
received in instalments, this may still constitute capital receipts (see Californian Oil Products v FCT).
Compensation
Compensation payments (e.g. insurance receipt) generally take the same character as the item or amount
it replaces (see C of T v Meeks (1915) 19 CLR 568). Accordingly, a payment which is compensation
for an item that would have been assessable income is itself assessable as income. On the other hand,
compensation that replaces a capital asset will be considered capital in nature.
The following is a brief summary of the types of compensation that a taxpayer may receive and the
taxation consequences.
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MODULE 2 Principles of Taxable Income 85
Compensation for Loss of Trading Stock
Compensation received for the loss of trading stock is considered assessable income, as that stock would
have been assessable if sold in the ordinary course of business (see FCT v Wade (1951) 84 CLR 105). This
is specifically provided for in s. 70-115 of ITAA97.
Income Protection Insurance
An income protection insurance policy replaces lost income, therefore, any payment received will be either
ordinary or statutory income depending on the type of income lost (see FCT v DP Smith (1981) 81 ATC
4114 and Maher v FCT (2005) ATC 2083).
Loss of Profits
Section 15-30 of ITAA97 specifically provides that insurance receipts received in return for the loss of the
taxpayer’s assessable income is included in assessable income in the year in which the compensation is
received. This includes compensation for loss of profits where the taxpayer is carrying on a business.
Compensation Received in Relation to a Capital Asset (e.g. Building)
If an amount is received as compensation in relation to the damage or destruction of a capital asset, it will
usually be considered capital in nature. However, if the compensation is received after 19 September 1985,
then it may be subject to the CGT provisions (see module 3).
If the compensation relates to distinct components and can be clearly identified (e.g. compensation for
loss of stock and compensation for the destruction of the building), then the compensation can be split
into an income component and a capital component for taxation purposes. On the other hand, where the
amount cannot be clearly split into income and capital, then the entire amount is treated as capital (see
McLaurin v FCT (1961) 104 CLR 381).
Where compensation is in relation to the damage of the firm’s profit-making structure, the compensation
will be of a capital nature (see Van Den Berghs Ltd v Clark (Inspector of Taxes) (1935) AC 431). However,
if the damage is in relation to something of a minor nature, such as the loss of one of many contracts, or
an agency agreement, then the compensation will be revenue in nature (see Kelsall Parsons & Co. v IRC
(1958) 12 TC 608).
Example 2.6 illustrates whether insurance proceeds are considered as ordinary income.
EXAMPLE 2.6
Income According to Ordinary Concepts
John Jackson is a builder who suffered a back injury in a workplace accident on 1 July 2021. John was
unable to work for the entire 2021–22 income year and received $82 500 as workers compensation for his
loss of income. Consider if the compensation received by John, is assessable as ordinary income.
In this case, the $82 500 is assessable to John under s. 6-5 as ordinary income, as it is received in
‘substitution for income’.
Generally, a compensation receipt takes on the same character as the item that it replaces (see C of T
v Meeks (1915) 19 CLR 568). Consequently, workers compensation payments for loss of wages are fully
assessable as ordinary income under s. 6-5 of ITAA97.
JobKeeper Payments
On 30 March 2020, the Federal government announced the introduction of the JobKeeper Payment
scheme to support businesses significantly impacted by the government’s response to the Coronavirus
(COVID-19). This scheme ended on 28 March 2021.
The JobKeeper Payment was paid as a subsidy by the government to eligible businesses to assist them
to continue paying their eligible employees even though the business had to cease operation or operated at
a reduced capacity. These payments were required to be passed on to the relevant employees in the form
of salaries and wages and therefore the JobKeeper payments were compensation received to pay amounts
that were tax deductible. As a result, JobKeeper payments were assessable income for the 2020–21 tax
year under either s. 6-5 of ITAA97 (as ordinary income) or s. 15-10 of ITAA97 (as a subsidy received by
a business).
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Compensation Received for the Termination of an Agency or Management Contract
Compensation receipts from the cancellation of ordinary business contracts will constitute income in the
hands of the recipient (see Heavy Minerals Pty Ltd v FCT (1966) 115 CLR 512) as this is compensation
for lost income.
Where the compensation relates to the loss of agency, it is necessary to determine the importance of
the agency to the firm’s business structure. Payments received in respect of the cancellation of a contract
that is integral to the way that a taxpayer conducts their business operations, or from the cancellation of
an exclusive agency agreement, were held to be of a capital nature (see Van den Berghs v Clark (1935)
AC 431; Californian Oil Products Ltd v FCT (1934) 52 CLR 28). Similarly, in the case of Californian Oil
Products (in liquidation) v FCT, the loss of the agency effectively terminated the company’s business. As
a result, the compensation received was of a capital nature.
By way of comparison, in Kelsall Parsons & Co. Ltd v IRC (1938) 21 TC 608, and IRC v Flemming
& Co. (Machinery) Ltd (1951) 33 TC 57, compensation for loss of an agency was held to be on revenue
account since the loss did not relate to or affect the firm’s underlying business structure. This was because
the agency which was terminated was one of nine agencies and the loss was a normal trading risk for their
type of business.
Restrictive Covenants
Sometimes an entity may receive money for the sale of a business or product line. As part of the sale
proceeds, the sale contract may expressly provide that the vendor (seller) is prohibited from operating
a similar activity for a period of time. This type of agreement is commonly referred to as a restrictive
covenant.
If the payment for the restrictive covenant reduces the taxpayer’s ability to trade for a significant
period of time, it will be capital in nature (see Dickenson v FCT (1958) 98 CLR 460). However, if the
taxpayer’s business continues because the restrictive covenant only limits the taxpayer’s ability to sell or
supply a particular product (or range of products), then the receipt is income, and not capital, because it is
compensation for the loss of income rather that for the loss of the ability to earn income, which would be
capital (see Kelsall Parsons & Co. Ltd v IRC (1938) 21 TC 608 and IRC v Flemming & Co. (Machinery)
Ltd (1951) 33 TC 57).
Example 2.7 illustrates the taxation implications of proceeds received from a restrictive covenant.
EXAMPLE 2.7
Compensation Received for a Restrictive Covenant
Jill Jones runs a successful design business in the Brisbane CBD. Jill signed a contract restricting her
right to set up a similar business in the Melbourne CBD and received compensation of $96 000. Consider
if the compensation received by Jill is income or capital.
The $96 000 received by Jill is capital in nature and not assessable as ordinary income because it
restricts the way in which she can do business. It alters her ability to expand her business into the
Melbourne CBD and is, therefore, capital in nature. This will need to be considered in relation to CGT.
QUESTION 2.2
Consider the following independent transactions.
(a) Coconut Essence is a retailer of coconut water. It has been storing its stock in a warehouse.
Ten years after they bought the warehouse, the company sells its warehouse.
(b) Coconut Essence imports and sells six products, including coconut water, coconut oil, coconut
ice cream, coconut chips, coconut marshmallows and coconut juice. A major competitor
pays Coconut Essence $2.5 million to stop importing and selling coconut water, which is its
top-selling product.
(c) At the end of the income year, Coconut Essence decides to accept a $4 million offer from another
competitor to stop importing and selling its remaining five coconut products. As there were no
more products left to sell, Coconut Essence ceased its business operations.
Discuss whether the abovementioned amounts are income or capital?
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MODULE 2 Principles of Taxable Income 87
The Principal of Mutuality
The principal of mutuality is derived from the concept that a person cannot derive income by dealing
with themselves. In other words, a person’s income consists only of money derived from external sources.
Therefore, amounts received by a club from members for the services provided by the club (e.g. poker
machine proceeds, bar and dining room sales) are not assessable income of the club under the mutuality
principle. This is because the club and the members are one and the same. Only income received from nonmembers (i.e. visitors) is assessable because this income comes from external sources (see Coleambally
Irrigation Mutual Co-operative Ltd v FCT (2004) ATC 4835).
The Commissioner adopts a formula (known as the Waratah’s formula) to determine the percentage of
total receipts attributable to non-members. For example, income from investments of a club or association’s
funds (e.g. interest, dividends and rental income) would be included in the assessable income of the club
as it is received from non-members.
The concept of mutuality is illustrated in example 2.8.
EXAMPLE 2.8
Principle of Mutuality
A golf club received $350 000 from members in respect of food and drink sales. Consider whether this
amount constitutes ordinary income.
Under the principle of mutuality, income derived from oneself does not constitute assessable as ordinary
income. In the case of a club, this means that the $350 000 received from the members is not assessable
as ordinary income. Only receipts derived from non-members is included in the ordinary income of the
club and assessable.
Are Gifts Ordinary Income?
While wages, bonuses, commissions, allowances and tips clearly constitute ordinary income, other
payments connected with services have caused the courts more difficulty when attempting to determine
their assessability. Nowhere is this more evident than in the case of gifts.
In order to characterise a receipt as ordinary income, a nexus (connection) must be established between
the receipt and the provision of services by the taxpayer. As stated in Midland Railway Co v Sharpe (1904)
AC 349 at 351:
As long as the receipt accrues by virtue of the taxpayer’s office, it constitutes income.
Whether an amount is considered a gift or constitutes income depends on whether the payment is a
reward for the services provided (in which case it will constitute ordinary income and is assessable), or
given because of the taxpayer’s personal qualities (in which case it is not ordinary income and is not
assessable as it is a gift). Essentially, the main distinction is to consider whether the gift was made as a
thank you for services rendered or given as a result of the close personal friendship that existed between
the two parties.
If there is a personal relationship between the two persons and the gift was made because of personal
reasons, then the payment will be properly characterised as a gift. Conversely, if the payment was made
as a result of the provision of services, then the payment is more likely to be characterised as ordinary
income.
For example, in the case of Hayes v FCT (1956) 96 CLR 47, the court held that, where a client gave
his accountant shares in his company, it was considered a gift rather than ordinary income, due to the fact
that the gift of shares could not be traced to any income-earning activity of the taxpayer, and was given
primarily due to the close personal relationship that existed between the two parties. A decisive factor
in the court’s ruling in this case was that the taxpayer had already been adequately remunerated for his
services and the gift was of an exceptional kind which was not a normal incident of the taxpayer’s calling.
A similar decision was reached by the court in the case of Scott v FCT (1966) 117 CLR 514.
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QUESTION 2.3
Grant Lee, a volunteer Queensland beach lifesaver saves a small boy from drowning. The boy’s
mother is very appreciative and offers Grant $500 cash for saving her son’s life. Grant refuses the
money but later he is sent a $400 wristwatch in the mail from the boy’s mother, which he keeps.
Determine if the benefit of the wristwatch constitutes ordinary income to Grant? Give reasons
for your answers.
Business or Hobby?
Under s. 6-5 of ITAA97, ordinary income includes income from carrying on a business (i.e. gross sales).
The existence of a business activity is, therefore, relevant for determining whether the receipts of the
activity are ordinary income or not.
Therefore, it is necessary to determine whether a business exists. If no business exists, then the taxpayer
is pursuing a hobby or recreational activity, in which case, the receipts are not ordinary income.
In s. 995-1 of ITAA97, the definition of a ‘business’ includes ‘any profession, trade, employment,
vocation or calling, but does not include occupation as an employee’. However, in practice, whether or
not a taxpayer is carrying on a business is a question of fact and degree and the definition in s. 995-1 is of
little help.
Over the years, the courts have developed a number of criteria to determine whether a taxpayer is
carrying on a business. These characteristics (referred to as the ‘badges of business’) outlined in Taxation
Ruling TR 97/11 (see also TR 2019/1 in relation to companies) are summarised as:
(a) the repetition of acts and transactions
(b) the commercial nature of the activities
(c) the size and scale of the activities
(d) the existence of a profit motive
(e) whether the activity is conducted in a continuous and systematic manner.
None of the five characteristics alone is used to conclude that a business exists, so all characteristics
should be considered in reaching a conclusion (Evans v FCT 89 ATC 4540; (1989) 20 ATR 922). Whether
a business is being carried on will depend on the ‘large or general impression gained’ (Martin v FCT (1953)
90 CLR 470 at 474; 5 AITR 548 at 551) from looking at all the indicators, and whether those characteristics
provide the operations with a ‘commercial flavour’ (Ferguson v FCT 79 ATC 4261; (1979) 9 ATR 873).
Each of the above five criteria are explained and discussed by the Commissioner in Taxation Ruling
TR 97/11, and are summarised as follows.
(a) The Repetition of Acts and Transactions
The frequency and duration of a taxpayer’s activities have been seen as significant in distinguishing
between a business, hobby or infrequent investment. Repetitive and sustained conduct is indicative of
a business (see Ferguson v FCT (1979) 79 ATC 4261).
However, just because a business is going through a quiet period does not undermine its nature as a
business (FCT v Bivona Pty Ltd 89 ATC 4183). Furthermore, in some cases the very nature of the business
is such that its conduct may require little or infrequent activity (e.g. Christmas tree farm).
(b) The Commercial Nature of the Activities
In general, to carry on business means to conduct some form of commercial enterprise systematically and
regularly, and implicit in this idea are the features of continuity and system (see Hyde v Sullivan (1955)
56 SR (NSW) 113). A person in business is usually prepared to trade on the open market on normal terms
and conditions (see Ferguson v FCT 79 ATC 4261 and FCT v Walker (1985) 79 FLR 161), rather than
merely use products for themselves or to sell to family and friends.
(c) The Size and Scale of the Activities
The size and scale of the taxpayer’s activities may indicate whether a business exists. Generally, the smaller
the scale of the taxpayer’s activities, the less likely the courts will be to categorise them as a business (see
Martin v FCT (1953) 90 CLR 470). Equally, the larger and more extensive the activities, the more likely
they will constitute a business (see FCT v Whitfords Beach Pty Ltd (1982) 150 CLR 355).
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MODULE 2 Principles of Taxable Income 89
However, while volume and size are relevant, this is not determinative (see IRC v Livingston (1927)
11 TC 538). As Justice Walsh declared in Thomas v FCT 72 ATC 4094 at 4099, ‘a man may carry on a
business although he does so in a small way’.
Many of the cases have considered whether taxpayers involved in primary production activities are
carrying on a business. This issue was considered by the court in the case of FCT v Walker (1985)
79 FLR 161. In 1980, the taxpayer acquired a female Angora goat, Geraldine, for $3000. The goat was
to be used in a breeding process involving embryo transfer. It was intended that Geraldine would produce
four offspring which would be sold for $12 000. To fund the purchase of the goat and to pay additional
costs, the taxpayer borrowed $4000.
The taxpayer developed a business plan and tried to make himself informed about industry and market
conditions through membership of the Angora Goat Breeding Society of Australia and relevant trade
publications. The taxpayer organised his activities in a business-like way and kept banking and accounting
records for the breeding project.
Unfortunately, in 1983, Geraldine died after producing only two offspring. The taxpayer ultimately
sold the two kids for $300. The taxpayer claimed he was carrying on a business of primary production.
The Commissioner contended that the activities were of a hobby and the taxpayer was not carrying on a
business.
The court held that the taxpayer was carrying on a business of primary production as there was repetition
and regularity in his activities, he had a profit-making intention and that he organised his affairs in a
business-like manner. The court found that there was nothing to suggest that the taxpayer was merely
pursuing a hobby.
A similar decision was reached by the court in the case Ferguson v FCT 79 ATC 4261 where the taxpayer
was held to be carrying on a business where he leased (rented) five cows.
(d) The Existence of a Profit Motive
The courts have placed great emphasis on the existence of a profit motive. Most businesses are undertaken
with a view to making a profit. Conversely, activities with little prospect of commercial success would be
better described as hobbies.
Note that the existence of a profit motive does not necessarily mean that the business must actually
derive a profit. Just because a business generates losses, does not mean that it is not carrying on a business.
What is important is the intention to derive a profit. As stated by Bowen CJ and Franki J in Ferguson v
FCT 79 ATC 4261 at 4264:
A person may still be carrying on a business even if the profit is small, or if losses are being made, provided
enough of the other characteristics are present.
(e) Whether the Activity is Conducted in a Continuous and
Systematic Manner
The Australian Taxation Office (ATO) and the courts have placed great emphasis on the commerciality or
business-like nature of the taxpayer’s activities when distinguishing between a hobby and a business.
Businesses are usually conducted in an organised and systematic manner, whereas hobbies usually
display little or no commercial characteristics.
On its webpage entitled ‘Are you in business?’ (www.ato.gov.au/business/starting-your-own-business/
before-you-get-started/are-you-in-business-/) the ATO provides a list of questions that are designed to
assist taxpayers in determining whether they are carrying on a business or not.
The webpage also includes a video that provides the following questions (ATO 2021a).
•
•
•
•
•
•
•
Does your activity have a significant commercial character?
Have you made a decision to start your business and have done something about it?
Do you intend to make a profit and is there a prospect to profit?
Is there repetition and regularity to your activity?
Is your business similar to other businesses in your industry?
What is the size, scale or permanency of your activity?
Is your activity planned, organised and carried on in a business-like manner?
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The website also includes a list of characteristics of a business (ATO 2021a).
• You’ve made a decision to start a business and have done something about it to operate in a businesslike
•
•
•
•
manner, such as
– registered a business name, or
– obtained an ABN.
You intend to make a profit — or genuinely believe you will make a profit from the activity — even if
you are unlikely to do so in the short term.
You repeat similar types of activities.
The size or scale of your activity is consistent with other businesses in your industry.
Your activity is planned, organised and carried out in a businesslike manner. This may include
− keeping business records and account books
− having a separate business bank account
− operating from business premises
− having licenses or qualifications
− having a registered business name.
QUESTION 2.4
Consider each of the following independent transactions.
(a) Jason Clark owns and operates his own bookstore. It has a turnover of over $500 000 per year.
Jason uses an online accounting service to keep account of his transactions and employs three
part-time staff. However, even though the store opened three years ago, it has never made a
profit, mainly due to the intense competition in the area and because many customers prefer to
download eBooks. Jason is supported by monies provided by his parents.
(b) Jacinta Harris runs a ticketing activity from home, charging customers a fee per ticket for
sporting and entertainment events. Her operations have been building gradually over the past
10 years and now she has over 500 customers on her weekly distribution list. Jacinta spends
approximately 25 hours per week on this activity and the remainder of the time looking after her
young children. Jacinta keeps records and operates a separate bank account for these activities.
Her profit in the income year was approximately $16 000.
(c) Sarah Taylor’s three children have accumulated many unwanted toys, books and clothes so
she decides to sell them and declutter their house. Sarah lists the 100 unwanted items for sale
on an online selling platform. This is the first time that Sarah has sold items this way and she is
pleased that over half the items successfully sold. Sarah makes $900 from her sales. Most of the
items are sold for less than market value prices. The unsold items are donated to the children’s
kindergarten fair.
For each case, determine whether the taxpayer is carrying on a business for tax purposes.
Commencement of a Business
The time at which a business commences is a question of fact. This time factor is important in determining
when assessable income is derived and the point of time when allowable deductions may be claimed. In
Southern Estates Pty Ltd v FCT (1966) 117 CLR 481, it was held that a partnership, which bought land,
cleared it and sowed pasture in order to run sheep on it, had not commenced business because these costs
were in preparation of starting the business and not a business activity. In Softwood Pulp and Paper Ltd v
FCT 76 ATC 4439, a company incurred expenditure on a feasibility study to determine whether a paper
mill project should be undertaken. It was held the expenditure was of a capital nature as the company had
not commenced business at this point.
In order for a business to begin operation, it is necessary that there is a sign of commercial production
or activity being undertaken. In some cases, this may result in immediate production of goods for sale, in
other cases it may be that planting and cultivation has commenced notwithstanding that the actual produce
or crop may take a number of years to occur. An example of this would be the planting of fruit trees to
commence an orchard business.
Mere Realisation of Capital Assets and Profits from Isolated Transactions
It is essential to be able to determine the difference between an income and a capital receipt when deriving
business income for taxation purposes.
As Barwick, CJ observed in London Australia Investment Co v FCT (1977) 138 CLR 106, not every
receipt received by a business is necessarily income according to ordinary concepts. Routine proceeds
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from the sale of stock in trade or from the provision of services will be considered income according to
ordinary concepts and assessable under s. 6-5 of ITAA97.
Whether a transaction is merely the realisation of a capital asset or income according to ordinary
concepts is a difficult question and one of fact and degree.
In the case of Scottish Australian Mining Co Ltd v FCT (1950) 81 CLR 188, the taxpayer was a mining
company. In 1865, the company purchased 1771 acres of land near Newcastle, which it used for coal
mining purposes. In 1924, after exhausting the coal, the taxpayer ceased mining operations and sold
the land. The company realised a considerable profit on the sale of the land, which the Commissioner
duly assessed.
The taxpayer contended that the profits from the sale of the land were not assessable as all the
company had done was merely to realise a capital asset to its best advantage. The court disagreed with
the Commissioner and held that the taxpayer was not assessable on the profits as the taxpayer was neither
engaged in the business of selling land nor was it carrying on a profit-making undertaking or scheme. The
land was purchased in order to mine coal from it. The company has merely taken ‘the necessary steps to
realise the land to its best advantage’. The principle established in Scottish Mining was that a profit derived
from the sale of a capital asset is not income according to ordinary concepts.
In FCT v Whitfords Beach Pty Ltd 82 ATC 4031, a group of fishermen formed a company in 1954 to
acquire a piece of land adjacent to their beach shacks in Western Australia. The land was acquired solely
to secure access to the shacks.
On 20 December 1967, the fishermen were approached by three land development companies who
wanted to acquire, develop, subdivide and sell the land. They acquired a majority shareholding in the
fishermen’s company for a total of $1.6 million. Under the control of the new shareholders, the company
changed its Constitution and appointed two of the development companies to be its General Managers.
The company applied to the local council to have the zoning of the land changed, it subsequently developed
it for residential subdivision and sold the lots for a considerable profit. The Commissioner assessed the
profits as ordinary income.
The court held that as the activities of the company went beyond merely realising a capital asset. Instead,
the change in the land’s nature through rezoning and the extent of the subdivision and development activity
indicated that the company was now conducting a business of land development. As such, the proceeds
from the sale of the land were considered income according to ordinary concepts. According to Gibbs, CJ:
On 20 December 1967, the taxpayer was transformed from a company which held land for the domestic
purposes of its shareholders to a company whose purpose was to engage in a commercial venture with a
view to profit. In all circumstances, it could not be said that the company was merely realising a capital
asset (FCT v Whitfords Beach Pty Ltd 82 ATC 4031).
The principle to come out of Whitfords Beach is that the proceeds from the realisation of a capital asset
will give rise to income according to ordinary concepts if the realisation itself becomes so significant that
it amounts to a carrying on a business in its own right. The judge also cast doubt on the Scottish Australia
Mining decision given the magnitude of the redevelopment in that case.
As a result of the decision handed down by the court in Whitfords Beach, the concept of mere realisation
can only be relied upon where the taxpayer makes minimal efforts to dispose of the property (see
Statham v FCT (1988) 89 ATC 4070 and McCorkell v FCT (1998) 98 ATC 2199).
In Myer Emporium Ltd v FCT, 87 ATC 4363, the High Court of Australia had to decide whether a lump
sum receipt received outside the ordinary course of business was income or capital.
In that particular case, the taxpayer entered into a complex finance arrangement to borrow funds. On
6 March 1981, the taxpayer lent $80 million to its subsidiary for a period of seven years and three months
at a commercial rate of interest (12.5 per cent). Interest totalling $72 million was to be paid over the period
of the loan.
Three days later, on 9 March 1981, the taxpayer then assigned the right to receive the $72 million interest
to Citicorp Canberra Pty Ltd, a finance company with large tax losses. In return, Myer received a lump
sum of $45.37 million (which represented the net present value of this income stream).
The Commissioner regarded the $45.37 million as assessable income in the year of receipt arguing that it
merely represented the present value of a future income steam. Myer contended that it was a non-assessable
capital receipt, because the transaction was outside the ordinary course of its retailing business and was a
one-off transaction.
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The Full High Court of Australia held that the $45.37 million lump sum payment received by Myer was
income according to ordinary concepts, stating:
Although it is well settled that a profit or gain made in the ordinary course of carrying on a business
constitutes income, it does not follow that a profit or gain made in a transaction entered into otherwise than
in the ordinary course of carrying on the taxpayer’s business is not income (Myer Emporium Ltd v FCT 87
ATC 4363).
A receipt may constitute income according to ordinary concepts if it arises from an isolated business
operation or commercial transaction entered into otherwise than in the ordinary course of the carrying on
of a taxpayer’s business, so long as the taxpayer entered into the transaction with the intention or purpose
of making a relevant profit or gain from the transaction.
The decision is significant as it raises the question as to how widely the principle may be applied in
determining ordinary income. Furthermore, it raises difficulties in determining whether a gain should come
within the operation of s. 6-5 as income from carrying on a business or whether such a gain should be
taxed under the CGT provisions (see module 3). In the case of Myer-type transactions, the legislation was
amended by the insertion of s. 102CA into ITAA36. This section taxes any gain from the transfer of a right
to receive income without transferring the underlying property.
The decision in Myer’s case was applied in Westfield Ltd v FCT 91 ATC 4234. The taxpayer’s main
business was the design, construction and management of shopping centres. The company exercised an
option to buy some land for $450 000 which was sold shortly afterwards to the AMP for $735 000.
The Commissioner held the profit to be assessable income on the basis of the decision in Myer’s case.
The court held that where a sale of land is part of the taxpayer’s ordinary business, then the business activity
will characterise the transaction as having a profit-making purpose. However, in the case of Westfield, this
was not so because it was not part of their ordinary business to buy and sell property.
Therefore, if the profit was to be included as ordinary income, it was necessary that, at the time Westfield
purchased the land, there was a profit-making purpose that it would be sold to gain a profit.
The facts revealed that this was not the case, since the purpose of the taxpayer was not to profit from the
sale of the land but rather to gain from the design and construction of the shopping centre which would
eventuate upon the sale of the land to the AMP.
In Henry Jones IXL v FCT 91 ATC 4663, the Full Federal Court applied the decision in Myer’s case to
confirm the Commissioner’s view that an assignment of the right to receive royalties without an assignment
of the underlying property would be ordinary income. Where amounts are received as compensation for a
right to receive income, they have the character of income even if received as a lump sum payment. The
facts in this case revealed there was nothing more than a conversion of future income into present income.
While it would seem that each decision is based on its own facts, the impact of the Myer decision
cannot be ignored. This is especially so when regard is given to Taxation Ruling TR 92/3. In the ruling, the
Commissioner states that a profit from an isolated transaction is generally assessable income when both
of the following events are present.
1. The intention or purpose of the taxpayer in entering into the transaction was to make a profit or gain.
2. The transaction was entered into and the profit was made in the course of carrying on a business or
carrying out a business operation or transaction.
The ruling states that the taxpayer’s purpose is not determined subjectively but rather by an objective
consideration of the facts. In defining the purpose, the ruling also states that it is not necessary that
the purpose of profit making be the dominant purpose. It is sufficient that the profit-making purpose
is significant.
STATUTORY INCOME
If a receipt or benefit is not ordinary income under s. 6-5, it may still be assessable income under one of
the statutory provisions that specifically make certain receipts assessable.
Section 6-10(1) of ITAA97 states that assessable income includes some amounts that are not ordinary
income. Subsection (2) defines statutory income as income by reason of a specific statutory provision.
Figure 2.2 highlights statutory income as the second component of assessable income.
If income is included in assessable income by more than one provision of the Act, s. 6-25(1) of ITAA97
states that the amount is included only once in your assessable income. Furthermore, s. 6-25(2) provides
that the specific provision overrides the general provision. This means that if an amount is caught under
both ordinary and statutory income, the specific (i.e. statutory) provisions will apply unless the specific
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provision states otherwise. For example, s. 15-2(2) (c) of ITAA97 specifically makes certain allowances
assessable but only if they are not ordinary income; therefore, it is necessary to consider whether an
allowance is ordinary income first and only if it is not would you consider s. 15-2.
Section 10-5 of ITAA97 can be used as an index to statutory income as it contains a list of particular
kinds of statutory income. The list contains a reference to the relevant sections (in both ITAA36 and
ITAA97) that make specific receipts or benefits assessable income.
Division 15 of ITAA97 includes a range of statutory income including the following.
• Allowances provided in respect of employment or services (s. 15-2 of ITAA97). This statutory provision
includes assessable income of all allowances, gratuities, compensations, benefits, bonuses and premiums
provided to the taxpayer that relate directly or indirectly to the taxpayer’s employment or to services
rendered by the taxpayer. These benefits are assessable even if they are not convertible to cash (e.g.
non-transferable holiday).
Section 15-2 has limited operation because it does not apply to a benefit that is a fringe benefit (see
module 6) or is assessable as ordinary income under s. 6-5.
• Return to work payments (s. 15-3). This provision makes payments received by an employee to get them
to return to work following a stop-work action assessable.
• Accrued leave transfer payments (s. 15-5). This provision makes receipts by an employer for the accrued
leave transferred as a result of the employee moving to a new job assessable.
• Bounties and subsidies (s. 15-10). Bounties and subsidies received by a business taxpayer will be
assessable income even if they are capital in nature and not ordinary income.
• Profit-making undertaking scheme (s. 15-15). This provision has limited application as it only applies
to assets acquired before the introduction of CGT.
• Royalties not included as ordinary income (s. 15-20). Royalties are normally ordinary income but this
section makes royalties that are not ordinary income assessable (e.g. royalties that are capital in nature).
• Insurance and indemnity for the loss of assessable income (s. 15-30). This provision may apply to
amounts that are not assessable as ordinary income under s. 6-5 (e.g. an insurance payout received by
an employer on the death of an employee).
• Interest on overpayments and early payment of tax (s. 15-35). These amounts would not be ordinary
income but are specifically made assessable as statutory income (ITAA36, s. 21A).
• Reimbursed car expenses (s. 15-70). Makes the amount of any car expenses reimbursed that were
incurred by the employee in the use of their private car for work purposes assessable to the employee.
This excludes amounts that would be a fringe benefit.
Other provisions outside Division 15 of ITAA97 also make amounts assessable as statutory income and
include the following.
• Assessable recoupment (s. 20-20). This provision makes amounts that were previously tax deductible
but have since been refunded or recouped assessable.
• Disposal of leased car for profit (s. 20-110). Makes any profit from the disposal of a leased passenger
vehicle where the lease payments were deductible assessable.
• Trading stock (s. 70-35) (see ‘Trading stock core concepts’).
• Employment termination payments (s. 82-130). This section provides special rules relating to
payments made to an employee on termination of employment. Some of these provisions provide a
concessional rate of tax on amounts that otherwise would be assessable in full as ordinary income.
• Capital gains (ITAA97, parts 3-1 and 3-3). Capital gains realised on assets acquired after 19 September
1985 may be assessable under the CGT provisions.
Section 21A of ITAA36 applies to the value of non-cash property or service benefits received by a
taxpayer resulting from a business relationship (i.e. not in respect of employment). Section 21A applies
where the non-cash benefit provided is non-transferable and non-convertible into cash. The effect of the
rules contained in s. 21A is summarised as follows.
• In determining the income derived by a taxpayer, a non-cash business benefit that is not convertible into
cash will be treated as if it were convertible into cash (s. 21A(1)).
• The value of the benefit is reduced to the extent that the recipient of the benefit would otherwise have
been entitled to a deduction (the otherwise deductible rule) for its cost if the recipient had paid for
it (s. 21A(3)).
• The value of the benefit is reduced where the cost is a non-deductible entertainment expense to the
provider (s. 21A(4)).
Section 21A was inserted into the legislation to overcome the decision in FCT v Cooke & Sherden
80 ATC 4140 (see table 2.2), but it only applies to non-cash business benefits and not benefits from
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employment or services. Section 21A deems the arm’s length value of the non-cash business benefit to
be included in the recipient’s assessable income. However, the benefit is not assessable if the value is $300
or less (exempt income under s. 23L(2)) or the benefit would have been deductible if the recipient had
incurred the cost themselves (s. 21A(3)). Example 2.9 illustrates the application of s. 21A.
EXAMPLE 2.9
Section 21A Non-Cash Benefits
Sue Robinson is a computer retailer who receives a prize of a $1500 non-transferable, non-redeemable
voucher from one of her computer suppliers for having the highest turnover for the calendar year. The
prize entitles Sue to stay in an exclusive Sydney hotel for one week. Consider if the value of the voucher
is assessable to Sue.
Sue has received a benefit in respect of carrying on a business; however, it is not ordinary income due
to its non-convertible non-cash nature (see FCT v Cooke and Sherden (1980) ATC 4140). The arm’s-length
value of $1500 is statutory income under s. 21A(1) of ITAA36.
As a further example, assume that Sue used the voucher solely for attending a computer conference
that happened to be in Sydney that week. Consider if the value of the voucher is assessable to Sue.
In this instance, Sue has received a non-cash business benefit that would have been tax-deductible to
her if she had purchased the voucher in order to attend the computer conference as a business-related trip.
Therefore, no amount is included as statutory income to Sue under the ‘otherwise deductible’ exception
(ITAA36, s. 21A(3)).
QUESTION 2.5
Joe Harper is an electrical contractor who runs his own business. Upon the recent completion of
a job for a client Joe was paid $12 500. Joe also received the following benefits.
(a) Because of the early and prompt completion of the job, Joe received a non-transferrable, nonredeemable voucher for a two-night stay at a luxury resort in Bali, which had a market value of
$2000. Is Joe assessable on the value of this benefit?
(b) Joe was also offered an all-expenses paid trip to the Sydney Electrical Trade Expo. The Expo
featured the latest technical developments and trade products. The cost of the trip was $1250.
Would Joe be assessable on the value of this benefit?
(c) Joe also received from the client a fully paid trip to Sydney for him and his wife to see the
opening of a new stage play at the Sydney Opera House. The cost of the trip was $1500. Is Joe
assessable on the value of this benefit?
NON-ASSESSABLE INCOME
Ordinary income and statutory income are added to determine the positive components of assessable
income. However, amounts that are non-assessable are excluded from this total (see figure 2.2). Nonassessable income includes the ordinary income or statutory income that is exempt income (ITAA97,
s. 6-20) and non-assessable non-exempt income also known as NANE (ITAA97, s. 6-23).
EXEMPT INCOME
According to s. 6-1(3) of ITAA97, exempt income is not assessable. Exempt income consists of amounts,
that would be assessable as ordinary or statutory income, but are specifically made exempt from income
tax by a provision of the Act (s. 6-20). It is important to remember that an amount cannot be exempt income
unless it is firstly either ordinary or statutory income.
A summary of all of the exempt provisions of the Act can be found in ss. 11-5 and 11-15.
These exemptions are listed in alphabetical order with appropriate references to the specific sections
of the Act.
Income is made exempt under the Act in one of two ways.
1. The whole entity is exempt from paying income tax (Division 50).
2. The types of income are specifically made exempt under the Act (Divisions 51 and 52).
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Division 50: Entities that are Exempt from Paying Tax
Entities that are exempt from paying income tax under ITAA97 are listed in Division 50. These entities
include registered charities under the Australian Charities and Not-for-profits Commission Act 2012
(Cwlth), educational institutions, scientific and religious institutions, community service organisations,
public hospitals, government departments and certain sports and cultural organisations.
Division 51: Specific Types of Exempt Income
The Act also deems certain amounts received as exempt from income tax. Division 51 of ITAA97 lists
the types of income that are specifically exempted from assessable income. For example, Item 1.4 of
s. 51-5 specifically exempts income derived while being a part-time member of the Army or Navy
Reserve Forces.
Division 52: Social Security Payments
Most pension payments generally have the characteristics of ordinary income because they are regular and
relied on for living expenses. Without a specific section exempting them, they will generally be assessable
(see Keily v FCT 83 ATC 4248). Division 52 lists the various social security payments that are specifically
exempted under the Act.
The following four consequences result where an amount of income is declared exempt.
1. It is not assessable and is, therefore, tax-free. This means that the receipt or benefit is not included in
the income tax return of the taxpayer.
2. Exempt income will reduce the deduction available for a tax loss (see ‘Exempt income’).
3. A loss or outgoing incurred in deriving exempt income is not an allowable deduction (see ‘Exempt
income’).
4. The disposal of an asset used to produce exempt income does not give rise to a capital gain/loss. This
is relevant to the taxation of capital receipts through CGT (see module 3).
Example 2.10 illustrates the application of Division 52 and whether a Centrelink payment is considered
assessable or exempt. Example 2.11 discusses the assessability of a scholarship received by a student.
EXAMPLE 2.10
Exempt Income
Lucy Campbell receives a double orphan pension of $8250 from Centrelink during the 2021–22 income
year. Consider if this pension constitutes assessable income or exempt income for taxation purposes.
This income is exempt income as listed in Item 9.1 of s. 52-10(3) of ITAA97.
EXAMPLE 2.11
Exempt Income
Lauren Anderson, a full-time university student, receives a scholarship valued at $12 000 per annum from
an accounting firm to complete her Bachelor of Business (Accountancy) degree.
However, the scholarship is provided on the condition that Lauren commences employment with
the accounting firm immediately after graduating and that she remains with the firm for a minimum of
three years.
Consider whether the scholarship received by Lauren is assessable income or exempt income for
taxation purposes.
Regular payments in the form of a scholarship are normally ordinary income (see table 2.2), but most
scholarships, bursaries and other educations allowances received by students in full-time education at a
school, college or university are exempt income (see Item 2.1A, s. 51-10 of ITAA97).
However, according to s. 51-35 of ITAA97, scholarships received by a student on the condition that
the student will become, or continue to be, an employee of the payer are specifically excluded from
the exemption. In these cases, the scholarship is assessable (see Polla-Mounter v FCT 96 ATC 5249).
Therefore, the fact that Lauren is locked into working for the provider of the scholarship means that the
amount of the scholarship will not be exempt and will form part of Lauren’s assessable income.
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NON-ASSESSABLE NON-EXEMPT (NANE) INCOME
Exempt income is excluded from assessable income, but it is still relevant when calculating the amount
of loss available to be carried forward. Non-assessable, non-exempt (NANE) income is disregarded for
all purposes of taxation legislation. NANE was never assessable income in the first place. Examples of
NANE income include the 50 per cent discount applicable for CGT and receipts and benefits specifically
made NANE income by legislation. Section 11-55 of ITAA97 provides a list of NANE income provisions.
Some examples of NANE income are:
• GST payable to the ATO (ITAA97, s. 17-5)
• COVID-19 cash flow boost — BAS credits given during 2020 (ITAA97, s. 59-90)
• COVID-19 economic response payments (ITAA97, s. 59-95)
• COVID-19 state and territory small business grants from 13 September 2020 (ITAA97, s. 59-97)
• benefits on which FBT is payable (ITAA36, s. 23L(1))
• foreign equity distributions (ITAA97, Subdivision 768A).
2.3 DERIVATION
Assessable income is included in taxable income in the year it is derived (ITAA97, s. 6-5(4)). The point of
derivation is important because it determines in which tax year the income is to be included as assessable
income. Figure 2.2 shows that the final component of assessable income is determining in which year the
income is assessable.
There is no formal definition of derivation contained in either ITAA36 or ITAA97. Therefore, we must
use common law principles from court decisions. According to Justice Isaacs in FCT v Clarke (1927)
40 CLR 246 at 261, the word derived means ‘obtained’, ‘got’ or ‘acquired’. The Commissioner argued
that the word ‘derived’ meant ‘received’. However, Justice Isaacs stated the word ‘derived’ did not mean
‘received’. In fact, it is quite possible for a taxpayer to have derived income even though it has not been
received. As a result, the courts have adopted two approaches to the concept of ‘derived’, using either a
cash or accruals basis for the recognition of the timing of derivation of assessable income.
CASH OR ACCRUALS BASIS
The cash (or receipts) basis recognises income when a taxpayer actually receives cash. Conversely, the
accruals (or earnings) basis recognises income when a taxpayer accrues the legal right to receive income.
This is normally when the goods are delivered to the customer or the services have been performed for
the client.
Which Method to Use?
The guiding principle applied by the courts in determining which method is appropriate for recognising
income was set out by the Full High Court in C of T (SA) v Executor Trustee and Agency Co of South
Australia Ltd (Carden’s case) (1938) 63 CLR 108. According to Justice Dixon (at 4146):
. . . one view suggested is that a choice between the two methods is permitted and that choice lies with
the Commissioner.
Justice Dixon went on to state (at 4514) that:
The question whether one method of accounting or another should be employed . . . is one the decision of
which falls within the province of the Courts of law . . .
In other words, it has been left to the courts to determine the appropriate basis of accounting. The courts
determined that the correct basis of accounting (i.e. cash or accruals) is dependent on the type of income
derived, not the taxpayer.
Many of these principles are summarised by the Commissioner in Taxation Ruling TR 98/1, which
provides guidelines on which method provides the correct basis to determine income. In general, the
application of these two methods is mainly addressed in common law cases.
The cash method is generally applicable to small business/practice with few employees (see C of T
(SA) v Executor Trustee and Agency Co of South Australia Ltd (Carden’s case) (1938) 63 CLR 108; FCT
v Firstenberg (1976) 76 ATC 4141; FCT v Dunn (Dunn’s case) (1989) 20 ATR 356; 89 ATC 4141) and
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to income that is mostly a reward of personal exertion (e.g. provision of services heavily dependent on
provider’s personal skills, although there may be a small component of trading activity).
On the other hand, the accruals method is generally applicable to large businesses/practices with many
employees, or income predominantly from trading activities, or provision of services in large scale (see
Henderson v FCT (Henderson’s case) (1970) 119 CLR 612 70 ATC 4016 (1970) 1 ATR 596 and
Barratt & Ors v FCT (Barratt’s case) 92 ATC 4275 (1992) 23 ATR 339).
Table 2.3 summarises the appropriate accounting method (cash or accruals) for different sources
of income.
TABLE 2.3
Accounting method (cash versus accruals)
Source of income
Accounting
method
Salary and wages
Cash
Comments
In the case of income from personal exertion (i.e. salary and wages
and other consulting income), income is deemed to be derived when
received, whether it is payment for past or current services.
In other words, in the case of income from personal exertion, income
is to be recognised on a cash basis. This was confirmed in the case
of Brent v FCT 71 ATC 4195.
Business (trading)
income
Accruals
Trading income (i.e. income from carrying on a business) must be
brought to account on the accruals basis.
Taxpayers carrying on a business are required to recognise
assessable income in the period in which the income has been
earned, not when the cash is received (see Henderson v FCT (1970)
119 CLR 612).
Where there is a dispute over whether an amount is owing, the
amount is not considered to have been derived until the dispute
is resolved (see BHP Billiton Petroleum (Bass Strait) Pty Ltd v FCT
(2002) ATC 5169).
Revenue received in
advance
Accruals
Payments received up-front (or in advance) for services to be
delivered or rendered in subsequent periods are not income even
though the monies had been received by the taxpayer. Hence, the
accruals basis of accounting is appropriate (see Arthur Murray (NSW)
Pty Ltd v FCT (1965) 114 CLR 314).
However, this special treatment is only granted where:
• the taxpayer’s accounts are prepared on an accruals basis and
where the amounts received in advance are credited to the liability
account ‘unearned revenue’
• there is the possibility of refunds being provided to customers.
Hence, if the up-front receipts are non-refundable, the entire amount
will be regarded as assessable income in the year of receipt (see
Taxation Ruling TR 95/7).
Income from
professional services
Cash (if small)
Accruals (if
large)
For professional practice income (i.e. income derived by solicitors,
accountants, doctors, dentists, optometrists, architects, engineers
etc.), the correct basis for accounting is not as precise as for income
from personal exertion and trading.
The correct basis of accounting depends on several factors,
including the nature of the services, size of the professional practice
and contractual terms under which the service is provided.
For smaller professional practices, the cash basis of accounting is
considered appropriate as the earning of income is seen to be more
akin to personal exertion income than carrying on a business (see C
of T (SA) v Executor Trustee and Agency Co of South Australia Ltd
(Carden’s case) (1938) 63 CLR 108).
Conversely, in the case of larger professional practices, where the
derivation of professional income constitutes the carrying on of
business, the accruals method is considered the appropriate basis.
The professional income derived is seen as being akin to trading
income particularly where the scale of operations is substantial (see
Henderson v FCT (1970) 119 CLR 612).
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Income from property
(interest, rent and
dividends)
Cash
Income not derived until received. Interest is generally derived for
tax purposes when it is credited into the bank account (i.e. the cash
basis). An exception applies where the taxpayer is carrying on a
business of money lending (e.g. banks and financial institutions), in
which case, the accruals basis is considered appropriate.
In the case of dividends, the dividend is derived by a taxpayer when
paid or credited (ITAA36, s. 44). A dividend reinvestment plan is
treated as a constructive payment by a company of a dividend to
a shareholder.
Rent is generally derived for tax purposes when it is received (i.e. the
cash basis). An exception applies where the taxpayer is carrying
on business as a landlord, in which case the accruals basis is
considered appropriate.
Redirection of income
Doctrine of
constructive
receipt
Income is taken to have been derived by a taxpayer if it is applied or
dealt with in any way on the taxpayer’s behalf (ITAA97, s. 6-5(4)).
Source: CPA Australia 2022.
QUESTION 2.6
A toy store recorded the following transactions on 30 June 2022.
(a) Cash sales of $450.
(b) Gross credit card sales of $1350. However, the store did not receive payment until 2 July 2022.
When payment was received, the toy store received a net amount of $1323, being $1350 minus
a 2 per cent credit card commission of $27.
(c) A lay-by sale of $280. The customer paid the first instalment of $50 on 30 June 2022 and has
60 days to pay the remaining amount of $230. On 30 June 2022, the toy store also charged the
customer a non-refundable service fee of $10 for entering into the lay-by transaction (or sale).
(d) Interest accrual of $500 to 30 June 2022 in respect of a six-month term deposit which was
deposited with the bank on 1 April 2022. The term deposit matures on 1 October 2022. The $500
interest accrual is in respect of the period 1 April 2022 to 30 June 2022.
For each of these transactions, determine what amount of income, if any, has been derived during
the income year ended 30 June 2022?
QUESTION 2.7
On 18 December 2021, Rosemary Miller, who was born in Canada, arrived in Australia with an
unrestricted work permit to take up a job with Marketing Expertise Pty Ltd for a period of six years.
As an incentive to join the firm, on 18 December 2021, Rosemary was paid $5000 by her new
Australian employer who also paid her a $1500 travel allowance to cover the cost of a stopover in
Singapore where she met up with some former school friends.
For the year ended 30 June 2022, Rosemary received $70 000 by way of salary. As part of the firm’s
bonus plan, Rosemary was also entitled to a bonus of $4000 for the year ended 30 June 2022 as
she met the performance targets outlined in her employment contract. However, while Rosemary
was informed of the $4000 bonus payable to her on 30 June 2022, the $4000 bonus was not paid to
her until 5 July 2022.
Upon her departure from Canada on 17 December 2021, Rosemary rented out her house in
Vancouver at AUD 2400 per month. On 30 June 2022, Rosemary received a notice from her real
estate agent advising that rent received on her behalf for the period from 18 December 2021 to
30 June 2022 was $15 600. The agent advised her that an amount of $2600 rent that was paid by her
tenants on 30 June 2022 in advance for the month of July 2022 was included in the rent received
of $15 600.
A statement of account from Rosemary’s Vancouver bank indicated interest deposited in her
Vancouver bank account for the year ended 30 June 2022 was $1800, of which $400 related to the
period from 18 December 2021.
Determine the assessability of these income amounts to Rosemary.
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MODULE 2 Principles of Taxable Income 99
SUMMARY
Part A introduced the key concepts behind assessable income, beginning with defining and determining
income. Tax is levied on the taxable income of a taxpayer derived during the income year where taxable
income is calculated as assessable income less the allowable deductions. Deductions will be covered in
Part B of this module.
Ordinary income is referred to in the legislation as ‘income according to ordinary concepts’ and,
although it is not defined in the legislation, the courts have identified various factors that indicate whether
an amount is income according to ordinary concepts. A frequent characteristic of income receipts is
regularity, even if the receipts are not directly related to employment or services rendered. We also saw how
tax law draws an important distinction between income and capital gains, whereby income is assessable
under s. 6-5 of ITAA97 and capital gains are only assessable if caught under specific statutory income
provisions.
Part A then discussed the concepts of residence, source and derivation, which underpin the Australian
income tax system. The assessable income of a resident of Australia includes ordinary and statutory income
derived directly or indirectly from all sources inside and outside of Australia; whereas the assessable
income of a non-resident includes only the ordinary and statutory income that has an Australian source.
The legislation covers four circumstances in which an individual is a resident of Australia and three
circumstances in which a company is treated as a resident of Australia for tax purposes. There are two
accepted methods in accounting for the derivation of income: cash basis or accruals basis.
As ordinary income also includes income derived from carrying on a business, Part A examined the
criteria for determining when a business exists. The actual existence of a business is a question of fact and
degree and determined by decisions from the courts, through guidance in Taxation Determinations and
ATO rulings.
The key points covered in this part, and the learning objective they align to, are as follows.
KEY POINTS
2.1 Identify the different types of income in a given situation and the tax implications relating to
income source and residence.
• The concept of assessable income and its two components, (ordinary income and statutory income)
are explained using case law and tax legislation.
• The characteristics of ordinary income are demonstrated using case law.
• The factors used by the courts to determine whether a business activity exists or not are used to
determine whether a taxpayer is carrying on a business.
• The concept of statutory income, including how non-cash business benefits are taxed under s. 21A
are explained using relevant tax legislation and case law.
• The concept of exempt income and NANE income was explained using tax legislation. An index to
exempt income (ordinary income or statutory income) is contained in ss. 11 and 11-15 of ITAA97.
• Examples 2.5 to 2.11 demonstrate how to differentiate between the various types of income.
• Case law is used to distinguish between whether a receipt is income or capital.
• NANE plays no part in the determination of taxable income. An index to NANE is contained in
s. 11-55 of ITAA97.
• Circumstances in which income has been derived for tax purposes are explained.
• The difference between when to use the cash and accruals basis of accounting is explained using
case law and taxation rulings.
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100 Australia Taxation
PART B: PRINCIPLES OF GENERAL AND
SPECIFIC DEDUCTIONS
INTRODUCTION
Part A of this module explained that taxable income is assessable income minus all general and specific
deductions (ITAA97, s. 4-15). Part B of this module builds on this by examining the deductions in detail.
Section 8-1 of ITAA97 provides a general provision for deductions and s. 8-5 makes certain specific
expenditures deductible. These two types of deductions have become known as ‘general deductions’ and
‘specific deductions’. General deductions apply to all taxpayers and are covered in detail in the section
‘General deductions’. Specific deduction provisions, covered in the section ‘Specific deductions’, may
allow a deduction for expenditure that is not deductible as a general deduction or provide more specific
detail regarding the circumstances necessary for an expense to be deductible. As there are two provisions
providing deductions, double deductions are prevented by limiting an expense to be deductible only under
the most appropriate provision (ITAA97, s. 8-10).
The general deduction provision, s. 8-1, of ITAA97 also excludes certain expenses from being
deductible (in whole or in part) and these are covered in the sections ‘General deductions’ and ‘Limitations
of deductibility’.
There are similarities in the structure of the deduction provisions and assessable income provisions in the
legislation. Assessable income comprises ordinary income (general) plus statutory income (specific) less
exempt income, and deductions are made up of general deductions plus specific deductions less expenses
excluded from deductibility. This can be summarised for deductions with the following equation.
Total deductions = (General deductions + Specific deductions) − Deductions excluded by the legislation
Eligibility for deduction also depends, in some cases and for some taxpayers, on whether the required
records have been retained. These requirements are known as ‘substantiation’ and are covered in the section
‘Substantiation requirements for individuals’.
It is important to make the distinction between tax deductions and tax offsets as these have a very
different effect on the tax due. A deduction is an amount subtracted from assessable income when
determining the amount of taxable income on which a taxpayer’s basic income tax liability (gross tax
payable) is calculated. A tax offset (see section ‘Applying tax offsets’ in module 4) reduces the gross tax
payable that is calculated on the taxable income.
In 2020, a series of temporary tax-related economic stimulus packages were introduced by the
Federal government to support businesses during the COVID-19 pandemic. These included extending
and increasing the instant asset write-off of depreciating assets, accelerated depreciation for new assets
and the full expensing of the cost of depreciating assets for eligible entities.
2.4 INCOME TAX DEDUCTIONS
As summarised discussed in Part A, determining taxable income first requires an understanding of all the
components of assessable income. The second step is to determine the total amounts of deductions that
are allowed to be subtracted from assessable income to arrive at taxable income, as shown in figure 2.3.
Figure 2.3 shows that total deductions are made up of general deductions (ITAA97, s. 8-1) plus
specific deductions (ITAA97, s. 8-5), but there are also some limitations, and some expenses are excluded
from deductibility. In addition, there are special recordkeeping requirements (substantiation) and some
specific deductions for capital expenses.
GENERAL DEDUCTIONS
Figure 2.3 identifies the first source of deductibility available as a general deduction under s. 8-1 of
ITAA97. This section contains two positive and four negative elements, which are referred to as the limbs
of s. 8-1. The two positive limbs allow deductions and the four negative limbs deny a deduction for certain
expenses, but some of those denied may be allowed as a specific deduction.
Both positive and negative limbs need to be considered to determine the deductibility of a loss or
outgoing, both of which may provide the taxpayer with a deduction against assessable income.
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MODULE 2 Principles of Taxable Income 101
FIGURE 2.3
Tax deductions
Taxable income = Assessable income – Deductions
Deductions
General deductions
Specific deductions
Limitations to
deductions
Substantiation
Capital allowances
s. 8-1(1)
(Requirements)
s. 8-5
(Made deductible by
specific legislation)
s. 8-1(2)
(Limited or denied
deductibility)
Division 900
(Record
requirements)
Division 40 and 43
(Capital allowances
and capital works)
Source: CPA Australia 2022.
As a general rule, there is a two-step process involved in determining whether a deduction would be
allowed. The positive limbs are checked first and the negative limbs are examined as the second step. It
is only necessary to consider the second step if the first step has been satisfied (Gleeson CJ, Gaudron and
Gummow JJ, Steel v DFC of T 99 ATC 4242).
Two Positive Limbs
Section 8-1(1) of ITAA97 states:
You can deduct from your assessable income any loss or outgoing to the extent that:
(a) it is incurred in gaining or producing your assessable income; or
(b) it is necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income.
Four Negative Limbs
Section 8-1(2) states:
However, you cannot deduct a loss or outgoing under this section to the extent that:
1.
2.
3.
4.
it is a loss or outgoing of capital, or of a capital nature; or
it is a loss or outgoing of a private or domestic nature; or
it is incurred in relation to gaining or producing your exempt income or your NANE income; or
a provision of this Act prevents you from deducting it.
Each of the elements of s. 8-1 have been considered in detail by the courts and they have established
general principles for applying the section. The following principles apply to all the positive and
negative limbs.
Loss or Outgoing
The first general principle underlying s. 8-1 is that deductions from assessable income require there to be
a ‘loss or outgoing’.
Outgoings are normally deliberate expenses incurred for the purpose of earning assessable income.
In contrast, losses (e.g. losses through theft) do not directly produce assessable income as they are
outside the control of the taxpayer. However, they may still be deductible if they are associated
with earning assessable income or carrying on a business that produces income. For example, in
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102 Australia Taxation
Charles Moore & Co (WA) Pty Ltd v FCT (1956) 95 CLR 344 an employee of the taxpayer was robbed
while taking cash receipts from the business to the bank. The court concluded that the loss was deductible
as depositing takings at the bank was a normal activity of carrying on the business. Therefore, involuntary
losses are still deductible under this principle, provided they also satisfy one of the positive limbs and are
not excluded from deduction by any of the four negative limbs.
To the Extent That — Apportionment
The second general principle arising from s. 8-1 is the use of the phrase ‘to the extent that’. This phrase
requires that, where a loss or outgoing is not used wholly for a deductible purpose, it must be apportioned
into deductible and non-deductible amounts.
The High Court decided in Ronpibon Tin v FCT (1949) 78 CLR 47 that apportionment is to be
determined based on the amount the taxpayer actually spent, not on ‘how much a taxpayer ought to spend
in obtaining his income’. For example, if the taxpayer paid for a business advertising campaign that was
ineffective, the expense is still deductible even though the expense may be seen as a waste of money.
On the other hand, the taxpayer may wish to claim travel expenses for a trip involving both private and
business purposes, in which case only the business portion is deductible. For example, in Cunliffe v FCT
(1983) ATC 4380, an expense claimed by a restaurateur of $46 493 for the costs of a 16-month overseas
gastronomic tour was reduced to $15 730, as part of the trip was private in nature and not for the purpose
of earning assessable income.
Where the expense results in a tax loss (i.e. the expense is greater than the assessable income), the
expense may be partly non-deductible if there is a purpose other than producing assessable income. For
example, if a taxpayer borrows money at 10 per cent interest and on-lends it to their spouse at 1 per cent,
the interest paid on the loan by the taxpayer is partly private (90 per cent) and this private portion is not
deductible. This was the situation in Ure v FCT (1981) ATC 4100 where, even though interest on the
taxpayer’s loan earned assessable income, by on-lending the funds to his spouse, the interest Ure charged
his spouse was much less than what he was paying. As a result, the court concluded that there was a private
component to the expense and therefore only the portion of the interest that earned assessable income
was deductible.
The principle in Ure’s case may not always apply, even though the investment income is less than the
cost of debt used to fund it. This is known as negative gearing and is discussed in the section ‘Interest
expenses — An example of the application of the first positive limb’.
First Positive Limb
To gain a deduction under the first positive limb, it is necessary that the two general principles previously
discussed are satisfied and that the expense is also ‘incurred in gaining or producing your assessable
income’ (ITAA97, s. 8-1(1)(a)).
Incurred
To be deductible, expenses must be incurred. This will be the case either where there has been an actual
payment or there is an existing liability to pay (RACV Insurance Pty Ltd v FCT (1974) ATC 4169; Coles
Myer Finance Ltd v FCT (1993) ATC 4214). The case of W Nevill & Co Ltd v FCT (1937) 56 CLR
established the principle that an expense is incurred when the liability to pay has arisen even though no
payment has been made. For example, where goods have been ordered and delivered but the payment is
not due until the next tax year, the outgoing will still be incurred in the current year as the taxpayer is
legally required to pay, even though they have not actually paid during the current tax year. In this case,
the deduction will be in the current tax year, not when the payment is made at a later date.
In Part A, the cash and accruals bases of accounting for assessable income were discussed (see
‘Derivation’), but this same approach does not apply to the meaning of ‘incurred’ for deductions. A loss
or outgoing is incurred for the purposes of deduction when it is legally required to be paid. This applies to
taxpayers using both the cash and accruals basis of accounting.
The use of the term ‘incurred’ also means that accounting provisions such as provisions for long service
leave and doubtful debts will not be deductible as they are not incurred. For example, at the time of making
the provision for long service leave there is no loss or outgoing; this only arises when the employee actually
takes the long service leave.
In Gaining or Producing Your Assessable Income — Nexus
The second requirement of the first positive limb is that the expense must be related to the gaining or
producing (earning) of assessable income. This is generally described as having a nexus (connection) with
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MODULE 2 Principles of Taxable Income 103
the earning of assessable income or that it was incurred ‘in the course of’ earning assessable income.
In Herald and Weekly Times Ltd v FCT 1932 48 CLR 113, the taxpayer incurred expenses to settle a
defamation claim, and the High Court held that these expenses were deductible as there was a nexus with
assessable income. The nexus in this case was that the costs for damages was a result of the income-earning
activities (publishing) of the taxpayer.
In contrast, there is no nexus, and therefore no deduction, under the first positive limb for an employee’s
cost of travelling to work. This is because there is no income-earning activity in getting to work, and
therefore this cost is not in the course of earning assessable income. For an employee’s cost of travel to
show a nexus with assessable income, it would have to be in the course of carrying out employment duties
(e.g. travel from work to visit a client). In FCT v Finn (1961) 106 CLR 60, the taxpayer (an architect)
incurred additional overseas travel expenses as his employer had asked him to undertake research on
architectural developments that would add to his knowledge and improve his prospects of promotion.
The High Court agreed that there was a nexus with Finn’s future assessable income and therefore these
costs were deductible.
Finn’s case also demonstrates that a taxpayer is not required to show that the loss or outgoing has to
produce assessable income in the same year as the expense. It is sufficient that the expenditure is likely
to produce future income, is likely to reduce future expenditure or was incurred in deriving income of a
previous tax year.
Example 2.12 demonstrates the evaluation of losses or outgoings to determine if they satisfy the
requirements of the first positive limb of s. 8-1.
EXAMPLE 2.12
Deductions Under the First Positive Limb
James Johnson is employed as a tax specialist in an accounting firm and he has incurred the following
expenses during the 2021–22 tax year.
1. On 30 June 2022, paid for a 12-month subscription for a tax reporting service.
2. Paid a monthly subscription for a wake-up call each morning so he would not be late for work.
3. Travel from his work by train to visit a client.
4. Mobile phone account for a phone that is used 80 per cent for work.
5. Face masks required to be worn while meeting with clients during the COVID-19 restrictions.
Consider which of James’ expenses would satisfy the requirements of the first positive limb of s. 8-1.
As well as satisfying the first two general requirements of s. 8-1, the loss or outgoing must also be
incurred and show a nexus with James’s employment income.
1. Satisfies the general requirements and is incurred even though it relates to next year’s income. It is
in the course of earning assessable income as a tax specialist as it helps him perform his duties
(Finn’s case).
2. Satisfies the general requirements and is incurred but there is no nexus with earning assessable income
as the expense is not in the course of performing his job.
3. Satisfies the general requirements and is incurred in the course of earning assessable income as the
travel is incurred in the course of carrying out his duties.
4. It is a loss or outgoing but apportionment applies as the expense is only 80 per cent incurred in the
course of earning assessable income.
5. It is a loss or outgoing incurred in the course of earning assessable income because wearing a face
mask was required by the employer during the COVID-19 restrictions. Therefore, this expense has a
nexus with earning his salary.
Interest Expenses — an Example of the Application of the First Positive Limb
Interest expenses have a nexus with earning assessable income and are deductible if the funds borrowed are
used to purchase an income-earning asset or to fund business or income-earning expenses. For example,
interest costs are deductible if the funds borrowed are to purchase a property that earns rental income, a
factory used in the taxpayer’s business or shares that earn dividends. Similarly, interest will be deductible
if the funds borrowed are to fund operating costs such as the purchase of trading stock, consumables or
pay wages.
Security given for a loan is not relevant to the deductibility of interest. For example, if a loan used
to purchase an income-producing asset is secured over the taxpayer’s private home, the interest is still
deductible. Conversely, if income-earning assets are used as security to purchase a private home, the
interest has no nexus with assessable income and is not deductible.
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104 Australia Taxation
In FCT v Roberts; FCT v Smith (1992) 23 ATR 494 (decided jointly), the taxpayers’ partnership
borrowed funds to repay the partners’ share of the capital of the partnership. The partners then used some
of the repaid capital for private purposes. The Court held that the interest was deductible to the partnership
as the funds borrowed were to repay partnership capital, which was in the course of earning assessable
income. The use of the funds by the partners was not relevant.
If the funds borrowed are only partly used for earning assessable income, then apportionment will
apply. The proportion of the interest that is deductible is based on the degree to which the loan is used for
income-earning purposes (Ure v FCT (1981) ATC 4100).
However, does interest remain deductible if the income earned from an investment is less than the cost
of the interest? As a general principle, the courts only look at the purpose of the loan and do not ask the
question whether the investment is profitable or not. This leads to the concept of negative gearing, where
the allowable deductions associated with an investment exceed the assessable income from that investment.
In this situation, the excess of deductions over assessable income can be used as a deduction against other
assessable income such as wages. This can be the case where the taxpayer receives rental income from an
investment property and the expenses (including the interest on the loan borrowed to finance the property)
exceed the income earned from the property.
Example 2.13 shows how negative gearing works in practice to reduce tax payable. It also compares a
negatively geared property to a positively geared property. Positive gearing is when the income received
from the investment is higher than the interest paid plus other expenses.
EXAMPLE 2.13
Comparing Negatively and Positively Geared Properties
Rod and Karen Roberts are brother and sister and both earn a salary of $70 000 per year. They both intend
to purchase separate investment properties costing $400 000 each. Interest on an investment loan will be
4.5 per cent per annum, payable on an interest-only basis. Additional property expenses for each property
are estimated at $700 per month. Rental income is expected to be $2000 per month for each property.
Rod will need to borrow the full $400 000 to buy his investment property as he has no savings. Interest
on the loan is $1500 per month. Because the monthly cost of $2200 ($1500 + $700) is greater than the
$2000 monthly income, Rod is negatively geared.
Karen has some savings so she only needs to borrow $100 000 for her property. Karen’s interest payment
is $375 per month. As Karen’s monthly cost of $1075 ($375 + $700) is less than the monthly income of
$2000, she is positively geared and will have the profit added to her taxable income.
Assumptions:
• No account is taken of inflation, increases in rental income, changes to interest rates, tax offsets or
changes to income tax rates over time.
• Capital growth is not taken into account as it does not affect the comparison. The same capital gain
would be applicable under both scenarios.
• No account is taken of income from Karen’s other investments. Her savings may have been earning
assessable income before being used to purchase the investment property.
Reflect on the net income after tax for both Rod and Karen, and the effect of negative gearing compared
to positive gearing.
To determine the net after-tax effect, it is necessary to calculate the tax for Rod and Karen separately
based on the current 2021–22 individual tax rates. The following table shows this comparison.
Salary
Plus: Rental income
Less: Interest costs
Less: Property expenses
Taxable income
Tax + Medicare levy (see
module 4)
Net income after tax
Rod and Karen’s
income respectively
before buying an
investment property ($)
Rod’s negatively
geared investment
property ($)
Karen’s positively
geared investment
property ($)
70 000
—
—
—
70 000
(14 617)
70 000
24 000
(18 000)
(8 400)
67 600
(13 789)
70 000
24 000
(4 500)
(8 400)
81 100
(18 447)
55 383
53 811
62 653
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MODULE 2 Principles of Taxable Income 105
Karen is positively geared so her income is considerably higher than Rod’s. If Karen had left her money
in a savings account earning 2 per cent interest ($300 000 × 2% = $6000), her after tax income would
be lower because rental returns are higher ($11 100 = $24 000 – $4500 – $8400) than the 2 per cent she
would earn from leaving the funds in a savings account.
Rod actually has less money in his pocket as his total costs are more than the rental income (negatively
geared), so he has to cover some of his investment expenses from employment income reducing his ability
to meet other personal commitments. He will be hoping a future capital gain will recoup his losses but this
adds an element of risk to his investment.
Source: Adapted from ASIC MoneySmart, ‘Negative and positive gearing’.
Second Positive Limb
The second positive limb requires that the loss or outgoing ‘is necessarily incurred in carrying on a
business for the purpose of gaining or producing your assessable income’ (s. 8-1(1)(b)). This differs
from the first positive limb as it requires a nexus with carrying on a business. Therefore, only taxpayers
conducting a business can rely on the second positive limb for deductions.
Necessarily Incurred
A loss or outgoing must again be incurred but, in this case, the term ‘necessarily’ is added. In Magna Alloys
& Research Pty Ltd v FCT (1980) 11 ATR 276, the taxpayer incurred expenses in defending company
directors against criminal charges (which were later dropped). In relation to whether the expense had to
be ‘necessary’, the Court concluded that it was sufficient that the expense was ‘desirable or appropriate’
(related to the business) for the taxpayer to undertake, which is a lower test than necessary. The addition
of the term necessary therefore does not require that the expense is unavoidable.
In Carrying on a Business to Earn Assessable Income
The second positive limb also requires a nexus with assessable income but, in this case, it must be connected
to carrying on of the business. Therefore, the expense must be in the course of carrying on the business
to earn assessable income. For example, this rule applies to assessable government payments such as
JobKeeper payments (see ‘JobKeeper payments’) paid to employers to help retain employees during the
COVID-19 pandemic. JobKeeper benefits are assessable income for the employer; therefore, the passing
on of these benefits to the employee will be an allowable deduction as the payments to the employees have
a nexus with assessable income (assessable JobKeeper receipts). This is the case even though employees
may not be working for the employer, but are still being paid a wage or salary.
To make this connection, the courts have commonly considered whether the expense shows the character
of being connected with the operation of the business, rather than directly with earning assessable income
as was required for the first positive limb. In Charles Moore’s case (see section ‘Loss or outgoing’), the
theft of the daily takings was found to be a loss having a nexus with carrying on the business. This was
because it was a loss that had the character of a business loss. It was a normal activity of the business to
take cash to the bank and this activity included a risk of theft.
Timing of Nexus to Income Under the First and Second Positive Limbs
For there to be a nexus under either positive limb, there must be a connection to assessable income, but
which income? Does the nexus have to be with the current year’s assessable income or can it be for past
or future income?
In FCT v Maddalena (1971) 2 ATR 541, the taxpayer was a professional footballer who incurred
expenses in obtaining a contract to play with a new club. The High Court held that these expenses were
preliminary to earning assessable income and so there was no nexus to assessable income and the deduction
was denied. Also, in Softwood Pulp and Paper Ltd v FCT (1976) 7 ATR 101, the taxpayer incurred costs
for a feasibility study as to whether it was viable to establish a paper mill. The Court held that this expense
was not deductible as it was preliminary to the commencement of the business, and therefore there was no
nexus with carrying on a business under the second positive limb. Expenses incurred before the incomeearning activity starts are, therefore, not deductible under s. 8-1(1).
However, a taxpayer is not required to show that the loss or outgoing has to produce assessable income
in the same year as the expense. It is sufficient if the expenditure will produce future income, will reduce
future expenditure or was incurred in deriving income of a previous tax year. This is demonstrated in
Finn’s case (see ‘In gaining or producing your assessable income – nexus’) where it was sufficient that the
expense was likely to increase the taxpayer’s chances of promotion and increased future income.
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106 Australia Taxation
Even if the business has ceased (e.g. the mine has closed but the company still exists as in Amalgamated
Zinc (De Bavay’s) Ltd v FCT (1949) 78 CLR 47), an expense can still be deductible if it is connected with
past income such as compensation payments to employees who worked in the mine before it closed. For
example, in Placer Pacific Management Pty Ltd v FCT (1995) 31 ATR 253, the taxpayer incurred legal
costs and damages in relation to part of its business that it sold eight years previously. The Full Federal
Court allowed the deduction on the basis that there was a nexus with previous business income even though
this part of their business was no longer carried on.
QUESTION 2.8
Connect Pty Ltd (Connect) installs internet connections to businesses and private households.
During the 2021–22 tax year, Connect recorded the following transactions.
• Legal costs to defend against a client’s claim that the internet service provided did not meet
specifications.
• The cost of a feasibility study to assess the viability of expanding their business to providing
mobile phone services.
• The cost of a gift given to an employee who was about to be married.
Which of Connect’s expenses would satisfy the requirements of the second positive limb
of s. 8-1?
SPECIFIC DEDUCTIONS
The income tax legislation also provides specific deductions under s. 8-5 that are separate to the general
deductions found in s. 8-1. The specific deduction provisions may allow a deduction for expenditure that
is not deductible as a general deduction or is included in the legislation to provide more specific detail
regarding the circumstances necessary for an expense to be deductible (e.g. s. 25-10 of ITAA97 repairs).
Figure 2.3 also demonstrates the second avenue for deductibility through specific deductions.
As there are two avenues to obtaining a deduction (general and specific), the legislation includes
s. 8-10 to resolve the situation where a loss or outgoing may be deductible under more than one provision.
This section requires that an expense can only be deducted under one provision and, where more than
one is applicable, the most appropriate section must be applied. For example, the cost of regular repairs
to business assets would normally satisfy the second positive limb of s. 8-1(1). However, as s. 25-10
of ITAA97 specifically makes repairs deductible, this section is more appropriate and must therefore be
applied to determine the deduction for repairs, not s. 8-1.
The specific deductions covered in some detail in this module are:
• repairs
• bad debts
• tax losses and borrowing expenses
• capital allowances (covered in section ‘Capital allowances’)
• capital works (covered in subsection ‘Capital works’).
A list of some of the other specific deductions is included at the end of the section (see ‘Other specifically
deductible expenses’).
REPAIRS
Under s. 25-10(1), expenditure for repairs to premises or depreciating assets that are held or used for the
purpose of producing assessable income, is deductible in the year that the expenditure is incurred, provided
it is not capital in nature. Where the item repaired is only partly used to produce assessable income, only
that portion of the repair cost is deductible (s. 25-10(2)). For example, if a car is used 60 per cent for
business purposes and 40 per cent for private, then only 60 per cent of any repair will be deductible.
Unfortunately, there is no definition of the term repair in the legislation and therefore it is necessary to
rely on the decided cases for this meaning. The meaning of repair has been considered in numerous cases
and, in Lurcott v Wakely and Wheeler (1911) 1 KB 905 at 923, a repair was described as:
A restoration or replacement of a subsidiary part of the entirety. It is not a reconstruction or renewal of a
substantial part of the whole item.
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MODULE 2 Principles of Taxable Income 107
The Commissioner defines repairs in para. 15 of Taxation Ruling TR 97/23 to be a restoration of the
efficiency of function of the item being repaired without improving or changing its function. The definition
of repair means that if a taxpayer chooses to replace an asset (instead of repairing it), then the whole cost
of the replacement is considered a capital expenditure and not deductible as a repair, even if it was less
expensive to replace the asset than to have it repaired.
Figure 2.4 shows the steps to use to determe whether an expense is a repair and tax deductible under
s. 25-10.
FIGURE 2.4
Repair decision flowchart
Yes
Has the work
replaced the entirety?
The expense is
capital.
No
Did the work improve
or change the item?
Consider capital
allowance provision
(section ‘Capital
allowances’ in this module).
Yes
No
Is it an initial repair carried
out to bring the asset
into a functional state?
Yes
No
Is the item repaired
used wholly for earning
assessable income?
No
Percentage used to
earn assessable
income is deductible
under s. 25-10.
Yes
The full cost of the
repair is deductible
under s. 25-10.
Source: CPA Australia 2022.
The first step in applying the definition of a repair is to identify the ‘entirety’, or what it is that is
being repaired.
If the entirety is replaced then the expense is not a repair. If only a part of the entirety is replaced then the
expense could be a repair. For example, in Lindsay v FCT (1961) 106 CLR 377, the taxpayer operated a
boat repair business and undertook major works on the slipway used to bring boats from the water into the
repair shop. The slipway was constructed of timber, some of which had rotted out. The taxpayer dismantled
the whole slipway and then rebuilt it, partly with the existing timbers and partly with new concrete posts.
The High Court held that this was not a repair but a capital expense, because the slipway was an entirety as
it performed a separate function (moving boats into the workshop). The rebuilding of the whole slipway
was, therefore, more than fixing a defect. If the taxpayer had only removed the rotten timbers and replaced
them, it is more likely it would have been held to be a repair of part of the entirety.
Repairs Compared to Improvements
Section 25-10(3) excludes from deduction capital expenses, which means that any improvement to the
original item will not be deductible as a repair. While a repair restores an item to its former condition
or level of efficiency, an improvement makes the item functionally better. For example, if the front brick
wall of a building is cracked, caused by the shifting of the foundations, and a bricklayer is engaged to
re-lay and re-mortar the section of the wall that is cracked, the cost would be a repair. This is because the
work does not affect the whole building and is simply correcting a defect. However, if the whole wall is
reconstructed and the reinforcing added so it is less likely to crack in the future, then this is not a repair
but an improvement (capital) as the wall is now functionally better. Note that capital improvements to a
structure may still be deductible (see section ‘Capital works’).
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108 Australia Taxation
In FCT v Western Suburbs Cinemas Ltd (1952) 86 CLR 102, the ceiling of the taxpayer’s business
needed repair but the materials needed were not available so the taxpayer used a newer material and
replaced the whole ceiling. The taxpayer claimed a deduction for the amount that the ceiling would have
cost to repair had the original material been available. The High Court held that a deduction can only be
claimed on the expense that was actually incurred, not on an estimate of what might have been paid. The
actual work done was an improvement (capital) to the ceiling and not a repair because the new ceiling
reduced the need for future repairs.
However, using different materials will not of itself make the work an improvement. Administrative
Appeals Tribunal (AAT) decisions suggest that work can still be a repair even if different materials are
used. It is the restoration of efficiency in function that is important rather than the exact replacement of
parts (Case V167 88 ATC 1107 and Taxation Ruling TR 97/23). For example, if a computer requires repair
but the part required is no longer available, its replacement with a more recent part that performs marginally
better may still be a repair even though there is some improvement to the computer’s performance.
Initial Repair
The cost of work to remedy a defect in an asset that was in need of repair at the time of acquisition
is also a capital expense and not deductible as a repair. In The Law Shipping Company Ltd v Inland
Revenue Commissioners (1924) 12 TC 621, the taxpayer purchased a ship that was in need of repair,
and immediately after purchase carried out these works. The Court held that this expense was capital as it
was part of the cost of acquiring the ship and was not the cost of maintenance arising out of the taxpayer’s
use of it.
These repairs are known as ‘initial repairs’ and are treated as part of the cost of the asset for the purposes
of capital allowance deductions (see ‘Capital allowances’) because the repair is needed to bring the asset to
a functional state. An initial repair can also be seen as an improvement to the asset as it is being improved
from its condition at the time of purchase. An initial repair will still be capital and not deductible as a repair
even if the purchaser was not aware of the need for the repair at the time of purchase (Taxation Ruling
TR 97/23, para. 61).
Work Carried Out Prior to Sale
A similar principle applies as with initial repairs. If the work carried out before sale is only to repair defects
that have occurred due to normal wear and tear then this expense will be deductible as a repair. However,
if the work done increases the saleability of the asset, the expense is capital and not deductible as a repair.
For example, if the taxpayer is selling a rental property and, before sale, repaints some of the internal walls
that have been damaged by the previous tenant, then this is a repair. However, if a new kitchen is installed,
this will be a capital improvement and not deductible under s. 25-10.
Example 2.14 demonstrates how repairs are defined and deductible under s. 25-10.
EXAMPLE 2.14
Repairs
Rosie Lee operates a florist and nursery business as a sole trader. During the current tax year, she incurs
the following expenses.
1. A fire at the neighbouring property damaged the whole eastern side of her security fence and she had
it replaced with new material for a cost of $2000.
2. Rosie owns a van that she uses 80 per cent in her business. During the year she paid service charges
of $500 and had a new tow bar installed at a cost of $1500 to tow her trailer for making deliveries for
the business.
3. Rosie has a heated room for growing exotic plants. The heating system is made up of a gas furnace
which heats water and pipes that circulate the hot water to heat the room. During the year, the furnace
broke down and was replaced with the same model at a cost of $8000. The pipes circulating the water
did not have be replaced.
Reflect on which expenses, if any, would be deductible under s. 25-10 of ITAA97 and, if there is some
doubt, what factors the court would take into account in making the determination.
1. The replacement of an entirety is not a repair (see Lurcott v Wakely and Wheeler) but, in this case,
Rosie only replaced part of the entirety, not the whole fence around the entire property. Even though
new materials were used, this is the replacement of part of the whole fence and therefore is a repair
and the $2000 is deductible under s. 25-10.
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MODULE 2 Principles of Taxable Income 109
2. As the van is used 20 per cent for non-business purposes, only 80 per cent of relevant expenses will
be deductible. Therefore, $400 ($500 × 80%) of the service costs will be deductible under s. 25-10 as
these are normal repairs. However, the installation of the new tow bar is capital as it is an improvement
and not a repair which may give rise to a deduction for depreciation (see ‘Capital allowances’).
3. If the whole heating system (furnace plus piping) are the entirety, it can be argued that the replacement
of the furnace was not the replacement of the entirety and the $8000 would be deductible under
s. 25-10. However, this could be contentious and a court decision could go either way depending
on whether the piping was only a small part of the heating system or not. If the replacement of the
furnace with an equivalent model was the replacement of a substantial part of the entirety, the $8000
would be capital and not a repair under s. 25-10 but it may give rise to a deduction under the capital
allowance provisions (see ‘Capital allowances’).
BAD DEBTS
As discussed in the section ‘Derivation’, taxable income is brought to account on either a cash or accruals
basis. If amounts have been included in assessable income using the accruals basis, but are not actually
received and later written off as bad debts, the taxpayer has effectively paid tax on income that has not
been received. This situation cannot arise if the taxpayer is using the cash method of accounting because
the unpaid debt has never been included in assessable income. Therefore, a bad debt will only occur for a
taxpayer using the accruals system of reporting for assessable income.
Under s. 25-35(1) of ITAA97, if a debt cannot be collected, the taxpayer is entitled to a deduction for
the resulting bad debt that has already been taxed as assessable income. A deduction for the bad debt is
only allowable in the tax year that the debt is written off as bad. Therefore, an accounting provision for
doubtful debts will not be deductible under s. 25-35 or any other provision.
Four conditions must all be met for a debt to qualify as a bad debt for tax purposes.
1. There must be an existing debt.
2. The debt must be bad.
3. The debt must have been written off as bad during the tax year in which the deduction is claimed.
4. The debt must have been included in the taxpayer’s assessable income for the tax year or earlier tax
year, except in the case of money lenders.
If a bad debt that was previously claimed as a deduction is recouped in a subsequent tax year, the
recouped amount is assessable income under s. 20-20 of ITAA97.
For a company to claim a deduction for a bad debt it must satisfy additional requirements to those
specified in s. 25-35, which are the same as the additional requirement for claiming prior year losses as a
deduction (see ‘Deducting tax losses corporate entities’).
The Debt Must Be Bad
For a debt to be a bad debt at the time it is written off, it is necessary to show evidence that supports this
conclusion (Point v FCT (1970) 119 CLR453). Evidence to support that a debt is bad could consist of
showing:
• the debtor has died without leaving assets
• the debtors and/or their assets cannot be traced
• attempts have been made to recover the debt which have now been abandoned
• a reasonable taxpayer would consider it unlikely to be paid and not merely doubtful.
Bad Debts of Money Lenders
Section 25-35(1)(b) also allows a taxpayer who lends money in the ordinary course of business to write off
as a deduction the value of any loan that has not been repaid. This is regardless of whether it had previously
been included in assessable income. This specific deduction is in addition to any normal deduction for a
bad debt written off under s. 25-35(1)(a). For example, if interest owed by the borrower is not paid and is
written off as a bad debt it would be deducible under s. 25-35(1)(a) not s. 25-35(1)(b).
QUESTION 2.9
Sweety Pty Ltd (Sweety) manufactures chocolates and sweets that they sell directly to the public
from their shop and wholesale directly to specialist sweet shops. Wholesale sales are made on the
basis of payment within 30 days of invoicing and tax is accounted for on an accrual’s basis.
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110 Australia Taxation
During 2021–22 there was a small fire in the kitchen where the chocolates are made which
caused damage to the smoke extractor, a commercial oven and work benches. Also, during the
tax year, Sweety was informed that one of the businesses it sells wholesale to (Coffee & Cake) has
closed and the owners cannot be traced. As at 30 June 2022, Sweety’s accounts show the following
transactions.
1. Work carried out to remedy the effect of the fire.
(a) $7000 for the purchase of a second-hand commercial oven that immediately required rewiring
at a cost of $1000.
(b) Repainting the wall damaged by the fire cost $500.
(c) $3000 to replace the work bench as it was cheaper to replace than repair.
(d) The smoke extractor is only part (10%) of the exhaust system for the kitchen and there was
no equivalent one available, so it was replaced at a cost of $1500 with one that was similar
but looked better.
2. Provisions for doubtful debts were increased by $4000 due to the declining economic climate.
3. A note was made in the electronic accounting system that an invoice for $800 to Coffee & Cake
for goods supplied was written off as bad, as it had not been paid and all attempts to recover
payment had failed.
Determine if Sweety will be entitled to a deduction under the general or specific deduction
provisions as a result of the transactions listed.
TAX LOSSES OF CURRENT AND PREVIOUS YEARS
A tax loss arises when allowable deductions (other than unrecouped tax losses brought forward from an
earlier tax year) exceed total assessable income and net exempt income for the year. For an Australian
resident, ‘net exempt income’ under s. 36-20(1) of ITAA97 is:
Total exempt income − (Non-capital losses incurred in deriving exempt income
+ Foreign taxes payable on exempt income)
Deducting Tax Losses for Non-Corporate Tax Entities
The rules for the deduction of tax losses for entities, other than corporate tax entities, are found in
s. 36-15 of ITAA97. Under s. 36-15, tax losses can be carried forward and deducted from the taxpayer’s
assessable income of future income years. These tax losses can be carried forward indefinitely until they are
fully absorbed.
Section 36-15 provides that a tax loss shall be deductible in a later tax year where:
• the taxpayer has not derived exempt income and the total assessable income exceeds the total deductions
including carry forward tax losses
• there is net exempt income and the current year’s assessable income is greater than deductions (i.e.
net assessable income), carry-forward losses are first offset against net exempt income, and then any
remaining loss is deducted from net assessable income for the current year
• there is net exempt income and for the current year total deductions exceed assessable income (i.e. there
is a tax loss), the current year loss is first deducted from net exempt income and then carry forward
losses are deducted from any net exempt income that remains.
Where there are two or more tax losses, the losses are taken into account in the order in which they were
incurred (s. 36-15(5)).
Example 2.15 demonstrates how tax losses are carried forward and deducted against taxable income.
EXAMPLE 2.15
Tax Losses
A non-corporate taxpayer has $2000 of net exempt income each year. The results of the taxpayer’s other
business transactions for three years are as follows.
Year 1: tax loss $10 000.
Year 2: tax loss $3600.
Year 3: net assessable income $11 600.
Reflect on the tax loss to carry forward each year.
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MODULE 2 Principles of Taxable Income 111
$
Year 1
Year 2
Year 3
Tax loss incurred in carrying on business
Less: Net exempt income
Tax loss to be carried forward
Tax loss
Less: Net exempt income
Plus tax loss brought forward
Tax loss carried forward
Balance of tax loss brought forward
Less: Net exempt income
Net assessable income
Taxable income
$
(10 000)
2 000
(8 000)
(3 600)
2 000
(9 600)
2 000
(1 600)
(8 000)
(9 600)
(7 600)
11 600
4 000
QUESTION 2.10
Sally Symons has a carry forward loss from the 2020–21 tax year of $10 000. For the 2021–22 tax
year, Sally has assessable income of $30 000, net exempt income of $3000 and deductions totalling
$38 000. Determine the carry forward loss for the 2021–22 tax year, if any.
Tax losses incurred prior to a taxpayer becoming bankrupt are denied as a deduction and cannot be
carried forward. If the taxpayer repays the debt, they can then deduct as much of the repaid debt that does
not exceed the amount of the loss. Deductions for tax losses may also be limited under the non-commercial
loss rules contained in Division 35 of ITAA97 (see ‘Non-commercial loss rules’).
The treatment of losses for corporate entities is discussed in ‘Deduction tax losses for corporate entities’
and tax losses of a trust are discussed in section ‘Trust loss provisions’ of module 5.
Deducting Tax Losses for Corporate Entities
Section 165-10 of ITAA97 provides that, for a company to claim a deduction for a tax loss, it must satisfy
either the continuity of ownership test (COT) or the business continuity test (BCT). Similar provisions
apply for the treatment of bad debts of a company, but this section will focus on the treatment of losses.
Continuity of Ownership Test
Satisfaction of the COT under s. 165-12 of ITAA97 requires the same person/s must own the same shares
that, when taken together, carry more than 50 per cent of all voting, dividend and capital distribution
rights at all times during the ownership test period. This test applies where all shares are beneficially
owned by individuals, and it applies to all tax losses, net capital losses and bad debt deductions after
21 September 1999.
The ownership test period for tax losses and net capital losses is defined as the period from the start of
the loss year to the end of the tax year in which the loss is claimed.
Section 165-12(6) also allows for an alternative test to apply where a company is beneficially owned
by individuals through interposed companies at any time during the ownership test period. The alternative
test is satisfied where it is reasonable to assume, after tracing through interposed entities, that there are
person/s (none of them companies or trustees) who between them at all times during the ownership test
period owned more than 50 per cent of the voting rights and the rights to dividends and capital distributions
in the company (ITAA97, ss. 165-150(2), 165-155(2) and 165-160(2)).
Section 165-165(1) has a same-share test, requiring that a person’s share in a company is only counted
for the COT if the same person holds exactly the same shares throughout the relevant period. However,
share splits and consolidations are counted provided the same person beneficially owns them throughout
the ownership test period.
For the purposes of the COT, if the beneficial owner of shares dies, ownership is deemed to survive as
long as the shares are held by the trustee of the estate or by a beneficiary (s. 165-205).
A company is able to deduct part of a prior year’s tax loss where the COT is satisfied in relation to only
part of the year (s. 165-20).
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112 Australia Taxation
Business Continuity Test
If a company fails the COT, it may still be possible to obtain a deduction for tax losses if the BCT is
satisfied. The BCT is made up of both the same business test and, from 1 July 2015 a similar business test
(ss. 165-13, 165-210 and 165-211).
To satisfy the same business test, the company must not have derived any assessable income from a
business or transaction of a kind that it did not engage in prior to the change in ownership of shares
(s. 165-210(2)). Also, it must not commence a business or initiate a transaction in order to meet the same
business test (s. 165-210(3)). If this test is satisfied, the company can carry forward tax losses. If the
test is not satisfied, the company may still be able to carry forward losses if the similar business test can
be satisfied.
For losses made in income years starting on or after 1 July 2015, the more flexible similar business
test provides greater access to past year losses when businesses enter into similar transactions or similar
business activities, even though they may not strictly be the same as the previous business. The BCT is
satisfied under the similar business test if the new business is sufficiently similar to the previous business
in the following ways (s. 165-211):
• the extent to which the assets, activities and operations of the former business continue to be used to
earn assessable income in the current business
• the core functionality, activities and commercial operations of the previous business is similar to the
current business
• the extent to which the current business results from a natural development of the previous business
taking into account the use of assets, products, services and marketing employed by the previous
business.
For example, a taxpayer incurred losses while carrying on a business as a computer retailer, and failed
the COT and the same business test because in the current year they changed their business to include
retailing computer software. However, provided the loss occurred after 1 July 2015, the similar business
test would now allow the losses as a deduction because the identity of the business and the assets used
have not significantly changed as the new activities are a natural extension of the previous business.
Rules on How Tax Losses are Deducted for Companies
Corporate tax entities are generally able to choose the amount of prior year tax loss they wish to deduct
(ITAA97, s. 36-17), but there are some restrictions that apply so that a corporation cannot:
• choose to deduct any prior year losses where there is an amount of excess franking offsets (i.e. unused
franking credits) (s. 36-17(5) (a))
• deduct a loss that will result in an excess franking offset (s. 36-17(5) (b)).
These restrictions are designed to prevent companies from refreshing prior year tax losses into current
year tax losses, thereby making tests such as the COT easier to satisfy.
Temporary Loss Carry Back Tax Offset for Corporate Entities
As part of the COVID-19 business stimulus package announced in the 2020–21 Federal Budget, eligible
corporate entities can choose to claim a refundable tax offset (loss carry back tax offset) for current tax
losses against tax paid in previous years (ITAA97, Division 160). If the taxpayer chooses not to claim the
loss carry back tax offset, any tax losses will be carried forward as previously discussed.
This is a temporary concession that commenced on 1 January 2021 with eligible offsets claimed in the
2020–21 and 2021–22 tax years. The 2021–22 Federal Budget extended the eligibility for the offset to
2022–23. Capital losses are not eligible under the loss carry back provisions and the loss amount that can
be carried back is reduced by any net exempt income that has not previously been taken into account and
the closing balance of the franking account in the current year.
To be eligible for the refundable offset, the corporate taxpayer must:
• carry on a business and have a turnover of less than $5 billion during the loss year
• have a tax liability during the years 2018–19, 2019–20 or 2020–21
• have a tax loss during any or all of the years 2019–20, 2020–21, 2021–22 or 2022–23
• have sufficient surplus in the franking account at the end of the year to cover the offset claimed.
Example 2.16 shows how current year losses can result in a refundable tax offset as a result of the
temporary loss carry back provisions.
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MODULE 2 Principles of Taxable Income 113
EXAMPLE 2.16
Temporary Loss Carry Back Tax Offset
John’s Pty Ltd (John’s) has tax losses of $200 000 in 2020–21 and $300 000 for 2021–22 and the company
is looking to see what effect the loss carry back tax offset may have on their current year’s tax return
(2021–22). John’s had a tax liability of $109 000 in 2019–20 and a tax rate of 30 per cent. John’s also has
a $100 000 closing franking account balance for the current year (2021–22) and no net exempt income.
$
2019–20
2020–21
2021–22
Tax liability
Tax loss
Tax loss
Total accumulated tax loss to carry back
Maximum loss carry back offset*
Loss carried forward:
Accumulated loss less tax on loss carried back offset
($100 000 / 30%)
Unused tax loss
$
109 000
(200 000)
(300 000)
(500 000)
100 000
333 333
(166 667)
*The potential loss carry back offset is $150 000 ($500 000 x 30%) but the maximum offset is limited to the closing
balance of the franking account ($100 000).
The loss carry back tax offset applies in 2021–22 to the eligible loss of $500 000 ($200 000 + $300 000).
This would give a maximum offset of $150 000 ($500 000 × 30%), but the loss carry back tax offset is
limited to the lesser of the tax liability it is claimed against, and the balance of the franking account in the
current year (2021–22). Therefore, in 2021–22 the amount of the loss carry back tax offset is limited to
$100 000 because the balance of the franking account ($100 000) is lower than the $109 000 tax liability
from 2019–20. This leaves an unused loss carry back tax offset of $50 000 ($150 000 – $100 000) and a
carry forward loss of $166 667 (50 000 / 30%) which is the unused portion of the original $500 000 loss. For
2021–22, John’s will receive a tax refund of $100 000 which is a return of part of the tax paid in 2019–20.
BORROWING EXPENSES
Section 25-25 of ITAA97 allows as a deduction expenditure ‘incurred in borrowing money’ where the
money is used by the taxpayer for the purpose of producing assessable income. Expenses eligible for a
deduction under s. 25-25 are deducted over five years or the length of the loan if it is less than five years.
The cost of borrowing is the cost of establishing a loan. For example, the cost of borrowing includes
expenditure on legal expenses, valuation fees, survey fees and stamp duty incurred to establish the loan, but
it does not include interest on the loan which would be considered under the general deduction provisions
(s. 8-1) (see ‘Interest expenses — An example of the application of the first positive limb’).
Example 2.17 illustrates how borrowing costs are deducted over time.
EXAMPLE 2.17
Determining Borrowing Expenses
A taxpayer (not a small business entity) incurred the following expenses in connection with obtaining a
10-year loan of $200 000 at a rate of 4.5 per cent from 1 April 2022. The loan is secured against
the borrower’s private home and 80 per cent of the funds are used to purchase an income-producing
property. The costs incurred during 2021–22 are as follows.
$
Interest
Legal fees
Procuration fees
Valuation of security (taxpayer’s home)
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114 Australia Taxation
2250
1600
400
80
Consider the deductions that the taxpayer could claim for the year ended 30 June 2022 under s. 25-25.
The costs of establishing the loan are not deductible under s. 8-1 as they are capital in nature, but
they may be deducted as borrowing expenses under s. 25-25 to the extent the funds are applied to
earn assessable income. The legal fees of $1600, procuration fees of $400 and valuation fee of $80 each
qualify as a deductible borrowing expense under s. 25-25; however, only 80 per cent of the loan is used
to produce assessable income.
As the loan has not been repaid, s. 25-25(5) requires the deduction to be spread over the period of the
loan or five years, whichever is the shorter. Therefore, the amount that can be claimed as a deduction for
the 2021–22 tax year is $82.93, determined as follows.
• Step 1: Borrowing costs $2080 ($1600 + $400 + $80).
• Step 2: Claim over five years, which is 1826 days (includes one leap year).
• Step 3: Expenditure per day over five years period is $1.1391 ($2080 / 1826 days).
• Step 4: Maximum amount for the current period is $103.66 ($1.1391 × 91 days).
• Step 5: Deduction for 2021–22 is 80% × $103.66 = $82.93.
OTHER SPECIFICALLY DEDUCTIBLE EXPENSES
Other expenses not previously covered that are specifically deductible include:
• the expense of managing the taxpayer’s income tax affairs (ITAA97, s. 25-5)
• preparation of leases used in earning assessable income (ITAA97, s. 25-20)
• expenses in connection with the discharge of a mortgage given as security for a loan repayment, which
is solely for the purpose of producing assessable income. Where the mortgage was used partly to earn
assessable income, a part deduction is available (ITAA97, s. 25-30)
• transport expenses incurred for travel between workplaces where assessable income is earned in both
workplaces and one of the places is not the taxpayer’s main residence (ITAA97, s. 25-100)
• capital expenditure to terminate a lease or a licence, if incurred in the course of carrying on/cessation
of a business (ITAA97, s. 25-110)
• employer contributions to a complying superannuation fund on behalf of employees (ITAA97,
s. 290-60)
• employee contributions to a complying superannuation fund where the employee notifies the
superannuation fund that it is deductible (ITAA97, ss. 290-150 and 290-170)
• payments for membership of a trade, business or professional association (up to $42 for each association)
(ITAA97, s. 25-55) — the balance may be deductible under s. 8-1 of ITAA97
• charitable donations to qualifying funds or institutions (minimum of $2) (ITAA97, Subdivision 30-A).
2.5 LIMITATIONS TO DEDUCTIONS
The third step in determining the total deduction that can be claimed against assessable income, to
determine taxable income, is to exclude amounts that are denied a deduction or have limited deductibility
(see figure 2.5). These exclusions only apply if it is first shown that the loss or outgoing satisfied one of
the positive limbs. Therefore, it is necessary to first consider the requirements of the two positive limbs
because if neither applies there is no need to consider these exclusions. Figure 2.5 continues the process
of determining taxable income.
FOUR NEGATIVE LIMBS OF S. 8-1 OF ITAA97
Section 8-1(2) contains four negative limbs that exclude certain expenses from deductibility. Under
section 8-1(2) losses and outgoings excluded from deductibility are:
• capital, or of a capital nature (first negative limb)
• private or domestic nature (second negative limb)
• incurred in relation to gaining or producing your exempt income or your NANE income (third
negative limb)
• denied a deduction by a provision of ITAA36 or ITAA97 (fourth negative limb).
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MODULE 2 Principles of Taxable Income 115
FIGURE 2.5
Limitations to deductions
Taxable income = Assessable income – Deductions
Deductions
General deductions
Specific deductions
Limitations to
deductions
Substantiation
Capital allowances
s. 8-1(1)
(Requirements)
s. 8-5
(Made deductible by
specific legislation)
s. 8-1(2)
(Limited or denied
deductibility)
Division 900
(Record
requirements)
Division 40 and 43
(Capital allowances
and capital works)
Source: CPA Australia 2022.
First Negative Limb — Capital Expenses
In Part A it was explained that capital receipts are not ordinary income, and this same distinction applies
to general deductions because capital expenses are excluded from being deductible under s. 8-1(2)(a).
There is no definition in the legislation of the meaning of term ‘capital’, so it is necessary to rely on
case law decisions to make the distinction between expenses that are capital in nature and those that are
revenue in nature (relate to the production of assessable income). A simple comparison is that the purchase
of a new item of machinery is capital as it lasts for a number of years, and the cost of electricity to operate
this machinery is revenue in nature as it is the cost of operating the machine to produce assessable income.
However, there are many grey areas in this distinction which have been the subject of numerous court
decisions. For example, if a taxpayer pays a director to end their three-year contract early, is that a capital
expense or a cost of operating the business?
Early cases used two tests to make this distinction. First, in Vallambrosa Rubber Co Ltd v Farmer
(1910) 5 TC 529, the taxpayer incurred maintenance costs of a rubber plantation that would not produce
income for several years. The court made the distinction between expenses that were ‘once and for all’
(capital) compared to ‘regular’ operating expenses (revenue expenses). As these maintenance expenses
were required each year, it was held that they were not capital. The difficulty with the ‘once and for all’
approach is that it does not mean that an expense that is only incurred once must be capital. For example,
a taxpayer may only once incur legal costs in defending against a claim for damages, but this expense still
may not be capital (see Magna Alloys & Research case in ‘Necessarily incurred’).
Second, the idea that a capital expense has an ‘enduring benefit’ was considered in British Insulated and
Helsby Cables Ltd v Atherton (1926) AC 205. In this case, the taxpayer contributed to a fund to provide
a lump sum amount that would fund a retirement scheme for staff. The Court held that this was a capital
payment because it provided an enduring benefit of making available funds to pay regular pensions.
Both the concepts of ‘once and for all’ and ‘enduring benefit’ are still considered by the court, however,
the decision in Sun Newspapers Ltd & Associated Newspapers Ltd v FCT (1938) 61 CLR 337 is the one
that is most commonly used to determine whether or not an expense is capital. In this case, the taxpayer
operated a newspaper and wished to prevent the publication of a competitor’s newspaper. To do this, the
taxpayer leased the competitor’s printing equipment with an agreement that the printer would not print a
competing newspaper. The High Court held that the payments were capital as it related to the structure of
the business (reduced competition) rather than its operation.
In the case of Sun Newspapers the court asked three questions to help make this distinction.
1. What was the character of the advantage expected and does it have a lasting nature?
2. How the benefit was to be used, relied on or enjoyed, which relates to whether the benefit was once-off?
3. What was the means adopted to obtain the advantage, which also looks at whether it was periodic
or not?
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116 Australia Taxation
These principles were applied in AusNet Transmission Group Pty Ltd v FCT (2015) HCA 25, where the
taxpayer acquired a state-owned electricity transmission business via regular payments to the state. The
High Court held these regular payments were capital as they altered the structure of the business as the
‘advantage sought’ was to acquire the business. A similar decision was reached in FCT v Sharpcan Pty
Ltd (2019) HCA 36 where the High Court held that regular payments to acquire a gaming license were
capital as they added to the structure of the business rather than operating it.
On this basis, the cost of salary and wages could be capital if they are paid to employees who are engaged
in the construction or creation of the taxpayer’s capital assets (Draft Taxation Ruling TR 2019/D6, not
finalised at the time of writing).
The distinction between income and capital expenses remains a very important issue as seen in
Greig v FCT (2020) FCAFC 25. In this case, the taxpayer claimed a tax deduction under s. 8-1 of ITAA97
for losses of $11.85 million realised on the sale of shares. This was based on the argument that the losses
were incurred from commercial transactions and therefore were not capital. The Full Federal Court allowed
the deduction because of the large scale of the share dealings and the commercial steps undertaken, were
held to be sufficient to show a profit-making intention that was not capital.
Second Negative Limb — Private and Domestic Expenses
The negative limbs of s. 8-1 only need to be considered if the expense has first satisfied one of the positive
limbs, and by its very nature it will be rare that a private expense could do this as they are not generally
incurred in gaining assessable income. However, there have been numerous cases where taxpayers have
attempted to show a connection with assessable income of expenses that are essentially private in nature.
In Lodge v FCT (1972) 128 CLR 171, the taxpayer was a single parent who worked from home and
incurred childcare costs for her daughter. Ms Lodge argued there was a nexus with assessable income
as she could not have carried out her work without incurring this expense. The High Court rejected this
argument concluding that this was not an expense of deriving assessable income, but an expense in putting
the taxpayer in a position to earn assessable income. The same principle is applied for expenses of travel
to and from work, normal meals and everyday clothing; all of which do not satisfy the first positive limb
as they are not incurred in the course of earning assessable income.
Handley v FCT (1981) 148 CLR 182 is an example where an expense satisfied the first positive limb but
were partly of a private nature and denied a deduction in part. The taxpayer (a barrister) used a room in his
private home as an office for work purposes. He claimed a tax deduction for the costs of using the room
(e.g. a proportion of power costs and depreciation on furniture), and a proportion of the costs of owning
his home (e.g. interest on the mortgage and council rates). The High Court agreed that the costs of using
the room had a nexus with earning assessable income because these costs related to the amount the room
was used for income-earning activities. However, the costs of ownership were private in nature and not
deductible because the whole of the home is essentially private in nature, even though some part of it is
used to earn assessable income.
To show that a personal expense is deductible, it is first necessary to show that it is incurred in the course
of earning assessable income, and second it is not private in nature. The following examples illustrate this
in relation to selected personal expenses.
Childcare: In the Lodge case it was held that childcare expenses of an individual are not deductible
as they are private in nature. However, the expenses incurred by an employer to provide childcare
for employees would satisfy the second positive limb. This is because the expense is for carrying on
the business and is incurred to make a happier workplace and contribute towards increasing employee
productivity.
Commuting: Travel to and from work is not incurred in earning assessable income and is not deductible.
For travel expenses to satisfy the first positive limb, travel must be in the course of earning assessable
income (e.g. travel to visit clients, see also Finn’s case). In John Holland Group Pty Ltd v FCT (2015)
FCAFC 82, it was held that fly-in-fly-out employees commenced duties when they arrived at the airport
and therefore the cost of travel from the airport to the work site were deductible, but the cost of travel from
home to the airport was not.
Clothing: Everyday clothing is usually private in nature. This will include normal clothing (e.g. a dress
suit) required by an employer to meet a dress code. For clothing to be an expense in the course of earning
assessable income, the clothing must be specifically adapted to the work situation (e.g. protective clothing,
specific uniforms, high visibility clothing, face masks and sun protection clothing). Non-compulsory
uniforms are only deductible if the design is registered with AusIndustry (ITAA97, s. 34-10).
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Conventional clothing may be deductible if it is specific to the taxpayer’s occupation. For example,
a deduction would be allowed for conventional clothing a professional actor purchases to perform a
role, or specialist clothing for an undercover police officer. Examples that have been found to not be
deductible include sport clothes worn by sports teachers, swimming costumes worn by swimming coaches
and conventional clothing worn by members of an orchestra.
Self-education: The cost of education will not satisfy the first positive limb if it is for the normal process
of acquiring qualifications to gain employment or start a new income-earning activity. However, the first
positive limb can be satisfied (Taxation Ruling TR 98/9) if the expense is to keep up-to-date in your current
employment, or to improve the chances of promotion in your current employment (see Finn’s case).
The most common examples of self-education expenses that could satisfy s. 8-1(1)(a) are work-related
seminars and conferences together with associated costs of materials and relevant travel. If a formal
qualification can be justified on the basis of a nexus with earning assessable income in the taxpayer’s
current position, then costs such as textbooks and fees could be deductible. Textbooks and reference books
that are used during the course of study are generally deductible in full, under s. 8-1, in the year of purchase
because they are used only for a unit of study. However, if they are intended to be used for a number
of years as reference material for income-earning purposes, the deduction would be spread over the life
of the books and claimed under s. 40-25 of ITAA97 (see ‘Capital allowances’). In some circumstances
an immediate deduction may be available for books costing $300 or less by meeting the conditions in
s. 40-80(2) (see ‘Capital allowances for non-small business entities’).
Certain travelling expenses incurred in self-education could also be deductible if there is sufficient
nexus between the self-education and current employment. For example, deductions are allowed for travel
expenses from home to the place of education and back, and from work to the place of education and back
(Taxation Ruling TR 92/8 paragraph 11(d), which has been reproduced in the Note of TR 98/9).
Note that s. 82A of ITAA36 denies a deduction for the first $250 of self-education expenses. However,
this section does not require that the excluded $250 be deductible expenditure. The $250 could be used
up with non-deductible expenses such as childcare fees while attending a course, or it could be used up
with expenses deductible under a provision other than s. 8-1 (e.g. s. 25-10 ‘repairs’). For example, if the
taxpayer incurred $5000 in deductible self-education expenses, and also incurred $300 of non-deductible
expense on childcare, then the $300 childcare expense would reduce the $250 s. 82A exclusion to zero and
the full $5000 would still be deductible and not affected by the s. 82A exclusion.
Note that Treasury Laws Amendment (2021 Measures No. 7) Bill 2021 proposes to remove this $250
threshold from 1 July 2022.
Sections 26-19 and 26-20 of ITAA97 (see table 2.4) deny deductions for expenses associated with
receiving income from government support payments for education, and payments of (Higher Education
Contribution Scheme/Higher Education Loan Program) HECS-HELP obligations.
Third Negative Limb — Incurred in Gaining Exempt Income or
Non-Assessable Non-Exempt Income
If the income produced by the taxpayer is not assessable, it is reasonable to conclude that the costs of
earning this income are also not deductible.
Fourth Negative Limb — Deductions Specifically Denied
The fourth negative limb of s. 8-1(2) states that a loss or outgoing is not deductible where it is prevented
from being a deduction via another provision of the Act. Table 2.4 lists some of the more common specific
exclusions. The more important restrictions to deductibility are then covered in more detail.
TABLE 2.4
Specific exclusions from deductibility
Section of ITAA97
Deduction excluded
Section 26-5
Penalties imposed for breach of the law, except a penalty under Subdivision 162-D
of the GST Act.
Section 26-10
The provision for accrued long service leave, annual leave, sick and other leave.
However, the actual payment of the leave or a payment from one employer to
another employer in respect of accrued leave entitlements of transferred employees
is deductible (ITAA97, s. 15-15).
Section 26-19
Losses or outgoings incurred in gaining or producing a rebatable benefit (i.e. income
support payments such as Austudy, Youth Allowance and Jobseeker).
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Section 26-20
Payments made to reduce student debts owed to the Commonwealth under the
Higher Education Support Act 2003 (Cwlth) including HECS-HELP payments and
FEE-HELP repayments, unless the payment is made by an employer who is subject
to fringe benefits tax in respect of the payment (see module 6).
Section 26-22
Contributions and gifts made to political parties and individuals who are candidates
for, or members of, parliament and local government bodies.
Section 26-25A
Wages paid to seasonal workers for which tax has not been withheld under the
PAYG system (see module 1).
Section 26-30
Travelling expenses in respect of a relative accompanying an employee or selfemployed person on a business trip, unless there is a genuine and substantial
business purpose for the relative’s presence or the expenditure incurred is subject
to FBT (see module 6).
Section 26-31
Denies a deduction for travel in relation to earning assessable income from
residential rent, unless the property is part of a business of letting residential
properties.
Section 26-40
Expenditure incurred in maintaining a child under the age of 16 years or a spouse.
Section 26-45
Membership fees paid to a recreational club, whether paid by the member or
another person, unless the expenditure is incurred in providing a fringe benefit (see
module 6).
Section 26-50
The cost of a leisure facility, unless the expenditure is incurred in providing a fringe
benefit (see module 6), or the facility is used for the gaining of income or for the
recreation of employees (for this section, the term employee does not include
members or directors of a company).
Section 26-52/53
Bribes made to foreign and Australian public officials.
Section 26-54
Expenditure related to illegal activities, such as drug dealing or people smuggling,
in respect of which the taxpayer has been convicted of an indictable offence (an
offence punishable by imprisonment for at least one year).
Section 26-74
Excess superannuation concessional contributions charge.
Section 26-75
Excess superannuation non-concessional contributions tax.
Section 26-102
Denies a deduction for expenses associated with the holding of vacant land. Some
exclusions apply (e.g. vacant land is used in carrying on a business or held by a
superannuation fund other than a self-managed fund).
Section 26-105
Denies a deduction for payments to employees if the required PAYG tax has not
been deducted (see module 1).
Section 27-5
The GST component, to the extent that the taxpayer is entitled to an input tax credit
or decreasing adjustment (see module 6).
Source: Based on Income Tax Assessment Act 1997 (Cwlth), Federal Register of Legislation, accessed February 2022,
www.legislation.gov.au/Details/C2022C00055.
Example 2.18 demonstrates the application of the negative limbs of s. 8-1 in determining the deductibility of expenses for a doctor working from her private home.
EXAMPLE 2.18
Deductions Under s. 8-1 of ITAA97
Dr Jacobs runs her medical practice out of rooms in the front of her private home. Patients do not have
access to her family living area and enter by a separate door that only gives access to the waiting room
and consulting rooms. The doctor’s rooms occupy about 20 per cent of the house. Dr Jacobs employs a
receptionist, and incurred the following expenses during 2021–22:
1. interest on a loan used to purchase medical equipment for her practice. The medical equipment cost
$20 000
2. local council taxes paid on the whole property
3. parking fines paid due to parking illegally while visiting patients at their homes
4. $150 000 paid to acquire the patient list of a retiring doctor.
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MODULE 2 Principles of Taxable Income 119
Reflect on whether the expenses incurred by Dr Jacobs are deductible under s. 8-1 of ITAA97.
When determining whether a deduction is available under s. 8-1 it is important to work through all the
requirements of the section.
1. The interest expense is wholly for the carrying on her business and it is not capital in nature, but is the
regular payment to support the loan, therefore it is not excluded (s. 8-1(2)(a)) and is deductible. However,
the cost of the equipment is capital in nature and is excluded from deductibility by s. 8-1(2)(a). A specific
deduction under the capital allowance provisions may be available (see ‘Capital allowances’).
2. Dr Jacobs operates her medical practice from a separate and specifically adapted portion of the
property, unlike Handley’s case (see ‘Second negative limb — Private and domestic expenses’) where
the room used as an office was a normal room within the home. Because the portion of the house used
to conduct the business is not part of the private home and not suitable for living in, the house is not
wholly private. Therefore, 20 per cent of the local council taxes is not private and is incurred in carrying
on the business and deductible under s. 8-1.
3. The parking fines may satisfy the second positive limb incurred in carrying on a business and are not
private but they are specifically excluded from deduction by s. 26-5 of ITAA97 (see table 2.4).
4. The cost of the patient list satisfies the second positive limb but it may be capital in nature and not
deductible under s. 8-1. Applying the decision in Sun Newspapers (see ‘First negative limb — Capital
expenses’), this expense will be capital if it alters the structure of the business rather than being a cost
of operating it. The character of this expense is that it is a once-off payment and it is the acquisition
of a resource that will potentially produce extra future income from these additional patients. This is,
therefore, capital as it alters the structure of the business (FCT v Healius Ltd [2020] FCAFC 173).
QUESTION 2.11
Leslie Smith starts working at an accounting practice. She discovers she must complete an
undergraduate degree in accounting in order to gain a promotion in her employment. Leslie enrols
as a part-time student in an accounting degree program at a local university. She incurs the
following expenses.
Student union fees
Childcare while at university
Photocopying
Travelling expenses by train from work to university and return
Higher Education Assistance/HECS-HELP debt payment
$
120
550
68
310
2 500
What deductions, if any, is Leslie entitled to?
The following exclusions and limitations on deductibility are discussed in more detail.
ENTERTAINMENT EXPENSES
Entertainment expenses are generally excluded from deductibility (ITAA97, s. 32-5), unless they are
incurred in providing a fringe benefit (see module 6) or removed from this exclusion by ss. 32-30
to 32-50.
The definition of entertainment is broad and is defined in s. 32-10 of ITAA97 as the provision of
entertainment in the form of food, drink or recreational activities and any related accommodation or
travel. Recreational activities include activities in vehicles, vessels or aircraft; for example, an employer
taking their employees out for lunch on their private yacht is an entertainment expense. Other examples of
entertainment expenses include tickets to sporting events, business lunches and staff social functions.
The denial of entertainment-related deductions also relates to travel or accommodation to attend any of
these events. Any property used to provide entertainment, such as the rental of a space for a Christmas
party, is also not deductible.
There are some exceptions to the denial of a deduction for entertainment expenses (ss. 32-30 to 32-50),
provided they first satisfy the requirements of s. 8-1 of ITAA97 and are not excluded by another provision:
• meals that are provided in an in-house dining facility, meals provided in a dining facility for the staff
who work in the dining facility, and in an in-house recreational facility
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120 Australia Taxation
• taxpayers in the business of entertainment — where the taxpayer’s business consists of providing
entertainment to paying customers, such as running a winery, the cost of providing that entertainment
in the ordinary course of business can be deducted
• promotion/advertising expenses provided to the public
• overtime meals — if the employee is entitled to overtime meals under an industrial instrument
• expenses of food, drink, accommodation and travel for seminars of over four hours in duration
• charitable entertainment — the exception applies to the cost of entertainment provided to members of
the public who are sick, disabled or otherwise disadvantaged (e.g. if a company sponsors a concert for
an aged care facility).
Example 2.19 demonstrates the application of the entertainment exclusion.
EXAMPLE 2.19
Deducting Entertainment Expenses
Venturing Tech Pty Ltd, a company that packages and re-sells software, incurred the following expenses
during the year ended 30 June 2022:
• drinks provided at a public function to launch its new products: $4000
• meals and drinks for selected clients at a public hotel: $3000
• food and drinks provided to the company directors in an in-house dining room: $6000.
Reflect on which of the above expenses would be deductible.
The cost of promoting and advertising a product to the public ($4000) is deductible under s. 8-1, and
it is excepted from the denial of deduction for entertainment by s. 32-45 of ITAA97. However, the meals
and drinks provided to selected clients ($3000) would not be deductible as they are excluded by s. 32-5
of ITAA97 and none of the exceptions apply. The cost of food and drink provided on working days in an
in-house facility to company directors ($6000) is deductible under s. 8-1 and it is excepted from the denial
of deduction for entertainment by Item 1.1, s. 32-30, of ITAA97. As a result, the $6000 is deductible.
PAYMENTS TO RELATED ENTITIES
Payments to a related entity may be denied a deduction by s. 26-35 of ITAA97 if they are considered
unreasonable by the Commissioner. This is the case even if the payment could be deducted under another
provision such as s. 8-1 of ITAA97. Subsections 26-35(2) and (3) define a related entity as a relative of the
taxpayer, or a partnership in which your relative is a partner. The definition of related entity also includes
a relative of a partner in the partnership, and extends to relationships with directors of companies and
trustees’ that are connected with the partnership (s. 26-35(3)). A common example is a tradesperson who
employs a spouse to do the bookkeeping and administration for the business.
First, the taxpayer must be able to claim a deduction for the payment made to a related entity (e.g. spouse)
under another provision of ITAA36 or ITAA97 (normally s. 8-1(1) of ITAA97). Second, the amount of the
payment must then be considered as reasonable. The Commissioner has the power to reduce the deduction
to a reasonable amount where it is considered that the taxpayer has made an excessive payment to the
related entity.
PREPAID EXPENDITURE
Under s. 8-1, an expense is deductible when it is incurred (see ‘Incurred’). However, there are specific
prepayment rules that affect the timing of a deduction when the expense relates to services provided beyond
the current tax year.
A prepaid expense is an expense incurred under an agreement for something to be done (wholly or
partly) in a later income year and which, apart from the prepayment rules, would be deductible under
s. 8-1 (ITAA36, s. 82KZME). The prepayment rules do not apply to:
• deductible expenses less than $1000
• deductible salaries and wages
• certain financial arrangements (not covered in this subject)
• deductible amounts required to be paid by the court or federal, state or territory government legislation.
The treatment of prepayments depends on a number of factors including the status of the taxpayer, the
nature of the expense and whether the taxpayer is a small business entity (SBE) (see ‘Capital allowances’).
These rules determine the period over which the deduction is apportioned.
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General Prepayment Rule
The general rule for a prepaid expense is that there is no immediate deduction. The expenditure must
be apportioned over each tax year during which the services are provided (ITAA36, s. 82KZM). This is
known as the eligible service period (ESP). If the ESP exceeds 10 years, it will be taken as 10 years. There
are concessional rules in place for SBEs and individuals incurring non-business expenditure. These are
covered in the next section.
Example 2.20 demonstrates how the prepayment rules apply.
EXAMPLE 2.20
Application of Prepayment Rules
Reuben Franko runs a barber and coffee shop from leased premises. On 1 November 2021, Reuben made
a lease payment of $6000 to cover the period 1 November 2021 to 31 December 2022. Consider what
deduction Reuben will be entitled to for the 2021–22 tax year.
The ESP for this expenditure runs from 1 November 2021 and ends on 31 December 2022, a period of
426 days, but only 242 days (1 November 2021 – 30 June 2022) of this are within the current tax year.
As the ‘thing to be done’ under the agreement (access to the leased premises) is not wholly done within
the expenditure year, the prepayment rules will apply and the deduction will be $3408.45 ($6000 × (242 /
426)). The balance of $2591.55 ($6000 – $3408.45) will be deductible in the 2022–23 tax year.
SBEs and Non-Business Individuals: 12-Month Rule
SBEs that are eligible for small business tax concessions, and individuals incurring non-business expenditure, can claim an immediate deduction for prepayments where both of the following apply.
An SBE is defined as an entity (individual, company, trust or partnership) that carries on a business and
satisfies the $10 million aggregated turnover test (this drops to $5 million for the small business income
tax offset (see module 5) and $2 million for access to the CGT SBE concessions (see module 3).
From 1 July 2020 this concession is also available to entities with a turnover of less than $50 million.
1. The payment is incurred for an ESP not exceeding 12 months.
2. The 12-month period ends no later than the last day of the tax year following the year in which the
expenditure was incurred.
Where the ESP does not meet these requirements, the deduction for the prepaid expenditure is claimed
proportionately over each tax year during which the services are to be provided, to a maximum period of
10 years (s. 82KZM). A small business taxpayer who does not elect to enter the SBE tax system will also
have any prepayments apportioned over the ESP to a maximum period of 10 years under s. 82KZM.
Tax Shelter Arrangement
An immediate deduction is denied under s. 82KZMF of ITAA36 for prepaid expenses that are eligible for
the 12 months rule and are made under a tax shelter arrangement. A tax shelter arrangement is one where:
• the arrangement is designed to bring forward tax deductions relating to an investment
• you do not have day-to-day control of the arrangement
• there is more than one taxpayer participating in the arrangement or the organisers of the arrangement
carry out similar arrangements for other taxpayers.
The purpose of denying an immediate deduction in these cases is to prevent investment arrangements
being designed to bring forward tax deductions for the investor. For example, the promoter of an investment
in crocodile farming may structure the investment so that with an investment of $15 000, $10 000 will be
a management fee due immediately even though it covers future services. In this case, the $10 000 would
be deductible over the service period and in the year incurred.
QUESTION 2.12
Cushio Pty Ltd (Cushio) is a small manufacturer of bespoke cushions and furnishings. Cushio is
not an SBE and was required to prepay two years’ rent at a cost of $25 000 per annum. The lease
commenced on 1 May 2022 and ends on 30 April 2024.
How much, if any, can Cushio claim as a deduction in respect of rent for the year ended
30 June 2022?
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NON-COMMERCIAL LOSS RULES
A taxpayer can only claim a deduction for tax losses from a genuine business activity. A taxpayer cannot
claim a loss realised from a hobby because the income from such an activity is not assessable income.
Deduction for tax losses may also be limited through the non-commercial loss provisions in Division 35
of ITAA97. These limitations apply even if the activity has business-like characteristics but is not currently
profitable and does not have a significant commercial purpose. If the non-commercial loss provisions
apply, the taxpayer will be unable to offset tax losses made against income derived from other sources
(e.g. wages). However, the loss can be carried forward to be used as a deduction if at some later stage
Division 35 of ITAA97 does not restrict the deduction.
Note that these restrictions do not apply to losses from non-business activities (e.g. negatively geared
investments).
Sections 35-30 to 35-55 of ITAA97 set out the requirements that must be satisfied of a tax loss to be
deductible in the year incurred rather than being deferred as a non-commercial loss. There is a three-step
process to be applied, which is shown in table 2.5.
TABLE 2.5
Three-step process to determine the deductibility of non-commercial losses
Step
Details
Step 1: Look at assessable income and
other income
If the loss-making business is in primary production
or the professional arts (excepted activity) and the
assessable income from other sources is less than
$40 000, then losses can be offset against other income.
If the above applies, the process stops here. If the lossmaking business is in some other activity, then the
income test must first be satisfied. Under the income
test, if the taxpayer’s adjusted taxable income (the sum
of taxable income, which includes the investment loss,
reportable fringe benefits, reportable superannuation
contributions and net investment losses) is:
• less than $250 000, go to step 2
• $250 000 or more, go to step 3.
Net investment losses are added back to determine
adjusted taxable income as these investment losses
cannot be used to help the taxpayer reduce adjusted
taxable income to below $250 000. Not allowing net
investment losses in determining eligibility for a range
of tax concessions is discussed in module 4 ‘What is
adjusted taxable income?’.
Step 2: Check four tests
Losses can be offset in the current year if any one of the
four tests are met:
• assessable income test — the business has
assessable income of at least $20 000 or a reasonable
estimate for the year would be at least $20 000 in the
case of the business operating for only part of the year
• profits test — the business has a profit for tax
purposes in three out of the past five years (including
the current year)
• real property test — the value of real property or of an
interest in real property used by the taxpayer in the
business on a continuing basis was at least $500 000
• other assets test — the value of assets (excluding real
property, cars, motor cycles and similar vehicles) used
on a continuing basis in carrying on the business was
at least $100 000.
If none of the four tests are passed, then move to step 3.
(continued)
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MODULE 2 Principles of Taxable Income 123
TABLE 2.5
(continued)
Step
Details
Step 3: Commissioner’s discretion
Check if you should apply for a Commissioner’s
discretion. Application of the Commissioner’s discretion
is generally only for exceptional circumstances. For
example, situations where events outside the taxpayer’s
control have affected the results such as drought, flood
and other natural disasters.
Source: Based on ATO 2022, ‘Non-commercial losses’, accessed February 2022, www.ato.gov.au/business/non-commercial-losses.
Example 2.21 illustrates the circumstances where the non-commercial loss provisions apply, and how
they operate in practice.
EXAMPLE 2.21
Non-Commercial Losses
Peter Bell is an employee accountant earning $100 000 per annum. He has reportable superannuation
contributions of $10 000, no reportable fringe benefits and a total net property investment loss of $7000.
Peter also operates a business selling pottery, which commenced on the first day of the current tax year.
No assets of significant value are used in the business and he operates from his private home. During the
current tax year, Peter derives $12 000 in business income, but his business deductions amount to $16 000
resulting in a tax loss of $4000 ($12 000 – $16 000).
Consider whether Peter is able to use the loss from his pottery activities as a deduction against his
salary of $100 000.
Whether Peter can use the losses from his pottery activities against his salary will depend on whether
the loss is a non-commercial loss under Division 35 of ITAA97. Use the three-step process described
above in table 2.5.
In step 1, Peter’s business is not an excepted activity and his adjusted taxable income of $110 000
($93 000 taxable income ($100 000 salary – $7000 investment loss) + $10 000 reportable superannuation
+ $7000 investment loss) is less than $250 000. Note that the investment loss of $7000 first reduces taxable
income but is then added back to remove this benefit.
In step 2, none of the four tests are satisfied as his assessable income is less than $20 000, he has
no previous years where the business earned taxable income, and there are no significant assets used
in the business. Assuming the Commissioner does not exercise discretion, Peter cannot offset the $4000
loss from his pottery activities against his salary in this tax year. The loss is carried forward to be offset
against future net business income or salary income in a later year when at least one of the conditions in
s. 35-10(1) is met. However, Peter can use the $7000 property investment loss as a deduction against his
salary income because the Division 35 restrictions do not apply to non-business tax losses.
QUESTION 2.13
On 1 January 2022, Joe Jackson commenced a surfing instruction business called ‘Hang Ten’. While
the business is being established, he has kept his part-time employment as a traffic controller for
the local city council which earns him $60 000 per annum (Joe has no reportable fringe benefits or
reportable superannuation). To help get the business started, Joe incurred the following costs.
1. Meals costing $150 for himself while travelling to purchase surf boards.
2. $800 for a luncheon where he paid for the meals of local media and Surf Club representatives so
he could explain to them what he was planning to do.
3. Joe intends to make his surfing lessons available to people of all abilities. He paid $1500 for food
and drink provided at a five-hour seminar for organisations that provide support to people with
a disability.
At 30 June 2022 Joe’s accountant reported that ‘Hang Ten’ had assessable income for the year
of $5000 and deductible expenses of $20 000.
Explain the tax implications of the above transactions.
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THIN CAPITALISATION
Thin capitalisation occurs where the assets of an Australian multinational entity are predominantly
financed by debt (loans) with only a relatively low amount of equity (share capital). This ratio is known
as the ‘debt to equity ratio’. For example, a debt to equity ratio of 2:1 means that, for every $2 of debt, the
entity is funded by $1 of equity. This is also known as gearing. An entity that is regarded as highly geared
has a large debt to equity ratio and is financed predominantly by debt as opposed to equity.
The thin capitalisation rules aim to limit the amount of debt used to fund Australian operations/investments by capping the amount of an entity’s debt deduction (such as interest) that can be claimed against
assessable income, where the entity’s debt to equity ratio exceeds certain limits. The debt to equity limits
vary, but they are approximately a ratio of 1.5:1 debt to equity.
The thin capitalisation rules apply to both Australian-owned and foreign-controlled Australian resident
entities that are part of an international group. Australia’s thin capitalisation provisions are set out in
Division 820 of ITAA97.
Category of Entity
The thin capitalisation provisions can be complex to apply because there are eight different categories of
entities. Each category has its own prescribed formula or method statement on how the provisions will
apply to cap the amount of debt deductions available. ADI means Authorised Deposit-taking Institution,
such as a bank, and a non-ADI is any other entity. The eight entities are:
1. non-ADI general outward investor
2. non-ADI financial outward investor
3. non-ADI general inward investment vehicle
4. non-ADI financial inward investment vehicle
5. non-ADI general inward investor
6. non-ADI financial inward investor
7. ADI outward investing entity
8. ADI inward investing entity.
Applying the Thin Capitalisation Rules
To apply the thin capitalisation provisions, the Australian resident entity must apply the following
four steps.
1. Identify any exemptions available.
2. Determine which category of entity is affected.
3. Apply the specific thin capitalisation test for that particular type of entity (not covered in this subject).
4. Disallow any debt deductions to the extent the entity exceeds its maximum allowable debt.
The first step is to apply any exemptions. The thin capitalisation provisions will not apply in a tax year
where one of the following conditions is satisfied.
• The entity did not incur any debt deductions during the tax year (ITAA97, s. 820-40).
• The entity’s debt deductions do not exceed $2 million in a particular tax year (ITAA97, s. 820-35).
• The Australian resident entity is not foreign controlled and does not have any offshore investments as
its operations are wholly based in Australia.
• The entity is an outward investor (i.e. an Australian resident investor with offshore interests) that is
not also foreign controlled and the entity meets the asset threshold test (ITAA97, s. 820-37). The asset
threshold test requires that the total average value of Australian assets held by an entity and its associates
represents 90 per cent or more of the total average assets of the entity and all its associates.
Disallowing Excess Debt Deductions
Under the various formulas provided for each of the eight categories of entities, any debt deduction
is disallowed to the extent to which the adjusted average debt exceeds the maximum allowable debt.
Such excess amounts cannot be included in the cost base of an asset (ITAA97, s. 110-54) and any
interest payment disallowed will continue to be subject to interest withholding tax (see ‘Withholding tax
regime — interest’).
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MODULE 2 Principles of Taxable Income 125
2.6 SUBSTANTIATION REQUIREMENTS
FOR INDIVIDUALS
The substantiation rules also limit deductions as these rules require an individual taxpayer to retain
specified documentary evidence to substantiate certain deductions. If these records are not retained, the
expense is not deductible (see figure 2.5).
Corporate taxpayers are not subject to these substantiation requirements under Division 900 of ITAA97
but they are subject to the normal tax record requirements as are all taxpayers.
There are three types of expenses claimed as deductions that must be substantiated under Division 900.
These are:
1. work expenses
2. car expenses
3. business travel expenses.
Expenses excluded from these requirements under ss. 900-35 and 900-40 are:
• total expenses subject to substantiation less than $300
• individual expenses of $10 or less, and the total of these expenses does not exceed $200
• laundry expenses of $150 or less, even though total expenses (including laundry) are $300 or more
• work expenses plus laundry expenses are less than $300.
WORK EXPENSES
Section 900-30 defines a work expense as a loss or outgoing incurred in producing your salary, wage (see
Taxation Ruling TR 2020/1) or certain PAYG withholding payments (i.e. payments for work, services,
retirement payments, benefits and compensation payments) (s. 900-12). Work expenses include:
• home office expenses
• mobile phone use for work
• protective clothing
• tools or equipment required for work such as a doctor’s stethoscope
• self-education expenses.
Claims for work-related repairs (ITAA97, s. 25-10); election expenses (ITAA97, s. 25-60); subscriptions
to trade, business or professional associations (ITAA97, s. 25-55); and the decline in value of a depreciating
asset (ITAA97, s. 40-25) also require substantiation.
Work expenses do not include a loss or outgoing related to a motor vehicle (including a four-wheel
drive vehicle), unless the loss or outgoing is in respect of travel outside Australia or is a taxi fare or similar
loss or outgoing (s. 900-30(6)). Car expenses and travel expenses are the subject of separate substantiation
requirements, and these are discussed in the next two sections.
To substantiate a work expense claim, the taxpayer must provide written evidence (Subdivision 900-E)
using one of the following methods (see also ‘Evidence required’):
• evidence from the supplier
• evidence recorded by the taxpayer for
(a) small expenses, or
(b) expenses unable to be substantiated in the normal way
• evidence on a payment summary.
CAR EXPENSES
More detailed substantiation requirements apply in relation to claiming a deduction for car expenses. Two
methods (cents per kilometre and logbook) are available for substantiation depending on the number of
kilometres of travel claimed for income-producing purposes.
Cents Per Kilometre (5000 km or less)
Where business travel claimed is 5000 km or less, substantiation of the actual car expenses is not required
and receipts do not have to be retained. The taxpayer needs only to make a reasonable estimate of business
usage based on a diary record of work-related travel. The taxpayer’s deduction is then calculated by
applying a prescribed rate (72 cents per kilometre for 2021–22) to estimate the number of business
kilometres travelled (ITAA97, s. 28-25). When the cents per kilometre method is used to claim a deduction
for car expenses, none of the actual cost or depreciation can be claimed as a separate deduction.
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126 Australia Taxation
Note that if the actual business travel exceeds 5000 km, the taxpayer may still use the cents per kilometre
option but they can only claim a maximum of 5000 km using this method.
Logbook
The logbook method is optional for business travel of less than 5000 km per year, but it is compulsory
for claiming car expenses for more than 5000 km of business travel. Where a logbook is used, it must be
maintained for all travel for a continuous 12-week period that represents normal business travel for the
year. For example, it would be inappropriate for a business that delivers ice to select the busiest 12-week
period over summer. Included in the logbook record for each journey must be:
• the purpose of the journey — work or private
• odometer reading start and finish
• total distance travelled during the period.
The logbook record is then used to estimate the business use percentage which is the number of business
kilometres that the car has travelled divided by total kilometres travelled in that period. This estimate
of business use can be applied for five years when a new logbook must be completed. However, if
circumstances change, a new logbook can be prepared at any time.
Based on this method, the deduction is a proportion of actual car expenses including depreciation, based
upon the business use percentage. The taxpayer must then substantiate the actual car expenses, although
it is not necessary to retain records for fuel and oil costs as these can be estimated based on the kilometres
travelled. The following information is required to substantiate these expenses:
• original receipts for all car expenses
• detail on how depreciation of the vehicle was calculated
• if bulky goods or tools were transported; the work performed, weight and size of items and if the
employer did not provide secure storage.
TRAVEL EXPENSES
Travel expenses of an employee and non-employee (business travel) are subject to different substantiation
rules. Also, if part of the travel is for private purposes the total cost must be apportioned. The expenses
that can be claimed include:
• airfares
• train and tram travel
• taxi, ride-sharing and car hire
• fuel, tolls and parking where appropriate
• accommodation
• meals, if staying overnight.
Employee Travel Expenses
The substantiation required for employees differs depending on whether the employee receives a travel
allowance or not. An employee who does not receive a travel allowance must keep the same records as
required for work-related expenses (see ‘Evidence required’). In addition, if the travel involved six or more
consecutive days away from home, the employee must also keep a travel diary of all activities.
Employees receiving a travel allowance can deduct the cost of domestic travel without having to satisfy
the substantiation requirements provided their deductions are less than what the Commissioner considers
reasonable (TD 2019/11). The same rule applies for international travel except that a travel diary and
accommodation records must be kept.
If the employer is claiming a deduction for the employee’s travel, they must either have paid the costs
directly, reimbursed the employee or paid a travel allowance. In this case there may be fringe benefit tax
implications (see section ‘Types of fringe benefits’ in module 6).
Business Travel Expenses
Business travel is travel for which there is at least one overnight stay, and the costs incurred are for
producing assessable income other than salary or wages (e.g. self-employed taxpayer). Business travel
expenses do not include a loss or outgoing to do with a motor vehicle, unless in respect to travel outside
Australia or a taxi fare or similar loss or outgoing.
To substantiate a business travel expense, the records required are the same as for work-related expenses
and, in addition, a travel diary of all activities must be kept if the travel involved is six or more consecutive
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MODULE 2 Principles of Taxable Income 127
days away from home (Subdivision 900-E). Odometer records are required to support a claim for fuel or
oil, if incurred (s. 900-80(2)).
EVIDENCE REQUIRED
Written evidence from the supplier means a receipt, invoice or similar document giving full details of the
name of the supplier, the amount of the expense, the nature of the goods or services, the day the expense
was incurred and the date of the document. There are two exceptions (s. 900-115(3)).
1. If the document does not show the date on which the expense was incurred, the taxpayer can use
independent evidence such as a bank statement or credit card statement to show when the expense
was paid.
2. If the document does not specify the nature of the goods or services, the taxpayer may write in the
missing details.
If the expense is not wholly for income-producing purposes (e.g. private mobile phone use), a record
needs to be provided that can be used to estimate the private use. For example, in the case of mobile phone
use, an estimate can be made by determining from the phone account, the work calls and duration of these
calls compared to the total call duration.
Expenses $10 or Less
If an expense is $10 or less and the total of all such small expenses is $200 or less, the taxpayer need not
have documents from the supplier to substantiate the claim, but instead can maintain their own record of
the expenses in a notebook or diary. This is sufficient provided the records maintained by the taxpayer
contains the same details that are required for written evidence from the supplier (i.e. name of supplier,
amount, date and goods or services purchased).
Unable to Substantiate in the Normal Way
If it is not reasonable to expect that the necessary documentation can be provided (e.g. destroyed by
fire), an expense may still be claimed as a deduction under the Commissioner’s discretion. Normally,
the Commissioner will be satisfied that an expense has been substantiated if the taxpayer can provide
evidence similar to that required for amounts of $10 or less. This could include bank statement, credit card
statements or other documents that record the transaction. If the payment was made in cash, no deduction
can be claimed.
In some cases (e.g. laundry and home office use) it can be difficult to provide specific evidence in the
form of invoices or other documents; in which case the Commissioner may prescribe reasonable rates
to claim provided the income producing use of the activity can be justified with a diary or notebook
record. For example, the Commissioner accepts a rate of 52 cents per hour for work-related use of
a home office (increased to 80 cents per hour while working from home between 1 March 2020 to
30 June 2022 due to the COVID-19 restrictions), and laundry costs of $1 per load for washing and ironing
for work-related clothing.
Example 2.22 demonstrates how the substantiation rules affect the deductibility of certain expenses.
EXAMPLE 2.22
Substantiation
Jean Bolsano is an employee civil engineer. She wishes to claim a tax deduction for the cost of washing
and ironing her registered uniform of $200, mobile phone usage for work of $210 (30 per cent of her total
bill of $700), and travel for work purposes using her private car for 3000 km.
Consider what records Jean would have to retain to satisfy the substantiation requirements, and
provided she has these records, any deductions she would be entitled to.
Jean’s total work-related expenses are $410 ($200 + $210) and her work travel is 3000 km.
Jean’s laundry expenses are over $150 and, since the total work-related expenses are over $300 (without
car expenses), she will have to substantiate her deductions for both laundry and phone expenses.
Laundry expenses can be substantiated if Jean can show that the laundry costs related to her uniform
and she has retained a diary of her time, and some evidence of the costs involved or use the $1 per load
rate. However, it could be difficult to keep specific records, in which case Jean may be better opting to
claim a maximum of $150 as this will not have to be supported by any record of the actual cost but a diary
record should still be kept.
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128 Australia Taxation
Mobile phone costs could be substantiated from an itemised phone account, where the work calls
are identified together with the duration, which is compared to the total call duration. If she retains this
information, she can claim $210.
As the travel claimed is less than 5000 km, Jean could use the cents per kilometre or logbook method,
but there is no indication that she has kept a logbook. Under the cents per kilometre method, she could
substantiate the claim by keeping a diary of work-related travel. The cents per kilometre deduction would
be $2160 (3000 × $0.72).
RETENTION OF DOCUMENTS
A deduction is not allowable, and is deemed never to have been allowable for an expense subject to
substantiation, if the taxpayer fails to retain:
• written evidence of the expense or the relevant odometer records
• logbook and odometer records (where applicable)
• a travel diary (where applicable).
The retention period for all substantiation records is normally five years. This period is extended if the
expense is in dispute.
PENALTY TAX
A penalty tax will be applied if the taxpayer makes a false declaration on their income tax return that they
have substantiation records when they do not. Penalty tax will also be applied if a taxpayer does not sign
the declaration on their return, as then a claim cannot be substantiated.
Under Items 3, s. 284-90(1), Schedule 1 of the Tax Administration Act, penalty tax is applied on any tax
shortfall that results from the taxpayer’s failure to substantiate the expenses claimed as a deduction (see
section ‘Penalties and interest charges’ of module 1).
QUESTION 2.14
Jack de Boisy is an employee architect who regularly works from his home which he rents for $600
per week. Jack’s home office is not used for any other purpose and it occupies 5 per cent of the
floor space of the house. He estimates that he spends an average of 10 hours/week over the whole
year using the office for work-related activities (not related to COVID-19 restrictions). He also uses
his own car to visit clients.
Jack has kept a diary of work travel. He also keeps his receipts, but he does not have all his
power bills (such as electricity, gas and heating) for his home. He also paid:
• $250 on 1 June 2022 for paper on which to draw plans
• $1000 to repaint the office due to water damage.
Jack owns a luxury car and, during the 2021–22 tax year, he estimates that he travelled 6500 km
visiting clients.
For the expenses mentioned, outline the records that would be required to meet the substantiation requirements?
Determine Jack’s deductions for each of the expenses assuming his total work-related expenses
exceed $300 and, where not stated, that he has the required records.
QUESTION 2.15
Fumi Suzuki is employed as a lawyer in a medium-sized law firm in Wollongong, Australia.
She uses her own car for work as she is required to undertake extensive travel to regional towns.
Fumi is paid a car allowance of $2000 by her employer in the 2021–22 income tax year. Fumi keeps
a logbook for the entire year and receipts for any costs incurred. Fumi’s logbook shows that the
car travelled 16 000 km during the year, of which 4725 km were in the course of her employment.
The total costs of running the car for the year were $5000 including depreciation.
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MODULE 2 Principles of Taxable Income 129
Fumi is completing a Masters of International Law at a university. She catches the train to
university and does not use her private car. This course will improve her chances of promotion
with her current employer and her employer also gives her some time off to sit exams.
Fumi purchased a new investment property on 1 September 2021 and rented it out from
1 October 2021. Fumi borrowed $240 000 over 10 years on 1 September 2021 and incurred
borrowing costs of $2500. Interest paid on the loan during the 2021–22 income tax year was $16 000.
Fumi used the loan funds as follows:
• repayment of home loan (main residence): $180 000
• payment of expenses for her investment property that earns rental income: $60 000 for the
2021–22 income tax year.
Fumi incurred the following expenses during the 2021–22 income tax year.
$
Internet cost at home (40% personal use and 60% study related)
Student union fees
Train fares from work to university and return two nights per week
Childcare while at university
Clothing (normal suits) for work
Annual membership of The Law Society
Entertaining clients at business lunches
FEE-HELP (Higher Education Loan Program) debt paid duringthe year
660
300
180
180
2 400
209
2 000
3 600
Fumi’s costs for her new investment property are as follows.
$
New carpets throughout even though not worn-out —September 2021
Extension of new bathroom and bedroom — September 2021
Leaking roof and subsequent repairs — January 2022
Replacing faulty electrical sockets — March 2022
4 000
35 500
660
990
(a) Determine what amounts are allowable deductions to Fumi for the 2021–22 income tax year (not
including her car expenses).
(b) Has Fumi kept adequate records to substantiate her car expenses under either/both methods?
Determine Fumi’s highest car expenses deduction using the eligible methods.
(c) Calculate the total amount of allowable deductions Fumi can claim.
QUESTION 2.16
Portland Pty Ltd (Portland) is not an SBE and was incorporated in 1998. Since the time of
incorporation there has been no change in shareholders. The company builds domestic homes
for clients and employs eight employees. Due to falling house prices, Portland reported a tax loss
in the previous year of $50 000 (please ignore the loss carry back tax offset).
Portland incurred the following transactions during the 2021–22 income tax year.
$
Provision for long service leave
Long service leave paid
Legal expenses and damages for poor workmanship (see note 1)
Preparation of the 2020–21 tax return
Repairs and maintenance (see note 2)
Car costs (fuel and maintenance), the company car is used only
for work purposes (no complete logbook is kept)
Interest prepaid on a loan to purchase vacant land on which to
build houses that will be sold on the open market (see note 3)
Borrowing expenses on the above loan which is for three years
and was entered into on 1 February 2022
Christmas party for staff held at a local restaurant
Gift to a tax-deductible charity for homeless children
Dividend payment to shareholders
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130 Australia Taxation
3 600
1 500
12 000
5 000
15 000
2 000
45 000
2 500
1 600
1 000
80 000
Determine Portland’s allowable deductions for the 2021–22 income tax year.
Note 1: A client claimed that the building work carried out by Portland did not meet building
regulations and resulted in water leaks. Portland paid $5000 for legal advice and $7000 to settle the
claim with the client.
Note 2: Normal repairs to plant and equipment were $10 000 and an additional $5000 was paid to
repair a second-hand concrete mixer and concrete pump as it was faulty at the time of purchase.
Note 3: During the year there was insufficient work for employees, so the company purchased
vacant land (1 February 2022) and utilised its employees to build houses on the land. These houses
will later be sold on the open market.
SUMMARY
Part B discussed the principles of deductions. A taxpayer may be entitled to a deduction as either a general
deduction or a specific deduction. If an expense is only partly for a taxable purpose, the taxpayer is
only entitled to a deduction for the proportion of the expense connected with earning assessable income.
If a deduction is available under more than one provision, the most appropriate one must be applied
(ITAA97, s. 8-10).
Section 8-1 of ITAA97 enables a deduction under one of the two positive limbs, provided none of the
four negative limbs apply (which exclude capital and private expenses, expenses relating to earning exempt
income and expenses specifically excluded).
A specific deduction may be available (ITAA97, s. 8-5) under one of the specific provisions. Specific
deductions include deductions for repairs, tax losses, bad debts and borrowing expenses.
Even though an expense is deductible as either a general or specific deduction, the deduction may be
denied or limited if it is specifically excluded by the legislation. In addition to the general exclusions in
s. 8-1(2), there are specific exclusions that include expenses for entertainment, payments to related entities,
non-commercial losses, prepayments and thin capitalisation interest expenses. Lastly, Part B outlined the
documents taxpayers need to retain in order to prove certain employment and business-related deductions.
These substantiation requirements apply to work expenses, car expenses and travel expenses. Penalties
may apply if these records are not retained.
The key points covered in this part, and the learning objective they align to, are as follows.
KEY POINTS
2.2 Determine whether a loss or outgoing is deductible in a given situation.
• Figure 2.3 illustrates that a deduction may be available through the general or specific deduction
provisions.
• To be eligible for a general deduction either of the two positive limbs of s. 8-1 must be satisfied.
• Example 2.12 demonstrates how the first positive limb applies in practice.
• Examples 2.14 and 2.17 demonstrate how specific deduction provisions apply.
• Example 2.15 demonstrates how tax losses are carried forward and deducted against taxable
income.
• Deductions may be limited if the expense is capital or private, or the deduction is specifically
excluded by the legislation.
• Example 2.18 demonstrates deductibility and the negative limbs of s. 8-1.
• Substantiation rules require certain taxpayers to keep specific records for specified expenses to
be deductible.
• Questions 2.8 and 2.11 provide the opportunity to evaluate how the general deduction
provisions apply.
• Questions 2.9 and 2.10 provide the opportunity to evaluate how the specific deduction provisions
apply in practice.
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MODULE 2 Principles of Taxable Income 131
PART C: CAPITAL ALLOWANCES
INTRODUCTION
Part C introduces the capital allowance regime (commonly referred to as ‘tax depreciation’) for taxpayers.
Under Division 40 of ITAA97, taxpayers are able to claim a deduction for the decline in value of
depreciating assets — used for a taxable purpose — over the lifetime of the asset. The treatment of
depreciating assets varies depending on the type of asset and whether the taxpayer is an SBE or a non-SBE.
Part C will also examine the capital works deduction for certain structural improvements that are not
deductible under the capital allowance provisions.
The tax implications of trading stock the treatments of Australian-sourced income earned by nonresidents and the tax treatment of international transactions are discussed in Part C.
2.7 CAPITAL ALLOWANCES
The capital allowance regime (commonly referred to as ‘tax depreciation’) is a form of specific deduction.
Under Division 40 of ITAA97, taxpayers are able to claim a deduction, over the effective life of the
depreciating asset, for the decline in value of depreciating assets used for a taxable purpose. The treatment
of depreciating assets varies depending on the type of asset and whether the taxpayer is an SBE or a
non-SBE.
If the taxpayer is not an SBE, they can apply a certain set of capital allowance rules, including allocating
the asset to a low-value pool and temporary tax depreciation concessions. Otherwise, the non-SBE taxpayer
determines the effective life of the asset using either the diminishing value or prime cost method (known
in accounting terms as ‘straight-line depreciation’).
However, the rules are different for taxpayers that qualify as an SBE and who choose to use the simplified
capital allowance rules (see subsection ‘Capital allowance rules for small business entities’).
In 2020, a series of temporary tax-related economic stimulus packages were introduced by the Federal
government to support businesses during the COVID-19 restrictions. These concessions allowed an
increased depreciation or a 100 per cent deduction in the year of purchase.
Capital works deductions are also available for certain structural improvements that are not deductible
under Division 40 (see ‘Capital works’).
CAPITAL ALLOWANCES CORE CONCEPTS
A summary of the general capital allowance provisions covered in this module is shown in figure 2.6.
As previously discussed, a taxpayer is denied an immediate deduction for any outgoing of capital or of a
capital nature (s. 8-1(2)(a)). To overcome this problem, Division 40 allows taxpayers to claim a deduction
for the decline in value of a depreciating asset that was used partly or fully for a taxable purpose. However,
if the capital allowances provisions do not apply it may be possible to include the cost in the cost base of
a CGT asset (see module 3).
The capital allowance rules in Division 40 relate generally to assets that decline in value and specifically
include:
• plant and equipment
• software
• cars
• certain intellectual property
• depreciating assets in mining and quarrying
• depreciating assets used for primary production
• carbon sink forest expenditure
• blackhole expenditure (capital expenditure incurred by a business that is not generally deductible,
depreciable or included in the cost base of a CGT asset).
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132 Australia Taxation
Capital allowances under Division 40 of ITAA97
FIGURE 2.6
Capital allowances
Division 40 of ITAA97
Non-SBEs
2021–22
Temporary full
expensing
concesion (TFE)
SBEs
Depreciating assets
used for taxable
purpose
Non-business
assets
$300 or less
SBEs and
businesses with a
turnover of less
than $5 billion
Eligibility and
elected simplified
depreciation
Claim over effective
life of the asset
Low-value pool
100% deduction
for eligible assets
Small business
asset pool
Choice of two
methods
Computer software
Full expensing of
depreciating assets
Blackhole deduction
and write-off capital
start-up expenses
if eligible
Blackhole deduction
and write-off capital
start-up expenses
Core concepts
Division 40
Prime cost
Diminishing
value
Balancing
adjustment on
disposal
Source: CPA Australia 2022.
DETERMINING THE CAPITAL ALLOWANCE AMOUNT
Division 40 of ITAA97 permits a deduction for a capital allowance on depreciating assets that a taxpayer
constructs, starts to hold under a contract or starts to hold in some other way. The taxpayer may deduct the
cost immediately or an amount equal to the decline in value of a depreciating asset that the taxpayer holds
and uses, or has installed ready for use, for a taxable purpose during a year.
Where the deduction is based on the decline in value, it is calculated by spreading the cost of the
asset over its effective life and using either the prime cost or the diminishing value method (see ‘General
rules and determining effective life’). The effective life of the asset is either assessed by the taxpayer or
based on the Commissioner estimates (ATO 2020d). There may be a need for balancing adjustments if a
balancing adjustment event occurs on disposal or at the end of the life of the asset (see ‘Balancing
adjustment’).
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MODULE 2 Principles of Taxable Income 133
There are special rules for claiming depreciation on cars, defined in s. 995-1 of ITAA97 as:
a motor vehicle (except a motor cycle or similar vehicle) designed to carry a load of less than 1 tonne and
fewer than 9 passengers.
This definition restricts the capital allowance to what is known as the car limit (ITAA97, s. 40-230).
For 2021–22 the car limit is $60 733, which means that, regardless of the actual cost of the car, the
maximum cost for capital allowance calculation purposes cannot exceed this amount. The car limit is
based on the cost of the car excluding GST and not taking into account any trade-in.
There are also limitations on deprecation deductions for second-hand depreciating assets used in
residential rental properties. From 1 July 2017, second-hand depreciating assets that are acquired for
income-earning residential rental properties are not entitled to a deduction for depreciation (s. 40-27).
Second-hand assets in this case are assets that have been used by another entity (including by the taxpayer
for private purposes) prior to being used in the residential rental property. This includes depreciating
assets purchased as part of the purchase of residential rental property, where the contract to purchase the
property was signed, after 7.30 pm (AEST) on 9 May 2017.
Four Questions for Eligibility
There are four core questions used to determine whether a taxpayer is entitled to a deduction for a capital
allowance and to determine the amount of deduction available.
1. What is a depreciating asset? A depreciating asset is one that ‘has a limited effective life and can
reasonably be expected to decline in value over the time it is used’ (s. 40-30(1)). Examples of
depreciating assets include tangible assets with an effective life such as motor vehicles, computers,
tools and furniture. Land and trading stock are specifically excluded from being depreciating assets.
Intangible assets (such as licenses and permits) are also excluded unless they are listed in s. 40-30(2).
2. Was it used for a taxable purpose? A capital allowance is only deductible if the depreciating asset is
used for a taxable purpose in part or in full (s. 40-25(2)). Section 40-25(7) defines a taxable purpose as:
(a) producing assessable income
(b) exploration or prospecting
(c) mining site rehabilitation
(d) environmental protection activities.
Where the depreciating asset is only used partly for a taxable purpose, the deduction allowed is reduced
by the percentage the asset is used for some other purpose (e.g. private use).
3. When does the depreciating asset start to decline in value? The depreciating asset’s start time is the
earlier of the following (s. 40-60 (2)):
(a) when the taxpayer first uses the asset
(b) when the taxpayer has the asset installed ready for use for any purpose.
4. Which taxpayer holds the depreciating asset? The taxpayer that holds the asset is the one that can access
the asset’s economic benefits and, in turn, is entitled to the deduction for the decline in value. This is
generally the owner of the asset (s. 40-40), however, in some cases it may be the economic owner
that is entitled to the deduction. The economic owner under a lease agreement may be the lessee, in
which case the lessee would be entitled to the deduction for the decline in value rather than the legal
owner (lessor).
Example 2.23 demonstrates the time when a taxpayer starts holding an asset.
EXAMPLE 2.23
Depreciating Asset
Hannah Hackett acquires a laptop on 1 March 2022 and starts to use it for wholly private purposes.
On 15 June 2022, she commences using the laptop equally for business and private purposes. The
start time for the computer is 1 March 2022, the day the computer was first used for any purpose.
Hannah will need to work out the decline in value of her computer from 1 March 2022 to 30 June 2022,
but she will only be able to claim a deduction for 50 per cent of the decline in value of her computer from
15 June 2022.
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134 Australia Taxation
CAPITAL ALLOWANCES FOR NON-SMALL
BUSINESS ENTITIES
For all entities that are not classified as SBEs, a deduction may arise under one of six categories.
1. Non-business depreciating asset costing $300 or less.
2. Asset allocated to a low-value pool.
3. Asset allocated to a software development pool.
4. Immediate write-off of the cost of the asset.
5. Assets not included in categories 1 to 4, apply the general rules and determine the effective life of the
asset using either the diminishing value or prime cost methods of depreciation.
6. Capital expenses not covered by any of the above deductions that maybe eligible for a deduction under
the ‘blackhole’ provisions.
Figure 2.7 provides an overview of the capital allowance rules, which are then discussed in more detail.
FIGURE 2.7
Depreciation flowchart
Capital allowances
non-SBEs
Non-business asset
costing $300 or less
Yes
Immediate 100%
deduction
Yes
Depreciate via lowvalue pool
Yes
Depreciate via
software
development pool
Yes
Immediate 100%
deduction
Yes
Determine effective
life
Yes
Diminishing value
based on effective life
No
Low-cost or lowvalue asset added to
low-value pool
First Year 18.75% then
37.5% per year
diminishing value
No
Computer software
development costs
allocated to software
development pool
Year 1
Year 2
Year 3
Year 4
Year 5
Nil
30%
30%
30%
10%
No
Temporary Full
Expensing
concession
(see figure 2.9)
No
General Division 40
rules apply
Apply either prime
cost of diminishing
value depreciation
No
Project pool
expenditure
No
Consider s. 40-880
blackhole provisions
Source: CPA Australia 2022.
Pdf_Folio:135
MODULE 2 Principles of Taxable Income 135
Note that figure 2.7 excludes entities engaged in primary production, exploration, prospecting or entities
that invest in carbon sink forest.
NON-BUSINESS DEPRECIATING ASSET OF $300 OR LESS
(ITAA97, S. 40-80(2))
A non-business depreciating asset costing $300 or less is eligible for an immediate 100 per cent deduction.
The asset must be used by taxpayers predominantly in deriving non-business assessable income such
as personal services and property income (e.g. investment income, rental income or personal services
income). This expenditure cannot then be allocated to a low-value pool.
These assets cannot be part of a set with a total value in excess of $300 in a tax year. For example,
consider a set of eight books costing $500 that are sold as one package for learning to speak French. Even
though each individual book costs less than $300, this purchase would not be eligible as the books are part
of a set costing over $300. Further, the taxpayer cannot acquire one or more assets identical or substantially
the same in a tax year where the aggregate cost is more than $300.
LOW-VALUE POOL (ITAA97, SUBDIVISION 40-E)
Taxpayers can choose to claim the decline in the value of a depreciating asset via a low-value pool. Assets
can be depreciated using the low-value pool if they are a low-cost asset (costs less than $1000 excluding
GST) or a low-value asset (s. 40-425). A low-value asset is one which has been depreciated using the
diminishing value method, and its opening adjustable value for the current year (see ‘Adjustable value’)
is less than $1000 (s. 40-425(5)). Note: It is important to clearly differentiate between low-cost and lowvalue assets.
The closing value of the low-value pool for the previous tax year is depreciated at an annual diminishing
value rate of 37.5 per cent (s. 40-440). If a low-cost asset or a second element cost is allocated to the pool
during the income year, then the deduction is 18.75 per cent in the first year. When a low-value asset is
allocated to the pool, the deduction rate is 37.5 per cent starting from the year of allocation.
If a taxpayer chooses to create a low-value pool and allocate a low-cost asset to it, then all other lowcost assets acquired in the current or future years must be allocated in that pool (s. 40-430(1)). It is not
compulsory to add low-value assets to the pool and the taxpayer can decide on an asset-by-asset basis
whether or not to do so. Once an asset is allocated to the low-value pool, it must stay in that pool for the
duration of its life (s. 40-430(2)).
If the asset is used partly for business use, and partly for personal use, only the cost of the business-use
component is allocated to the low-value pool.
Example 2.24 demonstrates the application of the low-value pool.
EXAMPLE 2.24
Low-Value Pool
The closing balance of the low-value pool of Main Ltd (Main) for the year ended 30 June 2021 was $4500.
During the 2021–22 tax year, Main acquired a depreciating asset for $950 and its taxable use percentage
of 85 per cent was allocated to its low-value pool. Main also added to its low-value pool a low-value asset
(100 per cent taxable usage) that had been depreciated under the diminishing value method to $980 as
at 30 June 2021.
The closing value of Main’s low-value pool for the 2021–22 tax year is determined as follows.
Asset
New low-cost asset allocated to the pool for
the 2021–22 tax year
37.5% write-off of closing balance from
2020–21 ($4500 plus $980 for the lowvalue asset added at the start of the tax
year)
Total decline in value
Closing value of low-value pool
Pdf_Folio:136
136 Australia Taxation
Calculation
Amount
($)
18.75% × ($950 × 85%)
151
37.5% × ($4500 + $980)
2055
$4500 + $980 + ($950 × 85%) – $2206
2206
4082
COMPUTER SOFTWARE
Expenditure on developing, or having another entity develop, computer software that is intended to be used
solely for a taxable purpose (not for sale) is known as ‘in-house software’. In-house software is capital in
nature and the cost maybe allocated to a software development pool (Subdivision 40-E) or treated as inhouse software, which is written off under the general capital allowance provisions over five years under
(s. 40-95(7)) (see ATO 2019).
If expenditure on software development is not solely for a taxable purpose, it cannot be allocated to
a software development pool, and must be capitalised and treated as in-house software. Off-the-shelf
software (software that is mass-produced, which can be purchased in its completed state and suitable for
immediate use such as accounting software) cannot be included in a software development pool, but would
also be treated as in-house software.
Non-capital software costs can be deducted as a general deduction under s. 8-1 of ITAA97 provided the
costs satisfy the requirements of that section. These costs would include the cost of making minor changes,
correcting faults and the cost of updating software to function correctly on different devices.
Computer software expenses may be deducted in the following ways (see figure 2.8).
• Off-the-shelf software with an effective life of one year or less is fully deductible in the year
purchased (s. 8-1).
• Periodic licence payments for the use of software are deductible in the year incurred (s. 8-1).
• Software costing $300 or less that is not used to earn business income is fully deductible in the year
purchased (see ‘Non-business depreciating asset of $300 or less’).
• An SBE can use the simplified depreciation rules for software installed ready for use.
• Off-the-shelf software can be depreciated using the prime cost method of depreciation with an effective
life of five years.
• Expenditure incurred in developing (or having developed) in-house software may be allocated to a
software development pool (see ‘Allocating to the software development pool’).
• Expenditure incurred in developing (or having another entity develop) in-house software, that is not
allocated to a software development pool, can be depreciated as in-house software over five years using
prime cost (ITAA97, Item 8, s. 40-95(7)).
In-house software is defined in s. 995-1 of ITAA97 as:
• software that you acquire or develop (or have another entity develop) that is mainly for your use in
performing the functions for which it was developed
• software that is not deductible outside Division 40 of ITAA97 or the simplified capital allowance rules
for small business entities.
Allocating to the Software Development Pool
Once a taxpayer chooses to create a software development pool, the choice is irrevocable (ITAA97,
s. 40-450). Any expenditure incurred in developing software must be allocated to the pool. It must also be
written off in the pool if the project is terminated or abandoned. Any consideration for disposal of pooled
software is included in assessable income unless rollover relief applies.
Expenditure allocated to a software development pool declines in value at the following rate using the
prime cost method.
• first year: Nil
• second year: 30 per cent
• third year: 30 per cent
• fourth year: 30 per cent
• fifth year: 10 per cent.
A separate software development pool must be created for each separate software development project
(s. 40-450(4)). Figure 2.8 summarises the deductions for software.
Pdf_Folio:137
MODULE 2 Principles of Taxable Income 137
FIGURE 2.8
Deductions for software
Commercial off-the-shelf
with effective life less
than one year or
periodic licence payments
Deductible in full
Yes
No
SBE entity
In-house software still
in development
Yes
No
Simplified depreciation
via instant write-off
or SBE asset pool
No
Yes
Hold in-house business
software ready for use
Yes
From 1 July 2015: Prime cost
method of depreciation with
an effective life of five years
No
Still in development
stage
From 1 July 2015
Year 1: Nil
Year 2: 30%
Year 3: 30%
Year 4: 30%
Year 5: 10%
Source: CPA Australia 2022.
QUESTION 2.17
Vianden Pty Ltd (Vianden) creates computer games for children. To keep up with the current quality
of computer graphics, Vianden has commissioned two companies to develop software that will be
used solely to improve the quality of graphics in its new games being developed for sale. The first
project was commissioned in May 2022 and the full cost of $45 000 was paid in June 2022. The
second project was commissioned in September 2022 and the full cost of $20 000 will be paid in
January 2023. Vianden plans to allocate the cost of this software to a software development pool.
Determine the deduction that Vianden can claim via the software development provisions over
the life of the pools.
GENERAL RULES AND DETERMINING EFFECTIVE LIFE
The general method of depreciation, based on the decline in effective life, applies to all depreciating assets
that are not subject to specific depreciation rules, such as allocation to a low-value pool, immediate writeoff or in-house software development pool.
There are two methods used to work out the decline in value of a depreciating asset: prime cost method
or diminishing value method. A taxpayer can generally choose to use either method for each depreciating
Pdf_Folio:138
138 Australia Taxation
asset acquired. Once the taxpayer has chosen a method for a particular asset, they cannot change to another
method for that particular asset. Diminishing value gives higher deductions in the early years but these
reduce over time. The prime cost method spreads the deduction evenly over the effective life of the asset and
therefore gives smaller deductions in the early years but higher deductions in later years. Many taxpayers
select the diminishing value method as it gives the deductions earlier, but if the taxpayer is in a tax loss
situation, they may prefer the prime cost method to move the capital allowance deduction into later years
when there is taxable income.
Diminishing Value Formula
If the taxpayer started to hold the depreciating asset before 10 May 2006, the decline in value is calculated
under s. 40-70 of ITAA97 using the following diminishing value formula.
Days held
150%
×
365
Asset’s effective life
If the taxpayer starts to hold the depreciating asset on or after 10 May 2006, the diminishing value
formula under s. 40-72 is as follows.
Days held
200%
×
Base value ×
365
Asset’s effective life
To start to hold the depreciating asset on or after 10 May 2006, the taxpayer must have either:
• started construction of the asset on or after 10 May 2006
• held the asset in some other way on or after 10 May 2006.
Base value ×
Prime Cost Formula
The general formula for the prime cost method under s. 40-75(1) is as follows.
Days held
200%
×
365
Asset’s effective life
However, an adjusted prime cost formula must be used in later tax years under s. 40-75(2) if any of the
following circumstances occur in a subsequent tax year.
• The asset’s effective life is recalculated.
• A second element cost is incurred in a year after the tax year in which the start time occurred.
• There is an application of the commercial debt forgiveness provisions that reduces the asset’s opening
adjustable value.
• Certain GST adjustments are made under Subdivision 27-B of ITAA97.
• There is a change in the asset’s opening adjustable value due to short-term foreign exchange (FX)
realisation gains and losses.
In these circumstances, the prime cost formula is adjusted under s. 40-75(3) from the year in which the
change arose as follows.
Asset’s cost ×
Opening adjustable value
for the change year plus
×
any second element of
cost for that year
Days held
365
×
100%
Asset’s remaining effective life
Definitions
The ‘cost’ of a depreciating asset is the sum of two elements less any entitlement to input credits for
GST. For example, if an entity registered for GST purchases a depreciating asset for $110 000 (including
GST), the cost of the depreciating asset for the purpose of Division 40 of ITAA97 will be $100 000
($110 000 – $10 000 GST), provided the taxpayer is entitled to the full GST credit (see module 6). However,
if the taxpayer is not registered for GST, and uses the asset wholly for a taxable purpose, the cost is $110 000
as they are not entitled to any GST credit.
The two cost elements are known as the first and second elements (s. 40-175). The ‘first element of
cost’ is either an amount specified in the table in s. 40-180(2) or, if no amount is specified, what it cost the
taxpayer to start holding the depreciating asset, which is generally the amount paid (see example 2.25).
The ‘second element of cost’ is the additional cost to bring the asset to its present condition and location
after the taxpayer starts to hold the asset (s. 40-190).
‘Effective life’ is the estimated period a depreciating asset can be used by any entity for a taxable
purpose, or for the purpose of producing exempt income or NANE income, or for conducting research
Pdf_Folio:139
MODULE 2 Principles of Taxable Income 139
and development activities. Effective life of an asset can be self-assessed or the Commissioner’s estimates
can be used (s. 40-95) (see www.depreciationrates.net.au/table). In some cases, the effective life of an asset
is replaced with an accelerated depreciation rate or is specified by legislation (s. 40-95(7)).
To self-assess effective life, assume the asset will be subject to wear and tear at a rate that is reasonable
for the taxpayer’s expected usage and will be maintained in reasonably good order and condition. Effective
life is expressed in years and can include fractions of a year. A taxpayer may choose to recalculate the
effective life of a depreciating asset if its current effective life is no longer accurate due to a change in
circumstances relating to the use of the asset such as changes in technology, redundancy or changes in the
environment where the asset is used.
‘Base value’ is only relevant where the diminishing value formula is selected. In the first year, the base
value is the cost of the asset (s. 40-70(1)). In later years, it will be the asset’s opening adjustable value plus
any second element cost added in a subsequent year.
Days held is the number of days that a taxpayer has held the depreciating asset for any purpose
(s. 40-70(1)). The days held for an item that is purchased during the tax year includes the day purchased
plus the remainder of days the asset is installed for any purpose. Days held for an asset that ceases to be
used for any purpose during the tax year includes the last day. If the tax year is a leap year, and the asset is
held for the whole year, the total number of days held in the year is 366, even though the denominator in
the formula for calculating depreciation under both the diminishing value and prime cost methods is fixed
at 365 (ss. 40-72 and 40-75).
‘Adjustable value’ is the cost of the asset less the decline in value to a particular time, if any. Where
an asset has yet to be used or is installed ready for use for any purpose, the adjustable value is the asset’s
cost (s. 40-85(1)(a)). For the first year and subsequent years the asset is held, the adjustable value is the
asset’s opening adjustable value for that year, plus any additional second element cost for that year, less
the asset’s decline in value for that year up to that time (s. 40-85(1)(c)). The decline in value is not the
deductible amount, which may be reduced if not fully used for income purposes, but it is the actual decline
in value based on the asset’s cost and effective life.
Examples 2.25 and 2.26 demonstrate the application of the general depreciation rules.
EXAMPLE 2.25
Cost for Depreciating Asset
Nick Lim, a painter, buys a panel van from Alex Pham. The agreement for the purchase of the panel van
is that Nick will:
• pay Alex $2000 in cash excluding GST
• paint Alex’s house (market value of this service is $3000)
• undertake maintenance work for Alex for the next three years (market value $1000 per year).
For the purposes of Division 40 of ITAA97, the cost of the panel van is $8000 ($2000 + $3000 + ($1000
× 3 years)), which is below the car limit of $60 733 (2021–22); therefore, the full $8000 will be the cost of
the panel van for depreciation purposes.
EXAMPLE 2.26
Comparing Diminishing Value and Prime Cost Methods
Tony Dalton acquires a depreciating asset on 29 July 2021 and immediately uses it for a taxable purpose.
The number of days Tony holds the asset in 2021–22 is 337 days. The denominator is 365 as given in
the legislated formula. Assume the depreciating asset cost Tony $10 000 (excluding GST), and has an
effective life of 10 years.
For Tony, reflect on the decline in value of the asset and the adjustable value for the 2021–22 and
2022–23 tax years using the diminishing value and prime cost methods. Tony continues to use the asset
wholly for income-producing purposes.
Diminishing value method 2021–22:
$10 000 ×
(
) (
)
337
200%
×
= $1846.58
365
10
Adjustable value at 30 June 2022 is $8153.42 ($10 000 – $1846.58).
Pdf_Folio:140
140 Australia Taxation
Diminishing value method 2022–23:
) ( 365 ) ( 200% )
$10 000 – $1846.58 ×
×
= $1630.68
365
10
(
Adjustable value at 30 June 2023 is $6522.74 ($8153.42 – $1630.68). Note: If the full year was a leap
year, the factor of 366/365 would be used.
Prime cost method 2021–22:
$10 000 ×
(
) (
)
100%
337
×
= $923.29
365
10
Adjustable value at 30 June 2022 is $9076.71 ($10 000 – $923.29).
Prime cost method 2022–23:
$10 000 ×
(
) (
)
365
100%
×
= $1000
365
10
Adjustable value at 30 June 2022 is $8076.71 ($9076.71 – $1000).
BALANCING ADJUSTMENT (SUBDIVISION 40-D)
A balancing adjustment event arises where an entity:
• stops holding a depreciating asset (e.g. due to disposal, loss or theft, conversion to trading stock or death)
• stops using a depreciating asset or having it installed for any purpose and expects never to use it again
(e.g. business cessation)
• has not used a depreciating asset and decides never to use it
• changes its interest or holding of a depreciating partnership asset (s. 40-295).
When a balancing adjustment event occurs, the asset’s adjustable value at the time of the event is
compared to its termination value. If the termination value is greater than the adjustable value, the taxpayer
includes the excess in their assessable income (s. 40-285(1)). If the termination value is less than the
adjustable value, then the taxpayer can deduct the difference (s. 40-285(2)).
Termination value is defined in s. 40-300(2) as the amount the taxpayer received, or is taken to have
received, as a result of the balancing adjustment event, and is reduced by any GST payable on the supply.
Termination value of the depreciating asset is set by s. 40-300(2) in some specified circumstances; for
example, it is zero for in-house software never to be used again.
Example 2.27 demonstrates the tax effect of a balancing adjustment event.
EXAMPLE 2.27
Tax Effect of a Balancing Adjustment Event
Bobbie Blackwell purchased a machine that she held for two years and used wholly for a taxable purpose.
She then sold it for $2750 including GST. Its adjustable value at the time of sale was $2200. Consider the
tax effect of the balancing adjustment event.
The sale value of $2750 includes GST so it is necessary to deduct GST to determine the termination
value of the machine. The GST is $250 ($2750 × 1/11) giving a termination value of $2500 ($2750 – $250).
As the termination value of $2500 is greater than the adjustable value of $2200 at the time of sale, the
difference of $300 ($2500 – $2200) is included in Bobbie’s assessable income as an assessable balancing
adjustment amount.
Reduction for Non-Taxable Use
Where a depreciating asset has not been used solely for a taxable purpose, the balancing adjustment is
reduced by the amount that is attributable to the non-taxable portion using the following reduction formula
(s. 40-290).
Sum of reductions for a non-taxable purpose
× Balance adjustment amount
Decline in value of depreciating asset since start time
Pdf_Folio:141
MODULE 2 Principles of Taxable Income 141
Balancing Adjustment Events in a Low-Value Pool
Special rules apply where a balancing adjustment event happens to a depreciating asset that has been
allocated to a low-value pool (ITAA97, s. 40-445). When this occurs, the pool’s closing balance for that
year is reduced (but not below zero) by the taxable use percentage of the asset’s termination value.
If the termination value of a pooled asset exceeds the pool closing balance, the excess is included in the
taxpayer’s assessable income.
Relief for Involuntary Disposals
Rollover relief may apply where a depreciating asset ceases to be held by a taxpayer because it is:
• lost or destroyed
• compulsorily acquired by an Australian government agency
• disposed of to a private acquirer under a statutory power of compulsory acquisition,
• other than compulsory acquisition of minority interest under the Corporations Act 2001 (Cwlth)
• disposed of to an entity (other than a foreign government agency) under threat of compulsory acquisition
• fixed to land that is compulsorily subject to a mining lease and disposed of to the lessee (other than a
foreign government agency)
• fixed to land that is disposed of to an entity that would have been the lessee (other than a foreign
government agency) in circumstances where a mining lease would have been compulsorily granted
if the land had not been disposed of, and the lease would have significantly affected the taxpayer’s use
of the land (s. 40-365(2)).
If any of these conditions apply, the taxpayer can reduce the amount of assessable balancing adjustment
by applying all or part of the balancing adjustment amount to reducing the cost of a replacement asset
(s. 40-365(1)).
If the taxpayer chooses to apply the balancing adjustment amount against the cost of a replacement
asset, the taxpayer must incur expenditure on the replacement asset, or must start to hold it:
• no earlier than one year before the involuntary disposal occurred, and
• no later than one year after the end of the tax year in which the involuntary disposal occurred
(s. 40-365(3)).
In addition, the taxpayer must have used the replacement asset, or have it installed ready for use, wholly
for a taxable purpose by the end of the tax year in which the taxpayer incurred the expenditure on the asset,
or started to hold it, and be able to deduct an amount for it (s. 40-365(4)). Note that the replacement asset
does not have to fulfil the same function as the original asset.
The amount covered by the choice is applied in reduction of either:
• the cost of the replacement asset — where the replacement asset’s start time occurs in the current year
• the sum of the replacement asset’s opening adjustable value for a later year and any amount included
in the second element of its cost for that year — where the replacement asset’s start time occurs in an
earlier year (s. 40-365(5)).
Other than for an involuntary disposal, there is no other provision to offset the balancing adjustment
against a replacement asset under the general provisions in Division 40 of ITAA97.
Rollover Relief
Where a depreciating asset is transferred between certain related entities and CGT rollover relief is
available (see section ‘Rollover provisions and other reliefs’ in module 3), then no balancing adjustment
amount arises immediately (s. 328-425 of ITAA97). The balancing adjustment is effectively deferred until
the next balancing adjustment event occurs.
TEMPORARY 100 PER CENT ASSET WRITE-OFF FOR
BUSINESS USE
As a result of the economic impact of COVID-19 restrictions, the Federal government implemented a
number of temporary concessional deduction provisions for depreciating assets (instant assets write-off,
temporary full expensing and accelerated depreciation), with the aim of stimulating economic activity.
Most of these provisions allowed for a 100 per cent deduction for the business percentage use in the year
of acquisition. However, the accelerated depreciation provisions only applied to assets installed ready for
use by 30 June 2021, and the instant asset write-off concession does not apply to assets first held that were
first held from 7.30 pm (AEDT) 6 October 2020 and used or installed ready to use for taxable purpose
before 1 July 2022 and installed ready for use between 6 October 2020 and 30 June 2022. The remaining
Pdf_Folio:142
142 Australia Taxation
temporary full expensing (TFE) concession is available for 2021–22 and was extended to 2022–23 in the
2021–22 Federal Budget.
Under these temporary concessions, many of the normal rules regarding deductions for depreciating
assets were not applicable for assets acquired in 2019–20, 2020–21 and 2021–22, but these normal rules
continue to apply to previously acquired assets.
Temporary Instant Asset Write-Off
The instant asset write-off concession is not available for the 2021–22 tax year, but in previous years it
allowed an immediate deduction of 100 per cent of the business-use portion of eligible assets for eligible
entities (based on aggregated turnover). This applied to both new and second-hand assets and could
be applied to multiple assets provided each meet the required threshold of $150 000 (in 2020–21). This
concession did not apply for assets that were first held and used or installed ready to use for taxable purpose
between 7.30 pm (AEDT) on 6 October 2020 and 30 June 2022. The instant asset write-off concession
was also not available if the asset cost was equal to or more than the threshold, even if the businessuse proportion was less than the threshold. Cars were also eligible for this concession up to the relevant
car limit.
Temporary Full Expensing of Depreciating Assets
Temporary provisions enacted in Subdivision 40-BB of Income Tax (Transitional Provisions) Act 1997
(Cwlth) allow a deduction of 100 per cent of eligible capital costs incurred by eligible entities. Entities
with an aggregate turnover of less than $5 billion can claim an immediate deduction of the cost of eligible
assets that were first held from 7.30 pm (AEDT) 6 October 2020 and used or installed ready to use for
taxable purpose before 1 July 2022 (2021–22 Federal Budget proposes to extend the TFE concession to
30 June 2023). This deduction applies automatically to eligible entities unless an election is made to opt out
of this concession. (SBEs using the simplified depreciation rules cannot opt out.) For corporate taxpayers
that exceed the $5 billion turnover test, there is an alternative test based on assessable income (less than
$5 billion in 2018–19 or 2019–20), and the combined value of depreciating assets held and first used during
the period 1 July 2016 to 30 June 2019 exceeds $100 million.
For entities with a turnover under $50 million, eligible assets include new and second-hand depreciating
assets, but entities with an aggregate turnover of $50 million or more are limited to new assets. The
100 per cent deduction includes both the first and second element costs of the of the depreciating asset.
Cars are also eligible for this concession up to the car limit of $60 733 (2021–22).
The full expensing deduction is not available if:
• the asset is allocated to a low-value or software pool
• the asset is sold in the same year as acquired
• an entity with an aggregate turnover of $50 million or more made a commitment to purchase the asset
before 6 October 2020, even though it was not held or installed ready for use until after this date.
Where the TFE provisions apply, they have precedent over the other temporary measures and are
automatically applied unless the taxpayer elects not to apply them, in which case the other deprecation
options are available.
Figure 2.9 outlines the application of the temporary 100 per cent deduction for depreciating assets.
QUESTION 2.18
Miles Miller is a sole trader who operates a retail non-SBE business with a turnover of $11 million.
Three years ago, he purchased for $2500 a point-of-sale cash register to record sales and control
stock levels. On 1 November 2021, the cash register was stolen and it was not insured. The cash
register had been depreciated using the prime cost method and at the time of loss had an adjustable
value of $1750.
A second-hand replacement cash register was installed ready for use three days after the theft
(4 November 2021) and cost $4500 (excluding GST) with an effective life of 10 years.
Evaluate the tax consequences from the theft and replacement of the cash register both under the
normal application of Division 40 of ITAA97 and the TFE concession. If relevant, consider whether
Miles should apply for tax relief as a result of the theft.
Pdf_Folio:143
MODULE 2 Principles of Taxable Income 143
FIGURE 2.9
Application of the temporary 100 per cent depreciation measures
Temporary 100%
depreciation
deduction
SBE using simplified
depreciation rules
Yes
100% deduction for
new or second-hand
assets (TFE)
Write-off of closing
balance of the small
business asset pool
No
Turnover less than
$50 million
Yes
Optional 100%
deduction for new or
second-hand assets
(TFE)
No
Turnover less than
$5 billion or passes
the alternative test
Yes
New asset
Yes
Optional 100%
deduction (TFE)
No
No
General Division 40
rules apply
Source: CPA Australia 2022.
BLACKHOLE EXPENDITURE
Prior to 1 July 2001, some business capital expenditure was neither deductible, depreciable, nor included
in the cost base of a CGT asset. These expenses fell into a so-called blackhole and could not be deducted
anywhere under ITAA36 or ITAA97; they became known as ‘blackhole’ expenditure. For example, prior
to 1 July 2001 the costs associated with establishing a new business or winding up a business would not
have been deductible under any provision of the legislation.
From 1 July 2001, s. 40-880 of ITAA97 gives a deduction for business-related costs that previously
fell into this blackhole, provided they cannot be deducted under any other provision of the legislation or
included in the cost base of a CGT asset (see module 3).
The deduction for blackhole expenditure is claimed equally over five years at the rate of 20 per cent
for the year in which the business capital expenditure is incurred and 20 per cent in each of the following
four tax years. No balancing adjustment applies.
Business-related expenditure under s. 40-880(2) must be incurred by the taxpayer:
(a)
(b)
(c)
(d)
in relation to the taxpayer’s business, or
in relation to a business that used to be carried on, or
in relation to a business proposed to be carried on, or
to liquidate or deregister a company of which the taxpayer was a member, wind up a partnership of
which the taxpayer was a partner, or wind up a trust of which the taxpayer was a beneficiary, that carried
on a business.
Examples of blackhole expenditure are the costs incurred for the establishment or winding up of a
business, establishing the business structure and altering the business structure.
From 1 July 2020, taxes, government charges, and professional, legal and accounting advice incurred to
establish a new business by a taxpayer with an aggregate turnover of less than $50 million can be written
off in full under s. 40-880 in the year incurred.
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144 Australia Taxation
PROJECT POOL EXPENDITURE
Project pool expenditure is expenditure that relates to a project, but does not form part of the cost of a
depreciating asset. It can be written off over the life of the project, and this is achieved through allocating
project amounts to a project pool.
A project amount is defined under s. 40-840 to be expenditure that:
• does not form part of the cost of a depreciating asset
• is not deductible under another provision of the income tax law
• is directly connected with the business or project.
The project amount includes:
• site preparation
• feasibility studies
• environmental assessments
• obtaining rights to intellectual property
• upgrading community infrastructure.
To meet the project expenditure requirements, the project must have a finite (limited) life; this
expenditure does not generally apply to SBEs.
Determining the Project Amount, Pool Value and DV Project Pool Life
Where the project amount is incurred before 10 May 2006, the formula to use is as follows (s. 40-830(3)).
Pool value ×
150%
DV project pool life
Where the project amount is incurred on or after 10 May 2006, then the formula to use is as follows
(s. 40-832(1)).
Pool value ×
200%
DV project pool life
Pool value is defined as follows.
• Year 1 of allocation to the pool, the pool value is the sum of the project amounts allocated to the pool
for that year.
• Year 2 and subsequent, the pool value is the closing pool value for the previous tax year (project costs
allocated less amounts claimed), plus any project amounts allocated in the current year.
Pool value must be reduced by the amount of any applicable GST input credit, and the DV project pool
life is the effective life of the project, or if that life has been recalculated, the most recently recalculated
project life.
QUESTION 2.19
Prior to commencing the construction of an office building, Sunrise Building Ltd undertook an
environmental assessment in August 2021 that cost $60 000 excluding GST. Construction was
completed on 13 June 2022, and the company commenced leasing floor space from that date.
The building is expected to produce rental income for the next 30 years (its project life). Sunrise
Building can commence deducting the $60 000 environmental assessment cost in the 2021–22
tax year.
What is the deduction for project pool expenditure in the 2021–22 tax year?
QUESTION 2.20
Woolly Pty Ltd (Woolly) operates a sheep grazing property and business which is not an SBE and
has a turnover of $20 million. Over the past two years, the business has reported an accumulated
income tax loss of $1.9 million. However, in the current tax year (2021–22), it is estimated that
there will be a taxable income of $1.8 million. With increased wool prices it is also expected that
the business will generate good profits over the next three years. With the prospect of increased
profitability the management of Woolly plan to replace some aging machinery and restructure the
business at a cost of about $800 000. The expenses under consideration include the following.
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MODULE 2 Principles of Taxable Income 145
• Engaging a software company to write and install livestock management computer software.
• Purchasing new machinery with an expected life of seven years. However, it is expected that
these assets will be retained and used in the business for about 10–12 years.
• Restructuring the business to include a series of family trusts to hold the shares in Woolly.
• A feasibility study on the viability of selling wool directly to an English woollen mill for the
production of super fine material for high quality business suits.
Evaluate the choices that Woolly has in relation to how these expenses could be treated for
income tax purposes given their current tax situation, and the possible tax implication of incurring
these expenses in the current tax year or future years. Consider both the general Division 40
measures and the TFE provisions for 2021–22.
CAPITAL ALLOWANCE RULES AND SMALL
BUSINESS ENTITIES
Before explaining the capital allowance rules for small business entities, concepts relating to the definition
of an SBE will be explained. Figure 2.10 summarises the different thresholds for the small business
concessions.
FIGURE 2.10
Thresholds for small business entity concessions
SBE
Carries on a
business
Turnover threshold
for general
application
Turnover threshold
for CGT SBE
concessions
Turnover threshold
for SBE offset
Turnover threshold
for restructure
rollover
$10 million
$2 million
$5 million
$10 million
Source: CPA Australia 2022.
WHAT IS A SMALL BUSINESS ENTITY?
There are two requirements for an SBE to qualify for tax concessions (s. 328-110 of ITAA97):
1. carries on a business, and
2. satisfies the aggregated turnover test of less than $10 million, but for some of the SBE concessions the
turnover test is different (see figure 2.10).
The $10 million threshold applies to the calculation of the capital allowances discussed in ‘Capital
allowance rules for SBEs’. It also applies to other general concessions covered in module 5 and FBT
concessions covered in module 6. For the purposes of determining if a business is eligible for the small
business income tax offset, the aggregated turnover test is limited to $5 million. Finally, for the purposes
of the SBE CGT concessions, a small business entity is defined as one with an aggregated turnover of
$2 million.
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146 Australia Taxation
CARRYING ON A BUSINESS
For an entity to be an SBE it must first be carrying on a business. This will affect whether the earnings
of the business are to be included in assessable income, and whether deductions can be applied to these
earnings (see ‘Business or hobby?’ in Part A).
Example 2.28 revises the factors used to determine whether an activity amounts to the carrying on of a
business for tax purposes and could be eligible to be classified as an SBE.
EXAMPLE 2.28
Determining if a Taxpayer is Carrying on a Business
Sally Simpson works full-time as an accountant for a major accounting firm. She is also a passionate cake
decorator, and makes and sells wedding and celebration cakes in her home in her spare time.
In the last income year, Sally’s cake decorating business has increased four-fold, and she generated
$30 000 additional income from the venture, $18 000 of which is profit. Sally has spent all her spare hours
after work and every weekend making and selling cakes, and has been actively promoting her services
via social media and at wedding fairs. She is so overwhelmed with orders that she is looking at hiring an
assistant to help her on the weekends.
The factors that are most important in determining whether Sally is carrying on a business are as follows.
• The degree of system and organisation used. Where the activity is conducted on a systematic and
organised basis, it is more likely to be considered a business. This is especially important where the
activities have a commercial basis.
• Scale of activities. The size and scale of the activities are important. Are the activities of such a scale
that whatever is produced is in excess of that which would be required by the taxpayer for personal
use? The smaller the business, the more likely it is to be hobby and not a business.
• Repetitive transactions. A business activity is generally associated with regular and repetitive transactions. This is not always the case, as sometimes isolated transactions can be regarded as a business.
• Profit motive. A business operation is usually carried on in order to make a profit.
• Type of activity. Where the goods are unsuitable for personal or domestic use, this will be more indicative
of a business.
• Time. Although not decisive, the more time the taxpayer spends on the activity, the more likely it is to
be of a business nature.
(For details, see Ferguson v FCT (1979) FCA29 and Tax Ruling TR 97/11.)
Weighing up all the factors; the growing size, her profitability, the large amount of sustained effort,
advertising her cake services and taking on an employee, it is likely that Sally is carrying on a business
and will pass the first test towards being an SBE.
Note that an SBE will be taken to be carrying on a business in the year the business is wound up,
provided the taxpayer is an SBE during that period (ITAA97, s. 328-110(5)).
QUESTION 2.21
Kim Tey is a retired army officer and she plans to use her redundancy pay to start a horse breeding
activity. Her plan is to acquire a five-hectare property during the 2021–22 tax year on the outskirts of
a major city to raise and breed miniature horses for sale as pets. Kim has never owned horses before
and she has done very little research on the viability of this project, but a friend has suggested it
would be a great money earner. Being cautious, Kim decides to lease the land and only purchases
two miniature horses in 2021–22 to see how difficult they are to manage and maintain. After six
months, she has fallen in love with the horses and decides to expand the operation by purchasing
in June 2022 five more mares and one stallion at a cost of $60 000.
Unfortunately, she did not seek advice from a vet on how to feed the horses and two of the mares
died. She has also realised that she will have lots of expenses over the next two years and no
income for three years. Kim has become very fond of her horses and cannot imagine that she will
be able sell any of the foals.
Evaluate whether Kim is carrying on a business for the purposes of being eligible to be classed
as a small business for the SBE depreciation regime.
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MODULE 2 Principles of Taxable Income 147
AGGREGATED TURNOVER TEST
The second condition to qualify as an SBE is that the business must meet the aggregated turnover test
which is generally less than $10 million, but also see figure 2.10 for differing thresholds for other
SBE concessions. The aggregated turnover threshold can be satisfied using one of three tests (ITAA97,
s. 328-110), which are as follows using the $10 million threshold example.
• Aggregated turnover for the previous income year was less than $10 million.
• Aggregated turnover for the current income year is likely to be less than $10 million, as calculated on
the first day of the income year or the first day the entity commenced carrying on a business (if later).
This applies unless the aggregated turnover was $10 million or more for both the two previous years.
• Aggregated turnover for the current income year was less than $10 million as calculated at the end of
the income year.
Aggregated turnover is the sum of the annual turnover for the income year, the annual turnover of
any entity connected with the main entity during the income year, and the annual turnover of an affiliate
(s. 328-115).
CAPITAL ALLOWANCE RULES FOR SMALL BUSINESS
ENTITIES
Being classified as an SBE allows certain concessions to the general capital allowance rules, providing a
simplified method of determining the deductions (see figure 2.11). Note that it is also necessary to take
into account the temporary concessional capital allowance deduction provisions summarised in figure 2.9.
SBEs who choose to apply the small business capital allowance rules must use these rules to calculate the
deductions for all depreciating assets (except those specifically excluded). Note that this flowchart does
not consider the effects of CGT (see module 3).
FIGURE 2.11
Capital allowances for SBEs
Is the asset eligible
for TFE write-off?
Yes
100% write-off of
business use
Yes
1st year: 15%
Subsequent years:
30% dimishing value
No
Depreciating asset
added to SBE asset
pool
No
Consider s. 40-880
blackhole expenses
Yes
Immediate write-off of
business establishment
costs or claimed over
five years
No
Not deductible
Source: CPA Australia 2022.
SBEs and Temporary Full Expensing concession
SBEs using the simplified depreciation rules must claim the 100 per cent deduction under the TFE
concession for assets (no limit to value) first held from 7.30 pm (AEDT) 6 October 2020 and used or
installed ready to use for taxable purpose before 1 July 2023. In addition, the SBE must use this concession
to fully deduct the balance of their small business asset pool for the 2020–21 and 2021–22 income years.
Specifically, the amount of the pool balance to be deducted is the sum of the (s. 328-210(2)):
• pool’s opening balance for the income year
• taxable purpose proportion of the adjusted value of each depreciating asset allocated to the pool and
used in the income year
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148 Australia Taxation
• taxable purpose proportion of any additional amount incurred in the income year. For example,
upgrades and improvements to the assets in the pool less the sum of the taxable purpose proportion
of the termination value of any depreciating assets, for which a balancing adjustment event occurred
during the income year (see ‘Balancing Adjustment’).
SMALL BUSINESS ASSET POOL
Any assets that are not eligible for immediate deduction are placed in a small business asset pool. When
placed in the small business asset pool, the taxpayer can claim:
• 15 per cent deduction in the first year (regardless of when the asset was purchased or acquired during
the year) (s. 328-190(2))
• 30 per cent diminishing value deduction each year after the first year (s. 328-190(1)).
The closing value of the pool is determined using a two-step process outlined in s. 328-200 of ITAA97.
Step 1. Add to the opening value of the pool:
• the taxable purpose proportion of any assets added during the year
• any second element costs incurred that relate to existing assets in the pool.
Step 2. Deduct from the amount calculated in step 1:
• the taxable purpose proportion of any assets removed from the pool
• the tax deduction of 30 per cent on the opening value of the pool
• the tax deduction of 15 per cent of amounts added to the pool during the current year
• the tax deduction of 15 per cent of second element costs incurred that relate to existing assets.
If an SBE chooses to stop using the small business capital allowance rules, the general capital allowance
rules for non-SBEs will apply to the acquisition of future assets. However, any assets that are currently in
the small business asset pool will continue to be depreciated in that pool. The previous lockout rules that
prevent SBEs from accessing the simplified depreciation regime for five years after opting out, have been
suspended for the 2020–21 and 2021–22 years.
Prior to the introduction of TFE concession, the balance of the small business asset pool at the end of
the income year could be written off in full if it was less than the instant asset write-off threshold for that
year (e.g. $150 000 for 2020–21).
Example 2.29 demonstrates how to evaluate the tax implications for a small business entity’s asset writeoff and general pool deductions.
EXAMPLE 2.29
Small Business Entity Depreciation Claim
Paul O’Leary, an eligible SBE taxpayer, purchased a commercial refrigerator for $26 000 (exclusive of GST)
on 2 September 2021. Paul estimates that the refrigerator will be used 70 per cent for business purposes
over its four-year effective life. Consider the depreciation deduction that Paul can claim on the refrigerator.
Paul can claim $18 200 ($26 000 × 70%) as an immediate deduction for the 2021–22 tax year under the
TFE concession.
In years when TFE did not apply (or any other immediate deduction concession), Paul could include the
business-use percentage of the cost of the refrigerator in his general small business asset pool and claim
a deduction of $2730 (15% x ($26 000 x 70%)).
QUESTION 2.22
Trend Pty Ltd (Trend) is an SBE that operates a printing business and currently has an existing SBE
asset pool with a closing value for 2020–21 of $158 000. During 2021–22, Trend made the following
transactions.
• Purchased (1 April 2022) a new car costing $77 000 (including GST) and used it 100 per cent for
income producing purposes.
• Sold a vehicle for $11 000 (including GST) as a trade-in on the new car. The vehicle sold had been
used 80 per cent for income producing purposes.
• Carried out a major upgrade of printing equipment at a cost of $45 000 (1 July 2021). The
equipment that was upgraded had been added to the SBE asset pool in 2020–21 and is used
wholly for income producing purposes.
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MODULE 2 Principles of Taxable Income 149
(a) For the 2021–22 tax year, disregarding TFE, evaluate what depreciation deduction would be
available for Trend and determine the closing value of the SBE asset pool.
(b) What deduction would be available in 2021–22 under the TFE concessions?
BLACKHOLE EXPENDITURE AND START-UP EXPENDITURE
Taxpayers not yet carrying on a business are allowed to claim specific deductions immediately when
starting up a small business (ITAA97, s. 40-880(2A)). This deduction relates to certain start-up capital
expenditure that would otherwise be deducted over five years under s. 40-880 of ITAA97 (see also
‘Blackhole expenditure’).
For the deduction to apply, it must relate to capital expenditure for a proposed business. The expense
needs to be incurred through the obtaining of professional advice or services about the structure or
operation of the proposed business. It can also be a tax, charge or fee paid to an Australian government
agency relating to the establishment or ongoing structure of the business.
An SBE must also satisfy the turnover threshold of less than $10 million. Also, from 1 July 2020, nonSBEs with an aggregate turnover of less than $50 million are also eligible for the 100 per cent deduction.
Example 2.30 demonstrates the application of s. 40-880.
EXAMPLE 2.30
Determining if a Start-up Expense can be Immediately Deducted
Ziggy Pty Ltd (Ziggy) is an SBE and is in the process of setting up a dance supplies company. Ziggy is
uncertain as to the best way to set up its ownership structure. The directors of Ziggy obtain advice from
a lawyer and from a consultant in order to assist them in determining the best structure.
Reflect on whether Ziggy can obtain an immediate deduction for the cost of advice regarding the best
structure for the dance supplies company.
As Ziggy is an SBE and the start-up expenditure rules apply to the costs of obtaining this advice, it can
be fully deducted in the income year in which it is incurred.
QUESTION 2.23
WritingNow is an SBE sole trader with a turnover of $200 000 per year from selling news articles
to TV stations, which uses the simplified depreciation regime. On 1 August 2021, WritingNow
purchased a new car for $32 000, a new set of office furniture for $9000, a new printer for $700,
a new laptop for $1300 and a second-hand bookcase for business reference materials for $4000
(all used in the 2021–22 tax year and exclusive of GST). The printer and the laptop are both
100 per cent business use, the furniture and the bookcase are both 80 per cent business use and
the car is used 50 per cent for business.
Determine the capital allowance deduction for 2021–22 tax year for WritingNow.
QUESTION 2.24
Beverly De Lavaux is employed as a pilot and she also owns a property (Hill Side) that she purchased
in 2002 and rents out for residential accommodation. On 1 February 2022, she purchased a second
property (Tree View) which she also intends to rent out for residential purposes. Beverly has an
expected turnover of $75 000 from the two properties and the transactions for each property in
2021–22 include the following.
1. Hill Side:
• Replaced the free-standing washing machine with a second-hand refurbished washing
machine as the current washing machine could not be repaired.
• Second-hand furniture purchased and installed on April 2017, has been depreciated using the
diminishing value method.
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150 Australia Taxation
• Replaced the kitchen benchtop with the same granite top because it had been damaged by
the tenant.
• Installed a built-in spa with tile surrounds matching the other tiles in the bathroom.
2. Tree View:
• The purchase price of Tree view was $800 000 and included the existing curtains and
other furniture.
• Commenced renting the property in March 2022.
• Purchased a new lounge suite, beds and kitchen table for $14 000 (1 March 2022) and installed
them in the property.
Evaluate what capital allowance provisions are available to Beverly in relation to both properties.
CAPITAL WORKS
Types of Capital Works
Capital works relate to buildings and structural improvements that are used in producing assessable income,
or in carrying on research and development activities.
Division 43 of ITAA97 allows the taxpayer a deduction for capital works that are used to produce
assessable income. These provisions provide a deduction for construction expenditure on capital works
used to produce assessable income or carrying on research and development activities. Assets deducted
under Division 43 are excluded from deduction under the Division 40 general capital allowances provisions
previously discussed. These terms are defined as follows.
Capital works refers to buildings, structural improvements and environmental improvement earthworks, and any extensions, alterations and improvements to them. This also applies to rental properties
(s. 43-20).
Construction expenditure is the capital expenditure incurred in the construction of capital works. It
includes actual construction cost and other costs such as architect fees, engineering fees, permit costs
associated with obtaining approval for the construction and the cost of foundation excavations.
Structural improvements are not specifically defined in the legislation. Examples include sealed
roads, sealed driveways, sealed car parks, bridges, pipelines, fences and concrete or rock dams.
Figure 2.12 summarises the different requirements for capital works.
Capital works requirements
FIGURE 2.12
Capital works
Types of
construction
Date of
commencement
Deductions
2.5% or 4%
Apportionment
Source: CPA Australia 2022.
Example 2.31 demonstrates the eligibility for a capital works deduction under Division 43.
EXAMPLE 2.31
Capital Works Deduction
Shaun Stock owns a rental property that produces assessable income. He has recently completed
extensions to the property; a new outdoor entertaining area and garage. As part of these extensions,
the driveway was sealed and new retaining walls were built.
In this situation Shaun would be eligible for a deduction under Division 43 of ITAA97. Shaun would
be able to claim a capital works deduction for these improvements as they satisfy the definition of
construction expenditure and structural improvements.
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MODULE 2 Principles of Taxable Income 151
Calculating Capital Works Deductions
Rate of Deduction and Rules When Applying Deduction
To calculate the rate of the capital works deduction (ITAA97, s. 43-10), three elements are needed:
• the type of capital works
• the extent to which it is used for income-producing purposes/research and development activities
• the date construction commenced.
There are also rules applying to calculating the capital works deduction and they are as follows.
• The deduction can be claimed from the date construction was completed.
• Generally, it is the owner of the building who is entitled to claim the deduction, but this can be transferred
to an eligible lessee or quasi-ownership rights holder.
• Construction commencement date requires a physical start, usually the pouring of foundations.
• The deduction is apportioned between income-producing and non-income producing purposes, as well
as any different income-producing purposes.
• The deduction commences on the day the building is first used for income-producing purposes after
construction is completed.
• If the actual construction costs cannot be determined, an estimate from a quantity surveyor or other
independent qualified person can be used.
• The capital works expenses incurred reduce the cost base of the property for CGT purposes. If the
taxpayer claims the capital works deduction, that will need to be considered when determining a capital
gain or loss (see module 3).
Type of Construction and Date of Commencement
The rates of capital works deductions are based on a prime cost rate of either 2.5 per cent or 4 per cent
(s. 43-25), depending on the type of capital works, the date construction began and how the capital works
are used.
Table 2.6 lists various types of construction along with the date at which work must have commenced
for the taxpayer to be eligible to claim a capital works deduction. For each type of construction, it also
shows the rate of deduction and the period over which the deduction can be claimed.
TABLE 2.6
Capital works deductions for buildings and structural improvements
Types of construction
Construction
commenced after
Deduction rate applicable years
Building intended to be used on completion
to provide short-term accommodation to
travellers in:
• apartment buildings in which you own or
lease at least 10 apartments
• units or flats
• hotels
• motels
• guest houses with at least 10 bedrooms.
21.08.79
22.08.79 –21.08.84 —2.5%
22.08.84 – 15.09.87 —4%
16.09.87 – 26.02.92 —2.5% (where
the construction related to certain pre16.09.87 contracts, the rate is 4%)
27.02.92 onwards —4%
Building intended to be used on completion
for non-residential purposes such as a shop
or office.
19.07.82
20.07.82 – 21.08.84 —2.5%
22.08.84 – 15.09.87 —4%
16.09.87 onwards —2.5%
Building intended to be used wholly or mainly
for industrial activities.
26.02.92
27.02.92 onwards —4%
Any building intended to be used on
completion for residential purposes or to
produce income.
17.07.85
18.07.85 – 15.09.87 —4%
16.09.87 – onwards —2.5% (where
the construction related to certain pre16.09.87 contracts, the rate is4%)
Structural improvements intended to be used
on completion for residential purposes or to
produce income.
26.02.92
27.02.92 onwards —2.5%
Environment protection earthworks intended
to be used on completion for residential
purposes or to produce income.
18.08.92
18.08.92 onwards —2.5%
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152 Australia Taxation
Any capital works used to produce income,
even if they were not intended to be used for
that purpose. For pre-01.07.97 works only,
the capital works must have been intended
for use for specified purposes at the time of
completion.
30.06.97
The capital works must actually be
used in a deductible way in the income
year in which the deduction is claimed
(see onwards rates details earlier in the
table for each type of construction).
Note: 2.5 per cent means that deductions can be claimed over 40 years and 4 per cent means they are claimed over 25 years.
Source: ATO 2021e, ‘The type of construction and the date construction commenced’, accessed February 2022,
www.ato.gov.au/Individuals/Investments-and-assets/In-detail/Rental-properties/Work-out-your-capital-works-deductions/?
page=1#Typesofconstructionandthedateconstructio.
Note: Section 43-150 defines industrial activities as including manufacturing operations, metal refining
and extraction from ore, petroleum refining, timber milling and a range of processes used for fresh produce
such as milk and meat.
Example 2.32 demonstrates the calculation of the allowable deductions for qualifying expenditure on
capital works.
EXAMPLE 2.32
Capital Works Deductions and Changing Use
A taxpayer commences construction of a 30-unit motel on 15 January 2020. Construction is completed on
30 June 2021 and qualifying expenditure is $1 million. From 1 July 2021 until 31 January 2022, the whole
of the motel is available to travellers. However, from 1 February 2022, the taxpayer leases 10 units for six
months to a company as accommodation for its employees. Consider what deductions are available in
2021–22 under Division 43 of ITAA97.
The whole motel was used in the prescribed 4 per cent manner (table 2.6) from 1 July 2021 until
31 January 2022 because all 30 units were wholly used for short-term traveller accommodation.
However, only 20 of the 30 units were used as short-term accommodation in the prescribed 4 per cent
manner from 1 February 2022 to 30 June 2022. The remaining 10 units are deductible at a 2.5 per cent rate
for that period because they were used for other income-producing purposes (i.e. rental accommodation,
see table 2.6).
The total allowable deduction for the 2021–22 tax year is as follows. Deductions only start when
construction is completed, and it is used for income-producing purposes.
• 1 July 2021 to 31 January 2022:
$1 000 000 × 0.04 ×
• 1 February 2022 to 30 June 2022:
$1 000 000 × 0.04 ×
• 1 February 2022 to 30 June 2022:
215
days = $23 562
365
150
20
days ×
units = $10 959
365
30
$1 000 000 × 0.025 ×
150
10
days ×
units = $3425
365
30
The formula in s. 43-210 requires the use of 365 days as the denominator even in a leap year, although
the days used will be based on a 366-day year in a leap year.
QUESTION 2.25
On 1 October 2021, Matthew Miller purchased a rental property for $425 000 and immediately rented
it out. Matthew received a report from a quantity surveyor stating that:
• construction of the property commenced in February 2005
• the property was a residential townhouse
• construction was completed in November 2005
• the townhouse was built by a developer
• the estimated cost of constructing the townhouse was $200 000.
Calculate Matthew’s capital works deduction claim in the 2021–22 tax year.
Source: Adapted from ATO 2021d, ‘Rental properties: Claiming capital works deductions’, accessed February 2022,
www.ato.gov.au/Individuals/Investments-and-assets/In-detail/Rental-properties/Work-out-your-capital-works-deductions.
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MODULE 2 Principles of Taxable Income 153
QUESTION 2.26
FineFoods Pty Ltd (FineFoods) purchased a large retail and restaurant building on 1 April 2022.
FineFoods immediately occupied the building to commence trading as a new Asian fusion restaurant and bar. The building was originally built in 2002 at a cost of $325 000. Construction commenced
on 1 May 2002 and was completed on 12 November 2002.
FineFoods is classified as an SBE and applies the simplified depreciation rules.
FineFoods made the following purchases on 1 April 2022 to commence business:
• coffee machine: $6000
• industrial oven: $165 000
• freestanding preparation benches: $8000.
Part 1
Determine the following capital allowances FineFoods can claim in the 2021–22 income tax year.
(a) Capital works deduction
(b) Deductions on depreciating assets
Part 2
Assume that FineFoods has been operating for five years (with other restaurants in other
locations) and has elected to not be classified as an SBE for the 2021–22 income tax year.
FineFoods purchased specialist refrigerator units across its businesses for a cost of $65 000
(excluding GST) on 5 March 2022. FineFoods determines that the effective life of the equipment
is 9.5 years.
FineFoods purchased $2000 worth of low-cost assets in 2021–22 and allocated them to its lowvalue pool. The closing balance of the low-value pool on 30 June 2021 was $18 000.
(a) Calculate the depreciation claimable for the specialist refrigerator units using the diminishing
value method.
(b) Calculate the capital allowance attributable to the low-value pool for the 2021–22 income
tax year.
2.8 TRADING STOCK CORE CONCEPTS
Part A builds an understanding of the determination of taxable income, which is what taxpayers are taxed
on, and to this point the module has covered the components of taxable income (assessable income and
allowable deductions) separately. However, as shown in figure 2.13 the tax treatment of trading stock
requires an application of both assessable and deductible amounts.
FIGURE 2.13
Trading stock
Taxable income = Assessable income – Deductions
Assessable income
Ordinary income
Trading stock
(Assessable income
and deductions)
Deductions
General deductions
Specific deductions
Statutory income
Limitations to
deductions
Non-assessable
income (excluded)
Substantiation
Derivation
Capital allowances
Source: CPA Australia 2022.
A taxpayer derives ordinary income from the sale of trading stock under s. 6-5 of ITAA97 and is allowed
a deduction under s. 8-1 of ITAA97 for the cost of purchasing trading stock. However, Division 70 of
ITAA97 also affects the tax treatment of trading stock by taking into account the opening and closing
trading stock values. Division 70 deals specifically with:
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154 Australia Taxation
•
•
•
•
the definition of trading stock for tax purposes and whether it is on hand
taking the opening and closing values of trading stock into account
the methods of valuing opening and closing trading stock
valuation rules for special events such as sales not in the ordinary course of business.
DEFINITION OF TRADING STOCK AND WHETHER ON HAND
Trading stock is defined in s. 70-10 of ITAA97 to include anything produced, manufactured or acquired
that is held for the purposes of manufacture, sale or exchange in the ordinary course of business. It also
specifically includes livestock. Accountants may refer to trading stock as inventory.
Some examples are as follows.
• The purchase of a mine is capital; the minerals (when extracted) constitute trading stock.
• Shares are trading stock if the shares are traded rather than held as a longer term investment.
• Land is trading stock when held by a property developer for resale.
The question as to whether trading stock is ‘on hand’ is important in determining when purchases are
deductible under s. 8-1 and what stock must be valued at the end of the year for tax purposes (ITAA97,
ss. 70-15 and 70-35).
Goods invoiced but not in the physical possession of the taxpayer (e.g. in transit) are regarded as stock
on hand if the owner has the power to dispose of the stock (All States Frozen Foods Pty Ltd v FCT (1990)
90 ATC 4175). In other words, stock on hand is not a question of physical possession. The issue lies with
whether the taxpayer has the legal power to dispose of the goods. As such, the terms of shipment are crucial
as this will determine who owns the stock and when.
Section 70-15 of ITAA97 provides that a deduction is available under s. 8-1 for the purchase of trading
stock in the year it becomes part of trading stock on hand. Alternatively, if the trading stock is ‘on hand’ in
the year before the loss or outgoing, then it is deductible in the year it is on hand even if not yet paid for.
ACCOUNTING FOR TRADING STOCK
As previously mentioned, the gross value of sales of trading stock is ordinary income under s. 6-5, and
purchases are deductible under s. 8-1. In addition, s. 70-35 requires an adjustment to taxable income based
on the difference in value of opening and closing trading stock:
• where the value of closing stock is greater than the value of the opening stock (i.e. it has increased), the
difference is assessable income (s. 70-35(2))
• where the value of closing stock is less than the value of the opening stock (i.e. it has decreased), the
difference is an allowable deduction (s. 70-35(3)).
The taxation consequences of trading stock are illustrated in example 2.33.
EXAMPLE 2.33
Tax Consequences of Trading Stock
Just Jewellery is a small jewellery store that sells a range of items including diamond rings, bracelets,
earrings and watches. For the year ended 30 June 2022, the business derived gross sales of $1 million.
Purchases of trading stock for the 2022 income year totalled $560 000. Opening stock at 1 July 2021 was
$240 000 and closing stock at 30 June 2022 was $280 000.
Consider the income tax consequences of the trading stock transaction for the income year ended
30 June 2022.
1. The gross sales of $1 000 000 are assessable income (s. 6-5).
2. The purchases of $560 000 are an allowable deduction (s. 8-1).
3. The value of the closing stock ($280 000) is greater than the value of the opening stock ($240 000);
therefore the difference of $40 000 is assessable (s. 70-35(2)).
4. The final effect on taxable income is an increase of $480 000 ($1 000 000 − $560 000 + $40 000).
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MODULE 2 Principles of Taxable Income 155
VALUATION OF TRADING STOCK
Example 2.33 illustrates how the opening and closing values of trading stock are taken into account for
tax purposes; therefore, it is necessary to understand how these values are determined. Section 70-40
states that opening trading stock has the same value as closing trading stock for the previous tax year. In
addition, s. 70-45(1), describes the options available for valuing closing trading stock as:
(a) cost
(b) market selling value
(c) replacement value.
Section 70-45(1) refers to the valuation of each item of trading stock. In other words, a different basis
may be adopted for each class of stock and even for each individual item of stock. Furthermore, a taxpayer
may choose to change the valuation of each item of trading stock at the end of each income year.
A taxpayer is required to notify the Commissioner in their tax return as to which method was the primary
method used to value closing stock.
Trading Stock Valuation Options
The following definitions are important for valuing trading stock.
• Cost price — the cost of the stock to the taxpayer plus all charges incurred in getting it to its
existing condition and bringing it to the place where it is on hand. This includes all direct and indirect
costs — for example, import duties and other taxes, freight inwards and handling costs, and any other
costs directly attributable to the cost of acquisition, less trade discounts, rebates and subsidies. In the
case of manufacturers, the Commissioner considers the absorption costing method as the only method
appropriate in determining the cost of trading stock (see Taxation Ruling IT 2350 and Phillip Morris v
FCT 79 ATC 4352). First in, first out (FIFO), weighted average cost, standard cost and retail inventory
method are also the only methods accepted by the Commissioner to estimate cost price. Last in, first out
(LIFO) is not permitted.
• Replacement value — the price the taxpayer would have to pay in its normal buying market on the
last day of the income year to replace (or re-buy) a substantially identical article on the last day of the
income year. Replacement value can only be used as a method of trading stock valuation if replacement
items are available in the market and these are substantially identical to the replaced items (see Taxation
Determination TD 92/198).
• Market selling value — the current selling value of stock in the taxpa’er’s own selling market. In
the case of a wholesaler, this is the current wholesale value of comparable items and, in the case of a
retailer, the current retail value. The market selling value of stock is determined based on a sale in the
ordinary course of the taxpa’er’s business and not the amount realisable as the result of a forced sale
(see Australasian Jam Co Pty Ltd v FCT (1953) 88 CLR 23).
In addition to the three optional methods of valuation, specific values apply where a capital item of the
business is transferred to trading stock and where stock is deemed to be obsolete.
• Assets that become trading stock — at the time the assets become trading stock, the taxpayer is treated
as if, just before the item became trading stock, the taxpayer sold it to someone else at arm’s length and
then immediately bought it back for the same amount (s. 70-3). This situation will arise where a capital
asset of the business is transferred to trading stock; for example, a second-hand car dealer has a car that
is used for business purposes but then decides to sell the car and adds it to their cars for sale (trading
stock).
• Obsolete stock — s. 70-50 provides that, where the value of trading stock falls below its cost, market
selling value or replacement value, due to obsolescence or other circumstances (e.g. discontinuation of
a product line or a fickle market), the taxpayer may elect to value the trading stock at its obsolete value,
as long as that value is considered reasonable. The Commissioner has issued general guidelines for
trading stock valuations where obsolescence or other special circumstances exist (see Taxation Ruling
TR 93/23).
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156 Australia Taxation
A summary of the taxation valuation rules for trading stock is summarised in figure 2.14.
FIGURE 2.14
Tax valuation rules of trading stock
Stock can be valued at
Market selling
value
Cost
Replacement
value
FIFO
Weighted
average cost
Standard cost
Retail inventory
compare to
Obsolete value
Source: CPA Australia 2022.
Example 2.34 illustrates how the trading stock valuation rules are applied to determine the value of stock
at the end of the tax year.
EXAMPLE 2.34
Tax Consequences of Trading Stock
Golf World operates a golf store in Melbourne and on 1 July 2021 its opening stock was valued
at $176 000.
The company purchased $800 000 worth of stock during the 2022 income year that was delivered and
received by Golf World. In addition to this, the company purchased 250 golf bags from a supplier in
Malaysia; however, at 30 June 2022, these golf bags were in transit and had not yet been delivered to
Golf World. An invoice for these items shows that Golf World paid $120 per golf bag (total of $30 000)
on 28 June 2022 and had received a bill of lading for shipment of the stock. The bill of lading showed that
the goods were shipped, terms FOB (free-on-board) at shipping point — that is, the purchaser has title to
the goods at this point.
During the 2022 income year, sales totalled $1.3 million.
As at 30 June 2022, the business had the following stock on hand with the following values.
Item
Golf bags
Golf clubs
Golf balls
Quantity on
hand 30.06.22
Cost price ($)
Replacement
cost ($)
Market selling
price ($)
1500
300
600
100
200
8
150
150
6
200
180
5
Consider the income tax consequences of the trading stock purchased and sold as well as the
closing stock.
Assuming that Golf World wishes to minimise its assessable income, it will value closing stock using
the lowest values for each item, as the taxpayer can use different values for each item of stock.
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MODULE 2 Principles of Taxable Income 157
Closing stock valued using s. 70-45 methods would be as follows.
Item
Golf bags
Golf bags (in transit)*
Golf clubs
Golf balls
Total
Quantity
Value
used ($)
1500
250
300
600
100
120
150
5
Total value ($)
150 000
30 000
45 000
3 000
228 000
* As the goods have been paid for by Golf World and the bill of lading shows that the golf bags were shipped FOB
at shipping point, the 250 golf bags are therefore considered on hand for the purposes of s. 70-15 (All States
Frozen Foods Pty Ltd v FCT (1990) 90 ATC 4175). For tax purposes, stock on hand is not a question of physical
possession. The issue is whether the taxpayer has the legal power to dispose of the goods. In this case, as the
goods were shipped FOB at shipping point, legal ownership of the 250 golf bags rests with Golf World. Hence,
they need to be included in the closing stock of Golf World at 30 June 2022.
Based on the above facts, the taxation consequences to Golf World are outlined as follows.
• Sales of $1.3 million are assessable under s. 6-5.
• Purchase of trading stock ($800 000) is deductible under s. 8-1 and so is the purchase of the 250 golf
bags from Malaysia for $30 000 (in transit but deemed to be on hand).
• Closing stock of $228 000 (including the $30 000 golf bags) is greater than opening stock of $176 000
by an amount of $52 000. Hence, $52 000 is assessable under s. 70-35(2).
• The final effect on taxable income is an increase of $522 000 ($1 300 000 − $830 000 + $52 000).
DISPOSAL OF TRADING STOCK
There are five methods for disposing of trading stock. The tax treatment for each method is summarised
in table 2.7.
TABLE 2.7
Disposal of trading stock
Method of disposal
Treatment
In the ordinary course of
business
The sales are assessable under s. 6-5.
Not in the ordinary course of
trading
For example, a business may donate items of stock for a sporting club raffle,
stock may be given away to friends or family members, or disposed of in
liquidation.
In these instances, s. 70-90 requires that taxpayer include in assessable income
the market value of that stock on the date of disposal. A person who acquires
the trading stock is deemed to have acquired it at the same value (s. 70-95).
Notional disposal of trading
stock
Treated as having been disposed of outside the ordinary course of business if
it stops being trading stock on hand of an entity (e.g. a partner in a partnership)
and, immediately afterwards, the transferor is not the item’s sole owner, but an
entity that owned the item immediately beforehand still has interest in the item
(s. 70-100).
This situation typically occurs where there is a change in members interest in a
partnership. Under s. 70-100, the partial change in the ownership of the trading
stock is treated as a notional disposal of the trading stock at its market value on
the date of dissolution of the old partnership.
The result could be that the net income of the old partnership is artificially
inflated by the difference between the market value of the trading stock on the
date of the reconstitution of the partnership and the book value of the trading
stock (usually at cost).
This would be the case, even though those partners in the old partnership who
continue to have a partnership interest in the new partnership have not derived
any profit.
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158 Australia Taxation
Cease to hold item as trading
stock, but still own it
Typically applies when stock is taken by the owner for their own personal use.
Section 70-110 provides that, if the taxpayer takes stock for personal use and
it remains in possession of the taxpayer, the taxpayer is required to include
the cost price of that stock as at the date of transfer as part of the assessable
income of the business.
Trading stock lost or
destroyed
When a taxpayer receives compensation for lost trading stock, the assessable
income is the amount that is received by way of insurance or indemnity for the
loss (s. 70-115).
Source: CPA Australia 2022.
Death of an Owner
Upon the death of the taxpayer, their assessable income up to the time of death includes the market value
of the trading stock of the business at that time. The beneficiary is deemed to have acquired the trading
stock at its market value (s. 70-105).
TRADING STOCK CONCESSIONS FOR SMALL BUSINESS
ENTITIES
Simplified trading stock rules apply to small business entities (see ‘What is a small business entity?’).
According to s. 328-285 of ITAA97, where the difference between the value of opening stock and closing
stock of an SBE is less than $5000 (determined by a reasonable estimate), the small business taxpayer does
not have to:
• value each item of trading stock on hand at the end of the income year, or
• account for any change in the value of trading stock on hand.
If the small business taxpayer chooses to adopt this option, then their opening stock value will be deemed
to become their closing stock value (s. 328-295). The effect of these provisions is to defer the recognition
of any stock increases or decreases until it exceeds $5000.
Where the difference between the value of trading stock on hand at the start of the year and the end of
the year is more than $5000, the amount of the change is included in taxable income as per the ordinary
rules contained in s. 70-35.
From 1 July 2021, businesses that are not SBEs because their turnover is $10 million or more but less
than $50 million are also eligible to access the simplified trading stock rules.
Example 2.35 illustrates the application of the trading stock concessions and how they apply to SBEs.
EXAMPLE 2.35
Trading Stock Concessions for Small Business Entities
Kirsten Kofoed operates a clothing shop. The clothing shop has an annual turnover of $630 000. As
such, the business qualifies as an SBE. Assume that Kirsten has elected to adopt the SBE trading stock
concessions for the 2022 income year.
On 1 July 2021, the value of Kirsten’s trading stock is $25 000. Using her reliable inventory system,
Kirsten estimates that the value of trading stock at 30 June 2022 is $28 000.
Consider the income tax consequences to Kirsten of adopting the SBE trading stock provisions.
As the difference between the opening and closing trading stock values is less than $5000 (i.e.
$3000 = $28 000 − $25 000), Kirsten may choose not to account for change in the value of her trading
stock. Therefore, the closing value of trading stock will be $25 000 (being, the same as the opening value)
and not $28 000. As a result, the increase in value of trading stock ($3000) is not included in Kirsten’s
assessable income as it would have been if the SBE simplified trading stock option had not been used.
On the other hand, if Kirsten elected not to apply the SBE trading stock provisions, then the normal
rules contained in Division 70 of ITAA97 would apply. In this case, Kirsten would include the difference in
value of the opening and closing stock ($3000) in her assessable income, and the value of closing stock
would therefore be $28 000.
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MODULE 2 Principles of Taxable Income 159
QUESTION 2.27
A company buys and re-sells old furniture. As at 1 July 2021, the opening stock was valued at
$40 000. Old furniture costing $60 000 was purchased during the 2022 income year. Labour costs
for restoration totalled $15 000, parts and materials cost $8000.
Sales for the 2022 income year totalled $125 000 and closing stock was valued at $50 000 as at
30 June 2022.
Prepare the trading account for tax purposes indicating the relevant sections of ITAA97, and
summarise the items of assessable income and allowable deductions.
QUESTION 2.28
Bike Universe sells bicycles and bicycle accessories to the general public. It is owned by
Marcel Davidson. The following transactions were undertaken by Bike Universe during the 2022
income year.
(a) On 1 June 2022, Marcel purchased a bike that cost $400. The current market value of this bike is
$700 and the replacement value is $350. This bike is still on hand at the end of the income year.
(b) On 8 June 2022, Bike Universe donated two bicycles which cost $1200 to a local charity to assist
in their fundraising activities for sick and disadvantaged children. The two bikes had a market
value of $3000.
(c) On 15 June 2022, Marcel, the owner took a bike costing $450 for his own personal use. The bike
had a market value of $800.
(d) Bike Universe had opening stock on 1 July 2021 of $108 000 and closing stock on 30 June 2022
of $127 000.
(e) Included in the closing stock amount of $127 000 was a bike that was found to be damaged.
The bike was purchased in December 2021 at an original cost of $500 and has been marked for
sale at $750. However, as a result of the damage to the bike, Bike Universe has advertised the
bicycle for sale at 30 June 2022 for $450.
Assuming that Bike Universe wishes to minimise its taxable income, calculate the income tax
impact of the above transactions from the perspective of the applicable trading stock rules. Assume
that Bike Universe is not an SBE and is not eligible to apply the simplified trading stock provisions.
2.9 INTERNATIONAL TAXATION CORE CONCEPTS
As shown in figure 2.15 the final component of determining taxable income is to understand the
tax treatment of Australian-sourced income earned by a non-resident for tax purposes of international
transactions. In Part A it was explained that under s. 6-5 of ITAA97 residents are taxed on worldwide ordinary and statutory income, whereas non-residents are only taxed on income derived from an
Australian source.
TREATMENT OF FOREIGN INCOME, DEDUCTIONS
AND OFFSETS
Table 2.8 summarises the differences between the taxation of individual resident and non-resident
taxpayers.
Non-resident companies are taxed at the same rate as resident companies, but are treated differently
in areas such as consolidation and dividend imputation. Withholding rules for dividends are discussed
later in this section, and the dividend imputation rules for resident companies are discussed further in
module 5.
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160 Australia Taxation
FIGURE 2.15
Taxation of international transactions
Taxable income = Assessable income – Deductions
Assessable income
Ordinary income
Trading stock
(Assessable income
and deductions)
Taxation of
international
transactions
Deductions
General deductions
Specific deductions
Statutory income
Limitations to
deductions
Non-assessable
income (excluded)
Substantiation
Derivation
Capital allowances
Source: CPA Australia 2022.
TABLE 2.8
Income tax differences between individual resident and non-resident taxpayers
Residents
Non-residents
Individual resident taxpayers receive:
• tax-free threshold
• tax offsets.
Individual non-resident taxpayers do not receive:
• tax-free threshold
• tax offsets.
Individual resident taxpayers are subject to the 2%
Medicare levy as well as the Medicare Levy surcharge
if applicable (see module 4).
Individual non-resident taxpayers are not subject to the
2% Medicare levy and Medicare Levy surcharge.
Under the capital gains tax provisions, individual
resident taxpayers are taxed on worldwide
capital gains.
Under the capital gains tax provisions, individual nonresident taxpayers are taxed in relation to the disposal
of taxable Australian property.
Resident individual taxpayers are eligible for a 50%
CGT discount on assets held for at least 12 months
or more.
Non-residents are not eligible for the 50% CGT
discount on capital gains.
Source: CPA Australia 2022.
Non-Residents and Capital Gains Tax
As briefly mentioned in table 2.8, under the capital gains tax provisions, individual non-resident taxpayers
are only subject to Australia’s CGT regime if the asset is taxable Australian property (ITAA97, s. 855-10).
Section 855-15 of ITAA97 lists five categories of CGT assets that are taxable Australian property.
1. Australian real property.
2. An indirect interest in Australian real property.
3. A CGT asset used to carry on a business through a permanent establishment in Australia.
4. Mining, quarrying or prospecting rights in Australia.
5. An option or right to acquire any of the CGT assets in items 1, 2, 3 or 4 above.
6. A CGT asset deemed to be Australian taxable property where a taxpayer, on ceasing to be an Australian
resident, makes an election as such under s. 104-165 of ITAA97.
The term ‘taxable Australian real property is defined’ in s. 855-20 of ITAA97 to mean real property
situated in Australia or a mining, quarrying or prospecting right (to the extent that the right is not real
property) where the minerals, petroleum or quarry materials are situated in Australia. It also now expressly
includes a lease of land situated in Australia.
The 50 per cent CGT discount is not available to foreign and temporary resident individuals (including
the beneficiaries of trusts and partners in a partnership) for assets acquired after 8 May 2012. The 50 per
cent discount will be apportioned where a CGT event occurred after 8 May 2012 and the non-resident had
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MODULE 2 Principles of Taxable Income 161
acquired the asset before that date, or they held a period of Australian residency after that date. CGT events
that occurred before 8 May 2012 are not affected (ATO 2021c).
From 1 July 2020, a taxpayer who sells their main residence while a non-resident is not eligible to
claim the main residence CGT exemption. In such situations, the individual is not even eligible for a
partial exemption for the period they lived in the residence. Any resulting capital gain will be taxed at
non-resident rates.
There are exemptions from the new rules if the property owner experiences ‘certain life events’ during
their period of foreign residency and has been a non-resident for a continuous period of six years or less
at the time of the CGT event. Certain life events during the period of foreign residency are:
• the taxpayer, their spouse or child under 18 years old had a terminal medical condition
• the taxpayer, their spouse or child under 18 years old passed away
• the sale of the home involved the distribution of assets between the taxpayer and their spouse as a result
of divorce, separation or similar maintenance agreements.
DOUBLE TAXATION AGREEMENTS AND ALLOCATION OF
TAXING RIGHTS
A double taxation agreement (DTA) is an agreement between two countries governing the way in which
income derived by residents of those countries is taxed. The aim of a DTA is to avoid double taxation, to
prevent fiscal evasion and, sometimes, to assist in tax collection. Australia has DTAs in place with most
of its major trading partner countries.
The chief piece of legislation in this area is the International Tax Agreements Act 1953 (Cwlth). The tax
provisions in the DTAs prevail if there are conflicting provisions in ITAA36 or ITAA97. The International
Tax Agreements Act are available from the Australian Treaty Series online database available through the
Australasian Legal Information Institute at www.austlii.edu.au/au/other/dfat/treaties.
Each DTA is unique to the two countries involved as are the respective articles in the tax agreements,
and they must be individually consulted when considering the implications of dual residency and double
taxation. The allocation of taxation rights and the operation of the DTAs generally follow these two broad
principles.
1. First, the DTAs state that the allocation of taxing rights, namely where the liability for taxation arises
for the resident, over certain classes of income, are reserved entirely to the country of residence of the
person deriving the income.
2. Second, all other income is able to be taxed (sometimes only to a limited extent) by the country where
the income has its source. If the country of residence of the taxpayer also taxes that income — meaning
the same income is taxed twice — then the resident country is required to grant a credit against its tax
for the tax imposed by the source country.
However, income may also be taxed solely in the country of residence where:
• the duration of the recipient’s visit in the country of source does not exceed a specified limit (usually
183 days), and
• the salary is paid by a non-resident of the source country.
Example 2.36 considers the application of a DTA agreement and how it operates for an Australian
individual taxpayer who derives income overseas. Note that the Australia/Singapore DTA adopts the above
approach as stipulated in Articles 11 and 12.
EXAMPLE 2.36
Application of DTA
Caine Miller, a resident of Australia employed as a logistics manager by an Australian company, is sent
to Singapore on a specific project for nine months. While in Singapore, Caine also does some part-time
lecturing at the Singapore Management University.
Consider the tax treatment of Caine’s income from both sources while in Singapore.
As Caine’s stay in Singapore is greater than 183 days, then the exemption from taxation in Singapore
under Article 12 of the Australia/Singapore DTA will not apply. Rather, as provided in Article 11, Caine’s
income earned from both his activities as a logistics manager and a lecturer will be assessable in
Singapore. As Caine is a resident of Australia, the same income will also be assessable in Australia.
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162 Australia Taxation
Caine will therefore receive a foreign income tax offset in Australia for the tax paid in Singapore (ITAA97,
Division 770; Article 18 of the Australia/Singapore DTA).
Under certain DTAs, visiting academics and teachers are often exempt from tax on their remuneration
in the source country provided their visit does not exceed two years. However, there is no such exemption
in the Australia/Singapore DTA.
WITHHOLDING TAX REGIME
Dividend, interest and royalty withholding (DIR withholding) tax is imposed by Part III, Division 11A
of ITAA36. Section 128B of ITAA36 is the operative provision. DIR withholding is levied when interest,
dividend and royalty income is paid to non-residents.
Withholding tax operates so that an amount representing the total tax payable is withheld from the
payment by the payer (before being paid to the non-resident) and this amount is remitted directly to the
ATO. The withholding taxes applied to dividends, interest and royalties are the final taxation liability for
each of these payments. The amounts subject to withholding tax are NANE income of the non-resident
under s. 128D of ITAA36.
Dividends
Dividend withholding tax is paid by a resident company on dividends paid to non-residents is set at a flat
rate of 30 per cent. However, for dividends paid to residents of countries where Australia has a DTA, the
withholding amount is generally 15 per cent. The withholding rate may change depending on the specific
DTA, and the DTA should be checked in each instance.
Note that withholding tax does not apply to the franked part of the dividend. Dividend franking is
discussed in module 5.
Interest
Interest withholding tax is paid on interest that is (ITAA36, s. 128B(2)):
• derived by a non-resident, and consists of interest that is:
– paid by a resident, except where the interest is wholly incurred by the resident as an expense of
carrying on a business overseas at or through a permanent establishment, such as a branch, or
– paid by a non-resident and the interest is wholly or partly incurred by the non-resident in carrying on
a business in Australia at or through a permanent establishment in Australia.
Withholding tax must be withheld from the payment of interest and remitted to the ATO when the
interest is paid, and also when it is payable and is dealt with in some other manner at the direction of the
non-resident, such as reinvestment of funds.
Interest withholding tax is imposed at a flat rate of 10 per cent, which is generally the same amount
in most DTAs. However, this rate may change depending on the specific DTA, and the DTA should be
checked in each instance.
Royalties
Royalties (as per the broad definition in s. 6(1) of ITAA36) derived by a non-resident are subject to
withholding tax, unless a specific exemption applies. The tax applies where the royalties are paid by:
• a resident, except where they are outgoings wholly incurred by the payer in carrying on a business
outside Australia at or through a permanent establishment, such as a branch, or
• a non-resident and are outgoings wholly or partly incurred by the payer in carrying on a business in
Australia at or through a permanent establishment in Australia.
The rate of royalty withholding tax is a flat rate of 30 per cent.
Where the royalties paid flow to a resident of a country where Australia has an extensive DTA in place,
the rate is generally limited to 10 per cent of the gross amount of the royalties. The withholding rate may
change depending on the specific DTA, and the DTA should be checked in each instance.
This lower rate applies unless these royalties are effectively connected to a branch in Australia. In this
instance, the royalties are treated as business profits and are taxed accordingly. If the country of residence
of the receiver of the royalties also taxes that income, then that country will give credit against the tax paid
for the Australian tax.
Example 2.37 illustrates the tax treatment of royalties paid by an Australian resident company to a
non-resident entity.
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MODULE 2 Principles of Taxable Income 163
EXAMPLE 2.37
Royalty Withholding Tax
Aussie Pharmaceuticals Pty Ltd (an Australian resident company) has entered into an agreement with
a Hong Kong Pharmacy Group (a company resident in Hong Kong). Under the agreement, Aussie
Pharmaceuticals has the rights to sell certain prescription drugs manufactured in Hong Kong in Australia,
but will have to pay a royalty of 10 per cent to the Hong Kong Pharmacy Group for each sale.
Consider the tax treatment of the royalties paid to Hong Kong Pharmacy Group.
As a non-resident, Hong Kong Pharmacy Group is liable for tax in Australia in respect of any Australiansourced royalty payments from Aussie Pharmaceuticals (ITAA97, s. 6-5). Withholding tax at a rate of
30 per cent applies to the royalty payments made by Aussie Pharmaceuticals to Hong Kong Pharmacy.
This rate is subject to the operation of double taxation treaties.
As the royalty payment is to a location outside Australia, Aussie Pharmaceuticals is required to withhold
and remit the withholding tax to the ATO (Taxation Administration Act 1953, s. 12-280).
Foreign Resident Capital Gains Withholding
From 1 July 2016, where a foreign resident disposes of certain taxable Australian property, then they are
subject to a foreign resident capital gains withholding (FRCGW) regime.
For all new contracts entered into from 1 July 2017, the following rate and threshold applies:
• taxable Australian property with a market value of $750 000 or more
• an indirect Australian real property interest, or
• an option or right to acquire such property or interest.
Where the seller of these Australian assets is deemed a foreign resident, the buyer must withhold
12.5 per cent of the purchase price and remit it to the ATO as a foreign resident capital gains withholding
payment. The foreign resident seller can claim a credit for the foreign resident capital gains withholding
payment by lodging a tax return for the relevant year (ATO 2021b).
TRANSFER PRICING REGIME
Transfer pricing can occur between two domestic entities or between a resident and a non-resident entity.
Transfer pricing that occurs between two domestic entities is generally not a problem from an Australian
tax perspective because, usually, one entity will record the amount as assessable income, while the other
will claim the amount as an allowable deduction.
However, if one of the parties to the transaction is a non-resident, Australian tax can be avoided. This
can occur where:
• deductions are shifted to Australia (e.g. a resident buys goods from a non-resident at an inflated price)
• income is shifted offshore (e.g. a resident sells goods to a non-resident at a discounted price).
The transfer pricing rules contained in Subdivisions 815-B and 815-C of ITAA97 are designed to counter
these transactions. Essentially, the Australian transfer pricing tax regime is in place to ensure that an
Australian entity does not pay less tax in Australia because it has entered into non-arm’s-length crossborder dealings with another entity.
Transfer pricing generally occurs for tax purposes where an Australian resident entity enters into a crossborder transaction (e.g. the supply or acquisition of goods and services) with an overseas entity, which is
part of the same multinational group, for profit-shifting purposes.
Apart from applying the transfer pricing rules to particular transactions, the Australian tax transfer
pricing regime also considers whether the division of profits between an Australian entity and another
entity that is part of the same multinational group needs to be adjusted because the entities have not been
acting on an arm’s-length basis.
The key concept underpinning the transfer pricing regime is the application of the arm’s-length
principle. Under the arm’s-length principle, the conditions that apply to a related party cross-border
transaction should approximate those that would be expected to operate between an Australian entity
and an overseas entity dealing wholly independently with each other in comparable circumstances (the
arm’s-length conditions).
Where the actual conditions differ from the arm’s-length conditions, a transfer pricing adjustment may
be required, so that the Australian entity’s tax position reflects the arm’s-length value of the goods or
services supplied or acquired.
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164 Australia Taxation
Such an outcome is generally aligned with the transfer pricing adjustments that may be required under
the associated enterprises articles of the various DTAs that Australia has entered into with most of its major
trading partners.
CONVERSION OF FOREIGN CURRENCY RULES
There are rules for the conversion of foreign currency into Australian currency. They are found in
Subdivisions 960-C to 960-D of ITAA97. The main operative provision is s. 960-50(1), which states that an
amount in foreign currency is to be translated into Australian currency. The rules apply to all transactions
that affect a taxpayer’s tax liability and are not limited to just income and deductions.
Amounts that need to be translated into Australian currency are:
• ordinary income
• expenses
• obligations and liabilities
• a receipt or payment
• an amount of consideration or a value.
An overview of the main foreign currency translation rules for particular events is presented in table 2.9.
TABLE 2.9
Translation rules into Australian currency
Item
Translation rules
Ordinary income
The exchange rate to be used is the rate prevailing at the time of derivation;
however, where derivation occurs after the time of receipt, it is the rate at the time
of receipt.
Statutory income
(excluding capital gains)
The applicable exchange rate is the rate at the time the amount must be returned
as income or at the time of receipt, whichever occurs first.
Deductions (excluding
capital allowance rules)
The exchange rate to be used is the rate at the time the amount becomes
deductible or at the time at which payment occurs, whichever is the earlier.
Cost of a depreciating
asset
If an obligation to pay for the asset is not satisfied before the taxpayer holds
the asset, the cost of the asset is to be translated into Australian currency at
the exchange rate when the taxpayer began to hold the asset. Otherwise, the
exchange rate to be used is the exchange rate when the obligation is satisfied.
Trading stock
Where an item of trading stock at the end of the year is valued at cost, the
exchange rate to be used is the rate prevailing when the item became on hand.
However, if it is valued at market selling value or replacement value, the exchange
rate to be used is based on the rate applicable at the end of the year.
CGT
Where there is a transaction or event that involves an amount of money or the
market value of other property, to which the CGT provisions apply, the exchange
rate applicable is the one at the time of the transaction or event.
Non-specified receipts and
payments
Where any receipt or payment is not covered by the specific rules contained in
s. 960-50(6), the exchange rate to be used is the rate at the time of receipt or
payment.
Source: CPA Australia 2022.
Functional Currency Rules
The translation rules in table 2.9 and found in s. 960-50 concerning foreign-sourced income do not apply
where the functional currency rules apply. This is where the eligible tax entity (e.g. a company) keeps
its accounts solely or predominantly in a foreign currency — the functional currency. When this occurs,
only the net income of the entity must be translated into Australian currency. This is opposed to translating
each individual transaction (using the standard translation rules).
The functional currency rules apply to an Australian resident company that is required to prepare
financial reports under s. 292 of the Corporations Act, namely:
• a permanent establishment
• a controlled foreign company
• an offshore banking unit
• a transferor trust.
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MODULE 2 Principles of Taxable Income 165
The functional currency rules apply when the taxpayer makes a written election to apply them. The
functional currency rules continue until the taxpayer seeks withdrawal or at the end of the year in which
the taxpayer is no longer required to prepare a financial report under s. 292 of the Corporations Act.
Foreign Exchange Gains and Losses
Gains and losses caused by movements in exchange rates, which are either on revenue or capital account,
are assessable or deductible under Division 775 of ITAA97 unless there is a specific exemption. Normally,
the gains or losses arising from a movement in exchange rates are assessable or deductible upon realisation.
The basic rule is contained in s. 775-15 which states that assessable income for the year includes a
foreign exchange realisation gain as a result of a foreign exchange realisation event that happens during
the year.
However, an exception to the above approach applies to short-term foreign currency realisation gains
and losses where the gain or loss is closely linked to a capital asset (ss. 775-70 to 775-80).
The legislation relating to gains and losses on foreign currency transactions focuses on five main foreign
exchange events contained in Division 775, Subdivisions A–E. These are summarised in table 2.10.
TABLE 2.10
Foreign realisation event rules (FRE)
FRE
Happens if…
Time of event
1
The taxpayer disposes of foreign currency or a right to receive foreign currency
in circumstances that would satisfy the change of ownership requirements in
CGT event A1 (s. 775-40).
Time of disposal
2
The taxpayer ceases to have the right to receive foreign currency (s. 775-45).
The right must be one of the following.
• A right to receive income or a right that represents ordinary income or
statutory income.
• A right created in return for ceasing to hold a depreciating asset.
• A right created or acquired for paying or agreeing to pay Australian or foreign
currency.
• A right created in return for a realisation event happening in relation to a
CGT asset.
When the right
ceases
3
The taxpayer ceases to have the obligation to receive foreign currency and the
obligation was incurred in return for the creation or acquisition of a right to pay
foreign or Australian currency (s. 775-50).
When the
obligation ceases
4
The taxpayer ceases to have the obligation to pay foreign currency (s. 775-55).
The obligation must be one that:
• represents an expense the taxpayer can deduct
• is an element in the calculation of a net assessable or deductible amount
• forms part of the cost base of a CGT asset
• is incurred in relation to a depreciating asset or a project amount under the
capital allowances regime
• was incurred in return for receiving Australian or foreign currency, or the right
to receive such currency.
When the
obligation ceases
5
The taxpayer ceases to have a right to pay foreign currency and the right is
created or acquired in return for assuming specified types of obligations in
relation to either foreign or Australian currency (s. 775-60).
When the right
ceases
Source: CPA Australia 2022.
Example 2.38 illustrates the application of FRE 4.
EXAMPLE 2.38
Foreign Exchange (FX) Events
On 1 April 2021 (when AUD 1 = USD 0.78*), Taj Khan, a doctor, purchased medical products for his surgery
from an overseas supplier for USD 10 000. Taj therefore assumed an obligation to pay foreign currency
and is entitled to a deduction of AUD 12 821 (USD 10 000 / 0.78). This amount is deductible to Taj in the
2020–21 tax year under s. 8-1 of ITAA97.
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166 Australia Taxation
On 15 March 2022 (when AUD 1 = USD 0.70), Taj pays his supplier USD 10 000.
Consider which foreign realisation event has occurred and how much Taj will need to pay on 15 March
2022 in AUD to satisfy this debt. Consider how this event impacts on the 2021–22 tax year.
As a consequence, FRE 4 happens because Taj ceases to have an obligation to pay the foreign currency.
The AUD amount Taj pays on 15 March 2022 in respect of the event is AUD 14 286 (USD 10 000 / 0.70)
and this exceeds the amount on assuming the obligation on 1 April 2021 of AUD 12 821.
Taj has made an FX realisation loss of AUD 1465, which he can deduct in the 2021–22 tax year.
*The exchange rates in this example are for illustration purposes only and may be different to the actual rates.
QUESTION 2.29
On 1 April 2022 (when AUD 1 = USD 0.78), Fred Fitzgerald, a distributor of slippers, entered into a
contract to supply slippers to a customer in the United States for USD 10 000. As a result of entering
into a contract, Fred has a right to receive foreign currency.
(a) Calculate the amount that must be included in Fred’s assessable income for the 2021–22
income year in respect of the supply, assuming that Fred derives the income on the date of
contract.
(b) The US customer paid Fred for the slippers on 15 May 2022 (when AUD 1 = USD 0.70). At this
time, Fred ceases to have the right to receive the foreign currency because the debt has now
been satisfied. What FRE occurs, and on what date?
(c) Refer to the facts provided in part (b). What amount does Fred receive because of this event?
(d) Refer to the facts provided in part (b). Determine the amount of any FX realisation gain or loss.
QUESTION 2.30
Yasmin Habib is a full-time graphic designer and works as an employee for Creative Design Pty Ltd
(Creative Design). She receives an annual full-time salary of $90 000 (exclusive of superannuation).
Yasmin worked for Creative Design from 1 July 2021 until 1 October 2021.
On 2 October 2021, Yasmin took two months paid annual leave. Yasmin travelled to Europe on
3 October 2021. After travelling for two months, Yasmin returned to Australia on 1 December 2021
due to the unexpected death of her mother.
Instead of returning to her job on 2 December 2021, Yasmin resigned from the company. Yasmin
had used all her annual leave so she was not paid any leave entitlements upon leaving the company.
Yasmin decided to remain in Australia and returned to work for Creative Design on 1 February
2022, receiving her previous annual salary of $90 000 per annum.
Yasmin purchased a two-bedroom apartment in Sydney in August 2017, which she immediately
rented out to tenants. Yasmin has never lived in the property herself, but it has been continuously
rented to tenants from August 2017 up until the end of February 2022. On 3 March 2022, Yasmin
sold the property resulting in a gross capital gain of $240 000.
(a) What type and amount of income has Yasmin received in the 2021–22 tax year?
(b) While travelling in Europe from 3 October 2021 to 1 December 2021, what is the source of the
income received by Yasmin?
(c) Is Yasmin a resident or non-resident taxpayer for all or part of the 2021–22 tax year?
(d) In January 2022, Yasmin started selling framed graphic art prints at two local markets near her
house. Yasmin creates the graphic art prints herself and has them framed by a local supplier.
Yasmin entered into a contract to purchase picture frames from Vietnam for her business for
30 million Vietnamese dong (VND) on 22 January 2022 (when AUD 1 = VND 15 850*). On 22 June
2022, Yasmin pays her supplier for the frames (when AUD 1 = VND 17 860). Calculate the FX loss
or gain that Yasmin has realised. What effect, if any, do these transactions have on Yasmin’s
taxable income?
*The exchange rates in this example are for illustration purposes only and may be different to the actual rates.
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MODULE 2 Principles of Taxable Income 167
SUMMARY
Part C introduced the capital allowance regime (commonly referred to as tax depreciation) for taxpayers.
The capital allowance rules under Division 40 of ITAA97 allow taxpayers to claim a deduction for the
decline in value of depreciating assets. This deduction is based on the percentage business usage of the
asset and is spread over its effective life. Either the prime cost or diminishing value methods can be used to
calculate the deduction. Non-SBE taxpayers can allocate low-value assets to a low-value pool and write-off
these assets at a fixed rate.
As the treatment of depreciating assets varies depending on the type of asset and whether the taxpayer is
an SBE or not, Part C discussed the rules for capital allowances for both non-SBEs and SBEs. An SBE is
defined as an entity that carries on a business and satisfies the $10 million aggregated turnover test. Under
the capital allowance provisions, an SBE can benefit from an immediate write-off of depreciating assets
costing less than the relevant threshold. Assets not eligible for the instant write-off are added to a general
asset pool and the pool value is written off at a fixed rate.
Specific assets such as software, some intangibles, cars and project pool expenses are dealt with
separately. In addition, s. 40-880 of ITAA97 allows capital expenses (blackhole expenses) that are not
eligible for deduction under other capital allowance provisions to be written off over five years, or
immediately if they are start-up costs of an SBE.
Recently, the Federal government introduced a series of temporary concessional deductions for depreciating assets aimed at increasing economic activity. These include extending the instant asset write-off for
SBEs, extending the instant asset write-off to some taxpayers that are not SBEs, accelerated depreciation
rates and the full expensing of depreciating assets for eligible entities.
When the depreciating asset is sold or no longer used (a balancing adjustment event), a balancing
adjustment is required to adjust for the previous estimated decline in value. If the termination value is
greater than the adjustable value, the excess is assessable and, if the termination value is less than the
adjustable value, the difference is deductible.
The final sections of Part C explained how capital works deductions are calculated. Capital works used to
earn assessable income are not deductible under the general capital allowance provisions, but a deduction
may be available under Division 43 of ITAA97. The rates of capital works deductions are either 2.5 per
cent or 4 per cent, depending on the type of capital work, the date construction began and what the capital
works are used for.
Part C also covered the core taxation concepts related to trading stock given that a taxpayer derives
ordinary income from transactions in selling trading stock. Accounting for and valuation (using cost,
replacement or market selling value) of closing trading stock were examined as were the tax treatments
when disposing of trading stock and the tax concessions available for SBEs.
Finally, the core concepts of international tax were then explored in relation to the tax obligations of
non-residents. There is an emphasis on DTAs, foreign currency translation and exchange rules, and the
withholding tax and transfer pricing regimes. The aim of DTAs is to relieve taxpayers from double taxation
and mitigate tax evasion, and the transfer pricing system is there to ensure Australian entities do not pay
less tax in Australia by entering into non-arm’s-length cross-border dealings with another entity.
The key points covered in this part, and the learning objectives they align to, are as follows.
KEY POINTS
2.1 Identify the different types of income in a given situation and the tax implications relating to
income source and residence.
• The sale of trading stock is assessable (ITAA97, s. 6-5) and the purchase is deductible (ITAA97, s.
8-1). Division 70 of ITAA97 requires the change in the value of trading stock over the year to be
taken into account for tax purposes.
• Trading stock is defined for tax purposes in s. 70-10 of ITAA97.
• There are three methods of valuing closing trading stock, and some special valuation rules that
apply to stock disposed of outside the ordinary course of business.
• There are special trading stock valuation rules available for SBEs.
• The capital gains tax rules that apply to non-resident taxpayers are discussed.
• How double tax agreements work and their importance in the context of international taxation is
covered.
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168 Australia Taxation
• The withholding tax regime affects the taxation of dividends, interest and royalties paid to nonresidents.
• The Australian transfer pricing tax regime is in place to ensure that an Australian entity does not
pay less tax in Australia because it has entered into non-arm’s-length cross-border dealings with
another entity.
• Foreign currency conversion rules apply in certain situations.
2.3 Evaluate the tax implications of the capital allowance and capital works rules available to
different types of entities.
• Division 40 of ITAA97 provides deductions for the decline in value of assets which are known as
capital allowances.
• Capital allowance deductions generally apply to depreciating assets held by the taxpayer that are
used fully or partly for the production of assessable income.
• There are some limits placed on the deduction allowed including the deduction available for cars
and second-hand assets used in residential rental properties.
• There are a range of capital allowances available for non-SBEs (see figure 2.8).
• Depreciating items costing $300 or less used in the earning of non-business income are deductible
in full in the year purchased.
• Low-cost assets and low-value assets can be added to a low-value pool to save keeping track of
individual items. Low-cost assets are depreciated at 18.75 per cent in the year added and 37.5 per
cent in the following years. Low-value assets are depreciated at 37.5 per cent starting from the year
of allocation.
• Specific write-off rules apply to computer software (see figure 2.9).
• The TFE concession for 2021–22 allows a 100 per cent deduction to eligible entities for the purchase
of eligible depreciating assets (see figure 2.10).
• If none of the special capital allowance provisions apply, non-SBEs can claim a deduction for the
cost of depreciating assets based on the effective life of the asset.
• A balancing adjustment may give rise to assessable income or a deduction when a balancing
adjustment event occurs.
• Write-off of capital expenses that are not eligible for depreciation may be available under s. 40-880
of ITAA97; this is known as the blackhole provision.
• Capital expenditure on specific business projects may be written off under the project pool
expenditure provisions.
• Specific tax concessions are available to SBEs including a simplified depreciation system.
• Two key factors determine whether a taxpayer is eligible to be classified as an SBE.
– The taxpayer must be carrying on a business.
– The taxpayer’s aggregate turnover must be below the relevant threshold.
• For 2021–22, an SBE is eligible for a 100 per cent deduction under the TFE concession for the
business use of eligible assets. There is no limit to the value of the asset written off except for the
purchase of a car.
• Figures 2.15 and 2.16 summarise the depreciation rules for the small business concessions.
• Certain blackhole expenses of a small business can be written off in full in the year incurred.
• Capital expenses incurred on structural improvement and construction are not depreciable under
Division 40 of ITAA97.
• Division 43 of ITAA97 allows a write-off of the cost of capital works, construction expenditure and
structural improvements.
• The rate of write-off varies depending on the type of capital works and the date the works
commenced (see table 2.6).
2.4 Determine the taxable income for different types of taxpayers in a given situation.
• Examples 2.33 to 2.35 explain the impact on taxable income for entities that hold trading stock.
• Question 2.28 provides an opportunity to review how the trading stock provisions influence
taxable income.
• Residents for Australian tax purposes are taxed on worldwide income and non-residents are taxed
on Australian-sourced income.
• There are specific tax rules that effect non-resident taxpayers with Australian-sourced income in
relation to CGT, tax rates and Medicare levy.
• Residency for tax purposes also affects the country entitled to collect tax on income, whether tax
must be withheld before payment, transfer pricing rules and the conversion of foreign currency
to AUD.
• Question 2.30 is a comprehensive problem that reviews the effect on taxable income of a particular
type of taxpayers earning different forms of income.
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MODULE 2 Principles of Taxable Income 169
REVIEW
This module introduced the key concept of taxable income, starting with the income tax equation showing
that taxable income is determined by deducting allowable deductions from assessable income. It was noted
that before taxable income can be determined it is necessary to ascertain whether the taxpayer is a resident
or not for tax purposes.
Residents for tax purposes are taxable on their worldwide income and non-residents are only taxed on
their Australian-sourced income. The legislation covers four circumstances in which an individual is a
resident of Australia and three circumstances in which a company is treated as a resident of Australia for
tax purposes.
Once the residency status of the taxpayer is established, it is necessary to determine the taxpayer’s
assessable income and allowable deductions. Each of these components are discussed in detail.
Assessable income comprises both ordinary income and statutory income, except when these components are exempt income or otherwise excluded from assessable income. Ordinary income is referred to in
the legislation as ‘income according to ordinary concepts’ and, although it is not defined in the legislation,
the courts have identified various factors that indicate whether an amount is income according to
ordinary concepts.
There is an important distinction between income and capital gains, whereby income is assessable under
s. 6-5 of ITAA97 and capital gains are only assessable if caught under specific statutory income provisions
(e.g. CGT). Other characteristics of ordinary income include it is money or monies worth, regularity, it is
earned and not a gift or windfall gain and it is a reward for services or from carrying on a business.
Statutory income is assessable because of specific provisions of the legislation and may make assessable
receipts or benefits that are not ordinary income (e.g. capital gains). The time when assessable income is
derived (year assessable) is based on either the cash or accruals basis of accounting.
The second component of taxable income is allowable deductions. A taxpayer may be entitled to a
deduction as either a general deduction or a specific deduction. If an expense is only partly for a taxable
purpose, the taxpayer is only entitled to a deduction for the proportion of the expense connected with
earning assessable income. If a deduction is available under more than one provision, the most appropriate
one must be applied. However, deductions may be denied or limited if they are specifically excluded by
the legislation or do not meet the substantiation requirements.
A major component of specific deductions are the capital allowance provisions that allow a deduction
for certain capital expenses. The capital allowance rules under Division 40 of ITAA97 allow a deduction
for the decline in value of depreciating assets. This deduction is based on the percentage business usage of
the asset and is spread over the asset’s effective life. Either the prime cost or diminishing value methods
can be used to calculate the deduction. The treatment of depreciating assets varies depending on the type
of asset and whether the taxpayer is an SBE or not. For 2021–22 there is also a temporary concessional
100 per cent deduction for eligible assets and eligible taxpayers.
Specific assets such as software, some intangibles, cars and project pool expenses are dealt with
separately. In addition, s. 40-880 of ITAA97 allows capital expenses (blackhole expenses) that are not
eligible for deduction under other capital allowance provisions, to be written off over five years, or
immediately if they are start-up costs of an SBE or other eligible taxpayers.
When the depreciating asset is sold or no longer used, a balancing adjustment is required to adjust for the
previous estimated decline in value. If the termination value is greater than the adjustable value, the excess
is assessable, and, if the termination value is less than the adjustable value, the difference is deductible.
Assets that are not depreciating assets may be eligible for a capital works deduction under Division 43
of ITAA97. The rates of capital works deduction are either 2.5 per cent or 4 per cent depending on the type
of capital work, the date construction began and what the capital works are used for.
Finally, this module deals with trading stock and international tax, which have components of both
assessable income and allowable deductions affecting the determination of taxable income.
Purchases of trading stock are a general deduction and the sale is ordinary income. However,
Division 40 of ITAA97 also requires an adjustment to taxable income based on the change in the value of
trading stock over the year. This requires trading stock to be valued for tax purposes based on one of the
three optional methods: cost, replacement value or market selling value. There are also special rules for
SBEs and the disposal of trading stock outside the ordinary course of business.
International tax rules impose obligations on both resident and non-resident taxpayers and these rules
may affect taxable income. For example, DTAs determine in which country taxable income will be taxed,
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170 Australia Taxation
foreign currency translation and exchange rules influence the amount of assessable income and deduction,
and the withholding tax and transfer pricing regimes aim to insure that tax is collected in Australia on
Australian-source income.
REFERENCES
ATO 1991, Taxation Ruling IT 2650 ‘Income Tax: Residency — Permanent Place of Abode Outside Australia’, accessed January
2021, www.ato.gov.au/law/view/document?Docid=ITR/IT2650/NAT/ATO/00001.
ATO 1998, Taxation Ruling TR 98/17 ‘Income tax: residency status of individuals entering Australia’, accessed January 2022,
www.ato.gov.au/law/view/pdf/pbr/tr1998-017.pdf.
ATO 2019, ‘In-house software’, accessed February 2022, www.ato.gov.au/Business/Depreciation-and-capital-expenses-and-allowa
nces/In-detail/Depreciating-assets/In-house-software.
ATO 2020d, ‘Taxation Ruling: TR2020/3: Income tax: effective life of depreciating assets’, accessed January 2021, www.ato.gov.a
u/law/view/document?docid=TXR/TR20203/NAT/ATO/00001.
ATO 2021a, ‘Are you in business’, accessed February 2022, www.ato.gov.au/business/starting-your-own-business/before-you-getstarted/are-you-in-business-/.
ATO 2021b, ‘Capital gains withholding: Impacts on foreign and Australian residents’, accessed February 2022, www.ato.gov.au/In
dividuals/Capital-gains-tax/In-detail/Foreign-resident-capital-gains-withholding/Capital-gains-withholding---Impacts-on-foreign
-and-Australian-residents.
ATO 2021c, ‘CGT discount for foreign resident individuals’, accessed February 2021, www.ato.gov.au/Individuals/Capital-gains-t
ax/Foreign-residents-and-capital-gains-tax/CGT-discount-for-foreign-residents.
ATO 2021d, ‘Rental properties: Claiming capital works deductions’, accessed February 2021, www.ato.gov.au/Individuals/Invest
ments-and-assets/In-detail/Rental-properties/Work-out-your-capital-works-deductions.
ATO 2021e, ‘The type of construction and the date construction commenced’, accessed January 2021, www.ato.gov.au/Individuals
/Investments-and-assets/In-detail/Rental-properties/Work-out-your-capital-works-deductions/#Thetypeofconstruction.
ATO 2022, ‘Non-commercial losses’, accessed February 2022, www.ato.gov.au/business/non-commercial-losses.
Wolters Kluwer 2021, Australian Master Tax Guide 2021, 68th edition, Oxford University Press, Australia.
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MODULE 2 Principles of Taxable Income 171
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MODULE 3
CGT FUNDAMENTALS
LEARNING OBJECTIVES
After completing this module, you should be able to:
3.1 determine which CGT event(s) applies/apply in a given situation
3.2 analyse the tax implications of different types of CGT assets
3.3 calculate the capital gain or capital loss that arises from a CGT event
3.4 calculate an entity’s net capital gain or capital loss.
LEGISLATION AND CODES
• Family Law Act 1975 (Cwlth)
• Income Tax Assessment Act 1997 (Cwlth) (ITAA97)
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PREVIEW
Capital gains tax (CGT) is levied on capital gains arising from CGT events happening (generally) to
CGT assets. A capital gain can arise in many circumstances and does not always involve a CGT asset (see
figure 3.1). Capital gains are included as part of assessable income and subject to the income tax
provisions.
CGT module overview
FIGURE 3.1
Australian CGT regime and
module overview
General types
of CGT assets
CGT events
Capital
proceeds
General
assets
Collectables
Personal
use
assets
Calculate the net
capital gain or loss
Cost
base or
reduced
cost base
Indexation
method and
discount
method
Separate
CGT
assets
CGT
exemptions
/rollover
relief
Small
business CGT
concessions
Source: CPA Australia 2022.
The calculation of a capital gain or capital loss follows a standard six-step process, which is presented
in figure 3.2, as well as in the section ‘CGT core concepts’ in this module. It is important that all
candidates have a working knowledge of the six-step process for calculating a capital gain and a capital loss.
Figure 3.2 also contains the important terms relating to CGT.
FIGURE 3.2
CGT definitions and process
CGT definitions
Six-step process for CGT
CGT event
1. Determine CGT event
CGT asset
2. Identify CGT asset
Capital gain/loss
3. Calculate capital gain/loss
Other legislation
4. Determine exceptions/exemptions
5. Consider rollover provisions
6. Calculate total gain/loss
– Apply CGT discounts
– Apply small business concessions
Source: CPA Australia 2022.
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174 Australia Taxation
The final step in the process is to calculate the total capital gain or loss to the taxpayer. As part of this
step, any relevant discounts and small business concessions are applied.
3.1 CGT CORE CONCEPTS
WHAT IS CAPITAL GAINS TAX?
Capital gains tax (CGT) is levied on capital gains arising from CGT events happening (generally) to
CGT assets.
A capital gain or loss arises when a CGT event occurs, generally in relation to a CGT asset
(e.g. the disposal of a CGT asset). Sometimes a capital gain or loss can be triggered in other circumstances,
including when a managed fund or trust makes a distribution to a taxpayer (see table 3.2 in section
‘CGT events’).
A capital gain or loss may also occur when certain gifts are received by taxpayers. CGT events are
covered in the next section, ‘CGT events’. The section ‘Determining gain/loss from CGT event’ later in
this module examines how to determine the capital gain or loss for each CGT event.
It is important to understand that CGT is not a separate tax, but that it is part of an individual’s income
tax. Taxation is levied on the net capital gain at the taxpayer’s marginal tax rate.
CGT was introduced into Australia on 20 September 1985, and normally only applies to CGT assets
acquired by the taxpayer from that date. If an asset is acquired before 20 September 1985, it is generally
exempt from CGT. Note that income that comes from the disposal of a pre-20 September 1985 asset
may still be liable for taxation under other non-CGT provisions of the legislation. In some instances,
such income might be assessable under the ordinary income provision s. 6-5 of ITAA97 (see the section
‘Mere realisation of capital assets and profits from isolated transactions’ in module 2) or under s. 15-15 of
ITAA97, which applies to a profit-making undertaking or plan involving the disposal of a pre-CGT asset.
Capital gains are included as part of assessable income and subject to the income tax provisions.
What is a CGT Event?
CGT events are the different types of transactions or events that might result in a capital gain or capital loss.
Many CGT events involve a CGT asset (see section ‘CGT assets’) and some relate to capital receipts.
There are a wide range of CGT events, and these are discussed in section ‘CGT events’ in this module.
What is a CGT Asset?
The definition of a CGT asset is discussed in more detail later in the section ‘CGT assets’. Included in
the definition of a CGT asset is any kind of property, including items such as shares in a publicly listed
company, or an investment property used to generate rental income. Also included are legal/equitable rights
other than property (ITAA97, s. 108-5).
No CGT is paid on the disposal of an individual’s main residence — the main residence exemption is
discussed later in section ‘Determining gain/loss from CGT event’. In fact, most personal assets are exempt
from CGT, which includes the main residence, car and some personal use assets. Personal use assets and
collectables are discussed in more detail in section ‘CGT assets’.
Depreciating assets used solely for taxable purposes — for example, fittings in a rental property
or business equipment — are also exempt from CGT.
What is a Capital Gain/Loss?
A capital gain or loss is generally calculated as the difference between the cost to acquire the asset and the
proceeds received as a result of the CGT event.
For many of the CGT events, if the proceeds received from the CGT event are higher than the cost base
(discussed in the section ‘Cost base’ later in this module), then a capital gain is made.
Likewise, for many CGT events, if the proceeds received from the CGT event are less than the reduced
cost base of the asset (discussed in the section ‘Reduced cost base’), a capital loss is incurred. A capital
loss can be applied against capital gains for the same income year and carried forward into future
income years to offset against future capital gains. A capital loss cannot be deducted from the taxpayer’s
other income.
There is no limit on how long the loss can be carried forward (subject to certain rules applying to
companies), and the losses are applied in the order they were incurred.
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MODULE 3 CGT Fundamentals 175
When Does a Capital Gain/Loss Occur?
Each CGT event sets out its own rules for when each event occurs and a capital gain or loss arises. For
example, in CGT event A1, a capital gain or loss occurs when the contract for disposal of the asset is
entered into — not the settlement date. When applying CGT event A1, if a contract is signed to sell an
investment property in June 2022, and settles in September 2022, then any gain or loss is reported in the
2021–22 tax year, not the 2022–23 tax year.
What About Residency?
For Australian residents, CGT applies to any assets held anywhere in the world. This is irrespective of
whether the Australian residents are individuals, partnerships, trusts, superannuation funds or companies.
For foreign residents (non-Australian residents for taxation purposes), a capital gain or loss is incurred
if a CGT event happens to an asset that is a taxable Australian property (see the section ‘Non-residents
and capital gains tax’ in module 2).
CGT INTERACTION WITH OTHER TAXES
Other (non-CGT) tax provisions take precedence over CGT. For example, if a disposal of a CGT asset is
subject to another form of taxation under Australian tax legislation, then any capital gain on that asset is
reduced accordingly.
Where the disposal of the asset occurs in the ordinary course of a business, then the gross proceeds from
that transaction will be assessed as ordinary income under s. 6-5, and no capital gain will arise.
Figure 3.3 shows how this operates.
CGT interaction with other taxation legislation
FIGURE 3.3
Has a CGT event
occurred?
No
No CGT. Consider
whether any other tax
legislation applies.
Yes
Income is subject to tax
under that legislation
(e.g. s. 6-5).
Yes
Is there a profit-making
undertaking or plan?
Yes
Does any tax legislation
apart from CGT and
s. 15-15 apply?
No
Is a pre-CGT asset
(acquired before
20 September 1985)
involved?
No
CGT may apply to
any gain, subject to
exemptions, exclusions
and rollover relief.
Source: CPA Australia 2022.
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176 Australia Taxation
Yes
Profit may be taxed
under s. 15-15.
SIX-STEP PROCESS FOR DETERMINING CGT
To determine a taxpayer’s net capital gain, a universal six-step process is followed, as shown in table 3.1.
TABLE 3.1
Six-step process for determining CGT
Step
Description
Module section/subsection
Step 1: Determine
CGT event
A CGT event must occur for a capital gain or loss
to arise.
‘CGT events’
Step 2: Identify a
CGT asset
The CGT event often (but not always) involves a
CGT asset. The underlying asset or assets must be
determined to calculate any capital gain or loss.
‘CGT assets’
Step 3: Calculate the
capital gain or loss
This must be considered separately for each
CGT event.
‘Determining gain/loss from
CGT event’
Step 4: Determine
exceptions or
exemptions
Applying an exception or an exemption may prevent a
capital gain occurring.
‘Determining exception
or exemption’
Step 5: Apply
applicable rollover
provisions
Applying a rollover will defer a capital gain until
a subsequent CGT event occurs. Sometimes the
taxpayer must choose the rollover. In other instances,
the rollover applies automatically.
‘Rollover provisions and
other reliefs’
Step 6: Calculate net
capital gain/loss
Step 6 brings together all the capital gains for the year
and the capital losses for the current and previous
tax years. CGT discounts and the small business
concessions are applied, if applicable, to further
reduce net capital gain.
‘Calculating net capital
gain/loss’
Source: CPA Australia 2022.
Figure 3.4 represents the six-step process as a decision tool.
CGT EQUATION
FORMULA TO LEARN
Calculating the final net capital gain or loss can be a complex process. The equation is as follows.
Net capital gain = Capital gains − Capital losses − CGT discount − CGT small business concessions
The calculation of net capital gain or loss is Step 6 in the CGT six-step process and is covered later in
section ‘Calculating net capital gain/loss’.
RECORD KEEPING
We know now that net capital gains are included in assessable income (ITAA97, s. 102-5) and tax is paid
at marginal tax rates. Therefore, taxpayers are required to keep proper records of all CGT assets acquired
after 19 September 1985. Taxpayers can choose to maintain records or keep an asset register.
Records
Where a taxpayer elects to maintain records, the taxpayer must keep details, in English, of the:
• date the asset was acquired and its cost, including any incidental costs
• date the CGT event occurred and any costs related to the CGT event
• capital proceeds received or deemed to be received (s. 121-20).
Records must be kept for five years after the last relevant CGT event in relation to the asset. This applies
to all records, unless the Commissioner of Taxation advises otherwise or the company has been dissolved
(s. 121-25). Records do not have to be kept for events where the capital gain or loss is disregarded, except
upon a rollover (s. 121-30).
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MODULE 3 CGT Fundamentals 177
FIGURE 3.4
CGT six-step process
Step 1:
Did a CGT event
happen in the tax year?
No
Yes
Step 2:
Identify the CGT asset
(if relevant)
Step 3:
Calculate the capital
gain/loss
Step 4:
Do any exceptions
or exemptions apply?
Yes
No
CGT liability
is deferred
Yes
Step 5:
Do rollover
provisions apply?
No
Step 6:
Determine net capital
gain/loss
Net loss
Carried forward for
offset against futureyear net capital gains
Net gain
Included in
assessable income
No capital
gain or loss
Source: CPA Australia 2022.
Asset Register
Taxpayers can keep a ‘CGT assets register’ with a separate entry for each asset. The entries in the register
must be in English. All entries in an assets register must be certified by a tax agent. The original records
pertaining to the asset listed in the register must be kept for five years. This five-year period is from when
the entry of the asset in the register was certified, not the date of the CGT event. For the Commissioner’s
view on the use of asset registers, see TR 2002/10.
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178 Australia Taxation
3.2 CGT EVENTS
OVERVIEW OF CGT EVENTS
A capital gain or loss can only potentially arise if a defined CGT event occurs. This is found in s. 100-20(1)
of ITAA97 and the defined CGT events are listed in Division 104 of ITAA97. They are also presented in
the next section.
DEFINED CGT EVENTS
The CGT events are set out in Division 104 of ITAA97, and summarised in table 3.2. Note that events
relating to tax consolidation (L1–L8) are not included in the table and are not examinable.
Table 3.2 outlines the main defined CGT events.
TABLE 3.2
Event
number
(section)
CGT events
Description
Timing of event
Example
A1
(s. 104-10)
Disposal of a CGT asset.
When the taxpayer enters
into the disposal contract. If
no contract, when ownership
transfers.
Sale of shares by an investor.
B1
(s. 104-15)
Use and enjoyment before
title passes.
When use of CGT asset
passes to another entity.
Hire purchase arrangements.
End of a CGT asset (C1–C3)
C1
(s. 104-20)
Loss or destruction of
a CGT asset.
When the taxpayer receives
compensation or, if none,
when loss is discovered or
destruction occurred.
Factory destroyed by fire.
C2
(s. 104-25)
Cancellation, surrender and
similar endings.
When taxpayer enters into
contract to end an intangible
asset. If no contract, when
asset ends.
Cancellation of legal rights arising
from a contract.
C3
(s. 104-30)
End of option to acquire
shares, etc.
When option ends.
Gain/loss made by company
when option to acquire its shares
expires without being exercised.
Bringing into existence a CGT asset (D1–D4)
D1
(s. 104-35)
Creating contractual
or other rights.
When taxpayer enters into
contract or right is created.
Non-compete clause in a
business sale contract.
D2
(s. 104-40)
Granting an option.
When option is granted.
Option to purchase land within a
specified period granted.
D3
(s. 104-45)
Granting a right to income
from mining.
When taxpayer enters into
contract or right is granted.
Taxpayer holds a mining
entitlement and grants a right to
income from operations permitted
under the entitlement.
D4
(s. 104-47)
Entering into a conservation covenant.
When covenant is
entered into.
Landowner enters into covenant
with government to conserve
their property for environmental
purposes.
When trust is created.
Assets are transferred to a new
family trust.
Events relating to trusts (E1–E10 )
E1
(s. 104-55)
Creating a trust over a CGT
asset.
(continued)
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MODULE 3 CGT Fundamentals 179
TABLE 3.2
(continued)
Event
number
(section)
Description
Timing of event
Example
E2
(s. 104-60)
Transferring a CGT asset
to a trust.
When asset is transferred.
Assets are transferred to an
existing family trust.
E3
(s. 104-65)
Converting a trust to a
unit trust.
When trust is converted.
Non-unit trust is converted to a
unit trust.
E4
(s. 104-70)
Capital payment for
trust interest.
When trustee makes
payment.
Amounts distributed from a unit
trust that are non-assessable
due to the small business 50%
concession.
E5
(s. 104-75)
Beneficiary becoming
entitled to a trust asset.
When beneficiary becomes
absolutely entitled.
In specie distribution of trust
assets to a beneficiary.
E6
(s. 104-80)
Disposal to beneficiary to
end income right.
Time of the disposal.
Property transfers on the
winding-up of a trust.
E7
(s. 104-85)
Disposal to beneficiary to
end capital interest.
Time of the disposal.
Property disposals on the
winding-up of a trust.
E8
(s. 104-90)
Disposal by beneficiary
of capital interest.
When disposal contract is
entered into or, if none, when
beneficiary ceases to own
CGT asset.
Sale of trust interests originally
acquired for nil consideration.
E9
(s. 104-105)
Creating a trust over future
property.
When taxpayer makes
agreement.
Assignment of prospective
interest in partnership to a
discretionary trust.
E10
(s. 104-107A)
Annual cost base reduction
of interest in attribution
managed investment trust
(AMIT).
When the reduction
happens.
The annual reduction in cost base
due to tax-deferred distributions
exceeds the cost base of the
asset.
Events relating to leases (F1–F5)
F1
(s. 104-110)
Granting, renewing or
extending a lease.
When lease agreement is
entered into or, if none, at
start of lease. For lease
renewal/extension, at start
of renewal/extension.
Lessor grants a lease and, if it is a
long-term lease, does not choose
to apply event F2.
F2
(s. 104-115)
Granting, renewing or
extending a long-term
lease.
When lessor grants the
lease or at start of renewal
or extension.
Lessor grants lease over land and
lease is for at least 50 years.
F3
(s. 104-120)
Lessor pays lessee to get
lease changed.
When lease term is varied or
waived.
Payment made by lessor to
shorten duration of lease.
F4
(s. 104-125)
Lessee receives payment
for changing lease.
When lease term is varied or
waived.
Payment received by lessee for
agreeing to shorten duration of
lease.
F5
(s. 104-130)
Lessor receives payment
for changing lease.
When lease term is varied or
waived.
Payment received by lessor for
agreeing to shorten duration of
lease.
Events relating to shares (G1 and G3)
G1
(s. 104-135)
Capital payment for shares.
When company pays nonassessable amount.
Liquidator’s interim distribution
made more than 18 months
before company ceases to exist.
G3
(s. 104-145)
Liquidator or administrator
declares shares or financial
instruments worthless.
When declaration is made.
Liquidator makes declaration
before final winding-up of a
company where no further
shareholder distributions
expected.
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180 Australia Taxation
Special capital receipts (H1 and H2)
H1
(s. 104-150)
Forfeiture of a deposit.
When deposit is forfeited.
Deposit paid to taxpayer is
forfeited when purchaser pulls
out of contract for sale of land.
H2
(s. 104-155)
Receipt for event relating to
a CGT asset (residual event
— designed to ensure tax
is paid where no other CGT
event applies).
When act, transaction or
event occurs.
Payment to the owner of land
who plans to build a building on
the land as an inducement to
commence building early, but
with no legal obligation to do so.
Australian residency ends (I1 and I2)
I1
(s. 104-160)
Individual or company
stops being an Australian
resident.
When individual or company
stops being Australian
resident.
Taxpayer owning certain assets
leaves Australia to become
permanent resident of the UK.
I2
(s. 104-170)
Trust stops being resident
trust.
When trust ceases to be
resident trust for CGT
purposes.
Trustee and central management
and control of a trust move
overseas.
CGT events relating to rollovers (J1, J2, J4–J6)
J1
(s. 104-175)
Company stops being
member of wholly owned
group after rollover. (Note:
Since the tax consolidation
regime was introduced, this
event occurs only rarely.)
When the company is
no longer fully owned by
the group.
Rollover of Australian asset
from a non-resident group
company to a resident group
company, followed by break-up
of corporate group.
J2
(s. 104-185)
Change in relation to
replacement asset or
improved asset after
small business rollover.
When the change happens.
Replacement asset acquired by
taxpayer under small business
rollover becomes trading stock.
J4
(s. 104-195)
Trusts fails to cease to exist
after its assets are rolled
over into a company.
When failure occurs.
Trust continues to exist six
months after its assets have been
rolled over into a company under
Subdivision 124-N.
J5
(s. 104-197)
Failure to acquire
replacement asset
or undertake capital
expenditure in respect of
existing active asset after
small business replacement
asset rollover.
At end of replacement asset
period (generally two years
after the rollover).
Taxpayer claims small business
rollover relief on disposal of an
asset but does not purchase a
replacement asset within two
years after the disposal.
J6
(s. 104-198)
Cost of replacement asset
or capital expenditure
in respect of existing
active asset not sufficient
to cover capital gain
disregarded under small
business rollover.
At end of replacement asset
period (generally two years
after the rollover).
Taxpayer claims small business
rollover relief on disposal of
an asset but purchases a
replacement asset costing
less than the gain that was
disregarded under the rollover.
Other CGT events (K1–K12)
K1
(s. 104-205)
International transfer
of emissions unit
(CGT implications of
carbon pricing).
When the unit starts to
be held as a registered
emissions unit.
Taxpayer starts to hold an
international emissions unit as
a registered emissions unit.
K2
(s. 104-210)
Bankrupt pays amount in
relation to debt.
When payment is made.
Bankrupt taxpayer can claim part
of pre-bankruptcy capital loss
if taxpayer repays some of the
related debt.
(continued)
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MODULE 3 CGT Fundamentals 181
TABLE 3.2
Event
number
(section)
(continued)
Description
Timing of event
Example
K3
(s. 104-215)
Asset passes to taxadvantaged entity
after death.
Just before death.
Asset is transferred to a foreign
resident beneficiary on death of
taxpayer.
K4
(s. 104-220)
CGT asset becomes
trading stock of taxpayer.
When asset becomes trading
stock.
Land previously held as an
investment is subdivided by
the taxpayer in preparation
for development and sale
and becomes trading stock.
K5
(s. 104-225)
Companies and trusts
holding collectable assets
that have fallen in market
value.
When CGT events A1, C2
or E8 happen to shares in
the company or interests
in the trust that owns
the collectable.
Taxpayer sells shares in a
company that owns artwork that
has decreased in value.
K6
(s. 104-230)
Sale of pre-CGT shares
or trust interest, where
market value of postCGT assets held by
company/trust represents
at least 75% of net value
of the company/trust.
When another CGT event
involving the shares or
interest occurs.
Taxpayer sells pre-CGT shares
in private company. 80% of the
value of the company relates to
post-CGT assets.
K7
(s. 104-235)
Balancing adjustment event
occurs for a depreciating
asset used wholly or partly
for private purposes.
When balancing adjustment
event occurs.
Disposal of a truck partly used for
private purposes.
K8
(s. 104-250)
Direct value shifts affecting
equity or loan interests in
a company or trust.
When decrease in
value of equity or loan
interest occurs.
Existing shares in a family
business held by a husband
and wife are devalued when new
shares are issued to the son.
K9
(s. 104-255)
Entitlement to receive
certain amounts in
respect of venture
capital investments.
When the entitlement arises.
Capital gains on sale of eligible
venture capital investments.
K10
(s. 104-260)
Foreign exchange gains.
When the foreign currency
amount is paid to the
taxpayer.
Foreign exchange gain on the
sale of a CGT asset for foreign
currency consideration, paid
within 12 months of the sale.
K11
(s. 104-265)
Foreign exchange losses.
When the foreign currency
amount is paid to the
taxpayer.
Foreign exchange loss on the
sale of a CGT asset for foreign
currency consideration, paid
within 12 months of the sale
(see module 2).
K12
(s. 104-270)
Foreign hybrid loss
exposure adjustment.
Just before the end of the
tax year.
Capital loss made by partners in
foreign hybrids (e.g. UK limited
partnerships).
Source: Based on Income Tax Assessment Act 1997 (Cwlth), Division 104-5, Federal Register of Legislation, accessed January 2022,
www.legislation.gov.au/Details/C2022C00029.
The table shows that there is a large number of CGT events, but some of these rarely occur. Candidates
are not required to have an in-depth knowledge of all events.
The chief CGT events, which are examined in more detail later in ‘Specific CGT events’, are:
• A1 — Disposal of a CGT asset
• C1 — Loss or destruction of a CGT asset
• C2 — Cancellation, surrender and similar endings
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182 Australia Taxation
• D1 — Creating contractual or other rights
• F1 — Granting, renewing or extending a lease
• H1 — Forfeiture of a deposit.
DETERMINING THE CGT EVENT
The first step is to determine which CGT event is the correct one to apply to the taxpayer’s situation.
It is very important that the most appropriate CGT event is selected. This is because each CGT event
has its own rules for determining the timing of that event (as summarised in table 3.2), and a capital gain
or loss is calculated differently for different CGT events. Exemptions and relevant concessions only apply
to certain CGT events.
Section 102-25 outlines how to determine the appropriate CGT event, which is shown in figure 3.5.
FIGURE 3.5
Order of application of CGT events (s. 102-25)
Has a CGT event
occurred?
No
CGT cannot apply. Consider
whether the transaction is subject
to tax under other legislation.
Yes
Apply only the most specific CGT
event, unless an exception applies
(see below).
Yes
Does any CGT event
apart from D1 and H2
apply?
No
Does CGT event D1
(creating contractual or
other rights) apply
Yes
Apply CGT event D1.
No
Does CGT event H2
(receipt for event
relating to a CGT asset)
apply?
Yes
Apply CGT event H2.
Source: CPA Australia 2022.
SPECIFIC CGT EVENTS
This section examines the chief CGT events most likely to occur in a given tax year. To recap, these are:
• A1 — Disposal of a CGT asset
• C1 — Loss or destruction of a CGT asset
• C2 — Cancellation, surrender and similar endings
• D1 — Creating contractual or other rights
• F1 — Granting a lease
• H1 — Forfeiture of a deposit.
For many of the CGT events, the determination of the capital gain or loss generally involves a comparison
of capital proceeds upon the CGT event occurring with the cost base or the reduced cost base of the asset.
These terms are discussed in more detail in ‘Determining gain/loss from CGT event’.
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MODULE 3 CGT Fundamentals 183
Event A1: Disposal of a CGT Asset
Disposal of a CGT asset is the most common CGT event. It occurs where there is a disposal or part disposal
of a CGT asset (s. 104-10). This disposal occurs only where there is a change in the beneficial ownership
of the asset. There would not be a change of ownership where an asset is destroyed (CGT event C1 would
apply) or where there is a change in trustee without any change to the beneficial ownership of trust assets
(see module 5).
CGT event A1 is involved in the compulsory acquisition of a CGT asset. It should be noted that when
determining the cost base of the part of the CGT asset that was compulsorily acquired, the compensation
to the extent that it reflects the reduction in value of the remaining part of the CGT asset, will form part of
the capital proceeds for the CGT event happening to the part of the CGT asset compulsorily acquired (see
TD 2001/9). This is calculated using the following formula (s. 112-30(3)).
Cost base of the asset ×
Capital proceeds for the CGT event happening to the part
Those capital proceeds + Market value of the remainder of the asset
Timing
CGT event A1 occurs at the date the disposal contract is entered into or, if there is no contract, when the
change of ownership occurs.
Calculation of Capital Gain or Loss
A capital gain is made if the capital proceeds from the disposal are more than the cost base of the asset.
Conversely, a capital loss arises if those capital proceeds are less than the asset’s reduced cost base.
Exceptions for Pre-CGT Assets
A capital gain or loss is disregarded if the asset was acquired before 20 September 1985 (i.e. for pre-CGT
assets).
Example 3.1 considers a scenario in which a specific CGT event occurs.
EXAMPLE 3.1
Determining the CGT Event — Lucy Yee
On 20 June 2022, Lucy Yee entered into a contract to sell land that she had acquired on 1 April 1997.
The contract is settled on 1 October 2022. Lucy made a capital gain of $650 000 from the sale. Consider
what CGT event has occurred, the timing of the event and what would happen if the contract falls through
and is not completed.
Assuming the contract is completed, the gain is made in the 2021–22 tax year, as the time of the CGT
event A1 is when the contract is made (20 June 2022), not when settlement takes place.
If the contract falls through, then CGT event A1 does not occur because there is no change in beneficial
ownership of the land. Assuming Lucy had lodged her income tax return for the 2021–22 tax year,
and included the capital gain, if the contract subsequently fell through, she would request an amendment
to the 2021–22 income tax assessment to exclude the capital gain.
Event C1: Loss or Destruction of a CGT Asset
Where a CGT asset that is owned by the taxpayer is lost or destroyed, CGT event C1 occurs (s. 104-20).
Timing
The time of the event is when the taxpayer first receives compensation (such as a payment from an
insurance policy) for the loss or destruction or, if no compensation is received, when the loss is discovered
or the destruction occurred.
Capital Gain or Loss
The taxpayer makes a capital gain if the capital proceeds from the loss or destruction — meaning any
compensation received — are more than the asset’s cost base, and a capital loss if those proceeds are less
than the asset’s reduced cost base.
Exception
A capital gain or loss is disregarded if the asset that was lost or destroyed was acquired before
20 September 1985 (i.e. for pre-CGT assets).
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184 Australia Taxation
Example 3.2 considers another scenario in which a specific CGT event has occurred, as well as the
timing of the event.
EXAMPLE 3.2
Determining the CGT Event — Tony Paton
On 1 February 2021, Tony Paton’s dairy farming business is destroyed by fire. Tony receives $1.2 million
in compensation from his insurance company on 1 October 2021.
Consider what CGT event has occurred and when is it considered to have occurred.
As Tony received compensation, CGT event C1 occurred on 1 October 2021 (2021–22 tax year) and not
on 1 February 2021 (2020–21 tax year) when the fire occurred.
Event C2: Cancellation, Surrender and Similar Endings
CGT event C2 only applies to intangible assets. An intangible asset has no physical form and includes
contractual rights, options, leases or shares in a company.
CGT event C2 occurs if ownership of an intangible asset ends, due to any of the following reasons.
• It is redeemed or cancelled.
• It is released, discharged or satisfied.
• It expires.
• It is abandoned, surrendered or forfeited.
• It is exercised (for options).
• It is converted (for convertible interests) (s. 104-25).
Timing
The event occurs when the taxpayer enters into the contract that results in the ending of the asset or, if
there is no contract, when the asset actually ends, for example, the expiration date.
Calculation of Capital Gain or Loss
A capital gain arises if the capital proceeds on the ending of the asset are more than the asset’s cost base.
A capital loss arises if those proceeds are less than the asset’s reduced cost base.
Exceptions
There are some exceptions to CGT event C2, and these are detailed in s. 104-25(5). The most common
one is that it does not apply to pre-CGT assets.
QUESTION 3.1
Coffee Roasters and Bikes & Beans Cafe entered into a contract on 31 July 2021. The contract
specified that Coffee Roasters was the sole provider of roasted coffee beans and all associated
coffee-making hardware and support services to Bikes & Beans Cafe for the following five years.
Coffee Roasters paid $20 000 for the right to provide the beans, hardware and support. As a result
of a dispute, the contract was dissolved on 15 June 2022 and Coffee Roasters received $30 000 for
giving up its right to be sole provider of coffee beans, hardware and support.
What CGT event was triggered, and what was the capital gain amount?
Event D1: Creating Contractual or Other Rights
Events A1 and C1 to C2 all relate to CGT assets being disposed of or ceasing to exist.
In comparison, events D1 to D4 all relate to when a new asset is created. So, the question is, why does
the creation of an asset result in CGT? While an asset is indeed created, the transactions may also involve
the disposal of legal rights, often in return for a cash sum.
The four CGT events that apply to situations where a new asset is created are:
1. the creation of contractual or other rights — CGT event D1 (s. 104-35)
2. the granting of an option — CGT event D2 (s. 104-40)
3. the granting of a right to income from mining — CGT event D3 (s. 104-45)
4. entering into a conservation covenant — CGT event D4 (s. 104-47).
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The most common events in this group are D1 and D2. We will look in detail at CGT event D1.
CGT event D1 has wide application because it occurs whenever a taxpayer creates a contractual right
or other legal or equitable right in another entity. One common example of CGT event D1 is a restrictive
covenant in a business disposal contract. Under the covenant, in return for a cash amount, the vendor of
the business agrees not to establish a similar business within a given time frame and locality. In such an
instance, a right has been created in favour of the purchaser.
Timing
The event occurs when the contract is entered into or, if no contract exists, when the right is created.
Calculation of Capital Gain or Loss
A capital gain occurs if the capital proceeds from the creation of the rights are greater than any
incidental costs incurred in creating them. A capital loss occurs if the capital proceeds are less than the
incidental costs.
Exceptions
It is important to remember that CGT event D1 does not apply where another CGT event, other than H2,
occurs. If a taxpayer entered into a contract to sell an asset such as land or shares, CGT event A1 would
occur when the contract to dispose of the asset is entered into, and CGT event D1 is disregarded, even
though there are contractual rights associated with the contract of sale.
Alternatively, if a contract involves different sums received for different purposes, it is possible for CGT
event D1 to be triggered together with other CGT events.
Example 3.3 presents illustrates a specific CGT event being triggered when a restrictive covenant is
entered into.
EXAMPLE 3.3
Determining the CGT Event — David Wong
David Wong is a dentist and sells his business for $800 000. He also promises not to compete with the
new buyer for three years for $200 000.
The sale of the business will trigger CGT event A1 and the restraint of trade (not to compete) provision
will trigger CGT event D1.
There are other specific exclusions for CGT event D1. These are as follows (s.104-35(5)).
• The right is created ‘by borrowing money or obtaining credit from another entity’.
• The right requires the taxpayer to do something that gives rise to another CGT event for the taxpayer.
• A ‘company issues or allots equity interests or non-equity shares in the company’.
• The ‘trustee of a unit trust issues units in the trust’.
• A ‘company grants an option to acquire equity interests, non-equity interests or debentures in the
company’.
• The ‘trustee of a unit trust grants an option to acquire units or debentures in the trust’.
• The taxpayer created the right ‘by creating in another entity a right to receive an exploration benefit
under a farm-in farm-out arrangement’.
QUESTION 3.2
Mandy Johnston sells her clothing retail business to Naomi Harris. As part of the transaction, Mandy
enters into a restrictive covenant to not open a competing business for the next four years within
10 km of the clothing store. Mandy is paid $150 000 by Naomi for entering into this agreement, and
neither party incurs any associated costs with this payment.
What CGT events occur due to the above events, and what are the resulting capital gains or
losses?
Event F1: Granting a Lease
A lease is a CGT asset as it involves legal rights over property. CGT events F1 to F5 specifically address
transactions in relation to leases. We will look specifically at CGT event F1, the most common of these
events.
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Two different taxpayers can be caught by these events:
1. the lessor — the taxpayer who grants the lease, usually the owner of the property
2. the lessee — the taxpayer who is given the right to use the property, in return for rental payments and
(sometimes) a lease premium. The premium is the amount paid for obtaining the lease.
Where a lessor grants, renews or extends a lease, CGT event F1 occurs (s. 104-110) and can result in a
capital gain or loss for the lessor.
Timing
Where a lease is granted, CGT event F1 occurs when the lease contract is entered into or, if there is no
contract, at the start of the lease.
Where an existing lease is renewed or extended, CGT event F1 occurs at the start of the renewal
or extension.
Calculation of Capital Gain or Loss
The lessor will make a capital gain if the capital proceeds (any lease premium paid by the lessee) are
greater than the cost to the lessor of granting, renewing or extending the lease.
A capital loss arises where the capital proceeds are less than such costs. A lease premium is typically
paid at the beginning of the lease (the capital component) and does not include rent payable under the
lease, which is assessable income for the lessor.
Exceptions
The lessor can choose to apply CGT event F2 (instead of event F1) to certain long-term leases (50 years
or more). Note that the capital gain or loss is calculated differently under CGT event F2, so consideration
should be given as to which provides the taxpayer with the best result.
QUESTION 3.3
On 15 May 2022, Solving Solutions Ltd (Solving Solutions) granted a lease of office premises to
BooksareUs Pty Ltd in return for a lease premium payment of $15 000. The legal expenses incurred
by Solving Solutions to prepare the lease agreement were $1500.
What is the capital gain derived and under which CGT event?
Event H1: Forfeiture of a Deposit
CGT event H1 occurs where a deposit is forfeited because a prospective sale or other transaction does not
proceed (s. 104-150).
Timing
The time of the event is when the deposit is forfeited.
Calculation of Capital Gain or Loss
A capital gain arises where the deposit is more than the expenditure incurred in connection with the
prospective sale or other transaction. A capital loss occurs if the deposit is less than that expenditure.
Example 3.4 is another example illustrating the application of a specific CGT event.
EXAMPLE 3.4
Determining the CGT Event — Beau Morris
On 22 October 2021, Beau Morris received a deposit of $60 000 for the prospective sale of his investment
property, a beach house, for $620 000. The sale was to take place on 1 December 2021. The purchaser
did not proceed with the sale and the deposit was forfeited on 5 November 2021. Beau decided not to
offer his beach house for sale to anyone else.
Consider what CGT event occurred and when it occurred. Also consider if a different CGT event would
be caused if Beau did continue to offer his beach house for sale.
CGT event H1 would occur at this time and Beau would make a capital gain on 5 November 2021 of
$60 000 (reduced by any incidental costs incurred by Beau in entering into the contract).
Note that if Beau did continue to offer his beach house for sale, the forfeited deposit could be included
in CGT event A1 (and H1 would not apply) when the house was subsequently sold (see Taxation Ruling
TR 1999/19).
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QUESTION 3.4
For the following scenarios, evaluate what CGT event has been triggered and identify the date of
the CGT event.
(a) Aarav Agarwal’s expensive watch is stolen on 4 March 2022, but he does not discover this till
10 March 2022. Insurance pays him for the loss of the watch on 9 April 2022.
(b) Janelle Jones informs her daughter that she will give her one of her investment properties as a
wedding gift on 1 February 2022. Transfer of the property takes place on 1 March 2022.
(c) A company, Breakfast Ltd (Breakfast), has a five-year agreement to be the sole supplier of a
certain breakfast cereal to a major supermarket chain. Three years into this agreement, on
4 December 2021, the supermarket chain and Breakfast agree to cancel the original agreement,
with Breakfast Ltd being compensated financially for the early termination.
(d) Chen Zhen is a landlord who, on 3 May 2019, enters into a three-year lease with Donna Wilson.
In addition to the monthly rent, there is an upfront payment of $15 000 payable by Wilson to Chen
at the commencement of the lease. The lease expires on 2 May 2022.
3.3 CGT ASSETS
WHAT IS A CGT ASSET?
As introduced in the first section, ‘CGT core concepts’, a CGT event generally occurs to a defined ‘CGT
asset’ (see figure 3.1). That CGT asset must have been acquired on or after 20 September 1985.
A CGT asset is defined in s. 108-5(1). It includes any kind of property and extends to include legal or
equitable rights that are not property. Examples of a CGT asset include:
• land and buildings (treated together, or as separate assets — this may vary)
• shares in a company
• units in a unit trust
• rights and options
• leases
• goodwill
• licences
• convertible notes
• contractual rights
• foreign currency
• any major capital improvement made to certain land or a pre-CGT asset
• collectables
• personal use assets
• interest in a partnership or in an asset of a partnership.
The knowledge of methods or techniques used to perform technical or practical tasks is commonly
referred to as know-how. This knowledge cannot be bought or sold. Know-how is not regarded as a CGT
asset because it is not property, or a legal/equitable right. However, knowledge and ideas can be protected
through various intellectual property statutes such as those created by copyrights, patents, trademarks and
designs. This change from know-how to intellectual property changes its status to a CGT asset.
Note that special CGT rules apply to CGT assets that are defined as collectables or personal use assets
(see figure 3.1).
QUESTION 3.5
Discuss whether the following are CGT assets.
(a) A patent to make a new highly efficient type of engine.
(b) A secret mining technique that allows minerals to be extracted from the ground more efficiently
as compared to current techniques.
(c) A contract to be employed as a senior manager by a leading retail chain, with an annual salary
of $100 000.
(d) The right to a safe workplace under laws that apply to all workers in Australia.
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COLLECTABLES
Section 108-10(2) provides a definition of collectable as:
(a) artwork, jewellery, an antique, or a coin or medallion; or
(b) a rare folio, manuscript or book; or
(c) a postage stamp or first day cover;
that is used or kept mainly for your (or your associate’s) personal use or enjoyment.
An interest in, a debt arising from, or an option or right to acquire a collectable will also be a collectable
(ITAA97, s. 108-10(3)).
CGT Treatment
Any capital gain or loss is disregarded if the first element of the collectable’s cost base (or first element of
its cost if it is a depreciating asset) on acquisition was $500 or less (s. 118-10(1)).
The first element of cost base is what the person paid for the asset or its market value if the person was
given the asset or acquired it through a non-arm’s length transaction. This $500 threshold excludes any
goods and services tax (GST) input tax credits, if these can be claimed. Where a taxpayer is registered
for GST and fulfils the other requirements for claiming an input tax credit on a cost base expenditure, the
input tax credit amount that the taxpayer is entitled to is not included in the CGT asset’s cost base. This is
explained later in this module (see ‘Additional cost base considerations’).
A set of collectables is taken to be a single collectable, so having the seller sell a set of individual separate
assets that were each acquired for no more than $500 would not stop the total acquisition being treated
as a collectable acquired for more than $500 (s. 108-15).
Example 3.5 illustrates the CGT implications involving the sale of a set of collectables.
EXAMPLE 3.5
CGT Treatment of Sets of Collectables
A taxpayer acquired an antique set of 24 pieces of cutlery consisting of knives, forks and dessert spoons
and teaspoons (usually sold as a set) for $2400.
Consider the CGT treatment If the taxpayer sold individual pieces of this set.
This would be considered a full set for CGT purposes. Thus, any gain or loss on the sale of individual
pieces of cutlery would need to be determined, even if the taxpayer claimed that, as there were 24 pieces,
the apportioned cost of individual pieces of that cutlery was $100 each, and so acquired at no more than
$500 each.
Importantly, any capital losses from collectables can only be offset against capital gains on other
collectables in either the current year or in a future year (s. 108-10(4)). A capital gain from a collectable
can qualify as a discount capital gain if all the eligibility conditions to apply the 50 per cent CGT discount
are met. Concessions are calculated in Step 6 of the CGT process and discussed in the last section of this
module, ‘Calculating net capital gain/loss’.
PERSONAL USE ASSETS
A personal use asset (Subdivision 108-C) is defined as a non-collectable asset, other than land or buildings,
used or kept mainly for personal use or enjoyment of the taxpayer or an associate (s. 108-20(2) and (3)).
A debt arising from, or an option or right to acquire, a personal use asset will also be a personal use asset.
Examples
Examples of personal use assets include boats, caravans, televisions and sporting equipment.
An option or right to acquire a personal use asset, a debt arising from a CGT event in which a personal
use asset was the subject of the event, and debt arising other than from gaining assessable income or
carrying on a business will also be a personal use asset (s. 108-20(2)). For example, the debt arising on a
personal, interest-free loan between a parent and their child is a personal use asset as it did not arise from
gaining income or carrying on a business.
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CGT Treatment
Any capital gain is disregarded where the first element of the personal use asset’s cost base (or first element
of its cost if it is a depreciating asset) on acquisition was $10 000 or less (s. 118-10(3)). The $10 000
threshold excludes any GST input tax credit, if these can be claimed. Where a taxpayer is registered for
GST and fulfils the requirements for claiming a GST input tax credit on a cost base expenditure, the input
tax credit amount does not form part of the cost base (see ‘Additional cost base considerations’).
Where personal use assets are a set and would ordinarily be disposed of as such, the set of personal use
assets will be taken to be a single asset for the purposes of the $10 000 threshold.
Any capital loss arising from a personal use asset is disregarded for CGT purposes regardless of the
asset’s cost base (s. 108-20(1)). Such losses are not available to offset capital gains on any type of
CGT asset.
Example 3.6 considers a case involving both personal use assets and other assets. This example will
help you understand how to apply the personal use asset provisions.
EXAMPLE 3.6
Personal Use Assets
On 30 August 2021, Sophie McCullough disposed of the following assets, all of which were acquired after
19 September 1985.
Asset
Shares
Painting
Motor boat
Cost base
Capital gain/(loss)
$7800
$1750
$8000
$3270
($1250)
$2500
Consider what capital gains and losses Sophie has, and if any of the losses can be used to offset any
of the gains.
As a result of CGT event A1, Sophie will incur a capital gain of $3270 in respect of the shares. The capital
loss of $1250 from disposal of the painting, which is a collectable, cannot be offset against the capital gain
from the shares. It can only be offset against a gain from a collectable, and shares are not collectables.
The motor boat is a personal use asset. As the first element of its cost on acquisition did not exceed
$10 000, the capital gain on the disposal of the boat is disregarded.
QUESTION 3.6
In the 2021–22 tax year, Dan Davies makes the following sales:
• shares sold for $90 000 that had been purchased for $100 000 two years earlier
• spiderman costume worn by an actor in a famous movie, sold for $12 000 — he had bought it on
eBay for $11 000 three years earlier
• an antique table (that Dan’s family uses when having their nightly family dinner) sold for
$45 000 — it had been purchased 18 months earlier for $30 000
• a 100-year-old stamp sold for $15 000 and had been purchased for $25 000 four years previous.
Disregarding the 50 per cent discount, what is Dan’s net capital gain/loss from these sales?
Include in your answer what capital losses (if any) Dan can carry forward.
SEPARATE CGT ASSETS
A separate CGT asset (Subdivision 108D) differentiates the common law principle that what is attached
to the land is part of the land. That is, in certain circumstances, buildings or structures on land, or capital
improvements to a CGT asset, can be treated as separate assets for CGT purposes. Therefore, if the principal
asset of land was acquired and contracted before 20 September 1985 (pre CGT), any improvements or
additions to the principal asset added after 20 September 1985 (post CGT) will be treated as separate CGT
assets if it meets certain scenarios, as outlined below.
Note that for assets acquired before 20 September 1985 but without a contract, the construction is said to
have started on or after the 20 September 1985. Therefore, all land, structures and improvements without
a contract prior to the 20 September 1985 will be treated as post-CGT assets for CGT purposes.
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The four main scenarios that apply are outlined in the legislation.
1. A building is a separate asset from the land (s. 108-55). In this case a post-CGT structure or building
is separate to the land if a balancing adjustment provision applies to the structure or building (see
Subdivision 40D or s. 355-315, discussed in module 2).
2. A depreciating asset that is part of the building is a separate CGT asset from the building or structure
(s. 108-60).
3. Land that is acquired post CGT is adjacent to land acquired pre CGT and both are amalgamated into
one title (s. 108-65).
4. Capital improvements are made to land or unrelated improvements are made to pre-CGT assets
(s. 108-70). A capital improvement is generally a structural change that is added to an existing CGT
asset or there is a reconstruction or replacement of the entire existing CGT asset. A capital improvement
will generally enhance the value, or improve the efficiency, of the existing asset.
Examples
An example of the first scenario is where the taxpayer constructed a timber mill building on land they
owned since 1990. If the building is subject to a balancing adjustment on its disposal, loss or destruction
the building will be taken to be a separate CGT asset from the land.
An example of the second scenario is where the taxpayer owns a factory from which they carry on a
business. They install restrooms for the employees and the plumbing fixtures and fittings are depreciating
assets. These assets are taken to be a separate CGT asset from the factory.
An example of the third scenario is where the taxpayer bought a block of land pre-September 1985. On
1 June 1999 the taxpayer bought another block of land adjacent to the first block. The taxpayer
amalgamated the titles to the two blocks into one title. In this case the second block is treated as a separate
CGT asset and the taxpayer can make a capital gain or loss from it if they sell the whole area of land.
In the final scenario, a capital improvement to an original pre-CGT asset is taken to be a separate CGT
asset if its cost base when a CGT event occurs in relation to the original asset is:
• more than the improvement threshold of $156 784 for the 2021–22 income year in which the event
happened, and
• more than 5 per cent of the capital proceeds from the event.
For example, a taxpayer buys a boat in 1982. In 1999 they installed a new mast (a capital improvement)
for $30 000. Later, the taxpayer sells the boat for $150 000.
If the cost base of the improvement in the sale year (when the CGT event occurs) is $41 000 and the
improvement threshold for that year is $156 784, the improvement will not be treated as a separate asset.
CGT TREATMENT
Note that if a capital improvement is treated as a separate CGT asset, the capital proceeds resulting
from the CGT event will be apportioned between the original asset and the capital improvement in
working out the capital gain (s. 116-40). Example 3.7 highlights the different outcomes from undertaking a
capital improvement.
EXAMPLE 3.7
Separate CGT Assets
In December 1984, Malcom purchased a Sydney investment property with two rooms for $120 000,
$80 000 for the land and $40 000 for the house. In order to enhance the value of the property and increase
the rental income, Malcom extended the house in 1995 by adding another two rooms with the same size
and quality of the existing rooms. This extension cost $90 000. Malcom sold the property in September
2021 for $1 000 000. At the time of this transaction, a licensed property valuer indicated that the land was
valued at $700 000 and the house was valued at $300 000, with the two newer rooms and the two original
ones in very similar condition. The improvement threshold is $156 784 for the 2021–22 income year.
Scenario 1
If the cost base of the extension (capital improvement) at the time of sale in September 2021 (when the
CGT event occurs) is $150 000, the extension is not treated as a separate CGT asset as the value is below
the improvement threshold (ITAA97, s. 108-70(2)). Therefore, s. 116-40 of ITAA97 does not apply and
Malcom does not need to apportion the capital proceeds between the original house and the extension.
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Even though Malcom has made a capital gain of $880 000 (the proceeds of $1 000 000 minus the original
value $120 000), he does not include this capital gain in his assessable income for the 2021–22 income
year, because the whole house is a pre-CGT asset (s. 104-10(5)).
Scenario 2
If the cost base of the extension at the time of sale is $200 000, the extension will be taken to be a
separate CGT asset because it meets the two threshold tests contained in s. 108-70(2). That is, the value of
$2000 00 is above the improvement threshold, $156 784 and it is greater than 5 per cent of the capital
proceeds pertaining to this extension ($1 000 000 × 5%= $50 000).
According to s. 116-40, Malcom needs to apportion the capital proceeds that he received from the sale
between the original house and the extension. As stated, two rooms were added of the same size and
quality as the original rooms, and they were in very similar condition according to the licensed property
valuer. Therefore, it would be reasonable to apportion the proceeds pertaining to the four-room house on
a 50/50 basis, being $150 000 (half of the value of the house, $300 000) each to the original house and
the extension.
Based on the discussion, the calculation of Malcom’s taxable capital gain relating to this transaction
will be as follows.
CGT assets
Original asset (land and original two rooms)
Capital improvement (the added two rooms)
Total
Original value/cost
incurred
$
Capital
proceeds
$
Capital gain
or loss
$
120 000
90 000
850 000*
150 000
0**
60 000***
60 000
* (700 000 + 150 000)
** This original house is a pre-CGT asset. Therefore, any capital gains or losses are disregarded (s. 104-10 (5)).
*** This extension is treated as a separate CGT asset. Thus, apportionment applies (ss. 116-40 and 104-10(4)).
Source: Adapted from Bevacqua, J et al. 2022, Australian Taxation, 2021–22 Tax Update Edition, pp. 87–8, John Wiley &
Sons, Milton.
QUESTION 3.7
On 1 February 1982, Reg Peters purchased a block of land for $2 900 000 on which to erect a factory.
After receiving several quotes for the construction, Reg eventually signed a contract on 15 March
2019 with Trusted Builders Ltd.
The factory was constructed and completed on the 30 June 2020 at a cost of $3 500 000. However,
due to financial difficulties, the land and buildings were later sold for $8 000 000 on 1 September
2021. An independent valuation revealed that the land component of this value was $5 200 000 at
the time of sale.
Advise Reg Peters of the CGT treatment of the transaction for the 2021–22 tax year.
3.4 DETERMINING GAIN/LOSS FROM CGT EVENT
HOW TO CALCULATE THE GAIN/LOSS
Having established that a CGT event has occurred and identified the relevant asset(s), Step 3 is to calculate
the capital gain or capital loss that arises from each CGT event.
Each CGT event outlines how to calculate the capital gain or capital loss for that CGT event. There are
rules that apply to many events, being that the taxpayer must:
• determine the capital proceeds arising from the CGT event
• determine the cost base of the CGT asset
• subtract the cost base from the capital proceeds.
Where the capital proceeds exceed the cost base, a capital gain arises.
If the capital proceeds are less than the cost base, then the reduced cost base must be ascertained. If the
reduced cost base exceeds the capital proceeds, there is a capital loss.
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If the capital proceeds are less than the cost base but more than the reduced cost base, there is neither a
capital gain nor a capital loss.
Figure 3.6 is a flowchart demonstrating how to determine the capital gain and loss.
FIGURE 3.6
Flowchart of determining capital gain/loss for many of the CGT events
Are proceeds greater
than cost base?
Yes
Capital gain
Consider whether indexation or CGT
discount is available to reduce
tax payable (refer to later notes).
No
Are proceeds less than
reduced cost base?
Yes
Capital loss
Consider whether loss is available to
offset other capital gains made in
current of future tax year.
No
NO GAIN, NO LOSS.
Source: CPA Australia 2022.
Now let’s turn to the definitions and operation of capital proceeds, cost base and reduced cost base.
CAPITAL PROCEEDS
The capital proceeds arising from a defined CGT event is the sum of:
• any money the taxpayer has received or is entitled to receive
• the market value of any property the taxpayer received or is entitled to receive in respect of the CGT
event occurring.
Determining Capital Proceeds: The General Rule
Capital proceeds will be taken into account at the time of the CGT event, irrespective of whether they were
actually received at that time.
A CGT event involving the taxpayer supplying a CGT asset will sometimes result in the taxpayer
incurring a GST liability. This will typically be the case where the taxpayer is registered for GST and the
other requirements of a taxable supply (see module 6) are fulfilled. In such an instance, the capital proceeds
will not include the GST liability amount (s. 116-20(5)). For instance, if a business that is registered for
GST sells a commercial property for $2.2 million and, as a result incurs a GST liability of $200 000, then
the capital proceeds would be $2 million.
Where the capital proceeds are in a foreign currency, it is necessary to determine the Australian
equivalent at the time of the CGT event (s. 960-50) (refer to module 2 for the foreign currency
translation rules).
Example 3.8 provides some facts illustrating how capital proceeds are ascertained when a CGT asset is
sold by instalments.
EXAMPLE 3.8
Capital Proceeds
Megan Marshall sells a CGT asset for $90 000 and receives payments from the purchaser in three equal
annual instalments of $30 000 each. Consider Megan’s capital proceeds attributable to the sale of the
CGT asset.
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Megan’s capital proceeds in the year of the CGT event will be $90 000, even though she may only receive
$30 000 at the time of selling the asset.
If Megan was registered for GST, and the supply of this CGT asset fulfilled the other requirements of
constituting a taxable supply, then the capital proceeds would not include the portion of the $90 000 that
constitutes Megan’s GST liability.
Modifications to the Determination of Capital Proceeds
There are six modifications to the general rule in the calculation of capital proceeds. Note that not all
capital proceeds modifications apply to all CGT events (s. 116-25).
These modifications are explained in table 3.3.
TABLE 3.3
Capital proceeds — modifications to the general rule
Modification
1. Market value substitution rule (s.
Description
116-30)†
Capital proceeds are deemed to be equal to the market
value of the underlying CGT asset where:
• no proceeds are received (e.g. a gift)
• some or all of the proceeds cannot be valued
• actual proceeds differ from the market value of the
asset, and the parties to the transaction did not deal
with each other on an arm’s-length basis (i.e. parties
are not acting independently, or one party exercises
influence or control over the other)
• actual proceeds differ from the market value and the
CGT event is event C2 (cancellation, surrender and
similar endings).
2. Apportionment rule (s. 116-40)
Capital proceeds are apportioned if:
• a payment relates to more than one CGT event
• only part of the proceeds relates to the CGT event.
3. Non-receipt rule (s. 116-45)
Capital proceeds are reduced by any amount not
received after reasonable steps have been taken to
recover the amount. The non-receipt must not be
attributable to anything that the taxpayer or taxpayer’s
associate has done or omitted to do.
4. Repaid rule (s. 116-50)
Capital proceeds are reduced by any non-deductible
amount a taxpayer has to repay.
5. Assumption of liability rule (s. 116-55)
Capital proceeds are increased if another entity acquired
the CGT asset from the taxpayer subject to a liability by
way of security over the asset. The increase is equal to
the amount of the liability the other entity assumes.
6. Misappropriation rule (s. 116-60)
Capital proceeds are reduced if an employee or an
agent of the taxpayer misappropriates (whether by
theft, embezzlement, larceny or otherwise) all or part
of those proceeds. However, if the taxpayer later
receives an amount as recoupment for all or part of
the misappropriated proceeds, capital proceeds are
increased accordingly.
†
The market value substitution rule does not apply to:
• CGT event D1 (creating contractual rights) where no capital proceeds are received
• the expiry of a CGT asset or the cancellation of a statutory licence (both CGT event C2) where no capital proceeds are received
• CGT event C2 when the event occurs in respect of shares or units in widely held companies or unit trusts (at least 300
shareholders/unitholders) and some capital proceeds are received (s. 116-30(2B).
Source: Based on Income Tax Assessment Act 1997 (Cwlth), Division 116, Federal Register of Legislation, accessed January 2022,
www.legislation.gov.au/Details/C2022C00029.
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194 Australia Taxation
Examples 3.9 and 3.10 illustrate the operation of some of the capital proceeds modification rules.
EXAMPLE 3.9
Market Value Substitution Rule
Soren Pedersen gifts land, worth $300 000 to his son. Consider the capital proceeds to Soren and the
CGT difference if Soren sold the land to his son for $100 000.
To determine the capital proceeds in calculating any capital gain or loss under CGT event A1, Soren
is deemed to receive capital proceeds of $300 000 (market value substitution rule). The capital proceeds
would also be $300 000 if Soren sold the land worth $300 000 to his son for $100 000, as this would be
regarded as a non-arm’s length transaction (i.e. between father and son).
EXAMPLE 3.10
Assumption of Liability Rule
Greg Goodwin sells land in return for $360 000 in cash and the buyer becoming responsible for a $160 000
liability under Greg’s mortgage. Consider how the assumption of liability rule affects the capital proceeds.
The capital proceeds of $360 000 are increased by $160 000 to $520 000 (assumption of liability rule).
QUESTION 3.8
Prisha Patel enters into a contract to sell her investment property in exchange for:
• $600 000 in cash
• the buyer’s car, worth $50 000
• the buyer taking over her mortgage of $200 000.
However, of the $600 000 cash Prisha is supposed to receive, she only receives $550 000
because her personal assistant, who helped manage the settlement, has stolen $50 000 and cannot
be located.
However, it turned out that the whole property was termite infested. The buyer subsequently sues
Prisha because the sales contract stated that the property had no termites. Prisha settled the legal
action by giving the buyer $20 000.
What are Prisha’s capital proceeds?
COST BASE
The cost base generally includes all non-deductible expenditure incurred in acquiring, maintaining,
improving and disposing of a CGT asset.
Where a CGT event occurs in relation to a CGT asset, the asset’s cost base must generally be calculated
in order to determine the capital gain. The gain is generally the difference between capital proceeds and
cost base.
As with capital proceeds, the cost base is modified in certain circumstances, often by substituting market
value for any amounts actually paid for an asset.
For assets acquired before 21 September 1999, the cost base may also be increased by indexation. This
is discussed in section ‘Indexed cost base’.
Where a capital loss has arisen from a CGT event, the amount of that loss is calculated by reference to
the reduced cost base, which can be different to the cost base. This is discussed in ‘Reduced cost base’.
Five Elements of Determining Cost Base
Section 110-25 states that an asset’s cost base consists of five elements. These elements are shown in
table 3.4.
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TABLE 3.4
Five elements of cost base
Element
1.
Examples
The money paid, or required to
be paid, in acquiring the asset
plus the market value of any
property given or required to
be given.
A taxpayer pays $1000 for a painting at an art auction. The
first element of the painting’s cost base is $1000.
2.
Incidental costs incurred where
no tax deduction has been or will
be allowed for these costs.
The incidental costs can only include the following costs
which, with the exception of the second last bullet point
(concerning the head company of a consolidated group),
relate to acquiring the CGT asset, or to the CGT event
(s. 110-35):
• remuneration for the services of a surveyor, valuer,
auctioneer, accountant, broker, agent, consultant or legal
adviser
• transfer costs
• stamp duty
• advertising and marketing costs
• valuation and apportionment costs
• search fees
• conveyancing kit costs
• borrowing expenses, such as loan application and
mortgage discharge fees
• costs incurred by a head company of a consolidated group
to a person outside the group that reasonably relates to a
CGT asset transferred between members of the group
• termination or similar fees as a direct result of the
ownership of an asset ending.
3.
The costs of owning the CGT
asset, but only where the asset
was acquired after 20.08.91 and
where no tax deduction has been
or will be allowed for these costs.
These costs include:
• interest on money borrowed to acquire the asset
• costs of maintaining, repairing and insuring it
• rates or land tax
• interest on money borrowed to refinance the money
borrowed to acquire the asset
• interest on money borrowed to finance capital expenditure
to increase the asset’s value.
4.
Capital expenditure incurred:
• for the purpose or expected
effect of increasing or
preserving the asset’s value
(does not apply to capital
expenditure incurred in relation
to goodwill)
• that relates to installing or
moving the asset.
Initial (non-deductible) repair expenditure incurred on a
CGT asset after its acquisition would be included in the
fourth element of the cost base of the asset (see Taxation
Determination TD 98/19; see module 2).
5.
Capital expenditure incurred to
establish, preserve or defend title
to the asset or a right over
the asset.
Compensation payment made to a potential purchaser of a
CGT asset when the sale contract is terminated would be
included in the fifth element of the cost base of the asset.
A taxpayer purchases land for $600 000. The vendor
agrees that the purchase price can be paid in three monthly
instalments of $200 000. The first element of the land’s cost
base is $600 000, even if all instalments have not yet been
paid (s. 110-25).
Source: Based on Income Tax Assessment Act 1997 (Cwlth), Subdivision 110-A, Federal Register of Legislation, accessed January
2022, www.legislation.gov.au/Details/C2022C00029 .
Additional Cost Base Considerations
Any expenditure relating to illegal activities, entertainment, penalties and bribes to a public official are
excluded from the cost base of a CGT asset.
Where the taxpayer is registered for GST and is able to claim GST input tax credits upon making cost
base expenditures (which will reduce their net GST liability, see module 6), the cost base will not include
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196 Australia Taxation
the net input tax credit amounts (s. 103-30). For instance, a GST registered business that purchases a
business premises for $660 000 (GST inclusive) and is entitled to claim an input tax credit of $60 000 will
only include $600 000 in the first element of the cost base of the premises.
For CGT assets acquired after 13 May 1997, the cost base is reduced to the extent that an amount in
respect of the asset’s cost is deductible (e.g. a capital works deduction for a building) or a non-assessable
recoupment of costs is received in respect of the asset (s. 110-45). Note that expenditures that have been
deducted, or are deductible, are excluded from the cost base (s. 110-45(1B) and(2)) and the reduced cost
base (s. 110-55(4)). That is, if the taxpayer has already had the benefit of the income tax deduction reducing
taxable income, they cannot also gain the benefit of an increased cost base and potential reduction in the
capital gain (see TD 2005/47).
QUESTION 3.9
Adam Zwar purchases a block of land with the intention of erecting two townhouses on it.
The following costs were incurred by Adam in acquiring the land (net of any GST input tax credits).
Item
Purchase price
Legal fees
Stamp duty
Valuation fees
$
250 000
3 500
10 660
1 500
Calculate the cost base.
Gifting and the Market Value Substitution Rule
The most common modification to the cost base is the replacement of the actual price paid with the market
value of the asset at the time of acquisition. This is known as the ‘market value substitution rule’ (this was
also discussed in earlier section ‘Capital proceeds’).
The market value substitution rule applies for the first element of the cost base when, at the time of
acquisition of the asset:
• there is no expenditure incurred by the taxpayer, which is generally when they are in the receipt of a
gift, or
• some or all of the expenditure incurred is unable to be valued, or
• the asset was acquired in a transaction where the parties were not dealing at arm’s length in connection
with the acquisition (s. 112-20(1)).
Example 3.11 illustrates the impact of a gift of a CGT asset from both the donor’s and recipient’s
perspective.
EXAMPLE 3.11
Gifting and the Market Value Substitution Rule
Yasmin Liu received a gift from her parents of 3000 shares in Angels Ltd. At the time, the market value of
each share in Angels Ltd was $10. Consider the first element of cost base for Yasmin due to receiving the
shares, the capital proceeds attributable to Lucy’s parents due to gifting her the shares.
Because Yasmin did not incur any expenditure in acquiring the asset, she would be deemed to have
acquired the shares at their market value of $10 per share on the date of acquisition.
The first element of the cost base of Yasmin’s shares is, therefore, $10 × 3000 = $30 000.
Yasmin’s parents would be deemed to have disposed of the shares at their market value at the time
of the gift (see the earlier section ‘Modifications to the determination of capital proceeds’). Their capital
proceeds would be $10 × 3000 = $30 000.
Section 112-20(2) provides that the market value substitution rule will not apply, despite the parties not
dealing at arm’s length, where the acquisition of the asset resulted from another entity doing something
that did not constitute a CGT event, and what was paid to acquire the asset was not more than its market
value at the time of acquisition. This would typically apply where a company issues shares or a trust issues
units for less than the market value.
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Note that, although in general the issuing of company shares or trust units does not trigger a CGT event,
in some limited situations it can trigger CGT event K8. This will be the case where such shares or units
are issued to other related parties in an attempt to shift value from the existing owners of the interests
in the company or trust to the new owners of the interests in the company or trust. For instance, a sole
shareholder of a company that causes further shares in that company to be issued to their spouse at under
market value is value shifting by essentially devaluing their own shareholding, and so they are potentially
triggering CGT event K8. (The details of CGT event K8 are beyond the scope of this course.)
Example 3.12 presents a situation where the market value substitution rule does not apply to a
share issue.
EXAMPLE 3.12
Non-Applicability of Market Value Substitution Rule
Albert fully owns a company called QLT Pty Ltd (QLT). Albert arranges for QLT to issue 1000 shares worth
$100 000 to himself in exchange for him paying the company $40 000. Although the parties were not
dealing at arm’s length, the market value substitution rule will not apply because (s. 112-20(2)):
• Albert’s acquisition resulted from another entity (QLT) doing something which did not constitute a CGT
event, being the issuing of shares (note that CGT event K8 would not apply here because there is no
attempt to shift value to another shareholder)
• Albert paid $40 000 to QLT, which is less than the market value of the shares of $100 000.
As a result, the first element of the cost base of the shares for Albert would be what he paid for them,
being $40 000.
However, if Albert had overpaid for the shares, for instance, by paying $200 000, the latter requirement
of s. 112-20(2) would not be fulfilled. As a result, the market value substitution rule would deem the first
element of the cost base of the shares to be their market value of $100 000, not $200 000.
INDEXED COST BASE
Indexing of the cost base occurs for CGT assets acquired prior to 11.45 am on 21 September 1999. The
following three conditions must be met for indexing to be applied.
1. The asset was acquired at or before 11.45 am on 21 September 1999.
2. The asset was acquired at least 12 months before a CGT event occurred in relation to the asset.
3. The taxpayer elects to use the indexation method.
Increasing the cost base by indexation (s. 110-36) has the result of decreasing any capital gain from the
CGT event.
Although indexation is available for all taxpayers, its importance is now severely limited as indexation
was frozen from the quarter ended 30 September 1999 and is not available for assets acquired after
21 September 1999. Further, expenditure on CGT assets acquired before this date can only be indexed
to September 1999. Indexation is never available when calculating a capital loss.
Calculation of Indexed Cost Base
FORMULA TO LEARN
To calculate the indexed cost base, the following steps should be followed.
1. Elements 1 (money paid plus market value), 2 (incidental costs), 4 (capital expenditure for asset’s value)
and 5 (capital expenditure to establish title or right over asset) of the cost base should be indexed by
the consumer price index by multiplying each of the relevant expenditures by the indexation factor.
2. The unindexed element 3 (costs of ownership) should be added.
Any expenditure incurred on a CGT asset after 11.45 am on 21 September 1999 cannot be indexed.
So, in order to index expenditure, it must be multiplied by the indexation factor, calculated as follows.
The index number for the quarter of the year in which the CGT event occurred to the asset
(frozen at the quarter ended 30 September 1999 if CGT event occurred after that date)
The index number for the quarter in which the amount was paid
(or the expenditure incurred)
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198 Australia Taxation
The indexation factor is calculated to three decimal places, rounding up if the fourth decimal place is
five or more (s. 960-275(5)).
In practical terms, if indexation is available, then unless the CGT event occurred prior to the
September 1999 quarter, the numerator for the indexed cost base formula will be 68.7 (the figure for
the September 1999 quarter, see table 3.5) as indexation is frozen from the September 1999 quarter
onwards.
Consumer price index (CPI) numbers are published for all quarters up to the current date and are used
for other tax and superannuation purposes. Note that table 3.5 stops at September 1999, when indexation
was frozen for CGT cost-base purposes.
TABLE 3.5
CPI numbers
Year
31 March
30 June
30 September
31 December
1999
67.8
68.1
68.7
—
1998
67.0
67.4
67.5
67.8
1997
67.1
66.9
66.6
66.8
1996
66.2
66.7
66.9
67.0
1995
63.8
64.7
65.5
66.0
1994
61.5
61.9
62.3
62.8
1993
60.6
60.8
61.1
61.2
1992
59.9
59.7
59.8
60.1
1991
58.9
59.0
59.3
59.9
1990
56.2
57.1
57.5
59.0
1989
51.7
53.0
54.2
55.2
1988
48.4
49.3
50.2
51.2
1987
45.3
46.0
46.8
47.6
1986
41.4
42.1
43.2
44.4
1985
37.9
38.8
39.7
40.5
Source: ATO 2021a, ‘Consumer price index (CPI) rates’, accessed January 2022, www.ato.gov.au/rates/consumer-price-index.
For CGT events that occur from 21 September 1999, some taxpayers can choose to apply the CGT
discount instead of using an indexed cost base. The CGT discount is discussed in the last section
‘Calculating net capital gain/loss’.
REDUCED COST BASE
We know that a capital gain is determined by reference to an asset’s cost base or indexed cost base.
However, a capital loss is determined with reference to an asset’s reduced cost base.
All elements of the cost base discussed previously (except for the third element — costs of ownership
of the CGT asset incurred after 20 August 1991) form part of the reduced cost base.
When determining the reduced cost base, the taxpayer excludes the following elements (s. 110-55):
• any amount allowed or allowable as a deduction
• any decline in value of a CGT asset (i.e. depreciation deduction)
• any recouped costs not included in assessable income
• certain costs that give rise to a tax offset rather than a deduction
• if the CGT asset is shares in a company, certain distributions from amounts derived by the company
before you acquired the shares
• any expenditure on illegal activities, entertainment, contributions to political parties, water infrastructure
improvement payments, penalties and bribes of public officials
• any GST input tax credits after 19 February 2004 (s. 103-30).
Items included in the reduced cost base are never indexed.
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Example 3.13 illustrates how a reduced cost base, used in ascertaining a capital loss, is calculated.
EXAMPLE 3.13
Determining Reduced Cost Base
Deirdre Green acquired an investment property in November 2007 for $400 000. The incidental costs of
acquisition and disposal were $60 000. Deirdre had claimed a capital works deduction of $24 000 on
the construction cost of the dwelling (capital works deductions are available under Division 43 — see
module 2). On 10 May 2022, Deirdre sold the property for $420 000. Consider the capital loss due to the
sale of the property.
As there is a capital loss here, it is calculated as the reduced cost base minus the capital proceeds. The
reduced cost base is calculated as follows.
Item
Cost of property (first element)
Add: Incidental costs (second element)
Less: Capital works deduction (as this is a deduction, it is subtracted from the reduced
cost base)
Total reduced cost base
To calculate the capital loss:
Less: Capital proceeds (sales price)
Capital loss
$
400 000
60 000
(24 000)
436 000
(420 000)
16 000
QUESTION 3.10
Sandra Savage purchase shares in March 1993 for $50 000. Sandra sold the shares in February 2022
for $55 000 at which time she incurred brokerage fees of $200. If possible, Sandra wishes to use
indexation to minimise her CGT liability.
What is Sandra’s capital gain or loss on the shares?
DETERMINING EXCEPTION OR EXEMPTION
Pre-CGT Assets
The chief exemption to CGT is of course pre-CGT assets. These are assets acquired before
20 September 1985. There is one exception to this exemption — CGT event K6. CGT event K6 may
result in a capital gain if certain CGT events occur to pre-CGT shares in a company, or pre-CGT interests
in a trust.
The date of acquisition of the CGT asset is therefore very important. Refer back to table 3.2, which lists
the timing of each CGT event.
Specific CGT Exemptions
Division 118 exempts various capital gains and losses from CGT. As explained by the Australian Taxation
Office (ATO), exemptions from the CGT regime include (ATO 2020):
• a capital gain or loss made from a car (which is defined as a motor vehicle designed to carry a load of
less than one tonne and fewer than nine passengers), motorcycle or similar vehicle (s. 118-5). Note that a
car may be classified as a collectable under s. 108-10(2) if it is an antique or a personal use asset under
s. 108-20(2) if it is used or kept mainly for the taxpayer (or their associate’s) personal use or enjoyment.
Nevertheless, in either case, it remains a car for the purposes of s. 118-5 and any capital gain or loss is
disregarded (TD 2000/35)
• a capital gain or loss made from a decoration awarded for valour or brave conduct (unless the taxpayer
paid money or gave any other property for it) (s. 118-5)
• a capital gain or loss from a collectable where the first element of the cost base (acquisition cost) is $500
or less (refer back to the section ‘Collectables’ under ‘CGT assets’) (s. 118-10)
• a capital gain from personal use assets where the first element of the cost base (acquisition cost) is
$10 000 or less (s. 118-10) (refer back to the section‘ Personal use assets’ under ‘CGT assets’)
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200 Australia Taxation
• any capital loss from a personal use asset (s. 118-10) (refer back to the section ‘Personal use assets’
under ‘CGT assets’)
• a capital gain or loss from CGT assets used solely to produce exempt income or some amounts of nonassessable, non-exempt (NANE) income (i.e. tax-free income) (s. 118-12)
• a capital gain or loss from a CGT asset classified as trading stock at the time of a CGT event (s. 118-25)
• a capital gain or loss made from a CGT event relating to compensation or damages received for any
wrong, injury or illness suffered by the taxpayer or their family (s. 118-37)
• a capital gain or loss made from a CGT event happening to a depreciating asset (however, not CGT
event K7) (s. 118-24)
• a capital gain or loss made from a CGT event relating to winnings or losses from gambling, a game or
a competition with prizes (s. 118-37)
• a capital gain or loss due to the taxpayer receiving a reimbursement or payment of their expenses (but not
for the loss, destruction or transfer of an asset) under a scheme established by an Australian government
agency, a local government body or foreign government agency (s. 118-37)
• a capital gain or loss arising from a reimbursement or payment of the taxpayer’s expenses (but not
for the loss, destruction or transfer of an asset) under a scheme established under an Act or legislative
instrument (e.g. regulations or local government by-laws) (s. 118-37)
• a capital gain or loss arising from a right or entitlement to a tax offset, deduction or a similar benefit
under an Australian law, or under the law of a foreign country (s. 118-37)
• a capital gain or loss arising from some types of testamentary gifts (s. 118-60)
• a capital gain or loss arising from CGT event C2 happening due to the ending of rights that directly
relate to the breakdown of a marriage or relationship, including cash received as part of the marriage or
relationship breakdown settlement (s. 118-75)
• in certain circumstances, a capital gain or loss arising from a general insurance policy, a life insurance
policy or an annuity instrument (s. 118-300).
MAIN RESIDENCE EXEMPTION
An important and commonly used exemption is the main residence exemption (Subdivision 118-B). The
main residence exemption means that there is no capital gain or capital loss made from a CGT event that
relates to a dwelling that is the taxpayer’s main residence (s. 118-110).
The main residence rule can change depending on how the taxpayer came to own the dwelling and how
they subsequently treated it — for example, if it was later rented out. There are also different rules relating
to foreign investment and the main residence.
Definition of Dwelling
A dwelling is defined under the legislation as a unit of residential accommodation and includes a building,
caravan, houseboat or other mobile home. It also includes the land under the unit of accommodation
(s. 118-115).
The land that is adjacent to a dwelling will be eligible for the main residence exemption where the land
was used for private and domestic purposes. The maximum area of such land eligible for the exemption is
two hectares (s. 118-120). However, where a taxpayer’s land exceeds two hectares, the taxpayer can select
which two hectares the main residence exemption applies to (TD 1999/67).
Definition of Main Residence
There is no definition of ‘main residence’ in the taxation legislation. Instead, the ordinary meaning applies
and this involves a question of fact. The following are taken into account:
• the length of time the taxpayer has lived in the dwelling
• the place of residence of the taxpayer’s family
• whether the taxpayer’s personal belongings have been moved into the dwelling
• the address to which the taxpayer’s mail is delivered
• the taxpayer’s address on the electoral roll
• the connection of services such as telephone, gas and electricity
• the taxpayer’s intention in occupying the dwelling
• whether the taxpayer freely chooses or is obliged to spend time at a residence (CASE 26/93 AAT).
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AMOUNT OF MAIN RESIDENCE EXEMPTION AVAILABLE
Subdivision 118-B (ss. 118-100–118-210) states that the main residence exemption will not apply where
the residence was:
• only a main residence for part of the ownership period, or
• used for the purpose of producing assessable income.
More Than One Residence
If a taxpayer owns more than one residence that qualifies as a main residence, they must choose which
one is the main residence for CGT purposes. This choice occurs in the income year where the CGT event
occurs in relation to the dwelling in question.
Where a taxpayer has a main residence and acquires another dwelling that is to become the new main
residence, then both dwellings are treated as the taxpayer’s main residence for the shorter of:
• six months ending when the ownership interest in the existing main residence ends, or
• the period between the acquisition of the new ownership interest and end of the old ownership interest
(s. 118-140(1)).
This change of main residence exemption only applies where the existing main residence was used as a
main residence for a continuous period of at least three months in the preceding 12 months, ending when
the taxpayer’s ownership interest in it ends and it was not used for income-producing purposes during that
12-month period (s. 118-140(2)).
Absence From Main Residence
A taxpayer who initially occupies a dwelling as a main residence and then is absent from the dwelling can
choose to continue to treat the dwelling as the main residence (s. 118-145):
• for a maximum of six years if the dwelling, which is the main residence, is used to produce assessable
income during the absence. A taxpayer is able to claim a maximum period of six years every time the
dwelling becomes, and then ceases to be, the individual’s main residence
• for an indefinite period if the dwelling is not used for income-producing purposes during the period
of absence.
This absence rule will only apply if another dwelling is not being claimed as a main residence at the
same time.
Different Main Residences
If a spouse has a different main residence, then a choice has to be made by the couple about which dwelling
will be the main residence. Where the spouses nominate a different dwelling as their main residence and
each has a 50 per cent interest in each, then each dwelling is deemed to be a main residence at 50 per cent.
However, this also applies in cases where the spouses nominate a different dwelling as their main
residence and a spouse has an interest in a property of more than 50 per cent; in this case the dwelling
is taken to be the main residence for only half of the period. If the ownership interest is 50 per cent or less,
the dwelling is deemed to be the spouse’s main residence for that period (s. 118-170).
QUESTION 3.11
When Shaun Simnett and Jane West married, they bought and moved into a townhouse. They each
own 50 per cent of the townhouse. They also own a beach house that is 70 per cent owned by Jane
and 30 per cent owned by Shaun. From 1 July 2021, Shaun mainly lives in the townhouse and Jane
mainly lives in the beach house.
For the period 1 July 2021 to 30 June 2022, Shaun nominates the townhouse as his main residence
and Jane nominates the beach house as her main residence.
On 30 June 2022, Shaun and Jane dispose of both dwellings.
Apply the CGT treatment and any main residence exemption to this event for the period 1 July
2021 to 30 June 2022.
Source: Adapted from Income Tax Assessment Act 1997 s. 118-170, Federal Register of Legislation, accessed January 2022,
www.legislation.gov.au/Details/C2022C00029.
Partial Exemption
Where the dwelling was the main residence for only part of the ownership period, then an individual will
only get a partial exemption (s. 118-185).
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FORMULA TO LEARN
The capital gain, or loss, is calculated by using the following formula.
Capital gain or capital loss amount ×
Non-main residence days
Days in your ownership period
However, a different rule will apply in partial exemption situations where:
• the property was initially subject to the main residence exemption, and
• on or after 7.30 pm on 20 August 1996, it was subsequently used for income-producing purposes
(s. 118-192).
Where these conditions are fulfilled, s. 118-192 rather than s. 118-185 will apply. The effect of
s. 118-192 is that the first element of the cost base will be reset to the market value of the residence at
the time it was first used for income-producing purposes. Further, any other relevant expenditures from
that point will be taken into account in the asset’s cost base, meaning that the property will be treated as if
it was acquired at the point that it started being used as an income-producing asset.
Where a taxpayer initially uses a house as their main residence, then rents it out (on or after 20 August
1996), and then subsequently moves back into it (without being able to utilise the absence provision in
s.118-145), both of the above sections will apply. In such a situation, s. 118-192 will apply for when it is
first used for rental purposes, meaning that the first element of its cost base will be the market value at that
time. Then, when calculating the capital gain for the remainder of the ownership period, it will be subject
to the pro-rata rule under s. 118-185 for this remaining period.
Example 3.14 considers capital gains on a partial main residence.
EXAMPLE 3.14
Capital Gain Where Partial Use as a Main Residence
Lucas Veiszadeh initially lived in the house he purchased in 2014 for two years, and then, in 2016, it was
used for rental purposes for three years (assume Lucas was claiming another main residence for these
three years). In 2019, Lucas moved back into the house for another three years before selling the house
in 2022. Consider how the CGT partial exemption provisions affect the calculation of the capital gain on
the house.
The first element of the cost base for this house would be its market value when it was first used
by Lucas for rental purposes in 2016 (s. 118-192). Further, the capital gain would then be subject to a
50 per cent main residence exemption (because, after it was initially used for rental purposes, it was then
used as a main residence for half of that time between 2016 and 2022).
QUESTION 3.12
The following events relate to Tania Watson’s purchase and sale of a house.
• Tania purchased a house on 1 February 2014 for $300 000. $10 000 was paid in stamp duty.
• Tania initially lived in this house for five years.
• On 1 February 2019, Tania purchased an apartment and she moved into the apartment on the
same day. For tax purposes, this apartment was regarded by Tania as her main residence from
1 February 2019.
• Also on 1 February 2019, Tania rented out her house to a tenant. On this day, her house was worth
$420 000.
• During July 2019 the bathroom of the house was renovated, which cost $30 000.
• On 1 February 2020, she sold her apartment and moved back into her house. The house was
worth $550 000 at this time.
Tania sold the house on 1 February 2022 for $1 million. Real estate agent fees were $20 000.
What would be the capital gain made on the house (before applying any possible discounting)?
Figure 3.7 contains a flowchart that illustrates when s. 118-185 and when s. 118-192 are to be utilised.
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MODULE 3 CGT Fundamentals 203
204 Australia Taxation
No
Are the
conditions
in s. 118-192 for
s. 118-192 to apply
fulfilled?
No
Is a main
residence exemption
available for the full
ownership period?
Yes
Yes
Apply the rules in s. 118-192 that, in essence,
assume that the property was acquired at market
value when the taxpayer commenced using it for
income-producing purposes.
No
After
the premises
commenced being
used for income-producing
purposes, was it
subject to the main residence
exemption for any portion
of the remaining
ownership period?
Sections 118-185 and 118-192
are not required to be applied.
Flowchart for determining the application of ss. 118-185 and 118-192
Apply the pro-rata
formula in s. 118-185.
FIGURE 3.7
Source: CPA Australia 2022.
Pdf_Folio:204
Yes
Apply both sections 118-185 and 118-192.
Section 118-192 will, in essence, assume that
the property was acquired for its market value
when the taxpayer commenced using it for
income-producing purposes. Section 118-185
will be applied to the ownership period after
the property was first used for incomeproducing purposes. It will take into account to
what extent for that period the property was
not subject to the main residence exemption.
FOREIGN RESIDENTS AND THE MAIN
RESIDENCE EXEMPTION
The Treasury Laws Amendment (Reducing Pressure on Housing Affordability Measures) Act 2019
confirmed that taxpayers who are foreign residents at the time of a CGT event cannot benefit from either
the full (s. 118-110(3)–(5)) or partial main residence (s. 118-185(3)) provisions regarding their period
of ownership. For instance, a taxpayer who was initially an Australian resident and lived in their main
residence for many years, and then subsequently became a foreign resident and then later sold their house,
would be unable to utilise the main residence exemption (full or partial) upon the sale of their house.
However, there are exceptions under these provisions so that, in some instances, foreign residents can
utilise the main residence exemption. For instance, an exception applies when certain life events occur,
such as, when the taxpayer has been a foreign resident for less than six years at the time of the CGT event,
and either they or their spouse had a terminal medical condition at the time of their foreign residency
(ss. 118-110(3)–(5), 118-185(3)).
Example 3.15 considers capital gains on a partial main residence.
EXAMPLE 3.15
Main Residence Exemption for a Foreign Resident
David Montgomery, an Australian resident and a senior executive with LTD Bank, purchased a townhouse
in Sydney for $450 000 in June 2018. This became the main residence for him and his family. In July 2026,
LTD Bank posted David to London for a period of 10 years and provided him with a Bank residence for
him and his family to live there. David immediately rented out the Sydney townhouse for the period of
his absence. David’s wife returned to Sydney for a few months in 2028 as she was homesick, but then
returned to London. David considered the Sydney residence to be too small for his family’s needs and
later sold it in 2035, while still overseas, for $1 300 000.
In this case, David’s residency status had change to a non-resident, and he had been a non-resident
for a continuous period of greater than six years (i.e. 2026 to 2035) and therefore does not qualify as an
excluded resident (s. 118-110(4)). Likewise, the temporary return of David’s wife due to homesickness
does not constitute a life event (s. 118-110(5)). Consequently, as no exceptions apply, CGT would be
payable on the sale of the Sydney townhouse.
Foreign Resident Capital Gains Withholding Regime
There is a 12.5 per cent withholding obligation for foreign residents who dispose of:
• taxable Australian real property with a market value of $750 000 or above
• an indirect Australian real property interest
• an option or right to acquire such property or interest.
Under this rule, when the vendor (owner) of these Australian assets is a foreign resident, then the
purchaser of the property is required to pay 12.5 per cent of the purchase price direct to the ATO. The
vendor can then claim a credit for the foreign resident capital gains withholding payment that the purchaser
has made by lodging a tax return for the relevant year (see module 2).
CGT — EXEMPTION ON GRANNY FLATS
A CGT exemption to some granny flat arrangements has been effective since 1 July 2021, where the
following conditions are fulfilled (Subdivision 137-A).
• There is a formal written agreement arising from a family arrangement or other personal tie (commercial
rental agreements will not be covered s. 137-15, s. 137-20).
• The agreement involves the creation, variation or termination of a granny flat arrangement (s. 137-10).
• The granny flat arrangement involves the provision of accommodation to an older person or a person
with a disability (where the older or disabled person is an Australian resident) (ATO 2021b).
For instance, assume that an elderly person agrees to transfer their main residence to their daughter to
live in and, in exchange, the daughter agrees to build a granny flat at the rear of the property that their
parent can live in and provide domestic support for the parent. In such a case, the daughter creating such
a right for their parent would typically trigger CGT Event D1. This is because the daughter has created a
contractual right in the parent — the parent has the right to have a granny flat built for them, and they have
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MODULE 3 CGT Fundamentals 205
the right to be able to live in it and receive domestic support from the daughter (refer back to ‘Event D1:
creating contractual or other rights’ under ‘Specific CGT events’). However, this exemption is aimed at
making such a transaction CGT free for the daughter. Note that, in such an instance, the elderly person’s
transfer of the house would come under the pre-existing main residence exemption and so would not be
subject to CGT.
ROLLOVER PROVISIONS AND OTHER RELIEFS
How Rollovers and Reliefs Operate
Applying a rollover allows the taxpayer to defer or disregard — or rollover — a capital gain or a capital loss
until a further (or later) CGT event occurs. There are many types of rollovers under the taxation legislation;
the chief ones are:
• rollover for the disposal of assets to, or creation of assets in, a company (Division 122)
• replacement assets rollovers (Division 124)
• small business restructure rollovers (Division 328-G)
• demerger relief (Division 125)
• same asset rollovers (Division 126).
Disposal of Assets to, or Creation of Assets in, a Wholly Owned Company
This rollover event allows taxpayers to incorporate their businesses into a company without incurring
a CGT liability. The rollover will apply where there is a change in the entity legally owning the assets;
however, there is no change in the underlying beneficial ownership of the actual assets (Subdivision 122-A,
s. 122-15).
It applies to individuals, trustees or all partners in a partnership. The CGT assets must be transferred to
a wholly owned company, and the consideration is in the form of non-redeemable shares. The shares must
be of substantially the same market value as the net assets transferred for the rollover to be applied.
The assets transferred to the wholly owned company also retain their previous tax attributes, meaning
that the cost base, the reduced cost base and the pre-CGT status remain the same.
Example 3.16 contains an example illustrating how the transfer of assets to a company can benefit from
a rollover.
EXAMPLE 3.16
Transferring Assets Over to Designing Now
Michael James runs a business as a graphic designer. After speaking with his accountant, he decides that
the business should be incorporated. Michael sets up a new company, Designing Now Pty Ltd, of which
he is the sole shareholder, and transfers his business assets to Designing Now.
Consider how a Subdivision 122-A rollover potentially applies to this situation.
CGT event A1 would occur on transfer of any CGT assets to the company. However, if Michael chooses
a rollover under Subdivision 122-A, any capital gains or losses are disregarded. Michael will be deemed
to have acquired the shares in Designing Now for an amount equal to the total cost base of the business
assets. Further, if the assets were acquired before 20 September 1985, Michael’s shares will also be
deemed to be pre-CGT assets.
Designing Now will be deemed to have acquired the business assets at the same time as Michael,
so to the extent that Michael originally acquired the assets before 20 September 1985, the company will
continue to treat the assets as pre-CGT assets. Designing Now will take on Michael’s cost base or reduced
cost base for the assets he acquired post-CGT.
Replacement Asset Rollover Events
Replacement asset rollovers involve the ownership of one CGT asset ending and the acquisition of a new
(replacement) CGT asset. When a replacement asset rollover event occurs, the following happens.
• Any capital gain or loss made from the original asset is disregarded.
• The new (replacement) asset takes on the cost base of the original asset.
• If the original asset was acquired before 20 September 1985 (pre-CGT), the new (replacement) asset is
also deemed to be a pre-CGT asset (ITAA97, Subdivision 124-A).
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206 Australia Taxation
The various replacement asset rollovers available in the legislation are detailed in table 3.6.
TABLE 3.6
Replacement asset rollovers
Division/Subdivision
Type of rollover
Subdivision 124-B
Involuntary disposal of a CGT asset owned by the
taxpayer due to:
• compulsory acquisition (or threat of impending
compulsory acquisition) by an Australian government
agency or certain other entities
• whole or partial loss or destruction of the asset
• land becoming compulsorily acquired subject to a
mining lease
• a lease granted by an Australian government agency
expiring and not being renewed
where the taxpayer receives compensation in the
form of a replacement asset or money to purchase a
replacement asset (or a combination of both).
Subdivisions 124-E and 124-F Division 615
Exchange of shares, units, rights or options.
Subdivision 124-I
Conversion of a body to an incorporated company.
Subdivision 124-M
Scrip-for-scrip exchange, where a share in a company
or an interest in a trust is replaced by a share or an
interest in another entity and the other entity obtains at
least 80% of the voting rights in the original company
or trust (e.g. company takeover situations). Various
conditions apply in obtaining such relief.
Subdivision 124-N
Disposal of assets by a fixed trust to a company under a
trust restructure.
Source: Based on Income Tax Assessment Act 1997 (Cwlth), Division 124, Federal Register of Legislation, accessed January 2022,
www.legislation.gov.au/Details/C2022C00029.
Example 3.17 considers one of the instances in which a replacement asset rollover applies.
EXAMPLE 3.17
Replacement Asset Rollover Event
Limor Chan purchased land in June 1985. On 1 March 2022, the government compulsorily acquired
the land, and gave Limor some different land in return. Consider how replacement asset rollover applies
and its effect.
There is no capital gain or loss on the disposal of the original land, as it is a pre-CGT asset. However,
if Limor elects to apply rollover under Subdivision 124-B, the new land would also qualify as a pre-CGT
asset, even though it was acquired on 1 March 2022.
Small Business Restructure Rollover
The small business restructure rollover allows small businesses to transfer active assets (discussed later in
this module, and generally applies to assets used in the course of a business, or intangible assets inherently
connected with the business) from one entity (the transferor) to one or more other entities (transferees)
without incurring an income tax liability (including, but not limited to, CGT liability). It applies to transfers
on or after 1 July 2016.
Small businesses who meet the standard small business entity (SBE) rules (including an aggregated
turnover of less than $10 million) can access this concession. The rollover applies to the transfer of active
assets that are CGT assets, trading stock, revenue assets or depreciating assets.
The rollover is available when the following conditions are met.
• The entity is an applicable SBE or related entity.
• The rollover is part of a genuine restructure (not an artificial or tax-driven scheme).
• The rollover must not result in a change to the ultimate economic ownership of the transferred assets
(see s. 328-430).
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MODULE 3 CGT Fundamentals 207
Specifically, this requires that the individuals who directly or indirectly own the asset remain the same.
Further, where there is more than one individual involved, it requires that the share of each individual’s
economic ownership remains materially the same before and after the restructure (s. 328-430)(1)(c)).
Note the following.
Non-fixed (discretionary) trusts may be able to meet the requirements for ultimate economic ownership,
for example, where there is no practical change in which individuals economically benefit from the assets
before and after the transfer.
Family trusts may meet an alternative ultimate economic ownership test where:
• the trustee has made a family trust election, and
• every individual who had ultimate economic ownership of the transferred asset before the transfer, and
• every individual who has ultimate economic ownership after the transfer, must be members of the family
group relating to the family trust (ATO 2019).
Examples 3.18 and 3.19 illustrate whether, for the purposes of the small business restructure rollover,
there has been a change in the ultimate economic ownership of transferred CGT assets.
EXAMPLE 3.18
Small Business Restructure
Janey Hall runs a small marketing and public relations agency business as a sole trader. She now wishes
to run the business through a unit trust. Janey sets up the Whistles Media Trust with herself as sole unit
holder and transfers the active assets of the business to the trust. Consider if this would result in a change
in the ultimate economic ownership of the CGT assets.
This would not result in a change in ultimate economic ownership of those assets.
Source: Adapted from ATO 2019, ‘Small business restructure rollover’, accessed January 2022, www.ato.gov.au/Business/
Small-business-entity-concessions/Concessions/CGT-concessions/Small-business-restructure-rollover.
EXAMPLE 3.19
Ultimate Economic Ownership Changes
Joan Baldwin, Michelle Murphy and David Hall operate the small marketing and public relations agency
business as equal partners. They want to transfer their interests in the assets of the partnership to a
company. Michelle and David are a couple.
Joan, Michelle and David establish a company, whereby 300 identical shares are issued as follows.
• 100 shares are issued to Joan.
• 150 shares are issued to Michelle.
• 50 shares are issued to David.
Consider if Joan, Michelle and David could utilise the small business restructure.
David receives fewer shares because he has other income and Michelle and David, as a couple, want to
lower their overall income tax bill.
While this does not change the individuals who have the ultimate economic ownership of the asset, there
is a change in the proportionate share of that ultimate economic ownership. Accordingly, Joan, Michelle
and David cannot use the small business restructure rollover.
However, if the shares were distributed equally between the partners, the ultimate economic ownership
of the assets would be unchanged; and Joan, Michelle and David could use the rollover, subject to
satisfying the other conditions.
Source: Adapted from ATO 2019, ‘Small business restructure rollover’, accessed January 2022, www.ato.gov.au/Business/
Small-business-entity-concessions/Concessions/CGT-concessions/Small-business-restructure-rollover.
Demerger Relief
Rollover relief is available where the original interests in a company or trust demerge, and the taxpayer
receives new or replacement interests in the demerged entity. A demerger generally involves the splitting
of a corporate group into two or more groups or entities, with ultimate ownership remaining the same.
The aim of this rollover is to ensure businesses can restructure without triggering costly capital gains.
Where demerger relief applies, any capital gain or loss for the ultimate shareholders and for members
of the corporate group can be disregarded (ITAA97, Division 125).
Example 3.20 illustrates a demerger.
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208 Australia Taxation
EXAMPLE 3.20
Demerger Relief
Peter Schmidt owns shares (his original interests) in Company A, a public company. Company B is a
wholly owned subsidiary of Company A. Company A announces a demerger utilising a proportionate
capital reduction and the disposal of all its shares in Company B to its 320 000 shareholders. Following
the demerger, all of the shareholders in Company A, including Peter, will own all of the shares in
Company B (their new interests). Consider how the demerger relief provisions in Division 125 apply in
this situation.
The demerger rollover relief provisions apply in this situation, as Peter owned shares in
Company A, which has demerged from Company B and, due to the demerger, Peter has received shares in
Company B.
Source: Adapted from Income Tax Assessment Act 1997 (Cwlth), s. 125-55, Federal Register of Legislation, accessed
January 2022, www.legislation.gov.au/Details/C2022C00029.
Same Asset Rollover Events
A same asset rollover event means an asset can be transferred from one taxpayer to another — and no
CGT arises (Division 126). The applicable CGT is later paid by the transferee (i.e. the person to whom the
transfer is made, or who received the transferred asset) when a later CGT event occurs to the asset.
When a same asset rollover event occurs, the following happens.
• Any capital gain or loss the transferor makes is disregarded.
• The transferee acquires the transferor’s cost base in the asset at the time of the transfer.
• Where the asset is a pre-CGT asset (transferor acquired the asset before 20 September 1985), the asset
retains its pre-CGT status in the hands of the transferee.
• Where the asset is a collectable or personal use asset of the transferor, it retains this status in the hands
of the transferee.
The type of same asset rollovers found in the legislation is presented in table 3.7, while table 3.8 outlines
the effect of these rollovers.
TABLE 3.7
Type of same asset rollovers
Subdivision
Type of rollover
126-A
CGT assets transferred to a spouse or former spouse as a result of a binding legal agreement
following a marriage or relationship breakdown.
126-B
CGT assets transferred between companies in the same wholly-owned group, involving at
least one foreign resident company.
126-C
Changes to a trust deed of a complying approved deposit fund, complying superannuation
fund or a fund that accepts workers entitlement contributions.
126-D
Transfer of assets from a small superannuation fund with fewer than five members to another
complying superannuation fund on marriage breakdown.
126-G
CGT assets transferred between certain fixed trusts under a trust restructure.
Source: Based on Income Tax Assessment Act 1997 (Cwlth), Division 126, Federal Register of Legislation, accessed January 2022,
www.legislation.gov.au/Details/C2022C00029.
TABLE 3.8
Effect of rollovers
No rollover
Rollover applied
Capital gain or loss arises on transfer/disposal
of original assets under CGT event A1.
Capital gain or loss on transfer/disposal of original assets
is disregarded.
Assets (either same assets or replacement assets)
acquire new cost base and acquisition date.
Assets (either same assets or replacement assets) maintain
the cost base and acquisition date of the original assets.
Assets lose any pre-CGT status.
Assets (both existing and replacement assets) maintain any
pre-CGT status.
Source: Based on Income Tax Assessment Act 1997 (Cwlth), Division 126, Federal Register of Legislation, accessed January 2022,
www.legislation.gov.au/Details/C2022C00029.
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MODULE 3 CGT Fundamentals 209
Example 3.21 illustrates the impact of the same asset rollover in a marriage breakdown situation.
EXAMPLE 3.21
Same Asset Rollover Event 126-A
Meg Colombo’s ex-husband Francesco Colombo owns land (purchased in 1997) with a cost base of
$75 000. As a result of a court order under the Family Law Act 1975 (Cwlth), Francesco is required to
transfer the land to Meg. Consider the effect of the same asset rollover in this situation.
Rollover relief under Subdivision 126-A automatically applies to ensure that Francesco does not
crystalise a capital gain or loss on the transfer. Meg’s cost base in the land is $75 000 (the same as
Francesco’s cost base).
QUESTION 3.13
Which rollover would potentially apply in the following situations, and what would be the effect of
each particular rollover?
(a) Simone Small divorces Neil Small and, as part of the divorce settlement, Simone’s investment
property purchased in 2017 is transferred to Neil.
(b) Mel Kumar owns shares in a conglomerate called CGG Ltd that she acquired three years ago.
CGG owns a major supermarket chain, SPM Ltd, which it demerges from. Due to the demerger,
Mel receives shares in SPM Ltd, and part of her shares in CGG Ltd are cancelled.
(c) Kerrie Kelly owns a business (not an SBE) as a sole proprietor that she acquired two years
ago. Kerrie transfers all assets in the business to a company that she is the sole owner of, in
exchange for receiving shares in the company. The value of the shares equals the value of the
assets transferred to the company.
(d) Bryanna Browning owns shares in a mining company, MIN Ltd (acquired in 1984) which is then
fully acquired by a larger mining company, RHP Ltd. Due to the takeover, Bryanna’s shares in
MIN are replaced with shares in RHP.
CGT Consequences of Death
Generally, when a person dies, any capital gain or loss from a CGT event involving a CGT asset that the
deceased owned at the time of death is disregarded (s. 128-10).
This general rule does not apply where the CGT asset passes to:
• a tax-advantaged beneficiary who is a tax-exempt entity
• the trustee of a complying superannuation entity
• a foreign resident, and the asset is not taxable Australian property (see module 2, section ‘Non-residents
and capital gains tax’).
In these three cases, the trustee of the deceased’s estate must include any capital gain in the tax return
of the deceased (s. 104-215).
Where the deceased’s CGT asset(s) devolves to a legal personal representative, or passes to a beneficiary
in the deceased’s estate, then either of these parties is taken to have acquired the asset on the day of the
deceased’s death. In this case, any capital gain or capital loss the legal representative makes if the asset
passes to a beneficiary in the deceased’s estate is disregarded (s. 128-15).
Where a CGT asset is transferred to a legal personal representative or beneficiary, the following
modifications are made to the cost base and reduced cost base as a result of the death.
• If the asset was acquired by the deceased before 20 September 1985, it is taken to be acquired by the
trustee or beneficiary on the date of death at its market value.
• If the asset was acquired by the deceased on or after 20 September 1985, it is taken to be acquired by
the trustee or beneficiary on the date of death at the deceased’s cost base or reduced cost base (unless it
was the main residence of the deceased just before the time of death).
• If the asset was a dwelling that was the main residence of the deceased just before death and not being
used to earn assessable income at that time, it is taken to be acquired by the trustee or beneficiary on the
date of death at its market value.
Under these rules, when a CGT asset is taken to be acquired for its market value at the time of death,
and then the beneficiary later triggers a CGT event (such as by selling the inherited asset), only the gain
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210 Australia Taxation
(or loss) accrued since the deceased passed away is accounted for. In contrast, when the beneficiary’s cost
base is based on the deceased’s cost base, and the beneficiary later triggers a CGT event on behalf of the
asset (usually by selling it), CGT will be based on the accrued gain that occurred during the combined
ownership period of both the deceased and the beneficiary. Figure 3.8 illustrates this concept.
FIGURE 3.8
Capital gain on an inherited asset that is subsequently sold
Deceased acquired asset post
20 September 1985, and not their
main residence.
Deceased acquired asset pre
20 September 1985, or it was their
main residence.
Date deceased acquired asset
Date deceased passed away
Date beneficiary sold inherited asset
As the first element of the cost base
of the beneficiary is the deceased’s
cost base, the net effect is that when
the beneficiary disposes of the asset,
CGT will be payable on the gain
attributable to the combined
ownership period of the deceased
and the beneficiary.
As the first element of the cost
base of the beneficiary is the
market value at the time the
deceased passed away, the net
effect is that when the beneficiary
disposes of the asset, CGT is
payable on the gain attributable to
the ownership period of
the beneficiary.
Source: CPA Australia 2022.
Different rules apply where the asset was trading stock of the deceased (s. 128-15(4), Item 2).
Moreover, a beneficiary can include in the cost base (or reduced cost base) of any CGT asset,
any expenditure incurred by the legal representative that would have been able to be included in the asset’s
cost base at the time the asset passes to the beneficiary (s. 128-15(5)).
As a result of these provisions, it is important that any beneficiary keeps appropriate records, especially
concerning:
• the market value of assets acquired by the deceased before 20 September 1985 or the deceased’s main
residence, and
• the cost base and reduced cost base of assets acquired by the deceased on or after 20 September 1985.
QUESTION 3.14
Laura Lovell passed away in January 2022 and left her estate to her daughter Jill Jackson. Laura
had owned the following assets.
• Property 1, which had been used as an investment property by Laura. This was purchased in
1984 for $100 000. At the time, stamp duty of $4000 was paid. The property had renovations worth
$20 000 undertaken in 1994. Its market value at the time of Laura’s death was $800 000.
• Property 2, which was also used as an investment property by Laura. This was purchased in 1991
for $200 000. At the time, stamp duty of $10 000 was paid. It had $30 000 of renovations undertaken
in 2001. Its market value at the time of Laura’s death was $900 000.
• Property 3, used by Laura exclusively as a main residence for the full time she owned it. It was
purchased in 2001 for $300 000. At the time, stamp duty of $15 000 was paid. Its market value at
the time of Laura’s death was $1.5 million.
Jill wishes to use all three properties as long-term investments. What will be the CGT implications
of her inheriting the properties from Laura?
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MODULE 3 CGT Fundamentals 211
3.5 CALCULATING NET CAPITAL GAIN/LOSS
FORMULA TO LEARN
As introduced in the first section, ‘CGT core concepts’, a taxpayer’s net capital gain for a tax year is
calculated as follows (s. 102-5(1)).
Net capital gain = Capital gains − Capital losses − CGT discount − CGT small business concessions
The earlier section ‘Determining gain/loss from CGT event’ covered the calculation of each individual
capital gain or loss.
This section examines the determination of net capital gain, which can be reduced by capital losses, the
CGT discount and CGT small business concessions.
DETERMINING NET CAPITAL LOSS
A net capital loss arises in a tax year:
• if a taxpayer incurred a capital loss in the year and did not make a capital gain that could be offset against
that loss, or
• where a capital gain arose during the year, and the sum of the capital losses realised during the year
exceeded the capital gain made during the year (s. 102-10).
We already know that net capital losses are able to be carried forward and offset against any capital gains
arising in future years. However, net capital losses cannot be used to reduce any other assessable income
of the taxpayer.
DETERMINING NET CAPITAL GAIN
Capital gains arising in a tax year can be reduced by:
• capital losses arising in the current tax year
• any unused net capital losses and collectable losses brought forward from previous tax years.
Note that, for companies, using prior year capital losses to reduce current year’s gains depends upon the
continuity of ownership or the business continuity test being satisfied (see module 5).
Example 3.22 illustrates how to calculate a net capital gain when a variety of CGT assets have been
disposed of.
EXAMPLE 3.22
Realising Capital Gains and Losses
During the year ending 30 June 2022, Frederick Ho disposed of some shares. Electing to use the indexation
method for his capital gains, he realises the following capital gains and losses.
Company
Result
ABC Ltd
DEF Group Ltd
Hello Ltd
IJK Ltd
Lolly Ltd
Gain
Loss
Gain
Gain
Loss
$
5 000
(2 500)
500
1 750
(450)
Consider Frederick’s net capital gain for the year ending 30 June 2022. The example also shows how
the result would differ if the loss from Lolly Ltd was $4950 rather than $450.
The sum of the capital gains of $7250 would be reduced by the sum of the capital losses ($2950) to
produce a net capital gain of $4300. However, if the loss from Lolly Ltd had been $4950 (rather than $450),
a net capital loss of $200 would have arisen that could be carried forward to the 2022–23 tax year to be
offset against any subsequent capital gain.
Where the taxpayer has more than one capital gain (such as two capital gains due to selling two
properties), as well as a capital loss (current or carried forward), the taxpayer can decide in which order
to apply the capital loss against the capital gains.
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212 Australia Taxation
Note that, where there are capital losses from both the current year as well as carried-forward ones
from previous years, the current year capital losses are to be applied first (s. 102-5). Also, where there are
carried-forward capital losses from multiple previous years, they are applied in the order in which they are
made (s. 102-15).
QUESTION 3.15
In the 2021–22 tax year, James Sinclair (who does not own any collectables) made capital gains
of $20 000 and capital losses of $12 000. James also had net capital losses carried forward from
previous years, as follows.
Year
2020–21
2019–20
Net capital loss
$6000
$4000
How will James reduce his capital gain for 2021–22 to zero?
APPLYING THE CGT DISCOUNT
After applying capital losses, the next step is to apply the CGT discount. It is important that the CGT
discount percentage is only applied after the gain is reduced by any capital losses.
The CGT discount applies to individuals, trusts, complying superannuation funds and certain life
insurance companies. All other companies are not able to claim the CGT discount.
The CGT discount percentage for individuals and trusts is 50 per cent. The CGT discount percentage
for complying superannuation funds and life insurance companies is 33.33 per cent.
To qualify for the CGT discount, the following four conditions must be satisfied (Subdivision 115-A).
1. The underlying CGT event creating the gain must occur after 11.45 am on 21 September 1999.
2. Indexation must not have been applied in calculating the capital gain.
3. The CGT event must relate to a CGT asset that has been owned by the taxpayer for at least 12 months.
(This is the 12-month rule — see the next section.)
4. The taxpayer must generally be an Australian resident.
Note that, for assets acquired after 8 May 2012, the CGT discount of 50 per cent is generally not
available to foreign and temporary resident individuals (including beneficiaries of trusts and partners in
a partnership).
The 12-Month Rule
To qualify for the CGT discount, a CGT asset must have been acquired by the taxpayer making the capital
gain at least 12 months before the CGT event.
The 12-month period excludes both the day of acquisition and the day of the CGT event. Therefore, a
period of 365 days (or 366 in a leap year) must elapse between the day of acquisition and the occurrence
of the CGT event to satisfy the 12-month rule (Taxation Determination TD 2002/10). For example, if
the asset was acquired on 30 June 2021, the discount would not apply if the CGT event occurred before
1 July 2022.
Example 3.23 gives an example involving whether a buy and sale of shares by an individual can benefit
from the CGT discount in calculating the net capital gain of the individual.
EXAMPLE 3.23
12-Month Rule
In May 2021, John Norris (an Australian resident) acquired 1000 ordinary shares in a listed public company
for $10 per share. He sells these shares in April 2022 for $16 per share. Consider if John is eligible for the
CGT 50 per cent discount.
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MODULE 3 CGT Fundamentals 213
At the date of sale, John has owned the shares for less than 12 months and therefore he is unable to
choose the CGT discount. John must, therefore, include a capital gain of $6000 ($6 per share for 1000
shares) in calculating his net capital gain for the 2021–22 tax year.
Certain CGT events, such as those that create a new asset, cannot qualify for the CGT discount because
the asset will not have been acquired at least 12 months before the CGT event (s. 115-25(3)). The CGT
events for which the CGT discount cannot apply are CGT events D1, D2, D3, E9, F1, F2, F5, H2, J2, J5,
J6 and K10.
Under s. 115-125, taxpayers who invest in certain types of affordable housing are also eligible to an
additional 10 per cent discount on their capital gain on such dwellings. To be eligible under this law,
the taxpayer, must have used their investment property to provide affordable housing for at least three
years. A dwelling will be regarded as providing affordable housing where it is managed by an eligible
community housing provider, and that provider has given the owner a housing certificate (in its approved
form). Further, only amounts subject to the general CGT discount can be eligible for this further
10 per cent discount.
QUESTION 3.16
Kirsty Sweeney is an Australian resident who works as a school teacher and makes the following
share sales in the 2021–22 tax year:
• ANH Ltd shares sold for $100 000, purchased six months beforehand for $90 000
• BNS Ltd shares sold for $200 000, purchased 18 months beforehand for $185 000
• CJL Ltd shares sold for $50 000, purchased eight months beforehand for $70 000.
Assuming that Kirsty wishes to minimise her tax liability, what would be her net capital gain?
CGT SMALL BUSINESS CONCESSIONS
Four specific CGT concessions may be available to qualifying SBEs, which may allow them to disregard
or defer part or all of a capital gain from an active asset used in a small business.
The basic conditions, as set out in s. 152-10 of ITAA97, that must be met before any of the four
concessions can be considered are:
(a) a CGT event happens in relation to a CGT asset of yours in an income year. Note: This condition does
not apply in the case of CGT event D1: see section 152-12.
(b) the event would (apart from this Division) have resulted in the gain;
(c) at least one of the following applies:
(i) you are a CGT small business entity for the income year;
(ii) you satisfy the maximum net asset value test (see section 152-15);
(iii) you are a partner in a partnership that is a CGT small business entity for the income year and the
CGT asset is an interest in an asset of the partnership;
(iv) the conditions mentioned in subsection (1A) or (1B) are satisfied in relation to the CGT asset in
the income year;
(d) the CGT asset satisfies the active asset test (ITAA97, s. 152-35).
Condition (a) is that a defined CGT event happens in relation to a CGT asset in the income year (except
for CGT event D1). Under condition (b), the CGT event in condition (a) results in a capital gain. Under
condition (c), the entity must be a CGT SBE for the income year with an aggregated turnover of less than
$2 million, or they must meet the maximum net asset value test under s. 152-15 of ITAA97. Under this
maximum net asset value test, the entity (including related entities or affiliates) must have net assets of no
more than $6 million (excluding personal use assets such as a home, to the extent that it has not been used
to produce income).
Condition (d) is that the CGT asset satisfies the active asset test. A CGT asset satisfies the ‘active asset
test’ under s. 152-35 if the taxpayer has owned the asset for:
• 15 years or less and the asset was an active asset of theirs for a total of at least half of the relevant
period, or
• more than 15 years and the asset was an active asset of theirs for a total of at least 7.5 years during the
relevant period.
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214 Australia Taxation
The ‘relevant period’ commences at the time of acquiring the asset and ceases upon the time of the CGT
event. However, if the business ceased within 12 months of the CGT event, the relevant period will end at
that time instead.
Note that for gains from CGT event D1, rather than the active asset test being satisfied, the taxpayer
must show that the CGT event D1 was inherently connected with an active asset of theirs (s. 152-12).
For instance, if the taxpayer sells a restaurant that was an active asset and has entered into a restrictive
covenant to not compete with this restaurant for three years, then the covenant will trigger CGT event D1,
and will fulfil this alternative test as it was inherently connected with an active asset of theirs, that is, the
restaurant business.
A CGT asset is an active asset if the taxpayer owns it, and:
• they use it or hold it ready for use in the course of carrying on a business (whether alone or in partnership)
• it is an intangible asset (e.g. goodwill) inherently connected with a business they carry on (whether alone
or in partnership) (s. 152-40).
EXAMPLE 3.24
Active Asset
Racheal Ward runs a small business selling tailored fabrics for clothing retailers. Rachael purchased an
industrial sewing machine for the business in March 2001. She upgraded the sewing machine with a
computerised system in November 2021, at which time she sold the industrial sewing machine. As the
sewing machine had been used exclusively in her business for the entire 20-year period, it would satisfy
the active asset test.
Certain CGT assets cannot be active assets, even if they are used or held ready for use in the course
of carrying on a business — for example, assets whose main use is to derive rent (unless the asset was
rented to an affiliate or connected entity for use in their business). Generally, a rental property will not be
an active asset.
Shares in a resident company or interests in a resident trust are active assets if the market value of the
company or trust’s active assets, cash and financial interests that are connected with the running of the
business is 80 per cent or more of the market value of all the company’s or trust’s assets (s. 152-40(3)).
Note that where the capital gain has arisen from a sale (or other CGT event) of shares in a company or units
in a trust, then there are other conditions that also need to be fulfilled for CGT small business concession
eligibility. They are as follows.
• The individual making the sale has to be a CGT concession stakeholder in the company or trust just
before the CGT event occurs (s. 152-10(2)(d)). This means that either they, or their spouse, must be a
significant individual of the company or trust that is sold (s. 152-60) (if it is their spouse who is the
significant individual, then the taxpayer themselves must also directly or indirectly have some interest
in the entity before it is sold). A significant individual is one who has a direct or indirect interest in the
company or trust of at least 20 per cent (s. 152-55). Note that there are alternative rules where there is
an interposed entity between the individual and the company/trust that is sold, and the interposed entity
is the one that has actually made the sale (e.g. Bill owns X Ltd, which owns Y Ltd, and X Ltd sells
Y Ltd), but these situations are beyond the scope of this course.
• The company or trust being sold must be a CGT SBE by having an aggregated turnover of less than
$2 million or pass the maximum net asset value test by having net assets of no more than $6 million
(s. 152-10(2)(c)). In other words, it is not sufficient that the taxpayer making the sale fulfils one of the
requirements in condition (c) above; the entity sold must also pass one of these two tests as well. Note
that the way the maximum net asset value test is calculated for such purposes is slightly modified as
compared to how it is usually calculated, but such modifications are beyond the scope of this course.
• Unless the taxpayer making the sale of the shares or units, in fulfilling condition (c) above, is relying
on satisfying the maximum net asset value test, then they must also show that they themselves have
been carrying on a business just before the CGT event. This means that if a taxpayer is not themselves
carrying on a business but sells an interest in a company/trust that does, then in fulfilling condition (c)
above, they must rely on the maximum net asset value test (s. 152-10(2)(b)).
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MODULE 3 CGT Fundamentals 215
EXAMPLE 3.25
Not an Active Asset
ABC Co. owns five commercial rental properties. The properties have been leased for several years under
formal lease agreements to various tenants who have used them for office and warehouse purposes. The
commercial tenants are neither affiliates nor connected entities of the taxpayer. The terms of the leases
have ranged from one year to three years with a three-year option and provide for exclusive possession.
The company has not engaged a real estate agent to act on its behalf and manages the leasing of the
properties itself.
In this situation, the company has derived rental income from the leasing of a number of properties.
Accordingly, the main and only use of the properties is to derive rent and they are therefore excluded from
being active assets under s. 152-40(4)(e), regardless of whether the activities constitute the carrying on of
a business.
Source: Adapted from ATO 2012, ‘Taxation Determination TD 2006/78’, accessed January 2022, www.ato.gov.au/law/vie
w/print?DocID=TXD%2FTD200678%2FNAT%2FATO%2F00001&PiT=99991231235958&Life=20121219000001-9999
1231235959#LawTimeLine.
CGT Cap Amount
The non-concessional CGT cap allows individuals to make non-concessional superannuation contributions, up to the lifetime CGT cap amount. The CGT cap amount applies to capital gains subject to the CGT
small business concessions, where the retirement exemption or 15-year exemption applies (see below), and
the gain is contributed to superannuation.
The CGT cap applies to all excluded CGT contributions and is a lifetime cap. For the 2021–22 income
year, the CGT cap is $1.615 million (was $1.565 million for 2020–21). The CGT cap amount is indexed
in line with average weekly ordinary time earnings (AWOTE) in increments of $5000 (rounded down).
Four Types of CGT Small Business Concessions
The four concessions available are as follows.
• A 15-year exemption — if the business has continuously owned an active asset for at least 15 years and
the taxpayer is aged 55 or over and is retiring or permanently incapacitated, then there will not be an
assessable capital gain upon sale of the asset (Subdivision 152-B).
• A 50 per cent active asset reduction — reduction of the capital gain on an active asset by 50 per cent.
This is in addition to the 50 per cent CGT discount, if applicable (Subdivision 152).
• Retirement exemption — capital gains from the sale of active assets are exempt up to a lifetime limit of
$500 000. If the taxpayer is under 55, the exempt amount must be paid into a complying superannuation
fund or a retirement savings account (Subdivision 152-D).
• Rollover — upon sale of an active asset, all or part of the capital gain can be subject to a rollover where
the taxpayer makes an election to do so (Subdivision 152-E). However, if such an election is made, then
by the end of two years after the CGT event, the amount subject to the rollover must have been used
for the acquisition of a replacement active asset, and/or for incurring expenditure on making capital
improvements to an existing active asset. If this is not the case, the rollover will be reversed and the
taxpayer will be subject to a CGT liability (refer CGT events J5 and J6 in table 3.2).
These four CGT small business concessions are separate to the small business restructure rollover
discussed in the earlier section ‘Small business restructure rollover’. Eligible taxpayers can apply as many
of the concessions available to them until the capital gain is reduced to nil. There are rules about the
order in which you apply the concessions, any current year or prior year capital losses, and the application
of the 50 per cent CGT discount. Specifically, the 15-year exemption, if applicable, will mean that the
other concessions are irrelevant as no CGT will be payable. If it is not applicable, then the 50 per cent
active asset reduction is generally applied. After that, the remainder of the gain will be potentially subject
to the retirement exemption and/or the rollover to the extent that the taxpayer elects to use one or both
of them (each of these two concessions can be used if the abovementioned conditions for each of them
are fulfilled).
Figure 3.9 illustrates the order in which the CGT small business concessions are generally applied.
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216 Australia Taxation
FIGURE 3.9
Order of applying CGT small business concessions
Does the 15
year
exemption
apply?
Yes
No CGT payable
on the gain.
No
Apply the 50 per cent
active asset reduction.
Part or all remaining
gain can be further
reduced by the retirement
exemption if requirements
fulfilled.
Part or all remaining gain can be
further reduced if there is an
election made to utilise the
rollover (though this might be
subsequently reversed).
Source: CPA Australia 2022.
QUESTION 3.17
Cameron Cooke, an Australian tax resident who is 47 years old, owns premises from which he
operates a restaurant business. Cameron acquired the newly-built premises three years ago for
$500 000 and has operated the restaurant there from that time. Prior to this time, Cameron had
been an employee, not a business owner. Turnover for the restaurant was approximately $1 million
per annum.
In the 2021–22 tax year, Cameron entered into a contract to sell the business. The contract
includes the following amounts:
• $700 000 for the business premises
• $150 000 for the goodwill attached to the business
• $60 000 to not compete with the new owner of the business for three years.
(a) What is Cameron’s net capital gain before applying the CGT small business concessions?
(b) Which of the small business concessions could Cameron utilise, and how would they affect his
net capital gain?
QUESTION 3.18
Mohamad purchased a residence (called Property A) on 1 June 2014 and lived it in it for four years
before moving to a new area. He then rented Property A for four years and sold it on 1 June 2022
for $850 000. He purchased and moved into a new residence on 1 June 2018 (Property B), at which
time Property A was worth $700 000.
The costs incurred for Property A were as follows.
$
Purchase price
Valuation fees at time of purchase
Selling costs
Capital improvements undertaken in 2021
600 000
4 500
18 000
70 000
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MODULE 3 CGT Fundamentals 217
Mohamad has previously claimed $12 000 in capital works deductions on the improvements for
the period it was a rental property.
Mohamad purchased a parcel of shares for his investment portfolio in May 1995 for $15 000.
He sold these shares in November 2021 for $35 000.
(a) What is the maximum period for which Mohamad can claim the main residence exemption on
Property A which was sold on 1 June 2022?
(b) Mohamad has chosen to make Property B his main residence for the purposes of the main
residence exemption. Calculate the capital gain amount to be included in Mohamad’s income
tax return.
(c) Calculate the indexed cost base of the share package sold in November 2021 for $35 000.
(d) Assuming that Mohamad has chosen to treat Property B as his main residence, use the facts
from the former parts of this question to calculate the net capital gain amount to be included in
Mohamad’s income tax return.
The key points covered in this module, and the learning objectives they align to, are as follows.
KEY POINTS
The first section ‘CGT core concepts’ gives an overview of the CGT regime and introductory points.
• Figure 3.1 illustrates different components of the Australian CGT regime and provides a module
overview.
• Figure 3.2 contains the important terms relating to CGT, as well as a summary of the relevant steps
for applying the CGT.
• Figure 3.3 shows how CGT interacts with other taxation legislation.
• Table 3.1 explains the universal six-step process used to determine a taxpayer’s net capital gain.
• Figure 3.4 illustrates the CGT six-step process using a flowchart.
• The formula used to calculate the net capital gain or loss in Step 6 in the CGT six-step process is
introduced.
• Taxpayer’s record-keeping requirements for CGT events are outlined.
3.1 Determine which CGT event(s) applies/apply in a given situation.
• A capital gain or loss will potentially arise only where a CGT event has been triggered.
• Table 3.2 summarises most of the CGT events, including when they occur, and how to calculate
the capital gain/loss for each of them.
• The main CGT events that are more common than others, and discussed in greater detail in this
module, are as follows.
– CGT event A1 — Disposal of a CGT asset, which will typically occur when a CGT asset is sold,
gifted or otherwise disposed of.
– CGT event C1 — Loss or destruction of a CGT asset, which will typically occur when a tangible
asset is destroyed or lost, such as by being burned or stolen.
– CGT event C2 — Cancellation, surrender and similar ending, which will typically occur when
an intangible CGT asset ends, such as when a legal right to operate a certain type of business
expires.
– CGT event D1 — Creating contractual or other rights, which will typically occur when someone
creates a legal right in another, such as by entering into a restraint of trade.
– CGT event F1 — Granting a lease, which will typically apply when a lessor rents out a property
and receives a lease premium.
– CGT event H1 — Forfeiture of a deposit, which will typically occur when someone receives a
deposit for selling a CGT asset, but then the contract falls through and the sale does not proceed,
leading to the seller keeping the deposit.
• If potentially more than one CGT event could apply to a transaction, figure 3.5 illustrates which
CGT event to apply.
3.2 Analyse the tax implications of different types of CGT assets.
• Many (though not all) of the CGT events involve an existing CGT asset.
• A CGT asset is defined in s. 108-5 as including both property, as well as legal/equitable rights other
than property.
• Collectables are a subset of CGT asset, and there is an exhaustive list of what is a collectable in s.
108-10(2). When a CGT asset is a collectable, it is exempt from CGT if the first element of its cost
base is $500 or less. Further, if a non-exempt collectable results in a capital loss, then that loss can
only be offset against a capital gain from a collectable.
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218 Australia Taxation
• Personal use assets are also a subset of CGT assets, and are defined in s. 108-20(2) as assets that
are kept mainly for personal use or enjoyment of the taxpayer. They are exempt from CGT if the
first element of their cost base is $10 000 or less. Further, regardless of their cost, capital losses
made on personal use assets are disregarded for CGT purposes.
• Separate CGT assets have their own rules. A capital improvement to an original pre-CGT asset
that is then taken to be a separate CGT asset if its cost base when a CGT event occurs in relation
to the original asset is:
(a) more than the improvement threshold of $156 784 for the 2021–22 income year in which the
event happened
(b) more than 5 per cent of the capital proceeds from the event.
3.3 Calculate the capital gain or capital loss that arises from a CGT event.
• For many of the CGT events, a capital gain will be equal to the capital proceeds less the cost base,
and a capital loss will be equal to the reduced cost base less capital proceeds.
• Figure 3.6 illustrates the process for determining the capital gain/loss for these CGT events.
• Capital proceeds will consist of what the taxpayer receives and is entitled to receive for the CGT
event. In the case of a sales contract, this will typically be the sales price.
• As illustrated by table 3.3, in some cases, the capital proceeds will be subject to modifications.
• Cost base is defined in s. 110-25, and consists of five elements, which are explained in table 3.4.
• A reduced cost base is defined in s. 110-55, and is calculated similarly to a cost base, but with
some differences, including that it has no third element (costs of owning the CGT asset), and is not
subject to indexation.
• The cost base and reduced cost base can, in a similar way to capital proceeds, also be subject to
modifications.
• In some instances, the capital gain can be reduced by indexing the cost base, which will increase
the cost base to account for general inflationary price rises that occurred up till the September
1999 quarter, as noted in table 3.5.
• There are a number of CGT exemptions, including an exemption that applies to assets acquired
prior to 20 September 1985.
• One of the most important exemptions is the main residence exemption (s. 118-110), which allows
a CGT exemption where the taxpayer has owned and lived in a house or other residence.
• In some instances, a taxpayer who lived in their house and then moves out of it can continue to
claim their house as their main residence under the absence provision (s. 118-145), but they can
only generally do this where they are not claiming another main residence at the same time.
• Where a taxpayer is eligible to claim a house as their main residence for only part of the time that
they own it, depending on the circumstances, the pro-rata formula in s. 118-185 will potentially
apply; in other situations, the property will be regarded, under s. 118-192, as reacquired for its
market value when it started being used for rental purposes. In some instances, as illustrated by
example 3.14, both sections will apply. Figure 3.7 summarises the application of these sections.
• In most instances, a taxpayer can claim only one main residence at a time. However, under
s. 118-140, when changing main residences, in some instances, taxpayers can claim both as their
main residence for a period of up to six months.
• If spouses simultaneously claim different properties as their main residences, under s. 118-170
there are limits as to how much of an exemption they can each claim on their individual properties.
• The law in many instances prevents foreign tax residents from claiming the main residence
exemption.
• Under Subdivision 122-A, in some circumstances transferring a business to a company structure
can benefit from rollover relief. When this is the case, no CGT liability will be incurred from the
transfer, the assets in the company will continue to have the same tax attributes as they did prior to
the transfer, and the shares in the company will adopt the tax attributes of the transferred underlying
assets.
• Table 3.6 lists the situations in which a replacement asset rollover is available under Division 124.
These cover various situations where a taxpayer stops owning CGT assets and instead ends up
owning replacement CGT assets. When this is the case, the replacement CGT asset takes on the
attributes of the original CGT asset.
• Table 3.7 lists the situations in which a replacement asset rollover is available under Division 124.
These cover various situations where a taxpayer stops owning CGT assets and instead ends up
owning replacement CGT assets. When this is the case, the replacement CGT asset takes on the
attributes of the original CGT asset.
• Under Division 328-G, a small business restructure rollover relief applies to an SBE that transfers
their active assets to a different type of business entity. This rollover will only apply where is no
change to the ultimate economic ownership of the transferred assets.
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MODULE 3 CGT Fundamentals 219
• Under Division 125, demerger relief is available where a parent company or trust demerges from
another entity, and the holder in the parent entity receives interests in the demerged entity. When
this rollover applies, no CGT liability will be triggered.
• Table 3.7 lists the situations under Division 126 where an asset can be transferred without the
transferor triggering a CGT liability. When this occurs, as noted in table 3.8, the CGT asset will
have the same tax attributes for the transferee as it did for the transferor.
• In most instances, the transfer of CGT assets due to death does not trigger a CGT liability
(s. 128-10). The first element of cost base for the beneficiary of the asset will be the cost base
of the deceased if the asset was acquired by the deceased on or after 20 September 1985 and
was not their main residence (s. 128-15(4)). On the other hand, when the CGT asset was acquired
by the deceased prior to 20 September 1985 or was their main residence just before their death
(and was not being used to produce income), then the cost base for the beneficiary will be its
market value at the time the deceased passed away (s. 128-15(4)), as illustrated in figure 3.8.
3.4 Calculate an entity’s net capital gain or capital loss.
• The net capital gain is the amount that increases the assessable income of a taxpayer. In contrast,
a net capital loss is carried forward and can be used to offset future capital gains.
• The net capital gain is calculated by offsetting capital gains and capital losses, and then applying
the general discount and any of the small business concessions if applicable.
• The general discount is set at a rate of 50 per cent for most taxpayers, except for superannuation
funds, where it is set at the rate of 33.33 per cent. Companies cannot benefit from the discount.
• For eligible taxpayers to benefit from the discount, the CGT event must have occurred after
21 September 1999, they must generally be an Australian resident for tax purposes, and they must
have held the asset for at least 12 months.
• For taxpayers to be eligible for the small business concessions, they must fulfil the requirements
in s. 152-10 and, where the gain is a result of CGT event D1, s. 152-12.
• Once taxpayers are eligible to use the small business concessions, depending on the facts, they
can benefit from one or more of the four concessions: the 15-year exemption, the 50 per cent active
asset reduction, the retirement exemption and the rollover. Figure 3.9 illustrates the order in which
these exemptions are generally applied.
REVIEW
This module introduced and reviewed the laws regarding the CGT provisions in the income tax legislation.
It started off by discussing the core CGT concepts, including an overview of what are capital gains, capital
losses and CGT events. It then went on to discuss CGT events in more detail, including an overview of
many of these events, as well as the more important CGT events.
Many of the CGT events involve a CGT asset of the taxpayer, and so the module went on to explain what
is considered a CGT asset. This included an examination of collectables, personal use assets and separate
assets that are subsets of CGT assets and are subject to specific rules.
The module then discussed how to calculate the capital gain or loss resulting from a CGT event being
triggered. Many of the CGT events utilise the concepts of capital proceeds, cost base and reduced cost
base in determining the capital gain or loss, and so these concepts were explained in some detail.
A discussion on when capital gains and losses are disregarded for CGT purposes was covered along
with a discussion of the highly important main residence exemption, and rollovers, which also allow CGT
relief in certain situations.
Lastly, the module described how to calculate the net capital gain/loss of the taxpayer. This is an
important step, as the net capital gain is the amount included in the taxpayer’s assessable income. This
part of the module comprised an explanation of the general 50 per cent discount, as well as the small
business CGT exemptions.
REFERENCES
ATO 2012, ‘Taxation Determination TD 2006/78’, accessed January 2022, www.ato.gov.au/law/view/print?DocID=TXD%2FTD2
00678%2FNAT%2FATO%2F00001&PiT=99991231235958&Life=20121219000001-99991231235959#LawTimeLine.
ATO 2019, ‘Small business restructure rollover’, accessed January 2022, www.ato.gov.au/Business/Small-business-entity-concessi
ons/Concessions/CGT-concessions/Small-business-restructure-rollover.
ATO 2020, ‘Exemptions and rollovers’, accessed January 2022, www.ato.gov.au/Individuals/Tax-return/2020/In-detail/Publication
s/Guide-to-capital-gains-tax-2020/?anchor=Exemptions.
ATO 2021a, ‘Consumer price index (CPI) rates’, accessed January 2022, www.ato.gov.au/rates/consumer-price-index.
Pdf_Folio:220
220 Australia Taxation
ATO 2021b, ‘Supporting older Australians – exempting granny flat arrangements from capital gains tax’, accessed January 2022,
www.ato.gov.au/General/New-legislation/In-detail/Direct-taxes/Income-tax-on-capital-gains/Supporting-older-Australians---ex
empting-granny-flat-arrangements-from-capital-gains-tax.
Bevacqua, J, Marsden, S, Morton, E, Xu, L, Devos, K & Whait, R 2022, Australian Taxation, 2021–22 Tax Update Edition, John
Wiley & Sons, Milton.
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MODULE 3 CGT Fundamentals 221
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MODULE 4
TAXATION OF
INDIVIDUALS
LEARNING OBJECTIVES
After completing this module, you should be able to:
4.1 analyse the income tax implications of various types of income received by individuals
4.2 calculate the allowable deductions available to individuals in a given situation
4.3 apply the tax offsets that an individual is entitled to in a given situation
4.4 calculate the tax payable or tax refund for individuals.
LEGISLATION AND CODES
• Family Law Act 1975 (Cwlth)
• Fringe Benefits Tax Assessment Act 1986 (Cwlth) (FBTAA86)
• Income Tax Assessment Act 1936 (Cwlth) (ITAA36)
• Income Tax Assessment Act 1997 (Cwlth) (ITAA97)
• Income Tax Rates Act 1986 (Cwlth)
• Treasury Laws Amendment (Personal Income Tax Plan) Act 2018 (Cwlth)
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PREVIEW
Individual taxation is calculated through a seemingly simple taxation equation. We already know that
taxable income equals assessable income minus allowable deductions. There are special rules for
individual assessable income and certain allowable deductions, which are discussed in this module.
Gross tax is payable on the taxpayer’s taxable income. From this amount it is necessary to apply the
correct marginal tax rate in order to determine gross tax payable. From this, the taxpayer needs to subtract
any non-refundable tax offsets.
Added to this sub-total is the Medicare levy and Medicare levy surcharge (if applicable). From this
amount, refundable tax offsets, such as tax already paid by the taxpayer during the income year is subtracted
to give the amount of net tax payable (or tax refund).
The module content is summarised in figure 4.1.
FIGURE 4.1
Module summary — tax equation components
Tax equation components
Assessable
income
Allowable
deductions
Tax offsets
Tax payable
Tax refund or tax
payable
Accumulated HELP,
SSL, ABSTUDY
SSL and TSL debts
Medicare levy and
Medicare levy
surcharge
Tax rates
Source: CPA Australia 2022.
4.1 INDIVIDUAL TAXATION CORE CONCEPTS
STEPS FOR CALCULATING INDIVIDUAL TAXATION
In the Australian taxation system, marginal rates of taxation are applied to an individual’s taxable income.
• Step 1: The first step is to determine the taxpayer’s assessable income. The next section, ‘Defining types
of assessable income’, examines the types of assessable income that are included at this stage.
• Step 2: Determine other types of special case assessable income that may have to be included at this
point. This includes any employment termination payments, personal services income and income
derived from employee share schemes. It may also include any income from capital gains, after the
application of applicable capital gains tax (CGT) reliefs. These items are covered in the sections
‘Employment termination payments, personal services income and employee share schemes’ and
‘Capital gains tax relief for individuals’.
• Step 3: Deduct allowable deductions from assessable income — see the sections ‘Taxing superannuation
for individuals’ (for relevant superannuation deductions) and ‘Calculating allowable deductions’ (for all
other deductions).
• Step 4: Apply the correct tax rate (see the final section, ‘Calculating tax payable’, for this year’s marginal
rates) to determine gross tax payable. The rates will depend on whether the taxpayer is a resident or
non-resident of Australia for tax purposes. From this amount, non-refundable tax offsets are subtracted,
and then added to this sub-total is the 2 per cent Medicare levy and Medicare levy surcharge for high
income earners who do not maintain adequate private health insurance (see the final section, ‘Calculating
tax payable’).
• Step 5: Deduct any refundable tax offsets. This includes pay-as-you-go (PAYG) withholding, PAYG
instalments, TFN withholding, ABN withholding and franking credits in respect of franked dividends.
This then determines the total amount of net tax payable (or tax refund due).
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224 Australia Taxation
THE TAX EQUATION
The tax equation is presented in figure 4.2.
FIGURE 4.2
The individual tax equation
Assessable income
minus
Deductions
Taxable income
From tax rates
determine
Gross tax payable
minus
Non-refundable tax offsets†
plus
Medicare levy†
HELP assessment debt‡
minus
Refundable tax offsets
(private health insurance
and franking)
minus
Tax paid (if any)§
Tax refund
or
Tax payable
†For individuals, apart from the private health insurance tax offset, the franking tax offset and other refundable tax offsets, the sum of
these tax offsets cannot exceed the amount of tax payable (see Divisions 63 and 67 of ITAA97, and s. 160AD of ITAA36). Therefore,
they are not refundable. Non-refundable tax offsets cannot be carried forward to offset tax payable in a future year, and any excess
credit cannot be used to reduce the Medicare levy, Medicare levy surcharge or HELP assessment debt.
‡ The term ‘HELP assessment debt’ includes assessment debt under the former Higher Education Contribution Scheme (HECS).
§Includes tax instalments, tax withheld under the PAYG system and tax file number (TFN) amounts deducted.
Source: CPA Australia 2022.
4.2 DEFINING TYPES OF ASSESSABLE INCOME
EMPLOYEE-RELATED INCOME
Employee-related ordinary income typically includes salary and wages, gratuities (tips), commissions and
allowance paid in relation to employee-related activities.
If an employer provides an employee with a defined fringe benefit as part of their employment, then tax
is not levied on the employee in respect of that fringe benefit. The fringe benefit will be subject to fringe
benefits tax (FBT) payable by the employer. FBT is the subject of module 6.
TAX TREATMENT OF MINORS
Special rules apply in calculating the tax payable on income of minors. These rules are found in
Division 6AA (comprising ss. 102AA to 102AGA) of ITAA36 and were introduced to discourage incomesplitting by means of the diversion of income to children.
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MODULE 4 Taxation of Individuals 225
The various types of assessable income specifically discussed in this module are outlined in figure 4.3.
There are three key terms pivotal to the operation of Division 6AA, namely:
1. prescribed persons
2. excepted assessable income
3. eligible taxable income.
FIGURE 4.3
Types of assessable income
Types of assessable
income
Employee-related
income
Tax treatment
of minors
Remuneration for
overseas services
Income derived from
the sharing economy
Income derived
from dividends
Income derived
from interest
Income derived
from property
Income derived from
trust investments
Main residence
exemption
Income derived
from trusts
Income derived
from royalties
Other assessable
income
ETPs, PSI &
ESSs
CGT relief
Marriage
breakdown
Small business
concessions
Contributions
Taxing
superannuation
Benefits
Source: CPA Australia 2022.
Prescribed Persons
According to s. 102AC(1) of ITAA36, a prescribed person is any person under 18 years of age (i.e. a
minor) at the end of the income year and who is also not an excepted person in relation to the income year.
However, s. 102AC(2) provides a variety of situations where a person will be considered an excepted
person in relation to a year of income if, for example:
1. the minor was engaged in full-time employment on the last day of the year
2. the minor was a person to whom a carer allowance or disability support pension was payable in respect
of a period that included the last day of the year.
Excepted Assessable Income and Eligible Taxable Income
A minor can derive one of two types of income:
1. excepted assessable income (the minor’s own income)
2. eligible assessable income (income given to the minor).
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226 Australia Taxation
Figure 4.4 provides a summary of the taxation of minors.
FIGURE 4.4
Taxing the income of minors
Is the person a
‘prescribed person’ (i.e. a minor
and not an excepted person) as
defined in s. 102AC(1)?
No
Division 6AA does not apply.
Taxed at normal tax rates.
Yes
Excepted assessable
income
(s. 102AE(2))
Regarded as the minor’s income.
Income taxed at normal tax rates.
Eligible taxable income
(s. 102AD)
+
Not regarded as the minor’s income.
Income taxed at special rates contained
in Division 6AA of the 1936 Act.
Source: CPA Australia 2022.
Excepted Assessable Income (The Minor’s Own Income)
Excepted assessable income is income derived by the child. Excepted assessable income is defined in
s. 102AE (2) and typically includes:
• salary and wage income earned by the minor
• assessable trust income of the minor under ss. 97 and 100
• income from a deceased person’s estate
• business income where the minor is carrying on a business themselves
• income from the investments of any of the above amounts.
The special rates of tax contained in Division 6AA do not apply to excepted assessable income. Instead,
excepted assessable income is taxed at ordinary rates of tax.
Eligible Taxable Income (Income Given to the Minor)
Only eligible taxable income is caught by the special rules contained in Division 6AA. Essentially, eligible
taxable income arises from monies given or provided to the minor by guardians (e.g. parents, grandparents,
brothers, sisters, aunts or uncles). The income derived from this money is not regarded as the child’s
true income. Eligible taxable income is all the assessable income of the person which is not classified as
excepted assessable income. As such, it is taxed at penalty (high) rates.
Eligible taxable income, also referred to as ‘unearned income’, may include:
• interest
• royalties
• corporate dividend distributions.
In determining whether the income is eligible taxable income or not, consideration should also be given
to the type of employment and business income it comprises and the features that are required (s. 102AF).
What constitutes eligible trust income and excepted trust income for the purposes of Division 6AA are
indicated in s. 102AG.
Table 4.1 summarises the tax rates applicable on eligible taxable income for resident minors.
TABLE 4.1
Tax rates on eligible taxable income
Income
Tax rates for the 2021–22 income year
$0 – $416
Nil
$417 – $1307
Greater of 66% of the excess over $416 and the difference between tax on the whole of
the taxable income and the tax on the taxable income other than eligible taxable income
Over $1307
45% on each $1 of the whole of the eligible taxable income
Source: CPA Australia 2022.
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MODULE 4 Taxation of Individuals 227
Please note the following points in addition to table 4.1.
• If the minor’s eligible taxable income does not exceed $416, the special rates contained in table 4.1 for
the purposes of Division 6AA do not apply, and such eligible taxable income is taxed at normal resident
rates of tax. (Note: Non-minor Australian tax resident tax-free threshold is $18 200).
• An extra 2 per cent Medicare levy may be due and payable in part or in full depending on the minor’s
total taxable income for the income year (in part if the total taxable income exceeds $22 801 but is less
than $28 501, in full if the minor’s total taxable income is equal to or more than $28 501, for the 2019–20
income year.
• A minor is not entitled to either the low income tax offset or the low and middle income tax offset in
respect of eligible taxable income.
Where eligible taxable income is up to $1307 (i.e. over $416 but less than $1307), the first $416 is still
taxable at the taxpayer’s marginal tax rate.
Example 4.1 considers the special rules that apply to the taxation of minors.
EXAMPLE 4.1
Applying Minor Taxation Rates
Jill Jackson, a minor, has a taxable income of $9000 for 2021–22 of which $400 comprises eligible taxable
income. Reflect on the tax consequences of Jill’s taxable income.
To calculate Jill’s tax payable, the amount of excepted assessable income, $8600 ($9000 − $400), is
taxed at ordinary resident tax rates. The tax payable on this amount is $nil as $8600 is below the tax-free
threshold of $18 200. The special rates for the purposes of Division 6AA do not apply to the eligible taxable
income of $400 because it is less than $416. This $400 will be added to the excepted income and taxed
at normal tax rates. Therefore, applying the 2021–22 rates, and given that Jill’s taxable income of $9000
($8600 + $400) is still below the $18 200 tax-free threshold, the tax payable is $nil.
She is also not liable for the Medicare levy as her taxable income is below the Medicare levy reduction
threshold of $23 226.
QUESTION 4.1
Eli Thompson is 17 years of age on 30 June 2022 and is, therefore, considered a minor for taxation
purposes. Eli has a taxable income of $13 000 in the 2021–22 income tax year, which comprises
$826 of eligible income and excepted assessable income of $12 174.
Calculate the amount of tax payable in respect of Eli’s excepted assessable income and eligible
taxable income for the year ended 30 June 2022. Ignore the Medicare levy and any tax offsets in
your answer.
QUESTION 4.2
Joshua James is an Australian resident. He is a full-time high school student and is 16 years of age
as at 30 June 2022.
Joshua derived the following amounts during the 2022 income year.
$
Gross wages earned working part time at a supermarket
Rental income derived from a rental property left to him by his grandmother
who passed away six years ago
Interest on bank account (account used to receive rental income)
Fully franked dividends received from Bank Ltd shares
7400
21 500
100
1400
The shares were bought for Joshua by his older brother, Sean, who makes all the decisions about
those shares. All dividend income and any profit from the sale of those shares are deposited into a
bank account in Joshua’s name, but such account is controlled by Sean.
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228 Australia Taxation
(a) Calculate Joshua’s taxable income for the year ended 30 June 2022 showing the eligible taxable
income and excepted assessable income components of his income.
(b) Calculate the amount of tax payable in respect of Joshua’s excepted assessable income and
eligible taxable income for the year ended 30 June 2022. Ignore the Medicare levy and any tax
offsets in your answer.
REMUNERATION FOR OVERSEAS SERVICES
Where an Australian resident individual receives remuneration for services performed overseas, which is
subject to tax in the overseas country, then the remuneration may be exempt from tax in Australia. This is
when there is a period of continuous foreign service of 91 days or more and certain conditions are satisfied.
To be exempt from Australian tax, the foreign service must be directly attributable to:
• aid or charitable work as an employee of a recognised non-government organisation
• work as a government aid worker, or
• work as a government employee deployed as a member of a disciplined force (ITAA36, ss. 23AG
and 23AF).
INCOME DERIVED FROM THE SHARING ECONOMY
The key terms used in this section are defined as follows.
Crowdfunding is the practice of using the internet and/or social media to find supporters and raise funds
for a project or venture (ATO 2020a).
The sharing economy allows people to connect with others to complete various transactions, including
sharing resources or assets, providing services or crowdfunding. These transactions generally occur online
or through smart devices (ATO 2019).
Examples include renting out a room in a house or a whole house on Airbnb, or providing ride sourcing
services for a fare, such as through Uber and Ola ridesharing cabs.
Income Sourced Through the Sharing Economy
Although the sharing economy business model differs from that of a traditional service provider, the
Australian Taxation Office (ATO) has published guidance that it will apply the tax law as it currently
stands. Those individuals providing services through the sharing economy have the same tax obligations
as traditional service providers.
Basically, service providers using the sharing economy will have their payments for services treated
as assessable income. This is unless there are reasonable grounds to consider the activity of providing
the services as a hobby or recreational pursuit (so the factors to be considered in determining whether a
business exists, discussed in module 2, must be applied).
The same rule applies for the goods and services tax (GST), so if the individual is carrying on a business
and the annual turnover meets the $75 000 threshold, they must register for GST. GST is covered in
module 6. The rules for applying the main residence exemption and CGT are particularly important
in relation to Airbnb services, and are also applied in the same manner. See the section ‘Capital gains tax
relief for individuals’ for more information.
Watch this video from the ATO at the following link for a simple description of how tax applies to the
sharing economy, www.ato.gov.au/General/The-sharing-economy-and-tax.
INCOME DERIVED FROM DIVIDENDS
Where a resident individual receives a dividend from a resident Australian company, that dividend may be
franked, partly franked or unfranked.
A franked dividend is one that has been paid out of profits on which the company has paid tax. The
tax paid by the company is imputed to the shareholder by means of a franking credit that is attached to the
dividend received by the shareholder.
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MODULE 4 Taxation of Individuals 229
For franked dividends, the individual shareholder includes in assessable income the amount of the
dividend received plus the franking credit attached to that dividend and claims a tax offset for the tax
already paid by the company.
An unfranked dividend is one that has been paid from profits that have not been taxed to the company.
There are no franking credits attached to unfranked dividends.
For unfranked dividends, the individual shareholder includes the dividend received in assessable income
and there is no tax offset.
For partly franked dividends, the franked portion is treated as a franked dividend and the unfranked
portion is treated as an unfranked dividend.
Franking of dividends is discussed in detail in module 5.
Where a resident individual receives a dividend from a non-resident company, the individual is assessed
upon the amount of dividend received plus any foreign tax paid on the dividend, such as withholding tax.
The taxpayer then receives a credit for the foreign tax paid equal to the lower of the foreign tax paid, or
for the Australian tax payable on that dividend.
Tax Treatment for Non-Residents
The tax treatment of dividends is different for non-residents.
Non-residents are only assessed on dividends that are paid out of profits derived from sources
within Australia.
Dividends are subject to tax in Australia via the withholding system (discussed in module 2) and so the
foreign resident does not include the dividend income in their Australian assessable income. Further, to
the extent that the dividend is franked, withholding tax is not levied, so the dividend income is free from
Australian tax in the hands of the non-resident (because it has already been taxed in the company).
However, an unfranked dividend, or an unfranked portion of a dividend, is subject to withholding tax
at the rate of 30 per cent, or 15 per cent if Australia has a tax treaty with the non-resident’s country. No
further tax is then payable in Australia on the dividend.
Income Derived from Interest
Australian residents are required to include interest income as assessable income. Interest income
consists of:
• interest earned from financial institution accounts and term deposits
• interest earned from any other source including penalty interest received on an investment
• interest earned from children’s savings accounts if you opened or operated an account for a child and
the funds in the account belong to you, or you spent or used the funds in the account
• interest … paid or credited to you [by the ATO]
• life insurance bonuses (you may be entitled to a tax offset equal to 30 per cent of any bonus amounts
included in your income)
• interest from foreign sources (you may be entitled to a tax offset for any tax paid on this income)
(ATO 2021f).
Interest received by non-residents from Australian sources is subject to the withholding tax system
(discussed in module 2) and is therefore not included in the non-resident’s Australian assessable income.
INCOME DERIVED FROM PROPERTY
The chief source of income derived from real property is rental income. Taxpayers are subject to taxation
on rent and rent-related payments and the full amount must be included on the tax return. Rent-related
payments are:
• letting/booking fees
• insurance payment paid to the taxpayer as compensation for lost rent
• a reimbursement or recoupment for deductible expenditure, such as an amount from a tenant to cover
the cost of repairing damage to the rental property (where the whole amount received from the tenant
would be included in income and a deduction claimed for the cost of the repairs)
• rent received from renting out a room or a whole house or unit on a short-term basis, through a website
or app, via the sharing economy.
If goods or services are received by the taxpayer instead of monetary rent, then the taxpayer must work
out the monetary value and include that as assessable income.
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230 Australia Taxation
If the taxpayer owns an investment property jointly or in-common with another person, or has an interest
in a rental property business, then the individual taxpayer’s share of the rent is assessable. This is in contrast
to a residential tenancy bond, which is not generally income and consequently refunds cannot be claimed
as a deduction. However, where part of the bond is kept for repairs or maintenance, then this amount is
returned as income and a deduction can be claimed when the expenditure is incurred. Similarly, where the
bond is kept due to unpaid rent, then it will be regarded as income.
The use of negative gearing in respect of rental properties as an offset against other income is discussed
in more detail in module 2.
CGT upon the sale of the property where rent was derived is discussed in module 3.
INCOME DERIVED FROM TRUST INVESTMENTS
Income received from trust investment products is included as assessable income. Income and credits
from the following must be included:
• cash management trust
• money market trust
• mortgage trust
• unit trust
• managed fund, such as a property trust, share trust, equity trust, growth trust, imputation trust or balanced
trust (ATO 2021h).
Also included are income and credits from managed investment trusts (MITs) — a form of fixed interest
unit trust. Resident taxpayers are required to withhold the final tax amount from MIT payments made to
foreign residents.
INCOME DERIVED FROM TRUSTS
A trust is not a separate taxable entity, but the trustee is required to lodge a tax return for the trust. Trust
beneficiaries are required to declare their amount of the trust’s income to which they are entitled in their
individual tax return. They are required to pay tax on it, even if they did not receive the actual income.
One exception is that you do not need to declare a trust distribution if family trust distribution tax has
already been paid. This is discussed in more detail in module 5, which deals with trust income.
INCOME DERIVED FROM ROYALTIES
Royalties are payments made by one person for the use of rights owned by another person. Royalty
payments can be either periodic, irregular or one-off payments and are generally only assessable when
actually received.
Examples include the right to use a copyright or patent, the supply of scientific, technical, industrial or
commercial knowledge or information, or film and video tape royalties (see Taxation Ruling IT2660).
Royalties received by non-residents from Australian sources are subject to the withholding tax system
(discussed in module 2) and are therefore not included in the non-resident’s Australian assessable income.
Royalties received by a resident taxpayer are generally included as ordinary income and assessable under
s. 6-5 of ITAA97. Where a receipt is not assessable as ordinary income it will be assessable under s. 15-20
of ITAA97. Alternatively, where the royalty is not assessable as income under these other provisions, it
could be subject to CGT.
4.3 EMPLOYMENT TERMINATION PAYMENTS,
PERSONAL SERVICES INCOME AND EMPLOYEE
SHARE SCHEMES
EMPLOYMENT TERMINATION PAYMENTS
An employment termination payment (ETP) is defined in s. 82-130 of ITAA97 as a payment made in
consequence of the termination of employment of a person. Termination of employment includes situations
where an employee resigns, is retrenched, dismissed or dies.
Payments must be made within 12 months of the date of the termination of employment; however, the
Commissioner of Taxation (the Commissioner) has the discretion to increase this timeframe (s. 82-130(5)).
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MODULE 4 Taxation of Individuals 231
The general rule is that ETPs cannot be rolled into a superannuation fund but instead must be taken as
cash (s. 82-130(1)(c)).
ETPs are typically paid by the employer and are therefore subject to PAYG withholding. These
ETPs include:
• a payment in lieu of notice
• a payment for unused sick leave
• a payment for unused rostered days off
• ex-gratia payments or ‘golden handshakes’ (also known as ‘golden parachutes’)
• compensation for loss of employment
• compensation for wrongful dismissal
• a payment for permanent disability (excluding a compensation payment)
• a redundancy payment or payment under an early retirement scheme that exceeds the tax-free limit for
the 2022 income year of $11 341 plus $5672 for each year of completed service
• lump sum payments paid on the death of an employee.
Certain payments are not considered ETPs (s. 82-135). These include:
• salary, wages and allowances owing to the employee for work done or leave already taken
• lump sum unused annual leave and lump sum long service leave payments
• compensation for personal injury
• payments from a superannuation fund
• pensions and annuities
• foreign termination payments
• payment for restraint of trade
• an advance or loan to an employee
• FBT under FBTAA86
• an income stream (i.e. periodic payments) from a superannuation pension or annuity
• a genuine redundancy and early retirement scheme payment that fall within the tax-free amount.
To fall within the definition of an ETP under s. 82-130(1)(a)(i), the payment must be ‘in consequence
of termination of employment’. Termination of employment can occur at the request of the employer or
employee, or by mutual agreement.
For a termination to be valid, there must usually be no agreement between the employer and the
employee for re-employment of the employee at some later stage for the same or a different position.
Hence, a change in hours worked by an employee (e.g. a full-time employee going to casual or part-time)
will not generally be recognised as a valid termination.
If an employee is dismissed on the takeover of a business, termination occurs even if the person is
re-engaged by the new owner. A termination also occurs where an employee ceases to work for a subsidiary
company and is re-engaged by the parent entity (Case K76 78 ATC 703).
There are two types of termination payments, namely:
1. life benefit termination payments (s. 82-130(1)(a)(i))
2. death benefit termination payments (s. 82-130(1)(a)(ii)).
Each of these two ETPs are discussed in more detail below.
Life Benefit Termination Payment
The amount of PAYG withholding tax to be deducted from a life benefit termination payment is based on:
• the type of payment
• the age of the taxpayer
• the amount of the payment
• whether the recipient has reached their preservation age on the last day of the income year in which
the payment is received (see below).
A taxpayer’s preservation age is set out in regulation 6.01 of the Superannuation Industry (Supervision)
Regulations 1994 and differs according to the taxpayer’s date of birth. Table 4.2 sets out the various
preservation ages.
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232 Australia Taxation
TABLE 4.2
Preservation age table
Taxpayer’s date of birth
Preservation age
Before 01.07.60
55
01.07.60 to 30.06.61
56
01.07.61 to 30.06.62
57
01.07.62 to 30.06.63
58
01.07.63 to 30.06.64
59
After 30.06.64
60
Source: Adapted from ATO 2020c, ‘Withdrawing and using your super’, accessed January 2022, www.ato.gov.au/Individuals/Super/
Withdrawing-and-using-your-super.
A life benefit termination payment has two possible components:
1. the tax-free component
2. the taxable component.
Tax-Free Component
According to s. 82-140 of the ITAA97, the tax-free component of a life benefit termination payment may
be comprised of one of two components, namely:
(a) that part of the ETP relating to employment before 1 July 1983 as per s. 82-155(1) of ITAA97 —
referred to as the ‘pre-July 83 segment’ (determined by an apportionment of those days worked before
this date divided by the total number of days of eligible employment)
(b) an invalidity segment (s. 82-150) — part of an ETP that is paid because the employee sustained a
permanent disability. An invalidity segment can be paid if both:
– the employment ceased as a result of ill health
– two medical practitioners have certified that it is unlikely the employee can ever be gainfully
employed in the capacity for which they are reasonably qualified.
A death benefit ETP cannot include an invalidity segment.
According to s. 82-150(2), the component of an invalidity payment that is regarded as exempt is
calculated in accordance with the following formula.
Amount of the employement termination payment ×
Days to retirement
Employment days + Days to retirement
Any part of the invalidity payment in excess of this amount is considered an ETP. That part of the
ETP is taxed in accordance with the rates of tax in table 4.3. The tax-free component is non-assessable,
non-exempt (NANE) income (s. 82-10(1)).
TABLE 4.3
Life benefit employment termination tax rates for 2022
Taxpayer’s age at the end of income year
Tax rate
Under preservation age
Taxed at 30% plus 2% Medicare levy for the first
$225 000 and the remainder taxed at the top marginal
tax rate (45% plus 2% Medicare levy)
Preservation age and over
Taxed at 15% plus 2% Medicare levy for the first
$225 000 and the remainder taxed at the top marginal
tax rate (45% plus 2% Medicare levy)
Source: CPA Australia 2022.
Taxable Component
The taxable component of a life benefit termination payment is included in the taxpayer’s assessable
income and taxed subject to an ETP cap. This ETP cap is indexed in line with average weekly ordinary
times earnings. The life termination payment cap for the 2022 income year is $225 000 (2021: $215 000).
Where the total taxable income component received by a taxpayer exceeds the limit, a tax offset is
available to limit the tax payable.
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MODULE 4 Taxation of Individuals 233
For a life benefit termination payment, the tax treatment of the taxable component of an ETP
depends on:
• the age of the individual
• whether they are under or over preservation age
• the taxpayer’s other taxable income
• whether or not the ETP is an ‘excluded payment’.
Which Cap Applies?
If the life benefit ETP is considered an excluded payment, the ETP cap amount of $225 000 applies in the
2021–22 income year.
According to s. 82-10(6), an excluded (ETP) payment includes:
• genuine redundancy and early retirement scheme payments that exceed the tax-free limit (i.e. only the
amount in excess of the limit is subject to the cap)
• a payment that includes an invalidity segment (i.e. only the amount not included in the tax-free
component is subject to the cap)
• certain types of compensation payments for genuine disputes or are related to personal injury, unfair
dismissal, harassment or discrimination
• death benefit ETPs.
All other ETPs are referred to as ‘non-excluded payments’. These payments include:
• golden handshakes and gratuities
• non-genuine redundancy payments (unless it would have been a genuine redundancy, had the employee
not reached their retirement or age-pension age)
• payments in lieu of notice
• payments for unused sick leave or unused rostered days off.
For these payments, the lesser of the ETP cap and the whole-of-income cap will apply. For the 2021–22
income year, the whole-of-income cap is $180 000 less other taxable income that the employee receives
in the income year (e.g. salary or wages).
In the majority of cases, the whole-of-income cap will be less, so it will apply to these payments. The
concept of the whole-of-income cap and how it applies is discussed later in this section.
Table 4.3 sets out the tax treatment in relation to life ETPs received by individual taxpayers in the 2022
income year.
Examples 4.2 and 4.3 illustrate the taxation treatment of ETPs received by a taxpayer. In both examples,
the employee receives a non-excluded ETP and the above tax rates apply.
Example 4.2 illustrates the tax consequences for a taxpayer who has reached preservation age, whereas
in example 4.3, the taxpayer is under preservation age.
EXAMPLE 4.2
ETP Payment
Crystal Cooke was born in March 1952. She is 69 years of age. In accordance with table 4.2, her
preservation age is 55. On 17 August 2021, she resigned from her employment and received an ETP
of $190 000. Consider how Crystal’s ETP of $190 000 is taxed.
This $190 000 is a non-excluded life benefit termination payment. For the purposes of this example,
ignore the whole-of-income cap as this example illustrates the application of the ETP cap only.
As Crystal’s life benefit termination payment of $190 000 was below the upper limit of $225 000 and,
because she was over the preservation age on the last day of the income year in which the payment
is received, the life benefit termination payment received by Crystal will be taxed at 15 per cent plus
2 per cent Medicare levy (see table 4.3).
EXAMPLE 4.3
ETP Payment
Martin Mathews was born in March 1964. In accordance with table 4.2, his preservation age is 59. Martin
has been working for the Department of Health for the past 19 years. On 4 September 2021, he resigned
and received an ETP of $230 000. At the time of resignation, Martin was 58 years of age. Consider how
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234 Australia Taxation
Martin’s ETP of $230 000 is taxed. The $230 000 is a non-excluded payment. Ignore the whole-of-income
cap for the purposes of this example.
As Martin’s ETP was above the upper limit of $225 000 and, because he was under the preservation
age on the last day of the income year in which the payment is received, the first $225 000 received is
taxed at 30 per cent plus 2 per cent Medicare levy, while the amount received in excess of $225 000 (i.e.
$5000) is taxed at 45 per cent plus 2 per cent Medicare levy (see table 4.3).
Example 4.4 illustrates how the split between the tax-free component and taxable component of an ETP
is calculated and the subsequent amount of tax payable in respect of an ETP received by a taxpayer.
EXAMPLE 4.4
Applying Employment Termination Payment Taxation
On 1 July 2021, Paul Metts received an ETP of $150 000, having retired from his employment at age 71
after working for his employer for 46 years. His preservation age is 55. His employment service period is
16 801 days of which 2922 days relate to service prior to 1 July 1983. Consider the amount of tax payable
on Paul’s ETP.
This $150 000 is a non-excluded life benefit termination payment. For the purposes of this example,
ignore the whole-of-income cap as this example illustrates the application of the ETP cap only. Furthermore, assume for the purposes of this example that Paul did not have any other income, nor any
deductions.
The amount of tax payable on the ETP is calculated as follows. The tax-free component only comprises
the pre-July 1983 segment as there is no invalidity segment.
Number of pre-July 1983 days
× $150 000
Total number of days of employment
)
(
2922
× $150 000
=
16 801
Therefore, the pre-July 1983 segment =
= $26 088
The taxable component = $150 000 − $26 088
= $123 912
Paul’s taxable income only comprises the $123 912 taxable component. The tax-free component of
$26 088 is not included in Paul’s assessable income.
Paul has reached preservation age and the amount of the ETP of $123 912 is below the ETP cap. Thus,
he pays tax at 15 per cent on the first $123 912, namely $18 587 (excluding Medicare levy).
Example 4.5 illustrates the taxation treatment of an ETP comprising an invalidity segment component.
EXAMPLE 4.5
Tax Treatment of an ETP Including an Invalidity Segment
Drew started his current employment on 1 January 2010 and has an earliest retirement date of 1 January
2025. However, due to a disability, Drew retires on 1 April 2022, aged 63. Drew receives an ETP from his
employer totalling $100 000.
The number of days from the date when employment was terminated to Drew’s retirement date (i.e.
1 April 2022 to 1 January 2025) is 1005. The total number of days of Drew’s employment with his employer
between 1 January 2010 to 1 April 2022 is 4474.
According to s. 82-150(2), the tax-free component of Drew’s $100 000 invalidity payment is calculated
in accordance with the following formula.
Amount of the employement termination payment ×
Days to retirement
Employment days + Days to retirement
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MODULE 4 Taxation of Individuals 235
Applying this formula to Drew’s situation results in the following tax-free amount:
$100 000 ×
1005
= $18 343
4474 + 1005
The remaining $81 657 (i.e. $100 000 – $18 343) of the termination payment is taxed as an ETP. As Drew
was 63 years of age, he is over the preservation age of 55. Accordingly, the $81 657 ETP is taxed at
15 per cent plus the 2 per cent Medicare levy as per table 4.3.
Whole-of-Income Cap Threshold of $180 000
From 1 July 2012, a non-indexed ‘whole-of-income cap’ applies to high income earners who are resigning
or retiring and receive an ETP. For the 2021–22 income year, the whole-of-income cap is $180 000 less
other taxable income that the employee receives in the income year (e.g. salary or wages). Tax losses are
not taken into account when working out a taxpayer’s whole-of-income cap.
Essentially, only that part of an affected ETP, such as a golden handshake that takes a person’s total
annual income (including the ETP) up to a $180 000 whole-of-income cap will receive the ETP tax offset.
This means that only this part is eligible to be taxed at a maximum of 15 per cent or 30 per cent, depending
on the taxpayers’ age in accordance with table 4.3. Amounts above this whole-of-income cap will be taxed
at the taxpayer’s marginal tax rate.
For example, if a person receives salary and wages in the current year of $120 000, then their wholeof-income cap is reduced from $180 000 to $60 000. If that person resigns or retires from their job and
receives an ETP of $20 000, then as the ETP is less than his whole-of-income cap of $60 000, the employer
will tax the whole $20 000 at a maximum of 15 per cent or 30 per cent (plus Medicare Levy), depending
on the taxpayer’s age in accordance with table 4.3 (s. 82-10).
In 2021–22 the cap for non-excluded payments is the lesser of:
• the ETP cap (i.e. $225 000 less the taxable component of any previous ETPs related to the same
termination or received in the same financial year and excluded payments)
• the whole-of-income cap (i.e. $180 000 minus other taxable income).
EXAMPLE 4.6
Applying the Whole-of-Income Cap
Colin Miller is aged 63 years. In October 2021, he retired from his job. Colin’s taxable income for the year
ended 30 June 2022 totalled $100 000, which includes gross salary and wages of $90 000 plus $10 000
income from other investments.
Upon termination, Colin received a golden handshake from his employer of $50 000. The golden
handshake is a non-excluded ETP, so the cap used to determine tax payable on the ETP is the
lesser of:
• the ETP $225 000
• the whole-of-income cap of $180 000 – other taxable income of $100 000 = $80 000.
The lesser of these two amounts is $80 000. Since Colin’s ETP of $50 000 is less than his calculated
whole-of-income cap ($80 000) and he has reached his preservation age, his ETP will be taxed at the
concessional rate of 15 per cent plus Medicare levy of 2 per cent.
Death Benefit Termination Payment
A death benefit termination payment is an ETP received by a person after another person’s death in
consequence of the termination of the other person’s employment (s. 82-130(1)(a)(ii)). A death benefit
also does not include an invalidity segment because such segment is received by the taxpayer themselves,
but a death benefit is paid to a dependant or another person (ss. 82-65(1) and 82-150).
Like a life benefit termination payment, a death benefit termination payment is also made up of two
components:
1. the tax-free component
2. the taxable component.
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236 Australia Taxation
Tax-Free Component
The tax-free component of a death benefit termination payment is that amount of the payment related
to work performed by the employee before 1 July 1983. The tax-free component is NANE income
(s. 82-65(2)(a)).
Taxable Component
The taxable component of a death benefit termination payment is included in the assessable income of the
dependant or non-dependant but a tax offset puts a ceiling on the tax rate that may apply.
The way in which superannuation member benefits paid from a complying superannuation fund are
taxed in the hands of the beneficiary depends on whether the beneficiary is a dependant of the deceased or
not (ss. 82-65 to 82-70).
A person is considered a dependent of the deceased if that person is:
• the deceased’s spouse or former spouse
• the deceased’s child under the age of 18
• any other person who was financially dependent on the deceased just before he or she died
• any other person with whom the deceased had an interdependency relationship with just before he or
she died.
The taxable component of an ETP is included in the taxpayer’s assessable income and taxed subject to
the application of the employment termination cap. This ETP cap is indexed in line with average weekly
ordinary times earnings. Table 4.4 summarises the various death benefit termination benefit cap amounts
for the 2022 income year.
TABLE 4.4
Taxation of death benefit termination payments — 2021–22
Dependant
Tax rate
Dependant of the deceased taxpayer
Tax-free for the first $225 000 and the remainder taxed at the
top marginal tax rate (45% plus 2% Medicare levy)
Non-dependant of the deceased taxpayer
Taxed at 30% plus 2% Medicare levy for the first $225 000
and the remainder taxed at the top marginal tax rate (45%
plus 2% Medicare levy)
Source: CPA Australia 2022.
Genuine Redundancy Payments and Early Retirement Scheme Payments
There are two other payments that may be made to an employee as a consequence of the termination of
their employment. These payments are:
• genuine redundancy payments
• early retirement payments.
Concessional tax treatment applies to both of these termination payments. The taxation treatment of
each of these is discussed as follows.
Genuine Redundancy Payments
A payment is classified as having been made due to a genuine redundancy where a person’s employment
has been prematurely ended as part of a reduction in the workforce of the employer and the employees
position is genuinely redundant (ITAA97, s. 83-175).
A genuine redundancy payment must satisfy the following conditions (s. 83-175(2)).
(a) the employee is dismissed before the earlier of the following:
(i) the day the employee reached pension age;
(ii) if the employee’s employment would have terminated on reaching a particular age or completing
a particular period of service—the day the employee would reach the age or complete the period
of service (as the case may be);
(b) if the dismissal was not at arm’s length—the payment does not exceed the amount that could reasonably
be expected to be made if the dismissal were at arm’s length;
(c) at the time of the dismissal, there was no arrangement between the employee and the employer, or
between the employer and any another person, to employ the employee after the dismissal.
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MODULE 4 Taxation of Individuals 237
‘Pension age’ for the 2021–22 tax year is defined by the ATO as:
66 years and 6 months for people born from 1 July 1955 to 31 December 1956 inclusive. [For people born]
on or after 1 January 1957, you’ll have to wait until you turn 67. This will be the [pension age] from 1 July
2023 (Services Australia 2021).
A genuine redundancy payment comprises a tax-free amount and an assessable amount (s. 83-170). The
amount in excess of the tax-free amount is assessable as an ETP.
The tax-free component of a genuine redundancy payment is calculated in accordance with the following
formula (s. 83-170(3)):
Base amount + (Service amount × Each whole year of completed service)
Parts of years of service are ignored (e.g. 7½ years service = 7 years).
For the year ended 30 June 2022, the base amount is $11 341 and the service amount is $5672.
The employer is required to include the tax-free component of a genuine redundancy payment next
to the label ‘Lump Sum D’ on the employee’s Income Statement (formerly known as a PAYG payment
summary). This amount is effectively tax-free in the hands of the employee and should have no PAYG
withholding tax deducted from it.
Any part of the redundancy payment in excess of the tax-free component is considered an ETP. That part
of the ETP is taxed in accordance with the rates of tax applicable to a life termination payment contained
in table 4.3.
Example 4.7 illustrates how a genuine redundancy payment is taxed.
EXAMPLE 4.7
Taxation of Genuine Redundancy Payments
Emily Thistlewaite was born in April 1960. She is 62 years of age. Her preservation age is 55. She is
dismissed on 4 December 2021 by her employer because there was not enough work to keep her on. Emily
has been working with the employer for 11 years and 8 months. Emily was given a genuine redundancy
payment from her employer of $70 000 on this date. Consider how Emily’s $70 000 genuine redundancy
payment is taxed.
Emily’s tax-free amount for the 2022 income year is calculated as: $11 341 + ($5672 × 11 whole years
of service) = $73 733. As the redundancy payment of $70 000 is less than the tax-free amount of $73 733,
the entire $70 000 redundancy payment is tax-free in Emily’s hands.
However, if Emily received a genuine redundancy payment of $80 000 instead of $70 000, then $73 733
would be exempt and the remaining $6267 would be taxed as an ETP. As she is over the preservation
age, and this amount is below the ETP cap, the $6267 is taxed at 15 per cent plus 2 per cent Medicare
levy (as per table 4.3).
Early Retirement Scheme Payments
An early retirement scheme payment is the amount of payment received by an employee because the
employee retires under an early retirement scheme that exceeds the amount that could reasonably be
expected to be received by the employee as a consequence of the voluntary termination of his or her
employment (s. 83-180).
An early retirement scheme must satisfy the following conditions (s. 83-180(2)).
(a) The employee retires the earlier of the following:
(i) the day the employee reached pension age;
(ii) if the employee’s employment would have terminated when he or she reached a particular age or
completed a particular period of service—the day he or she would reach the age or complete the
period of service (as the case may be);
(b) If the retirement was not at arm’s length—the payment does not exceed the amount that could
reasonably be expected to be made if the retirement were at arm’s length;
(c) at the time of retirement, there was no arrangement between the employee and the employer, or between
the employer and any another person, to employ the employee after the retirement.
According to s. 83-180(3), a ‘scheme’ is an early retirement scheme if:
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(a) all the employer’s employees who comprise such a class of employees as the Commissioner approves
may participate in the scheme; and
238 Australia Taxation
(b) the employer’s purpose in implementing the scheme is to rationalise or re-organise the employer’s
operations by making any change to the employer’s operations, or the nature of the work force, that the
Commissioner approves; and
(c) before the scheme is implemented, the Commissioner . . . approves the scheme as an early retirement
scheme.
An early retirement scheme payment comprises of a tax-free amount and an assessable amount
(s. 83-170). The amount in excess of the tax-free amount is assessable as an ETP.
The tax-free component of an early retirement scheme payment is calculated in accordance with the
following formula.
Base amount + (Service amount × Each whole year of completed service)
Once again, parts of years of service are ignored (e.g. 4¾ years service = 4 years).
For the year ended 30 June 2022, the base amount is $11 341 and the service amount is $5672.
The employer is required to include the tax-free component of an early retirement scheme payment next
to the label ‘Lump Sum D’ on the employee’s Income Statement. This amount is effectively tax-free in the
hands of the employee and, as such, should not have any PAYG withholding tax deducted from it.
Any excessive amount of the tax-free component is taxed in accordance with the rates of tax applicable
to a life termination payment contained in table 4.3.
Unused Annual Leave and Long Service Payments
Payments made to employees on termination of employment for unused annual leave and/or unused long
service leave are not ETPs and are subject to Subdivisions 83-A and 83-B of ITAA97.
Unused Annual Leave Payments
The taxation of unused annual leave depends on the period in respect of which the annual leave has been
accrued.
Leave Accrued Before 18 August 1993
Where a lump sum payment is made in respect of the unused annual leave that accrued before 18 August
1993, the lump sum amount received is fully assessable. However, this component is taxed at a maximum
of 30 per cent plus 2 per cent Medicare levy (s. 83-10(3)). That is, the taxpayer is entitled to a tax offset
to ensure tax on the payment does not exceed 30 per cent (s. 83-15).
Leave Accrued on or After 18 August 1993
Where a lump sum payment is made in respect of the unused annual leave that accrued after 18 August
1993, the lump sum amount received is fully assessable. In other words, the amount of tax withheld is at
the taxpayer’s marginal rate of tax.
As the tax treatment for lump sum annual leave payments varies depending on when the leave entitlement
is accrued, it is necessary to apportion the annual leave between:
• pre-18 August 1993, and
• on or after 18 August 1993.
The amount of any payment made for annual leave that occurred before 18 August 1993 is calculated
using the following formula.
Payment ×
Number of days in accrual period that occurred before 18 August 1993
Number of days in the accrual period
Where the termination is due to a genuine redundancy or early retirement scheme, the amount of leave
accrued on or after 18 August 1993 is fully assessable by virtue of s. 83-70.
However, in this instance, the taxpayer is entitled to a rebate on all of the unused annual leave. This
is regardless of whether it was before or after 18 August 1993, such that the maximum amount of tax paid
is 32 per cent (i.e. 30 per cent tax plus 2 per cent Medicare levy).
Unused Long Service Leave Payments
Payments made to an employee on termination of employment in respect of their unused long service leave
are specifically covered in ss. 83-65 to 83-115 of ITAA97.
Like unused annual leave, the taxation of unused long service leave depends on the period in respect of
which the annual long service leave has been accrued.
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MODULE 4 Taxation of Individuals 239
Leave Accrued Before 16 August 1978
Where a lump sum payment is made in respect of the unused long service leave that accrued before
16 August 1978, only 5 per cent of the lump sum amount received by the taxpayer is included in the
taxpayer’s assessable income for the year of income and is taxed at the taxpayer’s marginal tax rate
(Item 1, s. 83-80). The remaining 95 per cent of the payment is exempt.
Leave Accrued Between 16 August 1978 and 17 August 1993
Where a lump sum payment is made in respect of the unused long service leave that accrued between
16 August 1978 and 17 August 1993, the lump sum amount received is fully assessable. However, this
component is taxed at a maximum of 30 per cent plus 2 per cent Medicare levy (Item 2, s. 83-80).
Leave Accrued on or After 18 August 1993
Where a lump sum payment is made in respect of the unused long service leave that accrued after 18 August
1993, the lump sum amount received is fully assessable. In other words, the amount of tax withheld is at
the taxpayer’s marginal rate of tax (Item 3, s. 83-80).
As the tax treatment for lump sum long service leave payments varies depending on when the leave
entitlement accrued, it is necessary to apportion the long service leave between:
• pre-16 August 1978
• 16 August 1978 and 17 August 1993, and
• on or after 18 August 1993.
The calculation of the unused long service leave for the pre-18 August 1993 period or the post-17 August
1993 period is performed using the following formula (s. 83-95(2)).
Amount of payment ×
Unused long service leave days in the relevant period
Total unused long service leave days
Where the termination is due to a genuine redundancy or early retirement scheme, the amount of leave
accrued on or after 18 August 1993 is fully assessable by virtue of s. 83-70.
However, in this instance, the taxpayer is entitled to a rebate on all of the unused long service leave.
This is regardless of whether it was before or after 18 August 1993, such that the maximum amount of tax
paid is 32 per cent (i.e. 30 per cent tax plus 2 per cent Medicare levy).
Table 4.5 summarises the taxation of payments in lieu of unused annual leave and long service leave.
TABLE 4.5
Taxation of payments in lieu of unused annual leave and unused long service leave
Amount
assessable
Maximum rate
of tax (excluding
Medicare levy)
Type of leave
Actual date
Long service leave
Accrued to
15.08.78
5%
16.08.78 to
17.08.93
100%
32%
18.08.93 onwards
100%
Marginal rate
Accrued to
15.08.78
5%
Marginal rate
16.08.78 to
17.08.93
100%
32%
18.08.93 onwards
100%
32%
Accrued to
17.08.93
100%
32%
18.08.93 onwards
100%
Marginal rate
Any date
100%
32%
Long service leave received as a result of genuine
redundancy, invalidity or early retirement scheme
Annual leave
Annual leave received as a result of genuine
redundancy, invalidity or early retirement scheme
Marginal rate
Source: Based on ATO 2020b, ‘Schedule 7 — Tax table for unused leave payments on termination of employment’, accessed
February 2022, www.ato.gov.au/Rates/Schedule-7—Tax-table-for-unused-leave-payments-on-termination-of-employment.
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240 Australia Taxation
PERSONAL SERVICES INCOME
What is Personal Services Income?
According to s. 84-5(1) of ITAA97:
Your ordinary income or statutory income, or the ordinary income or statutory income of any other entity,
is your personal services income if the income is mainly a reward for your personal efforts or skills.
Under this provision, income is treated as personal services income (PSI) if it is considered a reward
for the individual taxpayer’s personal efforts or skills.
This is the case regardless of whether the income was derived by the individual or through an entity
controlled by the taxpayer (e.g. company, trust or partnership), which is referred to as a ‘personal services
entity’ (PSE). A PSE is an entity whose ordinary income or statutory income includes the PSI of one
or more individuals (s. 86-15(2)). An exception to this general rule is where amounts of the income are
promptly paid as salary and wages to the individual or the income of the PSE comes from the conduct of
a personal service business (PSB) (s. 86-15(3), discussed later).
PSI is not employment income derived by employees. PSI must be included in the taxpayer’s personal
income tax return.
However, PSI does not include income generated mainly from:
• the supply or sale of goods (e.g. retailing, wholesaling or manufacturing) where the labour is incidental
• granting a right to use property (e.g. the copyright to a computer program) where the labour is incidental
• an income-producing asset (e.g. a bulldozer)
• a business structure (e.g. an accountant working for a large accounting firm).
PSI is ordinary income or statutory income gained mainly as a reward for the personal efforts or
skills of an individual. For example, in Fowler FCT (2008) ATC 2476 it was held that the amounts paid
were the PSI of the taxpayer and were ordinary income of the company that was a PSE. According to
paragraphs 24–25 of Taxation Ruling TR2001/7:
The use of ‘mainly’ in the definition means that the income referred to needs to be ‘chiefly’, ‘principally’
or ‘primarily’ a reward for the provision of the personal efforts of, or for the exercise of the skills of an
individual. Therefore, the use of tools of trade or plant and equipment does not itself preclude the income
from being personal services income, if they are ancillary to the generation of the income. Implicit in the
word ‘mainly’ is that more than half of the relevant amount of the ordinary or statutory income is a reward
for the personal efforts or skills of an individual.
Examples 4.8 and 4.9 illustrate whether a payment in respect of services provided qualifies as PSI or
the running of a PSB.
EXAMPLE 4.8
Example of Personal Services Income
New IT Pty Ltd provides computer programming services to clients and their only employee, Ron, does
all of the work. Ron uses the client’s equipment and software to do the work. Consider if this is PSI or
a PSB.
New IT Pty Ltd’s income from providing the service is Ron’s PSI because it is a reward for his individual
personal efforts and skills.
EXAMPLE 4.9
Example of Personal Services Business
Todd Wilson owns and drives a semi-trailer that he uses to transport goods. Consider if this is PSI or
a PSB.
The income is not Todd’s PSI because it is produced mainly by the use of the semi-trailer and not by
his personal efforts or skills.
If it is concluded that a person is not deriving income from PSI, then they are considered to be
conducting a PSB. In this instance, Divisions 84, 85 and 86 of ITAA97 do not apply.
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MODULE 4 Taxation of Individuals 241
Tests for Whether a Person is Conducting a Personal Services Business
The tests as to whether a taxpayer is conducting a PSB or deriving PSI are contained in s. 87-5 of ITAA97.
Where an individual or a PSE does not have a PSB determination in force, it must satisfy at least one of
the four tests in order to be said to be conducting a PSB. Alternatively, if the taxpayer does not pass any
of the four tests, they can apply for a PSB determination from the Commissioner.
Figure 4.5 summarises the tests contained in Division 87 as to whether a person is conducting a PSB.
FIGURE 4.5
Tests for whether a person is conducting a personal services business
Is there a personal services business
determination?
Yes
No
Is the results test satisfied?
Yes
No
Does 80% or more of your personal
services income come from one source?
No
Is the unrelated clients
test satisfied?
Yes
Yes
No
Is the employment test
satisfied?
Yes
No
Is the business
premises test satisfied?
Yes
No
The personal services income is not
income from conducting a personal
services business
The personal services income
is income from conducting a
personal services business
Source: Income Tax Assessment Act 1997 (Cwlth), s. 87-5, Federal Register of Legislation, accessed January 2022,
www.legislation.gov.au/Details/C2022C00029.
There are two primary PSB tests. Each of these tests are discussed in turn.
Test 1: The Results Test
Section 87-18 of ITAA97 provides that an individual or an entity meets the ‘results test’ in an income year,
if, in relation to at least 75 per cent of the individual’s or entity’s PSI, the following three tests are met.
1. The income is from producing a result — this means that the contract requires the individual/entity to
complete a set task, with payment being based on performance of the contract. Usually, the individual/
entity has a degree of flexibility as to how the work is done.
2. The individual/entity is required to supply the plant and equipment or tools of trade to perform the work
from which the individual/entity produces the result.
3. The individual/entity is, or would be, liable for the cost of rectifying any defect in the work performed
at the individual’s/entity’s own cost.
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242 Australia Taxation
The results test is regarded as the easiest of the four tests to meet and is intended to exempt genuine
independent contractors from the PSI regime.
For example, a contract to build an earth dam for a set price would be a contract for a result. In contrast,
the payment on an hourly basis to dig the hole in the ground is more than likely a contract for personal
services (labour) and would not satisfy the criteria.
In determining whether the contractor satisfies the results test, the custom and practice in the particular
industry will be considered.
Example 4.10 illustrates the application of the results test.
EXAMPLE 4.10
Application of the Results Test
Mark Lee is a carpenter who contracts through his company, Aussie Home Builders Pty Ltd (Aussie Home),
to build wooden frames for houses sold as house and land packages on new estates. Aussie Home is
paid a fixed amount for each frame and is required to complete each one within a specified time.
Under its contract, Aussie Home is required to provide all the tools and equipment needed to do the
work, although the materials are supplied by the contracting company according to the standard plans
for each house. If a frame is faulty, Aussie Home fixes the fault under its contract.
Consider if this is PSI to Mark Lee or a PSB.
Aussie Home would satisfy the conditions of the results test, so the PSI provisions will not apply to
Mark’s PSI.
Test 2: The 80 per cent Rule
The 80/20 rule asks the question as to whether 80 per cent or more of the individual’s PSI comes from one
client (or associate of that entity)?
A concession is available where income is derived from two or more Australian government agencies,
as government agencies are not treated as associates of each other. If the answer to this question is ‘Yes’,
then the PSI legislation applies and the taxpayer must attribute the income in their individual tax return.
Conversely, if the 80 per cent rule is not satisfied, then the income will only be exempt from the PSI
regime provided the individual satisfies one of the following three tests:
1. unrelated clients test
2. employment test
3. business premises test.
The Unrelated Clients Test
According to s. 87-20 of ITAA97, in order to satisfy the ‘unrelated clients test’:
(a) the individual/entity must, during the income year, produce income from providing services to two or
more unrelated entities (who are not associates of each other or the individual/entity)
(b) the services provided are as a direct result of the individual/entity making offers to the public at large
or to a section of the public through advertising.
Examples of an offer or invitation to the public, or a section of the public, may include:
• advertising in a national, state or local newspaper
• letter box drop over a reasonable area
• public sign on a building, motor vehicle, etc.
• advertising in the yellow pages
• television advertisements
• public tender
• internet website
• word of mouth.
Note having a LinkedIn profile was found to be insufficient in satisfying the unrelated clients test (see
FCT v Fortunatow & Anor (2020) FCAFC 139).
The Employment Test
According to s. 87-25(1), an individual meets the employment test if they engage one or more entities
(either through employment or by engaging sub-contractors) to perform at least 20 per cent (by market
value) of the individual/entity’s principal work (i.e. the work that generates the PSI).
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MODULE 4 Taxation of Individuals 243
Principal work does not include administrative work, such as bookkeeping work, issuing invoices, the
banking of receipts and answering telephone calls.
The employment test will also be met if, for at least half the year, the individual/entity employs an
apprentice (s. 87-25(3)).
Example 4.11 illustrates the application of the employment test.
EXAMPLE 4.11
Application of the Employment Test
James Taylor Pty Ltd is contracted to provide engineering services. Its sole income is James’ PSI. The
principal work is James’ engineering work. James’ wife, Alicia is employed by the company to attend to
the bookkeeping work, including issuing invoices and a range of administration matters, including banking
the monies, scheduling meetings and collecting the mail.
Consider if the work performed by Alicia meets the requirements of the employment test.
The work done by Alicia does not count as part of the principal work and thus, cannot be considered
when considering whether the 20 per cent requirement is met.
The Business Premises Test
According to s. 87-30, the business premises test is met, if at all times during the income year, an
individual/entity maintained and used business premises:
• to gain or produce the PSI
• to which the individual/entity has exclusive use (the premises cannot be shared)
• that are physically separate from any premises that the individual/entity used for private purposes
• that are physically separate from the premises of the entity to which the individual/entity provides
private services.
It is important that all of the above criteria be satisfied as demonstrated in FCT v Dixon Consulting
Pty Ltd (2006) ATC2550. In this Federal Court case, Justice Emmett overturned an AAT decision by
concluding that the business premises test was not satisfied where the taxpayer conducted their business
from a garage located on the same block as the taxpayer’s residence, notwithstanding that the garage was
a physically separate building as the PSE did not have exclusive use of the garage. It was also held that the
garage could not be considered as being physically separate from the taxpayer’s residence, merely because
it was a separate structure, as it shared common facilities.
Application of the Personal Services Income Rules
If an individual/entity fails to satisfy any of the four PSI tests, they are not conducting a PSB for that year.
There are three consequences of deriving PSI.
1. The PSI earned by the individual/entity will be treated as the personal income of the individual taxpayer
and must be included in their personal income tax return.
2. The PSE (company, trust or partnership) must pay the taxpayer the PSI promptly as salary or wages
(and withhold the appropriate amount of PAYG withholding tax and remit it to the ATO) or remit PAYG
instalments tax on the PSI attributed to them.
3. The individual is limited to claiming only certain deductions.
Specifically, the deductible amounts are:
• costs of gaining work (i.e. advertising)
• costs of insuring against loss of income or income earning capacity
• costs of insuring liability arising from the taxpayer’s acts of omissions in the course of earning income
(e.g. professional indemnity insurance)
• amounts paid to other persons (including associates) who assist in performing the principal’s work
(including superannuation) regardless of whether their contribution is more or less than 20 per cent
of the principal work
• superannuation contributions made on behalf of the taxpayer
• meeting obligations under workers compensation law
• meeting obligations or exercising rights under the GST law.
The taxpayer is specifically denied deductions in respect of:
• rent, mortgage interest, rates or land tax relating to the taxpayer’s residence
• payments to associates (including superannuation) for non-principal work.
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244 Australia Taxation
Where a PSE has been interposed and PSI that is not PSB income is derived, Division 86 applies.
Division 86 treats the income as if it was derived by the individual and reduces the deductions that the
entity is entitled to claim.
It is important to note that the PSI provisions only affect the income tax treatment of PSI. They do not
affect the legal, contractual or workplace arrangements. Furthermore, the individual will not be treated as
an employee.
Finally, regardless of whether a taxpayer is treated as conducting a PSB and therefore excluded from
the PSI rules, the ATO can still use the anti-avoidance provisions contained in Part IVA of ITAA36. The
Commissioner has already indicated that it will apply its anti-avoidance powers to prevent the splitting of
income through the use of companies and trusts.
Calculating how much Personal Services Income to Include in the
Individual’s Assessable Income
The amount of PSI included in assessable income under s. 86-15 may be reduced (not below zero) by
certain deductions to which a PSE is entitled. Figure 4.6 outlines the method statement under s. 86-20(2)
that is used to work out whether and by how much the amount can be reduced.
Calculating personal services income
FIGURE 4.6
Step 1: Determine the amount of any PSI deductions to which the PSE is entitled.
Step 2: Determine the amount of any entity maintenance deductions to which the PSE is entitled.
Step 3: Determine the PSE’s other assessable income, disregarding any PSI.
Step 4: Subtract the other income (Step 3) from entity maintenance deductions (Step 2).
Is the amount calculated in Step 4 greater than zero?
Yes
Step 5: The PSI is reduced by the total amount
of Step 1 + Step 4. Step 6 does not apply.
No
Step 6: The PSI is reduced by the total amount
under Step 1 only, Step 5 does not apply.
Source: CPA Australia 2022.
Consequently, either Step 5 or Step 6 will apply depending on the result in Step 4. After the income
attributable to the individual under s. 86-20 has been calculated, the income for the PSE can be determined.
Example 4.12 illustrates how income that is regarded as PSI is attributed to the individual in relation to
the method statement in s. 86-20(2).
EXAMPLE 4.12
Taxation Implications of Personal Services Income Method Statement
Helen Orange is a computer consultant who provides her consulting services through her private company,
Comsolv Pty Ltd (Comsolv). The company has contracted with Alpha Pty Ltd for Helen to provide
consulting services for software development and network design maintenance.
Assume that the income derived by Comsolv for personal services constitutes PSI and will be attributed
to Helen and included in her assessable income.
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MODULE 4 Taxation of Individuals 245
The income and deductions of Comsolv consist of the following.
$
PSI
Other income
Entity maintenance deductions
Other income deductions
PSI deductions
100 000
2500
4000
500
30 000
Consider the amount of assessable income attributed to Helen and the PSE.
To determine the amount by which the PSI should be reduced, the steps in the s. 86-20(2) method
statement should be followed.
$
Step 1
Step 2
Step 3
Step 4
Step 5
Step 6
Determine any PSI deductions.
Determine any entity maintenance deductions to which PSE is entitled.
Determine any other assessable income.
Entity maintenance deductions are reduced by other income (Step 2 – Step 3).
PSI is reduced by the sum of Step 1 and Step 4 ($30 000 + $1500).
PSI is reduced by the deductions in Step 1 under this step. (Step 6 does not
apply as the amount under Step 4 is greater than zero.)
30 000
4000
2500
1500
31 500
The amount of assessable income attributed to Helen is $100 000 – $31 500 = $68 500. This amount is
included in Helen’s assessable income to be taxed at her marginal income tax rates.
The balance of the other income of the entity, which is now zero, is reduced by the other income
deductions still available.
$0 − 500 = ($500)
The PSE has an overall loss of $500. This loss is retained in the PSE to be offset against any future
income that the entity earns.
Alternatively, if the PSI deduction had been $130 000 rather than $30 000, then Helen’s net PSI loss
would have been $100 000 – ($130 000 + $4000 – $2500) = $31 500 loss. The net loss of Comsolv would
remain at $500.
Division 85 outlines the deductions that an individual can and cannot claim against PSI where they are
not conducting a PSB. With some exceptions, the deductions against PSI are essentially limited to the
deductions that are available to an employee (s. 85-10(1)).
QUESTION 4.3
Jack Kendall is an academic who provides consulting services through his private company JJ Ltd.
The company has contracted with B Ltd for Jack to provide consulting services. The income gained
from JJ, which does not constitute a PSB, will be attributable to Jack and will be included in his
assessable income.
The income and deductions of JJ for the 2021–22 tax year consisted of the following.
$
PSI
Other income
Entity maintenance deductions
Other income deductions
PSI deductions
100 000
4000
3000
500
55 000
Determine the amount attributable to Jack under the PSI regime for the 2021–22 tax year.
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246 Australia Taxation
DIVISION 83A EMPLOYEE SHARE SCHEMES
Employee share schemes (ESSs), also known as employee share purchase plans or employee equity
schemes, give employees shares in the company they work for, or the opportunity to buy shares in the
company. Employees on higher incomes are often eligible to receive shares as a performance bonus, or as
a form of remuneration, instead of receiving a higher salary.
ESSs are a way of attracting, retaining and motivating staff as they align employees’ interests with
shareholders’ interests, achieving greater benefits for the company and a sharing of these benefits with the
employees. Employees can benefit financially if the company performs well.
Many Australian public companies and multi-nationals operating in Australia use ESSs. However, ESSs
are not just for large companies. Private companies, large and small, can also achieve significant benefits.
Division 83A of ITAA97 deals with the taxation treatment of ESSs. It contains rules for the up-front
and deferred taxation of discounts on shares and rights provided under ESSs.
ESSs are either taxed up-front or deferred. The tax treatment depends on the design of the plan.
Up-Front Taxation
A person receiving shares from their employer is taxed on the discount in the year in which they acquired
the interest. Such schemes are known as ‘taxed-up-front schemes’. This means that the discount received
by the employee (being the difference between the market price of the share and the price actually paid
by the employee for the shares) is included in the taxpayer’s assessable income in the year that the shares
were issued and taxed accordingly (s. 83A-25).
This immediate inclusion of the discount in assessable income, as per Subdivision 83A-B, does not
apply if the ESS interest is a beneficial interest in a share that a person acquires by exercising a right if
that person acquired a beneficial interest in the right under an ESS (s. 83A-20(2)).
However, if the taxpayer and the scheme meet certain conditions, then the taxing point is deferred until
a later time. These tax-deferred schemes are known as ‘deferral schemes’.
One of the main benefits accruing to a taxpayer under the up-front taxation option is that, whilst
they must include the amount of the discount in their tax return in the year that the shares are
issued, the assessable amount of the discount is reduced by $1000 (s. 83A-35(1) and (2)). In other
words, the first $1000 of the discount is exempt from income tax if the sum of the taxable income,
reportable fringe benefits, reportable superannuation contributions and net investment loss, does not exceed
$180 000 (s. 83A-35(2)(b)).
For this $1000 discount to apply, certain conditions must be met. These conditions contained in
ss. 83A-35 and 83A-45 are as follows.
• The ESS interests offered under the scheme must relate to ordinary shares only.
• The employee must be employed by the company providing the ESS or by one of its subsidiaries.
• The scheme must be offered to at least 75 per cent of the permanent employees with three or more years
of service and who are Australian residents.
• The shares or rights provided must not be at real risk of forfeiture.
• The shares or rights must be required to be held by the employee for three years or until the employee
ceases employment.
• The employee must not receive more than 10 per cent ownership of the company or control more than
10 per cent of the voting rights in the company as a result of participating in the scheme.
Example 4.13 illustrates the taxation implications of an employee receiving shares under an ESS.
EXAMPLE 4.13
Eligibility for $1000 ESS Exemption
Kerrie Stock is employed by Axiom Software Pty Ltd. She is offered 1000 shares in the company under
an ESS on 16 September 2021. Assume the ESS satisfies all the conditions contained in ss. 83A-35 and
83A-45 so the shares under the ESS are ordinary shares.
The market value of the shares is $4 per share. Kerrie is offered the shares for $2.80 each, being a
discount of $1.20 per share. She pays her employer $2800 to acquire 1000 shares (market value $4000).
Kerrie has effectively received a discount of $1200. Assume that Kerrie’s adjusted taxable income (ATI) is
below $180 000. Consider the taxation consequences of this transaction.
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MODULE 4 Taxation of Individuals 247
Kerrie is eligible for the up-front $1000 exemption. She will include an amount of $200 in her tax return
(being $1200 discount less the $1000 concession). This amount is added to her other taxable income and
taxed at her marginal tax rate.
When the shares are eventually sold by the employee, the capital gain is taxed under the normal CGT
rules. If the shares were held for more than 12 months from the date of acquisition to the date of sale, the
individual will benefit from the general 50 per cent CGT discount. For an ESS interest that is taxed up-front,
the shares are taken to have been acquired for market value on the date of acquisition (s. 83A-30(1)). The
$1000 discount is ignored for CGT purposes.
Example 4.14 illustrates the CGT tax implications of an employee selling shares under an ESS.
EXAMPLE 4.14
CGT Consequences of Sale of ESS Interests
Following on from the previous example, assume that in four years’ time, Kerrie Stock sells the 1000
shares in Axiom Software Pty Ltd for $7000. Consider the CGT consequences of this transaction.
Kerrie has derived a gross capital gain of $3000 ($7000 capital proceeds minus $4000 cost base taken
as the market value on the date of acquisition). As she has held the shares for more than 12 months, she
is entitled to a 50 per cent discount. Hence, her net capital gain is $1500.
Taxation Concessions for Start-up Companies
There is a tax concession in place for employees of eligible small start-up companies when acquiring
shares (or rights) in their employer (or in a holding company of their employer) on or after 1 July 2015.
Where the conditions are satisfied (refer below), then the discount on the shares is not included in the
employee’s assessable income up-front. However, the share, once it is acquired, is then subject to CGT
when it is sold or transferred with a cost base reset at market value.
To access the small start-up concessions, s. 83A-33 outlines that the following conditions must be met.
• The company must not be listed on the stock exchange.
• The company has an aggregated turnover less than $50 million in the previous income year.
• The employing company must be a resident for tax purposes in Australia.
• The company has been incorporated for less than 10 years.
• If it is a share, the discount provided to the employee cannot exceed 15 per cent of market value.
• If it is a right, the amount to be paid to exercise the right must be equal to or greater than the market
value of the underlying share in the company when the ESS interest is acquired.
Where the conditions have been met, employees of ESSs in eligible small start-up companies do not
have to include any discount on acquiring the shares in their tax return. Furthermore, employees can access
the 50 per cent CGT discount even when the underlying shares are held for less than 12 months.
Example 4.15 illustrates the application of the ESS eligibility for an employee who receives shares from
her employer, a small start-up company.
EXAMPLE 4.15
ESS Concessions for Start-ups
Gladiator Computing Pty Ltd (Gladiator Computing) is a small IT company that commenced operations
in Australian on 16 October 2021. On this date, Kylie Kelly, a resident of Australia, who is a senior
programming employee, was offered 2000 shares in the company for $2.00 per share. The market value of
the shares at the time was $2.20. Therefore, Kylie acquired the shares at a discount of $400 (being $4400
market value – $4000 cost).
Consider if Kylie has met the conditions for the ESS tax concession afforded to taxpayers under
Division 83A.
Kylie has acquired the shares at a 9.1 per cent discount to market value (i.e. $0.20 / $2.20), which is
within the 15 per cent discount permitted. As all of the conditions contained in s. 83A-33 for the start-up
concession have been satisfied, Kylie is not required to include the discount amount of $400 in her 2022
income tax return in relation to the acquisition of the shares.
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248 Australia Taxation
It should be noted that s. 115-30 of ITAA97 contains special rules about the time of the CGT asset
acquisition. In particular, Item 9A, s. 115-30 states that where the shares are acquired by exercising an
ESS interest by employees of start-up company, the critical time will be when the acquirer acquired the
ESS interest.
Example 4.16 illustrates the CGT consequences for an employee who receives shares from her employer,
a small start-up company.
EXAMPLE 4.16
CGT Discount for Start-ups
Elizabeth Jones acquires ESS interests that are rights from Totalconcept Pty Ltd (Totalconcept) on 1 July
2018, under the start-up concession. Elizabeth exercises the rights on 1 September 2021 and sells the
resulting shares on 1 January 2022.
Consider the CGT consequences for Elizabeth on the sale of her shares in Totalconcept Pty Ltd on
1 January 2022.
For CGT discount purposes, the acquisition date of the shares is taken to be the acquisition date of the
rights (1 July 2018). Although Elizabeth held the resulting shares for less than 12 months, as she has held
the ESS interests that were the rights to acquire the shares and the resulting shares for a combined period
of more than 12 months, she is eligible to apply the 50 per cent CGT discount as per Item 9A, s.115-30.
Deferred Taxation
Deferred taxation is possible but is not as commonly used as up-front taxation. Deferred taxation would
apply to ESS interests where:
• the ESS interest relates to ordinary shares and is subject to a real risk of forfeiture. This results in a real
risk of forfeited shares. Deferred taxation operates to mitigate this risk
• the relevant ESS interest is acquired under a salary sacrifice arrangement, and the employee must receive
no more than $5000 worth of shares under such arrangements in a tax year (certain other conditions must
also be met)
• the ESS restricts the employee from immediately disposing of a right (s. 83A-105).
The general requirements for deferred taxation are the same as for up-front taxation. However, start-up
companies have particular concessions that apply to them, which will be discussed in the next section.
An interest would be at real risk of forfeiture if a reasonable person would consider that there is a real
risk that the employee would lose the interest, or never receive it, or through the market value of the interest
falling to nil.
When tax on an ESS discount is deferred, it is deferred until the ESS deferred taxing point occurs.
When is the Deferred Taxing Point?
For shares it is the earliest of when (s. 83A-115):
• there is no real risk that the employee will lose the share under the conditions of the scheme, other than
by disposing of it, and there are no restrictions preventing disposal
• the employee ceases the employment in respect of which they acquired the share
• fifteen years have elapsed since the employee acquired the share.
For rights, under s. 83A-120(4):
The first possible taxing point is the earliest time when:
(a) you have not exercised the right; and
(b) there is no real risk that, under the conditions of the employee share scheme, you will forfeit or lose
the ESS interest (other than by disposing of it, exercising the right or letting the right lapse); and
(c) if, at the time you acquired the ESS interest, the scheme genuinely restricted you immediately disposing
of the ESS interest — the scheme no longer so restricts you.
At the deferred taxing point, s. 83A-110 includes an amount in the employee’s assessable income equal
to the current market value of the ESS interest less its cost base.
Example 4.17 illustrates how the risk of forfeiture affects the taxation of ESS interests.
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MODULE 4 Taxation of Individuals 249
EXAMPLE 4.17
Risk of Forfeiture
Suzy Weeks enters into an ESS arrangement with her employer, Capricorn Holdings Pty Ltd (Capricorn
Holdings). She will receive 1000 shares in Capricorn Holdings in three years if she is still employed by
Capricorn Holdings at that time.
Furthermore, Capricorn Holdings will grant her shares if she ceases employment for an unexpected
reason before three years, such as sickness or invalidity under a ‘good leaver clause’. Consider how the
risk of forfeiture effects the taxation of Suzy’s ESS interests.
In this situation, there is a real risk of forfeiture as Suzy’s shares are at risk and she will defer tax for
three years. However, if employees at Capricorn Holdings routinely received their shares, regardless of
their reason for leaving, the ATO may consider that the scheme has contrived a real risk and is not eligible
for deferral of tax.
The 30-Day Rule
If the ESS interests are disposed of within 30 days after the day that would be the ESS deferred taxing
point, the ESS deferred taxing point is instead the date of disposal. This is the 30-day rule (ss. 83A-115(3)
and 83A-120(3)).
Employer Reporting Obligations
Employers are required to provide an employee share statement (similar to a PAYG summary) to any
employees who are provided with an interest in an ESS at a discount and who had a taxing point during
the income year. An annual ESS annual report must also be provided to the ATO to facilitate data-matching
with employees’ tax returns.
Figure 4.7 provides a high-level summary of the operation of the ESS rules contained in Division 83A.
CAPITAL GAINS TAX RELIEF FOR INDIVIDUALS
Capital Gains Tax Main Residence Exemption
CGT was explored in detail in module 3.
In this section we will examine the main elements of CGT that impact individual taxation, starting with
the main residence exemption. There is no capital gain or capital loss made from a CGT event that relates
to a dwelling that is the taxpayer’s main residence.
The sections ‘Main residence exemption’ and ‘Amount of main residence exemption available’ in
module 3 looked at how the main residence exemption operates for resident individuals in more detail,
particularly in relation to the rules about when the main residence exemption will not apply.
Does the Main Residence Exemption Apply in the Sharing Economy?
Basically, the main residence exemption does not apply where:
• the residence was only a main residence for part of the ownership period, or
• the residence was used for the purpose of producing assessable income.
It is necessary to consider how a main residence is treated for CGT where it is used in the sharing
economy, such as when it is rented out as a whole house, or a room in a house on websites such as Airbnb.
The current view is that when a main residence is used in such a manner, it is likely that part of the
CGT exemption will be lost. If the main residence is used for the purpose of producing assessable income
during the ownership period, the taxpayer will lose a proportion of the exemption based on the proportion
of the property made available for rent and the length of time it was rented.
However, the full CGT main residence exemption may still be available if the taxpayer moves out of the
main residence to live in another home for a period of time.
If the property is used for income-producing purposes in this period of absence, the maximum period
the dwelling can be treated as the taxpayer’s main residence is six years (under the absence from main
residence rules in s. 118-145). If they are simply leaving their property to stay with friends or family
while renting out their house via Airbnb, or a room in that house, then the property is still considered their
main residence.
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250 Australia Taxation
FIGURE 4.7
Operation of the employee share scheme rules
Employee receives
shares or options
under employee
share scheme
Concessionally
taxed schemes
All others
Further conditions:
1. No risk of forfeiture
2. Restriction on disposal
(minimum of 3 years or
at time of ceasing
employement if sooner)
3. Non-discriminatory access
to shares (or rights) and
the provision of finance
Employee is taxed on
discount when shares
or rights are acquired
Schemes eligible for
a tax exemption
Conditions:
1. Employee share scheme
2. Employee of the group
3. Ordinary shares
4. At least 75% of employees can
participate in the scheme
5. Does not result in employee
owning more than 10% of shares
6. Does not result in employee
owning more than 10% of
voting rights
Schemes eligible for
a tax deferral
Further condition:
Genuine risk of forfeiture
Acquisition taxing point
Employee is taxed on discount
when shares or rights are
acquired, less a tax exemption
for the first $1000 of discount
$1000 tax exemption only
applies if income is less than
$180 000
Later taxing point
Any subsequent capital
gains/losses are covered
by CGT (access to CGT
discount)
Any subsequent capital
gains/losses are covered by
CGT (access to CGT discount)
At cessation time
discount and captial
gains are taxed as
income (no CGT
discount)
Cessation time:
Earliest of (shares and rights):
• 15 years
• Ceasing employment
• Employee can pass legal
title or could, but for a
waiting period (extra point
for rights)
• Rights can be exercised
Source: Based on The Treasury 2009, Reform of the Taxation of Employee Share Schemes, Consultation Paper, Australian
Government, Canberra, p. 49.
Capital Gains Tax and Marriage Breakdown
Marriage Breakdown and Same Asset Rollover
A CGT same asset rollover event under Subdivision 126-A will occur when CGT assets are transferred to
a spouse or former spouse as a result of a binding legal agreement following a marriage or relationship
breakdown.
Marriage Breakdown and the Main Residence Exemption Rule
Where a post-CGT acquired ownership interest in a dwelling is transferred to a former spouse as a result of
a CGT marriage breakdown rollover under Subdivision 126-A, the CGT main residence exemption rules
are applied.
They will consider the way both the transferor and transferee spouses used the dwelling during their
combined period of ownership when determining the transferee spouse’s eligibility for the main residence
exemption on a future disposal of the property (s. 126-5).
Example 4.18 illustrates how the CGT main residence exemption is modified in the case of a marriage
breakdown, whereas example 4.19 illustrates how the CGT rollover provisions apply where assets are
transferred from one spouse to another in a marriage breakdown.
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MODULE 4 Taxation of Individuals 251
EXAMPLE 4.18
Same Asset Rollover and Relationship Breakdown
Reece Roberts (the transferor spouse) was the sole owner of a dwelling that he used as rental property
for two years, then he used it as a main residence for a period of four years.
After living in the house for four years, he transferred it to his former spouse, Eliza Roberts (the transferee
spouse), because of a marriage breakdown that satisfied the rollover conditions of Subdivision 126-A. Eliza
used the dwelling only as a rental property for a further six years before selling it. She never lived in the
house. Consider how the main residence exemption would be modified in this situation.
Eliza will only be eligible for a 33.33 per cent main residence exemption as the dwelling was only used
as a main residence for four years of the 12-year collective period that Reece and Eliza collectively owned
the dwelling.
EXAMPLE 4.19
Crystallising Gain/Loss on Transfer
Lucy Lane’s ex-husband Chris Lane owns land (purchased in 1997) with a cost base of $75 000. As a
result of a court order under the Family Law Act 1975 (Cwlth), Chris is required to transfer the land to
Lucy. Consider how the CGT rollover provisions apply in this situation.
Rollover relief automatically applies to ensure that Chris does not crystallise a capital gain or loss on
the transfer. Lucy’s cost base in the land is $75 000 (the same as Chris’ cost base).
Individuals, Capital Gains Tax and the Small Business Concessions
There are four small business concessions available to SBEs, which include small business owners and
sole traders (individuals) who met the requirements of a CGT SBE. These concessions are summarised in
table 4.6 and discussed in detail in section ‘Refresher on capital gains tax concessions for small business
entities’ in module 5.
TABLE 4.6
Capital gains tax small business concessions
Rule
Description
15-year exemption
If the business has continuously owned an active asset for at least 15 years and
the taxpayer is aged 55 or over, and is retiring or permanently incapacitated,
then there will not be an assessable capital gain upon sale of the asset.
50% active asset reduction
Reduction of the capital gain on an active asset by 50%. This is in addition to
the 50% CGT discount if applicable.
Retirement exemption
Capital gains from the sale of active assets are exempt up to a lifetime limit of
$500 000. If the taxpayer is under 55, the exempt amount must be paid into a
complying superannuation fund or a retirement savings account.
Rollover exemption
Upon sale of an active asset, all or part of the capital gain can be subject to a
rollover where the taxpayer makes an election to do so. However, if such an
election is made then, by the end of two years after the CGT event, the amount
subject to the rollover must have been used for the acquisition of a replacement
active asset, and/or for incurring expenditure on making capital improvements to
an existing active asset. If this is not the case, the rollover will be reversed and
the taxpayer will be subject to a CGT liability.
Source: CPA Australia 2022.
These concessions are important to consider when an individual is carrying on a small business and
makes a capital gain in relation to an active asset.
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252 Australia Taxation
QUESTION 4.4
Suzi Wong operated a restaurant for nine years as a sole trader. On 2 May 2022, she sold the
business for $500 000 and made a capital gain of $100 000. Suzi has a current year capital loss
of $10 000 from sale of shares and prior year capital losses totalling $20 000.
Assuming that Suzi satisfies all the basic conditions of Subdivision 152-A and chooses to use any
small business concessions available to her, determine the net capital gain to be included in Suzi’s
assessable income for the 2021–22 tax year using the CGT discount method.
TAXING SUPERANNUATION FOR INDIVIDUALS
Superannuation contributions can be paid either by employers on behalf of employees, or directly by the
employee or self-employed person into their superannuation account.
Employer Contributions
Since 1 July 1992, in Australia, every employer (regardless of their taxation status) has been required to
make employer-sponsored superannuation contributions on behalf of its employees. This is referred to as
the ‘superannuation guarantee scheme’.
For 2021–22, the rate is 10 per cent of the employee’s wage or salary (ordinary times earnings) and this
rate will continue to progressively increase to 12 per cent by 1 July 2025.
Under the superannuation guarantee scheme, an employer is required to make superannuation contributions on behalf of their employees on the employee’s earnings base (referred to as ‘ordinary times
earnings’, or OTE). Ordinary time earnings are defined as what the employee earns for ordinary hours of
work, including over-award payments, commissions, allowances, bonuses and paid leave.
Concessional Contributions
Concessional contributions are also known as pre-tax contributions. These contributions are generally
taxed in the superannuation fund at 15 per cent. Concessional superannuation contributions include:
• employer contributions, including the compulsory superannuation guarantee contributions, plus any
additional voluntary contributions made by the employer
• voluntary pre-tax superannuation contributions made under an effective salary sacrifice arrangement
• personal superannuation contributions made by employees, that are claimed as a tax deduction in the
employee’s income tax return. To claim the deduction, the person must be under the age of 65 (regardless
of their work situation) and give notice in the approved form to the superannuation fund stating their
intention to claim the superannuation contribution as a tax deduction (and received acknowledgment of
this notice from the superannuation fund). In Khanna v FCT [2022] AATA 33 a taxpayer was not able
to claim a tax deduction for personal superannuation contributions of $9600 for 2018–19 because he
did not submit his notice of intent to claim form on or before 3 July 2019 as required by s. 290-170(1)
of ITAA97.
Tax-deductible contributions are also available to the self-employed and non-employed, and this has
now been extended to all employees who wish to make a direct contribution up to the contributions cap
and receive a tax deduction. Table 4.7 outlines the concessional contributions caps and the treatment of
any excess contributions.
TABLE 4.7
Concessional contributions caps
Income year
Concessional contribution
cap threshold
2021–2022
$27 500 regardless of age
Treatment of excess
Included as taxable income, taxed at marginal tax rate
(less 15% tax already paid in the fund) plus an excess
concessional contributions charge.
Source: Based on ATO 2021a, ‘Contribution caps’, accessed January 2022, www.ato.gov.au/Super/Self-managed-superfunds/Contributions-and-rollovers/Contribution-caps/#Concessional_contributions.
The maximum amount of concessional contributions that are able to be made into an employee’s
superannuation fund in any one given income year is limited to the ‘concessional contributions cap’.
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MODULE 4 Taxation of Individuals 253
It is important to note that the concessional contribution caps outlined in table 4.7 apply to both
employer-sponsored contributions plus pre-tax employee superannuation contributions. In other words,
in determining concessional contributions per annum, both the employer and the pre-tax employee
superannuation contributions must be considered.
If a person has more than one superannuation fund, all concessional contributions made to all
superannuation funds in the particular financial year are added together and counted towards the cap.
Unused Concessional Cap Carry Forward
From 1 July 2018, a person can carry forward any unused amount of their concessional cap to be used
to add concessional superannuation contributions above the cap in subsequent years, on a rolling basis
for a period of up to five years. Amounts carried forward that have not been used after five years will
expire. The first year in which a person is entitled to use carry forward unused amounts is the 2019–20
income year.
However, an individual will only be able to carry forward unused concessional contributions if their
total superannuation balance at the end of 30 June of the previous financial year is less than $500 000.
Example 4.20 illustrates how the unused concessional cap is able to be carried forward.
EXAMPLE 4.20
Carry-Forward Concessional Contributions
During 2019–20 to 2022–23, Sam Smith has minimal superannuation contributions, primarily because he
was working part-time at a local coffee shop while completing his university studies. His superannuation
balance is continuing to grow with earnings and a small amount of superannuation contributions but, in
2021–22, his account balance reduced due to negative returns in that year. Sam has unused cap amounts
for each of the 2019–20 to 2022–23 financial years as follows.
Carry-forward concessional
contribution
General contributions cap
Total unused available cap accrued
Maximum cap available
Superannuation balance 30 June
prior year
Concessional contributions
Unused concessional cap amount accrued
in the relevant financial year
2019–20
($)
2020–21
($)
2021–22
($)
2022–23
($)
25 000
0
25 000
25 000
22 000
47 000
27 500
44 000
27 500
27 500
71 500
27 500
480 000
3000
490 000
3000
505 000
nil
490 000
nil
22 000
22 000
27 500
27 500
Consider which years Sam would be entitled to use the unused concessional cap amounts.
The first year in which a person is entitled to use carry forward unused amounts is the 2019–20 income
year. As such, Sam would be entitled to use the unused concessional cap amounts in 2020–21 and
2022–23, as his total superannuation balance at the end of 30 June in the year immediately preceding
was less than $500 000.
Sam would not be able to use his unused concessional cap contributions in 2021–22, as his total
superannuation balance at the end of 30 June of the previous year (2020–21) was $505 000.
Assume that, in 2022–23, Sam returns to work. For that year he has a maximum concessional cap
amount available of $71 500 ($27 500 + $ 44 000) for 2021–22 and is eligible to contribute this amount as
this total superannuation balance at the end of 30 June 2022 was now less than $500 000 (i.e. $490 000).
Source: Based on ATO 2021b, ‘Excess concessional contribution charge’, accessed January 2022, www.ato.gov.au/rates/
key-superannuation-rates-and-thresholds/?page=3.
Excess Concessional Contributions
If a taxpayer’s concessional superannuation contributions into their superannuation fund exceed the
concessional contributions cap for the relevant income year, the excess amount is included in the taxpayer’s
assessable income and taxed at their marginal tax rate.
However, in recognition that the contribution has already been taxed in the taxpayer’s superannuation
fund at 15 per cent, the ATO applies a non-refundable tax offset equivalent to 15 per cent of the excess
contribution.
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254 Australia Taxation
QUESTION 4.5
Darren Taylor, aged 39, is an Australian resident for tax purposes. Darren is employed as the CEO
for a firm of management consultants, called Business Time Pty Ltd (Business Time). Darren is on
a gross salary of $200 000.
During the 2022 income year, Business Time contributed $20 000 into Darren’s complying
superannuation fund (being the compulsory 10 per cent of Darren’s gross $200 000 salary). Darren
also made salary-sacrificed superannuation contributions totalling $10 000.
What are the tax consequences of these contributions made into Darren’s superannuation fund?
Low-Income Superannuation Tax Offset
From 1 July 2017, the government introduced the low-income superannuation tax offset (LISTO) to assist
low income earners to save for their retirement.
If a taxpayer has an ATI of up to $37 000 a year and at least 10 per cent or more of their total yearly
income is attributable to employment activities or the carrying on of a business, or both, they may be
eligible to receive a LISTO payment. This is usually paid directly into the taxpayer’s super fund. LISTO is
15 per cent of the concessional (before tax) super contributions made by the employee or their employer
into the employee’s superannuation fund. The maximum payment able to be received by a taxpayer in any
one financial year is $500, and the minimum is $10.
Division 293 Tax
On 1 July 2012, Division 293 was introduced into ITAA97. From 1 July 2012, high income earners
with an ATI greater than $250 000 are subject to an additional tax of 15 per cent on their concessional
superannuation contributions (including their employer’s superannuation guarantee contributions). This
effectively takes their tax payable in respect of their concessional superannuation contributions to
30 per cent.
Division 293 tax is payable on the excess over the threshold, or on superannuation contributions,
whichever is less. The rate of Division 293 tax is 15 per cent. The ATO sends the taxpayer an assessment
notice showing the additional Division 293 tax owing, equivalent to 15 per cent on the concessional
contributions made into the superannuation fund during the relevant income year.
Non-Concessional Contributions
Non-concessional contributions are those contributions made by the taxpayer into their superannuation
fund that generally come from a taxed source. In other words, they usually represent after-tax voluntary
superannuation contributions that have already been taxed at some point in time. These contributions used
to be referred to as ‘undeducted contributions’.
Non-concessional contributions also include any excess concessional contributions in excess of the
concessional cap threshold referred to in table 4.8 as well as transfers from foreign superannuation funds.
TABLE 4.8
Non-concessional contributions cap
Financial year
1 July 2021
Non-concessional cap
Tax on amounts over cap
$110 000
47%
Source: Based on ATO 2021a, ‘Contribution caps’, accessed January 2021, www.ato.gov.au/Super/Self-managed-superfunds/Contributions-and-rollovers/Contribution-caps/#Nonconcessionalcontributions.
A taxpayer is not able to claim a tax deduction for these contributions (ITAA97, ss. 290-155, 290-160
and 290-165). Furthermore, these contributions are generally not taxed in the superannuation fund.
The maximum amount of non-concessional contributions that are able to be made into an employee’s
superannuation fund in any one given income year is limited to the non-concessional contributions cap. In
the 2021–22 year, the non-concessional cap is four times the concessional cap of $27 500 (i.e. $110 000)
(see table 4.8).
Concessional contributions in excess of the concessional contributions cap for the year are also included
in non-concessional contributions. Note that both the excess concessional contributions charge (discussed
earlier) and the excess non-concessional contributions tax are not tax deductible.
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MODULE 4 Taxation of Individuals 255
For those members under age 67 with a total accumulated superannuation balance of $1.7 million or
more, the cap is reduced to nil for 2021–22.
Bring-Forward Arrangement
Individuals under age 65 at any time during the tax year may be able to make non-concessional
contributions.
The bring-forward rule allows eligible super fund members under the age of 67 years with a superannuation balance of less than $1.48 million to make up to $330 000 of non-concessional (after-tax) contributions
above the non-concessional contributions cap over three years. The current non-concessional contributions
cap is $110 000 per year.
From 1 July 2017, the bring-forward amount and period is dependent on the total superannuation balance
as at the 30 June of the prior financial year. This option is not available for those members with a total
accumulated superannuation balance of equal to or over $1.7 million (see table 4.9).
TABLE 4.9
Contribution and bring forward available to members under 67 years of age
Total superannuation balance
Contribution and bring forward available
Less than $1.48 million
Access to $330,000 cap (over three years)
Greater than or equal to $1.48 million and less than
$1.59 million
Access to $220,000 cap (over two years)
Greater than or equal to $1.59 million and less than
$1.7 million
Access to $110,000 cap (no bring-forward period,
general non-concessional contributions cap applies)
Greater than or equal to $1.7 million
Nil
Source: ATO 2021a, ‘Contribution caps’ accessed January 2022, www.ato.gov.au/Super/Self-managed-super-funds/Contributionsand-rollovers/Contribution-caps/#Nonconcessionalcontributions.
Capital Gains Tax Cap Amount
The non-concessional CGT cap allows individuals to make non-concessional superannuation contributions, up to the lifetime CGT cap amount. The CGT cap amount applies to capital gains subject to the
CGT small business concessions, where the retirement exemption or 15-year exemption applies, and the
gain is contributed to superannuation.
The CGT cap applies to all excluded CGT contributions, and is a lifetime cap. For 2021–22 income
year, the CGT cap is $1.615 million (2020–21: $1.565 million). The CGT cap amount is indexed in line
with average weekly ordinary time earnings (AWOTE), in increments of $5000 (rounded down).
Superannuation Benefits
From 1 July 2007, the taxation consequences of payment of superannuation benefits are covered under
Divisions 301 and 307 of ITAA97.
Superannuation benefits can be paid in a retirement income stream (s. 307-70) or as a lump sum
(s. 307-65). Most retirement benefits are now paid as retirement income streams, also known as ‘accountbased pensions’, which have no set time limit and are paid on a regular basis to the retiree, or annuities,
which generally have a fixed time period.
The tax treatment of superannuation member benefits paid from a complying superannuation fund
depends on:
• the age of the recipient
• whether the benefit is a superannuation lump sum or income stream
• whether the taxable component contains a taxed element or an untaxed element.
Furthermore, the amount of tax payable on the superannuation payment depends on whether the recipient
has reached their preservation age on the last day of the income year in which the payment is received.
For all individuals’ superannuation benefits accessed on or after the age of 60, benefits paid from a taxed
superannuation fund (which nearly all superannuation funds are) are received tax free.
Components of a Superannuation Benefit
There are two possible components of a superannuation benefit (s. 307-120):
1. the tax-free component
2. the taxable component.
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256 Australia Taxation
Tax-Free Component
The tax-free component is made up of the contributions segment and the ‘crystallised segment’.
The contributions segment generally includes the non-concessional contributions made after 30 June
2007 made by the member for which they have not claimed a tax deduction.
The crystallised segment is comprised of the pre-July 2007 contributions as (s. 307-225(2)):
• concessional component
• the post-June 1994 invalidity component
• undeducted contributions
• CGT exempt component
• pre-July 1983 component.
Taxable Component
The taxable component of a benefit is made up of employer contributions (e.g. SG contributions), salary
sacrificed contributions and personal contributions where a tax deduction was claimed. It will typically
also include the earnings that the fund has made by investing the superannuation balance.
Benefits Paid to Persons Aged below the Preservation Age
In very limited and specific circumstances, benefits can be paid out to people aged under their preservation
age. The preservation age is shown in table 4.2.
This usually occurs in exceptional circumstances such as permanent incapacity, terminal illness or severe
financial hardship. Even if the payment is made, the taxpayer must include this amount in their assessable
income, which is then taxed at 20 per cent (plus Medicare levy) or at the taxpayer’s marginal tax rate,
whichever percentage is lower.
Example 4.21 illustrates the tax implications to a taxpayer who withdraws part of their superannuation
balance prior to attaining their preservation age.
EXAMPLE 4.21
Withdrawing Superannuation Prior to Preservation Age
Charlotte Boyd is 52 years old and applies to withdraw some superannuation on compassionate grounds.
She was born in October 1969, hence, her preservation age is 60 (see table 4.2). In other words, she has
not yet reached her preservation age.
Charlotte receives a lump sum payment from her superannuation fund of $50 000. Her superannuation
fund advises her that this amount consists of $10 000 tax-free and a $40 000 taxable component, which
has been taxed in her superannuation fund. Consider how the $50 000 received by Charlotte is taxed.
No tax is payable in respect of the $10 000 tax-free component. The balance of $40 000 must be
included in Charlotte’s assessable income (as per the proportioning rule in s. 307-125) and is taxed at
a maximum tax rate of 20 per cent plus 2 per cent Medicare levy.
Tax Status of Lump Sum Benefits for those Aged between Preservation Age and 59
Individuals can access their superannuation when they reach preservation age and retire, or if they
commence a transition to retirement income stream.
For those who have reached preservation age but are under the age 60, no tax is payable on the tax-free
component of the lump sum payment.
There is also no tax on the taxable component of lump sums received below the low rate cap of $225 000
for the 2021–22 income year.
The $225 000 low rate cap is a lifetime cap. Amounts withdrawn from the superannuation fund above
the low rate cap are taxed at 15 per cent plus Medicare levy, or the taxpayer’s marginal tax rate, whichever
is lower.
Example 4.22 illustrates the tax implications for a taxpayer who makes a lump sum withdrawal of part
of their superannuation balance after attaining their preservation age, but prior to age 60.
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MODULE 4 Taxation of Individuals 257
EXAMPLE 4.22
Withdrawing Superannuation — Reached Preservation Age but Prior to
the Age of 60
Tim Robertson is 58 years old and is retired. He has reached his preservation age but has not yet reached
the age of 60. He receives his first lump sum superannuation payment of $300 000 on 16 September
2021. His superannuation fund advises him that the $300 000 consists of $50 000 tax-free and a $250 000
taxable component, which has been taxed in his superannuation fund. Assume that Tim has no other
income for the 2021–22 income year. Consider how the $300 000 received by Tim is taxed.
No tax is payable in respect of the $50 000 tax-free component. The $250 000 must be included in Tim’s
assessable income. It is taxed accordingly as:
• the first $225 000 (up to the low rate cap) is taxed at 0 per cent, and
• the remaining $25 000 is taxed at Tim’s marginal tax rate or 15 per cent, plus 2 per cent Medicare levy,
whichever, is the lower.
QUESTION 4.6
Lauren Long is 57 years old and is retired. She has reached her preservation age but has not yet
reached the age of 60.
Lauren receives a lump sum superannuation payment of $270 000 on 9 March 2022. Her superannuation fund advises her that this consists of $20 000 tax-free and a $250 000 taxable component,
which has been taxed in her superannuation fund.
What are the tax consequences of the above amounts received by Lauren?
Benefits Paid Through a Transition to Retirement Income Stream
The taxation treatment where a person receives an income stream (referred to as a ‘transition to retirement
income stream’) is different to the taxation implications of a lump sum payment.
A transition to retirement income stream allows an individual to access some of their retirement benefits
while still working, thereby combining some employment income with some retirement income stream
benefit. This may allow the individual to reduce work and still maintain their living standards, or salary
sacrifice income into their superannuation account at a higher rate.
A transition to retirement stream can only be commenced if the individual has reached their
preservation age.
An individual cannot withdraw more than 10 per cent of the balance of their account each financial year
and lump sum withdrawals are prohibited. The taxation status for the receipt of benefits is the same as for
other income streams, dependent on the age of access.
The taxation treatment of a transition to retirement income stream is as follows.
• The tax-free component of the income stream benefits is not taxed.
• Income sourced from the taxable component is taxed at the marginal tax rates. However, the taxpayer is
able to receive a tax offset equivalent to 10 per cent of the untaxed element and 15 per cent of the taxed
element portion of the payment (subject to a maximum tax offset of $10 000 on the untaxed element).
Example 4.23 illustrates the tax implications to a taxpayer who makes a withdrawal of part of their
superannuation balance in the form of an income stream after attaining their preservation age, but prior to
age 60.
EXAMPLE 4.23
Withdrawing Superannuation Prior to Preservation Age (Income Stream)
Michelle Myers is 57 years old. She has reached her preservation age but has not yet reached the age of 60.
Michelle has begun a transition to retirement income stream. In addition to her income from employment
($60 000 a year), Michelle receives a transition to retirement income stream from her superannuation as
an annual payment.
On 15 June 2022, Michelle receives $30 000 from her superannuation fund and is advised that this
consists entirely of a taxable component, which has been taxed in her superannuation fund. The fund
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258 Australia Taxation
also advises Michelle that she is able to claim a 15 per cent tax offset. Consider how the $30 000 received
by Michelle is taxed.
Michelle must include the entire $30 000 as assessable income in her tax return and is taxed at her
marginal tax rate. However, she would be entitled to a tax offset of 15 per cent of the $30 000 taxable
component (i.e. Michelle’s tax liability would be reduced by an amount of $4500).
Tax Status of Benefits for those Aged 60 and Over
As stated previously, benefits paid from a taxed fund are tax-free to those aged at least 60. This constitutes
NANE income. Example 4.24 illustrates the tax implications for a taxpayer who makes a withdrawal of
part of their superannuation balance after attaining the age of 60.
EXAMPLE 4.24
Withdrawing Superannuation After 60
Colleen Donohoe is 64 years old and retired. She receives a lump sum of $280 000 from her superannuation
fund on 19 February 2022.
Colleen’s superannuation fund advises her that this amount consists of a $40 000 tax-free component
and a $240 000 taxable component, which has been taxed in her superannuation fund.
Consider how the $280 000 received by Colleen is taxed.
As Colleen is over the age of 60, no tax is payable in respect of the $40 000 tax-free component.
Furthermore, no tax is payable on the $240 000 taxable component.
If the superannuation fund made a payment to Colleen that came from an untaxed source (as distinct
from a taxed source), then tax is payable by Colleen at her marginal tax rate or 15 per cent, whichever is
lower (the untaxed part of the lump sum is less than the untaxed plan cap for 2021–22 of $1.615 million).
4.4 CALCULATING ALLOWABLE DEDUCTIONS
The various allowable deductions that are specifically discussed in this module are outlined in figure 4.8.
FIGURE 4.8
Allowable deductions
Allowable deductions
Employee
versus
contractor
Employmentrelated
expenditure
Negative
gearing
Integration test
Entertainment
Control test
Occupational
clothing
Other factors
Car expenses
ATO decision tool
Self-education
Income
protection/
replacement
Tax-deductible
superannuation
contributions
Source: CPA Australia 2022.
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MODULE 4 Taxation of Individuals 259
The first section of this module examined a number of categories of an individual’s assessable income.
The next step in determining an individual taxpayer’s taxable income is to consider the deductions that
may be available.
The principles of general and specific deductions and substantiation have already been discussed in
module 2. Consequently, there will be references to module 2 throughout sections of this module.
EMPLOYEE VERSUS CONTRACTOR TEST FOR DEDUCTIONS
The section ‘Income tax deductions’ in module 2 examines the general deduction provisions under the
first limb of s. 8-1 of ITAA97. As most individuals are employees, and are not carrying on a business,
satisfying the first positive limb of s. 8-1 is the main test for deductions.
Under the first positive limb of s. 8-1, the expenditure must be incurred in gaining or producing the
taxpayer’s assessable income. The loss or outgoing must also not be of a capital, private or domestic
nature.
Firstly, if the individual is deemed to be an employee (not a contractor), then only the first limb of s. 8-1
can apply.
This is different to a contractor carrying on a business, who can also use the second positive limb of
s. 8-1 to claim a deduction. The second limb is the ability to deduct any:
loss or outgoing to the extent ... [that] it is necessarily incurred in carrying on of a business for the purpose
of gaining or producing the taxpayer’s assessable income.
Therefore, it is necessary to establish whether the individual is an employee or a contractor.
Whether a person is an employee of another is a question of fact to be determined by examining the
terms and circumstances of the contract between the parties. Defining the contractual relationship is often a
process of examining a number of factors and evaluating those factors within the context of the relationship
between the parties. No one indicator of itself is determinative of that relationship. The totality of the
relationship between the parties must be considered.
Furthermore, just because a person holds an Australian Business Number (ABN) and supplies an invoice
or a tax invoice to the payer for payment, does not mean that they are automatically an independent
contractor.
The Commissioner has released Taxation Ruling TR2005/16 dealing with the issue of employees and
independent contractors. According to paragraph 17 of TR2005/16:
The relationship between an employer and employee is a contractual one. It is often referred to as a ‘contract
of service’. Such a relationship is typically contrasted with the principal/independent contractor relationship
that is referred to as a ‘contract for services’. An independent contractor typically contracts to achieve a
result whereas an employee contracts to provide their labour (typically to enable the employer to achieve
a result).
There are often many relevant facts and circumstances, some pointing to a contract of service, others
pointing to a contract for services.
Over the years, the courts have come up with criteria to assist in the determination as to whether a person
is considered an employee or independent contractor. These criteria are summarised in paragraphs 25 to 52
of TR2005/16. However, the two main tests for determining whether an employer-employee relationship
exists (as distinct from a contractor) are the integration test and the control test. These two tests are briefly
summarised next.
The Integration Test
An employer–employee relationship generally exists where an individual is part and parcel of the
principal’s business organisation, or an individual’s activities are restricted to providing service to one
principal, or if the benefits arising from the work flow to the principal.
The integration test refers to whether the worker operates on their own account or in the business of
the payer. In other words, how integral is the worker to the employer’s business?
The Control Test
The control test is a classic test for determining the nature of the relationship between a person who engages
another to perform work and the person so engaged is the degree of control which the former can exercise
over the latter. This is referred to as the ‘master/servant’ relationship. This test looks at the extent to which
one person is subject to the control and direction of the person for whom the contract is being performed.
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260 Australia Taxation
A common law employee is told not only what work is to be done, but how and where it is to be done.
The more control exercised, the more likely the relationship is to be one of employer/employee.
Other Factors
While the control test is generally a key factor, it is necessary to examine the totality of the relationship
between the parties. In the High Court decision in Stevens v Brodribb Sawmilling Co. Pty Ltd (1986)
HCA1, Justice Mason said:
The existence of control, while significant, is not the sole criterion by which to gauge whether a relationship
is one of employment. The approach of this Court has been to regard it merely as one of a number of indicia
which must be considered in the determination of that question … Other relevant matters include, but are
not limited to, the mode of remuneration, the provision and maintenance of equipment, the obligation to
work, the hours of work and provision for holidays, the deduction of income tax and the delegation of work
by the putative employee (© High Court of Australia. Stevens v Brodribb Sawmilling Company Pty Ltd
(1986) HCA1; (1986)160 CLR16 (13 February 1986)).
The following persons have been found by the courts to be employees rather than independent
contractors:
• workmen, and a supervisor, paid by the proprietor of a painting and decorating business (Glambed
89 ATC 4259)
• lecturers in the Weight Watchers organisation who were under contractual obligations as to the manner
in which the lectures were to be conducted and the information that was to be imparted (Narich
84 ATC 4035)
• interviewers engaged by a survey research company and given very detailed instructions on how to
proceed (Roy Morgan Research Centre 97 ATC 5070)
• delivery drivers who used motorcycles to deliver food and drinks as part of work in the gig economy
(Franco v Deliveroo Australia Pty Ltd 2001 73 AILR 103-313 and Klooger v Foodora Australia (2018)
FWC 6836).
On the other hand, the following have been held by the courts to be independent contractors, rather than
employees:
• clothing industry outworkers, who used their own sewing machines at home to sew pre-cut garments
from given materials in accordance with a sample (Filsel v Top Notch Fashion 94 ATC 4656)
• consultants who sold a company’s cosmetic products at private houses (Mary Kay Cosmetics
82 ATC 4444)
• booksellers engaged under a contract to sell books (World Book (Australia) Pty Ltd 92 ATC 4327)
• ride-sourcing services (e.g. Uber) drivers in the gig economy (Kaseris v Rasier Pacific (2017) FWC
6610 and Suliman Pacific Pty Ltd (2019) FWC 4807).
ATO Employee/Contractor Decision Tool
The ATO has published an employee/contractor decision tool, which individuals can use to establish if
they are an employee or a contractor for the purposes of taxation and superannuation.
Go to the calculator at the following link and use it to establish if you are an employee or
contractor: www.ato.gov.au/Calculators-and-tools/Host/?anchor=ECDTSGET&anchor=ECDTSGET
/questions/ECDT#ECDTSGET/questions/ECDT. Then think of the circumstances of close family and
friends, and test their status.
EXAMPLE 4.25
Employee or Independent Contractor?
Jane Funs retired early from her occupation as a senior manager of a marketing firm and wants to do
something challenging in her later years. Given that she loved cooking, she decided to start a catering
business providing services to the public. Initially, she planned to operate by herself and work directly with
the public, obtaining work through advertising and word of mouth.
However, a local caterer made an offer to Jane whereby they would offer her work when the caterer
would not otherwise have sufficient staff to accept the job, subject to the following conditions.
• If work is offered by the caterer, Jane must accept it. (However, Jane has insisted that she be given at
least one week’s notice and can refuse if the notice is any shorter.)
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MODULE 4 Taxation of Individuals 261
• While performing the work, Jane must wear the caterer’s uniform.
• The menu and the timing of delivery of the courses are determined by the customer. It is Jane’s
responsibility to ensure that timing of the courses can be achieved and if they cannot she must advise
the client. Additionally, she is responsible for the purchase of all ingredients and the preparation of
the food.
• There will be a member of the caterer’s staff supervising all functions to ensure they run smoothly. Jane
will be advised of potential changes needed on the night — for example, if some of the guests are
late — but they cannot interfere with Jane in the preparation of the food.
Jane expects that if she accepts the caterer’s offer, she will continue to offer her services to the public
and each will represent approximately 50 per cent of her catering income.
If Jane accepts the offer, which will commence in the 2021–22 tax year, will she be treated as an
employee or independent contractor for tax purposes?
The control test and integration test can be considered. Pursuant to the decision in Stevens v Bradribb
Sawmilling (1986), the courts will examine the totality of the relationship. Control is only one of many
criteria that needs to be considered. It will be a balancing of the factors and those that have the greater
weight will be conclusive. However, the court decision also established that it is the right to control rather
than the actual exercise of control that is critical.
A consideration of the terms of the contract between the parties is also critical, that is, whether terms
are express or implied considering the circumstances surrounding the making of the contract. As there is
little evidence of the details of an actual contract, it can be assumed that the terms are implied where the
caterer has made an offer of work to Jane subject to certain conditions.
An examination of TR 2005/16 and the key indicators that apply to Jane’s case can be considered and
weighed up as follows.
• Control. Was ultimate authority over the performance of Jane’s work vested in the employee so that the
employee was subject to orders and directions? This does not appear to be the case as Jane appears
to have the freedom to make her own decisions about the purchase of ingredients and preparation of
the food. It appears the caterer’s supervisor does not have the right to control Jane but rather may
provide some direction.
• Does the worker operate on their own account or in business of the payer? It appears that Jane is left
to operate on her own in how she goes about the work with the support of the caterer.
• Results. Yes, Jane will produce a result in the preparation of the food, this is clear.
• Delegation of the work. It is uncertain if this is the case and whether Jane can do that but it appears the
work was offered to only Jane.
• Risk. Yes, it is clear that Jane will bear the commercial risk and responsibility for the purchase of
ingredients and the preparation of the food. If things go wrong here Jane will have to deal with it directly.
• Provision of tools and equipment. It is unclear whether Jane will provide her own cooking utensils,
although she must wear the caterer’s uniform. It is likely that Jane may use the caterer’s utensils if the
work is performed on their premises.
• Other factors. These include the caterers right to dismiss, which would appear to be the case, if the
caterer was to have sufficient staff, but there is no indication of provision of leave or other benefits (i.e.
superannuation) as part of further on-costs.
Overall on a balancing of the factors above, Jane would be deemed to be an independent contractor.
Based on the strong factors of producing a result, bearing the risk and the contractor not having a right of
control over Jane is fairly conclusive. In addition, as Jane also continues to offer 50 per cent of her services
to the general public, she is still holding herself out to be an independent contractor/self-employed person
providing a contract for services.
Source: Adapted from Bevacqua, J et al. 2022, Australian Taxation, 2021–22 Tax Update Edition, p. 311.
EMPLOYMENT-RELATED EXPENDITURE
Module 2 looks at employment-related expenditure in detail. The main provisions are summarised in
table 4.10.
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262 Australia Taxation
TABLE 4.10
Summary of chief employment-related expenditure deductions
Employment
Deduction Yes/No
Exemptions
Entertainment
Generally, no.
However, where an entertainment expense is incurred
in providing a fringe benefit, it is deductible. Other
limited exceptions also apply.
Occupational
clothing
Generally, no.
Clothing is generally regarded as
private and not deductible.
Deduction is available — if a compulsory uniform is
required or it is protective clothing.
Car expenses
Yes — if used for employment
purposes.
Extensive substantiation requirements must be met.
See the section ‘Types of expenses needing
substantiation’ in module 2.
Source: CPA Australia 2022.
NEGATIVE GEARING
Negative gearing relates to the application of allowable deductions associated with an investment property
owned by the individual taxpayer. Negative gearing is discussed in module 2.
Negative gearing refers to a situation where the taxpayer acquires an investment (typically a rental
property or shares) and borrows money against that income-producing asset.
As a result, the interest on the funds borrowed, together with the other expenses associated with that
investment (typically council rates, insurance, property agents commission and repairs associated with a
rental property), exceed the amount of assessable income derived from the investment.
This results in an overall loss associated with the investment for tax purposes, which is able to be offset
against the taxpayer’s other income (such as salary and wage income) to reduce the overall tax payable. In
many cases, the loss will result in the taxpayer receiving a tax refund.
INCOME PROTECTION/REPLACEMENT
Individuals are able to claim the cost of the premiums they pay directly to an insurance company for
income protection insurance as an allowable deduction. Income protection insurance protects a person’s
ability to generate income and pays a replacement income if they are injured and unfit to work based on
the replacement principle, as indicated in FCT v DP Smith (1981).
For the policy payment to be deductible, it must be paid directly by the employee. It is not deductible
where the insurance premiums are deducted from the superannuation contributions paid by the employer.
Basically, insurance can be capital or revenue in nature. Income protection premiums are deductible
against assessable income because they are revenue in nature.
If an income insurance or replacement policy provides a benefit that is income and capital in nature,
then only the premium attributable to the income benefit is deductible.
Individuals cannot claim a deduction for a premium or any part of a premium for a policy that
compensates for items like a physical injury. Deductions cannot be claimed on life, trauma or critical
care insurance premiums.
TAX-DEDUCTIBLE SUPERANNUATION CONTRIBUTIONS
Tax-deductible superannuation contributions are available under s. 290-150 of ITAA97 to most
individuals (including both employees and the self-employed) who wish to make a direct contribution up
to the contributions cap (maximum of $27 500 in the 2021–22 year). However, the individual must give
the trustee of the superannuation fund a notice of intention to claim the deduction in their tax return.
QUESTION 4.7
Tommy Lee pays the following insurance premiums during the 2022 income tax year:
1. income protection insurance: $4000
2. life insurance premiums: $800
3. trauma insurance (covering specified illnesses like cancer, strokes and heart attacks): $700.
Identify whether these insurance payments are tax-deductible to Tommy?
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MODULE 4 Taxation of Individuals 263
4.5 APPLYING TAX OFFSETS
A taxpayer may be entitled to claim certain tax offsets. The term ‘tax offset’ is a generic term used in
ITAA97 to describe what ITAA36 used to call rebates and credits.
A tax offset directly reduces the amount of income tax payable (see figure 4.2). Section 13-1 of ITAA97
contains a list of the tax offsets available to taxpayers. Only Australian resident taxpayers are eligible for
tax offsets.
As figure 4.9 shows, there are two types of tax offsets as well as tax credits.
FIGURE 4.9
Tax offsets and tax credits
Tax offsets
Non-refundable
Can reduce a taxpayer’s tax payable
to nil, but can’t result in a taxpayer
receiving a tax refund
Refundable
The excess credits can result in a
taxpayer receiving a tax refund
DICTO
Franking credits
LITO
Private health
insurance tax offset
LMITO
FITO
Zone rebate
SAPTO
Tax credits
PAYG withholding
credit
PAYG instalments
paid credit
Source: CPA Australia 2022.
Each of these tax offsets and credits are now considered in further detail.
NON-REFUNDABLE TAX OFFSETS
Dependant Invalid and Carer Tax Offset
According to s. 61-10 of ITAA97, a taxpayer may be eligible to claim a dependant invalid and carer tax
offset (DICTO) where they contribute to the maintenance of a dependent invalid and/or a dependant who is
a carer for a listed family member. In order to be eligible for the DICTO, the taxpayer and their dependant
must be Australian residents.
Eligibility for DICTO
A taxpayer can claim DICTO in one of two circumstances:
1. where their dependant is an invalid and is unable to work
2. where their spouse, parent or spouse’s parent is a dependant and is a carer who cares for a child, brother
or sister aged 16 years or over with a disability.
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264 Australia Taxation
Who is Considered a Dependant?
In order to claim DICTO, the taxpayer must contribute to the maintenance of an eligible dependant. An
eligible dependant of a taxpayer includes their:
• spouse
• parent
• spouse’s parents
• child (aged 16 years or over) — includes a biological child, adopted child and stepchild
• spouse’s child (aged 16 or over) — includes a biological child, adopted child and stepchild
• brother or sister (aged 16 years or over)
• spouse’s brother or sister (aged 16 years or over).
Invalidity
To be eligible to claim DICTO for an invalid dependant, the dependant must genuinely be unable to work
due to invalidity. A dependant is seen to be genuinely unable to work due to invalidity where they have
been assessed and approved by Centrelink and receive either:
• a disability support pension or a special needs disability support pension under the Social Security Act
(1991), or
• an invalidity service pension under the Veterans’ Entitlements Act (1986).
Carer
To be eligible to claim DICTO for a carer, the dependant carer must genuinely be unable to work due to
carer obligations. A dependant is seen to be genuinely unable to work due to carer obligations where they
have been assessed and approved by Centrelink and either:
• receive a carer allowance or carer payment under the Social Security Act, or
• are wholly engaged in providing care to a relative who receives a disability support pension or a
special needs disability pension under the Social Security Act, or an invalidity service pension under
the Veterans’ Entitlements Act.
A taxpayer may receive more than one dependency offset provided that each dependency offset is
claimed in respect of a different dependant. For example, a taxpayer who has an invalid dependant (such
as a son or daughter) and also has a spouse who has to care full-time for that person may be eligible to
claim two separate DICTOs.
To be eligible to claim DICTO for the 2021–22 income tax year the taxpayer’s ATI must be $100 900
or less.
The maximum DICTO available to a taxpayer for the 2021–22 income tax year is $2833.
However, according to s. 61-45 of ITAA97, where the dependant’s ATI is in excess of $282, the
maximum DICTO is reduced by $1 for every complete $4 of ATI received by the eligible dependant.
Therefore, the amount of DICTO can be calculated as:
DICTO = $2833 − (1∕4 × (ATI of eligible dependant − $282))
Where the eligible dependant derives ATI of $11 614 or more, the taxpayer is no longer eligible
for DICTO.
Note that cents are ignored in the calculation because the maximum tax offset is reduced by $1 only for
each complete $4 of ATI.
What is Adjusted Taxable Income?
The DICTO entitlement is based on the dependant’s ATI. ATI is calculated as the sum of the following
amounts:
• taxable income
• deductible personal superannuation contributions
• reportable employer superannuation contributions
• reportable fringe benefits amount
• certain tax-free government pensions and benefits received from Centrelink or Veterans’ Affairs
• income from overseas sources that have not been reported in the tax return because they have been
specifically made exempt (termed ‘target foreign income’)
• adding back the total net financial investment losses (i.e. the sum of net losses from financial investments
such as shares and the net loss from rental properties)
• less the amount of child support/child maintenance that the taxpayer pays.
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MODULE 4 Taxation of Individuals 265
The ATO has published an income test calculator for ATI, the rebate income and the income for
surcharge purposes (which determines eligibility for the Medicare levy surcharge and the private health
insurance rebate).
Go to the calculator at the following link and complete each test on the income test calculator using
your own (and/or other) situations, www.ato.gov.au/Calculators-and-tools/Host/?anchor=IncomeTests
&anchor=IncomeTests#IncomeTests/questions.
Example 4.26 illustrates the calculations required for DICTO.
EXAMPLE 4.26
Applying the Dependent (Invalid and Carer) Tax Offset
During the 2021–22 tax year, Jack Johnson’s spouse, Samantha, received dividend income and a disability
pension, giving her an ATI of $5600. Jack’s ATI for the 2021–22 tax year comprised $85 000 in salary. Jack
and Samantha lived together for the whole year.
Calculate Jack’s DICTO in respect of Samantha.
Jack is entitled to DICTO of $1503, calculated as follows.
$
Maximum DICTO available 2021–22
Less: Reduction for Samantha’s ATI (¼ × ($5600 – $282))
Offset allowable
2833
(1330)
1503
QUESTION 4.8
Adrian and Pauline Vanderlinde are married. They have a 21-year-old son, Jayden, who suffers from
cerebral palsy. Jayden receives a disability support pension from Centrelink for $6782.
Pauline does not work as she cares for Jayden on a full-time basis. Pauline receives a carers
payment from Centrelink in respect of Jayden. All three live together.
Assume that Adrian’s ATI for the year ended 30 June 2022 is $78 000. Furthermore, assume that
Pauline’s ATI is $14 700 (which comprises dividends and interest received as well as her carer
payment from Centrelink).
Calculate Adrian’s DICTO in respect of Pauline and Jayden (if applicable) in respect of the year
ended 30 June 2022.
Low Income Tax Offset
According to s. 159N of ITAA36, a taxpayer with a taxable income less than $66 667 is entitled to a low
income tax offset (LITO). The current maximum value of $700 has been extended for the 2021–22 income
year. However, the amount of the offset depends on the taxpayer’s taxable income. A summary of the rules
is as follows (s. 61-115(1)).
• If a resident taxpayer derives a taxable income of less than $37 500, they will receive the full LITO
of $700.
• If a resident taxpayer derives a taxable income between $37 501 and $45 000, they will receive a LITO
of $700 minus 5 cents for every $1 above $37 500.
• If a resident taxpayer derives a taxable income between $45 001 and $66 667, they will receive a LITO
of $325 minus 1.5 cents for every $1 above $45 000.
• If a taxpayer has a taxable income of $66 667 or more, they are not entitled to the LITO whatsoever.
However, as outlined in the next section, they may be entitled to the LMITO.
QUESTION 4.9
Wendy Watson has a taxable income for the year ended 30 June 2022 of $47 000. Calculate
Wendy’s LMITO.
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266 Australia Taxation
Low and Middle Income Tax Offset
In addition to LITO, a low and middle income tax offset (LMITO) is available for resident individual
taxpayers. LMITO is a tax offset that was introduced in the 2019 income year, and has been extended to
apply for eligible taxpayers for the 2021–22 income year. For the 2022–23 and later years, it is proposed
that both the LITO and LMITO will be replaced with a new low income tax offset.
Table 4.11 summarises the LMITO payments for the year ended 30 June 2022.
TABLE 4.11
Low and middle income tax offset for 30 June 2022
Taxable income
LMITO
Less than $37 000
A flat $255
$37 001 to $48 000
$255 + 7.5% of excess over $37 000
$48 001 to $90 000
A flat $1080
$90 001 to $126 000
$1080 − 3% over $90 000
Over $126 000
Nil
Source: Based on Income Tax Assessment Act 1997 (Cwlth), s. 61-107(1), Federal Register of Legislation, accessed January 2022,
www.legislation.gov.au/Details/C2022C00055/Html/Volume_2#_Toc94794028.
QUESTION 4.10
James Henries has a taxable income for the year ended 30 June 2022 of $43 500. Calculate James’
LITO and/or LMITO.
Foreign Income Tax Offset (FITO)
A resident taxpayer is entitled to a tax offset for the foreign tax paid on foreign source income. This is
referred to as the foreign income tax offset (FITO).
When a resident taxpayer receives foreign source income on which foreign tax has been paid, the
taxpayer is assessed on the gross amount of the foreign income, that is, the amount received plus the foreign
tax withheld. In other words, the gross amount (inclusive of withholding tax deducted at the foreign source)
is required to be included in the taxpayer’s assessable income.
This foreign income is added to the other assessable income. The taxpayer will pay tax on this total
taxable income at their Australian marginal tax rate. However, they will receive a credit (called the foreign
income tax offset) for the amount of foreign tax paid. FITO effectively reduces the Australian tax that
would be payable on foreign income by an amount up to the foreign income tax paid.
Where the amount of foreign tax paid is greater than the Australian tax payable, the excess is not
refundable and cannot be carried forward to a future income year (see Item 22, s. 63-10(1)). As such,
any excess FITO is effectively lost.
Zone Tax Offset
The income tax law recognises that taxpayers who live in remote areas of Australia incur extra expenses.
Such taxpayers are eligible to claim a zone tax offset (ITAA36, s. 79A).
The amount of the tax offset varies depending upon the zone in which the taxpayer resides. These remote
areas comprise two zones:
1. Zone A
2. Zone B.
Zone A comprises those areas where the factors of isolation, uncongenial climate and the high cost of
living are more pronounced. Zone B comprises the less badly affected areas. The tax offset for ordinary
Zone A residents is higher than the tax offset for ordinary Zone B residents.
A special category is available to taxpayers residing in particularly isolated areas — that is nominated
‘special areas’ within each zone. The tax offsets for these two special areas are the same and are higher
than the tax offsets for the two ordinary zones.
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MODULE 4 Taxation of Individuals 267
Hence, there are effectively four zones:
Ordinary Zone A
Special Zone A
Ordinary Zone B
Special Zone B.
In order to determine if a particular town in Australia qualifies for a zone tax offset, the ATO has created
a state-by-state search facility on its website. This search facility can be accessed at www.ato.gov.au/
Calculators-and-tools/Australian-zone-list.
In order to qualify for the zone tax offset, a taxpayer must have lived or worked in that remote area (not
necessarily continuously) for more than 183 days during the relevant income year. In counting the 183
days, non-continuous stays are added together. A day includes a fraction of a day.
From 1 July 2015, the zone tax offset specifically excludes fly-in, fly-out (FIFO) and drive-in, drive-out
workers where their normal residence is not within a zone. FIFO workers who spend more than 183 days
in a zone, but whose normal residence is not in that zone, will instead be taken to be resident of the area
that incorporates their normal residence.
The generic formula for the zone tax offset can be written as follows.
1.
2.
3.
4.
Zone tax offset = Basic component + (Relevant % × Relevant rebate amount)
According to s. 79A(2) of ITAA36, the amount of the zone tax offset is made up of two components:
1. a basic component (being a fixed amount)
2. plus a percentage of the relevant rebate amount.
The zone allowances for the 2021–22 income year are shown in table 4.12.
TABLE 4.12
Zone tax offset for the 2021–22 tax year
Zone
Allowance
Ordinary Zone A
$338 + 50% of the relevant rebate amount
Special Zone A
$1173 + 50% of the relevant rebate amount
Ordinary Zone B
$57 + 20% of the relevant rebate amount
Special Zone B
$1173 + 50% of the relevant rebate amount
Source: Income Tax Assessment Act 1936 (Cwlth), Section 79A, Federal Register of Legislation, accessed January 2022,
www.legislation.gov.au/Details/C2021C00582/Html/Volume_2#_Toc86739678.
What is Meant by the Term’ Relevant Rebate Amount’?
The ‘relevant rebate amount’ is defined in s. 79A(4) of ITAA36 as the sum of:
• ‘any tax offset to which the taxpayer is entitled under Subdivision 61-A of the [ITAA97]’ (this includes
the DICTO)
• any notional tax offset to which the taxpayer is entitled to because of any dependent child that lives at
home with the taxpayer.
Where the taxpayer has children under the age of 25 who are living with the taxpayer and are full-time
students, each student adds $376 to the relevant rebate amount.
For the oldest non-student child under the age of 21 who is living with the taxpayer, this non-student
child adds $376 to the relevant rebate amount. Each other non-student child after the first non-student child
under the age of 21 and living with the taxpayer adds $282 to the relevant rebate amount.
The relevant rebate amount is rounded to the nearest whole dollar.
QUESTION 4.11
Wayne Pound is a resident of Special Area Zone A. He lives with his invalid wife, Anne, who is in
receipt of a disability support pension from Centrelink. Wayne and Anne have 3 dependent children,
all of whom are still at high school and are under the age of 25.
Wayne’s ATI is $75 000. As this is less than $100 900, Wayne is eligible to claim a DICTO in respect
of Anne.
Anne’s ATI is $4142, which comprises her disability support pension from Centrelink.
Calculate Wayne’s entitlement to a zone tax offset.
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268 Australia Taxation
Seniors Australians and Pensioners Tax Offset
According to s. 160AAAA of ITAA36, a seniors and pensioners tax offset (SAPTO) is available to a
taxpayer who, for at least one day during the income year:
• had qualified for an age pension under the Social Security Act. Eligibility for an Australian
Government age pension from Centrelink requires an age of 66 years and 6 months or older from
30 June 2021
• was eligible for a pension, allowance or benefit under the Veterans’ Entitlements Act. The taxpayer must
also be at least 60 years or older on 30 June 2021, and
– has been an Australian resident for more than 10 years and has not been in prison for the full year
– included in their assessable income a social security pension, service pension, carer service pension,
income support supplement or allowance.
To be eligible for SAPTO, the taxpayer must have a ‘rebate income’ for the year ended 30 June 2022
under the cut-out threshold set out in table 4.13.
TABLE 4.13
SAPTO rebate and thresholds for the 2021–22 tax year**
Class
Maximum SAPTO
Minimum threshold
Rebate cuts out at
Single
$2230
$32 279
$50 119
Couple (each)
$1602
$57 948*
$83 580*
Couple separated because of ill
health (each)
$2040
$62 558*
$95 198*
*Refers to the combined income of the taxpayer and their spouse.
Source: Adapted from ATO 2021j, ‘Seniors and pensioners tax offset’, accessed February 2022, www.ato.gov.au/Individuals/
Income-and-deductions/Offsets-and-rebates/Seniors-and-pensioners-tax-offset.
A taxpayer’s rebate income is calculated as the sum of the total of the following amounts:
• taxable income
• reportable employer superannuation contributions
• adjusted fringe benefits total (i.e. the sum of the reportable fringe benefits amount that are exempt under
s. 57A of FBTAA1986 multiplied by 0.53, and other reportable fringe benefits amounts)
• adding back the total net financial investment loss (i.e. the sum of net losses from financial investments
such as shares and the net loss from rental properties).
The SAPTO covers low-income aged persons as well as self-funded retirees.
The amount of the rebate reduces at a rate of 12.5 cents for each dollar of rebate income in excess of
the minimum threshold. In other words for a single person:
(
)
$2230 – Rebate income – $32 279 × 0.125
For couples, any unused part of the rebate can be transferred to the spouse.
Example 4.27 illustrates the calculations required for SAPTO for a single taxpayer.
EXAMPLE 4.27
Calculation of SAPTO
Terry Bye is aged 67. He receives an aged pension from Centrelink. His rebate income for the year ended
30 June 2022 is $38 000. Consider Terry’s entitlement to a SAPTO.
Terry’s SAPTO is calculated as follows.
$
Maximum rebate available
Less: Reduced by 12.5 cents for every $1 over $32 279
(($38 000 − $32 279) × 0.125) SAPTO
2230
(715)
1515
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MODULE 4 Taxation of Individuals 269
QUESTION 4.12
Paul and Celeste Biggs are aged 68 and 67 years respectively. They live together and both receive
an aged pension from Centrelink. Paul has a rebate income of $33 000 and Celeste has a rebate
income of $36 500 for the year ended 30 June 2022. Both qualify for SAPTO.
Calculate each of Paul and Celeste’s SAPTO.
REFUNDABLE TAX OFFSETS AND TAX CREDITS
Unlike non-refundable tax offsets, where a taxpayer has a refundable tax offset, Division 67 of ITAA97
provides that a refundable tax credit can result in a taxpayer receiving a tax refund. In other words, if the
total amount of refundable credit exceeds the taxpayer’s net tax payable, the excess credits will result in
the taxpayer receiving a tax refund.
The following are the most common refundable tax offsets.
Franking Credit Tax Offset
Resident individual shareholders who receive franked dividends not only need to include the cash amount
of the dividend as assessable income (by virtue of s. 44(1)(a) of ITAA36) but also the franking credit in
respect of the dividend (as per s. 207-20(1) of ITAA97) as part of their assessable income.
According to s. 207-20(2) of ITAA97, the taxpayer is also entitled to a refundable tax offset in respect of
the franking credit. If the amount of the franking credit exceeds the taxpayer’s net tax payable, the excess
credit is a refundable tax-offset (ITAA97, s. 67-25).
Private Health Insurance Tax Offset
An individual taxpayer who has taken out private health insurance has a choice of claiming a federal
government rebate (or reimbursement) of the amount of their premiums paid as either a:
• reduction from their premiums charged by their private health fund
• refundable tax offset at the end of the income year through their tax return.
Most taxpayers elect to offset the Federal Government rebate against the cost of premiums paid to
their health insurer. However, some taxpayers elect to pay the full cost of the premium and receive the
government contribution as a refundable tax offset in their tax return. In this case, the rebate (see table 4.14
for the rebate percentage) applies to the amount of the health insurance premium paid by the taxpayer. The
exact amount of the rebate varies depending on the taxpayer’s status (i.e. single or family, their age and
income threshold).
TABLE 4.14
Private health insurance rebate entitlement by income threshold 2021–22
Income thresholds†
Status
Base tier
Tier 1
Tier 2
Tier 3
Single
$90 000 or less
$90 001 – $105 000
$105 001 – $140 000
$140 001 or more
$180 001 – $210 000
$210 001 – $280 000
$280 001 or more
Family‡
$180 000 or less
Rebate for premiums paid 1 July 2021 – 31 March 2022
Age
Base tier
Tier 1
Tier 2
Tier 3
Under 65 years
24.608%
16.405%
8.202%
0%
65–69 years
28.710%
20.507%
12.303%
0%
70 years or over
32.812%
24.608%
16.405%
0%
† The income thresholds were set on 1 July 2015 and will remain at the 2014–15 levels until the 2022–23 income year.
‡ The family income threshold is increased by $1500 for each Medicare levy surcharge dependent child after the first child.
Source: Adapted from ATO 2021e, ‘Income thresholds and rates for the private health insurance rebate’, accessed January
2022, www.ato.gov.au/Individuals/Medicare-and-private-health-insurance/Private-health-insurance-rebate/Income-thresholds-andrates-for-the-private-health-insurance-rebate; Department of Health 2020, ‘PHI24/20 Private health insurance rebate adjustment
factor effective 1 April 2020’, accessed January 2022, www.health.gov.au/phi-2420-private-health-insurance-rebate-adjustmentfactor-effective-1-april-2020.
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270 Australia Taxation
The cost of the private health insurance premiums are detailed on the annual private health insurance
statement provided by the health fund at the end of each financial year.
From 1 July 2012, the amount of the private health insurance tax offset is income and age tested. The
income thresholds, together with the age of the taxpayer and which tier they fall within is summarised in
table 4.14.
The tax offset is based on income for Medicare levy surcharge purposes. This is the sum of the taxpayers:
• taxable income
• reportable employer superannuation contributions
• reportable fringe benefits amount
• adding back the total net financial investment losses (i.e. loss from financial investments such as shares,
interests in managed investment schemes, rights and options) as well as adding back any losses from
rental properties
• less certain superannuation benefits that are eligible for a tax offset under s. 301-20(2) of ITAA97.
QUESTION 4.13
John and Alicia Jackson, aged 49 and 50 respectively, have one dependent child and paid $5100
towards their private health insurance premiums for the period 1 July 2021 to 30 March 2022.
They have not claimed any reduced premiums from their private health insurer. John’s income
for surcharge purposes is $85 000 and Alicia’s income for surcharge purposes is $109 000. Hence,
their combined income for surcharge purposes is $194 000.
What is their private health insurance tax offset amount for John and Alicia?
The following covers the refundable tax credits.
PAYG Withholding
When a person works as an employee, their employer is required to deduct PAYG withholding tax from
gross payments made to employees and remit these amounts to the ATO. A payer must deduct PAYG
withholding from the following gross payments:
• salaries, wages, allowances, bonuses or commissions paid to employees
• payments to company directors
• payments to office holders
• return to work payments
• ETPs
• payments for unused annual and long service leave
• compensation and sickness or accident payments.
The ATO publishes a wide range of tax tables (www.ato.gov.au/Rates/Tax-tables), which show the
amount of PAYG tax required to be withheld from payments of salaries and wages made to employees.
In the case of individual taxpayers, the gross amount is shown as assessable income and the amount of
PAYG withholding is shown as a refundable credit in determining the overall tax payable or tax refund.
PAYG Instalments
Some taxpayers are liable for PAYG instalments and not PAYG withholding. For example, a taxpayer
may be self-employed, running their own business or receive investment income in the form of interest,
dividends and distributions from partnerships and trusts.
Unlike PAYG withholding tax, no tax is deducted from these gross payments made to the taxpayer.
Instead, the ATO requires these taxpayers to pay income tax on these payments throughout the year, based
on their estimated tax liability.
These are referred to as ‘PAYG instalments’. PAYG instalments are usually paid by taxpayers to the
ATO on a quarterly basis through a one-page document entitled a ‘PAYG Quarterly Instalment Notice’.
PAYG instalments paid are taken into account and credited against the ultimate tax liability, resulting in
the taxpayer either having to pay additional amounts to the ATO or receiving a refund. PAYG instalments
paid by taxpayers are a refundable tax credit.
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MODULE 4 Taxation of Individuals 271
4.6 CALCULATING TAX PAYABLE/REFUNDABLE
This final section of this module presents the steps of calculating tax payable/refundable.
For resident individual taxpayers, the following steps should be followed in calculating the estimated
tax payable or tax refund for the relevant income year (see figure 4.2). Please note that these six steps are
an expansion of the four general steps outlined in the method statement contained in s. 4-10(3) of ITAA97.
1. Calculate the taxpayer’s taxable income. Taxable income equals assessable income minus allowable
deductions.
2. Calculate the tax on taxable income in line with table 4.15 (in the case of residents) or table 4.16 (in the
case of non-residents).
3. Deduct the non-refundable tax offsets or rebates that a taxpayer may be entitled to. A tax offset directly
reduces the amount of income tax payable. Section 13-1 of ITAA97 contains a list of the tax offsets
available to taxpayers. According to s. 63-10(1) of ITAA97, a non-refundable tax offset cannot exceed
the taxpayer’s basic tax payable to below zero. In other words, while a tax offset can reduce a taxpayer’s
tax payable to nil, it cannot result in a taxpayer receiving a refund.
4. Add the 2 per cent Medicare levy in the case of resident individual taxpayers to the sub-total of Steps 2
and 3. This gives net tax payable. The Medicare levy is calculated as 2 per cent of the taxpayer’s taxable
income. If applicable, a resident individual taxpayer may also be subject to an additional Medicare levy
surcharge which is either 1 per cent, 1.25 per cent or 1.5 per cent of the taxpayer’s taxable income.
5. Deduct the refundable tax-offsets or credits that the taxpayer is entitled to. Tax credits include tax
withheld on salaries and wages (termed ‘PAYG withholding tax’), franking credits, private health
insurance credits, TFN withholding tax and PAYG instalments. Unlike tax offsets described in
Step 3, where a taxpayer has a refundable tax credit, Division 67 of ITAA97 provides that a refundable
tax credit can result in a taxpayer receiving a tax refund. In other words, if the total amount of refundable
credit exceeds the taxpayer’s net tax payable, the excess credits will result in the taxpayer receiving a
tax refund.
6. Deduct Step 5 from the net tax payable calculated after Step 4. The difference is either the estimated
tax payable owing to the ATO (a positive amount) or the estimated tax refund owing by the ATO (a
negative amount).
TAX ON TAXABLE INCOME
Once a taxpayer’s taxable income has been determined, the first step is to calculate the primary tax payable
on this taxable income. The amount of tax payable depends on whether the taxpayer is a resident or a nonresident of Australia for tax purposes.
Income Tax Rates
The income tax rates for a resident individual for the year ended 30 June 2022 are shown in table 4.15.
TABLE 4.15
Resident individual tax rates 2021–22
Taxable income
Tax on this income
0 – $18 200
Nil
$18 201 – $45 000
19c for each $1 over $18 200
$45 001 – $120 000
$5092 plus 32.5c for each $1 over $45 000
$120 001 – $180 000
$29 467 plus 37c for each $1 over $120 000
$180 001 and over
$51 667 plus 45c for each $1 over $180 000
Source: Based on Income Tax Rates Act 1986 (Cwlth), Schedule 7, Federal Register of Legislation, accessed January 2022,
www.legislation.gov.au/Details/C2021C00305.
In addition to the above rates, a 2 per cent Medicare levy is payable by resident Australian taxpayers,
which is discussed shortly.
The income tax rates for a non-resident individual for the year ended 30 June 2022 are shown in
table 4.16.
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272 Australia Taxation
TABLE 4.16
Non-resident individual tax rates 2021–22
Taxable income
Tax on this income
0 – $120 000
32.5c for each $1
$120 001 – $180 000
$39 000 plus 37c for each $1 over $120 000
$180 001 and over
$61 200 plus 45c for each $1 over $180 000
Source: Based on Income Tax Rates Act 1986 (Cwlth), Schedule 7, Federal Register of Legislation, accessed January 2022,
www.legislation.gov.au/Details/C2021C00305.
Non-residents are not liable for the 2 per cent Medicare levy and they are not entitled to the tax-free
threshold nor any rebates and tax-offsets (including franking credits).
Reduced Tax-Free Threshold
Normally, every resident individual taxpayer is entitled to the standard tax-free threshold of $18 200.
However, ss. 18 and 20 of the Income Tax Rates Act 1986 (Cwlth) provide that a taxpayer’s $18 200
tax-free threshold is to be reduced where the taxpayer has either become, or ceased to be, an Australian
resident for income tax purposes during an income year.
A person who is a resident for part of the income year and a non-resident for the remaining part of the
income year is referred to as a ‘part-year resident’. This is the case for taxpayers arriving in Australia and
also for taxpayers leaving Australia.
The reduced tax-free threshold is calculated by applying the following formula.
FORMULA TO LEARN
The tax-free threshold is calculated as (Income Tax Rates Act, s. 20):
$13 464 +
(
$4736 × Number of months in the year the individual is resident
12 months
)
Applying this formula, an individual who is resident for only part of the year has a tax-free threshold of
at least $13 464, with an additional amount of tax-free threshold according to the number of months the
individual is a resident.
Example 4.28 illustrates how the reduced tax-free threshold applies to a newly arrived resident of
Australia.
EXAMPLE 4.28
Applying the Tax-Free Threshold Formula
Laila Korhonen arrived in Australia on 4 January 2022 to take up permanent residence. She commenced
work on 1 February 2022 and worked until 30 June 2022. Consider Laila’s reduced tax-free threshold.
The reduced tax-free threshold is calculated as:
= $13 464 +
$4736 × 6 months
12 months
= $13 464 + $2368
= $15 832
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MODULE 4 Taxation of Individuals 273
QUESTION 4.14
On 1 July 2021, Jenny Patel lived and worked in Vietnam. She is considered a non-resident of
Australia for taxation purposes. On 3 March 2022, Jenny decides to permanently leave Vietnam
and arrives in Australia to take up a full-time job which she was offered.
Jenny intends taking up permanent residency in Australia. She finds an apartment to rent,
redirects her mail from Vietnam, opens up Australian bank accounts and joins a local gym and
sporting club. From this date onwards, assume that Jenny is considered to be an Australian resident
for taxation purposes.
For the period 3 March 2022 to 30 June 2022 (120 days), Jenny derived assessable income of
$28 000. She had no other income and no allowable deductions. Hence, her Australian taxable
income is $28 000.
Calculate Jenny’s tax payable and Medicare levy for the year ended 30 June 2022. For the
purposes of this question, please ignore the LITO.
TABLE 4.17
Medicare levy reduction — single individual thresholds 2020–21*
Taxable income
Medicare levy payable
$23 226 or less
Nil
$23 227 to $29 032
10% of the amount in excess of $23 226
$29 033 or more
A flat 2% of taxable income
*The 2021–22 Medicare levy reduction thresholds are released in the Federal Budget, which is handed down by the Federal Treasurer
each year. As at the date of writing, the 2021–22 Medicare levy reduction thresholds were not available.
Source: Based on Income Tax Rates Act 1986 (Cwlth), Schedule 7, Federal Register of Legislation, accessed January 2022,
www.legislation.gov.au/Details/C2021C00305.
MEDICARE LEVY
The rules for determining the imposition of the Medicare levy are found in ss. 251R to 251Z of ITAA36
and the rate of the levy is imposed by the Medicare Levy Act 1986 (Cwlth). The Medicare levy is collected
in the same way as income tax (ITAA36, s. 251R(7)).
Generally speaking, only resident individual taxpayers are required to pay a 2 per cent Medicare levy
based on the taxpayer’s taxable income.
Medicare Levy Exemption
Sections 251T and 251U of ITAA36 outline persons who are exempted from paying the Medicare levy
(termed ‘prescribed persons’). These persons include:
• a person entitled to full free medical treatment as a member of the Defence Forces
• Veterans’ Affairs Repatriation Health Card (Gold Card) holders
• blind pensioners who receive sickness allowances from Centrelink
• persons who are not residents of Australia for taxation purposes for the entire income year
• persons who have a certificate from the Levy Exemption Certification Unit of the Health Insurance
Commission showing that they are not entitled to Medicare benefits
• members of diplomatic missions or consular posts who are not Australian citizens and do not ordinarily
reside in Australia.
Prescribed persons are not liable for the levy if they have no dependants or the dependants themselves
are prescribed persons (s. 251T(2)). If taxpayers qualify for an exemption, they can claim the exemption
through their tax return. In addition, those who are claiming an exemption because they were not entitled
to Medicare benefits, will also need to apply for a Medicare Entitlement Statement (MES) from Services
Australia (ATO 2021i).
Non-residents can also claim a full exemption from the Medicare levy if they were non-resident for the
full year. If they are non-resident for only part of the year, they can still claim full exemption from the
Medicare levy for that period if they didn’t have any dependants for that period or all their dependants
were in a Medicare levy exemption category for that period (ATO 2021c).
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274 Australia Taxation
Reduction for Individual Low-Income Earners
Certain taxpayers are entitled to a reduction in their Medicare levy. This is generally based on the taxpayer’s
taxable income. The thresholds relating to a reduction in the Medicare levy for a single resident individual
taxpayer for the 2020–21 income year are outlined in table 4.17.
The thresholds relating to a reduction in the Medicare levy for a family are outlined in table 4.18.
The thresholds relating to a reduction in the Medicare levy for a Senior Australian and pensioner are
outlined in table 4.19.
TABLE 4.18
Medicare levy reduction — family thresholds 2020–21*
Taxable income
Medicare levy payable
$39 167 or less
Nil
$39 168 to $48 958
10% of the amount in excess of $39 167
$48 959 or more
A flat 2% of taxable income
Note: A family consists of the taxpayer, their spouse and their dependent children. (For the threshold $48 958 add $4496 for each
extra child or student). The family threshold applies to taxpayers who had a spouse, or a spouse who died during the year, or were
entitled to an invalid carer tax offset in respect of a child or had full responsibility for the upbringing, welfare and maintenance of
one or more dependent children or students.
Source: Based on Income Tax Rates Act 1986 (Cwlth), Schedule 7, Federal Register of Legislation, accessed January 2022,
www.legislation.gov.au/Details/C2021C00305.
*The 2021–22 Medicare levy reduction thresholds are released in the Federal Budget, which is handed down by the Federal Treasurer
each year. As at February 2022, the 2021–22 Medicare levy reduction thresholds were not available.
TABLE 4.19
Medicare levy reduction — senior Australians and pensioners thresholds 2020–21*
Taxable income
Medicare levy payable
$36 705 or less
Nil
$36 706 to $45 882
10% of the amount in excess of $36 705
$45 883 or more
A flat 2% of taxable income
*The 2021–22 Medicare levy reduction thresholds are released in the Federal Budget, which is handed down by the Federal Treasurer
each year. As at February 2022, the 2021–22 Medicare levy reduction thresholds were not available.
Source: Based on ATO 2021, ‘Medicare levy reduction for low-income earners’, accessed February 2022, www.ato.gov.au/
Individuals/Medicare-and-private-health-insurance/Medicare-levy/Medicare-levy-reduction-for-low-income-earners.
MEDICARE LEVY SURCHARGE
In addition to the 2 per cent Medicare levy, since 1 July 1997, a Medicare levy surcharge has been imposed
under s. 8 of the Medicare Levy Act on certain resident individual taxpayers.
The Medicare levy surcharge (which ranges from 1 per cent, 1.25 per cent and 1.5 per cent of the
taxpayer’s taxable income) only applies where a high income earner does not maintain adequate private
health insurance. Both of these terms are explained below.
What is Private Health Insurance?
Private health insurance cover includes having private hospital cover (‘H’) for the person and all of their
dependants. A private health insurance policy must have an excess of no more than $500 for singles and
$1000 for families. Private health insurance is available through a variety of private health fund providers
such as Bupa, Medibank Private, NIB.
Who is a High Income Earner?
There are specific rules depending on whether the income earner is a single person or in a relationship.
Single Taxpayer
In the case of a single taxpayer without dependent children, a high income earner is defined as one whose
‘income for surcharge purposes’ exceeds $90 000.
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MODULE 4 Taxation of Individuals 275
Couples and Families
In the case of couples and families without dependent children, a high income earner is defined as those
whose combined income for surcharge purposes exceeds $180 000.
The $180 000 threshold increases where the taxpayers have more than one dependent child. In this
case the income threshold for surcharge purposes increases by $1500 per dependent child after the first
child. For a couple with two dependent children, the combined threshold is $181 500 ($180 000 + $1500
× (2 – 1)).
For the purposes of the Medicare levy surcharge, a dependent child is defined in s. 251R of ITAA36 as:
• a child of the taxpayer under 21 providing that you contribute to their maintenance, or
• a child of the taxpayer over 21 but less than 25 who is studying full-time at a school, college or
university providing that you contribute to their maintenance.
In the case of a couple, where both taxpayers do not have private health insurance, both are liable for
the Medicare levy surcharge. If the couple have dependent children (as outlined above), the dependent
children must also be covered by private health insurance.
In other words, where one person has private health insurance and the other does not (or the children
are not covered), then both taxpayers are subject to the Medicare levy surcharge. The only way that both
taxpayers will be able to escape the Medicare levy surcharge is for both of them to maintain private health
insurance for the full income year.
If a taxpayer is liable for the Medicare levy surcharge, the amount of the surcharge payable is dependent
on their income for surcharge purposes.
For Medicare levy surcharge purposes, the income for surcharge purposes is:
• the sum of:
– taxable income
– reportable employer superannuation contributions
– reportable fringe benefits amount
– exempt foreign employment income
– adding back the total net financial investment losses (i.e. loss from financial investments such as
shares, interests in managed investment schemes, rights and options) as well as adding back any
losses from rental properties
– any amount on which family trust distribution tax has been paid
• less any taxed superannuation benefit that qualifies for a tax offset under s. 301-20(2) of ITAA97.
However, once a person is subject to the Medicare levy surcharge, the actual amount of the Medicare
levy surcharge payable is based on the relevant surcharge percentage multiplied by the sum of their:
• taxable income
• reportable fringe benefits amount.
The amount of the Medicare levy surcharge payable (expressed as a percentage) increases based on the
taxpayer’s income. Table 4.20 outlines the amount of Medicare levy surcharge payable.
TABLE 4.20
Medicare levy surcharge — income thresholds and rates from 2014–15 to 2022–23
Base tier
Tier 1
Tier 2
Tier 3
Single threshold
$90 000 or less
$90 001 – $105 000
$105 001 – $140 000
$140 001 or more
Family threshold†
$180 000 or less
$180 001 – $210 000
$210 001 – $280 000
$280 001 or more
0%
1%
1.25%
1.5%
Medicare levy
surcharge
† The family income threshold is increased by $1500 for each Medicare levy surcharge dependent child after the first child.
Source: Adapted from ATO 2021d, ‘Income thresholds and rates for the Medicare levy surcharge’, accessed January
2022, www.ato.gov.au/Individuals/Medicare-and-private-health-insurance/Medicare-levy-surcharge/Income-thresholds-and-rates-forthe-Medicare-levy-surcharge.
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276 Australia Taxation
Example 4.29 illustrates how the Medicare levy surcharge is calculated for a single taxpayer.
EXAMPLE 4.29
Calculating the Medicare Levy Surcharge Payable for a Single Resident
Individual Taxpayer
Felix Fletcher is a single resident individual taxpayer who has no dependants and no private health
insurance. Felix’s taxable income for the year ended 30 June 2022 was $92 000. Felix also provides you
with the following information in respect of the year ended 30 June 2022:
• reportable fringe benefits of $18 000
• net investment losses from a rental property he owns of $7000.
Consider if Felix subject to the Medicare levy surcharge and how much is payable.
Felix’s total income for Medicare levy surcharge purposes is $117 000 ($92 000 + $18 000 + $7000),
which makes him a Tier 2 income earner for calculating the Medicare levy surcharge.
However, the actual amount of Medicare levy surcharge is only calculated against his taxable income
and reportable fringe benefits. In 2021–22, Felix’s Medicare levy surcharge liability is calculated as follows.
($92 000 taxable income + $18 000 reportable fringe benefits) = $110 000 × 1.25% = $1375
QUESTION 4.15
Michael and Sophie Jones are married and have two dependent children aged eight and four
respectively. Michael’s taxable income and reportable fringe benefits for the year ended 30 June
2022 is $120 000 and Sophie’s taxable income and reportable fringe benefits amount is $80 000.
Sophie and the two children are covered by private health insurance with Bupa, but Michael
is not.
What is the Medicare levy surcharge payable by Michael and Sophie?
ACCUMULATED STUDY AND TRAINING SUPPORT LOANS
Individuals with accumulated study or training support loans may be required to have additional amounts
withheld from the payments made to them.
From 1 July 2019, all study and training support loans are covered by one set of thresholds and rates.
‘Study and training support loans’ replace the following:
• higher education loan program (HELP)
• VET student loans (VSL)
• student financial supplement scheme (SFSS)
• student start-up loan (SSL)
• ABSTUDY student start-up loan (ABSTUDY SSL)
• trade support loan (TSL).
The repayment thresholds and rates for the compulsory repayment of these debts are updated annually
and indexed in line with CPI. Table 4.21 shows the repayment thresholds and repayment percentages (to
be multiplied by their repayment income) for the 2021–22 income year.
TABLE 4.21
2021–22 Study and training support loan thresholdsand percentages
Repayment income (RI) threshold*
Below $47 014
Repayment rate
Nil
$47 014 – $54 282
1.0%
$54 283 – $57 538
2.0%
$57 539 – $60 991
2.5%
(continued)
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MODULE 4 Taxation of Individuals 277
TABLE 4.21
(continued)
$60 992 – $64 651
3.0%
$64 652 – $68 529
3.5%
$68 530 – $72 641
4.0%
$72 642 – $77 001
4.5%
$77 002 – $81 620
5.0%
$81 621 – $86 518
5.5%
$86 519 – $91 709
6.0%
$91 710 – $97 212
6.5%
$97 213 – $103 045
7.0%
$103 046 – $109 227
7.5%
$109 228 – $115 781
8.0%
$115 782 – $122 728
8.5%
$122 729 – $130 092
9.0%
$130 093 – $137 897
9.5%
$137 898 and above
10%
* The repayment income threshold is calculated as the sum of the taxpayer’s taxable income, total reportable fringe benefits amounts,
reportable employer superannuation contributions (RESC) and exempt foreign employment income. Furthermore, the taxpayer
must add back any net investment losses (which includes losses associated with a rental property or investments).
Source: ATO 2021k, ‘Study and training loan repayment thresholds and rates’, accessed February 2022, www.ato.gov.au/
Rates/HELP,-TSL-and-SFSS-repayment-thresholds-and-rates.
The amount of the study and training loan repayment is based as a percentage of the employee’s
repayment income threshold (defined above) and forms part of the PAYG deducted from their gross salaries
and wages. The amount of the repayment is incorporated into the respective withholding tax tables meaning
that employees will have effectively provisioned for the levy when it comes to lodging their income
tax return.
For example, assume that a taxpayer has an accumulated HELP debt of $18 500. Assume that for the
year ended 30 June 2022, their taxable income was $65 000. The taxpayer also had a reportable fringe
benefits amount of $4800, reportable employer superannuation contributions of $5500 and derived a net
loss from their rental property of $4100.
Their study and training support loan thresholds is calculated as $79 400 (being the sum of these four
amounts). Accordingly, based on table 4.21, the taxpayer’s repayment rate is 5.0 per cent. Hence, the
taxpayer will be required to make a repayment of $3970 in respect of the 2022 income year (being
$79 400 × 5.0%).
In the case of an employee with a study and training support loan debt, the employer should deduct the
PAYG withholding tax using the appropriate ATO tax tables. Note that Australians who live overseas with
current education loans also need to make repayments.
Salary Packaging Implications
As previously mentioned, if an employee has an accumulated study and training support loan, the employer
is required to deduct the appropriate amount of the repayment out of the employee’s gross salary or wage
each payment period (e.g. weekly, fortnightly of monthly). These repayments amount to a repayment of
the loan made by the Australian government to the taxpayer to pay the tuition costs whilst studying the
course. These loan repayments are not tax deductible to the taxpayer.
Some employers may elect to make these repayments on behalf of their employees and effectively bear
the cost themselves. This constitutes an expense payment fringe benefit as the repayment of these loans on
the employee’s behalf is considered a private benefit and FBT applies. The employer is liable to pay the
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278 Australia Taxation
FBT on any fringe benefits provided to the employee or their associate. However, it is relatively common
in most salary packaging arrangements that, whilst the employer pays the FBT, they pass the FBT liability
onto the employee as a reduction in their gross salary. This has the effect of reducing the employee’s net
cash position. The issue of FBT and salary packaging is further discussed in module 6.
Example 4.30 illustrates the calculation of the tax payable for a resident individual taxpayer taking into
account the calculation of taxable income, tax payable, Medicare levy and tax offsets.
EXAMPLE 4.30
Calculating Tax Payable
During the 2021–22 tax year, Jane Miller, aged 39, an Australian resident, is an employee of Training
Teachers Now Pty Ltd. Jane provides you with the following information.
$
Gross salary (includes $7400 PAYG tax withheld)
Allowances received from her employer:
Telephone
Entertainment
Company car — fully maintained*
Jane personally incurred the following expenses:
Mobile telephone — business use
Entertainment of business clients
$
47 000
1 000
4 000
5 000
15 000
1 200
3 500
*Jane’s employer pays the FBT on this car and does not pass the associated FBT payable onto Jane as a reduction in her
salary package.
Assume that Jane is single, has no dependants and has private health insurance throughout the
2021–22 income tax year. Also assume that Jane has reduced her private health insurance premium by
the private health insurance tax offset.
Based on the above information, consider Jane’s tax payable/(refund) for the year ended 30 June 2022.
Determination of Jane Miller’s tax liability for year ended 30 June 2022 as follows.
$
Assessable income
Gross salary
Add: Allowances
Less: Allowable deduction
Business use of telephone
Taxable income
Tax payable (2021–22 tax rates)
Less: LITO
Less: LMITO‡
Add: Medicare levy (2% of $50 800)
Less: PAYG withholding tax
Estimated tax refund
47 000
5 000
52 000
1 200
50 800
6 977
(238)
(1080)
5 659
1 016
6 675
(7 400)
(725)
‡ Low income tax offset = [$325 – ($50 800 – $45 000) × 0.015)] = $238
Taxable income is between $48 001 and $90 000. Hence, Jane is entitled to a flat LMITO of $1080.
Jane Miller would not be assessed on the fully maintained company car as FBT would be payable
by her employer, Training Teachers Now, on the car fringe benefit. No tax deduction is allowable for the
entertainment of business clients (s. 32-5 of ITAA97 denies the deduction).
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MODULE 4 Taxation of Individuals 279
QUESTION 4.16
Christina Woodlands is an individual resident taxpayer for the 2021–22 income tax year. She is aged
46, is single and has no dependants.
Christina holds private hospital health insurance that meets the requirements of the private health
insurance tax offset. Her annual premium for the 2021–22 income tax year was $2200, which has
not been reduced to take into account any offset available.
Christina has the following transactions.
$
Income from wages
Rental income received
Interest received
87 000
15 000
1 400
Expenses
Substantiated car expenses having travelled 1200 km for work (calculated using the cents per km
method, 72 cents per km in 2021–22, applied to an estimate of the number of business kilometres
travelled).
$
Entertainment of clients
Landlord fees, rates, interest on rental property
4000
17 000
Determine Christina’s tax payable for the 2021–22 income tax year by answering the following
questions.
(a) Calculate Christina’s taxable income for the year ended 30 June 2022.
(b) Calculate the minimum amount of compulsory superannuation guarantee required to be paid
by Christina’s employer.
(c) Calculate Christina’s net tax payable ignoring the private health insurance tax offset.
(d) Calculate Christina’s private health insurance tax offset.
QUESTION 4.17
Stephen Summerfield and his wife, Elizabeth, have lived in Bullock Creek (Queensland) for the past
seven years. They have a 12-year-old daughter, Charlotte and a nine-year-old son, Ethan. Both
children attend a local school in Bullock Creek and are under the age of 25.
Stephen works as a journalist. For the period 1 July 2021 to 30 June 2022, Stephen derived the
following income and incurred the following expenses.
$
Gross salary (including PAYG withholding tax of $40 140 deducted)
Net capital gain from the sale of Australian shares
Gross interest income
Work-related deductions
138 000
1200
140
340
Stephen’s wife, Elizabeth, has no taxable income and no ATI. Stephen and Elizabeth have
adequate private health insurance. Stephen does not have any reportable fringe benefits and has
not made any reportable employer superannuation contributions during the 2022 income tax year.
Bullock Creek qualifies as an area within Ordinary Zone A.
(a) Calculate Stephen’s taxable income for the year ended 30 June 2022.
(b) Calculate Stephen’s tax payable/(tax refund) for the year ended 30 June 2022 ignoring any
private health insurance implications.
The key points covered in this module, and the learning objectives they align to, are as follows.
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280 Australia Taxation
KEY POINTS
Section ‘Individual taxation core concepts’ does not directly relate to a learning objective, but
provides key information relating to the core concepts relating to individual taxation.
• The five steps used to calculate individual taxation obligations are outlined.
• Figure 4.2 illustrates the individual tax equation.
4.1 Analyse the income tax implications of various types of income received by individuals.
• The different types of assessable income that an individual may receive, including salaries
and wages, interest, dividends, property and distributions from entities, including their taxation
consequences are described.
• Figure 4.4 provides a summary of the taxation of minors.
• The special rules that apply to the taxation of minors are explained.
• How ETPs are taxed in the hands of individuals, including life termination benefits and death
termination payments is illustrated.
• How other termination payments that may be paid to an employee in termination of employment,
including genuine redundancy payments, early retirement scheme payments and unused annual
leave and unused long service leave payments are taxed in the hands of an individual is illustrated.
• The concept of PSI and the tests to be applied in determining whether the taxpayer is conducting a
PSB, including the taxation consequences if income is attributed to the individual is demonstrated.
• The tests as to whether a taxpayer is conducting a PSB or deriving PSI are contained in s. 87-5 of
ITAA97 and are summarised in figure 4.5.
• Examples 4.8 and 4.9 illustrate whether a payment in respect of services provided qualifies as PSI
or the running of a PSB.
• Examples 4.10 and 4.11 illustrate the results test and employment test relating to PSI.
• Example 4.12 illustrated how income that is regarded as PSI is attributed to the individual via the
method statement.
• How ESS interests are taxed and the concessional tax treatment for individuals under Division 83A
of ITAA97 is explained and demonstrated using examples covering a range of circumstances.
4.2 Calculate the allowable deductions available to individuals in a given situation.
• The tests used in determining the differences between employees and independent contractors are
explained and illustrated in example 4.25.
• The significance of the control test and the integration test in determining whether a taxpayer is
considered an employee or contractor is explained.
• The concept of negative gearing and the tax consequences are explained.
• An overview of a range of other employee-related deductions, including entertainment, clothing,
car expenses and income protection insurance is provided.
4.3 Apply the tax offsets that an individual is entitled to in a given situation.
• Figure 4.9 illustrates the two types of tax offsets — refundable or non-refundable — and the types
of tax credits.
• What a refundable and a non-refundable tax offset is, and how it results in a reduction in the
taxpayer’s tax payable is explained.
• The calculation of the non-refundable tax offsets, including the DICTO, LITO, LMITO, FITO and zone
tax offset is demonstrated.
• Example 4.26 illustrates the calculations required for DICTO.
• Example 4.27 illustrates the calculations required for SAPTO for a single taxpayer.
• How to calculate the following refundable tax offsets and credits, including franking credits in
respect of franked dividends, PAYG withholding tax, PAYG instalments paid and the private health
insurance tax offset is explained.
4.4 Calculate the tax payable or tax refund for individuals.
• How the main residence exemption applies where the property is partly used for income-producing
purposes and partly as a main residence is demonstrated.
• How the CGT exemptions and concessions apply in the case of a marriage breakdown is illustrated.
• An overview of the CGT small business concessions and how they apply to individuals is explained.
• The four small business concessions available to SBEs, which includes small business owners and
sole traders (individuals) who meet the requirements of a CGT SBE, are summarised in table 4.6.
• The superannuation obligations imposed on employers to make superannuation contributions on
behalf of their employees are explained.
• The difference between concessional and non-concessional superannuation contributions, their
respective caps and how they are taxed is explained.
• Tables 4.7 and 4.8 contain the concessional and non-concessional contribution caps for the
2021–22 tax year.
• How excess concessional superannuation contributions over the allowed cap are taxed, including
the carry-forward excess option is demonstrated.
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MODULE 4 Taxation of Individuals 281
• Table 4.9 contains the contribution bring-forward rules for the 2021–22 tax year.
• How superannuation benefits withdrawn by taxpayers from their superannuation fund are taxed
and the taxation differences between lump sum withdrawals and payments made in the form of an
ongoing income stream are explained.
• The steps in calculating a taxpayer’s tax payable are explained.
• The tax rates applicable for resident Australian taxpayers and non-residents taxpayers are provided
in tables 4.15 and 4.16.
• How to calculate the Medicare levy, including understanding the rules surrounding the Medicare
levy exemption and reductions is explained and demonstrated.
• The thresholds relating to a reduction in the Medicare levy for individuals families and Senior
Australians are outlined in tables 4.17, 4.18 and 4.20.
• A taxpayer’s liability for the Medicare levy surcharge, including being able to calculate the Medicare
levy surcharge payable for high income earners who do not maintain adequate private health
insurance, depending on their income level and age, is explained and demonstrated.
• Example 4.29 illustrated how the Medicare levy surcharge is calculated for a single taxpayer.
• How individuals with accumulated study and training support loans may be required to have
additional amounts withheld from the payments made to them is explained.
• Table 4.21 shows the repayment thresholds and repayment percentages (to be multiplied by
repayment income) for the 2021–22 income year.
• Example 4.30 illustrated the calculation of the tax payable for a resident individual taxpayer taking
into account the calculation of taxable income, tax payable, Medicare levy and tax offsets.
• Questions 4.16 and 4.17 require the calculation of the tax payable or tax refund for individual
taxpayers under a range of circumstances.
REVIEW
Module 4 focused on the taxation of individuals and in particular the concept of the tax equation. In
determining the tax payable by an individual, it is required firstly to ascertain their taxable income, which
is their assessable income less their entitlement to particular deductions, if any. Depending upon the level
of taxable income, tax will be applied, and from this will be deducted entitlement to any non-refundable
tax offsets. To this figure is added the Medicare levy and Medicare levy surcharge (if applicable) less any
refundable tax offsets and tax already paid. The end result, is the net tax payable/refundable.
The module began with defining particular types of assessable income. These include income from
foreign sources, dividends, interest, property, trusts and royalties. The inclusion of income from the sharing
economy was covered, as was the particular tax treatment of minors.
The module then discussed three particular income regimes. First was the tax treatment of termination
payments, including ETPs (including both life and death benefit termination payments), genuine redundancy payments and schemes. The rules relating to the taxation of unused annual leave and long service
leave payments were also illustrated.
Second was the discussion of the PSI regime, in particular the rules for determining whether income
is PSI and whether a taxpayer is conducting a PSB. The operation of the PSI rules was illustrated along
with the application of the method statement. Third was the discussion of the ESS provisions, including
both up-front and deferred taxation. A brief reference was also made to the application of ESS to start-up
companies.
A brief overview of the CGT provisions as they apply to individuals was provided, including the
operation of the main residence exemption, marriage breakdown rollover relief and the small business
concessions.
The taxation of individual superannuation was illustrated, including the taxation of superannuation
contributions, the operation of LISTO, as well as the taxation of superannuation benefits and nonsuperannuation annuities.
A short reference was made to individual allowable deductions including an examination of the
employee versus contactor test for deductions and various employment-related expenditure, negative
gearing and income protection.
A major section of the module then examined the most common tax offsets and rebates available to
individuals, including family situation rebates, rebates that limit the effective tax rate of a class of receipt,
rebates that increase the tax threshold of recipients, rebates that prevent double taxation and rebates that
encourage government policy.
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282 Australia Taxation
Finally, in calculating the tax payable for an individual, the tax rates for both residents and non-residents
were indicated along with the application of the tax-free threshold formula. Application of the Medicare
levy, Medicare levy exemption and Medicare levy surcharge were also discussed and illustrated.
REFERENCES
ATO 2019, ‘The sharing economy and tax’, accessed January 2022, www.ato.gov.au/General/The-sharing-economy-and-tax.
ATO 2020a, ‘Crowdfunding’, accessed January 2022, www.ato.gov.au/Business/Income-and-deductions-for-business/In-detail/Cr
owdfunding.
ATO 2020b, ‘Schedule 7 — Tax table for unused leave payments on termination of employment’, accessed February 2022, www.a
to.gov.au/Rates/Schedule-7—Tax-table-for-unused-leave-payments-on-termination-of-employment.
ATO 2020c, ‘Withdrawing and using your super’, accessed January 2022, www.ato.gov.au/Individuals/Super/Withdrawing-and-us
ing-your-super.
ATO 2021a, ‘Contribution caps’, accessed January 2022, www.ato.gov.au/Super/Self-managed-super-funds/Contributions-and-roll
overs/Contribution-caps/#Concessional_contributions.
ATO 2021b, ‘Excess concessional contribution charge’, accessed accessed January 2022, www.ato.gov.au/rates/key-superannuatio
n-rates-and-thresholds/?page=3.
ATO 2021c, ‘Foreign residents Medicare levy exemption’, accessed February 2022, www.ato.gov.au/Individuals/Medicare-and-pri
vate-health-insurance/Medicare-levy/Medicare-levy-exemption/Foreign-residents-Medicare-levy-exemption.
ATO 2021d, ‘Income thresholds and rates for the Medicare levy surcharge’, accessed January 2022, www.ato.gov.au/Individuals/
Medicare-and-private-health-insurance/Medicare-levy-surcharge/Income-thresholds-and-rates-for-the-Medicare-levy-surcharge.
ATO 2021e, ‘Income thresholds and rates for the private health insurance rebate’, accessed January 2022, www.ato.gov.au/Individ
uals/Medicare-and-private-health-insurance/Private-health-insurance-rebate/Income-thresholds-and-rates-for-the-private-healthinsurance-rebate.
ATO 2021f, ‘Investment income’, accessed January 2022, www.ato.gov.au/Individuals/Income-and-deductions/Income-you-mustdeclare/Investment-income.
ATO 2021g, ‘M1 Medicare levy reduction or exemption 2021’, accessed February 2022, www.ato.gov.au/Individuals/Tax-return/2
021/Tax-return/Medicare-levy-questions-M1-M2/M1-Medicare-levy-reduction-or-exemption-2021.
ATO 2021h, ‘Managed investment trusts’, accessed January 2022, www.ato.gov.au/Individuals/Investments-and-assets/Managed-i
nvestment-trusts.
ATO 2021i, ‘Medicare levy exemption’, accessed February 2022, www.ato.gov.au/Individuals/Medicare-and-private-health-insura
nce/Medicare-levy/Medicare-levy-exemption.
ATO 2021j, ‘Study and training loan repayment thresholds and rates’, accessed February 2022, www.ato.gov.au/Rates/HELP,-TSL
-and-SFSS-repayment-thresholds-and-rates.
Bevacqua, J, Marsden, S, Morton, E, Xu, L, Devos, K & Whait, R 2022, Australian Taxation, 2021–22 Tax Update Edition, John
Wiley & Sons, Milton.
Department of Health 2020, ‘PHI24/20 Private health insurance rebate adjustment factor effective 1 April 2020’, accessed
January 2022, www.health.gov.au/phi-2420-private-health-insurance-rebate-adjustment-factor-effective-1-april-2020.
Services Australia 2021, ‘Age pension. Who can get it?’, accessed February 2022, www.servicesaustralia.gov.au/who-can-get-agepension?context=22526.
The Treasury 2009 Reform of the Taxation of Employee Share Schemes, Consultation Paper, Australian Government,
Canberra, p. 49.
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MODULE 4 Taxation of Individuals 283
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MODULE 5
TAXATION OF VARIOUS
TYPES OF ENTITIES
OTHER THAN
INDIVIDUALS
LEARNING OBJECTIVES
After completing this module, you should be able to:
5.1 evaluate the tax implications for eligible small business entities based on the available tax concessions
5.2 determine a partner’s share of the net partnership income or partnership loss and the tax implications from
an alteration of a partner’s interest
5.3 determine the net income or loss of a trust and the tax implications on distribution of the net income of
a trust
5.4 determine the tax payable for a resident company in a given situation
5.5 apply the principles of the imputation regime including the franking of distributions in a given situation
5.6 determine the tax implications of contributions received by a superannuation fund and the fund earnings.
LEGISLATION AND CODES
• Corporations Act 2001 (Cwlth)
• Income Tax Assessment Act 1936 (Cwlth) (ITAA36)
• Income Tax Assessment Act 1997 (Cwlth) (ITAA97)
• Income Tax Rates Act 1986 (Cwlth)
PREVIEW
This module considers the taxation of various types of entities other than individuals. Specifically, the
module discusses the taxation consequences of small business entities (SBEs), partnerships, trusts,
companies and superannuation funds.
To begin, the module explains the definition of an SBE, including the various tax concessions available
to SBEs.
The taxation of partnerships is also covered, including the concept of the net income. The most important
element about determining partnership income is that each partner is taxed in their individual capacity on
their share of the net income of the partnership, whether it is distributed to the partner or not.
The module next discusses the taxation of trusts. How trusts are taxed is governed by the provisions
in Division 6 of ITAA36. Under what situations these provisions potentially tax the trustee and/or the
beneficiaries of a trust will vary, depending on the individual facts. However, under the provisions, the
trust itself will not be taxed because, unlike a company, a trust (as opposed to its trustee and beneficiaries)
is not regarded as an entity that is subject to tax.
Pdf_Folio:285
Companies are treated as a separate taxation entity and must lodge a company tax return. For the year
ending 30 June 2022, the company tax rates are 25 per cent (for base rate entities) and 30 per cent (for all
other companies). Corporate tax entities that receive a franked distribution directly are required to include
the franking credit attached to the distribution in their assessable income. The module also provides an
overview of the dividend imputation system that applies when dividends are paid by a resident company
to a resident individual shareholder.
Superannuation is taxed at three points: on entry into the fund (via contributions made by the member
or an employer on behalf of the member), on earnings (usually taxed at 15 per cent while in the fund) and
upon exit from the fund, which is the retirement phase.
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286 Australia Taxation
PART A: TAXATION OF VARIOUS TYPES OF
ENTITIES OTHER THAN INDIVIDUALS
INTRODUCTION
Part A of this module discusses the taxation of SBEs and partnerships.
In module 2, we defined an SBE for taxation purposes. The first section, ‘SBE concessions core
concepts’, identifies the various eligibility requirements and the various thresholds available to determine
the different types of SBE for different types of tax concessions.
Figure 5.1 summarises Part A’s content related to the taxation of SBEs.
FIGURE 5.1
Taxation of SBEs
Taxation of SBEs
SBE tests
25% tax rate for companies
that are base rate entities
Simplified trading stock rules
Simplified depreciation
Certain start-up expenditure
CGT small business
concessions
Small business income
tax offset
Small business restructure rollover
Source: CPA Australia 2022.
The second section of Part A, ‘Calculating the small business income tax offset’, looks at core concepts
of partnerships, including income and loss, partner taxation and altering partner shares.
Figure 5.2 summarises Part A’s content related to the taxation of partnerships.
FIGURE 5.2
Taxation of partnerships
Taxation of partnerships
Core concepts
Tax status
Determining partnership
income or loss
Partnership income
tax return
Non-commercial
loss
Determining partner’s
share of tax
Salary
Alteration of
partner’s interest
Interest payable
Source: CPA Australia 2022.
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MODULE 5 Taxation of Various Types of Entities Other Than Individuals 287
5.1 SBE CONCESSIONS CORE CONCEPTS
REFRESHER ON THE DEFINITIONS OF SBE
Table 5.1 summarises the different types of SBEs, the different threshold amounts, and the type of taxation
law that applies to each amount.
TABLE 5.1
Refresher on SBE definitions and tax treatments
Title
SBE
Carrying on a
business
The entity must
be ‘carrying on a
business’ (ITAA97,
s. 328-110(1)). An
entity will also be
taken to be carrying
on a business if it
winds up a business
that it formerly
carried on, and it
was an SBE for
the income year in
which it stopped
carrying on the
business (ITAA97,
s. 328-110(5)).
Aggregated turnover test
Taxation area and study
guide reference
The SBE aggregated turnover
test is $10 million.
Simplified trading stock —
module 2.
Aggregated turnover is the
sum of the annual turnover
of the income year, the
annual turnover of any entity
connected with the main entity
during the income year, and the
annual turnover of an affiliate
(ITAA97, s. 328-115).
Immediate 100% deduction
for capital expenditure for
a proposed business. This
includes costs incurred in
obtaining professional advice
or services relating to the
structure or operation of the
proposed business as well as
a tax, charge or fee paid to an
Australian government agency
relating to the establishing
or ongoing structure of the
business — module 2.
From 1 July 2020, businesses
that are not small businesses
because their turnover is
$10 million or more but less
than $50 million can also
access an immediate deduction
for certain start-up expenses
and for prepaid expenditure
where the prepayment covers a
period of 12 months or less and
ends in the next income year —
module 2.
From 1 July 2021, non-SBEs
with a turnover between
$10 million and $50 million may
also be eligible to access these
small business concessions:
• simplified trading stock rules
• pay-as-you-go (PAYG)
instalments concession
• a two-year
amendment period.
Depreciation (capital
allowances regime). Different
turnover thresholds and
eligible periods apply for the
new/updated capital allowance
concessions — module 2.
Goods and services tax (GST)
simplified registration and
reporting — module 6.
PAYG instalments
concession — module 6.
Fringe benefits tax (FBT) from
1 April 2022 — module 6.
Company tax rate of 25% for
base rate entities for the year
ended 30 June 2022.
SBE (for the
purposes of the
small business
income tax offset
(SBITO))
Must carry on
a business.
$5 million aggregated
turnover test.
Eligibility for SBITO — see
‘Calculating net small business
income for the small business
income tax offset’.
Capital gains tax
(CGT) SBE
Must carry on
a business.
$2 million aggregated
turnover test.
CGT concessional treatment as
outlined in ITAA97,
Division 152— module 3.
Source: CPA Australia 2022.
Definitions
Section 995-1 of ITAA97 defines a business as including ‘any profession, trade, vocation or calling’. In
the majority of cases, it’s very clear whether or not a business is being carried out. It’s not always certain
though, especially when the activity is carried out as ancillary or as a side activity to the individual’s
main income. The criteria for meeting the business entity test are presented in the section ‘Carrying on a
business’ in module 2.
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288 Australia Taxation
Aggregated turnover is the sum of the annual turnover of the income year, the annual turnover of
any entity connected with the main entity during the income year and the annual turnover of an affiliate
(ITAA97, s. 328-115).
COMPANY TAX RATES
There are two company tax rates in Australia. For the year ended 30 June 2022, companies that are base
rate entities apply a 25 per cent flat company tax rate. A base rate entity is defined in s. 23AA of ITRA86
as a company with:
• an aggregated turnover of less than $50 million for the 2021–22 income year
• no more than 80 per cent of its assessable income as base rate entity passive income. This income
includes dividend income and franking credits on such dividends, interest income, royalties and rental
income, net capital gains and distributions from partnerships and trusts, to the extent it is referable to an
amount that is otherwise passive income (ITRA86, s. 23AB).
All other companies — that is, those that do not meet the requirements to be classified as a base rate
entity — are taxed at a flat rate of 30 per cent.
Sole traders, partnership and trusts do not qualify for the 25 per cent base entity tax rate as these legal
structures are not companies. Where applicable, the profit is taxed at the marginal tax rate of the respective
individual taxpayer.
REFRESHER ON TRADING STOCK AND CAPITAL ALLOWANCE
RULES FOR SBES
Table 5.2 presents an overview of the optional simplified trading stock rule for SBEs. Refer back to the
section ‘Trading stock concessions for SBEs’ in module 2 for more information.
TABLE 5.2
SBE simplified trading stock rules
Rule
Description
Application
Trading stock
concession
Where the difference
between the value of
opening stock and the
estimated value of closing
stock is $5000 or less.
Under these rules the taxpayer does not have to:
• conduct a stocktake at the end of the income year
• account for any changes in the value of the trading stock.
In other words, the value of the opening stock may be kept
as the value of the closing stock.
The taxpayer is required to record how they estimated the
value of the closing stock, but does not have to notify the
Australian Taxation Office (ATO) of how they have chosen to
apply the estimate.
Note: The optional simplified trading stock rules outlined above apply to SBEs (i.e. those entities with an aggregated turnover of
less than $10 million). However, from 1 July 2021 businesses that are not small businesses because their turnover is $10 million or
more but less than $50 million will also be able to access this concession.
Source: CPA Australia 2022.
Table 5.3 presents an overview of the capital allowance rules that can be used by SBEs. Refer back to
the section ‘Capital allowance rules for SBEs’ contained in module 2.
TABLE 5.3
Capital allowance rules applicable to SBEs
Rule
Description
Application
Temporary full
expensing
On 6 October 2020, in the Federal Budget, the federal
government announced that businesses with an annual
turnover of less than $5 billion (including SBEs) will
be able to claim an immediate deduction for the full
(uncapped) cost of an eligible depreciating asset
purchased on or after 7.30 pm on 6 October 2020 and
first used or installed by 30 June 2023 in the year the
asset is first used or is installed ready for use. This is
what is referred to as ‘temporary full expensing’.
An eligible depreciable asset or any
new depreciable asset or the cost
of an improvement to an existing
eligible asset.
For those businesses with an
aggregated annual turnover of less
than $50 million, the asset can be a
second-hand asset.
(continued)
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MODULE 5 Taxation of Various Types of Entities Other Than Individuals 289
TABLE 5.3
(continued)
Rule
Description
Application
Temporary full
expensing
An eligible entity can make an irrevocable election to
opt out of temporary full expensing for an income year
on an asset-by-asset basis if they are not using the
simplified depreciation rules. The election is made
in the tax return for the income year to which the
choice relates.
Eligible assets do not include:
• assets allocated to a low-value
pool or a software development
pool
• certain depreciating primary
production assets, including water
facilities, fencing, horticultural
plants or fodder storage assets
• buildings and other capital works
that fall under the provisions of
Division 43
• assets that either will never be
located in Australia or will not be
used principally in Australia in
carrying on business.
As a result of the temporary full expensing rules and the
fact that there is no instant asset write-off threshold,
small businesses (i.e. those with aggregated annual
turnover of less than $10 million) can fully deduct the
balance of their simplified depreciation pool at the end
of the income year while full expensing applies (i.e. up
to 30 June 2023). Hence, where an entity acquires an
eligible depreciating asset any time during the 2021/22
income year, the entity will be able to claim a deduction
for the full cost of the depreciating asset.
Source: CPA Australia 2022.
REFRESHER ON CGT CONCESSIONS FOR SBES
As discussed in module 3, there are four CGT small business concessions for certain SBEs. These are
separate to the small business restructure rollover discussed in detail in section ‘Small business restructure
rollover’ in this module.
There are four specific concessions available that allow qualifying SBEs to disregard or defer part or all
of a capital gain from an active asset used in a small business. The first requirement is that the asset must
be an active asset to meet the concessions.
A CGT asset is an active asset if the taxpayer owns it, and:
• the taxpayer, their affiliate or an entity connected to them uses it, or holds it ready for use, in the course
of carrying on a business (whether alone or in partnership)
• it is an intangible asset (e.g. goodwill) inherently connected with a business they carry on (whether alone
or in partnership).
Shares in a resident company and interests in a resident trust may be active assets in certain circumstances. Note that where the capital gain has arisen from a sale (or other CGT event) of shares in a company
or units in a trust, there are additional conditions that need to be fulfilled for CGT small business concession
eligibility. Certain CGT assets cannot be active assets, even if they are used or held ready for use in the
course of carrying on a business — for example, assets whose main use is to derive rent (see module3
‘CGT small business concessions’).
A CGT asset must also satisfy the active asset test under s. 152-35(1) of ITAA97. The active asset test
is met if:
(a) you have owned the asset for 15 years or less and the asset was an active asset of yours for a total of at
least half of the period specified in subsection (2) or
(b) you have owned the asset for more than 15 years and the asset was an active asset of yours for a total
of at least 7½ years during the period specified in subsection (2) (ITAA97, s. 152-35(1)).
The entity must be a CGT SBE for the income year with an aggregated turnover of less than $2 million,
or it must meet the maximum net asset value test under s. 152-15 of ITAA97. Under this test, the entity
(including related entities or affiliates) must have net assets of no more than $6 million (excluding personal
use assets such as a home, to the extent that it hasn’t been used to produce income).
The small business concessions are summarised in table 5.4. Additional examples showing the application of the CGT concessions are provided after this table.
TABLE 5.4
CGT SBE concessions
Rule
Description
15-year
exemption
If the business has continuously owned an active asset for 15 years and the taxpayer is aged
55 or over, and is retiring or permanently incapacitated, there will not be an assessable capital
gain upon sale of the asset.
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290 Australia Taxation
50% active
asset reduction
Reduction of the capital gain on an active asset by 50%. This is in addition to the 50% CGT
discount if applicable.
Retirement
exemption
Capital gains from the sale of active assets are exempt up to a lifetime limit of $500 000. If the
taxpayer is under 55, the exempt amount must be paid into a complying superannuation fund
or a retirement savings account.
CGT
replacement
asset rollover
concession
All or part of the capital gain can be subject to a rollover where the taxpayer makes an election
to do so. The small business rollover allows the taxpayer to defer all or part of a capital
gain made from a CGT event happening to an active asset. However, if such an election is
made, then by the end of two years after the CGT event, the amount subject to the rollover
must have been used for the acquisition of a replacement active asset, and/or for incurring
expenditure on making capital improvements to an existing active asset. If this is not the case
then, in effect, the rollover will be reversed and the taxpayer will be subject to a CGT liability.
Source: CPA Australia 2022.
Example 5.1 illustrates the application of the CGT small business 15-year exemption in relation to the
sale of an active asset by an SBE.
EXAMPLE 5.1
15-Year Exemption
Nathan and Mary are partners in a partnership that conducts a coffee wholesale business on commercial
land they purchased in 1990 and have owned continuously since that time. Assume that the net value of
their CGT assets for the purpose of the maximum net asset value test is less than $6 million.
Nathan and Mary are both over 60 years old and wish to retire. As they have no children, they decide to
sell the major asset of the wholesale commercial business, namely, the land. They sell the land, which
results in a gross capital gain of $870 000. They elect not to roll over these sale proceeds into their
respective superannuation funds.
Consider whether Nathan and Mary will qualify for the small business 15-year exemption in relation to
the capital gain and how this would impact on their assessable income.
Both Nathan and Mary qualify for the small business 15-year exemption in relation to the capital gain
as they are both over 55 years of age and have continuously owned the business for more than 15 years.
Consequently, the capital gain is not included in their assessable income.
Example 5.2 illustrates the application of the 50 per cent active asset reduction of a capital gain on the
sale of an asset by an SBE.
EXAMPLE 5.2
50 Per Cent Active Asset Reduction
Tony Ryan, aged 48, operated a car-washing business for 10 years as a sole trader. On 2 May 2022,
Tony sold the business for $950 000 and made a gross capital gain of $300 000. Assume that Tony has
prior-year capital losses totalling $40 000.
Assuming all the conditions for the 50 per cent active asset reduction are met, Tony’s assessable capital
gain for the 2021–22 tax year would be calculated as follows.
$
Gross capital gain
Less: Prior years capital losses
Less: 50% general CGT discount (> 12 months)
Less: 50% small business reduction
Assessable capital gain
300 000
40 000
260 000
130 000
130 000
65 000
65 000
This $65 000 capital gain may be further reduced by the small business retirement exemption or small
business rollover, or a combination of both (if applicable).
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Example 5.3 illustrates the application of the retirement exemption of a capital gain on the sale of an
asset by an SBE upon retirement.
EXAMPLE 5.3
Retirement Exemption
Suppose, using the information in example 5.2, that Tony Ryan was aged 60 when he sold the car-washing
business and that he used the sale proceeds to roll into his complying superannuation fund in order to
fund his retirement. Tony had not previously used any of his lifetime CGT retirement limit.
In this situation, Tony would be eligible for small business retirement relief if he elects so in writing, as
the resulting net capital gain of $65 000 (after applying the 50 per cent CGT discount and the 50 per cent
small business CGT reduction) is less than the CGT retirement limit of $500 000.
As Tony is aged 60, he can disregard the $65 000 gain and is not required to contribute that amount to a
complying superannuation fund or retirement savings account. Thereafter, Tony’s lifetime CGT retirement
limit will be reduced to $435 000 ($500 000 – $65 000).
Example 5.4 illustrates the application of the CGT replacement asset rollover concession that applies
to SBEs.
EXAMPLE 5.4
CGT Replacement Asset Rollover Concession
Anne McDonough sold the premises from which she had operated her small business (a bookshop) since
2001, deriving a gross capital gain of $450 000.
As Anne satisfies the basic conditions for the CGT small business concessions, and has elected to
use the rollover concession, this capital gain is reduced by the 50 per cent general CGT discount to
$225 000 and, secondly, by the 50 per cent small business reduction to $112 500, which is then subject
to the rollover.
If Anne acquires a replacement CGT active asset within the replacement asset period, she can disregard
the $112 500 capital gain.
Assume that at the end of the two-year replacement period, Anne has only spent $72 500 acquiring a
CGT replacement active asset and a CGT event J6 occurs. Consequently, Anne will incur a capital gain
of $40 000 (i.e. the difference between the original capital gain rolled over of $112 500 and the amount of
expenditure incurred on the replacement asset of $72 500).
QUESTION 5.1
Neil and Sue are considering selling their coffee shop, Coffee on the Run, a partnership which they
operate as 50/50 partners. They have been operating their coffee shop for the past six years.
Over the past six years, the coffee shop had an annual turnover of between $1 million and
$1.4 million per annum. The company’s net assets are $800 000 (consisting exclusively of plant and
equipment used in their coffee shop).
If they sell their coffee shop, they estimate that they will generate a gross capital gain of $600 000.
Neil is currently 56 years of age and Sue is currently 52 years of age. When you ask, Sue advises
you that she has previously rolled over $200 000 into her superannuation fund from the sale of a
small business that she operated herself and sold in 2005.
Neither Neil or Sue have any plans to buy another business nor do they have any capital losses
carried forward in their own personal names.
(a) Determine if Neil and Sue meet the criteria as a small business for the purposes of the CGT
small business concessions.
(b) Assuming that they meet the basic conditions contained in s. 152-10, are they eligible for the
15-year exemption contained in Subdivision 152-B?
(c) Assuming that they meet the basic conditions contained in s. 152-10, are they eligible for the
50 per cent active asset reduction concession contained in Subdivision 152-C?
(d) Assuming that they meet the basic conditions contained in s. 152-10, are Neil and Sue eligible
for the retirement exemption contained in Subdivision 152-D? If so, what other conditions, if
any, must be satisfied before it can be accessed?
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292 Australia Taxation
5.2 CALCULATING THE SMALL BUSINESS INCOME
TAX OFFSET
WHAT IS THE SMALL BUSINESS INCOME TAX OFFSET?
The small business income tax offset (SBITO) reduces the tax paid by an eligible sole trader or SBE
by up to a maximum of $1000 each year. The offset is calculated using the proportion of tax payable
on business income. This offset is also known as the ‘unincorporated small business tax discount’ (see
ITAA97, Subdivision 328-F).
This non-refundable offset, which is worked out on the proportion of tax payable on business income,
is 16 per cent for the 2021–22 income year.
To be eligible for the offset, the taxpayer must be carrying on a small business as a sole trader or
have a share of net small business income from a partnership or trust. It is not available to incorporated
entities, namely companies. The small business must have an aggregated turnover of less than $5 million
(ATO 2020b).
The formula for calculating the small business tax offset is contained in s. 328-360(1) of ITAA97 and
is as follows.
(
)
Your total net small business income for the income year Your basic income tax
16% ×
×
liability for the year
Your taxable income for the income year
CALCULATING NET SMALL BUSINESS INCOME FOR
THE SBITO
Net small business income for the purposes of the SBITO is the sum of the assessable income from eligible
business activities minus deductions. It is not calculated on gross income.
The offset is applied to the net small business income earned as a small trader, or the individual’s share
of net small business income from a partnership or trust. If the net small business income is a loss, it is
treated as zero for the purposes of the application of the SBITO. In that case, there is no offset available.
If the taxpayer generated eligible business income from more than one sole trader or partnership during
the income year, then they must combine all of the assessable business income from all their sole trader
businesses, minus the deductions from that income, to determine eligibility.
If carrying on more than one business, and any of these made a loss, the non-commercial losses rules
must first be applied. Net small business income is only reduced by losses deductible in the current year.
To work out net small business income, start with the net business income or loss. Increase this amount by
any deferred non-commercial losses not deductible in the current year.
The non-commercial loss rules are discussed in ‘Non-commercial loss rules’ in module 2.
ELIGIBLE INCOME AND DEDUCTIONS
The following can be included in net small business income for the purposes of the offset:
• farm management deposits claimed as a deduction
• repayments of farm management deposits included as income
• net foreign business income that relates to sole trading business
• other income or deductions such as interest or dividends derived in the course of conducting your
business (ATO 2019a).
The following types of income cannot be included in net small business income for the purposes of
the offset:
• net capital gains you made from carrying on your business
• personal services income (unless you were a personal services business)
• salary and wages
• allowances and director’s fees
• government allowances and pensions
• interest and dividends unless it is related to a business activity
• interest earned on a farm management deposit (ATO 2019a).
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MODULE 5 Taxation of Various Types of Entities Other Than Individuals 293
Furthermore, the following deductions cannot be included in net small business income for the purposes
of the offset:
• tax-related expenses, such as accounting fees
• gifts, donations or contributions
• personal superannuation contributions
• current year business losses which are not deductible this year under the non-commercial loss rules
• tax losses from prior years (unless they are deferred non-commercial losses, as discussed in module 2)
(ATO 2019a).
Example 5.5 demonstrates the calculation of the SBITO for a sole trader.
EXAMPLE 5.5
Calculating the SBITO
For the year ended 30 June 2022, Lucy derived $65 000 in assessable income from eligible business
activities in her work as a freelance public relations consultant. She operates as a sole trader and does
not have any other sources of income. She has $18 000 deductions (all allowable for calculating net small
business income).
Lucy’s eligible income for calculating the tax offset is $47 000 ($65 000 – $18 000). Tax payable on
$47 000 for the 2021–22 tax year is $5742 (excluding the 2 per cent Medicare levy). The Medicare levy is
not included in computing the small business tax offset.
The rate of the small business tax offset for the 2021–22 tax year is 16 per cent. The amount of Lucy’s
small business tax offset is calculated as follows.
SBITO = 16% ×
(
$47 000
$47 000
)
× $5742 = $919 (rounded)
Note that Lucy would also be eligible for the low income tax offset (LITO) and the low and middle
income tax offset (LMITO), discussed in module 4. However, this does not affect the calculation of the
small business tax offset, which is based on the tax liability before tax offsets and rebates.
QUESTION 5.2
Lucian runs a small accounting practice as a sole trader, Ballarat Accounting, and has operated in
the same premises for eight years. During the 2021–22 income year, Lucian generated assessable
business income of $250 000. He employs a part-time bookkeeper who is paid a salary of $25 000.
His eligible allowable deductions (excluding the bookkeeper’s salary) totalled $130 000.
Lucian has no spouse or any children and holds private health hospital insurance. As such, he is
not liable for Medicare Levy Surcharge.
During the 2021–22 income year, Lucian received unfranked dividends of $20 000 from ASX
publicly listed companies in respect of investments that he owns in his own name.
Ballarat Accounting’s annual aggregated turnover in the previous financial year was $220 000.
(a) Determine if Lucian is eligible to be an SBE and a CGT SBE.
(b) Calculate the amount of SBITO Lucian will receive in 2021–22.
5.3 SMALL BUSINESS RESTRUCTURE ROLLOVER
WHAT IS THE SMALL BUSINESS RESTRUCTURE ROLLOVER?
The small business restructure rollover allows small businesses to transfer active assets from one entity
(the transferor) to one or more other entities (the transferees) without incurring an income tax liability
(including, but not limited to, CGT).
The small business restructure rollover allows small businesses to transfer active assets from one entity
(the transferor) to one or more other entities (transferees), on or after 1 July 2016, without incurring an
income tax liability. The operation of the rollover is contained in Subdivision 328-G of ITAA97 and applies
to small businesses with an aggregated turnover of less than $10 million.
The following is a summary of the small business restructure rollover. It is discussed in more detail in
the section ‘Rollover provisions and other reliefs’ in module 3.
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294 Australia Taxation
WHO CAN ACCESS THE ROLLOVER?
The rollover will apply if each entity that is a party to the transfer event is (in the income year where the
transfer occurs):
•
•
•
•
a small business entity
an entity that has an affiliate that is a small business entity
an entity that is connected with a small business entity
a partner in a partnership that is a small business entity.
This means that an entity not carrying on a business, but holding assets for a small business entity, may
be able to apply the rollover; for example, where one entity owns a property in which another connected
entity is carrying on a business (ATO 2019b).
ELIGIBLE ASSETS
This rollover applies to active assets that are CGT assets, depreciating assets, trading stock or revenue
assets transferred between entities as part of a genuine restructure of an ongoing business.
Active assets are assets used, or held ready for use, in the course of carrying on a business.
The rollover is not available for any other business assets. Assets such as loans to shareholders of a
company are not active assets of the business carried on by the creditor, and as such are not eligible
(ATO 2019b).
WHEN IS THE ROLLOVER AVAILABLE?
The rollover is available when the:
• entity is an applicable SBE or related entity
• rollover is part of a genuine restructure (not an artificial or tax-driven scheme)
• rollover must not result in a change to the ultimate economic ownership of the transferred assets.
Determining a Genuine Restructure
The rollover is available where the transfer of assets forms part of a genuine restructure as opposed to an
artificial or inappropriately tax-driven scheme.
Determining whether a restructure is ‘genuine’ depends on all the facts surrounding the individual
restructure.
According to paragraph 6 of Law Companion Ruling LCR 2016/3, a ‘genuine restructure of an ongoing
business’ is one that could be reasonably expected to deliver benefits to small business owners in respect
of their efficient conduct of the business. This incorporates an arrangement whereby the restructure is
undertaken to facilitate growth, innovation and diversification, adapt to changed conditions, or reduce
administrative burdens, compliance costs and/or cash flow impediments for the business. As a result, the
small business continues to operate, albeit in the form of a different legal structure. A genuine business
restructure does not apply to small business owners who are in the process of winding down the business
or realising their ownership interests.
No Change to Ultimate Economic Ownership
The restructure must not result in a change to the ultimate economic