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Ruling

Subject: Effect of changing accounting methods

Question 1

Do payments relating to the opening value of the debtors accounts as at 1 July 2011 ('outstanding debts') form part of your assessable income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No.

Question 2

Do payments relating to the outstanding debts form part of your assessable income under the capital gains tax (CGT) provisions of the ITAA 1997?

Answer

Yes.

This ruling applies for the following period:

Year ended 30 June 2012

The scheme commenced on

1 July 2011

Relevant facts and circumstances

You operate a business offering professional services.

You used the cash receipts method to account for your income up to and including the relevant year.

You have substantially changed the amount and nature of your trade in the subsequent financial year.

Following the change to the amount and nature of your trade, it has become appropriate for you to use the accruals method to account for your income and you changed your basis of accounting for your income to the accruals method from 1 July 20XX.

On 30 June 20XX you had amounts outstanding to you for services provided which were not brought to account as taxable income in that financial year. These amounts formed your outstanding debts.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 6-5

Income Tax Assessment Act 1997 Section 104-25

Income Tax Assessment Act 1997 Subsection 108-8(2)

Reasons for decision

Payments of outstanding debts as ordinary income

Under section 6-5 of the ITAA 1997 a taxpayer's assessable income includes income according to ordinary concepts that the taxpayer derived during the income year.

The courts have recognised two methods by which a taxpayer may derive income. Taxation Ruling TR 98/1 provides guidance on the two methods and when income is taken to have been derived under each method.

Under the cash receipts method a taxpayer is taken to have derived only those amounts which they have received, actively or constructively, during the year. Under this method, the time when the services or goods were provided has no relevance.

Under the accruals method a taxpayer derives income when they have earned the right to a payment, that is, when the amount is receivable or recoverable. This can be either when the work has been completed, or when a client is billed for work performed. Under this method, the time of the actual receipt of money is of no relevance.

In your case, you have changed your basis of accounting for income from the cash receipts method in the relevant financial year to the accruals method in the subsequent financial year. As at 1 July 20XX you had debts outstanding for services performed prior to this date.

Had you been accounting for income using the accruals method in the relevant financial year the outstanding debts would have been derived in that financial year. However, as you were accounting for income on a cash receipts basis in the relevant financial year, the outstanding debts are not considered to have been derived in that financial year because the amounts were not received, either actually or constructively.

When payments are received for the outstanding debts for services rendered in previous income years, the amounts are not considered to have been derived in the financial year in which they are received as the amounts were not earned in that year. The point of time at which the recoverable debt (the outstanding debts) was created was prior to the subsequent financial year.

In Henderson v FC of T (1970) 119 CLR 612 the High Court said:

[T]here cannot be any warrant in a scheme of annual taxation upon the income derived in each year of taxation for combining the results of more than one year in order to obtain the assessable income for a particular year of tax ... Once it is decided that the ... income derived in the year in question will be the net amount of its earnings of that year, it is in my opinion, only the earnings of that year which can be included in the computation.

As you accounted for income using the accruals method in the subsequent financial year, the receipt of payments for the provision of serviced in the prior financial years is not assessable in the subsequent financial year under section 6-5 of the ITAA 1997 because the amounts are not earned or derived in the subsequent financial year.

Payments of outstanding debts as capital gains

A capital gain or capital loss is made if a CGT event happens. For most CGT events, the capital gain is the difference between the capital proceeds and the cost base of the CGT asset. A capital loss is made if the reduced cost base of the CGT asset is greater than the capital proceeds.

Section 108-5 of the ITAA 1997 states a CGT asset is any kind of property or a legal or equitable right that is not property. A note under subsection 108-5(2) of the ITAA 1997 states that debts owed to you are CGT assets. A debt owed to you is an intangible CGT asset.

CGT event C2 under section 104-25 of the ITAA 1997 happens when the ownership of an intangible asset ends by the asset being satisfied or surrendered.

When you converted to an accruals basis method of accounting for income you had to bring into your books of account outstanding debts owed to you at the beginning of the subsequent financial year. The cost base of these CGT assets at that time is nil (ATO ID 2005/211). The consideration on disposal of these assets is the amounts paid to you by debtors. Upon payment, the debt is extinguished at which time CGT event C2 takes place.

As the cost base of the debt is nil, the payment of the debt will result in a capital gain.