Chapter 2 Assessable Income National Core Accounting Publications

Chapter 2 Assessable Income © National Core Accounting Publications 1

Overview Definition of assessable income Assessable income consists of ordinary income and statutory income – s. 6 -1(1). Ordinary income means income according to ordinary concepts – s. 6 -5(1) Statutory income is any amount which is not ordinary income and which is assessable because of a specific ITAA section – s. 6 -10 © National Core Accounting Publications 2

Ordinary Income • Tax legislation refers only to “income according to ordinary concepts. ” • Case law has identified the factors which indicate whether a receipt has the characteristics of ordinary income. © National Core Accounting Publications 3

Ordinary Income Examples of ordinary income: Gross wages/salary Business income such as sales or fees for services rendered Rental income Gross interest © National Core Accounting Publications 4

Principles of Assessability Need to consider the following factors: Residency Source of income Capital vs. Income receipts Derivation Exempt status © National Core Accounting Publications 5

Residency A individual resident Australian taxpayer is a person: • whose permanent home is in Australia, or • who has continuously or intermittently been in Australia for more than half of the income year, unless their usual home is outside Australia. © National Core Accounting Publications 6

Residency The ATO considers a person to be an Australian resident for tax purposes if they have: • always lived in Australia or live here permanently, or, • been in Australia continuously for 6 months or more and have been in the one job and lived at the same place • been in Australia for more than half of the financial year. © National Core Accounting Publications 7

Residency The ATO uses residency tests to work out residency status for tax purposes. Test When to apply Resides Primary test - if a person resides in Australia according to the ordinary meaning of the word, there is no need to apply any of the other three tests Domicile Statutory tests - if a person doesn't satisfy the “resides test” (the primary test), they may still be considered an Australian resident if they satisfy one of the three statutory tests 183 day rule Superannuation © National Core Accounting Publications 8

Residency status guidelines If a person: they are generally: goes overseas temporarily and does not set up a an Australian resident for tax purposes. permanent home in another country is an overseas student enrolled in a course that is an Australian resident for tax purposes. more than six months long at an Australian institution is visiting Australia for more than six months and for an Australian resident for tax purposes. most of that time they live at the same place, and they either have or establish ties in the local community is visiting Australia for more than six months, and for not an Australian resident for tax purposes. most of that time they are travelling and working in various locations around Australia is either holidaying in Australia or visiting for less than not an Australian resident for tax purposes. six months migrates to Australia and intend to reside here an Australian resident for tax purposes. permanently leaves Australia permanently not treated as an Australian resident for tax purposes from the date of their departure. holds a temporary visa granted under the Migration considered to be a temporary resident of Australia and Act 1958 and neither they nor their spouse are will only be liable to pay Australian income tax on residents as described in the Social Security Act 1991 income they derive in Australia. However, as a temporary resident, their worldwide income may be assessable in some cases. © National Core Accounting Publications 9

Illustration: Resident for Tax Purposes Mee Kong, a Malaysian citizen, has been in Australia for 10 months on a working holiday visa during the current income year. During that time she has been employed as a medical research scientist and has lived in a rented apartment in Melbourne. Required: Determine whether Mee Kong is a resident of Australia for tax purposes. Solution: Mee Kong is a resident of Australia for tax purposes. Her behaviour during the time spent in Australia reflects a degree of continuity, routine or habit that is consistent with residing here as she has both resided and worked at the one location. © National Core Accounting Publications 10

Illustration: Non-resident for Tax Purposes Giovanni is an Italian citizen. He has been in Australia for the entire current income year on a working holiday visa. To help cover his living expenses during this time he has held several short-term part-time jobs in different locations whilst travelling around Australia. Required: Determine whether Giovanni is a resident of Australia for tax purposes. Solution: Giovanni is a not resident of Australia for tax purposes. Although Giovanni has obtained employment, by travelling from place to place he has not established a pattern of habitual behaviour, even though he has been physically present in Australia for twelve months. His main purpose for being in Australia is to have a holiday and he is merely supplementing his savings by working. © National Core Accounting Publications 11

Source of income Will often determine the assessability of receipts when linked with residency. As a general rule an Australian resident taxpayer is assessed on their worldwide sources of income. © National Core Accounting Publications 12

Derivation of income The question of when income is derived depends on the nature of the income and, in some cases, on the nature of the incomeearning activities of the taxpayer who derived the income. Capital vs. Income receipts • Covered in Chapter 4 Exempt status • Covered in Chapter 3 © National Core Accounting Publications 13

General Principles Resident • are assessed on income Australian derived in Australia and taxpayers overseas Non • are assessed only on income derived within resident taxpayers Australia © National Core Accounting Publications 14

Non-cash receipts The following non-cash business receipts are assessable: • Barter transactions • Non-cash business benefits ≤ $300 in value • Non-cash fringe benefits to employees (subject to Fringe Benefits Tax) © National Core Accounting Publications 15

Determination of Assessability © National Core Accounting Publications 16

Illustration: Determination of Assessability Su Lin has the following receipts: Dividends $200 Gross wages $40, 000 Cash received as Chinese New Year present $100 Required: Identify which of the above receipts are assessable income? Quote the relevant ITAA section where applicable. Solution: Dividends: Does a specific ITAA section apply? Yes, therefore Assessable income, s. 44(1) ITAA 36. Gross wages: Does a specific ITAA section apply? No, go to Step 2. Does s. 6 -5(1) apply? Yes, Assessable income, s. 6 -5(1). Present: Does a specific ITAA section apply? No, go to Step 2. Does s. 6 -5(1) apply? No, go to step 3. Not assessable (no section applicable). © National Core Accounting Publications 17

Income from Business defined s. 995 -1(1) defines a business as “any trade, profession, calling or vocation, but not as an employee. ” This is not a precise definition, so need to consider factors arising from case law. © National Core Accounting Publications 18

Commercial basis test Case law has led to the “commercial basis test” Is the activity being gone about in a commercial/ business-like manner? The following factors need to be looked at: • Profitability. • Size. • Effort. • Business records. © National Core Accounting Publications 19

Identifying a Business Indicators which suggest a business is being carried on Indicators which suggest a business is not being carried on A significant commercial activity Not a significant commercial activity Purpose and intention of the taxpayer in engaging in the activity No purpose or intention of the taxpayer to carry on a business activity The activity is or will be profitable The activity is inherently unprofitable Repetition and regularity of activity Little repetition or regularity Activity is carried on in a similar manner to that of the ordinary trade Activity carried on in an ad hoc manner Activity organised and carried on in a businesslike manner and systematically – records are kept Activity not organised or carried on in the same manner as the normal ordinary business activity – records are not kept Size and scale of the activity Small size and scale Not a hobby, recreation or sporting activity A business plan exists There is no business plan Commercial sales of product Sales of products to relatives and friends Taxpayer has knowledge or skill Taxpayer lacks knowledge or skill © National Core Accounting Publications 20

Business vs. Hobby Sometimes an activity carried out by a taxpayer may be regarded as something less than a business for tax purposes (i. e. a hobby). Business Hobby • Income is assessable, and expenses are generally deductible • Income is not assessable, and expenses are not deductible © National Core Accounting Publications 21

Business vs. Hobby Gambling and Betting Wins It is very rare that betting and gambling wins form part of a taxpayer’s taxable income. Only a handful of persons have been held to be carrying on a business of gambling/betting. © National Core Accounting Publications 22

Business vs. Hobby Prizes and Awards Lottery and competition wins are regarded as windfall gains and are generally not assessable. However, prizes and awards received as an incident of the taxpayer’s income producing activities are assessable under s. 6 -5(1) or s. 15 -2. © National Core Accounting Publications 23

Receipts for cancellation/ variation of business contracts Illegal business activities Bounties and subsidies Specific Types of Business Receipts Refunds and recoveries of previously deducted items Insurance recoveries Foreign Exchange gains © National Core Accounting Publications 24

Income from Personal Services Direct compensation • is assessable income under s. 6 -5(1) whether received in the capacity of employee or otherwise. e. g. wages, salaries, fees, commission. © National Core Accounting Publications 25

Income from Personal Services Allowances in relation to employment or services rendered: Are assessable income under s. 15 -2. e. g. travel allowances, bonuses, uniform allowances, tool allowances, tips received in recognition of services provided. © National Core Accounting Publications 26

Income from Personal Services Voluntary payments or gifts are assessable if a product of employment or services rendered, even if paid by a third party. e. g. tips received for services provided. Mere gifts such as a birthday present are not assessable. © National Core Accounting Publications 27

Income from Personal Services Compensation receipts are assessable under s. 6 -5(1). e. g. weekly or other periodical payments of worker’s compensation payments for whole or partial loss of wages. Fixed lump sum payments are not assessable. © National Core Accounting Publications 28

Compensation Receipts Life assurance policy reversionary bonuses Reversionary bonuses under life assurance policies are exempt (tax-free) where the policy has been held for 10 or more years. When a life assurance policy has been held by a taxpayer for less than 10 years, reversionary bonuses received on that policy are assessable as follows: all the bonus amount if received during the first eight years of the policy. • 2/ of the bonus if received in the ninth year. 3 • 1/ of the bonus if received in the tenth year. 3 The taxpayer may be entitled to a non-refundable tax offset when life policy bonuses are included as part of assessable income. The tax offset is equal to 30% of the assessable bonus amount. © National Core Accounting Publications 29

Illustration: Life Assurance Policy Reversionary Bonus Bruce surrendered his life assurance policy in year 9 of the policy. It has a $9, 000 bonus. His assessable investment income was $64, 000. Required: Calculate taxable income and tax payable. Solution: Taxable Income is: Assessable income: Investment income Reversionary bonus (9, 000 x 2/3) Tax payable is: Tax on $70, 000 less Tax offset (6, 000 x 30%) Medicare Levy (70, 000 x 2%) Balance Payable © National Core Accounting Publications $ 64, 000 6, 000 70, 000 $ 14, 297. 00 1, 800. 00 12, 497. 00 1, 400. 00 13, 897. 00 30

Income from Property and Foreign Income Specific examples of income from property are: • • • Interest Rental income Royalties Dividends Employee share schemes © National Core Accounting Publications 31

Dividends are assessable under s. 44(1) ITAA 36. Dividends may be franked or unfranked. Tax implications: Unfranked Dividends • are assessable income © National Core Accounting Publications 32

Franked Dividends Taxable Income • Are fully assessable • A franking credit is attached • Calculated as follows: • Franked dividend amount x 30/70 Tax Payable • A Franking tax offset is allowed equal to the Franking credit amount © National Core Accounting Publications 33

Dividends Franked Dividends: § The franking tax offset is a refundable tax offset. § Individual taxpayers are entitled to a refund where their franking tax offsets exceed their tax payable. © National Core Accounting Publications 34

Illustration: Treatment of Dividends During the current income year Rafa Hazeez, a resident taxpayer, has a gross salary of $68, 000 (PAYG tax withheld $15, 100), a fully franked dividend of $2, 000, an unfranked dividend of $1, 000, and a 60% franked dividend of $900. There are no deductions. Required: Calculate income and tax payable: Solution: Taxable Income is: Assessable income: Gross Salary Fully franked dividend Franking credit ($2, 000 x 30/70) Unfranked dividend 60% franked dividend Franking credit ($900 x 60% x 30/70) Taxable income Tax payable is: Tax on $72, 988 Medicare Levy (2% x 72, 988) less Franking tax offset 1, 000 231 72, 988 $ 15, 268. 10 1, 459. 76 16, 727. 86 15, 639. 86 less PAYG tax withheld Balance Payable 539. 86 © National Core Accounting Publications $ 68, 00 2, 000 857 900 1, 088. 0 15, 100. 0 35

Illustration: Refund of Franking Credits Gryffn, a resident taxpayer, has taxable income of $5, 000 consisting of a franked dividend of $3, 500 and a $1, 500 franking credit. Required: Calculate tax payable. Solution: Tax payable is: Tax on $5, 000 less Low income tax offset $445 but limited to nil less Franking tax offset Refund due © National Core Accounting Publications $ Nil Nil 1, 500 36

Employee Share Schemes (ESS) An ESS is a scheme under which shares are provided to an employee or their associates in relation to the employee’s employment. Generally, the difference between the market value of the ESS and what the employee paid is assessable. © National Core Accounting Publications 37

Employee Share Schemes (ESS) $1, 000 upfront tax concession If an employee’s adjusted taxable income is ≤ $180, 000 only the amount in excess of $1, 000 is assessable. © National Core Accounting Publications 38

Illustration: ESS with Up-Front Tax Concession Newt paid $800 for 800 shares in 2014/15 under an ESS. The market value at the date of allotment of the shares was $2. 45 per share. Newt’s adjusted taxable income in 2014/15 was $100, 000. Required: Calculate the amount assessable in the 2014/15 income year. Solution: Assessable income is: (800 x $2. 45) – 800 = $1, 160 less $1, 000 up-front concession = $160 © National Core Accounting Publications 39

Illustration: ESS Without Up-Front Tax Concession Geoff Wonderful paid $2, 000 for 500 shares in 2014/15 under an ESS. The market value at the date of allotment of the shares was $7. 00 per share. Geoff’s adjusted taxable income in 2014/15 was $300, 000. Required: Calculate the amount assessable in the 2014/15 income year. Solution: Assessable income is: (500 x $7. 00) – 2, 000 = $1, 500 There is no $1, 000 upfront concession because taxable income is in excess of $180, 000. © National Core Accounting Publications 40

Foreign Income Foreign income is “income derived from sources in a foreign country. ” Australian resident taxpayers are assessed on foreign income unless a specific exemption applies. © National Core Accounting Publications 41

Foreign Income © National Core Accounting Publications 42

Tax treatment of foreign income Grossing up of foreign income: The net amount of assessable foreign income is grossed -up by the amount of foreign tax paid on that income by the taxpayer and is included as part of assessable income. Foreign Income Tax Offset: To avoid double taxation, a tax offset is allowed for the foreign tax paid. © National Core Accounting Publications 43

Illustration: Grossing-up of Foreign Income During the year, Alan, a resident Australian taxpayer, worked continuously in Greece for 3 months. He received AUD$23, 000 net wages and paid AUD$4, 000 foreign tax. Required: Calculate Alan’s assessable foreign income. Solution: Alan’s assessable foreign income is the foreign wages (grossed up) of $27, 000. © National Core Accounting Publications 44

Foreign income tax offset Calculation § If foreign tax paid is ≤ $1, 000 The foreign income tax offset is equal to the amount of foreign tax paid. i. e. no calculation is necessary. © National Core Accounting Publications 45

Foreign income tax offset Calculation § If foreign tax paid is > $1, 000 The foreign income tax offset is the greater of: $1, 000, and The amount of income tax payable less the amount of tax that would be payable if s. 77575(4) assumptions were made. © National Core Accounting Publications 46

Foreign income tax offset Calculation: Where foreign tax paid is > $1, 000 the taxpayer may elect to claim a FITO of only $1, 000. © National Core Accounting Publications However, any excess is lost. 47

Illustration: FITO – foreign tax paid is less than $1, 000 Rebecca, an Australian resident taxpayer, derived $5, 000 investment income from Nigeria upon which $750 foreign tax was paid. Required: Calculate the foreign income tax offset. Solution: No calculation is required as the foreign taxes paid are less than $1, 000. The taxpayer simply claims the available amount of offset. Therefore, the FITO is $750. © National Core Accounting Publications 48

Illustration: FITO – foreign tax paid is more $1, 000 Vitaly, an Australian resident taxpayer, derived $9, 000 investment income from Russia upon which $2, 000 foreign tax was paid. Required: Calculate the minimum claimable foreign income tax offset. Solution: As the foreign tax paid exceeds $1, 000 the taxpayer may elect to claim a FITO of only $1, 000. Therefore, the minimum claimable FITO is $1, 000. Note that any excess over $1, 000 is lost. © National Core Accounting Publications 49

Illustration: FITO under s. 770 -75(4) formula Chen, an Australian resident taxpayer, derived AUD$8, 000 net dividend income from Spain upon which AUD$4, 000 foreign tax was paid. His assessable Australian source income was $76, 000. He has AUD$1, 000 deductions relating to the income from Spain and $5, 000 deductions relating to Australian source income. Chen has adequate private health insurance. Required: (a) Calculate taxable income. (b) Calculate the foreign income tax offset using the s. 770 -75(4) assumptions. (c) Calculate tax payable. © National Core Accounting Publications 50

Solution: Assessable income Australian source income Foreign income (grossed up) $ 76, 000 12, 000 88, 000 less Deductions Foreign deductions Australian deductions Taxable income 1, 000 5, 000 82, 000 Foreign Income Tax Offset is: Step 1 Australian tax payable on $82, 000 Step 2 Australian tax payable under s. 770 -75(4) formula: Disregarded assessable income is the foreign income of $11, 000 (12, 000 - 1, 000). Therefore, 82, 000 less 11, 000 = $71, 000 Tax on $71, 000 Step 3 Tax payable at Step 1 less Tax Payable at Step 2 Foreign Income Tax Offset limit 18, 287. 00 14, 622. 00 3, 665. 00 As the foreign tax paid of $4, 000 is greater than the FITO limit ($3, 665), the available FITO is the calculated limit (i. e. $3, 665. 00). However, had the amount of foreign tax paid been less than the FITO limit, the available offset would have been the amount of foreign tax paid. Tax Payable is: Tax on $82, 000 less Foreign Income Tax Offset Medicare Levy © National Core Accounting Publications $ 18, 287. 00 3, 665. 00 14, 622. 00 51 1, 640. 00

Converting foreign income to Australian dollars All foreign income, deductions and foreign tax paid must be converted to Australian dollars for tax purposes. There are two ways of doing this. Depending upon the circumstances, the taxpayer can use: • the exchange rate prevailing at the time of the transaction – the general transaction rule. • an average exchange rate. © National Core Accounting Publications 52

Converting foreign income to Australian dollars General transaction rule Under the general translation rule, all tax-relevant amounts must be translated into Australian currency. This enables all gains and losses to be calculated using a common unit of measurement. The general translation rule applies regardless of whether the foreign income is remitted to Australia or not. © National Core Accounting Publications 53

Converting foreign income to Australian dollars Average Exchange Rate A taxpayer can choose to translate an amount into Australian currency using an exchange rate that is an average of the exchange rates applicable during a period (which may be less than, but not exceeding, 12 months). However, an average rate cannot be used unless the average rate is a reasonable approximation of the exchange rates that would otherwise be applicable if the taxpayer had used spot rates at the specific translation times provided for by forex legislation. © National Core Accounting Publications 54