Capital Gain Tax Consequences And Deductibility Of Expenses Under ITAA 1997 - Case Study

Read the case study base on Electronic Submission via Turnitin on Moodle and answer the following question :

1. Advise Cassandra Pty Ltd of the capital gains tax consequences of the above transactions for it. 
2. Advise Oscar Pty Ltd as to whether, and if so when and to what extent, any of the above expenditures that it incurs will be deductible to in for Australian income tax purposes. 
3. Advise Ernest Constructions Pty Ltd as to whether and, if so, when the instalment payments in relation to its contract with Oscar Pty Ltd will be included in its assessable income.

Section 100-35 of the Income tax Assessment Act 1997 defines Capital Gain and Capital Loss

1: The Division 100 of the Income tax Assessment Act 1997 provides a guide to the capital or losses. The section 100-35 of the Income tax Assessment Act 1997 provides that a capital gain is made if the amount received from the CGT event is more than the cost associated with that CGT event and if it is vice versa then it is capital loss. That means on selling a capital asset, real estate, shares or other such assets, a person, whether an individual or an organization with separate legal identity, generally makes a gain or loss; these are termed as capital gain or capital loss of such person. The difference between the cost of the asset that the person has incurred to acquire it and the amount that the person has received from the disposal of such asset is either capital gain or capital loss. When the amount received from the disposal of a capital asset is more than the cost incurred on acquiring such asset then the resultant will be capital gain. However, in case the cost incurred in acquiring the asset is more than the amount received on disposal of such asset then the resultant will be capital loss.

The Section 6-5 of Income Tax Assessment Act, 1997, provides the meaning of the ordinary income. It states that income according to ordinary concept should be treated as ordinary income. On the other hand, the section 6-10 of the Income Tax Assessment Act 1997 states that income that is not an ordinary income is a statutory income. The section 6-25(2) of the Income tax Assessment Act 1997 states that if an income is caught between ordinary and statutory income then the specific provision shall apply. Therefore, in accordance with the section 102-5 of the Income tax Assessment Act 1997 it can be said that the capital gain should be included in the assessable income as statutory income.

The Section 25-10 of ITAA provides that one can deduct expenditures incurred on repair and maintenance on a depreciating asset only if such asset has sole been used to generate or to produce assessable income. Thus, in case the sole purpose of the depreciating asset includes anything else apart from using it for generation and production of assessable income then the whole expenditures incurred on repair and maintenance of the asset would not be allowed as deduction for computation of assessable income of the taxpayer concern. According to sub-section, 2 of this section (25-10 of ITAA) in case the property was party used for income generation and party used for other purposes then proportionate amount of such expenditures shall be allowed as deduction for computation of such assessable income. No capital expenditure shall be allowed as deduction in computation of assessable income provided in sub section 3 of section 25-10 of ITAA.

Section 6-5 and 6-10 of Income Tax Assessment Act 1997 defines Ordinary Income and Statutory Income

In determining the capital gain the concept of first element costs has to be worked out in relation to a depreciating asset in accordance with the provision of section 40-180 of ITAA. According to the provision of this section the first element is,

• The amount specified in an item; or
• The amount that has been paid by the existing owner to hold the asset.

In this case, since the requirement is only about advising the client, i.e. Cassandra Pty Ltd of the capital gain tax consequences other consequences of taxation has been ignored in this part of the document in respect of tax liability of Cassandra Pty Ltd.

On the basis of the information provided in the case study Cassandra Pty Ltd has purchased a building inclusive of an attached building which had to be dismantled and demolished to construct a theatre for the company. After running its own theatre in the newly constructed theatre the Cassandra Pty Ltd decided to sale the theatre to another company. The sale proceeds from the disposal of the theatre will attract capital gain tax in accordance with the provisions of the ITAA, 1997.

Taking into consideration the financial transactions in relation to construction of theatre, land acquisition and subsequent disposal of the theatre the following calculation has made to ascertain the capital gain tax consequences of Cassandra Pty Ltd.

Table 1: Computation of capital gain

(Source: created by Author)

Thus, the capital gain of Cassandra Pty Ltd for the particular income year on sale of the theatre is $1343000.00. The cost construction, land acquisition cost, stamp duty charges, legal fees for purchasing the land, building demolition costs and interests for the duration of construction have been considered in calculating the cost base of theatre. Costs relating to theatre business have been ignored in computing the capital gain of the company as these are costs which would have been deducted if the assessable income of the company from theatre business was to be ascertained. As can be seen that the company will have to pay capital gain tax on $1343000.00, i.e. on the amount of capital gain it made on the sale of theatre.

2: The Income Tax Assessment Act 1997 under Division 8 discusses the deductibility of the expenses. The act classified allowable deduction as general deduction and specific deductions. The section 8-1 of the ITAA 97 states that a taxpayer is allowed to deduct the expenses from the assessable income to the extent the expenses is used for producing the assessable income or is incurred for carrying out the business.  The section 8-1(2) also mentions the expenses that are of capital, private or domestic nature are not allowed as deduction. There are certain deductions that are allowed under specific provisions of the act. This type of deduction is termed as specific deduction as per section 8-5 of the ITAA 97. The section 8-1 of the ITAA97 contains two limbs that allows the taxpayer to deduct the loss or outgoing from the assessable income. The first limb is the positive limb it is the expenses that is incurred for producing the assessable income by the taxpayer. The second limb is the negative limb that states the loss or outgoings is not allowed as deduction if it falls under any of the negative limb.  In this case, the expenses that are allowed under these sections are discussed by referring to the provisions of the act.

Section 25-10 of ITAA allows deduction for repair and maintenance on a depreciating asset used to generate or produce assessable income

The amount of $500000.00 incurred by Oscar, the payment of which was decided to be made in four equal installments over a period of 16 months of which though the company failed to pay last two installments will not be allowed as deduction in computation of assessable income of Oscar Pty Ltd as the expenditure is capital expenditure in nature. Thus, the expenditure will be added to the cost of theatre on which the company can claim depreciation. This depreciation would have been allowed as deduction in computation of the assessable income of the company from its theatre business. However, apart from that all the expenses incurred by the company for and only for the business of the theatre will be allowed as deduction in computation of assessable income of the company from its theatre business. Accordingly, the salary costs of $15000 per week to employees which include carpenter, stage and lighting technicians, finance manager and a marketing manager. The material expenses of $50000 to be used for construction of stage requiring for the play; and all the payments to be made to actors i.e. $500 per rehearsal and $1000 per performance will be allowed as deduction in computing the assessable income / loss from the theatre business of the company for the particular income year to which these relate.

Oscar Pty Ltd is an organization that is in the business of theatre and thus, all expenses incurred by the company in relation to the stage play and theatre will be allowed as deduction in computation of taxable income from theatre business provided these are expenditures revenue in nature. In case of capital expenditure such as construction or strengthening of the theatre building to protect from earthquake shall be added to the cost of building since the expenditure has strengthen the existing building and enhanced its life period by a certain margin and will protect the building from future earthquake like the one took place in Christchurch, New Zealand. Accordingly, the expenses incurred as discussed above for creating and developing plays to be performed in theatre will be allowed as deduction to compute the taxable income of the company from theatre business.

Table 2: Expenditure

(Source: created by Author)

3: The section 4-1 of the Income Tax Assessment Act 1997 provides that every individual, business or other entity is required to pay tax on their taxable income. The taxable income is calculated by deducting allowable deductions from the assessable income. The assessable income is classified into ordinary income and statutory income. The income according to the ordinary concept is treated as the ordinary income as per section 6-5 of the ITAA 97. The income that is not an ordinary concept should be treated as statutory income as per section 6-10 of the act. The individual is required to pay tax on the income that is accrued or received.   In accordance with the concept of ordinary income as provided in section 6-5 of ITAA 1997-failed installment by customers will not be considered as an ordinary income until unless the customers have paid the installments at a later stage. Thus, in this case the contact between Ernest Construction Pty Ltd and Oscar Pty Ltd provided that the later will made four equal installment of $125000 within a period of 16 months to the former. The former, i.e. Earnest Construction Pty Ltd will only be under an obligation to include the installments received from Oscar if the same has actually been received as provided in section 6-5 of ITAA 1997. Since in this case Oscar Pty Ltd has failed to make payment of the last two installments of $125000 to Earnest Construction Pty Ltd the later will obviously not include the installment in its revenue to ascertain its assessable income. The failed installments in-fact should be disclosed as bad debts in the books of accounts and shall be deducted from revenue, if already included, as bad debts to reduce its assessable income from business.    

Section 40-180 of ITAA provides a guide to the First Element Cost of a Depreciating Asset

However, if at a later date, in case the Oscar Pty Ltd made good of its failed installments by making payment in the future to Earnest Construction Pty Ltd. Then, the later shall include the installments received as revenue of the business to ascertain its assessable income form business for the income year in which the installments were to be paid.

Based on the above it is clear that only if at a future date Earnest Construction Pty Ltd gets to receive the installments of $125000.00 that Oscar Pty Ltd failed to pay during the income year to be ended on 30 June, 2018 then the same shall be included in assessable income of Earnest Construction Pty Ltd for the year in which the installments shall be received by the company.  

References:

Barkoczy, Stephen. "Core Tax Legislation and Study Guide." OUP Catalogue (2017).

Berk, Jonathon, Peter DeMarzo, Jarrod Harford, Guy Ford, Vito Mollica, and Nigel Finch. Fundamentals of corporate finance. Pearson Higher Education AU, 2013.

Brigham, Eugene F., and Michael C. Ehrhardt. Financial management: Theory & practice. Cengage Learning, 2013.

Bryan, Michael, Simone Degeling, Scott Donald, and Vicki Vann. A Sourcebook on Equity and Trusts in Australia. Cambridge University Press, 2016.

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

Kang, Chuen Tat. Full Legal Report in Victoria of Australia: Chuen-Tat Kang V Swinburne University of Technology Australia. Kang Chuen Tat, 2015.

Kang, Chuen Tat. Full Legal Report in Victoria of Australia: Chuen-Tat Kang V Swinburne University of Technology Australia. Kang Chuen Tat, 2015.

Kellow, Aynsley, and Marian Simms. "Policy change and industry associability: The Australian mining sector." Australian Journal of Public Administration 72, no. 1 (2013): 41-54.

Khanh Hung, Tran, and Nguyen Duc Hung. "State Financial Transfers in Environmental Protection: The Case of Vietnam." Journal of Economics and Development 16, no. 2 (2014): 93.

Kumar, Rajesh. Strategic Financial Management Casebook. Academic Press, 2017.

Kurtz, Jennifer A., Roland J. Cole, and Isabel A. Cole. "Citizens and E-Government Service Delivery: Techniques to Increase Citizen Participation." In Digital Literacy: Concepts, Methodologies, Tools, and Applications, pp. 910-931. IGI Global, 2013.

Mintrom, Michael, and Joannah Luetjens. "Design Thinking in Policymaking Processes: Opportunities and Challenges." Australian Journal of Public Administration 75, no. 3 (2016): 391-402.

Mitchell, Richard. "The Evolution of the Idea of a Labour Law Subject in Australian Legal Scholarship:(And What Was Regulating'Labour'or'Work'Before Labour Law as We Know it)?." (2017).

Mumford, Ann. Taxing culture: towards a theory of tax collection law. Routledge, 2017.

Sjostrom Jr, William K. Business Organizations: A Transactional Approach. Wolters Kluwer Law & Business, 2015.

Zagaris, Bruce. International white collar crime: cases and materials. Cambridge University Press, 2015.