Edited version of your written advice

Authorisation Number: 1051383823715

Date of advice: 12 June 2018

Ruling

Subject: ‘Receipts’ versus ‘earnings’ method of accounting for income for tax purposes

Question

Is the Trust able to use the ‘receipts’ method to account for income in respect of a year of income for tax purposes?

Answer

No.

This ruling applies for the following period(s)

1 July 20xx to 30 June 20xx.

The scheme commences on

1 July 20xx.

Relevant facts and circumstances

A Trust operates a business which derives income primarily from fees received in respect of products it rents to clients, as well as from services rendered which includes the provision of skills and knowledge in relation to the installation and maintenance of the rented products.

The Trustee for the Trust is a private company.

The Trust’s business employs XX staff, all of whom work from the Trust’s only office. Two or three of the Trust’s staff are responsible for maintaining the Trust’s books of account. A computerised bookkeeping program is used to manage the book of accounts.

In terms of the services provided by the Trust’s business, the Trust bills its clients a fixed amount each month, based on the extent of the rental and maintenance service provided. The invoice for any particular month is submitted at the first of that month and is due for payment by the end of that month. In the majority of cases, the Trust’s clients pay their accounts on time. For the few clients who do not pay their accounts on time, their accounts are usually paid within a short period of time after the due date. In the event a client does not pay their account altogether, the Trust would not continue to deliver/provide the client’s requested products.

There is no formal debt collection policy or procedures in place for extending credit and collecting debts. The Trust has recorded a small amount of trade debtors in its tax returns for recent income years compared to total business income derived.

All of the products (that are to be rent to clients) for the Trust’s business are sourced from wholesalers. The Trust’s business receives deliveries of the products once a week, with the number and type of products depending on requirements. The products are delivered to the Trust’s warehouse and, from there, they are dispatched to service clients.

The Trust is a small business entity whose annual turnover is less than $10 million.

There is no trading stock in the Trust’s accounts.

The Trust’s business has no substantial fixed and circulating capital such as consumable stores and debtors.

The Trust does not significantly rely on the use of capital items such as plant and machinery to produce income.

The Trust has, to date, completed its books of account using the ‘earnings’ method of accounting for income.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 6-5

Income Tax Assessment Act 1997 Section 70-10

Income Tax Assessment Act 1997 Subsection 995-1(1)

Reasons for decision

Summary

Upon weighing the Trust’s circumstances and business income, while having regard to the factors and principles encompassed in Taxation Ruling TR 98/1, the Commissioner considers the ‘earnings’ method of accounting for income is the most appropriate method to be used in determining the Trust’s business income for taxation purposes.

Detailed reasoning

Relevant law

Subsection 6-5(1) of the Income Tax Assessment Act 1997 (ITAA 1997) provides that a taxpayer’s assessable income includes income according to ordinary concepts.

Under subsections 6-5(2) and 6-5(3) of the ITAA 1997, taxpayers must include in assessable income any ordinary income derived.

Subsection 6-5(4) of the ITAA 1997 states that, in determining if and when a taxpayer has derived an amount of ordinary income, the taxpayer is taken to have received it as soon as it is applied or dealt with in any way on their behalf or as they direct.

Methods of accounting

The Courts have recognised the following two methods for determining when income is derived in a relevant year of income:

1. The ‘receipts’ method (or ‘cash’ method). Under this method, income is derived when it is received, either actually or constructively, under subsection 6-5(4) of the ITAA 1997 (Brent v. Federal Commissioner of Taxation (1971) 125 CLR 418; 71 ATC 4195; (1971) 2 ATR 563 (Brent)), and

2. The ‘earnings’ method (or ‘accruals’ method). Under this method, income is derived when it is earned (Henderson v. Federal Commissioner of Taxation (1970) 119 CLR 612; 70 ATC 4016; (1970) 1 ATR 596 (Henderson)). The point of derivation occurs when a ‘recoverable debt’ is created. That is, income is accounted for when the right to receive it comes into being, when all the events that determine the right have occurred. It is not actual receipt but the right to receive that is critical.

Determining when each accounting method is the correct method

Taxation Ruling TR 98/1 Income tax: determination of income; receipts versus earnings (TR 98/1) discusses the factors that are relevant in determining when, in the Commissioner’s view, each method is the correct method to bring income to account for tax purposes.

Trading income versus non-trading income

To assist in determining whether the ‘receipts’ method or the ‘earnings’ method is the most appropriate method, TR 98/1 distinguishes between business income derived by taxpayers that is either trading income or non-trading income. For the purposes of TR 98/1, business income or income from business activities constitutes income generated by activities that amount to the carrying on of a business.

Paragraphs 40 and 41 of TR 98/1 provide that, in relation to non-trading income, the general rule is that there must be a receipt; that is, something ‘coming in’. It is when amounts are received that they have ‘come home to the taxpayer in a realized or immediately realizable form’, as held by Dixon J in The Commissioner of Taxes v. The Executor Trustee and Agency Company of South Australia Limited (1938) 63 CLR 108; (1938) 5 ATD 98; (1938) 1 AITR 416 (Carden). This would indicate that, generally, in respect of non-trading income, a taxpayer should adopt the ‘receipts’ method.

Conversely, as per paragraph 49 of TR 98/1, Dixon J also held in Carden that, in relation to trading income, the general rule is that ‘debts due but not yet paid must be included’ in gross income. Accordingly, business income from manufacturing or trading is, generally, to be determined by the ‘earnings’ method.

‘Substantially correct reflex’ of income

Paragraph 27 of TR 98/1 states that a taxpayer determines when income is derived by adopting a method of accounting for income. When accounting for income, for tax purposes, a taxpayer must adopt the method of accounting that, in the circumstances, is appropriate. A method of accounting is appropriate if it gives a 'substantially correct reflex' of that income. This is the principle established in Carden.

Paragraph 28 of TR 98/1 provides that whether a method gives a 'substantially correct reflex' and therefore is appropriate is a conclusion to be made from all circumstances relevant to the taxpayer and the income. It is necessary, according to Dixon J in Carden, to 'discover what gains have during the period of account come home to the taxpayer in a realized or immediately realizable form.'

Appropriateness of the accounting method used by a taxpayer is the sole test for determining which method of accounting should be used, according to paragraph 29 of TR 98/1: Henderson, Brent and Barratt & Ors v. Federal Commissioner of Taxation (1992) 36 FCR 222; 92 ATC 4275; (1992) 23 ATR 339 (Barratt).

As held in Henderson, only one method of accounting is appropriate to any one item of income; there is no choice available.

Case law approach: weighing of the circumstances

The approach of the Courts, when deciding whether one or another method of accounting for income was appropriate, has been to weigh the total circumstances of a taxpayer and the income to determine whether the accounting method produces the correct reflex of income for the year.

In FC of T v. Dunn 89 ATC 4141; (1989) 20 ATR 356 (Dunn), Davies J, when discussing whether one method or another was appropriate, said:

On the other hand, the question was not entirely one of law. The issue was the appropriate means of computing the income derived by the taxpayer. The circumstances of his occupation, how it was carried on and what records and books were kept were matters to be taken into account, and evidence as to accounting principles and practice was relevant. All these are matters of fact.

In Carden, Dixon J said:

The considerations which appear to me to affect any such question are to be found in the nature of the profession concerned and, indeed, the actual mode in which it is practised in a given case.

Paragraph 36 of TR 98/1 notes that, in some cases, the individual circumstances of the taxpayer and the income, when weighed, provide no clear direction or conflicting indicators as to which method of accounting is appropriate. The Commissioner considers that, in such cases, the ‘earnings’ method would generally prevail unless it is an ‘…artificial, unreal and unreasonably burdensome method of arriving at the income derived’ (FC of T v. Firstenberg 76 ATC 4141; (1976) 6 ATR 297 (Firstenberg).

Case law approach: non-trading income

As mentioned above, the Commissioner considers that, generally, in respect of non-trading income, a taxpayer should adopt the ‘receipts’ method.

Paragraph 18 of TR 98/1 provides that the ‘receipts’ method is likely to be appropriate to determine:

● Income derived by an employee

● Non-business income derived from the provision of knowledge or the exercise of skill possessed by the taxpayer, and

● Business income where the income is derived from the provision of knowledge or the exercise of skill possessed by the taxpayer in the provision of services.

With respect to the last dot point in paragraph 18 of TR 98/1, paragraph 44 of TR 98/1 states that where an individual taxpayer provides his/her knowledge or exercises skill as part of a business carried on by the taxpayer, the income of the business may represent a reward for the provision of those personal services. As per the Carden, Dunn and Firstenberg cases, where the income results primarily from the services rendered, or work performed by the taxpayer personally, it is generally assessable on a ‘receipts’ basis. Although, paragraphs 45 and 46 of TR 98/1 provides that where any of the following factors exist to a significant degree, it would indicate that the income is not simply a reward for the provision of personal services by the taxpayer, and therefore, that the ‘earnings’ basis may be the appropriate basis for determining income:

(a) the taxpayer's income producing activities involve the sale of trading stock;

(b) the outgoings incurred by the taxpayer, in the day to day conduct of the business, have a direct relationship to income derived;

(c) the taxpayer relies on circulating capital or consumables to produce income; or

(d) the taxpayer relies on staff or equipment to produce income.

However, paragraph 39 of TR 98/1 deals specifically with incorporated entities (as opposed to individuals as above) and makes it clear that the ‘earnings’ method is the preferred method of income recognition, except where that method was an 'artificial, unreal and unreasonably burdensome method of arriving at the income derived' (Firstenberg). Factors that would mitigate against the ‘receipts’ method being appropriate for business income of a company include:

● the commercial and accounting principles and practices governing accounts kept by companies generally require the ‘earnings’ method of bookkeeping, and

● a company generally relies upon employees; it is not able to provide personal services.

Case law approach: business income from trading

As mentioned above, as per paragraph 49 of TR 98/1, the Commissioner considers that business income from manufacturing or trading is, generally, to be determined by the ‘earnings’ method.

Business income: the in-between cases

Many taxpayers derive business income of a type that is not clearly covered by the non-trading or trading distinction. In such circumstances, the factors listed at paragraphs 53 to 59 of TR 98/1 are particularly relevant, as outlined in the sub-headings below.

Generally, however, as stated at paragraph 52 of TR 98/1, the Commissioner considers that the circumstances mentioned at paragraphs 53 to 59, if significant, indicate that the ‘earnings’ method should be used, except in those circumstances where it is an ‘…artificial, unreal and unreasonably burdensome method of arriving at the income derived’.

Size of the business

The larger the business structure, the more likely is the reliance on employees and capital equipment to generate income and the more likely the ‘earnings’ method of accounting is appropriate (Henderson). In this regard, the size and function of any related entity should be taken into consideration (Barratt).

Circulating capital and consumables

Income may be generated by circulating capital or consumables and not by the taxpayer's services.

Where a taxpayer relies to a significant extent on circulating capital or consumables to produce income it is likely that the appropriate method for determining income is the ‘earnings’ method. Similarly, where a taxpayer's employees directly generate significant income, the ‘earnings’ method is likely to be appropriate to account for that income in the relevant year. Also, where other variable costs of the taxpayer's business have a direct relationship, and significantly contribute, to the income produced, that income should be brought to account using the ‘earnings’ method.

Capital items

The reliance placed by the taxpayer on the use of capital items, such as plant and machinery, to produce income is relevant. This is particularly so where expenses relating to the capital items have a direct relationship to the income produced. The greater the reliance on the use of capital items, the greater the likelihood that the ‘earnings’ method is the appropriate accounting method.

Credit policy and debt recovery

Where a taxpayer has formal procedures in place for extending credit and collecting debts, the ‘earnings’ method is likely to be the most appropriate accounting method, whereas the ‘receipt’ method is likely to be the most appropriate method in instances where a taxpayers does not usually provide credit, the likelihood of debt recovery was low and recovery was generally not pursued.

Books of account

Subsection 262A(1) of the Income Tax Assessment Act 1936 requires that a taxpayer carrying on a business must keep records that ‘…record and explain all transactions and other acts’. The way books of account are kept is relevant, but not determinative to the question of when income has been derived. As per Henderson, Dunn and Barrett, the question is still whether the accounting method used produces the correct reflex of income for the relevant year.

Application to the Trust’s circumstances

Does the Trust’s business income constitute trading or non-trading income?

To facilitate a determination of whether the ‘receipts’ or ‘earnings’ method is the most appropriate method for the Trust to employ, the principles encapsulated in TR 98/1 provide high-level, general rules which are dependent upon whether the business income derived by the Trust constitutes either trading income or non-trading income.

Paragraph 15 of TR 98/1 defines ‘trading income’ as income from the sale of trading stock (as defined in subsection 995-1(1) of the ITAA 1997). Subsection 995-1(1) of the ITAA 1997 defines ‘trading stock’ to have the meaning as provided in section 70-10 of the ITAA 1997.

Section 70-10 of the ITAA 1997 defines ‘trading stock’ to include ‘anything produced, manufactured or acquired that is held for purposes of manufacture, sale or exchange in the ordinary course of a business, and livestock.’

Paragraph 49 of TR 98/1 provides that business income from manufacturing or trading is generally to be determined using the ‘earnings’ method.

The Trust’s business income is derived primarily from renting out products to clients, as well as their installation and ongoing maintenance. The Trust does not usually sell any of these products. The products rented out by the Trust do not meet the definition of ‘trading stock’ as defined in subsection 995-1(1) and section 70-10 of the ITAA 1997.

The Commissioner’s position that goods acquired for the purpose of hire or rental do not constitute ‘trading stock’ stems from the position held in (now withdrawn) Taxation Ruling IT 81 (‘Trading stock: hire and rental business’) and in (now withdrawn) Taxation Ruling IT 2248 (‘Income tax: depreciation of video tapes in video library’).

Therefore, the Trust’s business income would not be considered ‘trading income’ (as defined in paragraph 15 of TR 98/1) as the Trust’s business income is not income from the sale of trading stock.

Having established that the Trust’s business income is not ‘trading income’, it is necessary to determine whether the business income derived from the Trust’s operations can be clearly denoted as ‘non-trading income’. As mentioned above, the Commissioner considers that, where a taxpayer derives non-trading income, the ‘receipts’ method should generally be adopted.

Paragraph 44 of TR 98/1 refers to the Carden, Dunn and Firstenberg cases, which held that, where income results primarily from a taxpayer providing knowledge or skill as part of the taxpayer’s business, the income of the business may represent a reward for the provision of personal services, and thus, is generally assessable on a ‘receipts’ basis.

The Trust’s business income does result primarily from the provision of a service (mainly the delivery and installation of products available for hire to clients) as well as providing knowledge and skill of a consultative nature in respect of the installation and ongoing maintenance of those rented products.

Although, paragraphs 45 and 46 of TR 98/1 provides that where any of the following factors exist to a significant degree, it would indicate that the income is not simply a reward for the provision of personal services by the taxpayer, and therefore, that the ‘earnings’ basis may be the appropriate basis for determining income:

(a) the taxpayer's income producing activities involve the sale of trading stock;

(b) the outgoings incurred by the taxpayer, in the day to day conduct of the business, have a direct relationship to income derived;

(c) the taxpayer relies on circulating capital or consumables to produce income; or

(d) the taxpayer relies on staff or equipment to produce income.

As established above, the Trust’s business does not involve the sale of trading stock.

The Trust contends that expenses on capital items do not have a direct relationship to the rental income produced and the Trust does not rely substantially on fixed and circulating capital. However, the Commissioner considers that the expenditure is incurred to enable the business to be carried on and income to be derived.

In terms of the last factor above, it is considered that the Trust relies on its employees to generate income to a significant degree. Employees are relied upon to initially provide consultation with clients in respect of the products to be rented. The Trust also relies on its employees for the delivery and installation of the rented products to clients as well as for the ongoing maintenance of these products. As this factor exists to a significant degree, it would indicate that the ‘earnings’ basis may be the more appropriate method for determining income for tax purposes.

However, it is noted that the principles contained in paragraphs 44, 45 and 46 of TR 98/1 relate to an individual taxpayer as opposed to an incorporated entity.

Paragraph 39 of TR 98/1 deals specifically with incorporated entities and makes it clear that the ‘earnings’ method is the preferred method of income recognition, except where that method was an 'artificial, unreal and unreasonably burdensome method of arriving at the income derived' (Firstenberg). That paragraph particularly highlights factors that would mitigate against the ‘receipts’ method being appropriate for the business income of a company, which include:

● the commercial and accounting principles and practices governing accounts kept by companies generally require the ‘earnings’ method of bookkeeping, and

● a company generally relies upon employees; it is not able to provide personal services.

Whilst the taxpayer is a Trust, its Trustee is a private company, and the Trust runs a business in the same manner as an incorporated entity. In particular, the Trust’s accounts are considered to be governed by commercial and accounting principles and practices. Further, as per the analysis above in respect of paragraphs 45 and 46 of TR 98/1, the Trust relies upon its employees to a significant degree and, as a trust entity, is not able to provide personal services. Such an analysis would indicate that the ‘earnings’ method would be the appropriate method for income recognition.

Upon weighing the circumstances of the Trust and its business income above, it cannot be concluded with sufficient certainty that the business income derived by the Trust is of a type that is clearly covered by the non-trading or trading distinction. There is no clear direction as to which method of accounting is appropriate.

It is therefore necessary in such a ‘borderline’ case to weigh the Trust’s circumstances and income in light of additional considering factors to assist in determining which accounting method would produce the correct reflex of income.

Additional factors for consideration

According to paragraph 52 of TR 98/1, the circumstances listed in paragraphs 53 to 59 of TR 98/1, if significant, would indicate the ‘earnings’ method should be used, except in circumstances where it is an ‘…artificial, unreal and unreasonably burdensome method of arriving at the income derived’.

Size of business

As per the Facts, the Trust is a small business entity whose annual turnover is less than $10 million. It relies upon XX employees to a significant degree to generate income and, as a trust entity, is not able to provide personal services.

While the Trust’s business structure is not large, it is considered to be of a size large enough whereby it would be reasonable to suggest the ‘earnings’ method of accounting would be more likely to be appropriate.

Circulating capital and consumables

The Facts provide that the Trust’s business does not rely on substantial fixed and circulating capital (such as consumable stores and debtors) to produce income.

This would indicate that the ‘receipts’ method is the most appropriate method for accounting for the Trust’s income for tax purposes.

Capital items

As per the Facts, the Trust does not significantly rely on the use of capital items such as plant and machinery to produce income. The Trust contends that expenses relating to capital items do not have a direct relationship to the rental income produced, however the Commissioner considers that these expenses are incurred to enable the business to operate.

This factor is, on balance, neutral in the Trust’s circumstances.

Credit policy and debt recovery

According to the Facts, the Trust does not have a formal debt collection policy or procedures in place for extending credit and collecting debts.

This would suggest that the ‘receipts’ method is likely to be the most appropriate method of income recognition.

Books of account

The Trust’s business has, since its inception, completed its books of account on an ‘earnings’ basis. This factor may indicate that the ‘earnings’ basis may be appropriate for tax purposes, however, as flagged in paragraph 59 of TR 98/1, this attribute, although relevant, is not considered to be determinative of the question of when income is derived.

Weighing the total circumstances of the Trust and its business income

The question of when income is earned, and the method of accounting to be adopted for the purpose of ascertaining the income, depends upon business conceptions and the principles and practices of accountancy. As per TR 98/1, the method adopted should be that which is ‘calculated to give a substantially correct reflex of the taxpayer's true income’.

In TR 98/1, the Commissioner accepts that the ‘receipts’ basis is likely to be appropriate for business income derived by an individual taxpayer, but that the ‘earnings’ method may be appropriate for larger businesses.

In particular, the approach taken by the Commissioner in TR 98/1 is that the ‘earnings’ method is the most appropriate method for entities that are corporations carrying on a business, unless to do so would be an ‘…artificial, unreal and unreasonably burdensome method of arriving at the income derived’.

The Trust’s business has a corporate structure that would usually suggest the ‘earnings’ method is the more appropriate method of accounting. The Trust’s accounts have, to date, been completed on an ‘earnings’ basis, and are considered to be governed by commercial and accounting principles and practices. The Trust as a trust entity is unable to provide personal services, and relies upon its employees to a significant degree to generate income.

It is considered that, while the ‘earnings’ method may place a burden on the Trust’s business, such a burden would not be ‘unreasonably burdensome’ given the corporate nature of the business; the reasonable size of the business; the manner in which the Trust’s accounts are completed; and the fact the Trust has been utilising the ‘earnings’ method since the inception of the Trust’s business.

It is accepted that the Trust’s income-producing activities do not rely on substantial fixed and circulating capital (such as consumable stores and debtors) to produce income, nor on trading stock. The Trust also does not have a formal debt collection policy or procedures in place for extending credit and collecting debts and, as reflected in the Trust’s tax returns for recent income years, the Trust has recorded only a small amount of trade debtors compared to total business income derived. Such debtors are not considered to have a significant bearing on the Trust’s operations.

However, upon weighing all of the circumstances relevant to the management of the Trust, and the way the Trust conducts its income-earning activities – while having regard to the factors and principles encompassed in Taxation Ruling TR 98/1 – the Commissioner considers that, on balance, the ‘earnings’ method of accounting for income is the most appropriate method to be used in determining the Trust’s business income for taxation purposes.