SENATE

Revised Explanatory Memorandum

(Circulated by authority of the Treasurer, the Hon Peter Costello, MP) THIS MEMORANDUM TAKES ACCOUNT OF AMENDMENTS MADE BY THE HOUSE OF REPRESENTATIVES TO THE BILL AS INTRODUCED

Chapter 4 - Accounting method for Simplified Tax System taxpayers

Outline of chapter

4.1 This chapter explains the new accounting method (referred to as the cash accounting method) for STS taxpayers as it applies to ordinary income and general deductions. This method ensures that taxable income of an STS taxpayer broadly includes:

•

ordinary income when received ; and

•

general deductions when paid .

4.2 Two specific expenses, tax-related expenses and expenses for repairs, are also deductible when paid (see paragraph 4.21). This is because these expenses are recurrent expenses of carrying on a business.

4.3 Under this accounting method an STS taxpayer will not be required to bring to account, at year end, income from sales for which payment has not been received (debtors). Similarly, business expenses owing (creditors) at year end will not be deductible until paid. This also means that the cash accounting method does not extend to statutory income and most specific deductions.

4.4 Certain adjustments to ordinary income, general deductions and deductions for tax-related expenses and repairs are required when a business starts (entry adjustment rules) or stops (exit adjustment rules) being an STS taxpayer. These adjustments are a consequence of the cash accounting method for STS taxpayers.

4.5 The entry adjustment rules ensure that the transition to the cash accounting method does not result in business income and expenses being recognised twice or omitted. Refer to paragraphs 4.33to40 for details.

4.6 The exit adjustment rules ensure that the transition from the cash accounting method does not result in omission of business income and expenses. Refer to paragraphs 40 to 40 for details.

Context of reform

4.7 The cash accounting method is designed to provide for greater alignment with the cash basis of accounting for GST.

4.8 Under the cash accounting method, ordinary income is recognised when received and general deductions and deductions for tax-related expenses and repairs are allowable when paid. A business which records all sales, purchases and payment of expenses in a cash book will be able to determine its income tax liability largely from its cash flow records, if it enters the STS. This is because the new cash accounting method allows STS taxpayers to recognise ongoing business income (ordinary income) when received and ongoing business expenses (general deductions and deductions for tax-related expenses and repairs) when paid.

4.9 The effect of the cash accounting method is that it modifies the taxing point of most business income and expenses for STS taxpayers. The adjustment rules ensure that when a business enters or leaves the STS, the change in the taxing point of business income and deductions does not give rise to double counting or omissions.

4.10 The entry and exit adjustment rules only apply to ordinary income, general deductions and deductions for tax-related expenses and repairs of an STS taxpayer.

Comparison of key features of new law and current law

Example 4.1: How an STS taxpayer will be able to relate its tax liability with cash book records

Yash runs a plumbing business and is an STS taxpayer in the 2002-2003 income year.

He has received payment of $80,000 from various jobs during the year.

He completed a job on 29 June 2003 worth $1,000 but has not been paid as yet.

He has paid business expenses of $30,000 during the year.

He owes $2,000 for materials that he ordered on 30 June 2003.

Business income (ordinary income) that is owed to Yash, but has not yet received ($1,000), will not affect his tax liability for the 2002-2003 income year. This is because the cash accounting method recognises ordinary income only when it is received.

Similarly, business expenses (general deductions) that he owes for materials ordered ($2,000), which he has not yet paid for, will also not affect Yashs tax liability for the 2002-2003 income year. This is because the cash accounting method recognises general deductions when they are paid.

Yashs cash book, for the 2002-2003 income year, shows the flow of business funds as follows:

Business receipts (ordinary income)	$80,000
Less business expenses (general deductions)	($30,000)
Flow of business funds as per cash book	$50,000

Yashs tax liability as an STS taxpayer is calculated as follows:

Ordinary income received	$80,000
Less general deductions paid	($30,000)
Taxable income	$50,000

Detailed explanation of new law

Advantages of cash accounting

4.11 The cash accounting method minimises compliance costs for STS taxpayers because, for tax purposes, they will not be required to recognise sales for which payment has not been received . On the deductions side, they will not be required to recognise expenses that they have not paid .

4.12 In many instances the cash accounting method allows STS taxpayers with ordinary income from sales and day to day business expenses to work out their taxable income using their cashbook and bank statements. This method provides for greater alignment with the cash basis of accounting used for GST.

Ordinary income is recognised when received

4.13 An STS taxpayer applies section 6-5 of the ITAA 1997 so that ordinary income is taken to be derived only when it is received [Schedule 1, item 1, paragraph 328-105(1)(a)] . This means that an STS taxpayer is required to work out ordinary income in accordance with section 6-5 but only include amounts of ordinary income that have been received . The practical effect of this provision is that STS taxpayers are taxable on business income received , not on income owing from customers or clients. This enables them to relate their tax liability with inflow of business funds.

4.14 Broadly, ordinary income of a business includes ongoing business or trade income received whilst operating a business. Examples of ordinary income are income from sales of goods and/or services, professional fees and commissions. Statutory income, such as net capital gain from the sale of an asset, is not affected by the cash accounting method.

4.15 Another practical effect of paragraph 328-105(1)(a) is that where an STS taxpayer receives a payment that relates to services provided over the next few weeks, but which extend over to the next financial year, the income is taxable in the year that it is received . The main advantage of this rule is that (again) it allows STS taxpayers to relate their tax liability with flow of business funds.

Ordinary income applied or dealt with on behalf of an STS taxpayer is taken to have been received

4.16 Ordinary income that is applied or dealt with on behalf of an STS taxpayer is taken to have been received . This is the current tax treatment of ordinary income, for all taxpayers (subsection 6-5(4) of ITAA 1997).

Ordinary income not received by an STS taxpayer may still be assessable

4.17 If an amount of ordinary income has not been, and will not be, received by an STS taxpayer, it is not assessable under the cash accounting method [Schedule 1, item 1, paragraph 328-105(2)(b)] . This is because the cash accounting method only recognises income when received.

4.18 In some circumstances, such as when a debt is forgiven, an STS taxpayer may be assessable on a benefit or gain that has not been received . In such cases, income tax laws outside the STS provisions continue to apply. In other words, income that does not meet the received rule as required by the cash accounting method, may be assessable according to general concepts.

Example 4.2: How income not received by a taxpayer is assessable outside the STS rules

Dominic is an STS taxpayer who operates a boat making business. He owes $25,000 to another business who supply him with boat engines for his business.

Dominic agrees to make a boat in return for the debt of $25,000 to be forgiven.

The cash accounting rules do not recognise the benefit or gain to Dominic because he has not received that amount.

If the $25,000 is considered to be ordinary income applied on behalf of Dominic it will be assessable under subsection 6-5(4) of the ITAA 1997.

If the $25,000 is not considered to be ordinary income applied on behalf of Dominic (i.e. if subsection 6-5(4) does not apply), it will be assessable as income according to ordinary concepts - when it is derived.

General deductions are allowed when paid

4.19 An STS taxpayer applies section 8-1 of the ITAA 1997 so that the expenses are taken to be incurred only when they are paid [Schedule 1, item 1, paragraph 328-105(1)(b)] . This means that an STS taxpayer is required to work out general deductions in accordance with section 8-1 but only claim those amounts of general deductions that have been paid. The practical effect of this provision is that STS taxpayers can claim deductions for business expenses paid, not for amounts owed to suppliers. This enables them to relate their tax liability with outflow of business funds.

4.20 Another practical effect of paragraph 328-105(1)(b) is that where an STS taxpayer makes a payment for goods or services that may relate to a few weeks, but which extend over to the next financial year, the expense is deductible in the year that it is paid. The main advantage is that it (again) allows STS taxpayers to relate their tax liability with flow of business funds.

Certain specific deductions are also allowed when paid

4.21 Two specific deductions, namely tax-related expenses and expenses for repairs, are also deductible for STS taxpayers when they are paid [Schedule 1, item 1, paragraph 328-105(1)(b)] . These deductions are currently allowable for business when they are incurred. This rule has been modified for STS taxpayers so that most commonly used business expenses are deductible for STS taxpayers at the time they are paid.

General and certain specific deductions paid on behalf of an STS taxpayer are taken to have been paid

4.22 General deductions and deductions for tax-related expenses and repairs that are paid on behalf of an STS taxpayer are taken to have been paid . This rule is consistent with the tax treatment of ordinary income applied on behalf of an STS taxpayer. Refer to paragraph 40 for details.

A deduction for expenses not paid by an STS taxpayer may still be available

4.23 If an amount of general deduction, a tax-related expense or an expense for repairs has not been, and will not be, paid by an STS taxpayer, it is not deductible under the cash accounting method [Schedule 1, item 1, paragraph 328-105(2)(c)] . This is because the cash accounting method only recognises deductions when paid.

4.24 In some circumstances, such as loss from theft, an STS taxpayer may be allowed a deduction for a loss or outgoing that has not been paid. In such cases, income tax laws outside the STS provisions continue to apply. In other words, a deduction that does not meet the paid rule as required by the cash accounting method, may be deductible according to general concepts.

Example 4.3: How an amount not paid by an STS taxpayer is deductible outside the STS rules

Poh-Lee is an STS taxpayer who operates a delicatessen. She recognises income of the business by making a daily entry in her electronic cash book at the end of every trading day.

Poh-Lee is robbed while she is going to the bank to deposit the shops takings from the day before.

She loses $1,000 which was recognised as business income the day before.

Poh-Lees insurance does not cover loss of cash from theft and she does not recover the stolen amount.

The cash accounting method does not recognise the loss as it was not paid .

Poh-Lee can deduct the stolen amount, outside the STS rules, as a loss or outgoing under general concepts of the income tax law.

Cash accounting method does not affect statutory income and specific deductions

4.25 The cash accounting method (i.e. ordinary income is assessable when received and general deductions are allowable when paid ) does not extend to statutory income and specific deductions (other than tax-related expenses and repairs - see paragraph 4.21).

4.26 Statutory income is an amount that is not considered to be ordinary income but is included in assessable income by a specific provision of the income tax law. An example of statutory income, relevant to business, is a capital gain resulting from the sale of an asset. Specific provisions of income tax law bring such types of income to account which would otherwise not be assessable at specific times (see Division 102 of the ITAA 1997). The cash accounting method does not affect the operation of statutory income provisions. Those provisions continue to operate, for STS taxpayers, exactly as they do for all other taxpayers. The taxing point for statutory income of STS taxpayers will continue to be determined by the relevant provision of the income tax law.

4.27 A specific deduction is made allowable by a particular provision (outside of the general deduction provision) of the income tax law. Such deduction provisions allow an amount to be deducted from assessable income that may not have been allowable under the general deduction provision. An example of a specific deduction, for business, is expenditure incurred by a primary producer to install mains electricity supply. Specific deduction provisions currently allow a deduction for such capital expenses which would otherwise not be deductible at specific times. The STS timing rules do not affect the operation of specific deduction provisions. Those provisions continue to operate for STS taxpayers, exactly as they do for all other taxpayers.

Cash accounting method does not override specific rules about ordinary income, general deductions and deductions for tax-related expenses and repairs

4.28 The cash accounting method does not apply to ordinary income, general deductions, and deductions for tax-related expenses and repairs if another provision of the income tax law includes an amount or allows the deduction at a different time [Schedule 1, item 1, paragraph 328-105(2)(a)] . That is, if the taxing point of an amount of ordinary income, general deduction or a deduction for tax-related expenses and repairs is modified by another provision of the income tax law, that taxing point overrides the received and paid rules under the cash accounting method.

4.29 On the income side, this means that if another provision of the income tax law (other than section 6-5 of the ITAA 1997) specifically defers or brings forward the taxing point for a particular type of ordinary income, the timing rule in the specific provision overrides the received rule for STS taxpayers.

4.30 An example of an amount of ordinary income to which another timing rule applies is profit on the sale of a second wool clip within the one income year because of a natural disaster. The taxing point for such an amount is deferred by section 385-135 of the ITAA 1997. That section would override the received rule under the cash accounting method. This means that the STS taxpayer may elect to defer the taxing point even though the income has been received. Refer to Example 40 to see how paragraph 328-105(2)(a) applies.

4.31 On the deduction side, this means that if another provision of the income tax law (other than sections 8-1, 25-5 or 25-10 of the ITAA 1997) apportions or alters the deductibility of a particular type of general deduction, the timing rule in the specific provision overrides the paid rule for STS taxpayers.

4.32 An example of a general deduction to which another timing rule applies is prepayments made by an STS taxpayer for a magazine subscription for a period of 2 years.

Example 4.4: When an STS taxpayer recognises various types of income and deductions using the new cash accounting method

Ellita conducts a primary production business. She chooses to become an STS taxpayer in the 2002-2003 income year.

Most of the years business transactions consist of ordinary income and general deduction amounts. The cash accounting method ensures that these transactions are only recognised when they are received and paid.

For the 2002-2003 income year only, Ellita receives $200,000 from sales.

She is owed $2,000 by a customer who pays her on a monthly basis.

She will receive $5,000 (from the sale of shares) on 1 July 2003. The shares were sold on 29 June 2003 and settlement is expected on 1 July 2003. Ellita has calculated that she is assessable on a net capital gain of $800.

Due to a drought in the area, Ellita was required to shear sheep earlier than usual. Ellita made a profit of $10,000 on that second wool clip. She elects to defer the profit to the next income year.

Ellita has business expenses of $160,000 but of that amount has paid only $150,000.

Ellita also paid $500 for tax-related expenses on 10 June 2003.

She owes $1,000 for repair of farm equipment. She has not paid this amount as yet.

Ellita also owes $20,000 for upgrading the supply of mains electricity on her farm. She is committed to paying this expense in the 2003-2004 income year.

Under the cash accounting method for STS taxpayers, Ellita includes $200,000 (ordinary income) in her assessable income because it has been received. She does not include the $2,000 owed to her because she has not received it as yet.

She includes the net capital gain of $800 (statutory income), from disposal of shares because the capital gains tax event took place in the 2002-2003 income year even though she has not received it as yet. The cash accounting method does not apply to the net capital gain as it is not ordinary income.

Ellita defers including the profit (of $10,000) on the second wool clip to the next income year (section 385-135 of the ITAA 1997). The cash accounting rules do not apply to this transaction, even though it is ordinary income. This is because another provision of the income tax law includes the amount at a different time.

Ellita claims business expenses (general deductions) of $150,000 because she paid them in the 2002-2003 income year. She does not claim a deduction for business expenses that she has not paid as yet ($10,000).

The payment of $500 for tax-related expenses is deductible because it has been paid. Ellita does not claim a specific deduction of $1,000 for repairs (specific deduction) because she has not paid for the expense as yet.

Ellita also claims $2,000 for upgrading the mains electricity supply because the cost is allowable, over 10 years, as a specific deduction (Subdivision 387-E ITAA 1997) for primary producers. The cash accounting method does not apply to this expense as it is a specific deduction, not a general deduction.

Entry adjustment rules when entering the STS

4.33 The entry adjustment rules ensure that business income and expenses, that have, or should have, been recognised prior to the business entering the STS, are not recognised again under the cash accounting method when they are received and paid or omitted. [Schedule 1, item 1, section 328-110]

Entry adjustment rules for ordinary income

4.34 The entry adjustment rules ensure that an amount of ordinary income that was:

•

derived but not received ; and

•

was assessable in an income year before entering the STS,

is not included again when it is received in a later year. [Schedule 1, item 1, subsection 328-110(2)]

4.35 Similarly, any income that is received, but not derived before entering the STS is included in assessable income in the year the taxpayer enters the STS. This is designed to address situations where payment has been received before entering the STS but the relevant services are not provided until a later time. [Schedule 1, item 1, subsection 328-110(3)]

4.36 The practical effect of these provisions is that when an STS taxpayer receives business income that was previously assessable (because it was recognised under the accruals system of accounting) it is not taxed again under the cash accounting method when the income is received. The provisions also ensure that income is not omitted.

Entry adjustment rules for general deductions

4.37 The entry adjustment rules ensure that a general deduction and a deduction for tax-related expenses and repairs that were:

•

incurred but not paid; and

•

were deductible in an income year before entering the STS,

are not deductible again when they are paid in a later year. [Schedule 1, item 1, subsection 328-110(4)]

4.38 Similarly, any expenses that you paid, but did not incur, before entering the STS are deductible in the year you enter the STS. [Schedule 1, item 1, subsection 328-110(5)]

4.39 The practical effect of these provisions is that when an STS taxpayer pays business expenses that were previously deductible (because they were recognised under the accruals systems of accounting) they are not deductible again under the cash accounting method when the expenses are actually paid. The provisions also ensure that deductions are not omitted.

Entry adjustment rules for trading stock

4.40 The entry adjustment rules ensure that an outgoing for trading stock that was:

•

incurred and paid prior to entering the STS; and

•

was not deductible in that year because of section 70-15 of the ITAA 1997,

is deductible to an STS taxpayer during the year in which the item becomes part of trading stock on hand. [Schedule 1, item 1, subsection 328-110(6)]

4.41 The practical effect of this provision is that an STS taxpayer can claim a deduction for trading stock when it becomes part of stock on hand even though the stock had been paid for in an earlier year. This rule addresses situations where an STS taxpayer had purchased trading stock before entering the regime but could not claim a deduction due to the operation of section 70-15 of the ITAA 1997.

Exit adjustment rules when leaving the STS

4.42 The exit adjustment rules ensure that business income and expenses (that have not been recognised under the cash accounting method because they had not been received or paid) are recognised in the first year that a business is outside the STS (changeover year). [Schedule 1, item 1, section 328-115]

Exit adjustment rules for ordinary income

4.43 The exit adjustment rules ensure that an amount of ordinary income that was:

•

derived in an income year while the business was an STS taxpayer; and

•

was not included in assessable income because it had not been received,

is included in assessable income in the changeover year. [Schedule 1, item 1, subsection 328-115(2)]

4.44 The practical effect of this provision is that when an STS taxpayer leaves the STS, business income not brought to account under the cash accounting method (because it had not been received) is included in assessable income in the first year that the STS taxpayer is outside the STS.

4.45 The exit adjustment rules only apply to the first year that the business stops being an STS taxpayer. That is, all ordinary income derived, but not received by an STS taxpayer, is brought to account in the first year that the business is outside the STS.

Exit adjustment rules for general deductions

4.46 The exit adjustment rules ensure that a general deduction and a deduction for tax-related expenses and repairs that were:

•

incurred in an income year while the business was an STS taxpayer; and

•

were not deductible in that income year because they had not been paid,

are deductible in the changeover year. [Schedule 1, item 1, subsection 328-115(3)]

4.47 The practical effect of this provision is that when an STS taxpayer leaves the STS, any business expenses owing for which a deduction was not available under the cash accounting method (because they had not been paid) are deductible in the first year that the business is outside the STS.

4.48 Example 40 shows how the entry and exit adjustment rules ensure that ordinary income, general deductions and deductions for tax-related expenses and repairs are not recognised twice or omitted when a business enters and leaves the STS.

Example 4.5

Habibi enters the STS in the 2003-2004 income year.

Before entering the STS he used an accruals basis of accounting for tax purposes.

Habibi included amounts owing from customers as income derived in the 2002-2003 income year.

He also claimed deductions for business expenses outstanding at the end of the 2002-2003 income year.

The entry adjustment rule for ordinary income ensures that, when Habibi enters the STS, amounts owing from a previous year are not recognised again when received.

The entry adjustment rule for deductions ensures that expenses outstanding from a previous year are not recognised again when paid.

Habibi chooses to leave the STS in the 2005-2006 income year.

While he was an STS taxpayer he had derived ordinary income for which payment had not been received . Habibi did not include this amount as income as the cash accounting method does not recognise ordinary income until it is received .

While he was an STS taxpayer he had ordered business supplies but had not paid for them. Habibi did not claim a deduction for this expense as the cash accounting method does not recognise general deduction until they have been paid .

The exit adjustment rule for ordinary income ensures that Habibi includes in assessable income, amounts owing to him in the changeover year (2006-2007 income year).

The exit adjustment rule for deductions ensures that he can deduct expenses owed by him in the changeover year (2006-2007 income year).

Habibis time line

Consequential amendments

4.49 Notes are inserted in sections 6-5 and 8-1 of the ITAA 1997 to refer readers to the cash accounting regime for STS taxpayers. [Schedule 2, items 2 to 4]