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Ruling

Subject: Determination of income

Will the cash basis (receipts method) be the most appropriate method of determining assessable income for the purpose of subsection 6-5(2) of the Income Tax Assessment Act 1997 (ITAA 1997)?

Advice/Answers

No.

Scheme

The Taxpayer conducts a business that involves the purchase and sale of collectables and memorabilia.

The purchases come from a variety of sources.

Sales include shop and auction sales.

The auctions include items of substantial value supplied by vendors.

The vendors are not paid until the payment has been collected from the purchasers.

There are approximately X number of employees.

Some regular trade customers purchase stock on a credit basis with payment generally received within 30 days.

Debt collection companies are not used.

The turnover per annum of the Taxpayer is substantial.

An accounting system is utilised.

A small amount of capital items are purchased annually.

There are a large number of suppliers.

Relevant legislative provisions

Income Tax Assessment Act 1997 (ITAA 1197) subsection 6-5(2)

Reasons for decision

Issue 1

Question 1

Summary

The cash basis (receipts method) is not the most appropriate method of determining assessable income for the purpose of subsection 6-5(2) of the ITAA 1997.

Detailed reasoning

Discussion of the law

Under subsection 6-5(2) of the ITAA 1997 the Taxpayer's assessable income will include ordinary income derived during the income year.

Taxation Ruling (TR) 98/1 provides guidance on determining income and the use of the receipts (cash) versus earnings (accruals) methods of accounting. The Taxpayer must adopt the method that is the most appropriate, that is, the method of accounting that gives a substantially correct reflex of income.

The Commissioner has indicated in TR 98/1 that the point at which income is `earned' is generally when a recoverable debt comes into existence and this may occur before the point at which the Taxpayer can legally enforce recoverability of the debt. All that is required is that there must be a present right to receive a quantified amount without the presence of any element of contingency or defeasibility.

When deciding which method of accounting provides a substantially correct reflex of income, it is necessary to weigh the total circumstances of the Taxpayer and the income.

Where an individual Taxpayer provides their knowledge or exercises skill as part of a business they carry on, the income of the business may represent a reward for the provision of those personal services. Income resulting primarily from the services rendered, or work performed by the Taxpayer personally, is generally assessable on a receipts basis.

The presence of any of the following factors to a significant degree, indicate that the income is not simply a reward for the provision of personal services by the Taxpayer and that the earnings method may be the appropriate basis for determining income:

§ the Taxpayer's income producing activities involve the sale of trading stock;

§ the outgoings incurred by the Taxpayer, in the day to day conduct of the business, have a direct relationship to the income derived;

§ the Taxpayer relies on circulating capital or consumables to produce income; or

§ the Taxpayer relies on staff or equipment to produce income.

Business income from trading

Generally, business income from trading should be determined by the earnings method. Debts due but not yet paid should be included in gross income, because in relation to these types of activities, the book debts represent what was previously trading stock or circulating capital.

In a system of annual accounting, ordinary business considerations would indicate that what becomes owing to an entity for trading stock during a year should be brought into account to balance the reduction of trading stock which the transaction effects. Another method of accounting would misrepresent the financial position of the trader.

Income from the sale of stock is derived when the stock is sold and a debt created. It need not be payable in the year of income.

Books of account

The way the books of account are kept is relevant but not determinative to the question of when income has been derived. The question is still whether the accounting method used produces the correct reflex of income for the relevant year.

Application to your circumstances

Trading stock

The income producing activities of the Taxpayer involve the sale of trading stock. Circulating consumables are relied upon by the Taxpayer to produce income and the outgoings incurred have a direct relationship with income derived.

The business of the Taxpayer extends credit to some regular trade customers.

Size and structure

Sales are made through one of the Taxpayer's four shops and by auction. Auctions include a substantial number of lots of substantial value.

The business activities of the Taxpayer rely on a number of employees.

Computerised systems are utilised.

Conclusion

The income producing activities of the Taxpayer rely on the sale of trading stock and the employees to generate substantial income. These factors together with the size and structure of the business indicate that the earnings method of accounting is the most appropriate as it will give a substantially correct reflex of income under the circumstances.

While the accruals method may place an additional burden on the business, it is not considered that this burden is unreasonable given the size of the business.