LEGL602 Taxation Law

 1: On the basis of the accounting records and additional information about Bloomingdale Florists Pty Ltd, taxable profit of the company from business and resultant tax liability on such taxable income for the income year ending on June 30, 2018 are calculated below. The notes provided at the end of the calculation justify the tax treatments of different items to correctly calculate the taxable profit and tax liability of the company. 

 

Taxable income and tax liability of  Bloomingdale Florists Pty Ltd for the year ended on June 30, 2018
Particulars	Amount ($)	Amount ($)
Net profit as per books of accounts		126,000.00
Add: Expenditures not deductible and assessable income not included
Accounting depreciation (Tax depreciation shall be deducted)	12,000.00
Fines for misleading advertisement is not allowed deduction	5,000.00
Provision for long service leave is not allowed	20,000.00
Provision for doubtful debts not allowed as deduction	17,000.00
Replacement of rotten window with steel window is not revenue expenses	10,000.00
Painting expenses of Company premises is allowed as deduction	-
Gifts to Paramatta Eels League club is not allowed as deduction	10,000.00
Borrowing cost is not allowed as expenses as it is capital cost	3,000.00
Dividend from foreign resident company is taxable income	1,000.00
Unranked dividend from resident company is assessable income (9000 x 20%)	1,800.00
Directors' salary in excess of reasonable limits (50000 -40000)	10,000.00
		89,800.00
		215,800.00
Less: Expenditures not considered but allowed and income not assessable
Actual long service leave paid	10,000.00
Bad debt written off	15,000.00
Capital allowances allowed for tax purposes	10,000.00
Closing stock over valued (60000 -52000)	8,000.00
Annual amortization borrowing costs (3000/30	1,000.00
Exempt income not to be considered for assessable income	10,000.00
		54,000.00
Taxable income from business		161,800.00
Less: Unabsorbed income losses of previous year		20,000.00
Taxable income  after setting off unabsorbed losses		141,800.00

Demonstration of calculation process used in the table above is provided as notes below:

1. As per subdivision 83-B of Income Tax Assessment Act 1997 (ITAA 1997), provision for long term service leave is not allowed as deduction however, payment of such long service leave in cash is allowed as deduction for ascertaining taxable profit of business.
2. As per sec. 25.35 of ITAA 1997, bad debt written off is to be deducted from business revenue to calculate the profit from business liable to be taxed. Provision for bad debt is not an allowable expenditure in ascertaining income from business liable to be taxed.
3. Capital expenses are not allowed as deduction in computing taxable profit from business. Since, replacement of rotten wooden windows with steel windows are capital expenses hence, it is not allowed to be deducted for computing taxable profit from business.
4. Gifts to Paramatta Eels League is not allowed as expenditures of business.
5. Capital allowances for tax purposes amounting to $10,000 is to be treated accordingly.
6. Since the closing stock was taken at $60,000 instead of $52,000 hence, cost of goods sold is understated by $8,000. Hence, the same is to be added back to the accounting profit for taxable purpose.
7. Section 25.25 of ITAA 1997 provides that borrowing cost incurred at the time of borrowing is to be spread over the period of loan. Thus, the entire borrowing cost is not allowed as expenditure in computing taxable profit from business. Borrowing cost is to be spread over the loan period.
8. Outstanding trade debts is assessable income until unless there is substantial doubt as to the final recovery of such debt. Hence, the amount is correctly included in ascertaining taxable profit of the business. Income from retail sales is assessable income and needs to be included in calculation of assessable income. Since, it is already included in sales thus, there is no requirement to make any adjustment to the accounting profit for calculation taxable profit of business.
9. Unranked dividend and dividend receive from foreign companies are assessable income and to be considered for computing taxable income.      
10. Since, Tax Commissioner restrict the reasonable amount of salary for the directors at $40,000 thus, excess amount of salary is to be added back to accounting profit.
11. Unabsorbed losses of previous period is allowed to be set off against the business income of current year to ascertain the net taxable income of a business.

2: Issue:

The following are the issues in this case:

1. What is the tax implications of $1,000,000 received as compensation from one of the customers of Matchstick Limited for termination of contract?
2. Tax implications of profit of $10,000,000 from sale of land to Matchstick Limited.

Rules:

Div. 6 of Income Tax Assessment Act 1997 (ITAA 1997) provides that receipt of damages and compensation will be treated as ordinary or statutory income of business assessable for computation of taxable income. Eligible Termination Payments, here in after referred as ETPs, is considered as ordinary or statutory business income under div. 6 of ITAA 1997. However, compensation receipt as damages shall either be considered as ordinary income or capital gain depending on the circumstances of each case.

ITAA provides that practical consequences must be considered to characterize the receipts of compensation as ordinary income or capital gain. Income of capital gain is to be decided by considering the circumstances of each case.

The character of the compensation received for damages in the hand of the recipient shall be considered to characterize the compensation and its taxability. If the payment was to compensate of loss of income then the same would be considered as ordinary income. In case the payment was in capital account then the payment would be considered for capital gain.   

As per s6-5 of ITAA 1997, if the compensation is pertaining to income or to replace loss of profit then such compensations shall be considered as ordinary income (s6-5 of ITAA 1997) and accordingly, taxable as ordinary income. 

ATO provides that in case of assets sold by a business then, resultant profit or loss from such sale be considered as capital gain or capital loss for computation of tax liability of the business. A company is not allowed to use discount method to calculate capital from sale of non-current assets. In case of sale of land the proceeds received from sale shall be reduced by the cost of land to calculate the amount of capital gain.

Carapark Holdings Ltd v FCT (1967) 115 CLR 653, 660:

The above case ruling provides explanation as to the reason of treating of insurance claim received for death of one of the employees as income of the company. The factor to be considered is the character of the compensation. Thus, if the compensation is on revenue account then it is to be considered as ordinary income whereas if the same os on capital account then it will be considered as capital gain.   

Application:

Applying the provisions of s6-5 of ITAA 1997, the compensation received it is clear that one of the customers of Matchsticks Limited has paid a compensation of $1,000,000 for terminating the contract with the company. Since, the contract was to sale woods of the company in the ordinary course of business hence, the compensation paid by Strike a Light Pty Ltd is receipt to compensate the loss of ordinary revenue. Hence, the amount of compensation received by Matchsticks Limited is to be treated as ordinary income as per s6-5 of ITAA 1997. Accordingly, the amount of compensation received by Matchsticks Pty Ltd is ordinary income to be assessable as business income of the company, shall be taxed accordingly.        

The sale on profit of land though was not acquired with the objective or intention to sale at the time of acquisition but the resultant profit from sale of such land shall be treated as capital gain of the business. The company has realized a profit of $10,000,000 from sale of the land. Hence, the amount of capital gain from sale of land is $10,000,000 for the tax year ending on June 30, 2018. The company shall be liable to pay tax on its ordinary income as well as capital gain as per the applicable rate of tax.   

Conclusion:

As per the provisions of Income Tax Assessment Act 1997 (s6-5 of the act) the compensation of $1,000,000 receipt by Matchsticks Limited is in the nature of ordinary income to the company and shall be considered in calculating the business income of the company.

The realized gain from sale of land, i.e. $10,000,000 is capital gain of Matchstick Limited and shall be taxed accordingly in the hands of the company.

References:

Barnett, Katy, and Sirko Harder. Remedies in Australian private law. Cambridge University Press, 2014.

Borden, Bradley T. "Income-Based Effective Tax Rates and Choice-of-Entity Consideratins Under the 2017 Tax Act." (2018).

Burkhauser, Richard V., Markus H. Hahn, and Roger Wilkins. "Transitioning from an Historical to a Contemporary Use of Tax Record Data for Measuring Top Incomes in Australia." Economic Papers: A journal of applied economics and policy37, no. 2 (2018): 113-145.

Chardon, Toni, Brett Freudenberg, and Mark Brimble. "Tax literacy in Australia: not knowing your deduction from your offset." Austl. Tax F. 31 (2016): 321.

Eslake, Saul. "Reforming the Australian taxation system: a principled approach." Australian Financial Review Tax Reform Summit (2015).

Fry, Martin. "Australian taxation of offshore hubs: an examination of the law on the ability of Australia to tax economic activity in offshore hubs and the position of the Australian Taxation Office." The APPEA Journal 57, no. 1 (2017): 49-63.

Long, Brendan, Jon Campbell, and Carolyn Kelshaw. "The justice lens on taxation policy in Australia." St Mark's Review235 (2016): 94.

Mapp III, Richard C., John M. Peterson, and Robert Q. Johnson. "Qualified and nonqualified deferred compensation plans in small businesses: creative uses and problem solving." In Tax Conference (Marshall-Wythe School of Law). William and Mary Tax Conference, no. 63, pp. 1_1-1_26. College of William and Mary, Marshall-Wythe School of Law, 2017.

Richardson, Grant, Grantley Taylor, and Roman Lanis. "The impact of financial distress on corporate tax avoidance spanning the global financial crisis: Evidence from Australia." Economic Modelling 44 (2015): 44-53.

Richardson, Grant, Grantley Taylor, and Roman Lanis. "The impact of financial distress on corporate tax avoidance spanning the global financial crisis: Evidence from Australia." Economic Modelling 44 (2015): 44-53.

Woellner, Robin, Stephen Barkoczy, Shirley Murphy, Chris Evans, and Dale Pinto. "Australian Taxation Law 2016." OUP Catalogue (2016).