Supplementary Explanatory Memorandum(Circulated by authority of the Treasurer, the Hon Peter Costello, MP)
General outline and financial impact
The amendments, and the requests for amendments, will make the following changes to the Tax Law Improvement Bill 1997 ( the Bill ):
Proposal: To introduce specific rules for assets:
- that are converted into trading stock from another use or purpose; and
- that are taken from trading stock for another use or purpose.
Application: 1997-98 (and later) income years.
Financial impact: A revenue gain of approximately $30 million in 1998-99 and $25 million in each later income year.
Compliance cost impact: A small reduction in compliance costs.
Proposal: To ensure that the rewrite of the law allowing a deduction for expenditure on managing a taxpayers tax affairs correctly reflects the existing law.
Application: 1997-98 (and later) income years.
Financial impact: None.
Compliance cost impact: None.
Proposal: To remove from the Bill the rewrite of the exempt income provisions dealing with education and training payments that are to be amended by the Taxation Laws Amendment Act (No. 1) 1997
Application: 1997-98 (and later) income years.
Financial impact: None.
Compliance cost impact: None.
Chapter1 - Trading stock - changes in use
1.1 To request changes to Schedules 1 and 5 of the Bill to introduce rules covering assets that move into, or out of, a taxpayers trading stock.
1.2 Schedule 1 to the Bill contains a rewrite of the trading stock provisions in the Income Tax Assessment Act 1936 (the 1936 Act) . Schedule 5 contains the transitional provisions, and consequential amendments of Commonwealth legislation, needed to give effect to that rewrite.
1.3 The 1936 Act does not deal with the situation of taxpayers who convert:
- existing assets they own to trading stock; or
- trading stock to another use or purpose.
Some administrative practice has evolved to deal with assets taken from trading stock.
1.4 The amendments requested will:
- provide express rules for converting assets into trading stock and for taking trading stock for other purposes [Requests 4 and 8];
- amend the definition of trading stock to be consistent with those rules [Request 3];
- insert transitional provisions in the Income Tax (Transitional Provisions) Act 1997 to cover assets that become (or cease to be) trading stock because of the change to the definition [Request 9];
- make consequential changes to:
- the depreciation provisions to explain the effect of converting plant into trading stock, and vice versa [Requests 1 and 2];
- the rule about disposals of trading stock outside the ordinary course of business to prevent it applying to trading stock after it is converted to another use [Requests 5 and 6];
- some anti-avoidance provisions in the 1936 Act to prevent them applying to conversions of assets into trading stock (and vice versa) [Requests 10 and 11];
- the capital gains provisions in the 1936 Act so that they do not apply to any disposals of trading stock and do not give rise to a gain or loss if an asset is converted into trading stock at its original cost [Request 12];
- add a non-operative note to the partial disposal rules to alert readers to the effects of converting trading stock to another use [Request 7].
1.5 This request will amend the rewritten depreciation rules [Schedule 1: Division 42] as a consequence of the new rules for converting trading stock to another use - see Request 8. If the trading stock is converted into plant, this request will explain that its cost for depreciation purposes is the amount proposed under new section 70-110.
1.6 This request will amend the rewritten depreciation rules [Schedule 1: Division 42] as a consequence of the new rules for converting assets into trading stock - see Request 4. If the asset was plant, this request will explain that its termination value for depreciation purposes is the amount proposed under new section 70-30.
1.7 The definitions of trading stock in both the 1936 Act and the Bill [Schedule 1: section 70-10] only supplement the ordinary meaning of the expression. The difference between them is that the 1936 Act definition includes an asset if it was:
'...produced, manufactured, acquired or purchased for purposes of manufacture, sale or exchange.'
The definition in the Bill (as proposed to be amended by this request) will include an asset if it was:
'...held for purposes of manufacture, sale or exchange in the ordinary course of a business.'
1.8 The change, from a test determined when an asset is acquired, to a test determined according to the assets current use, is necessary for the rules proposed by Requests 4 and 8 to work. Those rules will only apply if an asset becomes, or stops being, trading stock. With the 1936 definition, some assets would always stay trading stock if they were first acquired for that purpose, so the proposed rules would never apply to them.
1.9 The expression 'in the ordinary course of a business' will be added to the definition to make clear that merely holding an asset for manufacture, sale or exchange will not make it trading stock. The Joint Committee of Public Accounts in An Advisory Report on the Tax Law Improvement Bill 1996 (Report 348) recommended the addition of those words after the word 'held'. They have actually been added after 'manufacture, sale or exchange' because they are intended to qualify those activities rather than the holding. These examples illustrate the significance of the words:
If a manufacturer, no longer requiring a factory, simply puts it up for sale, it might hold the factory for the purpose of sale but that sale would not be in the ordinary course of its business. In such a case, the factory would not be trading stock.
On the other hand, a potter might turn a hobby into a business. The pots, part-finished and completed, plus the clay and other raw materials, would become trading stock because they would be held for manufacture or sale in the ordinary course of a business.
1.10 This request will not have the effect of treating trading stock as sold just because a taxpayer decides to sell it outside the ordinary course of business. For example, if a taxpayer is about to sell a business, including all the stock, the items of stock will not cease to be trading stock until the sale of the business when, as under the 1936 Act, they would be treated as sold outside the ordinary course of the business.
1.11 This request will include in the rewritten trading stock provisions [Schedule 1: Division 70] specific rules dealing with assets that a taxpayer converts from a particular use or purpose into trading stock [Schedule 1: section 70-30] . The 1936 Act does not explain what happens in this situation and there is little case law on it. This request will provide a simple, easily understood treatment for this situation.
1.12 The essence of this request is that changes of use will be treated according to commercial reality. If an asset is held for trading, it will be treated as trading stock, regardless of the reason it was originally acquired.
1.13 When an asset is converted into trading stock, it will be notionally treated as sold for either its cost or its market value at the time of conversion. The taxpayer will be able to elect between those values [Schedule 1: subsection 70-30(1)] . This election effectively implements a recommendation made by the Joint Committee of Public Accounts in its report 348.
1.14 A taxpayer must make the election by the time they lodge their return for the income year they convert the asset to trading stock. However, if they did not realise that they had converted the asset, they can make the election within a reasonable time after they do realise. In either case, the Commissioner can allow extra time to make the election [Schedule 1: subsection 70-30(2)] .
1.15 The notional sale will mainly have the same taxation consequences as an actual sale. For example, if an asset has previously been depreciated as plant, there may be a balancing charge in the same way as there is for any disposal of plant. However, there will be neither a capital gain nor a capital loss if the taxpayer elects to convert the asset at cost (rather than at market value) - see Request 12, item 81C of Schedule 5.
1.16 The taxpayer will also be treated as immediately re-purchasing the asset for the amount that the taxpayer has elected to treat as its sale price (ie. cost or market value). Because that will be a purchase of trading stock, the cost will generally be deductible.
1.17 These proposed rules will only apply to genuine changes in an assets use. Whether there is a genuine change is determined objectively. For example, simply realising a capital asset will not amount to a change of use. However, if a taxpayer carries on a business of breeding thoroughbreds, sending a racehorse to stud would be a change of use. If a taxpayers dominant purpose in converting an asset to trading stock is to obtain a tax benefit, Part IVA (the general anti-avoidance provision) will apply and the Commissioner may cancel that tax benefit.
1.18 If a taxpayer elects to convert the asset into trading stock at its cost but the asset had no cost (eg. because it was acquired as a gift), then its cost will be the market value it had when it was acquired [Schedule 1: subsection 70-30(4)] . This will ensure that the taxpayer gets a deduction for the notional re-purchase of the trading stock, so that only the profit component of its eventual sale price will have been included in the taxpayers assessable income.
1.19 The cost of an asset acquired for no consideration but not by way of inheritance or disposal from someone else, will stay at nil [Schedule 1: subsection 70-30(4)] . This will be consistent with the treatment of these transactions under the capital gains and losses provisions (see paragraph 160ZH(9)(a) of the 1936 Act). It avoids an unintended exemption of part of the profits made on the sale of the asset that would otherwise occur for assets acquired in that way.
1.20 The notional sale and re-purchase will not apply to the harvesting of crops or plantation trees [Schedule 1: subsection 70-30(5)] . Such items can still become trading stock when they are severed from the land but will not be treated as sold and re-purchased because of the severing.
1.21 These requests will modify the rewritten trading stock rules that include an amount in a taxpayers assessable income if they dispose of an asset outside of the ordinary course of their business [Schedule 1: section 70-90] . Those rules cover assets that are, or were, trading stock of a business. The rules no longer need to cover assets that were trading stock but have been converted, before disposal, to another use. These assets will be covered by proposed section 70-110 - see Request 8.
1.22 This request will add a note to section 70-100 (which deals with partial disposal of trading stock) that draws the readers attention to the effect of new section 70-110 - see Request 8. The note is not an operative provision and the request will make no substantive change to the Bill.
1.23 This request complements the change proposed in Request 4. It will include in the rewritten trading stock provisions [Schedule 1: Division 70] specific rules dealing with trading stock that a taxpayer converts to another use [Schedule 1: section 70-110] .
1.24 The 1936 Act does not explain what happens in this situation. For goods taken for private use, taxpayers largely rely on the Commissioners administrative practice. Broadly, that practice is to include in the taxpayers assessable income an amount that reflects the value of the goods taken from stock. The Commissioner publishes schedules of acceptable values for particular types of business.
1.25 As with Request 4, this request proposes to treat changes of use according to commercial reality. If an asset ceases to be held for trading, it will no longer be treated as trading stock unless it is still within the extended meaning of trading stock (eg. if it is still live stock of a business).
1.26 If trading stock is converted to another use, it will be treated as sold at the time of its conversion for an amount equal to its cost. That amount will be assessable, like the proceeds from selling all trading stock. Including the cost of the asset in the taxpayers assessable income effectively recoups the deduction allowed for acquiring that stock.
1.27 The taxpayer will also be treated as immediately re-purchasing the asset for its cost. That amount will be relevant to working out the assets cost base for other income tax purposes (for example, for calculating a capital gain or loss if the asset is sold later, or for working out any later depreciation).
1.28 These proposed rules will only apply to genuine changes in an assets use. Whether there is a genuine change is determined objectively. For example, if an asset is still held for trading, then putting it to another minor use will not amount to a conversion from trading stock. On the other hand, if a taxpayer stops carrying on business, any remaining stock will be converted to another use. If a taxpayers dominant purpose in converting trading stock to another use is to obtain a tax benefit, Part IVA (the general anti-avoidance provision) will apply and the Commissioner may cancel that tax benefit.
1.29 The change to the definition of trading stock - see Request 3 - means that some assets that are not trading stock under the 1936 Act may become trading stock when the new law commences to apply (and vice versa). In the absence of specific transitional provisions, this would have these effects:
- an asset that becomes trading stock when the new law commences would be fully taxable on disposal but the taxpayer would never have obtained a deduction for its original purpose; and
- an asset that stops being trading stock when the new law commences may be disposed of without the deduction for its purchase being recouped.
1.30 For an asset that would otherwise become trading stock when the new law commences, this request will treat the asset as being converted to trading stock immediately after the commencement of the new law [Schedule 5: Section 70-5, Income Tax (Transitional Provisions) Act 1997] . The effect of this treatment is explained in Request 4. Broadly, it would ensure a deduction for the value of the asset.
1.31 There would be few assets covered by this situation. Judicial comment suggests that a manufacturers work-in-progress and raw materials are trading stock within the ordinary meaning. On that basis, it is unnecessary to apply this transitional provision if an asset that was not trading stock when acquired is held at the start of the 1997-98 income year as a manufacturers raw materials or work-in-progress.
1.32 For an asset that would otherwise cease to be trading stock when the new law commences, this request will ensure that the market value of the asset will be included in assessable income on a later disposal of that asset [Schedule 5: Section 70-10, Income Tax (Transitional Provisions) Act 1997] . In effect, this request will apply the new law to the asset in the same way as the 1936 Act would have applied.
1.33 These requests are consequential on the changes proposed by Requests 4 and 8. They are intended to ensure that the notional sale and re-purchase of assets converted to, or from, trading stock will not activate anti-avoidance provisions that can apply if property is transferred for less than its market value.
1.34 This request will make 2 changes to the capital gains provisions:
- Under the 1936 Act, a disposal of an asset is exempt from capital gains tax if it was trading stock throughout the time it was owned. It will now be exempt if it is trading stock when disposed of [Schedule 5: Items 81A and 81B] . The original form will no longer be necessary because of the proposed rules about converting trading stock to another use - see Request 8.
- Under the proposed rules about converting an asset into trading stock - see Request 4 - if a taxpayer elects to convert an asset at cost, there will be neither a capital gain nor a capital loss [Schedule 5: Item 81C] . However, a capital gain or loss can still arise if the taxpayer elects to convert an asset at market value.
Chapter2 - Tax-related expenses
2.1 The amendment will ensure that the rewrite of the law allowing a deduction for expenditure on managing a taxpayers tax affairs correctly reflects the existing law.
2.2 The Bill includes a rewrite of the provision (section 69) of the 1936 Act that allows a taxpayer to deduct expenditure on managing their tax affairs, provided the expenditure is not capital [Schedule 1: section 25-5] .
2.3 The 1936 Act (subsection 69(4)) provides that expenditure is not to be regarded as capital in nature just because the taxpayers tax affairs relate to matters of a capital nature. In rewriting the law, the clarification has incorrectly referred to income tax affairs that relate to matters of capital expenditure.
2.4 Amendment 1 will ensure that the new provision correctly reflects the existing law. Expenditure will not be taken to be capital expenditure merely because the taxpayers tax affairs relate to matters of a capital nature.
Chapter 3 - Exempt income - education and training payments
3.1 The amendments will omit from the Bill the rewrite of provisions which exempt from tax certain educational and training payments.
3.2 These amendments will make no change to the law.
3.3 Schedule 1 to the Bill includes a rewrite of the exempt income provisions of the 1936 Act. Schedule 3 contains consequential amendments of the Income Tax Assessment Act 1997 ( the 1997 Act ) and the 1936 Act to give effect to those provisions.
3.4 The provisions of the 1936 Act, which exempt from tax certain educational and training assistance to students, are to be amended by the Taxation Laws Amendment Bill (No. 1) 1997 ( the No. 1 Bill ). As the rewritten provisions do not include the changes proposed to the 1936 Act by the No. 1 Bill, the Government has decided to remove the rewrite of the current provisions. At a later date those provisions of the 1936 Act as at 1 July 1997 will be rewritten.
3.5 These amendments will remove the rewrite of:
- the exemption for education and training payments to full-time students [Amendment 2 - Schedule 1: item 2.1 of section 51-10] ; and
- the exclusions from that exemption [Amendment 4 - Schedule 1: section 51-35] .
3.6 The exemption and exclusions will remain as set out in paragraph 23(z) of the 1936 Act.
3.7 These amendments will remove the rewrite of:
- the exemption of certain Commonwealth educational assistance [Amendment 3 - Schedule 1: item 2.2 of section 51-10] ; and
- the exclusions from that exemption [Amendment 5 - Schedule 1: section 51-40] .
3.8 The exemption and exclusions will remain as set out in paragraph 23(zaa) of the 1936 Act.
3.9 As amendments 4 and 5 will remove sections 51-35 and 51-40, a note will be inserted after section 51-30 explaining that the next section is section 51-45 [Amendment 6] .
3.10 This amendment will remove the rewrite of the exemption of the supplementary amount of youth training allowance [Schedule 1: Subdivision 52-D] . The exemption will remain as set out in Subdivision BA of Division 1AA of Part 3 of the 1936 Act.
3.11 The 1997 Act contains a complete list of all the items of income that will be exempt if derived by certain entities and sets out for each item the reference to the provision of the 1936 Act or the 1997 Act where that exemption is located (section 11-15). The Bill proposes to update the references to items of exempt income that have been rewritten in the Bill. Amendments 8 and 9 will ensure that the update of the list excludes the items no longer being rewritten by the Bill as a result of these amendments [Schedule 3: items 6 and 9] .
3.12 The Bill proposes to insert in the Dictionary to the 1997 Act references to the defined terms ordinary payment, supplementary payment and tax free amount. These terms are used, and defined, in the rewrite of the exempt income provisions. The Dictionary signposts readers to where these terms are defined. Amendments 8 to 10 will remove signpost references to provisions that are proposed to be omitted from the Bill by the amendments discussed in this chapter [Schedule 3: items 26, 29 and 30] .
3.13 As a consequence of the rewrite of the exempt income provisions in the 1936 Act, the Bill proposes to amend those provisions by closing off their Amendments 13,14 and 15 propose to omit from those closing-off amendments the provisions dealing with educational and training assistance which are proposed to be omitted from the Bill [Schedule 3: items 31 and 36] .
3.14 The Bill proposes to amend the definitions of eligible income and salary and wages in the 1936 Act by replacing references to certain provisions that exempt payments with references to their equivalent provisions in the 1997 Act. Amendments 16 and 17 will modify those references to reflect the changes proposed by the other amendments discussed in this chapter [Schedule 3: items 55 and 58] .