Edited version of private advice

Authorisation Number: 1051621526546

Date of advice: 18 December 2019

Ruling

Subject: 'Receipts' versus 'earnings' method.

Question

Is the company required to report its income on an earnings (accruals) basis?

Answer

Yes

This ruling applies for the following periods:

Year ended 30 June 2018

Year ended 30 June 2019

Year ending 30 June 2020

Year ending 30 June 2021

The scheme commences on:

1 July 2016

Relevant facts and circumstances

The business moved to a company structure in the relevant income year.

The company employs two workers and casual and part-time staff.

The two workers are also the directors and shareholders of the company.

The company receives income from providing services. They do not receive income from any other activities.

The company relies on the knowledge and skills of their employees to derive income.

Depending on the type of case, the company either issues tax invoices to their clients at the end of each month or on completion of the case.

The company offers payment plans over a number of years.

The company's turnover in the 2017-18 income year was $X.

The company's trade debtors were approximately $Y in the 2017-18 income year.

No accounting method is currently being used as this is the first year accounts have been prepared for tax purposes.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 6-5

Reasons for decision

These reasons for decision accompany the Notice of private ruling.

While these reasons are not part of the private ruling, we provide them to help you to understand how we reached our decision.

Under subsections 6-5(2) and (3) of the Income Tax Assessment Act 1997 (ITAA 1997) taxpayers must include in assessable income the gross income derived.

Where income is earned in one year of tax but received in another, the adoption of an appropriate method of determining when income is derived under subsections 6-5(2) and (3) in a relevant year of income is important. Taxation Ruling TR 98/1 Income tax: determination of income; receipts versus earnings discusses the receipts (cash) method and the earnings (accrual) method.

Under the receipts method, income is derived when it is received.

Under the earningsmethod, income is derived when it is earned. 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.

In determining which accounting method is appropriate, we need to consider which method is likely to provide a substantially correct reflex of income in the relevant financial year (paragraph 17 of TR 98/1).

Paragraph 18 of TR 98/1 provides that the receipts method of accounting 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 (subject to the qualifications listed at paragraph 45).

In your case, the income is not derived by an employee and the business income is not derived from the provision of knowledge or the exercise of skill possessed by the taxpayer (i.e. the company). The knowledge and skill is that of the employees who provides services so the company can derive income.

Paragraph 39 of TR 98/1 states that a substantially correct reflux of a company's business would be given by the earning method except where that method was as 'artificial, unreal and unreasonably burdensome method of arriving at the income derived'. The factors that weigh against the receipts method and in favour of the earnings method are:

·        the commercial and accounting principles and practices governing accounts kept by companies generally require the accruals (earnings) method of bookkeeping; and

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

This indicates that the earnings method is most appropriate for companies unless there are relevant circumstances that suggest otherwise.

In cases that are uncertain, the factors that may assist to determine the correct method of accounting for income are set out in paragraphs 52 to 59 of TR 98/1. In the majority of cases, we expect that the earnings method would be the most appropriate method of determining the income that has been derived for tax purposes. The following factors are considered:

·        The size of the business

·        Circulating capital and consumables

·        Capital items

·        Credit policy and debt recovery

·        Books of account

In considering the factors above, factors such as 'reliance on capital items' may allow for the receipts method to be used. However, the remaining factors allude to the earnings method being the most appropriate.

A number of the factors consider the reliance on employees to generate a significant amount of the company's income. In addition to this, under the credit policy and debt recovery factor, having a policy which allows payments plans and readily giving credit for services provided alludes to the earnings method being most appropriate. It is expected that, to an extent, you would rely on income from trade debtors to support your operations.

Weighing of the total circumstances

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'. Therefore, it is not an open choice as to which method is used but rather the method which is most appropriate.

The approach taken by the Commissioner in paragraph 39 of TR 98/1 is that the 'earnings' method is the most appropriate method for companies, unless to do so would be an '...artificial, unreal and unreasonably burdensome method of arriving at the income derived'. This is due to the commercial and accounting principles generally requiring the earnings method and also the fact that companies rely on employees as a company cannot provide personal services itself.

There is no reason why the earnings method would be an artificial, unreal or unreasonably burdensome method to be used.

Upon weighing all of the circumstances relevant to the company, and the way the company conducts its income-earning activities - while having regard to the factors and principles encompassed in Taxation Ruling TR 98/1, particularly paragraph 39 - the Commissioner considers that the 'earnings' method of accounting for income is the most appropriate method to be used in determining the company's business income for taxation purposes.

Further assistance

You may find Taxation Ruling TR 93/11 Income tax: assessability of income on an accruals basis: when professional fees are derived, useful in determining how to report income on an earnings (accrual) basis.